貿易 / 国際収支

特別レポート

Highlights So what? The U.S.-China deal is not shaping up as well as the consensus holds. Why? The odds of reaching a deal by June are rising, but no higher than 50%. Unemployment is a constraint on the Chinese side but stimulus reduces urgency. Structural concessions on currency and foreign investment are limited in scope. Strategic concessions are limited to North Korea; Taiwan risks are rising. Stay overweight U.S. and Chinese equities on a relative basis at least until the deal is signed.   Feature Once again investors are faced with a stream of headlines suggesting that a U.S.-China trade deal is all but finished, only to find critical caveats buried on page six. For instance, President Donald Trump and President Xi Jinping have not yet scheduled a summit to sign a trade agreement, though Trump insists a summit is necessary. Chief U.S. negotiator Robert Lighthizer says that he is “hoping but not necessarily hopeful.”1 There is still room for U.S. and Chinese bourses to outperform on a relative basis while negotiations continue. Still, the news flow is encouraging. Trump has said “we’ve agreed to far more than we have left to agree to,” while Xi Jinping has called for an “early conclusion of negotiations.” The other negotiators are also making positive sounds, with Vice Premier Liu He saying that a “new consensus” has been reached on a text of the trade agreement. National Economic Council Director Larry Kudlow says that key structural issues are on the table and that negotiations are continuing by videoconference after two successful rounds of direct talks in Beijing and Washington. Even the notorious China hawk, Peter Navarro, Director of the U.S. National Trade Council, has begrudgingly admitted that the two sides are in the final stage of the talks, saying, “the last mile of the marathon is actually the longest and the hardest.”2 Readers know that we take a pessimistic view of U.S.-China relations over the long run. We were skeptical about the possibility of a tariff truce on December 1. However, the signs are stacking up in favor of a deal. While we would not be surprised if talks extended to the June 28-29 G20 summit in Osaka, Japan, President Trump has suggested that a summit could come as early as May 5-19. Chart 1Still Some Room To Run Judging by the performance of U.S. and Chinese equities relative to the rest of the world since the first tariffs were imposed on June 14, 2018, there is still room for these two bourses to outperform on a relative basis while negotiations continue. Relative to global equities excluding China and U.S., Chinese stocks have retraced 78% of the ground they lost, while U.S. stocks have not surpassed the high points reached at the peak of the global economic divergence in 2018 (Chart 1). Once a deal is reached, will investors that bought equities on the rumor sell the news? We would buy, though equity leadership should rotate away from the U.S. and China depending on the timing and external conditions discussed below. As a House we are overweight global equities on a 12-month horizon. Xi Is Not Mao China’s economic stimulus is a key swing factor for global growth and the corporate earnings outlook this year. Our China Investment Strategy has highlighted that the BCA Activity Indicator has now fully registered the negative impact of trade tariffs as well as the broader slowdown (Chart 2). Chart 2Slowdown Fully Priced In Previously it was more buoyant than our leading indicator suggested it should be, largely because companies placed orders throughout the second half of 2018 to front-run Trump’s tariffs and this artificially boosted China’s exports and manufacturing activity. Now that this front-running is over, any improvement or deterioration in underlying monetary conditions, money supply, and lending should be reflected in the BCA Activity Indicator itself. Hence a stout credit number for March will cause an uptick that will confirm that China’s economy is recovering. We expect this to occur because, to be blunt, President Xi Jinping is not truly a modern-day Chairman Mao Zedong. While he has revived aspects of Maoism, he has responded pragmatically, rather than ideologically, to the Communist Party’s Number one political constraint: the tradeoff between productivity and employment. When Xi consolidated power in 2017, he launched a deleveraging campaign and doubled down on various structural reforms in order to make progress in rebalancing China’s economy. The result was renewed weakness in the labor market as the stimulus measures of 2015-16 wore off (Chart 3). Labor “incidents,” or protests, particularly those sparked by the relocation of workers from closed factories, began to rise again (Chart 4). Significantly, the number of bankruptcies also increased, demonstrating that the government was willing to tolerate some economic pain in order to make the allocation of capital more efficient (Chart 5). Chart 3A Key Constraint On Xi Jinping Chart 4Labor Incidents On The Rise China’s policymakers pursued these reforms while believing that President Trump’s threat of a trade war was largely bluster. But when Trump proceeded to impose tariffs, confidence collapsed and China’s private sector found itself sandwiched between stricter government at home and an impending squeeze of demand abroad. The labor and business indicators in Charts 3-5 suffered further deterioration in 2018 as animal spirits evaporated across the economy. President Xi’s response could have been to close China’s doors to trade and to the West and undertake an even more aggressive purge of “capitalist roaders.” The possibility is inherent in his cult of personality, aggressive anti-corruption campaign, and cyber-security state apparatus. This would have meant a dramatic reckoning with the country's economic and financial imbalances, but it would have given the hardliners in the Communist Party an opportunity to establish absolute control and national “self-sufficiency.” Instead, Xi entered into talks with Trump and launched supply-side, tax-and-tape-cutting measures to stimulate private economic activity, and boosted fiscal spending. He chose reflation rather than revolution. Chinese stimulus does not make a trade deal more likely in itself, as it gives President Xi more leverage in negotiations. But without a trade deal, private sector sentiment and animal spirits will remain depressed and stimulus measures will eventually falter. So it makes sense that Xi wants a deal. China will be the center of two market-positive outcomes in the near term: more domestic reflation and less conflict with the United States. To put this into context: if China’s credit impulse turns positive it will push the overall fiscal-and-credit impulse higher than 2% of GDP (Chart 6), foreshadowing a rebound in Chinese imports and global growth and enabling China’s own corporate earnings to recover. Our China Investment Strategy estimates that if the past three months’ rate of credit growth continues, while manufacturing sentiment improves on a trade deal and the renminbi remains flat, then the probability of an earnings recession on the MSCI China Index falls from 92% to 21%, as shown in Chart 7. From a policy perspective this looks conservative, as the actual rate of credit growth will probably be faster than that of the past three months. Chart 6Credit Will Add To Fiscal Boost Chart 7Earnings Unlikely To Contract Of course, President Trump has even more acute political constraints than President Xi urging him toward a deal. A deterioration in the U.S. manufacturing sector is a serious liability, especially in the Midwestern battleground states (Chart 8), and Trump has apparently calculated that a tailored infusion of Chinese cash and promises is a better reelection strategy than a continuation of trade war amid a slowdown.   Chart 8A Key Constraint On Donald Trump The implication of all of the above is that China will be the center of two market-positive outcomes in the near term: more domestic reflation and less conflict with the United States. The former is not yet consensus, while the latter is lacking in specifics. Yet both are beneficial for Chinese equities on an absolute and relative basis. And once there is a concluded trade deal and clarity over stimulus, emerging markets can also outperform their developed market counterparts. Note that we do not expect China to launch a massive 2008-09-style stimulus unless the tariff war reignites. Such an outcome would only be bullish for some EMs, since beneath the initial surge in Chinese imports would lie the disruption of the global supply chain and broader de-globalization. Bottom Line: Unemployment is a key political constraint suggesting both that China’s stimulus will surprise to the upside and that a trade deal is forthcoming. We are reducing the odds of an extension of trade talks beyond June from 35% to 20%, leaving a 50% chance for some kind of trade deal to emerge by the end of that month (Table 1). Table 1Updated Trade War Probabilities (April 2019) Trump Is Not Nixon If Xi is not Mao, then Trump is not Nixon. Despite a likely trade deal, we are not on the verge of a historic 1972-esque “grand compromise” that will usher in a new era of U.S.-China engagement. This should temper enthusiasm regarding the long-term durability of the trade truce, highlighting that China’s credit data is the more important factor for the 12-month horizon, though the trade issue is an impediment that needs to be removed for a sustainable rally. China may be increasingly willing to embrace structural concessions, but the depth of the structural change should be doubted until the details of the trade deal prove otherwise. For example, at the moment there is still no agreement on tariff levels. And there can be no “enforcement mechanism” to satisfy the U.S. side other than the perpetual threat of tariffs, which erodes trust and discourages Chinese implementation of structural changes. Two structural issues highlight the conundrum: currency and foreign investment. First, while the details of the currency agreement are unknown, the U.S. will definitely not get anything comparable to what it got from Japan after the Plaza Accord in 1985. The Japanese were a subordinate ally to the U.S. in the midst of the Cold War; they did not negotiate with the suspicion that the U.S. secretly wanted to destroy their economy. China has neither the security guarantee nor the economic trust. The implication is that the CNY-USD may rise by about 10% or so from current levels (Chart 9), as opposed to the 54% that the JPY-USD witnessed from 1985-88. The upside for the U.S. is that Trump may get some yuan appreciation, while the upside for China is that limited appreciation means no excessively deflationary impact. Chart 9Currency Agreement: Far From A Plaza Accord Second, China’s new foreign investment law, which received a rubber stamp from the legislature in March, is not an unqualified success for American negotiators. We have illustrated this in Table 2 by denoting white flags for aspects of the law that are genuine concessions and red flags for aspects that will raise new suspicions about China’s foreign investment framework. It is a mixed bag. Moreover, the law itself has no power and will depend entirely on the central government’s dedication to imposing strict adherence down through the local layers of government, where forced technology transfer actually takes place. Table 2New Foreign Investment Law: A Mixed Bag American negotiators will also want bilateral agreements on tech transfer and intellectual property protection since otherwise they will not receive any particular benefit from a law that applies equally to all foreign investors (e.g. Europeans). But it is not yet clear that they will get anything more concrete. The upside for the U.S. is that it will have some means of redress for forced tech transfer and intellectual property theft, while the upside for China is that foreign direct investment should improve. The strategic conflicts between the U.S. and China are even less likely to be dealt with than the economic issues. How can we be sure? Peer Competition: The U.S.-China détente under Nixon occurred at a time when a vast asymmetry between U.S. and Chinese national power existed, whereas today China’s power increasingly rivals that of the U.S., making it easier for China to write its own rules for global interactions and to resist U.S. pressure (Chart 10). Unilateralism: Trump did not leverage American alliances and partnerships across the world to create a “coalition of the willing” to confront China over its mercantilist trade and investment practices. There is some cooperation but it has been inconsistent and tentative, even on deep national security concerns like Huawei’s involvement in 5G networks and the Internet of Things. Had the U.S. created such a coalition and then set out to prosecute its claims, the threat to China’s economy would have been so immense that much greater structural changes could be expected than is the case today (Chart 11). Chart 10The Era Of U.S.-China Detente Is Over Chart 11Trump Eschewed A Coalition Of The Willing Core Interests: The trade talks only nominally address dangerous conflicts in China’s near abroad. China’s enforcement of sanctions on North Korea has produced limited results so far but we ultimately expect diplomacy to bear fruit (Chart 12). However, Taiwan is more rather than less likely to be the site of conflict. This is not because of pro-independence sentiment, which is actually on decline in public opinion relative to pro-unification sentiment (Chart 12, second panel). It is because the lame duck Tsai Ing-wen administration may attempt to secure last-minute benefits from the U.S., while an unexpected primary election challenge could lead to the nomination of Lai Ching-te (William Lai), a more outspoken pro-independence candidate, on April 24. Either could provoke Beijing. There is zero chance that any trade deal in the coming months will reduce the threat of reunification of Taiwan by force. Underlying distrust will remain. Chart 12Geopolitical Risk Down In Korea But Up In Taiwan Furthermore, the South China Sea is not a “red herring” but a potential “black swan,” as it is connected to Taiwan’s security and more broadly to U.S. alliance security. After all, 96%-97% of Taiwan’s, South Korea’s, and Japan’s oil imports flow through these sea lanes. Critical supplies become vulnerable if China expands its military’s capabilities there (Diagram 1). The U.S. and China will likely be just as provocative as before in this area after they sign a deal. Technology: The tech conflict is more likely to limit the trade deal than vice versa. The sanctions and embargoes on Chinese companies like ZTE, Fujian Jinghua, and Huawei have operated on a separate track from the trade talks, and it is not at all clear that the U.S. will embrace Huawei as part of any final deal. The initial actions of the newly beefed-up Committee on Foreign Investment in the United States (CFIUS) send warning signals. CFIUS is largely a vehicle for U.S. oversight of China (Table 3) and, if anything, that country-specific focus is intensifying. For instance, the U.S. has deemed Chinese ownership of a gay and lesbian hook-up app, Grindr, to pose an excessive national security risk.3 This is not a high bar for intervention and it suggests that any trade deal will fail to improve China’s investment options in the U.S. tech sector. Diagram 1South China Sea As Traffic Roundabout Table 3CFIUS Is Mostly About China The takeaway is that while both sides want a deal over the short term, it will not mark the end of the trade war. It is more likely the end of the beginning of a cold war. As long as China’s economy and industrial capabilities continue to grow relative to the United States, its geographic periphery remains a cauldron of geopolitical risks, and its technological advancement remains rapid, the competition will continue. Bottom Line: There is no substantial evidence from the current trade talks that underlying strategic conflicts will be resolved. This implies that the U.S. and China will shift their focus to these conflicts in the weeks and months after any trade deal. That process will be a nuisance to global equity markets expecting a clean deal; Chinese and American tech stocks in particular will remain exposed to tail risks. The status of Chinese tech companies is a critical risk, as a deal for the U.S. to admit Huawei would be a game-changer. Investment Conclusions Ironically, an early resolution of the trade war – in April or May – offers less of a benefit for Chinese equities and other risk assets than a later resolution in June or thereafter. While we expect to have greater clarity on China’s stimulus magnitude from the March data, it is still possible that stimulus will remain mixed or disappointing. Stimulus measures may also be toned down after a deal is approved, which means that an earlier deal would reduce the total stimulus by the end of 2019. The Trump administration will use the new flexibility gained from a China deal to toughen its policies in other areas, potentially with negative market consequences. The decision to designate the Iranian Revolutionary Guard Corps (IRGC) as a foreign terrorist organization is an important example. This decision is squarely within the Trump administration’s policy of pressuring Iran, which is a high-risk policy with substantial market-relevance. Trump may have made the decision in order to save face while planning to renew waivers on Iranian oil sanctions on May 4 – we would be extremely surprised if he did not renew. Sanctioning the IRGC involves a string of consequences but it is not a direct attack on oil supply that could produce an oil shock dangerous to Trump’s re-election prospects in 2020 (Chart 13). Of course, Iran will retaliate to the IRGC blacklisting – and one way it could do so would be through oil production in various places, including Iraq. The result would be oil volatility and higher prices. Further, an early deal could encourage Trump to instigate a trade war with Europe. Trump’s four-to-six week time frame for the conclusion of talks with China is conspicuously close to the tentative May 18 deadline by which he is required to determine whether to impose tariffs on foreign auto and auto part imports (Chart 14). Such tariffs would be pursuant to the Section 232 investigation that likely found such imports a threat to national security. We have argued that a U.S.-China deal raises the risk of tariffs on European cars to 35%, with Japanese and Korean cars less at risk, progressively. The EU is ready to retaliate so this would be a drawn-out trade conflict.   By contrast, we are less concerned about the market impact of Trump’s recent threats to close the border with Mexico or include Mexico in car tariffs (Chart 15). True, Trump could close the border and generate a temporary drag on trade and the border economy. However, the Republicans have limited patience for the economic blowback of an extended border closure, and Trump cannot afford to jeopardize passage of his USMCA trade deal as long as he has alternative ways of looking tough on the border. Geopolitical Strategy would view the U.S. and China as good overweights relative to global equities and within their respective developed and emerging market contexts. What about a later resolution of the trade deal, in June or later in the summer? This would remove some risks. By that time, the Iran decision and possibly the car tariff decision will be past and there will be greater clarity on the magnitude of China’s stimulus. More extensive negotiations could also suggest that the ensuing trade deal will resolve deeper disagreements – unless the talks drag on without consequence amid signs of declining trust. Given the risk of trade war with Europe, oil volatility, and uncertainties about China’s stimulus, Geopolitical Strategy would view the U.S. and China as good overweights relative to global equities and within their respective developed and emerging market contexts. When and if the above political hurdles are cleared, the emphasis can shift to other bourses. Geopolitical Strategy’s preferred emerging market plays are EM energy producers and EM Asian states like Thailand and Indonesia.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 See Ailsa Chang, “U.S. Trade Representative Robert Lighthizer Discusses Ongoing Trade Talks With China,” National Public Radio, March 25, 2019, www.npr.org. 2 For the above quotations see Andrew Mayeda, Xiaoqing Pi, and Margaret Talev, “Kudlow Sees No Letup in China Talks as Both Sides Cite Progress,” Bloomberg, April 4, 2019, www.bloomberg.com. 3 See David E. Sanger, “Grindr Is Owned by a Chinese Firm, and the U.S. Is Trying to Force It to Sell,” March 28, 2019, www.nytimes.com.

Highlights Odds are that the recent improvement in Chinese manufacturing PMIs could be due to inventory re-stocking rather than a decisive turnaround in final demand. “Hard” data have not shown meaningful improvements in China’s final demand. Weighing the pros and cons, we are instituting a stop-buy on our EM strategy: We will turn tactically positive on EM risk assets if the MSCI EM equity index breaks above 1125, which is 4% above its current level. Keep Malaysia on an upgrade watch list. Downgrade Brazil to underweight. Feature The strong Chinese PMI prints released this week have challenged our negative view on EM assets and China plays. This week we take a deeper look at the underlying reasons behind the recent improvement in China’s PMI data. In addition, we elaborate on what it would take for us to alter our current strategy on EM risk assets. A Manufacturing Upturn The upturn in China’s manufacturing PMIs in March has been validated by improvement in Taiwanese PMI’s export orders (Chart I-1, top panel). The latter’s amelioration has been broad-based across all sectors: electronics and optical, electrical machinery and equipment, basic materials, and chemical/biological/medical (Chart I-1, bottom panel). China accounts for 30% of Taiwanese exports, making Taiwan’s manufacturing sector heavily exposed to China’s business cycle. Does this improvement in manufacturing PMIs reflect a final demand revival in China? Looking For Final Demand Revival China’s domestic and overseas orders remain weak, as exhibited in Chart I-2. These indicators give us the primary trajectory of the Chinese business cycle, while the PMI indexes exhibit considerable short-term volatility. Chart I-1One-Month Surge In China's And Taiwan's PMIs Chart I-2Noise And Business Cycle Trajectory   The domestic demand and overseas orders reflect quarterly data from 5,000 enterprises. The latest datapoints are from Q1 2019 and were released on March 22. To be sure, we are not suggesting an absence of bright spots, but at the moment “hard” data do not corroborate broad-based improvement in final demand. Consumer spending: There has been no improvement in households’ propensity to spend. Our proxy for households’ marginal propensity to spend has not turned up (Chart I-3). Consistently, China’s smartphone sales and passenger car sales are contracting at double-digit rates, while the growth rate in online sales of services has not improved (Chart I-4, top three panels). Chart I-3Chinese Consumers' Propensity To Spend Chart I-4China: No Improvement In "Hard" Data   The bottom panel of Chart I-4 demonstrates the retail sales of consumer goods during the Chinese New Year compared with the previous year’s spring festival. It is evident that as of mid-February, when this year’s spring festival took place, there was no improvement in Chinese consumer demand. Business spending / investment: Our proxy for enterprises’ propensity to spend continues to decline (Chart I-5). Companies’ propensity to spend has historically led the cyclical trajectory in industrial metals prices. Crucially, this has not corroborated the rebound in base metals prices over the past three months. Besides, China’s imports of capital goods, its total imports from Korea and its machinery and machine tool imports from Japan are all still contracting at a double-digit rate (Chart I-6). Chart I-5China: Enterprises' Propensity To Spend And Metals Chart I-6Contracting At A Double Digit Rate   China’s fixed asset investment in infrastructure has picked up of late and will continue to improve. However, this may not be sufficient to revive the mainland’s economy. China’s growth decelerated in 2014-2015 and industrial commodities prices dwindled, despite robust growth in infrastructure investment at the time (Chart I-7). The culprit was the decline in property construction in 2014-2015. As to the property market, the People’s Bank of China’s (PBoC) Pledged Supplementary Lending (PSL) financing points to further weakness in property demand in the coming months (Chart I-8). Chart I-7China's Infrastructure Investment And Base Metals Prices Chart I-8China: The Outlook For Residential Property Demand   Moreover, property starts have been surging, yet their completions have been tumbling. This suggests a ballooning amount of work-in-progress on real estate developers’ balance sheets. To be sure, we are not suggesting an absence of bright spots, but at the moment “hard” data do not corroborate broad-based improvement in final demand. It may well be that property developers do not have financing to complete work or that they are reluctant to bring new units to the market amid tame demand. Whatever the case, the mediocre pace of construction activity is negative for suppliers to the construction industry. Government spending: Aggregate government spending in China – including central and local government as well as government-managed funds (GMF) – has been very robust in the past year (Chart I-9). Hence, government spending has not been the reason behind the economic slowdown. Chart I-9China's Aggregate Fiscal Spending For 2019, overall government spending is projected to expand by 11% in nominal terms from a year ago, down from 17% in 2018. The key fiscal risk is shrinking land sales, which account for 86% of GMF revenues. The latter have substantially increased in size and now makeup 27% of aggregate fiscal spending. Local and central government expenditures account for 62% and 11% of aggregate fiscal spending, respectively. If land revenues undershoot, GMF and local governments will not be able to meet their expenditure targets without Beijing altering the former’s borrowing quotas. In brief, fiscal policy may be involuntarily tightened due to a shortfall in land sales revenues before the central government permits local governments to borrow more. Exports: Chinese shipments to the U.S. will recover as China and the U.S. finalize their trade deal. The media is extremely focused on the trade negotiations, and markets have been trading off the headlines. Nevertheless, it is essential to realize that China’s exports to the U.S. make up only 3.6% of the country’s total GDP (Chart I-10). This contrasts with capital spending that accounts for 42% of the mainland’s GDP.  Consequently, we believe the credit cycle that drives construction and capital spending is more important to China’s growth than its shipments to the U.S. Global ex-China Demand: The areas of global final demand that weighed on global growth last year remain depressed. Global semiconductors and auto sales have been shrinking at a rapid pace and have so far not experienced a reversal (Chart I-11). Chart I-10China Is Not Reliant On Exports To The U.S. Chart I-11Global "Hard" Data Are Still Bad   Bottom Line: There is a lack of pertinent “hard” business cycle data in China that have improved. What Does It All Mean Having reviewed final demand conditions in China, it is reasonable to argue that the improvement in the Chinese and Taiwanese manufacturing PMIs could be due to inventory re-stocking. Unfortunately, in China, there is limited reliable data that quantifies inventory levels well in various industries. Having reviewed final demand conditions in China, it is reasonable to argue that the improvement in the Chinese and Taiwanese manufacturing PMIs could be due to inventory re-stocking. The consensus view in the investment community is that China’s credit stimulus has boosted the economy since the beginning of this year. Business conditions have certainly improved. The rally in Chinese stocks has in turn mirrored this improvement. Yet it is not clear that this revival in the business cycle is due to the credit stimulus. Chart I-12 plots the credit impulse, including local government general and special bonds issuance, with the three typical business cycle variables: manufacturing PMI and nominal manufacturing production growth. Chart I-12China: Credit Impulse Leads "Hard" Data As can be seen from the chart, the manufacturing PMI is very volatile. In the short term, there is little correlation between it and the credit impulse (Chart I-12, top panel). Meanwhile, the credit impulse leads nominal manufacturing output growth by nine months (Chart I-12, bottom panel). Based on the past time lag relationships, the mainland’s business cycle should not have bottomed until the third quarter of this year. Hence, the bottom in the manufacturing PMIs in January does not fit the historical pattern of the relationship between the credit impulse and the mainland’s business cycle. Bottom Line: Presently, it is hard to make a definite conclusion on the reasons behind the pick-up in Chinese manufacturing. That said, business cycles do not always evolve in a common-sense manner that can be both rationalized and forecast by indicators. Therefore, it is essential for investors, to have confirmation signals from financial markets on the direction of the business cycle. Financial Markets As A Litmus Test We continuously monitor numerous financial markets that are sensitive to both the global and Chinese business cycles. These financial market-based indicators are often coincident with EM asset prices. Hence, they can be used to confirm or refute EM market direction. Our Risk-On-to-Safe-Haven (ROSH) currency ratio has recently softened, flashing a warning signal for EM share prices (Chart I-13). Chart I-13Currency Markets Are Flashing Amber For EM Stocks The ROSH ratio is the relative total return (including carry) of six commodities currencies (AUD, NZD, CAD, CLP, BRL and ZAR) versus two safe-haven currencies: the yen and Swiss franc. Hence, this currency ratio is agnostic to U.S. dollar trends, making its signals especially valuable. Our Reflation Confirming Indicator has retreated, also signaling a pullback in the EM equity index (Chart I-14). This indicator is composed of an equal-weighted average of industrial metals prices (a play on Chinese growth), platinum prices (a play on global reflation) and U.S. lumber prices (a proxy play on U.S. growth). Chart I-14Commodities Markets Are Flashing Amber For EM Stocks Within EM credit markets, corporate investment-grade spreads have begun narrowing versus high-yield spreads (Chart I-15). This typically coincides with lower EM share prices. Finally, EM share prices have been underperforming DM since late December. Relative performance of EM ex-China stocks against the global equity index has been even more underwhelming. In short, these markets are at a critical juncture. A decisive breakout will entail a lasting rally, while a failure to break out will signal imminent downside risk. Bottom Line: These financial market signals are not consistent with a durable China-led recovery in the global business cycle. Investment Strategy A number of financial markets are currently at a critical juncture. These markets will either break out or break down, with subsequently significant moves. The broad U.S. trade-weighted dollar has been flattish in the past nine months despite falling interest rate expectations in the U.S. and the risk-on market environment. We read this as a sign of underlying strength. The trade-weighted dollar is presently sitting on its 200-day moving average (Chart I-16). Consistent with a flattish trend in the greenback, the U.S. dollar volatility has dropped to very low levels. Exchange rates usually do not trade sideways much longer than that. Hence, the dollar is about to break out or break down and any move will be lasting and large. Chart I-15A Message From EM Corporate Credit Market Chart I-16The U.S. Dollar Is About To Make A Big Move   The Korean won has been forming a tapering wedge pattern from both short-term and long-term perspectives (Chart I-17, top and middle panels). Its volatility has also plunged to a record low (Chart I-17, bottom panel). Chart I-17The Korean Won Is At Crossroads Chart I-18A Stop-Buy On EM Stocks Finally, emerging Asian equities’ relative performance to global stocks is facing an important technical resistance as are copper and oil prices. In short, these markets are at a critical juncture. A decisive breakout will entail a lasting rally, while a failure to break out will signal imminent downside risk. Consistently, China’s “soft” data that has improved markedly yet there is no “hard” data confirmation. Moreover, there is some evidence to suggest that the pickup in the soft data may simply reflect inventory building.   Weighing the pros and cons, we are instituting a stop-buy on our EM strategy: We will turn tactically positive on EM risk assets if the MSCI EM equity index in U.S. dollar terms breaks above 1125, which is 4% above its current level (Chart I-18). Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Malaysia: Keep On Upgrade Watch List Malaysian equities have been underperforming their EM counterparts since 2013 and are now resting around their 2017 lows (Chart II-1). The odds are high that this market’s underperformance is late. Chart II-1Malaysian Stocks Relative to EM Investors should keep Malaysian equities on an upgrade watch list. We upgraded the Malaysian bourse from underweight to neutral in December 2018. In a Special Report published at that time, we argued that the structural outlook for Malaysia had improved, yet the cyclical downturn would persist. The latter did not warrant moving the bourse to overweight. This view is still at play. Economic Slowdown Is Advanced The Malaysian economy has been digesting credit and property market excesses. Property sector: Property sales have declined by 37% since 2010, and prices for some property segments are beginning to deflate (Chart II-2). Similarly, housing construction approvals have slumped severely since 2012. Consumers: Passenger vehicle sales have been falling since 2012 along with households' declining marginal propensity to consume, and retail trade has been very weak (Chart II-3). Chart II-2Property Sector Is Depressed Chart II-3Consumer Sector Is Weak   An ongoing purge of excesses by companies entails lower wage growth and weaker employment, resulting in subdued household income growth. The latter could extend the consumer slump. Business sector: Capital spending growth in real terms has decelerated and may contract. Both profit margins and return-on-equity (ROE) for non-financial publicly listed companies have slumped and are currently resting below their 2008 levels (Chart II-4). This warrants cost-cutting and reduced corporate spending/capital expenditures for now. Chart II-4Corporate Restructuring On The Way? Reduced employment and weak wage growth are negative dynamics for households but positive for companies’ profit margins. Commercial Banks: Malaysian banks remain unhealthy. At 1.5%, their NPLs remain low relative to the credit boom that occurred over the past decade. Moreover, Malaysian banks have been lowering their provisions levels to boost profits. This is an unsustainable strategy. Provided economic growth will remain weak, both NPLs and provisions will rise, hurting banks’ profits and share prices. Banks hold a very large market-cap weighting in this bourse, and the negative outlook for banks’ profits deters us from upgrading this equity market. Purging Excesses: Implications For The Exchange Rate Purging of economic excesses is painful in the short- and medium-term, as it instills deflation. A currency often depreciates during this phase to mitigate the deflationary forces in the economy. However, purging excesses, deleveraging and corporate restructuring are ultimately structurally bullish for a currency. First, corporate restructuring and improved capital allocation lift productivity growth in the long run. The Malaysian economy has been digesting credit and property market excesses. Second, low inflation or outright deflation allow the currency to depreciate in real terms. The Malaysian ringgit is already cheap based on the real effective exchange rate (Chart II-5). Finally, amid deflation and in the absence of widespread bailout of debtors funded by bank loans or excessive government borrowing, cash becomes “king”. Hence, deleveraging is ultimately currency positive. In contrast, pervasive bailouts funded by money creation – i.e., mushrooming money growth – usually undermine residents’ and foreigners’ willingness to hold the currency. A capital flight ensues and the currency plunges. Malaysia in 2015 was the latter case, with the ringgit plummeting as residents converted their ringgits to U.S. dollars (Chart II-6, top panel). Chart II-5The Ringgit Is Cheap Chart II-6Malaysia: 2015 Vs. Now   Presently, the opposite dynamics are at play. The central bank is reducing commercial banks’ excess reserves, domestic private credit growth is weak and residents are not fleeing the ringgit (Chart II-6). In addition, the structural reorientation of the economy from commodities to semiconductors/technology is beginning to bear fruit. As a result, overall trade balance has significantly improved, despite weak commodities prices. This is also positive for the currency. Finally, a more stable (i.e., modestly weaker) exchange rate amid both a global and domestic downturn will allow Malaysia’s central bank to reduce interest rates and smooth the growth slump. This is in contrast to 2015 when capital outflows and the plunging currency did not allow the central bank to reduce borrowing costs. Investment Conclusions We recommend keeping Malaysian stocks on an upgrade watch list for now. We recommend upgrading Malaysian sovereign credit and local currency government bonds from underweight to neutral relative to their respective EM benchmarks A relatively stable ringgit will benefit Malaysia’s local and U.S. dollar bonds. Furthermore, foreign ownership of local bonds has fallen meaningfully, diminishing the risk of future outflows. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Downgrading Brazil: The Honeymoon Is Over In our October 9 report, we upgraded Brazil following the outcome of the first round of presidential elections. We, like the market, gave a benefit of the doubt to the new president. However, the honeymoon is over for President Bolsonaro. The markets are becoming increasingly pessimistic because of the lack of progress on the social security reforms front. It is no secret that Brazil needs bold pension reform to make its public debt sustainable. As things stand now, the public debt dynamic in Brazil is precarious. Two prerequisites for public debt sustainability are (1) for interest rates to be below nominal GDP growth or (2) continuous robust primary fiscal surpluses. Hence, a government can stabilize its debt-to-GDP ratio by either having nominal GDP above its borrowing costs, or by running persistent and sizable primary fiscal surpluses. Neither of these two stipulations are presently satisfied in Brazil. The gap between government local currency bond yields and nominal GDP growth is still very wide (Chart III-1). Meanwhile, the primary fiscal deficit is 1.5% of GDP (Chart III-2). Chart III-1Brazil: An Unsustainable Gap Chart III-2Brazil: Public Debt Dynamics Are Precarious     In the early 2000s, the government stabilized its public debt dynamics by running persistent primary surpluses of about 4% of GDP (Chart III-2, top panel). Will Brazil achieve primary fiscal surpluses in the coming years assuming some form of the pension reform is adopted? It is doubtful. According to the government’s own forecasts, the submitted draft of social security reforms, including the one for the army, will save only BRL190 billion in next four years or 0.7% of GDP per year. The current primary deficit is 1.5% of GDP (Chart III-2). Unless nominal GDP growth and government revenue growth shoot up, the primary deficit will not be eliminated or the primary surplus will be very small. Overall, it seems unlikely that the government’s proposed pension reforms will be sufficient to turn around Brazil’s public debt dynamics in the next several years - barring very strong economic growth that will fill in government coffers. Bottom Line: We are downgrading Brazil from overweight to underweight within EM equity, local currency bonds and sovereign credit benchmarks. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Footnotes Equity Recommendations Fixed-Income, Credit And Currency Recommendations

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Dear Client, Instead of our regular Weekly Report, this week we are sending you a Special Report written on February 20 by our Geopolitical Strategy service colleagues that discusses China’s recent stimulating efforts. We have only made a few minor revisions to account for the past month’s events. We trust that you will find this Special Report useful and insightful. Best regards, Anastasios Avgeriou, U.S. Equity Strategist   Highlights So What? China’s January-February credit data suggest that stimulus is here. Why? China’s early-year credit and fiscal policies suggest that stimulus risks are to the upside. January-February credit was a blowout number and fiscal spending is up. Equity bourses in South Korea and Russia are the most likely to benefit from Chinese stimulus. Industrial metals such as copper will also benefit – with a delay. Feature New credit data for China in January-February improves the chances that Beijing’s stimulus measures will overshoot this year, causing China’s economy to bottom in 2019 and jumpstart global growth. In our annual outlook for this year we argued that while China was stimulating the economy, the magnitude of stimulus would be the decisive factor for the global macro environment in 2019. We argued that the type of stimulus would remain primarily fiscal – tax cuts for households and small and medium-sized enterprises – and hence that it would be modest as fiscal easing would merely offset relatively weak credit growth. This view stemmed from our assessment of the Xi Jinping administration, highlighted in April 2017, as an “elitist” (not populist) administration. Its policy priorities are to discipline the Chinese economy, and in particular to contain systemic financial risk, which President Xi has cited as a national security threat. This view is not wrong, but the latest data clearly show that Xi has decided to pause these painful efforts at limiting leverage and rebalancing China’s economy. Witness January-February’s decisive uptick in both total social financing (total private credit) and local government bond issuance (Chart 1). Chart 1Higher Risk Of An Overshoot A massive spike in new credit is the single most important criterion in our “Checklist For A Stimulus Overshoot.” Thus, from a policy perspective, we are now at higher risk of an overshoot (Table 1). Not only credit as a whole but also informal lending saw a surge in January-February, implying that the government is relenting in its crackdown on the shadow banks. The approval of local government bond issuance for early in the year – and the People’s Bank of China’s announcement of a “Central Bank Bills Swap” program – reinforce this policy shift.1 Table 1Checklist For A Chinese Stimulus Overshoot In 2019   A stimulus overshoot is positive for Chinese demand in the short run but negative for potential GDP in the long run. A “traditional” credit surge of this nature cannot be surgically targeted at SMEs or households. It will go to state-owned enterprises, privileged corporations, property developers, and the like, which have always had the advantage in China’s financial system. SOEs have taken a much larger share of new loans than private companies in recent years,2 and the only silver lining of this trend was the possibility that tighter credit controls would discipline the SOEs. That silver lining is now fading, barring some new and surprising development on the reform front. China needs to create 26 trillion renminbi in new credit over the course of the year to avoid a corporate earnings contraction. These January-February numbers put China on track to do just that (Chart 2), assuming that President Xi and U.S. President Donald Trump agree to a short-term, framework trade deal this year. Chart 2On Track To Avoid An Earnings Contraction Of course, a few caveats are in order. First, January-February’s credit number is only one data point and credit growth is always abnormally strong in the first month of the year. Early in the year, banks seek to expand their assets rapidly in a bid to get as much market share as possible before administrative credit quotas kick in. Because of Chinese New Year, it is best to combine January and February data to get a sense of the rate of credit expansion in the first part of the year. This year’s January-February numbers are very strong relative to previous years (Chart 3) and the context is more accommodative than the 2017 January-February credit surge, when authorities were beginning to tighten rather than ease macroprudential policy. Still a rapid rate of credit expansion will have to be sustained in the coming months in order to meet the 26 trillion RMB requirement highlighted above. Second, there is some risk that China’s households and private businesses will not respond as positively today as in the past. The intensification of Communist Party control over the society and economy, President Xi’s cancellation of term limits, and the strategic confrontation with the United States have created a bearish sentiment in the private sector. Our Emerging Markets Strategy would point out that if the propensity to consume, and money velocity,3 do not accelerate, then a surge in new credit may fail to ignite a reacceleration in China (Chart 4). Chart 4Chinese Are Holding On To Their Money Still, what we now know is that Xi Jinping and his top economic adviser, Vice Premier Liu He, are not initiating the “assault phase of reform” that their predecessors initiated in the late 1990s in order to cleanse China’s economy of bad loans and zombie companies. Instead, they are likely reestablishing the “Socialist Put” in order to reverse the current deceleration, demonstrate China’s continued economic might and face down the United States’ threat of tariffs. Bottom Line: China’s stimulus measures are increasingly likely to overshoot, with positive implications for both Chinese and global growth. China is still facing a corporate earnings recession, but the odds of averting it are increasing. Trade Deadline More Likely To Be Extended What of the trade war? First, we would warn clients that China’s annual credit origination is a much bigger factor for the global economy than China’s exports to the United States (Chart 5). The trade war can escalate from here and yet, if China’s stimulus works as it has in the past, the results will be manageable for China’s economy save for Chinese companies expressly exposed to the U.S. economy through exports. In reality, both the U.S. and China are now effectively stimulating their economies and in this sense global trade as a whole will benefit regardless of bilateral tariffs. Chart 5Watch China Credit, Not So Much The Trade War But it is possible that just as global equity markets ignored China’s economic slowdown and only sold off when the tariffs were levied (Chart 6), they may not continue to rally much on China’s credit data. Given the already considerable rally in global risk assets since October, markets may not be satisfied merely with one or two months of solid credit data out of China without a clear resolution to the trade conflict. After all, if a collapse in U.S.-China trade talks portends a new Cold War, then institutional investors may be justified in taking a wait-and-see approach despite China’s credit cycle upswing. Chart 6Will Equities Ignore China Data (Again)? In the past, we have highlighted that the U.S. and China are not economically prohibited from engaging in a trade war – the export exposure is too small – and China’s new stimulus reinforces this point. However, President Trump is concerned about causing a sell-off in the tech sector and hence the broad equity market which could translate into a bear market and raise the probability of a recession occurring prior to November 2020. Meanwhile, in China, given Beijing’s reported trade concessions, there is apparently a desire to pacify the relationship and discourage U.S. unilateral tariffs and sanctions that could become seriously destabilizing for the Chinese economy and society. The need to have a happy 2021 centenary celebration for the Communist Party may factor into policymakers’ thinking. The latest news flow is mildly positive for the odds of getting a framework deal sometime this year. President Trump visited the Chinese negotiators in Washington, D.C. while President Xi reciprocated with the American negotiators in Beijing. A new round of two-week shuttle diplomacy is beginning. Trump has extended the tariff ceasefire and the two sides reportedly have arrived at an agreement on currency and are drafting written agreements on other areas of dispute. China’s National People’s Congress has passed a new Foreign Investment Law that ostensibly guarantees many of the American demands on forced tech transfer, intellectual property theft, and discriminatory treatment of U.S. companies (Table 2). Table 2New Foreign Investment Law Would Be A Positive For U.S.-China Negotiations However, Presidents Trump and Xi have yet to schedule a new summit, which is probably necessary for a final deal. And there are murmurs from the press suggesting that China’s new law and other concessions are not going to satisfy the U.S. negotiators on the critical point of “structural changes” and a verification process. This leaves us inclined to change our trade war probabilities to increase the odds of an extension (Table 3). The improvement in U.S. financial conditions and China’s stimulus, if anything, make it more likely that negotiations will be extended, as both sides feel their economic and financial constraints less acutely. Table 3Updated Trade War Probabilities Bottom Line: Global and Chinese risk assets should rally on China’s credit uptick, but the lack of resolution of the trade war could continue to inhibit animal spirits – and the odds of a March 1 resolution are declining. Who Are The Equity Winners Of China’s Stimulus? China’s strong January-February credit number is supportive of global equity markets. That much is obvious. But which equity markets will benefit the most? In what follows we examine the relationship between Chinese credit and MSCI equity returns of various countries. We find that Malaysian, Australian, South Korean, and Indonesian equities are the most highly correlated with Chinese credit growth and are thus most likely to benefit from the recent upturn (Chart 7). On the other hand, France and Italy stand out as countries whose bourses are more insulated. Out of the markets that are positively correlated, South Korea and Russia stand out as relatively cheap (Chart 8). Thus we expect these equities to do especially well. By contrast, while Indonesia and the Philippines are highly leveraged to China, these markets are currently relatively expensive. BCA’s Emerging Markets Strategy is currently overweight Korean and Russian equities within the EM space, neutral Turkey (although recently upgraded from underweight), and underweight Indonesia and the Philippines. In addition to credit stimulus, we expect Chinese household consumption to also gain support going forward. This will likely be driven by policy stimulus targeting the consumer specifically and is best exemplified by the recently announced tax cuts (Chart 9), which we expect to trickle down to greater consumer demand and growth in retail sales. Our base case calls for 8%-10% growth in household consumption over the coming 12 months, up from the current 3.5%. However, consumer sentiment in China is weak. BCA’s Emerging Markets Strategy’s proxy for household marginal propensity to spend ticked up recently, after falling since early last year (see Chart 4 above). A resumption in the decline would highlight that households are increasingly unwilling to spend, which would translate into weaker retail sales despite policy efforts to boost consumption. Such a scenario – in which credit growth accelerates without a substantial uptick in consumer spending – is plausible, given that it occurred between mid-2015 and mid-2016 (Chart 10). In any case, whether Chinese stimulus comes in the form of the traditional credit channel, or instead in the form of fiscal stimulus to household consumption, the same equity markets will generally benefit the most (Chart 11). Chart 10...But Flattish Retail Sales Are Also A Possibility Indeed, global equity markets react the same way regardless of the type of stimulus implemented. For instance, MSCI returns for the Philippines, Sweden, Malaysia, Indonesia, and Turkey are more closely correlated to both Chinese credit growth and retail sales growth compared to Italy, Japan, and France. The same conclusion is reached when we look at the correlations between Chinese credit growth or consumption growth and individual MSCI sectors such as industrials and consumer discretionary (Chart 12). The relatively stronger correlation between Chinese credit growth and equity returns – as opposed to Chinese retail sales and equity returns – can be put down to the nature of Chinese imports. While industrial goods account for the bulk of China’s purchases of foreign goods, consumer goods excluding autos make up only 15% of China’s imports (Table 4). However, as Chart 12 illustrates, the relationship between China’s retail sales growth and global equities is much tighter in the case of the consumer discretionary sector, whether the latter is compared to global industrials sectors or the overall MSCI index. Table 4Import Composition Of Chinese Imports Equity market exposure to China is not always in line with the extent of each country’s trade exposure to China (Chart 13). There are some clear exceptions – most notably Mexico, which has the highest correlation coefficient with Chinese credit and consumption variables since 2010. However, this is likely due to idiosyncratic factors.4 Correlation does not imply causation, and we cannot conclude with certainty that Mexican equities will outperform amid China’s new round of stimulus. Nevertheless, given that Mexico is a very deeply liquid market that benefits amid EM bull markets, this may not be entirely coincidental. The correlations between global equity markets and Chinese credit peak two months after the stimulus measures are first implemented (Chart 14). This is more or less in line with adjusted total social financing’s correlation versus industrial metals. However, BCA’s Commodity & Energy Strategy has shown that copper’s correlations versus other measures of Chinese money and credit peak after roughly three quarters (Chart 15).5 This is evident in both the 2012 and 2015-16 stimulus episodes in which the bottom in copper prices lagged the bottom in China’s credit growth. Thus we may witness a rebound in equity markets on the back of China’s credit splurge before we see an improvement in annual returns on copper prices. Chart 15Copper Rallies Lag China Credit Stimulus Bottom Line: South Korean and Russian equities are best positioned to benefit from the positive surprise in China’s credit data. France and Italy are the worst positioned. Copper prices will rebound with a delay.  Investment Implications BCA’s Geopolitical Strategy recommends that investors stay long Chinese equities ex-tech relative to the emerging market benchmark. This is a tactical call initiated in August 2018 that is now becoming a cyclical call on the basis of the credit upswing. We also remain long the “China Play Index,” a basket of China-sensitive assets. A rebound in China’s credit data and stronger global growth will support copper demand. Prices are still 15% below the mid-2018 peak and are poised to benefit in this environment, especially given that global inventories are already falling. BCA’s Geopolitical Strategy recommends that investors go long copper. Meanwhile, BCA’s China Investment Strategy recommends (for now) staying only tactically overweight Chinese equities relative to the global benchmark, pending higher conviction that the pace of credit growth will be strong enough to overwhelm the negative ramifications of a continued deceleration in actual activity over the coming few months on sentiment and 12-month forward earnings expectations. Over the long run, Geopolitical Strategy would look to underweight Chinese equities, as we are not optimistic about China’s productivity and potential GDP. This is because of the negative structural consequences of continuing the Socialist Put (i.e., bad loans, zombie companies, trade protectionism). We would expect CNY/USD to remain relatively buoyant in the context of both trade negotiations with the U.S. and fiscal-and-credit stimulus. The trade talks can hardly succeed if CNY/USD is falling. Depending on whether and how soon China’s stimulus results in a durable economic bottom, global growth could stabilize and the USD could see a substantial countertrend selloff.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist roukayai@bcaresearch.com   Footnotes 1          Please see Emerging Markets Strategy Special Report titled “China: Prepping A Bazooka?” dated February 14, 2019 available at ems.bcaresearch.com 2      Please see Nicholas Lardy, “The State Strikes Back: The End Of Economic Reform In China?” Peterson Institute For International Economics, January 29, 2019, available at piie.com. 3          Please see Emerging Markets Strategy Weekly Report titled “Dissecting China’s Stimulus,” dated January 17, 2019 available at ems.bcaresearch.com 4       The 2012 election of President Enrique Peña Nieto caused Mexican equities to outperform their EM counterparts. Similarly in 2015-16, U.S. outperformance relative to EM also supported Mexico relative to EM because Mexico’s economy is highly leveraged to its northern neighbor. In both periods Mexico’s outperformance was not caused by – but instead coincided with – Chinese credit stimulus. These idiosyncratic events biased the correlation between Mexico’s equity markets and Chinese credit growth to the upside. 5      Please see Commodity & Energy Strategy Weekly Report titled “Trade Wars, China Credit Policy Will Roil Global Copper Markets,” dated June 21, 2018, available at ces.bcaresearch.com.                  

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ハイライト 通貨市場は、悪化する世界の成長と緩和する世界の金融環境との綱引きを続けている。 一方で、歴史的に見て、ポートフォリオ資金フローと金利差に基づけば実効為替レートベースのドルは10〜15％高くあるべきだったことを示唆している。実際の抑制された戻りは懸念材料だ。 この攻防が進む中、当面の勝者は円のような安全資産通貨であろう。 勢力バランスの変化を探る手掛かりとして金と債券の比率に注目すべきであり、この比率の上昇はドルにとってネガティブだ。 投資家が上昇する双子の赤字、世界経済の脱ドル化、及び米国資産の低い期待リターンに注目を移せば、最終的に米ドルに対する清算の日が到来すると我々は予想する。 特集 先週の世界の金融市場を襲った嵐を考えると、先進国の通貨市場の最近の落ち着きは非常に不気味だ。先週のヨーロッパと日本の冴えない製造業PMIは株式市場を急落させた。注目されている米国の10年対3か月のスプレッドが逆転し、これを最も信頼できる景気後退指標と考える投資家の間でパニック売りを誘発した。アジアの株式市場は年初来高値から下落しており、地域の国債利回りは取引安値付近にとどまっている。原油を除き、コモディティ市場も軟調だ。 これらの動きにもかかわらず、実効ドルは比較的安定している。ここ数か月、多くの通貨ペアは非常に狭いウェッジ形成の頂点に向けて狭く推移している。これがボラティリティを大幅に低下させている（チャート1）。長期的には、これらの通貨クロスの金に対する安定性は、ブレトン・ウッズ風の固定為替相場体制を彷彿とさせる恐ろしい響きがある（チャート2）。 チャート1 通貨市場の不気味な静けさ An Eerie Calm In Currency Markets An Eerie Calm In Currency Markets チャート2 金に対する固定為替相場か？ Fixed Exchange Rates Versus Gold? Fixed Exchange Rates Versus Gold?   物理学では、向心力系は平衡を保ちやすい一方で、遠心力は劇的に爆発することがある。ポスト・ブレトン・ウッズの世界では、長期にわたる通貨の安定が持続することは稀だった。これは、どの経済間で不均衡のトレンドと大きさを常に監視し、圧力点がどこにあるか、対応する為替レートがどの方向に最終的に崩れるかを見極める必要があることを意味する。ドル見通しを左右する力のバランスがこの作業の自然な出発点のように思える。 グローバル流動性とドル ほとんどの相対的トレンドの尺度で判断すると、ドルは今まさに急騰しているはずだ。3月のマークイット製造業PMI発表では、日本とユーロ圏はいずれも縮小域にある一方、米国は52.5と世界の他地域を確実に上回っている。確かにこのリーダーシップの勢いは最近失速してきているが、歴史的には米国と世界の他地域の間でこれほど大きな成長差があると、6か月間で10〜15％のドル高をもたらすことがあった（チャート3）。これまでのところ、DXYドル指数は10月以降で1.9％上昇している。 過去にこの指標が大幅に縮小したたびに、ドル不足がどこかで爆発を引き起こしてきた。 米連邦準備制度理事会（FRB）が最近の金融政策の急転換をするまでは、相対的利回りもまたドルに有利に働いていた。米国と世界の他地域との2年スワップ利回り差はDXYドル指数を105に押し上げ、これは現在水準より8％高い値を示していた（チャート4）。一方、相対的な政策金利も実効為替レートベースのドルが約6％高いはずだと示唆している。そして今日でさえ、FRBが明確な利下げ方向に動かない限り、世界の他の中央銀行のハト派シフトは米ドルにとって即時の追い風であり続けるだろう。 チャート3 成長差に基づけば米ドルはもっと高いはず USD Should Be Higher Based On Growth Divergences USD Should Be Higher Based On Growth Divergences   チャート4 スワップ差に基づけば米ドルはもっと高いはず USD Should Be Higher Based On Swap Differentials USD Should Be Higher Based On Swap Differentials   国際的には、FRBの資産購入のテーパリングが米ドル流動性に対する純流出を引き起こしてきた。これは米国の経常収支赤字が拡大しているにもかかわらず起きている。FRBのバランスシートは2015年初めに4.5兆米ドルをわずかに上回ってピークに達し、それ以来減少している。これが米国のマネタリーベースの深刻な縮小を招き（チャート5）、商業銀行の超過準備金を大幅に削減し、現在は前年比で20％超の縮小となっている。BCAのお気に入りの国際流動性の主要指標の一つはFRBに預けられた外国中央銀行の準備高だが、これは過去40年以上で最悪のペースで縮小している。過去にこの指標が大幅に縮小したたびに、ドル不足がどこかで爆発を引き起こし、典型的には双子の赤字を抱える国々で顕在化してきた。 チャート5 ドルの流動性逼迫 A Liquidity Squeeze Of Dollars A Liquidity Squeeze Of Dollars 付け加えれば、昨年の米国税制の改正により海外現金の還流が認められたことはドルを支援したが、期待されたほどの効果はなかった。ローリング12か月ベースで、米国は約4,000億米ドル、すなわちGDPの約2％に相当する純資産を還流させている。歴史的に見てこれは非常に大きな金額であり、ドルを火の出るように上昇させる可能性がある量だ—おおむね10％程度の上昇（チャート6）。 チャート6 還流フローに基づけば米ドルはもっと高いはず 本国送還フローを考慮すれば、米ドルは本来もっと高くなるはずだ 本国送還フローを考慮すれば、米ドルは本来もっと高くなるはずだ ドル流動性の不足は負のフィードバックループを引き起こすために悪性化しやすい。国際的な米ドルの回転率が上がると、オフショアのドル金利が上昇し、借入国の資本コストが上がる。これが限界点に達すると、設備投資や消費は返済に置き換わる。生産や物価の下落、またはその両方は債務デフレ問題をさらに悪化させる。 結論として、過去のトレンドを見ると、ドルは現在の水準よりずっと高くあるべきだ。実務的な投資家は相関のシフトに注意を払う必要性を認識している。我々の好む流動性指標が完全に機能しなくなったのか、より現実的には別の力が働いてドルの相対的安定を説明しているのか、どちらかだろう。 逆循環的な通貨 一つの可能性は、最近の米ドルの安定が今年後半の経済指標の改善を織り込んでいるということだ。我々は過去に何度も示してきたが、ドルは逆循環的な通貨であり、世界経済の勢いが回復すると成績が悪くなりがちだ。多くの投資家は現在中国に注目しており、最近の信用供給が中国経済、ひいては世界経済を立て直すのに十分かどうかを見守っている。さらに、米中貿易協議が進めば、人民元の対ドル下落を防ぐ通貨条項が盛り込まれる可能性が高い。 実際のところ、世界成長の底打ちを支持する十分な証拠はまだ乏しく、これをドル安定に結びつけるのは難しい。 実際のところ、世界成長の底打ちを支持する十分な証拠はまだ乏しく、これをドル安定に結びつけるのは難しい。典型的なリフレーションの指標であるコモディティ価格、新興市場通貨、輸送株価は安値から反発しているが再び失速している。3月の輸出データは世界的に依然として弱かったが、構成的には幾つかの緑の芽が見られた。シンガポールから中国向けの輸出は前年比で34％増、エマージング向けは前年比で22％増加した。日本の工作機械の対中受注も一部安定化を示した。歴史的に見ると、これらは底打ちプロセスに入るかを判断するには必要条件だが十分条件ではない（チャート7）。 もう一つの矛盾点がある：もしドルラリーが世界成長の改善見通しによって抑えられているなら、金は弱く推移し、ほとんどの通貨は金とドルの両方に対してアウトパフォームしているはずだ。昨日の金の売りまで、そうなっていなかった。つまり何らかの別の説明が米ドルの上昇を抑えている可能性がある。 チャート7 世界貿易における回復の兆しか？ 世界貿易における暫定的な回復の兆しか？ 世界貿易における暫定的な回復の兆しか？   レジーム・シフトか？ 米国居住者が資本を国内に呼び戻している一方で、外国人投資家は近年でも有数の速さで米国資本市場から逃避している。ローリング12か月トータルで見ると、米国からは外国人による株式の約2,000億米ドルの流出があり、これは過去最大だ（チャート8）。総じて、外国の公的・民間の長期ポートフォリオ投資はいずれも減少傾向にあり、投資家の関心はエージェンシー債や社債に限られている。外国人は依然として約4,500億ドルの米国証券のネット買い手であるが、近年の買い入れの下落トレンドは明白だ。興味深いことに、この期間において金は米国債をアウトパフォームしている。 米ドルは今日も世界の基軸通貨であり続けているが、その莫大な特権は確かに端がほころび始めている。 対公的フローの観点では、中国は米国の貿易赤字の最大の寄与国にまで台頭している。同時に、北京は米国の過去の政策への報復として、あるいは人民元の国際化のための余地を作るために、保有する米国債の在庫を削減してきた可能性がある（チャート9）。より広く見れば、FRBにおけるドル預金の減少は、世界経済がドルから離れ、より多様化した通貨バスケットへ向かう基礎的なシフトを示しているのかもしれない。原油、天然ガス、バルクコモディティ、さらにはソフトコモディティに至るまで、取引の相当部分が米国の取引所外で行われる割合が高まっていることを考えれば、これは理にかなっている。 チャート8 外国人が米国株を投げ売りしている 外国人投資家が米国エクイティを投げ売りしている 外国人投資家が米国エクイティを投げ売りしている   チャート9 中国は黒字を米国債に再循環させるのを止めた 中国は余剰資金をトレジャリーズに再投資するのをやめた。 中国は余剰資金をトレジャリーズに再投資するのをやめた。   国際通貨基金（IMF）のデータは、対外準備高におけるドルの割当が2000年代初頭に約72％でピークに達し、それ以来下落傾向にあることを示している。一方、英ポンド、スイスフラン、円など他の通貨への割当は急増している（チャート10）。同時に、中央銀行は金の準備を大量に積み上げており、特にロシアと中国は年間生産量のほぼ総量に匹敵する量を蓄えている（チャート11）。これらはドルが本来あるべきほど強くない理由を説明するのに役立つ。こうした要因は、金価格に対するこれらの通貨ペアの相対的安定性も説明する。 チャート10 世界はドルからの多様化を進めている 世界はドルからの分散化を進めている 世界はドルからの分散化を進めている チャート11 中央銀行が金の生産の大部分を吸収している Central Banks Are Absorbing Most Gold Production Central Banks Are Absorbing Most Gold Production 米ドルは今日も世界の基軸通貨であり続けているが、収支のダイナミクスは間違った方向に向かっており、その莫大な特権は確実にほころびつつある。今後5年間で米議会予算局（CBO）は米国の財政赤字がGDP比で4.5％まで膨らむと見積もっている。経常収支赤字が多少拡大してその後安定すると仮定すれば、双子の赤字はGDP比で8.1％に達する見込みだ。これは不況が起きないという前提での見通しであり、不況が発生すれば赤字はさらに膨らむ可能性がある（チャート12）。 チャート12 ドルにとっての双子の赤字の崖 ドルが直面する双子の赤字の崖 ドルが直面する双子の赤字の崖 金融危機後、米国の双子の赤字はGDP比でほぼ13％まで膨らんだが、その当時との違いはコモディティブームの結果ドルが割安であった（コモディティ通貨が過大評価されていた）ことだった。その後のシェール革命も米国の貿易赤字を大いに緩和した。シェールの生産性は引き続き堅調で米国の生産はさらに増えるだろうが、取りやすい果実はすでに摘み取られている。 何らかの理由で外国の中央銀行はドルからの多様化を進めている。貿易の景色が変わっているためであればこの傾向は続くだろうし、急速に拡大する米国の双子の赤字を避けたいという理由であればこれも続くだろう。そして米ドルが「良いニュース」で十分に上昇できないのであれば、悪いニュースが出始めたときに沈むことを期待すべきだ。ただしタイミングは不確実だ。   民間資本フロー 外国の公的フローが米ドルから離れている理由が基軸通貨としての魅力の低下であったとしても、民間資本は米国資産の投下資本利益率（ROIC）が資本コストを下回ると出口へ殺到し始めるだろう。長期保有の投資家にとっては、これはすでに起きている可能性がある。 例えば10年国債を見てみよう。日本やドイツの投資家にとって、現地通貨で借りて米国に投資するのは、国内金利がマイナスで10年米国債利回りが2.4％であることを考えれば論理的に思えるかもしれない。しかし、この正のキャリーはヘッジコストを考慮すると突然消えてしまう（チャート13）。 チャート13 ヘッジ済み米国債より日本国債が魅力的 日本国債はヘッジされた米国債より魅力的 日本国債はヘッジされた米国債より魅力的 強気相場では、マイナス金利の国々はキャリートレードによる強い資本流出を受けやすい。これらの影響を測るのは難しいが、ヘッジコストが低い期間（通常はボラティリティが低い期間に相当）には強力な触媒となり得ることは間違いない。市場が変動的になりこれらの取引が巻き戻されると、非ヘッジの取引はショートカバーのフローの犠牲になる。 世界の多くの利回り曲線が逆イールドになっている中で、長期債のリターンがスポット金利に対して相対的に劣後するため、このショートカバーの頻度が暗黙のうちに上昇する危険がある。ボラティリティが上がり始めると一つの勝者は円だ。投資家はヘッジとして今日ドル/円のショートポジションの組成を検討すべきだ。 フィクスト・インカム領域を除けば、重要なのは相対的なROICが資本コストより高いかどうかだ。どちらも多くの新興国や先進国の資産クラスで測るのは難しい。しかし株式市場に関しては、為替が国間のリターンを均等化する方向に動く傾向があるため、評価指標が常に良い出発点となる。 MSCIの米国、欧州、日本の各指数のフォワードP/Eはそれぞれ16.5倍、12.6倍、12.3倍だ。米国に偏るのは、市場参加者が米国の利益が引き続きアウトパフォームすると期待しているか、米国通貨が引き続き上昇すると期待しているか、その両方を見込んでいるためだ。だが経験的には、現在の米国のバリュエーションは将来の利益ストリームが既に今日の価格に織り込まれていることを示唆している（チャート14）。 チャート14A 投下資本利益率は米国で最も低い可能性がある（1） Return On Capital Could Be Lowest In The U.S. (1) Return On Capital Could Be Lowest In The U.S. (1) チャート14B 投下資本利益率は米国で最も低い可能性がある（2） Return On Capital Could Be Lowest In The U.S. (2) Return On Capital Could Be Lowest In The U.S. (2) チャート14C 投下資本利益率は米国で最も低い可能性がある（3） Return On Capital Could Be Lowest In The U.S. (3) Return On Capital Could Be Lowest In The U.S. (3) MSCI米国の期待される10年年率リターンは3.1％、MSCI欧州は5.5％、MSCI日本は9.6％だ。いくつかのモデルが示唆するように米ドルが過大評価されていると仮定すれば、これは将来の米国リターンをさらに侵食することになる。前述の図に示したように、米国への純株式ポートフォリオフローは既にマイナスだ。これは、現在の追い風が最終的に弱まったときに米ドルの清算の日が遠くない可能性を示唆している。   Chester Ntonifor, 外国為替ストラテジスト chestern@bcaresearch.com トレード＆フォーキャスト 予測概要 コア・ポートフォリオ タクティカル・トレード 決済済み取引

Highlights Just when it looked like the agricultural complex was starting to perk up, it was slapped down again. After crawling its way back from a mid-2018 crash – retracing more than half of its decline – the CCI Grains and Oilseeds index plummeted in February, declining by nearly 9% (Chart Of The Week). The decline was broad-based, but was led by wheat, which was dragged down by muted demand and accounted for most of the index’s decline. Looking forward, we expect U.S. financial conditions and developments on the trade-war front to remain the main forces driving ag prices. Ample inventories will provide the cushion necessary to moderate the impact of potential supply-side shocks. Highlights Energy: Overweight. Venezuela suffered another power outage earlier this week, indicating the deterioration of its infrastructure is accelerating. While officials claim to have restored power, we expect more such outages going forward, which will severely reduce the country’s production and export capacity. Separately, Aramco announced it will buy 70% of Sabic, a Saudi state-owned petchem producer, for $69 billion, according to the Wall Street Journal. Base Metals: Neutral. China’s MMG Ltd was set to declare force majeure following protests at its Las Bambas mine in Peru earlier this week. The mine produces ~ 385k MT p.a., most of which goes to China. Precious Metals: Neutral. The inversion of the U.S. yield curve put a bid into the gold market this week, as investors sought a safe-haven refuge. Continued weakness in bond yields, and accommodative central banks responding to low inflation expectations globally will continue to support gold. Agriculture: Underweight. A more patient Fed will be supportive of ag prices in 2H19, as we discuss below. Feature Chart of the WeekWheat Had A Rough Start To 2019 A Patient Fed Will Support Ags In 2H19 While differences across ag markets will arise due to idiosyncratic supply shocks and targeted trade policies, a common determinant of ag price movements more generally is U.S. financial conditions. Since our last assessment of global ag markets, Fed policymakers have adopted a much more patient approach to monetary policy.1 In line with the pause in the Fed’s rates-normalization policy, financial conditions have eased considerably (Chart 2). We believe this will, ceteris paribus, bring relief to commodity markets in general, ags in particular, in the second half of this year. Chart 2Easier Financial Conditions Bode Well For Ags The bulk of this relief will be transmitted through the impact of a weaker dollar. Since the dollar is a countercyclical currency, its weakness implies an improvement in global growth. This more solid economic backdrop is associated with greater aggregate demand, particularly in EM economies, as well as demand for agricultural products. The lagged effects of financial tightening, weak Chinese credit growth and the trade war will persist in 2Q19. Furthermore, when the USD weakens against the currencies of ag exporting countries, farmers there are incentivized to hoard or cut exports – thus reducing supply – awaiting periods when a stronger greenback will raise their profits. At the same time, ags priced in USD become relatively more affordable for importing nations, incentivizing them to raise consumption. The net impact of this contraction in supply amid greater demand will pull up prices – illustrated by the relatively tight inverse relationship between ag prices and the dollar (Chart 3). Chart 3A Weaker USD Will Be A Tailwind In 2H19 Going into mid-2019, we expect global economic indicators to continue to be uninspiring. The lagged effects of financial tightening, weak Chinese credit growth and the trade war will persist in 2Q19. However, as these factors fade and give way to an improvement in global economic conditions and easier financial conditions, we expect the dollar to peak around mid-year. As such, a resurgence in global growth in the second half of the year will be reflected in an improvement in the value of the currencies of major ag exporters ex-U.S. (Chart 4). Ceteris paribus, this also benefits ag prices. Chart 4Weak Local Currencies Supporting Farm Profits, Incentivizing Production China’s Economy Remains Central Our outlook hinges on developments in the Chinese economy. Peter Berezin – our Chief Global Investment Strategist – expects Chinese authorities to not only stabilize credit growth, but also increase it, creating room for improvement in the world’s second largest economy.2 This combination of supportive global growth and a softer dollar bodes well for ag prices in 2H19. The Fed pause and associated easing in U.S. financial conditions will support global growth, causing the U.S. dollar to weaken – a bullish force for ag markets. Apart from the currency impact, easy financial conditions are supportive of global growth. A rise in income levels of emerging economies will support demand for goods and services generally, and agricultural commodities specifically.3 The market now expects 36 and 51 basis points of rate cuts over the coming 12 and 24 months, respectively. Similarly, following last week’s FOMC meeting, the median Fed dot indicates no rate hikes this year from the U.S. central bank, and only one in 2020. While our Global Investment Strategists would not be surprised to see a hike this year, the noticeably less hawkish tone in the Fed’s forward guidance and dot plots are positive for ag markets.4 Looking beyond that into late-2020 or early 2021, a potential pick-up in inflation will force the Fed to take a more hawkish stance, and once again support the U.S. dollar. This will weigh down on ag prices over the strategic time horizon. Bottom Line: The Fed pause and associated easing in U.S. financial conditions will support global growth, causing the U.S. dollar to weaken – a bullish force for ag markets. However, this is unlikely to occur before mid-year. In the meantime, a stronger dollar on the back of the lagged effects of growth dampening events in 2018, will remain a headwind. Ample Inventories Will Cushion Against Supply Shocks Putting aside the more or less uniform impact of U.S. financial conditions, individual supply-demand fundamentals will manifest as idiosyncratic risks and opportunities. The USDA has been revising its projections for ending stocks higher in its monthly World Agricultural Supply and Demand Estimates (WASDE) across the board since it released the first projections for the 2018/2019 crop year last May. However, we find that solely on the back of fundamentals, soybeans are more likely to resist upward pressure from easier U.S. financial conditions in 2H19 vs. wheat and corn. The USDA’s latest projections for the current crop year indicate that global bean markets are well supplied. Expectations of a global surplus this crop year – for the seventh consecutive year – will add to the growing cushion (Chart 5). Chart 5Beans Surplus Will Add To the Glut Since May, global ending bean stocks have been revised higher by a total of 20.47mm MT. The change in projections comes on the back of upward revisions to production and beginning stocks, compounded by downward revisions to consumption. The latter will likely contract further if the U.S. and China do not reach an agreement on the trade front (see below). Consequently, unless a weather disruption weakens supply, we expect soybean inventories to stand at record highs relative to consumption at the end of the current crop year. In the case of wheat, the impact on prices will likely be marginal. The global balance is expected to shift to a deficit in the current marketing year, following five years of surplus (Chart 6). While this is a positive for wheat prices, given that global inventory levels are relatively elevated – capable of supporting 37% of consumption – and the current deficit is relatively small, we do not expect the deficit to pressure prices in the near term. Chart 6Elevated Wheat Inventories Will Cushion Against Minor Deficit Despite continued downward revisions to the USDA’s wheat production projections, expectations of ending stocks have actually risen on the back of downward revisions to consumption. Similarly, corn fundamentals are also unlikely to sway prices much. The grain is expected to remain in deficit for the second consecutive year, which will pull inventories down off their 2016/17 peak to be capable of covering ~27% of global consumption (Chart 7). Despite this contraction in availability, global supplies remain relatively elevated, especially compared to the 2003 to 2012 period. Thus unless there is a significant supply shock, we don’t expect much support from fundamentals. Chart 7A Global Corn Deficit ... Unlike wheat demand, which has been downgraded, the USDA has revised corn consumption up relative to the first projections for the crop year released last May. Nevertheless, stronger expectations of consumption have been overwhelmed by upward revisions to production and beginning inventory levels. Given that world inventories already are bloated, we do not expect the likely deficit in wheat and corn supplies this crop year to pressure prices much to the upside. Since the mid-1990s, U.S. farmers had been planting more corn and wheat at the expense of soybean acreage (Chart 8). On a global level, while wheat remains more popular in terms of acreage, it is generally trending downwards, while corn and soybean plantings are trending up. However, over the longer term, U.S. farmers are expected to dedicate more land to corn relative to soybeans. Chart 8... Will Be Met By Rising U.S. Acreage Bottom Line: Given that world inventories already are bloated, we do not expect the likely deficit in wheat and corn supplies this crop year to pressure prices much to the upside. Similarly, a global glut in soybean supplies will only add to swelling inventories. The Trade War And Soybeans: It Ain’t Over Till It’s Over Aside from U.S. financial conditions and supply-demand balances, U.S. trade policy has also been roiling ag markets since China slapped U.S. soybeans with 25% tariffs in mid-2018. In fact, since the escalation of the trade dispute, soybean prices have been moving largely in response to developments on the trade front (Chart 9). As developments since the G20 Summit in Buenos Aires last December have been more favorable, soybean markets are on the path to recovery. Chart 9Markets Optimistic Of A Trade War Resolution So far, even though U.S. soybean exports to China picked up over the past two months, total U.S. exports still lag levels typical for this time of year (Chart 10). This comes despite U.S. efforts to raise shipments to other trading partners. Furthermore, U.S. exports will now be in direct competition with the Brazilian crop, which usually dominates trade flows at this time of year (Chart 11). While the U.S. tariff hike from 10% to 25% on $200bn of Chinese goods has been postponed, a resolution to the trade war has yet to occur. The path to a resolution is fraught with risks. While the U.S. tariff hike from 10% to 25% on $200bn of Chinese goods has been postponed, a resolution to the trade war has yet to occur. The path to a resolution is fraught with risks. The Trump-Xi meeting that was expected to occur in late-March was postponed; the next most likely date for a meeting is at the G20 summit in end-June. This leaves another 3 months of trade uncertainty. Nevertheless, our models indicate that soybeans are now priced at fair value, based on U.S. financial variables – absent a trade war (Chart 12). Furthermore, the premium priced into Brazilian beans above those traded on the CBOT has returned to its historical average (Chart 13). Thus, we do not expect a further reduction in the premium in the event Sino-U.S. trade negotiations are successful. Chart 13Premium For Brazilian Beans Has Normalized Rather, markets will be disappointed if the U.S. and China are unable to conclude a deal. This would put CBOT prices at risk and support the premium on those traded in Brazil. Given that our geopolitical strategists assign a non-negligible 30% probability that the trade war escalates further, we believe markets are overly optimistic that a deal will be concluded.5 If the trade war drags on and turns into a multi-year conflict, soybean markets will likely take a more meaningful hit. According to the USDA’s latest long-term projections released earlier this month, China’s soybean imports were projected to rise 32.1mm MT during the 2018-28 period – a massive downward revision from the 46mm MT expected for the 2017-2027 period contained in the previous long-run projections. Furthermore, outbreaks of African swine fever in China may put demand there at risk. Over 100 cases have so far been reported in China, with several cases already reported in Vietnam as well. This threatens to depress China’s need for soybean as animal feed, regardless of what happens on the trade front. Bottom Line: A positive outcome from the U.S.-China trade negotiations is not a given. Nevertheless, soybean markets are treating it as such. Our geopolitical strategists assign 30% odds that a final deal falls through. This non-negligible probability threatens to cause soybean prices to relapse anew, should Sino-U.S. trade negotiations break down.   Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com Footnotes 1 Please see “2019 Key Views: Policy-Induced Volatility Will Drive Markets,” published by BCA Research’s Commodity & Energy Strategy December 13, 2018.  It is available at ces.bcaresearch.com. 2 Please see BCA Research’s Global Investment Strategy Weekly Report titled “What’s Next For The Dollar,” dated March 15, 2019, available at gis.bcaresearch.com. 3 Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled “Global Financial Conditions Will Drive Grain Prices In 2018,” dated November 30, 2017, available at ces.bcaresearch.com. 4 Please see BCA Research’s Global Investment Strategy Weekly Report titled “Questions From The Road,” dated March 22, 2019, available at gis.bcaresearch.com. 5 Please see BCA Research’s Geopolitical Strategy Special Report titled “China-U.S. Trade: A Structural Deal?,” dated March 6, 2019, available at gps.bcaresearch.com.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table   Trades Closed in 2019 Summary of Trades  

特別レポート

Highlights Taiwan’s semiconductor sector is facing both cyclical and structural headwinds. Semiconductor exports will continue to contract over the next six months or so, on retrenching global demand. In the long run, Taiwan is facing increasing competition from Korea in the high-end supply, and from mainland China in the medium- to low-end supply of the semiconductor market. The latest rebound in Taiwanese share prices is unsustainable, and they are about to relapse anew. Within an EM equity portfolio, we recommend staying neutral on Taiwanese stocks for now. Feature Taiwan’s exports and manufacturing are in full-blown recession. The equity market has rebounded after a major selloff last year. However, the overall manufacturing PMI and its export sub-component are extremely weak, and do not justify the latest share-price rebound (Chart I-1). Chart I-1Taiwanese Equities: Unsustainable Rally Are manufacturing activity and exports about to recover? Or will the stock market rally fade? Our answer is the latter. There are currently no signs suggesting a recovery in exports is imminent. Moreover, the engine of the economy – the semiconductor sector – is facing both cyclical and structural headwinds. We remain negative on Taiwanese stocks in absolute terms. Within an EM equity portfolio, we recommend a market-weight allocation to Taiwanese stocks for now. Importance Of Semiconductors Over the past 15 years, the semiconductor sector has become the cornerstone of the Taiwanese economy. The Taiwanese economy is highly dependent on its external sector, as exports contribute to nearly 70% of GDP. As such, Taiwan’s business cycle has often been closely associated with its export sector. This means the region’s growth outlook relies on both external demand (a cyclical factor) and the competitiveness of its export sector (more of a structural factor). Over the past 15 years, the semiconductor sector has become the cornerstone of the Taiwanese economy. It contributes to over one-third of the region’s total exports, up from 22% in 2009 (Chart I-2). Chart I-2Semiconductor: Cornerstone Of Taiwanese Economy Consistently, tech stocks also account for the lion’s share of the Taiwanese stock market, representing nearly 60% of the MSCI Taiwan Index and 47% of the Taiwanese Stock Exchange (TSE) index in market-value terms. There have been two key forces behind the significant growth of Taiwan’s semiconductor sector: booming global demand for smartphones/tablets and increasing competitiveness among domestic semiconductor companies. However, looking forward, the Taiwanese manufacturing sector and its semiconductor exports are facing a double-whammy: cyclical weakness in global demand and a relative decline in Taiwan’s export ability. In the context of a negative structural outlook, a cyclical downtrend engenders substantial deterioration in manufacturing, and by extension corporate profitability. Cyclical Downturn In Global Semiconductor Demand The outlook for the Taiwanese semiconductor industry remains poor. The global semiconductor industry has already been in a cyclical downtrend since early 2018. Global smartphone sales are shrinking. Both DRAM and NAND prices have been falling (Chart I-3). Chart I-3Falling Memory Chips Prices The freefall in Taiwan's new export orders seems to entail a further contraction in exports (Chart I-4). Chart I-4A Further Contraction In Exports Is Likely Importantly, exports of electronics parts lead Taiwanese tech EPS growth, and currently point to an impending contraction in corporate earnings (Chart I-5). Chart I-5An Impending Contraction In Corporate Earnings The outlook for the Taiwanese semiconductor industry remains poor. First, Taiwanese semiconductor producers are highly vulnerable to any further downside in global smartphone demand. There are two major pure-play wafer manufacturers in Taiwan: Taiwan Semiconductor Manufacturing Company (TSMC) and United Microelectronics (UMC). TSMC and UMC are the world’s largest and fourth-largest dedicated integrated circuit (IC) foundries, respectively. The smartphone sector has been the main revenue source for both companies, accounting for a 45% share for TSMC and 40% for UMC. Global smartphone demand is likely to decline further in 2019, as major markets such as mainland China and advanced economies have entered the saturation phase of mobile-phone demand. DRAMeXchange expects global smartphone production volume for 2019 to fall by 3.3% from last year following a 4% drop in 2018 (Chart I-6). Chart I-6Global Smartphone Demand Started A Downtrend Smartphone sales in mainland China remain in deep contraction after two consecutive years of declines (Chart I-7). Odds are that smartphone shipments will remain sluggish amid the ongoing economic slump in the mainland’s economy. Chart I-7Smartphone Sales In Mainland China Are In A Deep Contraction In addition, Taiwan’s TSMC is the sole chip supplier for Apple iPhones. A further decline in Apple smartphone shipments will reduce the company’s revenue and profits, damaging the region’s growth outlook. Mainland China now can produce top-notch quality smartphones at relatively cheaper selling prices. This will further crowd out higher-priced products from Apple, Samsung and others (Chart I-8). Chart I-8Apple Has Been Losing Market Share In Global Smartphone Market Second, the significant surge in bitcoin prices greatly boosted cryptocurrency mining activity in 2016-‘17 as miners quickly expanded their computing power. This boosted demand for graphic process unit (GPU) chips and in turn brought higher revenue for Taiwan chipmakers between June 2016 and early 2018. However, with the bust in bitcoin prices (Chart I-3 on page 3), demand from cryptocurrency mining has vanished and is unlikely to revive soon. Indeed, Taiwan chipmakers have suffered from last year’s plunge in cryptocurrency mining activity. According to TSMC, revenue from the cryptocurrency mining-related high-performance computing (HPC) sector contracted by double digits in 2018. Given that HPC demand is the second-biggest source of revenue for TSMC, with 32% share, TSMC revenue will be curtailed as HPC chip demand will continue to decline on weak bitcoin prices. Last, developments in new technologies, such as foldable smartphones, artificial intelligence, fifth-generation (5G) mobile networks and the so-called Internet of Things (IoTs) could only produce a modest pick-up in semiconductor demand. Most of these developments are still in their infancy and early stages. Hence, their growth will not be large enough to make a cyclical difference in global semiconductor demand. For example, the foldable smartphone that Huawei recently announced is indeed appealing. However, a lack of stability in panel supply and quite-high selling prices will limit sales. WitsView, a division of TrendForce, predicts that the market penetration rate of the foldable phone will be only 0.1% in 2019, and could rise to 1% in 2020 if more panel providers join the game, enabling a significant reduction in panel costs. Moreover, these categories together account for only ~23% of TSMC’s revenue; their modest growth will not be able to make up for the losses from the smartphone and HPC sectors within Taiwan’s economy. Besides, there has been a slowdown in demand from high-growth areas such as data center servers, as well as the automotive and industrial sectors. Putting it all together, odds are that global semiconductor demand will only materially recover in 2020. By that time, more-mature 5G technology and the increasing adoption of the 5G network and 5G-related products may be able to shift global semiconductor demand from the current downturn to a cyclical uptrend. Hence, the cyclical weakness in global semiconductor demand is likely to persist over the next six months. Consequently, Taiwan’s major types of semiconductor production will likely remain in contraction, and inventory levels will stay elevated (Chart I-9 and Chart I-10). Chart I-9Taiwan: Semiconductor Output Contraction Will Likely Continue Chart I-10Taiwan: Semiconductor Inventory Are Elevated Bottom Line: There are no signs of an imminent recovery in exports. A Potential Decline In Taiwan’s Semiconductor Competitiveness Taiwan wafer manufacturers are facing an increasing threat from their Korean and mainland China competitors. Leadership in advanced process technologies has been a key factor in Taiwan’s strong market position in the global semiconductor industry. With cutting-edge technologies, Taiwan has been the global wafer capacity leader since 2015. As of last year, it held about 22% of global installed wafer capacity (Chart I-11). However, Taiwan wafer manufacturers are facing an increasing threat from their Korean and mainland China competitors. Korean Chipmakers While Taiwan will remain highly competitive in 7 nanometer (nm) and 10 nm wafer production, it is facing fierce competition from Korea. Manufacturing technologies designated by smaller nanometer numbers tend to have faster speeds and be more power-efficient than technologies designated by larger numbers. TSMC was the first company in the world to mass-produce 7 nm node wafers. Its 7 nm deep ultraviolet lithography (DUV) node has been in mass production since April 2018, producing chips for AMD, Apple, HiSilicon, and Xilinx. Beginning at the end of this month, TSMC will be ready to begin mass production of 7nm wafers using extreme ultraviolet lithography (EUV). The switch from 7nm DUV to 7nm EUV allows for fewer defects and fewer steps required during the production process. The company also aims to boost volume production of its 5 nm nodes in early 2020 and has a target of 3 nm wafers for 2022. Last year, wafer revenue from 7nm and 10nm chips accounted for 9% and 11% of TSMC’s total revenue, respectively (Chart I-12). Samsung has been closely following TSMC in terms of technological innovation. It started mass production of EUV-based 7nm chips last October, with a plan of risk production1 of 5nm wafers in 2019 and a target of 4nm wafers in 2022. Meanwhile, IBM announced last December that it signed an agreement with Samsung to produce its next-generation processors with Samsung’s 7nm technology. As Samsung seeks to diversify its revenue source away from memory chips, which last year contributed to about 80% of its operating profit, the company has been determined to ramp up the development of its foundry business. It aims to replace TSMC as the world’s largest foundry producer by 2030. In the near term, Samsung aims to secure a 25% market share in the global pure-play foundry market by 2023, a rise from 19% currently. Last year, Samsung surpassed Taiwan’s UMC to become the world’s second-largest dedicated chipmaker. Moreover, Samsung’s capital spending has been and will continue to be much higher than TSMC. Over the course of 2017 and 2018, Samsung spent about $46.9 billion on semiconductor capital expenditures, more than double TSMC’s $21 billion. Hence, the competition between TSMC and Samsung in the high-end chip market will intensify in the coming years. Chipmakers In Mainland China The competition between TSMC and chipmakers from mainland China is also escalating. Chart I-12 shows that 80% of TSMC’s wafer revenue comes from bigger node wafers (bigger than 10 nm). Taiwan’s second-biggest chipmaker, UMC, only produces wafers equal to or bigger than 28 nm. Therefore, the chip market using less-advanced technology than 10 nm will be the main battlefield between Taiwanese and mainland China’s chipmakers. Before 2014, there were few wafer manufacturers in mainland China, and those that did exist were too weak to compete with giant market players like TSMC. In 2014, the Chinese central government made a move to foster development within the local IC industry. Since then, the authorities have poured significant amounts of capital into semiconductor foundries, as well as companies focused on memory production, chip design and related equipment and materials. Semiconductor Manufacturing International Corporation (SMIC) is the world’s fourth-largest dedicated wafer manufacturer, and is the largest in mainland China. While 28nm will likely remain a large part of its business, SMIC plans to go into production on its 14 nm technology in the first half of 2019. The company is also working on 10nm and 7nm nodes with the use of EUV. SMIC currently counts HiSilicon and Qualcomm as customers, manufacturing smartphone chips with medium-to-low technology. As mainland China aims to increase its self-sufficiency rate for ICs significantly over the next five to 10 years, the nation’s producers will significantly expand their wafer capacity. Mainland China is likely to reduce its semiconductor imports from Taiwan considerably in the coming years, especially wafer imports. According to IC Insights, nine 300mm wafer fabs2 are scheduled to open worldwide in 2019, with five of them in mainland China. Based on another set of data from SEMI, the number of 200mm wafer fabs in the world will increase from 194 in 2017 to 203 by 2022, with an additional 56 established fabs planning to expand their manufacturing capacity. Mainland China is expected to account for 44% of the growth. In comparison, Taiwan only accounts for about 10% of the growth. Mainland China currently accounts for over 30% of Taiwanese electronic parts exports (wafers, PCBs, mainboards and others). As mainland China continues to build new wafer manufacturing capacity and gradually improve its existing technology, it will switch its consumption from imports to domestic production. Consequently, mainland China is likely to reduce its semiconductor imports from Taiwan considerably in the coming years, especially wafer imports (Chart I-13). This is structurally bearish for Taiwanese semiconductor companies. Chart I-13Mainland China’s Semiconductor Imports From Taiwan Will Drop Bottom Line: Taiwan is facing increasing challenges from Korea in terms of defending its market share in the high-end wafer market. Meanwhile, Taiwan is also set to lose market share in the medium-to-low market to wafer producers from mainland China. What About The Rest Of The Economy? The rest of the economy is exhibiting mixed signals, with contracting major non-semiconductor export sectors but decent household consumption and property market. Table 1 shows Taiwan’s top 10 exported products, with the top three attributing to over half of total exports. Besides the semiconductor sector, exports of the other two major products – electrical machinery products and machinery – are beginning to contract (Chart I-14). Chart I-14Taiwan: Contracting Non-Semiconductor Exports However, the domestic economy seems to be running well at present. Production of construction materials in volume terms is growing rapidly, accompanied by a rebound in building permits granted (Chart I-15). While employment growth is decent, average wage growth has been quite strong (Chart I-16). With persistent contraction in exports and inflation very low, the central bank could cut rates in 2019. Chart I-15Decent Domestic Demand Chart I-16Strong Wage Growth Ongoing contraction in semiconductor exports will likely slow domestic demand with a time lag. In fact, the inverted 5-year/6-month yield curve is indeed signaling an economic slump in Taiwan (Chart I-17). Chart I-17Inverted Yield Curve Signals Continuing Economic Slump Ahead Investment Recommendations The latest rebound in Taiwanese stocks is unsustainable and share prices will relapse again. Within an EM equity portfolio, we recommend maintaining a market-weight allocation to Taiwan for now. We are reluctant to downgrade Taiwan to underweight because some other emerging markets and sectors within the EM universe have a poorer outlook. In addition, Taiwanese shares have already underperformed the EM benchmark since last September (Chart I-18). Chart I-18Taiwanese Stocks: Staying Neutral Within EM The Taiwanese currency is cheap (Chart I-19). The region has a massive current account surplus and foreigners do not hold any local bonds, which is very different from many other EM countries. Hence, Taiwan is less vulnerable to capital outflows than many current-account-deficit EM economies. The latter could be forced to raise rates, which will place pressure on their banks as well as on domestic demand. In contrast, Taiwan has the ability to cut rates. Chart I-19TWD Is Cheap Ellen JingYuan He, Associate Vice President Emerging Markets Strategy ellenj@bcaresearch.com     1 "Risk Production" means that a particular silicon wafer fabrication process has established a baseline in terms of process recipes, device models, and design kits, and has passed standard wafer level reliability tests. 2 A fab, sometimes called foundry, is a semiconductor fabrication plant where devices such as integrated circuits are manufactured. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The odds of a continued earnings contraction have not yet fallen to the point that would warrant an overweight stance towards Chinese versus global stocks over the coming 6-12 months. While we maintain Chinese stocks on upgrade watch and may recommend increasing exposure soon, the bottom line for investors is that it is still too early for us to confidently project a sustained uptrend. While most investors attribute the chronic discount of Chinese stocks relative to the global average as being due to a sizeable equity risk premium, our analysis suggests that China’s low payout ratio and mediocre earnings growth are the true causes. This implies that China’s re-rating potential is capped barring a major structural improvement in earnings growth. Investors should pay close attention to the details of a U.S./China currency stability pact that will reportedly be included in any trade deal between the two countries. Such a pact may set up an important natural experiment for CNY/USD, and could be a revelatory event for China’s exchange rate regime. Feature Last week’s FOMC meeting dominated the headlines of the financial press, and for good reason. The Fed surprised investors with a material downgrade to their expected path of the federal funds rate over the next three years, a shift that largely reflected concerns about global growth. The subsequent inversion of the U.S. 10-year / 3-month yield curve in response to the very disappointing euro area flash manufacturing PMI for March confirms that many investors remain convinced that Fed policy is too tight and that easing is likely over the coming year.1 On the positive side, investor concerns that reflationary policy is needed in the U.S. and euro area are likely overblown: the plunge in the euro area PMI at least in part reflects the near-term uncertainty over the possibility of a hard Brexit (which will probably be avoided), whereas the Fed is pausing at a level of real interest rates that is well below real GDP growth, which means that monetary policy is still stimulative for the U.S. economy (Chart 1). Chart 1U.S. Monetary Policy Is Still Stimulative But Chart 2 highlights that a generalized slowdown in global growth is responsible for at least part of the sharp weakness in Chinese export growth over the past few months, which we had been mostly attributing to a catch-up phase following a (perversely and ironically) beneficial tariff front-running effect that had temporarily boosted trade growth last year. Chart 2Global Weakness At Least Partly Responsible For A Sharp Export Slowdown Ongoing weakness in the global economy, were it to persist, would imply that China’s external demand outlook is even less encouraging than we had previously assumed. This would raise the stakes for a trade deal with the U.S. to be agreed upon soon, as well as a continued uptrend in the pace of Chinese credit growth. Investors should closely watch the new export orders component of the March NBS manufacturing PMI later this week for signs that exporter sentiment is improving, as well as the overall Caixin PMI to confirm that smaller firms continue to benefit from the PBOC’s targeted easing efforts. When Should Investors Upgrade Chinese Stocks On A Cyclical Basis? In our view, most global investors have been focused on the wrong risk factor for Chinese stocks for the better part of the past year. In the wake of the near-vertical February rise in Chinese domestic stocks, the most common question we have received from clients is whether they should be increasing their cyclical exposure to Chinese stocks in general, and A-shares in particular. In response to the January surge in credit we placed Chinese stocks on upgrade watch in our February 27 Weekly Report,2 but we are not yet ready to recommend an outright cyclical overweight. Investors should be at the ready and aiming, but should not yet fire. In our view, most global investors have been focused on the wrong risk factor for Chinese stocks for the better part of the past year. We have noted in several previous reports that investors have focused nearly exclusively on the U.S.-China trade war since the beginning of 2018, and have largely ignored a slowing domestic economy (Chart 3). Given this, it is not surprising that a sharp improvement in the odds of a deal (which occurred at the beginning of November) has led to a material rally over the past few months versus global stocks. Chart 3The Prospect Of A Trade Deal Has Been The Primary Driver Of China-Related Assets In fact, we predicted in our December 5 Weekly Report that positive sentiment about a deal would boost the relative performance of Chinese stocks over the coming few months, and recommended a tactical overweight stance at that time.3 A cyclical (i.e. 6-12 month) overweight, however, is a different story. Sentiment alone rarely drives financial markets over a 1-year time horizon, meaning that investors need to have some degree of confidence that domestic demand will meaningfully improve over the next 12 months to justify a cyclical upgrade. Certainly, we acknowledge that there have been several positive developments pointing to such an outcome. Chinese monetary conditions have become extremely easy, credit is no longer contracting and surged in January, the Caixin PMI rose notably in February, and some form of a trade deal remains the most likely outcome of the ongoing talks. In addition, Chinese stocks still remain significantly below their 2018 peak (Chart 4), meaning that there is still material potential upside if Chinese earnings do not contract. Chart 4Chinese Stocks Still Have Room To Rise If The Earnings Outlook Stabilizes A moderate credit expansion appears to be underway, but coincident activity continues to weaken and earnings appear to have more downside. However, there are also several reasons to be cautious cyclically: Chart 5The Past Three Months Imply A Moderate Credit Uptrend Chart 6Chinese Coincident Economic Activity Continues To Weaken Chinese and U.S. policymakers have not only failed to set a date for an agreement to be signed by President’s Xi and Trump, but recent new reports suggest that momentum may be slowing and that a meeting may be postponed until June or later.4 Even if the deal does not fall through, material further delays could cause investors to get anxious and vote with their feet. Such a selloff could be violent, given the extremely sharp rise in domestic stock prices over the past six weeks. The evidence so far points to a moderate expansion in credit (Chart 5), reflecting the fact that policymakers are still somewhat concerned about financial stability and the need to prevent significant further leveraging of the private sector. This means that the odds are not yet in favor of a credit “overshoot” like what occurred in 2015/2016, implying that the pickup in growth is likely to be comparatively weaker this time around. Since 2010, monetary conditions and money & credit growth appear to be the best predictors of investment-relevant Chinese economic activity.5 While a moderate credit expansion appears to be underway, there has been no discernable pickup in money growth.6 This discrepancy likely means that the recent improvement in credit has occurred due to non-bank financial institutions, further suggesting that this economic recovery will probably be less powerful and less broad-based than during past cycles. While a moderate expansion in credit does suggest that China’s economy will bottom at some point in the coming months, coincident economic activity continues to decelerate (Chart 6). A continuation of this trend, particularly if coupled with an investor “crisis of faith” in the trade talks, could lead to a very significant retracement in Chinese equity prices before durably bottoming for the year. Trailing EPS growth is decelerating, but it has yet to contract on a year-over-year basis as would be implied by the net earnings revisions ratio (Chart 7) and the coincident activity indicators shown in Chart 6. Chinese investable EPS fell 30% during the 2015/2016 episode (20% for domestic stocks), implying meaningful further downside even if economic activity does not weaken as significantly over the coming months. Chart 7Net Earnings Revisions Point To More Downside For Earnings Chart 8 presents a helpful way for investors to make a net assessment of all of the factors highlighted above. The chart shows our earnings recession model for the MSCI China Index, and shows what is likely to occur if a trade deal causes a full recovery in Chinese exporter sentiment, China’s export-weighted RMB stays roughly at current levels, and the very recent pace of credit growth (Dec-Feb) continues along its trend. Chart 8A Trade Deal And A Moderate Credit Expansion Will Likely Stabilize The Earnings Outlook This scenario, were it to occur, would reduce the odds of a continued earnings contraction to the point that we would be comfortable recommending an overweight stance towards Chinese versus global stocks over the coming 6-12 months. While such a recommendation could come as soon as mid-April, the bottom line for investors is that it is still too early for us to confidently project this outcome. Should Chinese Stocks Be Priced At A Premium Or A Discount To Global Stocks? Most investors attribute the discount applied to Chinese stocks to a high equity risk premium (ERP), but our work paints a different picture. Besides questions about the appropriate cyclical allocation to Chinese stocks, the recent spike in interest among global investors towards A-shares has also led to a renewed focus about the degree to which Chinese stocks are cheap versus the global average. In a world where many financial assets are chronically expensive and Chinese policymakers appear to be responding to weaker economic activity, some investors question whether Chinese stocks deserve to be priced at a discount (Chart 9). Our sense is that most investors attribute the discount to a high equity risk premium (ERP) stemming from the enormous rise in Chinese non-financial corporate debt over the past decade, but our research paints a different picture. Chart 9The Chinese Equity Discount: A High ERP, Or Something More Sinister? One way of analyzing the risk premium of an equity market is to use the well-known constant Gordon growth model. Equation 1 below presents the theoretically justified 12-month trailing P/E ratio as a function of the payout ratio, the risk-free rate, the ERP, and the long-term dividend growth rate (which is equal to the long-term earnings growth rate given a constant payout ratio). Equations 2 and 3 re-arrange equation 1 to express the ERP and long-term growth rate, respectively, on the left-hand side of the equation. Equation 1: P0/E0 = (D1/E0)/(rf + ERP – g) Equation 2: ERP = [(D1/E0)/(P0/E0)] + g - rf Equation 3: g = rf + ERP-[(D1/E0)/(P0/E0)] To illustrate the approach, Chart 10 applies equation 2 to the U.S. equity market and compares it with the annual dividend discount model equity risk premium published by Professor Aswath Damodaran from New York University’s Stern School of Business,7 a well-known expert in the theory and practice of asset valuation. While there are some differences in the level of the series owing to slightly different methodologies, the overall profile of the two series is generally similar. Chart 10Our DDM Methodology For The U.S. Generates Results Similar To Other Important Estimates Proxying the market’s long-term growth expectations in a large, mature economy such as the U.S. is materially easier than is the case in an emerging market such as China. As such, instead of solving for the equity risk premium directly when judging whether China’s discount is “deserved”, we use equation 3 to solve for the implied long-term growth rate given an assumed (and very conservative) ERP range of 2-3%, using the global P/E ratio. In other words, we ask the following question: what kind of earnings growth do Chinese stocks need to achieve over the long run in order to justify the same earnings multiple as the global average, given an equity risk premium of 2-3%? Chart 11 presents the answer to this question, for both the domestic and the investable market. We use domestic 10-year bond yields as the risk-free rate in the case of the A-share market, and U.S. 10-year bond yields in the case of the MSCI China index as a proxy for the global risk-free rate. Finally, in each panel, the dashed horizontal lines denote the actual compound annual growth rate in earnings per share for each market, since the year noted next to each line. Chart 11A Low But Still Difficult L/T Earnings Hurdle Rate To Be Priced In Line With Global Stocks Two important points are apparent from the chart: The required growth rate for both markets to be priced in line with global stocks are quite low, well below Chinese nominal GDP growth. At first blush, this might suggest that the valuation discount applied to China reflects a sizeable equity risk premium that could shrink over the coming 6-12 months (i.e. a beneficial re-rating of Chinese stocks). Since 2010 or 2011, actual growth rates in EPS are materially above the required growth range in both markets. However, over more recent time horizons, particularly 2013 and later, actual earnings growth has not only been below the range but has also been extremely poor in absolute terms. This is particularly true for the investable market, which has actually recorded negative growth in 12-month trailing EPS since 2014 or 2015. A dividend discount model approach suggests that the Chinese equity market discount is justified, barring a major structural improvement in earnings growth. Chart 12 highlights the problem with China’s stock market in a nutshell. For both the investable and domestic equity markets, the dividend payout ratio is well below the global average. This is a normal circumstance for small companies with high growth potential; firms re-invest a high portion of their earnings back into the company in order to build out their asset base and deliver even higher earnings in the future. Chart 12The Chinese Discount Visualized: A Low Payout Ratio, And Mediocre Earnings Growth But panel 2 of Chart 12 shows that relative earnings for Chinese stocks versus the global average have not trended higher over the past decade, meaning that a higher earnings retention ratio among Chinese stocks has not led to a superior earnings profile. In response, global investors have rightly discounted Chinese stocks versus their global peers, a circumstance that is likely to continue unless Chinese earnings growth materially and sustainably improves. Our analysis implies that there is a natural limit to how far Chinese equities can ultimately be re-rated barring a major structural improvement in the economy, a factor that we may eventually have to contend with were we to recommend a cyclical overweight stance. Capped re-rating potential is unlikely to prevent Chinese stocks from trending higher in relative terms if economic fundamentals warrant an uptrend, but it may suggest that the duration or magnitude of the rise may be shorter than many investors hope. A Sino-U.S. Trade Deal: A Natural Currency Experiment In The Making? What explains the link between CNY-USD and the interest rate differential between the two countries? Finally, a brief note on the RMB. Since June 2018, changes in CNY-USD appear to have been closely aligned with the magnitude of proposed tariffs as a share of Chinese exports to the U.S., as would be implied in a simple open economy model with flexible exchange rates. Chart 13shows the levels implied by this framework in a variety of tariff scenarios, calculated based on the percent decline from the peak in the exchange rate in 1H 2018. As noted in our March 13 Weekly Report,8 CNY-USD today is consistent with the current tariff regime, implying potential upside if a trade deal with the U.S. rolls back some of the tariffs that have been imposed. Chart 13A Simple Equilibrium Framework Suggests CNY-USD May Rise Materially Further If Tariffs Are Rolled Back However, Chart 14 shows that CNY-USD has been closely correlated with the interest rate differential between the two countries for several years, with the relationship having recently become a leading one. Chart 14 highlights that CNY-USD has moved higher than the rate differential would imply (painting the opposite picture as that shown in Chart 13), suggesting that the currency is more likely to depreciate than appreciate over the coming 6-12 months barring tighter monetary policy in China or outright rate cuts in the U.S. Chart 14Will Policymakers Or Rate Differentials Drive CNY-USD Over The Coming Year? The relationship shown in Chart 14 is surprising, and we have struggled to understand the exact dynamics at play. As we highlighted in a September report,9 many global investors take the relationship for granted, given the strong historical link between interest rate differentials and exchange rates in developed countries. However, a major problem that arises in explaining Chart 14 is the fact that uncovered interest rate arbitrage (or the “carry trade”) cannot easily occur or cannot occur at all when one or both countries involved maintains capital controls. It is an important conundrum, and one that we have not been able to solve. From our perspective, there are only two scenarios that explain the close relationship between the exchange rate and interest rate differentials between the two countries: The relationship is causal, implying that capital flows in and out of the country are sufficiently large to enable a carry trade. The two series are correlated because of a third factor related in some way to the other two. In our view, scenario 1 is not likely. Capital is flowing out of China, but at a much slower rate than before,10 and the relationship shown in Chart 14 did not break down following China’s capital crackdown in 2015/2016. Ruling out scenario 1 necessarily implies that scenario 2 is correct. Our best guess concerning the missing third factor is that Chinese policymakers are looking to the rate differential as a guide to set the exchange rate, in order to mimic a market-based exchange rate in support of China’s goals to progressively liberalize (and internationalize) the currency. If true, this implies that China has full control of their exchange rate regardless of the prevailing interest rate differential, but that they are often choosing to follow what the differential implies. This is significant, because if Chinese and U.S. negotiators do agree to a “yuan stability pact” as has been reported in the press, a trade deal may set up an important natural experiment for the currency. In our view, a major upward move in the rate differential is unlikely over the coming year, implying that CNY-USD will persistently deviate from the relationship shown in Chart 14 if President Trump is not inclined to tolerate any real weakness in the RMB over the coming year. While the details of the currency agreement and the trade agreement more generally could allow for some decline in CNY-USD if coupled with an offsetting benefit for the U.S. (such as materially higher U.S. exports to China for some period), our bias is to believe that President Trump does not want to see a stronger dollar over the coming year in the lead-up to the 2020 election. If true, investors should pay close attention to the behavior of CNY-USD, as it is stands to be a revelatory event for China’s exchange rate regime.   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com   1 Please see U.S. Bond Strategy and Global Fixed Income Strategy Weekly Reports “The New Battleground For Monetary Policy” and “Forward Guidance On Steroids”, dated March 26, 2019, for a detailed update on our view for Fed rate hikes and how investors should interpret the recent inversion in the yield curve. 2 Please see China Investment Strategy Weekly Report, “Dealing With A (Largely) False Narrative”, dated February 27, 2019, available at cis.bcaresearch.com 3 Please see China Investment Strategy Weekly Report, “2019 Key Views: Four Themes For China In The Coming Year”, dated December 5, 2018, available at cis.bcaresearch.com 4 Please see “Some U.S. Officials Said To See China Walking Back Trade Pledges”, Bloomberg News, dated March 19, 2019, and “Donald Trump-Xi Jinping meeting to end US-China trade war may be pushed back to June, sources say”, South China Morning Post. 5 Please see China Investment Strategy Special Report, “The Data Lab: Testing The Predictability Of China’s Business Cycle”, dated November 30, 2017, available at cis.bcaresearch.com 6 Please see Emerging Markets Strategy Weekly Report, “EM: A Sustainable Rally Or A False Start?”, dated March 7, 2019, available at ems.bcaresearch.com 7 Please see Professor Damodoran’s website for more information on his estimates of the equity risk premium. 8 Please see China Investment Strategy Weekly Report, “China Macro And Market Review”, dated March 13, 2019, available at cis.bcaresearch.com 9 Please see China Investment Strategy Weekly Report, “Moderate Releveraging And Currency Stability: An Impossible Dream?”, dated September 5, 2018, available at cis.bcaresearch.com 10 Please see China Investment Strategy Special Report, “Monitoring Chinese Capital Outflows”, dated March 20, 2019, available at cis.bcaresearch.com   Cyclical Investment Stance Equity Sector Recommendations

特別レポート

Highlights This report presents our framework for estimating Chinese capital outflows on a monthly basis, which investors can use as a real-time indicator to monitor the risk of another serious episode of capital flight. We also provide a monthly estimate of illicit capital outflow, which we find is negatively correlated with “on balance sheet” capital flows. This implies that Chinese residents alternate their use of the two channels in their attempt to move money out of the country. Our monitoring framework suggests that outflow pressure is more likely to ease than intensify if a trade deal is struck over the coming few weeks or months, especially given the rise in CNY-USD since early-November. However, we have identified a low-odds but high-impact scenario in which a shaky trade deal with the U.S. generates an unstable equilibrium that could ultimately escalate into a major Chinese capital outflow event. This could prove to be a highly destabilizing event for investors, and thus bears close monitoring. Feature Fears of a new round of capital outflow from China re-emerged in the second half of 2018 as USD-CNY approached 7, a psychologically important level for many investors (Chart 1). The last episode of significant capital outflows from China occurred in late-2015 following the PBOC’s devaluation of the RMB, and the sharp spike in volatility that resulted had a contagious effect for global financial markets. Chart 1A Near Miss Late Last Year In the very near term, the risk of a similar event appears to be low given the material trade talk-driven decline in USD-CNY that has occurred over the past five months. However, several news reports over the past year concerning the possible risk of another episode of capital flight underscore that China’s cross-border capital flow statistics are misunderstood by financial market participants. This raises the risk that investors either fail to anticipate a capital outflow event in the future or exaggerate the odds of one occurring. In this report we present our framework for estimating Chinese capital outflows on a monthly basis, which investors can use as a real-time indicator to monitor the risk of another serious episode of capital flight. We also adjust the typical measure of short-term capital flow derived from the quarterly balance of payments to account for cross-border RMB settlement, and present an estimate of illicit capital outflow that suggests Chinese residents alternate their use of legal and illegal channels in their attempt to move money out of the country. We then combine these three direct measures of capital flow with two indicators of expected RMB depreciation to further augment our monitoring efforts. We conclude by noting that while outflow pressure is more likely to ease than intensify if a trade deal is struck over the coming few weeks or months, we have identified a low-odds but high-impact scenario in which a shaky trade deal with the U.S. generates an unstable equilibrium that could ultimately escalate into a major Chinese capital outflow event. This scenario is not part of our base case outlook, but could prove to be a highly destabilizing event for investors and thus bears close monitoring. Defining Short-Term Capital Flow From The Balance Of Payments Table 1 presents China’s balance of payments (BOP) for the four quarters ending in Q3 2018, with all items shown on a net basis. The table is organized in a way that provides a helpful refresher on the formulation of the balance of payments, namely that the current account (“CA”, made up of the trade balance and primary & secondary income) plus the sum of the capital account (“KA”), the financial account (“FA”), and a balancing item (referred to as net errors & omissions, “NEO”) is equal to 0, when capital and financial outflows are recorded with a minus sign. Current account surpluses necessarily involve net financial outflows (i.e., investment); whereas current account deficits must be funded by financial inflows (i.e., borrowing). Table 1 highlights that what financial market participants typically refer to as “capital” flows are actually recorded in the financial account of the balance of payments. While derivatives are included in the table for the sake of completion, in practice they are usually quite small (as is the case for the actual “capital” account). Table 1China’s Balance Of Payments The bottom panel of Table 1 indicates that the balance of payments formula can be rearranged so that it represents how many market participants tend to define total and short-term capital outflows from a balance of payments perspective. As we will show in the next section of the report, this re-arrangement of the balance of payments formula is an essential element in building a more frequent proxy of short-term capital flow. We define short-term capital flow from the balance of payments as the combination of portfolio investment, other investment, and net errors & omissions. The bottom panel shows that by adding reserve assets (“RA”) to the current account (“CA”), the right hand side of the BOP equation becomes the sum of direct investment (“DI”), portfolio investment (“PI”), other investment “OI”, and net errors & omissions (“NEO”). Since direct investment tends not to be driven by short-term economic behavior and is normally not influenced by foreign exchange expectations or fluctuations, the formula can be further arranged to isolate short-term capital outflows on the right-hand side: Current Account + Changes in Reserve Assets + Direct Investment ≈ (Portfolio Investment + Other Investment + Net Errors & Omissions)*-1 Or using our line item notation, CA + RA + DI ≈ -PI - OI - NEO The formula above is expressed as an approximation rather than an identity simply because it excludes the capital account (“KA”) and financial derivatives (“FD”). As can be seen in Table 1, the net value of adding the four quarter rolling total of CA + RA + DI to PI + OI + NEO is US$ 3.3 billion; adding KA + FD (-0.35 and -2.95 billion US$, respectively) would result in a value of 0. Chart 2 shows this relationship visually; and highlights that both series are nearly identical. Chart 2Short-Term Capital Flow As Defined By The BOP Building A Better Proxy Of Short-Term Capital Flow The balance of payments approach is a useful starting point for measuring short-term capital flow, but it has two important drawbacks: Timeliness: Balance of payments data are reported in quarterly frequency, and often with a lag. This is inadequate for most investors, particularly when market participants are concerned that a crisis or crisis-like conditions may be emerging. This is the primary disadvantage of the BOP approach. Failure to account for cross-border RMB settlement: The balance of payments approach implicitly assumes that a current account surplus in China will automatically result in the importation of foreign exchange, but this assumption is no longer fully valid. Cross-border RMB settlement now accounts for part of China’s foreign trade settlement, reaching more than 30% during the 2015/2016 period. Compared with its peak level, RMB settlement as a share of total foreign trade has fallen over the past two years, but still accounts for 19% today (Chart 3). To more precisely gauge China’s capital outflows, cross-border RMB settlement should be removed from the current account surplus, because trade payments settled in RMB would not involve the receipt of foreign currency. This offsetting current account discrepancy would still show up in the balance of payments under net errors & omissions, but that would have the effect of distorting our definition of short-term capital flow. Chart 3Analysts Need To Adjust The Current Account For Cross-Border RMB Settlement Chart 4 illustrates the difference between our quarterly definition of short-term capital flow and the series adjusted for cross-border RMB settlement. The chart shows that the two series are quite similar for most of the past decade, with the notable exception of the 2015/2016 period. The adjusted series suggests that the intensity of China’s episode of capital flight did not peak in 2015, but rather late in 2016. This is consistent with domestic commentary at the time,1 and implies that the PBOC faced headwinds in their attempt to stem capital outflows that were even worse than has been generally acknowledged. Chart 4After Adjusting For Cross-Border Settlement, Outflow Intensity Only Peaked In Late-2016 Unfortunately for investors, dealing with the lack of timeliness in the release of China’s balance of payments statistics is a more challenging endeavor. This problem cannot be resolved with simple adjustments to the quarterly data, and instead requires the building of a proxy for short-term capital flow based on the BOP equation but using monthly statistics. Investors can proxy our adjusted quarterly balance of payments-based measure of short-term capital flow on a monthly basis. As we referenced above, the key to constructing a monthly capital flow estimate lies with the re-arrangement of the balance of payments equation such that short-term capital flow is expressed as being approximately equal to the sum of the current account, direct investment, and the change in reserve assets (when outflows of the latter two series are recorded as negative values). Table 2 highlights that high quality monthly series are available to act as proxies for these three balance of payments components, after accounting for cross-border RMB settlement and the following two additional adjustments: Table 2Components Of BCA’s Monthly China Capital Outflow Indicator Services Balance: The trade balance accounts for the vast majority of the current account of most countries, and this is also true in the case of China. An underappreciated fact about China’s trade balance is that it has shrunk considerably over the past several years, due to what is now a sizeable services deficit. Some market commentators who are aware of the services deficit point to it as evidence that China’s net importation of services is laying the groundwork for its “new economy” (via eventual import substitution), but the reality is that travel (i.e. net tourism spending) accounts for over 80% of it (Chart 5). For the purposes of our monthly capital flow proxy, a sizeable services deficit is a complication that must be accounted for, given that China’s monthly trade statistics (and most monthly trade data globally) represent the trade in goods, not the trade in services. Since most of the fluctuations in the trade balance occur due to net trade in goods, we include the history of the quarterly services balance in our monthly indicator as a structural variable, and extend the most recent quarterly value into the current quarter as a simplifying assumption. Currency Valuation Effect on Official Reserves: Foreign exchange reserves in the balance of payments are calculated by the historical cost method, whereas the highly followed monthly official foreign exchange reserve data released by the PBOC is measured using market value. Changes in its balance, in addition to genuine changes in foreign exchange reserve assets, also reflect revaluation effects caused by fluctuations in the foreign exchange market. To dampen these effects, we include foreign exchange reserves in our monthly capital flow proxy in SDR terms rather than in U.S. dollars, rebased to the value of the underlying U.S. dollar series as of December 2018. Chart 5Travel (i.e. Tourism) Accounts For The Majority Of China's Services Deficit Chart 6 presents our quarterly balance of payments-based capital flow measure (adjusted for cross-border capital flow) with our monthly proxy, based on the series shown in Table 2 and the adjustments noted above. Divergences between the series exist in level terms, but panel 2 shows that our monthly proxy does a good job capturing the trend in the quarterly series. The only major exception to this occurred at the beginning of 2016, when our monthly proxy fell sharply relative to the adjusted quarterly BOP version. Chart 6Our Monthly Proxy Captures The Trend In Quarterly Capital Flows This sharp decline is a bit of a mystery; it can be traced to the official reserves series, and either suggests that capital outflow was materially worse in Q4 2015 and Q1 2016 than officially recognized, or that China suffered outsized losses from the risky asset portion of its reserve portfolio during that period. However, the first explanation is at odds with the evidence noted earlier that the intensity of capital flight seems to have peaked in late-2016, and the second explanation is inconsistent with the history of financial market returns over the past decade. We noted in a February 2018 Special Report that risky U.S. assets (almost entirely stocks) accounted for as much as 9.5% of China’s foreign reserve assets in the summer of 2015,2 and it is true that U.S. equity returns were quite negative from December 2015 to February 2016. But this was certainly not the first and only period of extreme U.S. equity market volatility to occur since 2010, raising the question of why this sharp decline in official reserves only occurred in 2015/2016. Future research on the topic of Chinese capital flows will aim to reconcile the difference between our monthly proxy and our adjusted quarterly balance of payments series during this period, but for now we are confident that the former contributes meaningfully to our understanding of the latter, particularly on a rate of change basis. Import Over-Invoicing: A Third Measure Of Short-Term Capital Outflow Investors need to track both legal and illicit capital flows. Our first two measures of short-term capital flow were based on an attempt to track the legally allowable movement of funds out of China. However, illicit capital outflow is an acknowledged problem in China, which tends to occur through the practice of import over-invoicing.3 Chart 7 presents our estimate of import over-invoicing for China, based on a methodology articulated by Global Financial Integrity, a U.S. non-profit organization that provides analysis of illicit financial flows globally (see Appendix A). The chart highlights two important points: Chart 7Illicit Capital Outflows: Another Way That Money Leaves China Illicit outflows have increased significantly over the past 2 years following China’s capital control crackdown, particularly in Q3 2018 following the announcement of the second round of U.S. import tariffs against China. Panel 2 of Chart 7 illustrates that there is a negative correlation between “on balance sheet” capital flows and illicit capital outflows, implying that Chinese residents alternate their use of the two channels in their attempt to move money out of the country. This underscores the importance of monitoring both channels on an ongoing basis. Investment Conclusions Table 3 brings together the three measures of short-term capital flow that we have laid out above, as well as two indicators of expected RMB depreciation (Chart 8): net settlement of foreign exchange by Chinese banks (see Appendix B), and the 3-month moving average of the percent deviation of CNH-USD (offshore RMB) from CNY-USD (onshore RMB). Altogether, the series shown in Table 3 form the basis of our capital outflow monitoring efforts, and we plan on updating these series regularly to gauge whether outflow pressure is increasing. Table 3Dashboard For Monitoring Short-Term Capital Flows Chart 8Two Indicators Capturing Expectations Of Severe RMB Depreciation For now, only our measure of illicit capital outflow is flashing a warning sign, and the timing of the recent spike in the measure appears to be closely connected with the trade war with the U.S. This implies that outflow pressure is more likely to ease if a trade deal is struck over the coming few weeks, as we expect will occur. However, we noted in a March 6 joint Special Report with our Geopolitical Strategy service that a deal with only slight concessions from China may stand on shaky ground and that tariff rollbacks will be limited or non-existent.4 This would ensure elevated policy uncertainty in the aftermath of the agreement and would raise the probability of a relapse into another trade war ahead of the 2020 U.S. election. In this scenario we would be watching the indicators shown in Table 3 closely for signs that increasing pessimism about the long-term state of sino-U.S. relations is causing the capital outflow “dam” built by policymakers following the 2015/2016 episode to buckle. Our monitoring framework suggests that the odds of a major capital flight event are currently low. But a shaky trade deal with the U.S. could change that. It is not part of our base case outlook, but onshore concerns of a renewed trade war with the U.S. next year could theoretically become self-fulfilling, if another major episode of capital flight were to weaken the RMB in a way that could even remotely be construed as a violation of the yuan stability pact that will reportedly be part of any agreement between the U.S. and China. While this would in no way entail a purposeful devaluation by Chinese policymakers to boost trade competitiveness, it could nonetheless provide an excellent excuse for President Trump to reinstate damaging economic pressure on China in the midst of what is likely to be a highly competitive re-election campaign. This could, in turn, produce a feedback effect that magnifies the original desire to move capital out of China, and would likely prove to be a highly destabilizing event for global financial markets. Stay tuned!   Qingyun Xu, CFA, Senior Analyst qingyunx@bcaresearch.com Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com     Appendix A Measuring Import Over-Invoicing In this report we use one of the two methodologies employed by Global Financial Integrity to measure import over-invoicing in China, which compares a country’s reported trade statistics with that of its global trade partners.5 Using the IMF’s Direction of Trade Statistics data, we deflate Chinese import data measured on a C.I.F. (cost insurance and freight) basis to an F.O.B. (free on board) basis using an assumed freight and insurance factor of 10%. Then, we use Hong Kong re-export data to adjust global exports to China for re-exported trade through Hong Kong. The formula is listed below: Chinese Import Over-invoicing = [(Chinese Imports From The World)/1.1] - Adjusted Global Exports To China   Appendix B The Onshore Market For Foreign Exchange A poorly understood fact about China’s capital/financial account regime is that a material amount of foreign exchange reserves are now held by enterprises and individuals. Most investors are familiar with China’s old foreign exchange settlement policy (established formally in 1993), which prohibited enterprises from retaining foreign currency. Exporters receiving foreign currency as payment for goods and services had to sell all foreign exchange receipts to designed banks, and purchase foreign exchange from these banks when needed to make payments to offshore suppliers. Thus, while this policy was in effect, the PBOC held all China’s foreign exchange reserves and official reserves equaled total reserves. However, since the early-2000s, this policy has been gradually withdrawn. Since its complete abolishment in 2012, foreign exchange retained by enterprises and residents has increased materially. Chart B1 shows the impact of these changes on the bank foreign exchange settlement and sale rates. The settlement rate represents enterprises’ sale of foreign exchange to banks as a share of their total foreign exchange receipts in a given month, while the sale rate represents banks’ sale of foreign exchange to enterprises as a share of enterprises’ total foreign exchange payments. The chart shows that the settlement rate has dramatically dropped since 2012 (from 70% to less than 50%). We can also see there were spikes in the settlement rate and sale rate in August 2015 (in contrary directions) when the PBOC devalued the RMB, implying that the demand for forex and presumably the expectation of further RMB depreciation was severe. Chart B1The Evolution Of China’s Domestic Foreign Exchange Market​​​​​​​   Given this, we view net FX settlement (enterprises’ sale of foreign exchange to banks minus banks’ sale of foreign exchange to enterprises) as a reasonable proxy of expected RMB depreciation, and have included it as part of our capital flow monitoring framework.         1 “China’s capital outflow is still intensifying”, Reuters China Finance and Economics Column, December 19, 2016. 2 Please see China Investment Strategy Special Report, “Demystifying China’s Foreign Assets”, dated February 28, 2018, available at cis.bcaresearch.com. 3 Import over-invoicing occurs when an importer (in country A) attempts to evade capital controls by colluding with an exporting entity (in country B) to falsify the reported value of goods imported into country A from country B. The importer “overpays” for the goods in question and, usually through an intermediary, moves the surplus funds into the importer’s offshore account. Please see https://www.gfintegrity.org/issue/trade-misinvoicing/ for more information about the mechanics of and motivations behind trade misinvoicing. 4 Please see Geopolitical Strategy and China Investment Strategy Special Report, “China-U.S. Trade: A Structural Deal?”, dated March 6, 2019, available at cis.bcaresearch.com. 5 “Illicit Financial Flows to and from 148 Developing Countries: 2006-2015”, Global Financial Integrity, January 2019. Cyclical Investment Stance Equity Sector Recommendations

Highlights Global equities will remain rangebound for the next month or so, but should move decisively higher as economic green shoots emerge in the spring. A revival in global growth will cause the recent rally in the U.S. dollar to stall out and reverse direction, setting the stage for a period of dollar weakness that could last until the second half of next year. Rising inflation will force the Fed to turn considerably more hawkish in late-2020 or early-2021. This will cause the dollar to surge once more. The combination of a stronger dollar and higher interest rates will trigger a recession in the U.S. in 2021, which will spread to the rest of the world. Investors should maintain a bullish stance towards global equities for the next 12 months, but look to reduce exposure at some point next year. Feature Stocks Temporarily Stuck In The Choppy Trading Range We argued at the end of February that global equities and other risk assets would likely enter a choppy trading range in March as investors nervously awaited the economic data to improve.1 Recent market action has been consistent with this thesis, with the MSCI All-Country World Index falling nearly 3% at the start of the month, only to recoup its losses over the past few days. We expect stocks to remain in a holding pattern over the coming weeks, as investors look for more evidence that global growth is bottoming out. The U.S. dollar is a countercyclical currency, meaning that it moves in the opposite direction of global growth (Chart 1). This countercyclicality stems from the fact that the U.S. economy is more geared towards services than manufacturing compared with the rest of the world. This makes the U.S. a low-beta play on global growth (Chart 2). As such, when global growth accelerates, capital tends to flow from the U.S. to the rest of the world, translating into more demand for foreign currency and less demand for dollars. Chart 1The Dollar Is A Countercyclical Currency Chart 2The U.S. Is A Low-Beta Play On Global Growth Given the dollar’s countercyclical nature, it is not surprising that the slowdown in global growth over the past 12 months has given the greenback a lift. The broad trade-weighted dollar has strengthened by almost 8% since February 2018, putting it near the top of its post 2015-range (Chart 3). Chart 3The Dollar Has Gotten A Lift From Global Growth Disappointments Stocks Will Rally And The Dollar Will Weaken Starting In The Spring We expect the U.S. dollar to strengthen over the coming weeks as global economic data continues to underwhelm. However, an improvement in leading economic indicators in the spring will set the stage for a reacceleration in global growth and a decline in the dollar in the second half of this year. The combination of stronger growth and a weaker dollar later this year should be highly supportive of global equities. Equity investors with a 12-month horizon should overlook any near-term weakness and maintain a bullish bias towards stocks. We do not have a strong view on U.S. versus international equities at the moment, but expect to upgrade the latter once we see more confirmatory evidence that global growth is bottoming out. Equity investors with a 12-month horizon should overlook any near-term weakness and maintain a bullish bias towards stocks.   A Stronger China Will Lead To A Weaker Dollar Our expectation that the dollar will weaken in the second half of this year hinges on what happens to China. The deceleration in global growth in 2018 was largely the consequence of China’s deleveraging campaign. China’s slowdown led to a falloff in capital spending throughout the world. Weaker Chinese growth also put downward pressure on the yuan, pulling other EM currencies lower with it (Chart 4). All this occurred alongside an escalation in trade tensions, further dampening business sentiment. Chart 4EM Currencies Are Off Their Early 2018 Highs While it is too early to signal the all-clear on the trade front, the news of late has been encouraging. A recent Bloomberg story described how Trump watched approvingly as Asian stocks rose and U.S. futures rallied following his decision to delay the scheduled increase in tariffs on Chinese goods.2 As a self-professed master negotiator, Trump needs to secure a deal with China before next year‘s presidential election, while also convincing American voters that the deal was concluded on favorable terms for the United States. Reaching a deal with China early on in his term would have been risky if the agreement had failed to bring down the bilateral trade deficit — an entirely likely outcome given how pro-cyclical U.S. fiscal policy currently is.  At this point, however, Trump can crow about making a great deal with China while reassuring voters that the product of his brilliance will be realized after he has been re-elected. This means that we are entering a window over the next 12 months where Trump will want to strike a deal. For their part, the Chinese want as much negotiating leverage with the Trump administration as they can muster. This means being able to convincingly demonstrate that their economy is strong enough to handle the repercussions from turning down a trade deal that fails to serve their interests. Since the credit cycle is the dominant driver of Chinese growth, this requires putting the deleveraging campaign on the backburner. Admittedly, credit growth surprised on the downside in February. However, this followed January’s strong showing. Averaging out the two months, credit growth appears to be stabilizing on a year-over-year basis. Conceptually, it is the change in credit growth that correlates with GDP growth.3 Thus, merely going from last year’s pattern of falling credit growth to stable credit growth would still imply a positive credit impulse and hence, an uptick in GDP growth. In practice, we suspect that the Chinese authorities will prefer that credit growth not only stabilize but increase modestly. In the past, this outcome has transpired whenever credit growth has fallen towards nominal GDP growth (Chart 5). The prospect of a rebound in credit growth in March was hinted at by the PBOC, which spun the weak February data as being caused by “seasonal factors.” Chart 5Historically, China Has Scaled Back On Deleveraging When Credit Growth Has Fallen Close To Nominal GDP Growth Europe: Down But Not Out Stronger growth in China will help European exporters. Euro area domestic demand will also benefit from a rebound in German automobile production, the winding down of the “yellow vest” protests in France, and incrementally easier fiscal policy. In addition, the ECB’s new TLTRO facility should support credit formation, particularly in Italy where the banks remain heavily reliant on ECB funding. Our expectation that the dollar will weaken in the second half of this year hinges on what happens to China. Euro area financial conditions have eased significantly over the past three months, which bodes well for growth in the remainder of the year. It is encouraging that the composite euro area PMI has rebounded to a three-month high. The expectations component of the euro area confidence index has also moved up relative to the current situation component, which suggests further upside for the PMI in the coming months (Chart 6). Chart 6Easing Financial Conditions Bode Well For Euro Area Growth The selloff in EUR/USD since last March has been largely driven by a decline in euro area interest rate expectations (Chart 7). If euro area growth accelerates in the back half of the year, the market will probably price back in a few rate hikes in 2020 and beyond. Chart 7EUR/USD Sell-Off Has Been Driven By Falling European Rate Expectations What Will The Fed Do? Of course, the degree to which a steeper Eonia curve benefits EUR/USD will depend on what the Fed does. The 24-month discounter has fallen from over +100 bps in March 2018 to -25 bps today, implying that investors now believe that U.S. short rates will fall over the next two years (Chart 8). Chart 8The Fed's Dovish Messaging Has Worked... Almost Too Well We expect the Fed to raise rates more than what is currently priced into the curve, thus justifying a short duration position in fixed-income portfolios. However, the Fed’s newfound “baby step” philosophy will probably translate into only two hikes over the next 12 months. Such a gradual pace of Fed rate hikes is unlikely to prevent the euro from appreciating against the dollar starting in the middle of this year, especially in the context of a resurgent global economy. We do not expect any major inflationary pressures to emerge in the near term. In contrast to the euro, the yen should depreciate against the dollar in the back half of this year. The yen is a “risk-off” currency and thus tends to weaken whenever global risk assets rally (Chart 9). The government is also about to raise the sales tax again in October, a completely unnecessary step that will only hurt domestic demand and force the Bank of Japan to prolong its yield curve control regime. We would go long EUR/JPY on any break below 123. Chart 9The Yen Is A Risk-Off Currency A Blow-Off Rally In The Dollar Starting In Late-2020 What could really light a fire under the dollar is if the Fed began raising rates aggressively while the global economy was slowing down. In what twisted parallel universe could that happen? The answer is this one, provided that inflation rose to a level that evoked panic at the Fed. We do not expect any major inflationary pressures to emerge in the near term. The growth in unit labor costs leads core inflation by about 12 months (Chart 10). Thanks to a cyclical pickup in productivity growth, unit labor cost inflation has been trending lower since mid-2018. However, as we enter late-2020, if the labor market has tightened further by then, wage growth will likely pull well ahead of productivity growth, causing inflation to accelerate. Chart 10Decelerating Unit Labor Costs Will Dampen Inflationary Pressures For The Time Being All things equal, higher inflation is bearish for a currency because it implies a loss in purchasing power relative to other monies. However, if higher inflation spurs a central bank to hike policy rates by more than inflation has risen – thus implying an increase in real rates – the currency will tend to strengthen. Chart 11 shows the “rational expectations” response of a currency to a scenario where inflation suddenly and unexpectedly rises by one percent relative to partner countries and stays at this higher level for five years while nominal rates rise by two percent. The currency initially appreciates by 5%, but then falls by 2% every year, eventually finishing down 5% from where it started.4 The yen should depreciate against the dollar in the back half of this year. The real world is much messier of course, but we suspect that the dollar will stage a final blow-off rally late next year or in early-2021 (Chart 12). Since the Fed will be hiking rates in a stagflationary environment at that time, global growth will weaken, further boosting the dollar. The resulting tightening in both U.S. and global financial conditions will likely trigger a global recession and a bear market in stocks. Investors should maintain a bullish stance towards global equities for the next 12 months, but look to reduce exposure at some point next year.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1      Please see Global Investment Strategy Weekly Report, “Gretzky’s Doctrine,” dated March 1, 2019. 2      Jennifer Jacobs and Saleha Mohsin, “Trump Pushes China Trade Deal to Boost Markets as 2020 Heats Up,” Bloomberg, March 6, 2019. 3      Recall that GDP is a flow variable (how much production takes place every period), whereas credit is a stock variable (how much debt there is outstanding). By definition, a flow is a change in a stock. Thus, credit growth affects GDP and the change in credit growth affects GDP growth. 4      The 2% annual decline in the currency is necessary for the real interest parity condition to be satisfied. 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Highlights So What? The late-cycle rally still faces non-trivial political hurdles. Why? U.S.-China trade talks, the U.S. threat of tariffs on auto imports, and Brexit continue to pose risks. A shocking revelation from the Mueller report could have a temporary negative impact on equity markets. A bombshell would increase Trump’s chances of removal from office. We give 35% odds to tarrifs on autos and auto parts, and 10% odds to a hard Brexit. Feature In our February 6 report we outlined how a “Witches’ Brew” of geopolitical risks had the potential to short-circuit the late-cycle equity rally. A month later, that brew is still bubbling. President Donald Trump’s approval rating has rebounded but going forward it faces challenges from negative headlines (Chart 1). These include a soaring trade deficit, a large influx of illegal immigrants on the southern border, a weak jobs report for February, a setback in North Korean diplomacy, and an intensification of the scandals plaguing Trump’s inner circle. Chart 1Don't Get Comfortable Just Yet, Mr. President Each of these issues calls into question the effectiveness of Trump’s core policies and the stability of his administration, though in reality they are only potentially problematic. While Special Counsel Robert Mueller’s forthcoming report poses a tail risk, the substantial threat remains Trump’s trade policy.  Indeed, investors face “the persistence of uncertainties related to geopolitical factors” and the “threat of protectionism,” according to European Central Bank President Mario Draghi, who spoke as he rolled out a new round of monetary stimulus for Europe and its ailing banks. What did Draghi have in mind? The obvious culprits are the U.S.-China trade talks, the U.S. threat of tariffs on auto imports, and Brexit. There were other issues – such as “vulnerabilities in emerging markets” – but the first three are the most likely to have turned Draghi’s head. The global economic outlook is likely to improve on the back of Chinese stimulus and policy adjustments by the ECB and Federal Reserve. But growth has not yet stabilized and financial markets face additional volatility due to the fact that none of these “geopolitical factors” is going to be resolved easily. The good news is that Trump, overseeing a precarious economy ahead of an election, has an incentive to play softball rather than hardball.  Mueller’s Smoking Gun? News reports suggest that Mueller will soon issue the final report of his investigation into President Trump’s election campaign links with Russia. There is really only one way in which the Mueller report could be market relevant: it could produce smoking-gun evidence that results in non-trivial impeachment proceedings. Any scandal big enough to remove Trump from office or clearly damage his reelection chances is significant because financial markets would dislike the extreme policy discontinuity (Chart 2). Anything short of this will be a red herring for markets, though admittedly many of our clients disagree. Very little is known about what Mueller will report and how he will interpret his mandate. Mueller’s investigation may or may not make it to the public in full form, at least initially, and he may or may not make any major additional indictments. Congress will strive to get access to the report, which is internal to the Justice Department, while spin-off investigations will proliferate among lower-level federal district attorneys and congressional committees. The legal battle, writ large, will run into the 2020 election and beyond. House Democrats alone can decide whether to bring articles of impeachment against Trump, but the case would be struck down in the Senate if it did not rest on ironclad evidence of wrongdoing that implicated Trump personally. Republican Senators will not jump ship easily – especially not 18 of them. That would require a sea change in grassroots support for Trump. Trump’s approval among Republicans remains the indicator to watch, and it is still strong (Chart 3). If this number crashes in the aftermath of the Mueller report, then Trump could find himself on a Nixonian trajectory, implying higher odds of a Senate conviction (Chart 4). At that point, markets would begin discounting a Democratic sweep in 2020, with business sentiment and risk assets likely to drop at the prospect of higher taxes and increased regulation (Chart 5). Chart 5A 2020 Democratic Sweep Would Dent Business Sentiment After all, if scandals remove Trump from office, then not only is a Democrat likely to win the White House, but any Democrat is likely to win – even a non-centrist like Bernie Sanders or other Democratic candidates like Kamala Harris who have swung hard to the left. Meanwhile, the odds of Democrats taking control of the Senate (while keeping the House) will rise. With Democratic candidates flirting with democratic socialism and proposing a range of left-wing policies, the prospect of full Democratic control of the legislative and executive branches would weigh on financial markets. We doubt that the Mueller report can fall short of a smoking gun while still dealing a fatal blow to Trump. The Democrats control the House, so if the scandal grows to gigantic proportions, they will impeach. Yet if they impeach without an ironclad case, Trump will be acquitted. And if Trump is acquitted, it is hard to see how his chances of reelection would fall. The impeachment of former President Bill Clinton looms large over Democrats, since it ended up boosting his popularity. If Democrats are overzealous to no end, it will help Trump’s campaign. If Trump should then win re-election, he will have veto power and likely a GOP Senate, so his policies will remain in place. The outcome for markets would be policy continuity, though the market-positive aspects of Trump’s first term may not be improved while the market-negative aspects, such as his trade policy and foreign policy, may reboot. Mueller is an all-or-nothing prospect: he either leads us to the equivalent of the Watergate Tapes or not. Lesser crimes are unlikely to have a decisive impact on the election. But volatility is likely to go up as the report comes due, just as it did during the Lewinsky scandal (Chart 6), at least until the dust settles and there is clarity on impeachment. And an equity sell-off at dramatic points in the saga cannot be ruled out, especially if global factors combine with actual impeachment (Chart 7). Chart 6Impeachment Proceedings Likely To Raise Vol... Chart 7… And Potentially Dampen Returns Bottom Line: A specific, shocking revelation from the Mueller report could have a negative impact on equity markets and risk assets, but any such moves would be temporary as long as the growth and earnings backdrop remain positive and Mueller does not drop a bombshell that increases Trump’s chances of removal from office. Separating The Budget From The Border The president faces adverse developments on the southern border after having initiated a controversial national emergency in order to transfer military funds to construct new barriers. The U.S. has seen an abnormally large increase in apprehensions and attempted entries this year (Charts 8A & 8B). Ultimately the influx calls attention to the porous southern border and as such may help to justify Trump’s policy focus. For now it raises the question of why the administration’s tough tactics are failing to deter immigrants. Meanwhile his emergency declaration has divided the Republican Party, with several members likely to join with Democrats in a resolution of disapproval that Trump will veto. Congress will not be able to override the veto, but Trump’s decree also faces challenges in the judicial system. We doubt that the Supreme Court will rule against him but it certainly is possible. The ruling is highly likely to come before the election. Meanwhile Trump is kicking off the FY2020 budget battle with his newest request of $8.6 billion for the border wall and cuts to a range of discretionary non-defense spending. The presidential budget is a fiction – it is based on unrealistic cuts to a range of government programs. Any budget that is passed will bear no relation to the administration’s proposals. Opinion polls referenced above clearly demonstrate that Trump’s approval rating suffered from the recent government shutdown. This does not mean that he will conclude the next budget battle by the initial deadline of October 1 or that a late-2019 shutdown is impossible. He might accept a short shutdown to try to secure defense spending that would arguably legitimize his repurposing of military funds for border construction. But his experience early this year means that the odds of another long-running, bruising shutdown are low. Might Trump refuse to raise the debt ceiling later this year to get his way on the wall? This is even less likely than a shutdown due to the negative impact that a debt ceiling constraint would have on social security recipients and bond markets. Trump also has the most to lose if the 2011 budget caps snap back into place in 2020 due to any failure of the FY2020 negotiations (Chart 9). As such, the debt ceiling – which the Treasury Department can keep at bay until the end of the fiscal year in October – and the 2020 budget may be resolved together this time around. In short, Trump will be forced to punt on congressional funding for the wall later this year and will have to campaign on it again in November 2020, with the slogan “Finish the Wall.” This is a market-positive outcome, as the hurdles to fiscal spending in 2020 are likely to be reduced: Trump will have to concede to some Democratic priorities and abandon his proposed cuts. The Democrats, for their part, are likely to have enough moderates to get the next budget over the line with Republican support. To illustrate, Republicans only need 21 votes for a majority, while no fewer than 26 Democrats were recently chastised by House Speaker Nancy Pelosi for cooperating with Republicans. The implication is that a bipartisan majority can be found. Since Trump cannot get his budget cuts, and does not really even want them, the projected contraction of the budget deficit in 2020 will be reduced or erased (Chart 10). On the margin, this would support higher inflation and bond yields.  The biggest threat to Trump’s reelection is still the risk that the long business cycle will expire by November next year. However, the exceedingly low February payrolls print was misleading – the unemployment rate fell and wage growth was firm (Chart 11). American households are in relatively good shape and that bodes well for Trump, for the time being. Chart 11American Households Are In Good Shape Bottom Line: The economy is relatively well supported and Trump and the Democrats are ultimately likely to cooperate on the budget under the table, reducing the risks of a debt ceiling breach, or an extended government shutdown later this year, or a fall off the 2020 stimulus cliff. The Trade Deficit: Trump’s Pivot To Europe Trade policy is where Trump’s challenges merge with Draghi’s woes. The U.S. trade deficit lurched upwards to a ten-year high of $621 billion in 2018 (Chart 12). The trade deficit is uniquely important to Trump because he campaigned on an unorthodox protectionist agenda in order to reduce it. It will be very difficult for him to evade the consequences if the deficit is higher, as a share of GDP, in November 2020 than it was in January 2017. Chart 12Trade Deficit Jump Is A Blow To Trump The underlying cause of the rising deficit is that a growing American economy at full employment with a relatively strong dollar will suck in larger quantities of imports. This effect is overriding any that Trump’s tariffs have had in discouraging imports. Meanwhile the global slowdown, reinforced by trade retaliation and negative sentiment, are harming U.S. exports (Chart 13). The administration’s policies of fiscal stimulus combined with encouraging private investment are guaranteed to lead to a higher current account deficit, barring an offsetting (and highly unlikely) rise in private saving. The current account deficit must equal the gap between domestic saving and investment and a rising fiscal deficit represents a drop in saving. Chart 13Trade War Hurting U.S. Exports What does the trade deficit imply for the U.S.-China talks? On one hand, the U.S. could put more pressure on China after feeling political heat from the large deficit. On the other hand, China has always offered to reduce the bilateral trade deficit directly through bulk purchases of goods, particularly commodities. It is Trump’s top negotiator, Robert Lighthizer, who has insisted that China make structural changes to reduce trade imbalances on a long-term and sustainable basis.1  In a sign of progress, the U.S. and China have reportedly arrived at a currency agreement. No details are known and therefore it is impossible to say if it would mean a more “market-oriented” renminbi, which could fluctuate and have a variable impact on the trade deficit, or a renminbi that is managed to be stronger against the dollar, which would tend to weigh on the deficit, as Trump might wish. The two negotiating teams are working on the text of five other structural issues that should also mitigate the deficit. Moreover, China’s new foreign investment law, if enforced, could increase American market access by leveling the playing field for foreign firms. However, there is still no monitoring mechanism, the two presidents have not scheduled a final signing summit, and the deterioration in North Korean peace talks also works against any quick conclusion. If Trump concludes a deal, the next question for investors is whether he will impose Section 232 tariffs on auto and auto imports on the EU and other partners (Chart 14). The European Commission’s top trade negotiator, Cecilia Malmstrom, recently met with Lighthizer in Washington to discourage tariffs. She refused to admit agriculture into the negotiations, as per a U.S.-EU joint statement in July 2018, but proposed equalizing tariffs on industrial goods as a way for both sides to make a positive start (Chart 15). She said that the U.S. repealing the Section 232 steel and aluminum tariffs are necessary for any final deal. And she reiterated that any new tariffs (e.g., the proposed Section 232 tariffs on autos and auto parts) would prevent a deal and provoke immediate retaliation on $23 billion worth of American exports. Malmstrom also said that the EU would prefer to work with the U.S. on reforming the World Trade Organization and addressing China’s trade violations. This approach fits with that of Japan, which has joined the U.S. and EU in trilateral discussions toward reforming the global trade architecture in a bid to mitigate U.S. protectionism and constrain China. The problem with the EU’s position is that once the U.S. and China make a trade deal, the U.S. will not have as immediate of a need to form a trade coalition against China (other than in dealing with WTO issues). Moreover, Japan will be forced to accept a deal with the U.S. in short order. A rotation of Trump trade policy to focus on Europe is likely. We give 35% odds to tariffs on autos and auto parts. The USMCA will increase the cost of production in North America while Europe is so far excluding cars from negotiations with the U.S., so there is room for a clash. But any tariffs on autos will be less sweeping than those against China. Trump will play softball rather than hardball for the following reasons: The public is less skeptical of trade with Europe and Japan than with China. The auto sector is heavily concentrated in the Red States and many states that are heavily exposed to trade with the EU are also critical to Trump’s reelection (Map 1). Section 232 tariffs that are required to be enacted by May 18 would have plenty of time to impact the U.S. economy negatively by November 2020. Congress and the defense establishment are against a trade war with U.S. allies, while bipartisanship reigns when it comes to tougher actions toward China. The bilateral trade deficit is less excessive with Europe than with China (see Chart 12 above). The U.S. carmaker and auto parts lobby are unanimously against the tariffs – and in fact has called for the removal of the steel and aluminum tariffs in a stance that echoes that of the EU. The existing steel and aluminum tariffs provide Trump with leverage in the negotiations with the EU and Japan, whereas the U.S. has agreed not to impose new tariffs on these partners while trade negotiations are underway. New tariffs would nix negotiations and ensure that the ensuing quarrels are long and drawn out, with a necessarily worse economic impact. To initiate a new trade war in the wake of the U.S.-China war would be to undercut the positive impact on trade, financial conditions, and sentiment that is supposedly driving Trump’s desire for a China deal in the first place. The U.S. eventually will need to build a trilateral coalition to hold China to account and ensure that it does not slide back into its past mercantilist practices. Even limited or pinprick tariffs will have an adverse impact on equity markets, given that they will hit Europe at a time when its economy is decelerating dangerously and when Brexit uncertainty is already weighing on European assets and sentiment (see next section).  This may be why both the U.K. and Germany have recently softened their positions on Chinese telecom company Huawei, which they have been investigating for national security concerns related to the rollout of 5G networks. They are signaling that they are not going to sacrifice their relationship with China if the U.S. is dealing with China bilaterally while threatening to turn around and slap tariffs on their auto exports. If the U.S. goes ahead with tariffs – on the basis that its China agreement allows it to isolate Europe – the EU will not be a pushover, as exports to the U.S. only amount to 2.6% of GDP (Chart 16). The result of the U.S.-China quarrel has been a deepening EU-China trade relationship and that trend is set to continue (Chart 17), especially if the U.S. continues to use punitive measures that increase the substitution effect and the strategic value of the Chinese and European markets to each other. Chart 16The EU Will Not Be A Pushover In Face Of U.S. Tariffs Chart 17EU-China Trade Relationship Deepening Bottom Line: In the wake of any U.S.-China agreement, we give a 35% chance that Trump will impose tariffs on European cars and car parts. Such tariffs are not our base case because they are unlikely to shrink the U.S. trade deficit and would have a negative impact on the Red State economy. But lower magnitude tariffs cannot be ruled out – and the impact on the euro and European industrial sector would clearly be detrimental in the short run. Assuming that global and European growth is recovering, a tariff shock to Europe’s carmakers could present a good opportunity to buy on the dip. Any U.S.-EU trade war will ultimately be shorter-lived and less disruptive than the U.S.-China trade war, which is likely to resume at some point even if Presidents Trump and Xi get a deal this year. The United Kingdom: Snap Election More Likely A series of important votes is taking place in Westminster this week, with the end result likely to be an extension to negotiations over a withdrawal deal at the EU Council summit on March 21. Conditional on that extension, the odds of a new election are sharply rising. The first vote, as we go to press on Tuesday, has resulted in a rejection of Prime Minister Theresa May’s exit plan by 149 votes – the second rejection after her colossal defeat in January by 230 votes. The loss was expected because the EU has not offered a substantial compromise on the contentious Irish “backstop” arrangement, which would keep Northern Ireland and/or the U.K. in the European Customs Union beyond the transition date of December 31, 2020. All that was offered was an exit clause for the U.K. sans Northern Ireland. But Northern Ireland is part of the U.K. and the introduction of additional border checks on the Irish Sea would mark a new division within the constitutional fabric. This is unacceptable to the Conservative Party and especially to the Democratic Union Party of Northern Ireland, which gives May her majority in parliament. On Wednesday, we expect the vote for a “no deal” exit, in which the U.K. simply leaves the EU without any arrangements as to the withdrawal (or future relationship), to fail by an even larger margin than May’s plan. Leaving without a deal would cause a negative economic shock due to the automatic reversion to relatively high WTO tariff levels with the EU, which receives 46% of the U.K.’s exports and is thus vital in the maintenance of its trade balance and terms of trade (Chart 18). It is impossible to see parliament voting in favor of such an outcome – parliament was never the driving force behind Brexit, with most MPs preferring to remain in the EU.     Chart 18No Deal Brexit A Huge Blow To U.K. The risk is that parliament should fail repeatedly to pass the third vote this week, a motion asking the EU for an extension period to the March 29 “exit day.” This is unlikely but possible. In this case, the supreme decision-making body of the U.K. will be paralyzed. A bloodbath will ensue in which the country will either see Prime Minister May ousted, a snap election called, or both. If the extension passes, the EU Council is likely to go along with the decision. It is in the EU’s near-term economic interest not to trigger a crash Brexit and in its long-term interest to delay Brexit until the U.K. public decides they would rather stay after all. The problem is that it will not want to grant an extension for longer than July, when new Members of the European Parliament take their seats after the May 23-26 EU elections. The U.K. may be forced to put up candidates for the election. What good would an extension do anyway? The likeliest possibility is, yet again, a new election. The conditions are not yet ripe for a second referendum, though the odds are rising that one will eventually occur. The Labour Party has fallen in the opinion polls amidst Jeremy Corbyn’s indecisive leadership and a divisive platform change within the party to push for a second Brexit referendum (Chart 19). An election now gives May’s Conservatives an opportunity to build a larger and stronger majority – after all, in the U.K. electoral system, the winner takes all in each constituency, so the Tories would pick up most of the seats that Labour loses. May’s faction might be able to strengthen its hand vis-à-vis hard Brexiters who have less popular support yet currently have the numbers to block May’s withdrawal plan. Chart 19A New Election Would Be Opportunistic Theresa May might be unwilling to call an election given her fateful mistake of calling the snap election of 2017. If she demurs, she could face an internal party coup. There is a slim chance that a hard Brexiter could take the helm, bent on steering the U.K. out of the EU without a deal. Parliament, however, would rebel against such a leader. Ultimately, the economic and financial constraints of a crash Brexit are too hard and we expect that the votes will reflect this fact, whether in an adjusted exit deal or a new election. But both outcomes require an extension.  However, we must point out that the constitutional and geopolitical constraints alone are not sufficient to prevent a crash out: parliament is the supreme lawmaking authority and there is no other basis for the U.K. to leave in an orderly fashion. The United Kingdom has survived worse, as many hard Brexiters will emphasize. A crash is a mistake that can happen. But the odds are not higher than 10%-20% given the stakes (Diagram 1). Diagram 1The Path To Salvation Remains Fraught With Dangers With the EU economy not having stabilized and the U.S. contemplating Section 232 trade tariffs, Brexit is all the more reason to be wary of sterling, the euro, and European equities in the near term, especially relative to the U.S. dollar and U.S. equities. Gilts can rally even in the event of an extension given the uncertainty that this would entail, though the BCA House View is neutral. Bottom Line: Expect parliament to ask for an extension. At the same time, the odds of a new election have risen sharply. The absence of a new election could lead to a power struggle within the Tory party that could escalate the risk of a hard Brexit, though we still place the odds at 10%. A second referendum is rising in probability but will only become possible after the dust settles from the current crisis. Investment Conclusions The ECB’s stimulus measures are positive for European and global growth over a 6-to-12-month time frame. They suggest that financial assets could be supported later in the year, depending in great part on what happens in China. China’s combined January and February total social financing growth reinforces our Feb 20 report arguing that the risk of stimulus is now to the upside. As People’s Bank Governor Yi Gang put it, the slowdown in total social financing last year has stopped. The annual meeting of the National People’s Congress also resulted in largely accommodative measures on top of this credit increase. Nevertheless, stimulus operates with a lag, and for the reasons outlined above we are not yet willing to favor EUR/USD or European equities within developed markets. A 35% chance of tariffs is non-negligible. We expect U.S. equities to outperform within the developed world and Chinese equities to outperform within the emerging world on a 6-to-12 month basis.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Footnotes 1      Lighthizer now has bipartisan support in Congress, whose members will lambast Trump if he squanders the historic leverage he has built up in exchange for a shallow deal that only temporarily weighs on the trade deficit.