Asia

Highlights So What? More downside to CNY/USD ahead. Why? The trade war is spilling into political and military arenas, making it harder to de-escalate and negotiate a trade deal. Official U.S. and Chinese rhetoric is increasingly antagonistic, reflecting once-in-a-generation policy shifts toward a new Cold War. Tensions will not subside after the U.S. midterm election - neither the U.S.-Mexico-Canada agreement nor any quick deals with Japan and the EU will speed up U.S.-China negotiations. Feature Clients know that BCA's Geopolitical Strategy has been alarmist on U.S.-China relations since we started as a service in 2012.1 This structural view is based on the long-term decline of U.S. power relative to China and the emergence of global multipolarity.2 However, the rise of General Secretary Xi Jinping in 2012 and President Donald Trump in 2016 have reinforced our view that "Sino-American conflict is more likely than you think."3 This includes military as well as economic conflict. Setting aside the risk of war, a geopolitical "incident" of some kind is becoming increasingly likely. As the two sides engage in brinkmanship, the probability of a miscalculation or provocation rises, and the probability of a grand new compromise falls. For investors, the takeaway is supportive of Geopolitical Strategy's current stance: long U.S. dollar, long U.S. stocks relative to DM, and long DM stocks relative to EM. We expect CNY/USD to fall further as markets question the ability to discount trade uncertainties via tariff rates alone (Chart 1). We continue to recommend a "safe haven" hedge of Swiss bonds and gold. Chart 1CNY/USD Has More Downside CNY/USD Has More Downside CNY/USD Has More Downside The risk is that China could respond to U.S. pressure by stimulating its economy aggressively. So far, the "China Play Index," devised by our Foreign Exchange Strategy, does not signal reflation. Nor do Chinese domestic infrastructure stocks relative to global, which our China Investment Strategy watches closely (Chart 2). Chart 2Small Stimulus Thus Far Small Stimulus Thus Far Small Stimulus Thus Far Trade Tensions Are Spilling Over A corollary of our view that U.S.-China tensions are secular and strategic in nature - i.e., not limited to the U.S. trade deficit - is the view that trade tensions will spill over into strategic areas, exacerbating those tensions and generating negative outcomes for investors exposed to the U.S.-China economic partnership.4 This strategic spillover is now taking shape. Since President Trump went forward with the second round of tariffs - 10% on $200 billion worth of imports, to ratchet up to 25% on January 1, 2019 - a series of negative events have taken place in U.S.-China relations (Table 1), culminating in the USS Decatur incident on September 30. Table 1Trade War Spills Into Strategic Areas A Global Show Of Force? A Global Show Of Force? The Decatur, an Arleigh Burke-class guided-missile destroyer, was conducting operations in the Spratly Islands in the South China Sea when it sailed within 12 nautical miles of Gaven and Johnson Reefs, which China claims as sovereign islands. At around 8:30am that Sunday morning, a Luyang-class destroyer from China's People's Liberation Army Navy "approached within 45 yards of Decatur's bow, after which Decatur maneuvered to prevent a collision," according to the U.S. Pacific Fleet spokesman. This was not an unprecedented incident in itself, but it came very close to a collision that could easily have resulted in a shipwreck, a full-blown U.S.-China crisis, and a global risk-off event in financial markets. The Decatur sailed close to the Chinese-claimed reefs because it was conducting a "Freedom of Navigation Operation" (FONOP) to assert the international right of free passage. A major point of contention between China and the U.S. (and between China and most of its neighbors and the western world) is that China claims outright sovereignty over about 80% of the South China Sea, including the Spratly Islands. In July 2016, the International Court of Arbitration ruled that none of the contested rocks and reefs in the sea qualify as islands and hence that they are not entitled to 12 nautical miles of "territorial" sea. China rejects this ruling and asserts sovereignty over the maritime features and much of the sea itself.5 In Diagram 1 we illustrate how a FONOP works based on a similar operation last year. The U.S. has conducted these operations for decades, but in late 2015 it began a series of FONOPs focusing on countering China's excessive claims in the South China Sea.6 This was also a way of opposing China's construction, reclamation, and "militarization" of the reefs under its possession. Diagram 1What Is A 'Freedom Of Navigation Operation'? A Global Show Of Force? A Global Show Of Force? It is not remotely a surprise that this year's trade tensions came close to exploding in the South China Sea. It is the premier geographic location of U.S.-China strategic friction: a hub for international trade; a vital supply route for all major Asian economies; and the primary focus of China's attempt to rewrite global rules (Diagram 2).7 The Appendix updates our list of clashes in this area. Diagram 2South China Sea As Traffic Roundabout A Global Show Of Force? A Global Show Of Force? The takeaway is that, far from capitulating to the Trump administration's trade demands, China is taking a more aggressive stance - and it is doing so outside the trade context. The U.S., for its part, has not diminished the significance of this incident, as it has often done on similar occasions.8 Instead, Vice President Mike Pence gave a remarkable speech at the Hudson Institute on October 4 in which he highlighted the Decatur, among a range of other "predatory" Chinese state-backed actions, to make a comprehensive case that China is a geopolitical rival seeking to undermine the United States and specifically the Trump administration.9 Pence's comments reflect a decision to "go public" with a shift in national strategy that has been developing in recent years, beginning - albeit tepidly - even in the Obama administration. A similar shift is underway in China - and has accelerated with the U.S.'s implementation of tariffs. Official Communist Party rhetoric increasingly characterizes the U.S. as an enemy whose real intention is to "contain" China's rise and has recently called for Chinese "self-reliance" in the face of U.S. sanctions.10 The two sides are bracing for conflict and are now seeking to mold public opinion more actively. Bottom Line: Investors should take note: markets were 45 yards away from a significant correction! The U.S.-China trade tensions are spilling outside of economic relations into political and military domains, as we expected. The South China Sea remains a hot zone that could be the setting of a geopolitical incident as tensions mount. What Is A Show Of Force? Notably, the U.S. military is said to be considering a "global show of force" during an unspecified week in November in order to deter China from its current policy trajectory. If this occurs, it will be market-relevant as it will be seen as a provocation by China and other U.S. rivals. A "show of force" is a formal military operation conducted by a nation with the purpose of demonstrating that it has both the will and the ability to use force in defense of its interests. It is fundamentally a political action, even though it utilizes military resources. The declared intention is to demonstrate resolve and prevent or deter an undesirable course of action by a rival state.11 Nevertheless, it is the equivalent of a dog baring its teeth and should not be taken lightly, especially when conducted by one major power against another. The U.S. holds shows of force fairly frequently. Over recent decades it has been the third most common type of operation for U.S. forces.12 However, for most of the past several decades, the U.S. conducted very few operations in the Asia Pacific not pertaining to the Vietnam War, and these were usually of limited length and intensity. They were often shows of force to deter North Korea from various acts of terrorism and sabotage. China was rarely involved - there was, for example, no U.S. deployment during the Tiananmen crisis. Nevertheless there are a few highly relevant precedents: By far the most important exception is the Third Taiwan Strait Crisis in 1996. This was a major show of force - and one whose shadow still hangs over the Taiwan Strait. In July 1995, Beijing launched a series of missile tests and military exercises, hoping to discourage pro-independence sentiment and dissuade the Taiwanese people from voting for President Lee Teng-hui - who was rightly suspected of favoring independence - ahead of the 1996 elections. The United States responded on March 1, 1996 by deploying two aircraft carriers, USS Nimitz and USS Independence, and various warships to the area. The Nimitz even sailed through the strait. Tensions peaked ahead of the Taiwanese election on March 23, 1996 - in which voters went against China's wishes - and the show of force concluded after 48 days on April 17. Of course, tensions simmered for years afterwards. The Taiwan incident was the only operation involving China in the 1990s, and the first to do so since a minor contingency operation upon the Chinese invasion of Vietnam in 1979. It is generally deemed successful in demonstrating U.S. commitment to Taiwan's security - but it also spurred a revolution in Chinese military affairs, such that China is today in a far better position to attack Taiwan than ever before.13 The market effects were pronounced: Chinese and Taiwanese equities sold off. American stocks were unaffected (Chart 3). Chart 3Naval Shows Of Force Can Rattle Markets Naval Shows Of Force Can Rattle Markets Naval Shows Of Force Can Rattle Markets The second major exception was the Hainan Island Incident, or EP-3 Incident. On April 1, 2001 a Chinese jet struck a U.S. EP-3 ARIES II signals reconnaissance plane in the skies over the South China Sea. The U.S. plane landed on China's island province of Hainan, where its crew was detained and interrogated for 10 days while their aircraft was meticulously disassembled. Ultimately the U.S. issued a half-hearted apology and the crew was released. This was a much smaller show of force than the third Taiwan crisis. The U.S. Navy positioned three destroyers in the area for two days. Chart 4A South China Sea Incident Helped Kill The Bull Market A South China Sea Incident Helped Kill The Bull Market A South China Sea Incident Helped Kill The Bull Market This incident marked the peak of the cycle in U.S. equities ex-tech (Chart 4). In China, both A-shares and H-shares experienced volatility before selling off in subsequent months (Chart 5, top panel). Chart 5Volatility And Selloffs Amid Asian Shows Of Force Volatility And Selloffs Amid Asian Shows Of Force Volatility And Selloffs Amid Asian Shows Of Force The Cheonan and Yeonpyeong Island incidents occasioned a show of force. On March 26, 2010 a North Korean miniature submarine conducted a surprise torpedo attack against the Cheonan, a South Korean Corvette, sinking it and killing 46 sailors. The U.S. intended to respond by positioning the USS George Washington in the Yellow Sea, but was intimidated from doing so by China's fiercely negative diplomatic reaction. Instead it deployed the carrier to the Sea of Japan. Later that year, however, after North Korea shelled Yeonpyeong Island and killed four South Koreans, the U.S. responded with a beefed up version of regular military drills, including the George Washington, for four days in the Yellow Sea. This incident is significant in showing how aggressively China will oppose demonstrations of American naval power in its near abroad. Unlike in 1996, China is today much better positioned to react to U.S. naval action in its neighborhood. If Beijing was so resistant to a U.S. show of force against North Korea in the wake of a North Korean attack, it will be even more resistant to a U.S. display of might in China's nearby waters aimed at China in response to what China views as a defense of maritime-territorial sovereignty. Chinese A-shares sold off, while H-shares were somewhat more resilient, during this episode (Chart 5, second panel). Fire and Fury: The United States' latest significant show of force occurred in 2017 when the navy positioned three aircraft carrier strike groups in the region to deter North Korean nuclear and missile tests and belligerent rhetoric against the United States. This action ultimately led to Chinese enforcement of sanctions and North Korean capitulation to U.S. demands. Chinese stocks only briefly sold off during this episode (Chart 5, third panel). However, the U.S. 10-year Treasury yield fell during the peak of tensions in the summer. So what about the global show of force that the U.S. is considering in November? Details on the specific operation under consideration are scant because they fall under a "classified proposal," written by members of the U.S. Navy's Pacific Command and only partially leaked to the press (apparently to coincide with Vice President Pence's speech).14 The proposal is still being discussed by the Joint Chiefs of Staff and the Intelligence Community, so nothing is final. From the information that is publicly available, it is highly significant that the proposed show of force is supposed to be "global" in range. It would reportedly involve a "series" of military missions on "several fronts," including the South China Sea, the Taiwan Strait, an unspecified area near Russia, and the west coast of South America. It would also involve multiple military services - the navy, the air force, the marines, and potentially cyber and space capabilities. While the various missions would reportedly be "concentrated" and "focused," implying that the U.S. wants to manage the escalation of tensions carefully, the locations that have been named are extremely sensitive. A show of force in the Taiwan Strait and South China Sea would be provocative enough. A simultaneous show of force against both China and Russia in today's context would be truly extraordinary.15 In short, if the report is accurate, the U.S. is contemplating a rare and provocative display of its global power projection capabilities. Why would the U.S. stage such a grand demonstration merely because of a taunt by a Chinese ship? The Decatur incident is only the proximate cause. Washington is in the midst of attempting a very dangerous "two-front war" against China and Iran, the latter of whom faces oil sanctions from November 4.16 Moreover, this is a "three-front war" if today's historically bad relations with Russia are taken into account. Indeed, the U.S. may well be responding to the joint show of force by Russian President Vladimir Putin and Chinese President Xi in their own large-scale military exercises in September, in which Chinese soldiers participated in a Russian drill outside the auspices of the Shanghai Cooperation Organization for the first time.17 As such, we would not put any stock in the idea that a sudden drop-off in geopolitical tensions, with China or anyone else, will occur after the U.S. midterm election on November 6. Rather, investors should expect an increase in geopolitical risk. There is no combination of midterm election results in which Trump will be forced to pull back on his "Maximum Pressure" doctrine. The proposal is not final, and the idea alone is a low-level threat that could be used in negotiations. But under the circumstances, we think it more likely than not that the U.S. will go forward with it. Ultimately, the U.S. proposal epitomizes our mega-theme of multipolarity. The U.S. is in relative decline and is reasserting itself with a muscular national security policy, particularly against China and Iran but also against Russia. However, its actions are highly unlikely to cause a change in China's behavior now that Beijing has determined that the U.S. is seeking Cold War-style strategic containment. Instead, China will hasten its efforts to become self-reliant and to deter U.S. aggression in its near abroad. Global economic policy uncertainty, and trade policy uncertainty, are likely to increase, not decrease, in such an environment. Saber-rattling and supply-chain risk will weigh on EM Asia in particular. Bottom Line: The U.S. government is contemplating an extraordinary "global show of force" that could involve a series of joint military operations across the globe. The chief focus is China, but the unknown array of operations could also target Russia or Iran. We think such operations are plausible and will increase global economic uncertainty. We would expect them to create volatility in global markets, adding to jitters over China tariffs (supply-chain risks) and Iranian sanctions (oil prices). How Will China Retaliate? China does not have the ability to respond proportionately to the U.S. - it cannot hold a global show of force of its own. Because its own shows of force will appear diminutive next to American fireworks, it may not react immediately. Beijing is more likely to respond by changing its policies to address the underlying increase in antagonism with the United States and improve its national security. We would classify its potential responses into two main groups: the low road and the high road. The low road consists of policies meant to confront the U.S. directly and forcefully. In our view, these policies bring significant costs that will make China reluctant to embrace them fully: Raise the stakes in the South China Sea: China could go for broke and deploy the full range of military assets in the islands that it has repurposed. This would provoke an even larger international naval response from the U.S. and its allies.18 Remove sanctions on North Korea: China could reverse sanctions enforcement on North Korea (Chart 6) and undermine President Trump's signature foreign policy overture. The problem is that China would then provide the U.S. with a pretext for an even greater military presence in Northeast Asia. Chart 6China Could Reverse Sanctions Enforcement China Could Reverse Sanctions Enforcement China Could Reverse Sanctions Enforcement Flout sanctions on Iran: China could subsidize Iran (Chart 7) in the hopes of helping to create a huge American distraction comparable to the second Iraq war. But this confrontation would threaten China with an oil shock and economic dislocation, an even greater conflict with the U.S., and the risk of regime change in Iran.19 Chart 7China Could Flout Iran Sanctions China Could Flout Iran Sanctions China Could Flout Iran Sanctions Punish U.S. companies: China could raise the pressure on U.S. companies doing business on its territory. The problem is that the U.S. has already demonstrated, through the ZTE affair this year, that it can inflict devastating reprisals against the tech champions on whom China's economic future depends (Chart 8). Chart 8U.S. Could Punish Chinese Tech Firms U.S. Could Punish Chinese Tech Firms U.S. Could Punish Chinese Tech Firms Thus China is most likely to take the "high road," i.e. seeking alternatives to the United States throughout the rest of the world: Chart 9China's Market Is Its Biggest Advantage China's Market Is Its Biggest Advantage China's Market Is Its Biggest Advantage Import more goods: China's greatest strength in winning friends is that its domestic demand remains relatively robust (Chart 9). China can substitute away from the U.S. by shifting to other developed markets. Emerging markets are becoming more connected with China and less so with the U.S. (Chart 10). Chart 10China's Trade Ties Grow, Ex-U.S. China's Trade Ties Grow, Ex-U.S. China's Trade Ties Grow, Ex-U.S. Maintain outward investment: China's outward investment profile is expanding rapidly (Chart 11), but there is potential for a negative political backlash - as has occurred in Malaysia.20 China will need to focus on improving relations with those countries where it expands investment, including in the Belt and Road Initiative (BRI).21 Chart 11China's Outward Investment Strategy: Priorities Over The Past Decade A Global Show Of Force? A Global Show Of Force? Court U.S. regional allies: Relations with South Korea have already improved; Shinzo Abe of Japan is soon to make a rare state visit to China; and trilateral trade talks between these three have revived for the first time since 2015 (Chart 12). Both the Philippines and Thailand currently have governments that are friendly to China. Beijing will need to ensure that its growing trade surpluses do not get out of whack. Chart 12Can China Court U.S. Allies? Can China Court U.S. Allies? Can China Court U.S. Allies? Sign multilateral trade pacts: China is trying to position itself as a leader of free trade. This is a tough sell, but a successful completion of negotiations on the Regional Comprehensive Economic Partnership (RCEP) will generate some momentum. This Asia Pacific trade grouping is far larger in terms of total imports than its more sophisticated rival, the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP), the latter being shorn of U.S. participation (Chart 13). Chart 13RCEP Is Bigger Than CPTPP RCEP Is Bigger Than CPTPP RCEP Is Bigger Than CPTPP Play nice in the South China Sea: Now that the U.S. is proposing to push back against Chinese militarization of the islands, it makes sense for China to take a conciliatory approach. It is proposing joint energy exploration with the Philippines and others at least as long as offshore activity is depressed (Chart 14). China might also try to settle a diplomatic "Code of Conduct" for the sea with its neighbors. Chart 14A Reason For China To Play Nice A Reason For China To Play Nice A Reason For China To Play Nice The most important consequence is an alliance with Russia, whether formal or not. The security agenda of these two powers is increasingly aligned with their robust economic partnership (Chart 15).22 The differences and distrust between them cannot override their need to guard themselves against a more assertive United States. Chart 15Embrace Of Dragon And Bear Embrace Of Dragon And Bear Embrace Of Dragon And Bear Bottom Line: China's "high road" strategies are its best options when more aggressive options have higher risks of undermining China's own long-term interests. But an alliance with Russia is quickly becoming inevitable. Investment Implications A global show of force targeting China's "core interests" in Taiwan and the South China Sea will make trade negotiations even more difficult. China is not going to offer concessions when facing U.S. military intimidation in addition to tariffs.23 Investors should watch closely for any signs that nationalist protests and boycotts of U.S. goods are developing in China. Such a movement would not be allowed to continue for long without the Communist Party condoning it. A boycott would mark a form of retaliation that is much more impactful than tariffs. A deterioration in cultural ties is also in the cards. The United States is reported to be considering restrictions on Chinese student visas after intelligence assessments of non-traditional technological and intellectual property theft via graduate students in advanced programs such as artificial intelligence and quantum computing.24 U.S. markets remain insulated today, as in the last big rupture in U.S.-China relations in 1989, so we continue to expect U.S. equities to outperform Chinese (and global) stocks amid trade tensions and saber-rattling. Chart 16Last U.S.-China Crisis Prompted Stimulus... Last U.S.-China Crisis Prompted Stimulus... Last U.S.-China Crisis Prompted Stimulus... However, an important takeaway from the 1989 episode is that China stimulated the economy (Chart 16). This time we think stimulus will remain lackluster, reflecting Xi's need to keep overall leverage contained (Chart 17). But conflict escalation with the U.S. is clearly the biggest risk to this view. Chart 17...But Stimulus Muted Thus Far ...But Stimulus Muted Thus Far ...But Stimulus Muted Thus Far One oft-discussed retaliatory option is that China could sell off its vast $1.17 trillion holdings of U.S. treasuries. Rapidly dumping them is not effective, but slowly tapering is precisely what China has been doing since 2011 (Chart 18). This will accelerate its need to invest in real assets abroad and to purchase alternative reserve currencies, such as the euro, pound, and yen. Chart 18China Weans Itself Off Treasuries China Weans Itself Off Treasuries China Weans Itself Off Treasuries Ultimately, the significance of Vice President Pence's speech is that the U.S. now views China as both a great power and a threat to U.S. supremacy. This raises the potential for a large share of the $33 billion in cumulative U.S. direct investment in China since 2006 to become, effectively, stranded capital (Chart 19). If that is indeed the case, it would mean that investors in S&P 500 China-exposed companies would have to take note and re-rate their investments. Companies with significant investment in China may have to make capital investments in alternative supply-chain options, leading to a significant hit to their profit margin. Chart 19Stranded Capital In China? A Global Show Of Force? A Global Show Of Force? Other countries in Europe and the rest of Asia stand to benefit from the U.S. getting squeezed out of China's market, unless and until the new Cold War forces them to choose sides. Their choice is by no means a foregone conclusion, underscoring that China's policy response will be to seek better bonds with its neighbors and non-U.S. partners. Over the longer term, we think that our mega-theme of multipolarity will produce the bifurcation of capitalism. Within each sphere of influence globalization will continue to operate, but between spheres, or in the border areas, it will become a much less tidy affair. In addition to our recommendations above on page 2, we are reinitiating our short U.S. S&P 500 China-exposed stocks relative to the broad market. These companies have sold off heavily in recent months but the negative backdrop suggests that there is farther to go. Housekeeping On a separate note, BCA's Geopolitical Strategy is closing our long U.S. high-tax rate basket relative to S&P 500 trade for a gain of 8.26%. This was a play on the Trump tax cuts that we initiated in April 2017. Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation)," dated July 13, 2016, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Underestimating Sino-American Tensions," dated November 6, 2015, available at gis.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "The South China Sea: Smooth Sailing?" dated March 28, 2017, and "The Looming Conflict In The South China Sea," May 29, 2012, available at gps.bcaresearch.com. 8 Comparable incidents in December 2013, August 2014, May 2016, December 2016, August 2017, and March 2018 did not receive such a high-level response from U.S. leaders, reflecting both the seriousness of the Decatur incident and the administration's sense of political expediency amidst the trade conflict and midterm election cycle. 9 Pence criticized Chinese President Xi by name for allegedly breaking his word on the militarization of the Spratly Islands. He suggested that China's outward investment should be understood in strategic rather than economic terms, implying that the Belt and Road Initiative is a Soviet-style plan to organize a "bloc" of nations under Chinese hegemony. And he hinted at a new defense of the Monroe Doctrine in his criticism of China's recent assistance to the collapsing socialist regime in Venezuela. Please see the White House, "Remarks by Vice President Pence on the Administration's Policy Toward China," dated October 4, 2018, available at www.whitehouse.gov. 10 The Trump administration's key document is Secretary of Defense James Mattis, "Summary of the 2018 National Defense Strategy of the United States of America," Department of Defense, 2018, available at dod.defense.gov. For the Xi administration, see Orange Wang and Zhou Xin, "Xi Jinping says trade war pushes China to rely on itself and 'that's not a bad thing,'" South China Morning Post, dated September 26, 2018, available at www.scmp.com; and the Information Office of the State Council, "The Facts and China's Position on China-US Trade Friction," September 2018, available at www.chinadaily.com. 11 For this discussion of shows of force please see W. Eugene Cobble, H. H. Gaffney, and Dmitry Gorenburg, "For the Record: All U.S. Forces' Responses to Situations, 1970-2000 (with additions covering 2000-2003)," Center for Strategic Studies, May 2005, available at www.dtic.mil. 12 See footnote 11 above. 13 Please see William S. Murray, "Asymmetric Options for Taiwan's Defense," Testimony before the U.S.-China Economic and Security Review Commission, June 5, 2014, available at www.uscc.gov. 14 Please see Barbara Starr, "US Navy proposing major show of force to warn China," dated October 4, 2018, available at www.cnn.com. 15 Even the South American location implies that Chinese, Russian, and Iranian influence on that continent is now deemed meaningful enough to require a reassertion of the Monroe Doctrine. Over the past decade, the U.S. has tended to regard these activities as limited, but now that may be changing. 16 Please see BCA Geopolitical Strategy Special Report, "2019: The Geopolitical Recession?" dated October 3, 2018, available at gps.bcaresearch.com. 17 Please see "Russia Holds Massive War Games, As Putin And Xi Tout Ties," Radio Free Europe, Radio Liberty, September 11, 2018, available at www.rferl.org. 18 Australia, Japan, and the U.K. have already begun enforcing freedom of navigation alongside the U.S. 19 The U.S. could also impose secondary sanctions on China for non-compliance. State-owned energy firm Sinopec, for instance, was said to be reducing imports of crude from Iran by half in the month of September. Our Commodity & Energy Strategy notes that Chinese refiners, like other Asian refiners, are preparing to run more light-sweet crude from the U.S. in the future, which gives a good yield in high-value-added products like gasoline. So far China has not imposed retaliatory tariffs on these imports from the U.S. Please see Chen Aizhu and Florence Tan, "China's Sinopec halves Iran oil loadings under U.S. pressure: sources," Reuters, dated September 28, 2018, available at uk.reuters.com. 20 Please see BCA Geopolitical Strategy Weekly Report, "Are You Ready For 'Maximum Pressure?'," dated May 16, 2018, available at gps.bcaresearch.com. 21 Please see BCA Emerging Markets Strategy Special Report, "China's Belt And Road Initiative: Can It Offset A Mainland Slowdown?" dated September 13, 2017, available at ems.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Special Report, "Can Russia Import Productivity From China?" dated June 29, 2016, and "The Embrace Of The Dragon And The Bear," dated April 11, 2014, available at gps.bcaresearch.com. 23 Xi Jinping's refusal to meet with Secretary of State Mike Pompeo over the past weekend, and decision to visit North Korea for the first time in his term, underscores this point. 24 Please see Demetri Sevastopulo and Tom Mitchell, "US considered ban on student visas for Chinese nationals," Financial Times, dated October 2, 2018, available at www.ft.com. Appendix Notable Clashes In The South China Sea (2010-18) A Global Show Of Force? A Global Show Of Force? Notable Clashes In The South China Sea (2010-18) (Continued) A Global Show Of Force? A Global Show Of Force? Notable Clashes In The South China Sea (2010-18) (Continued) A Global Show Of Force? A Global Show Of Force?

Highlights Heightening geopolitical tensions between the U.S. and China, higher U.S. bond yields, tightening U.S. dollar liquidity and weakening EM/China growth - all combined - constitute a bitter cocktail for EM. Barring a meaningful improvement in Chinese growth, higher U.S. bond yields will be overwhelming for EM financial markets. U.S. banks are not creating new dollars sufficiently. In addition, they are shrinking their claims on EM. The U.S. dollar is primed for another upleg. Downgrade Indian stocks from overweight to underweight within a dedicated EM equity portfolio. Feature As China becomes more assertive and slightly hostile toward the U.S., this will likely mark a paradigm shift in the macro landscape and asset valuations and, hence, could become a grey swan1 event for emerging markets (EM). Investors remain complacent about the ongoing geopolitical confrontation between these two economic giants as well as other headwinds that China and EM are facing. The decision by the Trump administration to raise import tariffs to 25% on $200 billion of China's exports to the U.S. as of January 1, 2019 is an unambiguous signal that U.S. trade confrontation with China is not a pre-mid-term election political plot. Instead, it is the beginning of a long-term geopolitical battle between an existing and rising superpower. Remarkably, the just-concluded trade deal between the U.S., Mexico and Canada (USMCA) includes language that requires signatories to give notice if they plan to negotiate a free trade deal with a "non-market" economy.2 Provided "non-market" country is for now implied to be China, this corroborates that confrontation with the latter is a new long-term strategy for the U.S. In addition, investors should not expect China to be constantly on the defensive. Both the political leadership and people in China have realized that trade is not the only aspect where the U.S. is likely to challenge the Middle Kingdom, and they recognize it will be a long-term battle. Therefore, the communist party and President Xi will counter the U.S. with reasonably tough actions. Quite simply, failure to do so will place the political leadership's credibility in question. President Xi understands this well, and will not allow it to happen. It is hard to forecast the avenues and approaches that Chinese leadership will explore to confront the U.S. Yet the recent navy incident in the South China Sea exemplifies that China will not be silent in this row.3 More generally, EM financial markets are not ready for such negative surprises. For example, there has been little capitulation on the part of asset managers with respect to EM equities. In fact, they have lately been buying EM ETF futures (Chart I-1). Global financial market volatility calculated as an equally weighted average of volatility in U.S. and EM equities, U.S. bonds, various currencies, oil and gold are near its historic lows (Chart I-2). Chart I-1Asset Managers Have Been Buying EM Equity Futures Asset Managers Have Been Buying EM Equity Futures Asset Managers Have Been Buying EM Equity Futures Chart I-2Financial Markets Volatility Is Very Low Financial Markets Volatility Is Very Low Financial Markets Volatility Is Very Low Remarkably, the U.S. bond market volatility is at an all-time low while bond yields are breaking out (Chart I-3). Odds are the U.S. yields will move up considerably. The basis is that strong growth and rising inflation in the U.S. warrant considerably higher bond yields and more Fed rate hikes than are currently priced in. Barring a meaningful improvement in Chinese growth and global trade, higher U.S. bond yields will be overwhelming for EM financial markets. In particular, higher U.S interest rates could trigger another downleg in the value of Chinese yuan. Chart I-4 illustrates that the China-U.S. interest rate differential has been instrumental to moves in the RMB/USD exchange rate. Chart I-3A Breakout In U.S. Bond Yields A Breakout In U.S. Bond Yields A Breakout In U.S. Bond Yields Chart I-4China Vs. U.S.: Does Interest Rate ##br##Differential Explain Exchange Rate? China Vs. U.S.: Does Interest Rate Differential Explain Exchange Rate? China Vs. U.S.: Does Interest Rate Differential Explain Exchange Rate? Apart from the heightening geopolitical tensions between the U.S. and China and higher U.S. bond yields, weakening EM/China growth, tightening global U.S. dollar liquidity and a strong U.S. dollar all combined will constitute a bitter cocktail for EM. We discuss some of these negatives below. All in all, financial markets could be on the cusp of a volatility outbreak, and EM will still be at the epicenter of the storm. BCA's Emerging Markets Strategy service continues to recommend short positions in EM risk assets and an underweight allocation versus DM. A Dead Cat Bounce... Emerging markets share prices have attempted to stage a rebound lately, but so far it appears to be nothing more than a dead cat bounce. Even thought the aggregate EM equity index managed a 5% bounce in recent weeks, both the EM equally weighted equity and small-cap indexes have failed to rebound at all (Chart I-5, top and middle panels). Similarly, EM bank stocks - which make up 17% of the MSCI market cap and are the key to the benchmark's performance - have not rallied (Chart I-5, bottom panel). This is occurring at a time when the S&P 500 is at all-time highs. These are very unhealthy signs for EM risk assets. ...As China/EM Growth Continues To Downshift The premise behind the lack of meaningful rebound in EM equities in our view is that both global manufacturing and world trade growth continue to downshift (Chart I-6, top panel). The epicenters of the slowdown are China and other emerging economies (Chart I-6, middle and bottom panels). Chart I-5No Confirmation Of EM Rebound No Confirmation Of EM Rebound No Confirmation Of EM Rebound Chart I-6EM/China Growth Is Decelerating EM/China Growth Is Decelerating EM/China Growth Is Decelerating Importantly, the Markit PMI manufacturing surveys suggest export orders contracted in September in the world's important manufacturing hubs, including China, Japan, Taiwan and Germany. The last time such poor export performance was registered was more than two years ago. The slump in the aggregate EM manufacturing PMI explains not only the EM equity selloff but also EM credit spreads widening and EM currency depreciation since the beginning of this year (Chart I-7). So long as the weakening trend in EM/China and global trade growth persist, EM risk assets and currencies will continue to sell off. Regarding China, growth deceleration was already occurring before the initial import tariffs took hold. Specifically, not only are overseas orders weak, but also domestic orders have rolled over decisively, as indicated by the People's Bank of China's (PBoC) 5000 industrial enterprise survey (Chart I-8). Chart I-7Weakening Growth Explains Selloff In ##br##EM Credit And Currencies Weakening Growth Explains Selloff In EM Credit And Currencies Weakening Growth Explains Selloff In EM Credit And Currencies Chart I-8China: Domestic And Overseas Orders China: Domestic And Overseas Orders China: Domestic And Overseas Orders In the mainland, the boost to infrastructure spending in the coming months will likely be offset by a slump in property construction and other segments of the economy. We discussed this angle in our recent report,4 but in recent days there has been more real estate market tightening. Specifically, the authorities are considering the cancellation of the housing pre-sale system in Guangdong province - a policy that could be applied to other geographies. The motive of this tightening is to curb both the land-buying frenzy and Ponzi financing schemes that many developers are involved in. This fits the policy script of dealing with and purging speculation and excesses early to prevent a bust later. These policy measures will cut off property developers from their primary source of funding - presales - and force them to reduce their construction volumes. As an unintended consequence of this announcement, some developers have already begun cutting house prices to accelerate pre-sales and raise funds. Given already bubbly property valuations and the existence of substantial speculative buying, house price deflation could set off a domino chain effect of lower prices, reduced speculative investment purchases and financial strains on developers, leading them in turn to offer even larger price discounts to generate funds faster, and so on. Forecasting the exact trajectory of a downturn and the speed of its adjustment is impossible. This is why we focus on the presence of major imbalances/excesses and policy tightening that could cause disentangling of these excesses. Given the still-considerable property market excesses5 prevalent in China and the money/credit tightening that has already occurred in the past two years, we reckon the odds of a material property market downtrend are substantial. On the whole, our main theme for China and EM remains that mainland construction activity will continue to downshift, with negative implications for countries that supply construction goods, materials and equipment. U.S. Dollars Shortages? The U.S. economy is firing on all cylinders and inflationary pressures continue to rise. Barring a deflationary shock from China/EM, the Federal Reserve has little reason to halt its rate hikes or abandon its policy of shrinking its balance sheet. Not only are U.S. interest rates rising, but there are also budding U.S. dollar shortages that will get worse: The U.S. banking system's excess reserves at the Fed are dwindling, as the latter continues to shrink its balance sheet (Chart I-9). U.S. banks' dollar-denominated claims on foreign entities in general and emerging markets in particular are shrinking (Chart I-10). Thus, EM debtors in particular have found themselves short of dollars. Chart I-9The U.S. Dollar Is Primed For Another Upleg The U.S. Dollar Is Primed For Another Upleg The U.S. Dollar Is Primed For Another Upleg Chart I-10U.S. Dollar Shortages In Rest Of World U.S. Dollar Shortages In Rest of World U.S. Dollar Shortages In Rest of World Finally, U.S. banks are not creating enough dollars - their total assets are growing at a paltry rate of 1%, and U.S. broad money (M2) growth is expanding at 4% annually - the slowest pace in the past 14 years excluding the aftermath of the 2008 credit crisis (Chart I-11). Bottom Line: The Fed is shrinking its balance sheet, and high-powered money/liquidity in the banking system is falling. This and other factors are discouraging U.S. banks from creating new U.S. dollars. Along with rising U.S. interest rates, this will propel the greenback higher, which will be detrimental for EM risk assets. Equity Portfolio Rotation Amid High Oil Prices Given the recent breakout in oil prices, we make the following changes to our country equity allocation: Upgrade Russia from neutral to overweight.4 October 2018 Orthodox macro policy and high oil prices will help this bourse to outperform the EM benchmark (Chart I-12, top panel). We have already been overweight Russia within EM local bonds, currency and credit portfolios.6 Chart I-11U.S. Banks Are Not Creating Sufficient Amount Of Dollars U.S. Banks Are Not Creating Sufficient Amount Of Dollars U.S. Banks Are Not Creating Sufficient Amount Of Dollars Chart I-12Upgrade Russian And Colombian Equities ##br##From Neutral To Overweight Upgrade Russian And Colombian Equities From Neutral To Overweight Upgrade Russian And Colombian Equities From Neutral To Overweight Upgrade Colombian equities from neutral to overweight. Like Russia, high oil prices and orthodox macro policies justify an upgrade (Chart I-12, bottom panel). Upgrade Malaysia from underweight to neutral.4 October 2018 High energy prices, hope for structural changes and low inflation do not justify an underweight stance. Still, Malaysia is vulnerable to slowdown in global trade and credit excesses of the past years that have not yet been worked out. This prevents us from upgrading this bourse to overweight. Downgrade Philippines equities from neutral to underweight.4 October 2018 Inflation is breaking out and the central bank is behind the curve.7 Downgrade India from overweight to underweight. More detailed analysis on India starts on the following page. Our equity overweights are Taiwan, Korea, Thailand, Chile, Mexico, Colombia, Russia and central Europe. Our underweights are Brazil, South Africa, India, the Philippines, Indonesia and Peru. The complete list of our equity, fixed-income, credit and currency allocations are always presented at the end of our Weekly Reports, please refer to page 16. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Downgrade Indian Equities 4 October 2018 We are downgrading our allocation to Indian stocks from overweight to underweight within an EM-dedicated equity portfolio (Chart II-1). Rising stress in the country's non-bank finance companies - the recent default of finance company Infrastructure Leasing & Financial Services Limited and the fire-sale of Dewan Housing Finance bonds by a mutual fund - has been responsible for escalating financial risks, and will have ramifications for overall macro stability and growth. Stress Among Finance Companies: Liquidity Or Solvency? Finance companies account for about 12% of the MSCI India Stock Index. Further, there are deep interlinkages between them and mutual funds. Chart II-2 shows that mutual funds have exponentially increased their claims on non-bank finance companies by purchasing commercial paper (short-term debt obligations) issued by the latter. Chart II-1Failure To Break Out Is A Bad Omen Failure To Break Out Is A Bad Omen Failure To Break Out Is A Bad Omen Chart II-2Mutual Funds' Exposure To Finance Companies Mutual Funds' Exposure To Finance Companies Mutual Funds' Exposure To Finance Companies Further signs that the non-bank finance sector is having difficulties rolling over or repaying their debt obligations will hurt mutual funds. This might trigger redemptions from the latter by their own investors. Importantly, mutual funds' net purchases of equities as well as bonds has been very strong in recent years, often outpacing that of foreigners (Chart II-3). Given the former's large holdings of various securities, forced selling by mutual funds can often create an air pocket for Indian financial markets: local investors will be selling at a time when foreign investors are not yet ready to buy. Odds are considerable that stress will continue to escalate in the non-bank financial sector. Short-term interest rates and corporate bond yields are rising (Chart II-4). This is occurring at a time when non-bank finance companies are very vulnerable because of their liquidity mismanagement. Chart II-3Indian Mutual Funds Are Large Investors In Stocks And Bonds Indian Mutual Funds Are Large Investors In Stocks And Bonds Indian Mutual Funds Are Large Investors In Stocks And Bonds Chart II-4Rising Borrowing Costs Rising Borrowing Costs Rising Borrowing Costs Financial data from six non-bank finance companies included in the MSCI India Equity Index reveals that short-term debt levels for these companies are extremely elevated (Chart II-5, top panel) and their liquidity situation is grim. A measure of liquidity risk, calculated as short-term investments (including cash) minus short-term borrowing, has plummeted and is in deep negative territory (Chart II-5, bottom panel). In short, these finance companies have been borrowing short term and lending long term. Additionally, these entities will soon have to deal with surging non-performing assets (NPAs). Total assets for large finance companies - including the six companies included in the MSCI Equity Index - have grown at an annual average of around 20% since 2010. It is difficult to lend or invest at such a rapid pace while avoiding capital misallocation and the accumulation of bad assets. Crucially, the current level for NPAs for these six finance companies is 2.3% of risk-weighted assets, but could rise much further. Their provisions stand 2.1%, which barely covers existing NPAs. Hence, provisions have to rise multi-fold. For example, if NPAs rise to 12%, that would wipe out 32% of these companies' equity. We assume a recovery ratio of 30% on these bad assets. For comparison, the NPA ratio for overall the banking system has already surged to about 12%. Finally, commercial banks' lending to finance companies has been excessive in recent years (Chart II-6). Commercial banks are already swamped with rising non-performing loans, and any additional stress among finance companies will damage investor sentiment and negatively impact banks' share prices. Chart II-5Finance Companies: Liquidity Strains Are ##br##Rooted In Maturity Mismatches Finance Companies: Liquidity Strains Are Rooted In Maturity Mismatches Finance Companies: Liquidity Strains Are Rooted In Maturity Mismatches Chart II-6Banks' Exposure To Finance Companies Banks' Exposure To Finance Companies Banks' Exposure To Finance Companies Bottom Line: Odds are that the liquidity stress among finance companies will escalate and turn into a solvency problem. This will harm mutual funds in particular and cause them to liquidate their equity and bond holdings. Indian financial markets will selloff further. Limited Maneuvering Room For Central Bank High crude prices, rising inflation and mounting financial stress are placing the Reserve Bank of India (RBI) in an extremely precarious position: If the central bank provides sufficient liquidity or reduces interest rates to deal with budding stress in the financial system, the currency will plunge further; If the RBI does not provide sufficient liquidity or hikes rates to put a floor under the rupee, the stress in the financial system will worsen. It seems the central bank is currently biased to providing liquidity to contain financial system stress. In fact, the central bank has already injected bank reserves through the liquidity adjustment facility. In addition, it announced upcoming purchases of government securities in October in the order of Rs. 360 billion and has stressed its willingness to provide more injections if the need arises. This is negative for the currency which will continue to tumble, especially at a time when the U.S. dollar is well-bid worldwide. In turn, continued currency depreciation will make foreign investors net sellers of stocks and bonds. Bottom Line: We recommend investors downgrade India from overweight to underweight. We are also closing our long Indian banks / short Chinese banks at a 2% loss. Concerning equity sectors, we are reiterating our long Indian software companies' stocks / short EM overall equity benchmark. This trade is up 22%, and a cheaper rupee and strong DM growth herald further gains. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 A grey swan is an event that can be anticipated to a certain degree but is considered unlikely to occur and would have a sizable impact on financial markets if it were to occur. 2https://ustr.gov/trade-agreements/free-trade-agreements/united-states-mexico-canada-agreement/united-states-mexico# 3https://www-m.cnn.com/2018/10/01/politics/china-us-warship-unsafe-encounter/index.html?r=https%3A%2F%2Fwww.cnn.com%2F 4 Please see Emerging Markets Strategy Weekly Report "Desynchronization Compels Currency Adjustments," dated September 20, 2018, a link available on page 16. 5 Please see Emerging Markets Strategy Special Report "China Real Estate: A Never-Bursting Bubble?," dated April 6, 2018, available on ems.bcaresearch.com. 6 Please see Emerging Markets Strategy Special Report "Vladimir Putin, Act IV," dated March 7, 2018, link available on ems.bcaresearch.com. 7 Please see Emerging Markets Strategy Special Report "The Philippines: Duterte's Money Illusion," dated April 25, 2018, link available on ems.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Chart of the WeekIncreasing Gas-On-Gas Pricing Will Disrupt Global LNG Markets U.S. Set To Disrupt Global LNG Market U.S. Set To Disrupt Global LNG Market Growth in the global Liquefied Natural Gas (LNG) market will be fuelled by surging U.S. natural gas production, which will allow consumers in Asian and European markets to diversify away from oil-indexed pricing - with its attendant geopolitical risks - and falling European gas production. As a result, markets will move toward short- and long-term contracts priced in USD/MMBtu (Chart of the Week). This will favor gas producers and LNG merchants with access to U.S. shale-gas supplies, where production is growing at double-digit p.a. rates (Chart 2). Well-developed trading and risk-management markets in the U.S. - centered on Henry Hub, LA - will incentivize consumers to shorten the tenor of oil-indexed contracts, replacing them with hedgeable futures-based contracts. These markets allow producers and merchants to offer short- and long-term contracts that meet consumer preferences. As the global LNG market grows, shipping companies, along with producers and merchants with worldwide trading and transport capabilities - or access to such capabilities - will grow market share at the expense of exporters tied to the more rigid oil-indexing regime (Chart 3). Energy: Overweight. We remain long call spreads along the Brent forward curve over February - August; these positions are up an average 88.4% since inception, basis Tuesday's close. The long S&P GSCI position we recommended in December is up 21.8%, on the back of higher oil prices and backwardated crude-oil forward curves. Base Metals: Neutral. Copper is holding on to recent gains - up ~ 11% from its mid-August trough, following oil higher. Precious Metals: Neutral. Gold hovers around $1,200/oz, following the Fed's meeting last week, which resulted in a 25bp increase in fed funds to 2.25%. Ags/Softs: Underweight. The trade agreement to be signed by U.S. officials at the end of November with their counterparts in Mexico and Canada removes some of the uncertainty weighing on ag markets. Upward revisions to 2017 carry-out estimates by the USDA continue to pressure corn and beans. Chart 2Surging Production, Market Depth Favor U.S. Gas Producers And Merchants U.S. Set To Disrupt Global LNG Market U.S. Set To Disrupt Global LNG Market Chart 3Growing LNG Imports Will Favor Shippers, Producers And Merchants U.S. Set To Disrupt Global LNG Market U.S. Set To Disrupt Global LNG Market Feature Surging U.S. natural gas production will continue to find its way to global LNG markets over the next decade. The persistence of oil-indexing in Asian LNG contracts will fuel the growth of U.S. exports, given the arbitrage between cheaper natural gas - priced basis supply-demand fundamentals for gas - and more expensive oil-indexed contracts.1 Added to this cost advantage, U.S. exports can be linked to hedgeable futures prices, using NYMEX Henry Hub, LA, contracts. These stability-of-supply and pricing advantages also allow LNG buyers in Asia and Europe to diversify away from oil-production disruption risks, which can send prices sharply higher, and being overly reliant on Russian imports. Chart 4U.S. LNG Exports Will Surge U.S. Set To Disrupt Global LNG Market U.S. Set To Disrupt Global LNG Market This will give global consumers an incentive to continue shortening the tenor of more rigid oil-indexed LNG contracts, and to replace them with hedgeable contracts referencing Henry Hub, LA, futures contracts priced in USD/MMBtu. While a fairly stout increase of U.S. LNG exports already is expected by the EIA and IEA, we believe this dynamic likely results in export volumes that are higher than the ~ 10 Bcf/d expected by 2023, and close to 15 Bcf/d toward the end of the 2020s (Chart 4).2 Increasing volumes of associated natural gas production in the Permian Basin in west Texas, which will have to be transported from the basin so that it does not curtail oil production, will drive a large part of this growth. We expect a significant LNG export center to be developed in South Texas in Corpus Christi over the next five years or so, just as the U.S. surpasses 10 Bcf/d of exports in the middle of the next decade.3 Flexible pricing of LNG contracts basis Henry Hub already is supporting the buildout of Gulf Coast exports via take-or-cancel contracts. These contracts are replacing the more restrictive take-or-pay contracts still used in Asia.4 This will continue to evolve, allowing supply development to be hedged via Henry Hub natgas futures. Consumers ultimately benefit from cheaper supplies and hedgeable risks. This is not to say other benchmarks will fall away. There is always room for regional benchmarks - even oil-based benchmarks such as the Japan Crude Cocktail (JCC), or the spot- and swaps-market reference Japan/Korea Marker (JKM).5 The global crude oil market accommodates such regional benchmarks: WTI crude oil futures are the benchmark for oil markets in the Americas, while Brent crude oil futures serve as the benchmark for global markets. Crude oils with different chemical properties can be priced relative to these benchmarks for delivery anywhere in the world. The global LNG market could retain an Asian benchmark, but a lot of work needs to be done in terms of building the supporting infrastructure - pipelines, regasification facilities, deep futures markets, etc. - to make that happen.6 We are inclined to believe the build-out of U.S. LNG export capacity will occur before these pieces fall into place: Scale has never been an issue in the U.S. oil and gas patch. Global Supply - Demand Overview Chart 5Global LNG Demand Growth Likely Outpaces Current Expectations U.S. Set To Disrupt Global LNG Market U.S. Set To Disrupt Global LNG Market Global LNG demand is expected to rise at an impressive 1.7% p.a. out to 2040 (Chart 5). However, local supply and demand levels are increasingly unbalanced, implying that cross-border pipeline and LNG imports will need to increase as gas demand rises.7 A few key markets lead this trend, as seen in Chart 6, which illustrates the supply-gap in major consuming countries. Supply gaps are poised to grow in Emerging Asia and Europe, due to elevated demand growth in the former and lack of supply growth in the latter. World LNG demand grew by 10% last year, with Europe and Emerging Asia accounting for more than 95% of this increase. However, last year's stellar growth numbers should not be considered as the baseline growth forecast.8 The latest projections show demand increasing by 21 Bcf/d by 2025 - taking LNG imports from 38 Bcf/d at present to 58 Bcf/d by then. This implies a lower annualized growth rate of 5.5%. Chart 6Supply - Demand Imbalances Will Fuel LNG Demand Globally U.S. Set To Disrupt Global LNG Market U.S. Set To Disrupt Global LNG Market LNG Supply On Growth Trajectory World LNG export capacity is expected to go from 48 Bcf/d in 2017 to 61 Bcf/d by 2022 (Chart 7), with 53% of the additional capacity coming from the U.S., 18% from Australia, and 15% from Russia.9 Chart 7LNG Export Capacity Growth U.S. Set To Disrupt Global LNG Market U.S. Set To Disrupt Global LNG Market Our baseline forecast for the LNG market foresees a short-term supply surplus in 2020 (Chart 8), followed by a catch-up in demand and new waves of projects between 2024 and 2030. Among the supply-side developments we are following: Chart 8New LNG Projects In The Pipeline U.S. Set To Disrupt Global LNG Market U.S. Set To Disrupt Global LNG Market The Australian LNG market has undergone massive change in the last five years. While being a relatively small natural gas producer (8th largest producer, accounting for ~ 3% of world output), in 2015, the country became the second largest LNG exporting country in the world with now over 7.5 Bcf/d of exports. The bulk of new liquefaction facilities will be operational in 2019 with the completion of new trains at the Wheatstone, Prelude Floating and Ichthys LNG facilities.10 This will bring Australian total LNG export capacity to over 10 Bcf/d. Importantly, most of Australia's LNG trade is with Emerging Asian countries. This region still relies mostly on oil-linked, long-term, and fixed-destination contracts. Absent the OPEC market-share war of 2014 - 2016, when oil prices collapsed, Australia's LNG prices are subject to oil price risks and volatility (Chart 9). Chart 9Asian Oil-Indexed Contracts Trade Above Spot LNG U.S. Set To Disrupt Global LNG Market U.S. Set To Disrupt Global LNG Market The U.S. currently has ~ 3 Bcf/d liquefaction capacity and is increasingly exporting to Asian countries (Table 1). The present wave of projects under-construction will push capacity to ~ 9 Bcf/d in 2020. Following a two year pause in project Final Investment Decisions (FIDs) from 2016 to 2017, potential FIDs in 2018 and 2019 could increase the U.S. capacity to ~ 14 Bcf/d by 2025. This will make the U.S. the second-largest exporter of LNG in the world, surpassing Australia. This new wave of investment is yet to be finalized; therefore, final investment decisions in 2H18 and 2019 will be crucial to determine the medium-term potential of U.S. LNG. If a majority of these projects goes through, U.S. capacity risks being overbuilt for the next decade (Chart 10). Table 1U.S. LNG Exports By Country U.S. Set To Disrupt Global LNG Market U.S. Set To Disrupt Global LNG Market Chart 10U.S. LNG Capacity Risks Becoming Overbuilt U.S. Set To Disrupt Global LNG Market U.S. Set To Disrupt Global LNG Market Importantly, U.S. LNG exports already have had a massive impact on the global LNG market. The totality of U.S. export prices are determined by gas-on-gas pricing - i.e., gas priced in USD/MMBtu as a function of gas supply-demand fundamentals. Just as importantly, these contracts are without destination restrictions found in many oil-indexed contacts. In the U.S., the presence of a deep futures market allows flexible long-term contracting.11 According to Royal Dutch Shell, the spot LNG market doubled from 2010 to 2017, accounting for ~ 25% of all transactions, most of it due to the prodigious increase in U.S. LNG supply.12 An overbuilt U.S. market would increase spot LNG trading. Our own calculations based on EIA data indicate the U.S. could have too much capacity relative to demand in 2018 - 19, but goes into balance in 2020 - 2022.13 Russia's natural gas production is projected to increase from 66.7 Bcf/d in 2017 to 70.1 Bcf/d in 2023. However, the bulk of this increase will cover new pipeline exports. The country's LNG capacity is expected to grow by ~ 2.5 Bcf/d with the completion of trains at the Yamal, Vysotsk and Portovaya export facilities. Despite its low LNG capacity, Russia remains a key player in the LNG market. Its rising pipeline capacity connected to China - the fastest growing market in the world - competes directly with global LNG supplies. For Russia, the rise of natural gas availability on a global basis - in the form of LNG - shakes its foreign relationships and policies to the core. In loosening the once-tight relationship between buyers and sellers, the rise of spot LNG supplies will favor consumers and energy security, and foster the development of longer-term contracting.14 Global LNG Demand Could Outpace Supply By our reckoning, some 62% of additional global gas demand of 160 Bcf/d will be covered by rising domestic production, 12% by rising trans-national pipeline capacity, and the remaining 26% by LNG imports.15 Longer-term, we expect LNG and natural gas demand to keep rising as industry demand expands and major coal consumers build up their natural gas and renewables usage. As a result, LNG consumption will increase at a rate of ~ 3% p.a. until 2040, as overall gas demand grows ~ 1.7%.16 Key demand-side developments: Table 2Natgas Emits Less CO2 U.S. Set To Disrupt Global LNG Market U.S. Set To Disrupt Global LNG Market China's environmental reforms, supply-side industrial policies and continued economic growth will be the engine of global natural gas and LNG growth in the next decade. The Middle Kingdom's natural gas demand grew 15% to 23 Bcf/d in 2017, of which 54% came from additional LNG. This short-term growth surge required spot and short-term LNG imports, which pushed up North Asian LNG spot prices. Despite our expectation that China will continue leading global LNG growth, we believe 2017 to be an outlier. Two factors contributed to the rise in spot prices: To tackle its massive pollution without significantly altering economic development and growth, China's environmental policies favor natural gas as a bridge to a low-carbon economy, since natgas contains half the carbon content of coal (Table 2). China's supply-side reforms and winter capacity cut led to a spike in spot LNG demand, which had to be covered in global LNG markets. China has an extremely low level of storage to deal with seasonal natgas consumption fluctuations; this forces the country to rely on spot LNG to meet short-term peaks in gas demand (Chart 11). Chart 11China's Minimal Natgas Storage Forces It To Rely On Spot Markets U.S. Set To Disrupt Global LNG Market U.S. Set To Disrupt Global LNG Market While these factors still dominate Chinese markets, new Russian pipeline capacity is expected to start delivering gas in 2019, the ~ 247 bcf of additional domestic storage capacity and the rise in spot LNG supply will mitigate the effect. In addition, China is limited in its regasification capacity. Data re projects under construction and demand forecasts indicate the average utilization would rise to ~ 90% in 2020. Winter usage would push this to ~ 100% rapidly, constraining its ability to meet winter demand with spot LNG. As a result, we expect Asian spot LNG prices to rise above contracted oil-indexed prices next winter, but less so in 2020 and 2021. Longer term, China's gas consumption is expected to grow 4.6% p.a., outpacing the 4.0% p.a. domestic production growth. Some 23% of the gap will come from Russian and Turkmenistan pipeline imports. Europe's supply-gap rose in the past 3 years, and is expected to continue to widen. Unlike the rest of the world, this gap is growing because of supply depletion instead of strong demand growth. In fact, demand is expected to remain flat, based on the IEA's forecast of Europe's long-term growth. On the other hand, total European gas supply has decreased by 16% since 2010, and is expected to continue decreasing at a similar pace, reaching 21 Bcf/d in 2023 from 25 Bcf/d in 2017. These declines in European natgas supply are due to: The phase-out by 2030 of Netherlands' Groningen field. Continued concerns about the impact of natural gas production on earthquakes in nearby communities pushed the Dutch government to adopt, in March 2018, a plan to gradually stop gas extraction at the Groningen field. Production has been decreasing since 2013 and is expected to decrease by around three quarters between now and end-2023. U.K. natural gas production will decrease by 5% p.a. due to the lack of capex and the large number of fields reaching a mature state. Stagnation in Norway's gas production following its record production level in 2017. Europe's regasification capacity has considerable slack, which will allow it to expand its import volumes. Europe currently has 23 Bcf/d regas capacity, with a very low 27% utilization in 2017. This means it has ~16 Bcf/d capacity available. With the U.S. is expected to raise its exports by ~ 6 - 7 Bcf/d in the next couple of years, Europe could potentially absorb the entire U.S. LNG exports if it desires to diversify its source of energy supply. Pressure Builds For Competitive LNG Markets Chart 12Expect More LNG Spot Trading U.S. Set To Disrupt Global LNG Market U.S. Set To Disrupt Global LNG Market The movement toward an integrated global market - similar in structure to current oil markets - will be driven by sharply increased U.S. LNG exports, and more competitive pricing of LNG as a function of gas supply-demand fundamentals. This latter effort likely will find support from Japanese and EU regulators. In addition, U.S. exporters already are using futures-based pricing - using Henry Hub contracts - which provide greater flexibility for producers, consumers and merchants to hedge their risk. Either Asian markets will develop viable regional benchmarks, or the global market will increasingly adopt Henry Hub indexing. Again, this is a typical commodity-market evolution: wheat can be priced for delivery anywhere on the planet using Chicago Board of Trade indexing. Asia lacks an integrated pipeline network. Market-based pricing of gas as gas - i.e., based on regional supply-demand gas fundamentals - also has not fully developed. LNG-on-LNG competition is considered a way to promote market-based pricing. Thus, the rise in spot and short-term contracts priced on the basis of natural gas fundamentals in the region already visible in the data likely will continue (Chart 12). In addition, if we see the oil price spike we expect in 1Q19 - driven by the loss of Iranian exports due to U.S. sanctions, continuing losses in Venezuelan exports due to economic collapse, and still-strong global oil demand - LNG priced on gas fundamentals will become even more attractive.17 LNG consumers' exposure to oil prices - via oil-indexed supply contracts - is a disadvantage to consumers with super-abundant natural gas supplies (Chart 13).18 That said, the U.S. export capacity remains limited, thus it cannot completely substitute for the global trade being done basis oil-indexed LNG contracts. Still, higher oil prices will incentivize a shift to contracts with prices determined by natgas fundamentals, which favors continued growth in U.S. exports. If anything, it will push for a faster-than-expected expansion of U.S. LNG export capacity. Chart 13LNG Buyers Will Resist Oil-Indexed Exposure BCA Ensemble Forecast Lifts Brent To $95/bbl, As Market Tightens BCA Ensemble Forecast Lifts Brent To $95/bbl, As Market Tightens Bottom Line: Growth in global LNG markets likely will be faster than expected, as the U.S. develops its export capacity and continues to offer futures-based pricing. This will further reduce the attractiveness of rigid oil-indexed contracts. Gas producers and LNG merchants with access to U.S. shale-gas supplies, possessing trading and risk-management capabilities that allow them to offer flexible contracts globally, are favored in this quickly evolving market. Hugo Bélanger, Senior Analyst HugoB@bcaresearch.com Pavel Bilyk, Research Associate pavelb@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 The LNG cost structure is complex. A recent paper from the Oxford Institute For Energy Studies estimates U.S. breakeven costs for new LNG projects are roughly $7/MMBtu delivered, or ~ $4/MMBtu over current Henry Hub, LA, spot prices. This includes liquefaction costs, and transportation costs from the U.S. Gulf to Asia of ~ $1.50/MMBtu, and ~ $0.70/MMBtu from the U.S. Gulf to northwest Europe. Regasification charges and entry fees likely add ~ $0.70 to $1/MMBtu. Please see "The LNG Shipping Forecast: costs rebounding, outlook uncertain," published by the Oxford Institute For Energy Studies, March 2018. Transport costs are variable, and are only one part of the LNG pricing equation. The benefits of diversifying supplies cannot be overlooked, nor can the benefit of gas-on-gas pricing in a high-priced crude oil market. See also see "US powerhouse in the making," published June 14, 2018, by petroleum-economist.com. 2 Please see the International Energy Agency's Gas 2018 report published in March, particularly the discussion of supply beginning on p. 67. 3 Please see "The Price of Permian gas Pipeline Limits," by Stephen Rassenfoss, in the Journal of Petroleum Technology, published July 19, 2018. 4 Take-or-cancel contracts employ option-like features - e.g., cancelation payments that function as an option premium - that give buyer and seller flexibility in cancelling a contract or delivery in a manner that allows the seller to cover fixed costs, not unlike a tolling contact. This is possible because of the hedging latitude provided by the NYMEX natural gas futures market, which has Henry Hub, LA, as its delivery point. Please see "The Shift Away from Take-or-Pay Contracts in LNG," published by the Atlanta-based law firm King & Spalding on its Energy Law Exchange blog September 13, 2017. 5 Platts' JKM spot assessment for November was $11.35/MMBtu, which was down 6% from October assessments. Please see "Platts JKM: Asia November LNG spot prices fall on thin demand," published by S&P Global Platts September 21, 2018. The NYMEX JKM forward curve peaks at $13.50/MMBtu for January 2019 deliveries, and backwardates thereafter. 6 Big LNG consumers' antitrust regulators are increasing pressure on overly restrictive contracts, which could open these markets to further competition over the next three years. Japan's Fair Trade Commission (JFTC) in 2017 concluded a review of term LNG contracts, which raised the possibility heretofore standard term contract features - e.g., limits on destinations and diversions, and take-or-pay provisions - could run counter to its antimonopoly laws. Japan is the largest importer of LNG in the world, taking ~ 11 Bcf/d. Meanwhile, in June of this year, the European Commission opened an investigation into long-term LNG contracts between its member states and Qatar Petroleum. Akin Gump Strauss Hauer & Feld, the Washington, D.C., law firm, expects a ruling on destination and profit-sharing clauses that severely limit re-trading of LNG by purchasers. Akin Gump expects a ruling in the course of the next 3 years. While Japan's FTC did not specify remedies, it is possible buyers gain rights to re-sell and re-direct cargoes, following these reviews. This would make markets more competitive, although indexing the price of LNG to oil-based formulas likely will hinder this process. Please see "Revisiting LNG Resale Restrictions - Implications of Recent EU Decisions," published on the firm's website August 2, 2018. 7 Natural gas demand grew by 16% since 2010, according to the BP 2018 Statistical Review of World Energy, and is expected to grow by a cumulative 47% (1.6% p.a.) by 2040. 8 Many idiosyncratic factors helped Chinese LNG imports reach such an exceptional growth rate, mostly weather-related: China's environmental policy is resulting in widespread substitution of coal for natural gas for space-heating purposes, which, in colder-than-expected winters, results in surging demand. We do not believe this will be a long-term seasonal influence: Physical facilities are being built out to accommodate higher supply and demand. 9 World liquefaction capacity will rise to ~ 61 Bcf/d in 2022, based on our calculations of projects under construction. The bulk of additional capacity will come from the U.S., Australia and Russia. 10 Capacity of 0.6, 0.5 and 1.2 Bcf/d, respectively. 11 Please see U.S. Department of Energy, office of Oil & Natural Gas, LNG Monthly. 12 Like most globally traded commodities, LNG can be traded in USD/MMBtu. The global financial and clearing system already is set up to accommodate commodity transactions denominated in USD, therefore we do not see any impediments to extending it further into the LNG market. 13 Please see Chart 10 footnote for details. 14 We will be exploring the geopolitical dimension of LNG next week in a Special Report written with our colleagues in BCA Research's Geopolitical Strategy. Please see Meghan L. O'Sullivan, Windfall: How the new energy abundance upends global politics and Strengthens America's Power (New York: Simon & Schuster, 2012). 15 From 2017 to 2040, based on BP projections. The bulk of additional pipeline capacity will come from Russia with 12 Bcf/d destined to China and Europe expected to come on line in 2019. 16 Please see the International Energy Agency's GAS 2018 report published in March, BP's BP Statistical Review Of World Energy 2018 report published in June, Shell's Shell LNG Outlook 2018 report published in February, and U.S. the Energy Information Administration's International Energy Outlook 2017 report published in September. 17 Please see our most recent assessment of global oil fundamentals, published September 27, 2018, entitled "Risks From Unplanned Oil-Outage Rising; OPEC 2.0's Spare Capacity Is Suspect," and our updated forecast, "Odds Of Oil-Price Spike In 1h19 rise; 2019 Brent Forecast Lifted $15 To $95/bbl," published September 20, 2018. 18 Asia LNG prices are usually linked to the JCC according to predetermined formulae. However, the exact formula remains opaque and varies with each contract. Based on our calculations, we concluded that since 2010, the average formula uses a slope of ~14% on JCC prices lagged 4 months, with very low s-curve components and a constant. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table U.S. Set To Disrupt Global LNG Market U.S. Set To Disrupt Global LNG Market Trades Closed in 2018 Summary of Trades Closed in 2017 U.S. Set To Disrupt Global LNG Market U.S. Set To Disrupt Global LNG Market

Highlights Investors who are betting on a quick resolution to the U.S./China trade war following the "new NAFTA" deal and the U.S. midterm elections have likely been taken in by false hope. Stay neutral China relative to global stocks, and overweight low-beta sectors within the investable equity universe. The relative performance of Chinese industry groups since mid-June has been almost entirely determined by their beta characteristic, with almost all low-beta industry groups outperforming. Energy stocks have been among the top outperformers within the Chinese equity universe, and several factors support our recommendation that investors initiate an outright long position. While it is likely paused rather than stalled, broad "reform" as an investment theme will be less relevant over the coming 6-12 months. Consequently, we are closing our long ESG leaders / short benchmark trade. Feature September's PMI releases, both official and private, confirm that China's export outlook is deteriorating rapidly. Chart 1 highlights that the Caixin PMI is about to fall below the boom/bust line, and the new export orders component of the official PMI has sunk to a 2 ½ year low. Somewhat oddly, investors do not seem to be responding negatively to the de-facto announcement of a 25% rate on the second round of U.S. import tariffs against China. Chart 2 shows that domestic infrastructure stocks have actually been rising relative to global stocks since mid-September, and our BCA China Play Index appears to have entered a (so far very modest) uptrend. Chart 1The Export Shock Is Coming... The Export Shock Is Coming... The Export Shock Is Coming... Chart 2...But Investors Have Been Incrementally Upbeat ...But Investors Have Been Incrementally Upbeat ...But Investors Have Been Incrementally Upbeat One possible explanation for this is that investors are doubling down on the idea that China will have to aggressively stimulate in response to the shock. We have leaned against this narrative, by arguing in past reports that China's policy response to the upcoming export shock is not likely to be heavily credit-based, and that increases in fiscal spending today will involve more "soft infrastructure" than in the past.1 Chart 3 certainly shows no evidence of a spike in broad money or total credit; adjusted total social financing growth barely accelerated in August, against the backdrop of promises to front-run planned fiscal spending over the coming year. Chart 3No Major Acceleration In Credit Growth Evident Yet No Major Acceleration In Credit Growth Evident Yet No Major Acceleration In Credit Growth Evident Yet Chart 4Americans Support A Tough Stance Against China False Hope False Hope But a second explanation of recent investor behavior, one that we have been hearing more loudly from some market participants, is that China is waiting until after the midterm elections in the U.S. to make a deal, in anticipation that Republican losses in Congress will weaken Trump and change the political reality in terms of trade policy towards China. There are three reasons why investors holding this view are likely mistaken, and have been taken in by false hope: In the U.S., the actual implementation of tariffs lies within the control of the Presidency. Congress has delegated substantial authority to the president that would take time to be clawed back. Moreover, the president controls the execution of tariffs, and has a general prerogative over national security issues, which certainly includes the trade war with China. Democratic control of the House or Senate may cause President Trump to act even more forcefully against China, as trade will be among the few relatively unfettered policy options left to him. Chart 4 highlights that a sizeable majority of the American public views Chinese trade policy towards the U.S. as unfair, unlike the U.S.' other major trade partners. Reflecting this point, Democrats themselves maintain a hawkish stance on trade with China. This suggests that Trump will have a strong mandate to continue to demand major concessions from China even after the elections. We agree that Chinese stocks have already priced in a sizeable earnings decline, but we would still characterize buying now as an ill-advised case of trying to catch a falling knife. We highlighted in our September 19 Weekly Report that during the 2014-2016 episode Chinese stocks bottomed several months after stimulus began to take effect,2 because of a delayed decline in forward earnings. A similar situation would appear to be developing this time around: the third round of tariffs against China will likely soon be announced, the shock to Chinese export growth will soon manifest itself in the data, and yet Chinese forward earnings have only fallen 5-6% from their June peak. Bottom Line:Investors who are betting on a resolution to the U.S./China trade war following the U.S. midterm elections have likely been taken in by false hope. Stay neutral China relative to global stocks, and overweight low-beta sectors within the investable equity universe. Recent Sector Performance: A Beta Story, And A New Trade Idea Chart 5Last Week We Closed One Of Our Most Successful Calls Last Week We Closed One Of Our Most Successful Calls Last Week We Closed One Of Our Most Successful Calls We recommended closing one of our most successful trades of the past year in a brief Special Report last week.3 The report outlined major changes to the global industry classification standard (GICS) that took effect this week, as well as the implications for China's stock market. One key change is that Alibaba, one of the "BATs", is now part of the consumer discretionary sector and makes up roughly 60% of its market capitalization. Given this fundamental shift in the risk/reward profile of the position, we recommended closing our long MSCI China Consumer Staples / short MSCI China Consumer Discretionary trade for a profit of 47% (Chart 5). With the goal of identifying new trade ideas that are likely to outperform within the context of a trade war, Chart 6 presents the alpha and beta characteristics of 23 industry groups in the MSCI China index (the investable benchmark) from mid-June to the end of September. The x-axis of the chart represents the group's beta versus the benchmark, whereas the y-axis shows standardized alpha over the period. The chart also distinguishes between out/underperforming sectors. Chart 6Since Mid-June, Sector Performance Has Largely Been Beta-Driven False Hope False Hope Several points are notable: Largely speaking, the relative performance of Chinese industry groups since mid-June has been determined by their beta characteristic (with almost all low-beta industry groups outperforming). This supports our existing position of favoring low-beta sectors within the MSCI China index, a trade that we initiated on June 27.4 Four industry groups that belong to traditionally cyclical sectors have outperformed since mid-June and have had a beta less than 1: energy, capital goods, banks, and consumer durables and apparel. Energy and capital goods have been particularly notable, having outperformed by 24% and 15%, respectively. Technology-related industry groups have underperformed, including the pharma, biotech, and life sciences industry group within health care. Consumer services and retailers have significantly underperformed, due to the heavy influence of travel-related businesses in both indexes. Among the top performing industry groups over the past three months, Chinese energy stocks look like the most compelling trade in absolute terms. While we are normally reluctant to chase performance, several factors support an outright long position: BCA's Commodity & Energy Strategy service is bullish on oil prices, and recently increased their 2019 Brent price forecast to $95/bbl based on both supply and demand factors.5 Despite the recent outperformance of Chinese energy companies within the investable universe, they remain cheap versus global energy companies based on cash flow-based valuation metrics (Chart 7). This is true even after accounting for the fact that they are typically discounted relative to their global peers due to heavy state ownership. Chinese energy companies look reasonably priced relative to the value of global oil production (Chart 8). Chinese energy companies largely receive their revenue in U.S. dollars, which is an attractive hedge in an environment where CNY-USD may decline further. Chart 7Chinese Energy Stocks Are Cheap Versus Their Global Peers... Chinese Energy Stocks Are Cheap Versus Their Global Peers... Chinese Energy Stocks Are Cheap Versus Their Global Peers... Chart 8...And Versus The Value Of Global Oil Production ...And Versus The Value Of Global Oil Production ...And Versus The Value Of Global Oil Production Given this, we are updating our trade book and recommend that investors initiate an outright long position in Chinese energy stocks as of today. Chart 9Despite Outperforming, Absolute Capital Goods Performance Has Been Lackluster Despite Outperforming, Absolute Capital Goods Performance Has Been Lackluster Despite Outperforming, Absolute Capital Goods Performance Has Been Lackluster What about Chinese capital goods companies? For now, we are content with relative rather than absolute exposure, which (surprisingly) exists in our low-beta sectors trade. Capital goods companies account for almost 70% of the Chinese industrial sector, and industrial stocks have been less volatile than the broad market over the past year, in large part because they underperformed so significantly in 2017. Given this, they have been included in our low-beta sectors portfolio, despite being typically pro-cyclical. In absolute terms, though, it is far from clear that Chinese capital goods stocks will trend higher (Chart 9). Some investors are hopeful that capital goods producers will benefit from a significant acceleration in infrastructure spending but, as we noted above, the bar is high for the type of stimulus that investors have come to expect. In addition, potential weakness in property construction could be a drag, and could offset gains from a pickup in infrastructure investment.6 We recommend that investors stick with a relative position, until compelling signs of a stimulus overshoot emerge. Bottom Line: The relative performance of Chinese industry groups since mid-June has been almost entirely determined by their beta characteristic, with almost all low-beta industry groups outperforming. Energy stocks have been among the top outperformers within the Chinese equity universe, and several factors support our recommendation that investors initiate an outright long position. A Pause In Broad "Reform" As An Investment Theme Following last November's Communist Party Congress, we noted that China was likely to step up its reform efforts in 2018, and would take meaningful steps to: Pare back heavy-polluting industry Hasten the transition of China's economy to "consumer-led" growth Slow or halt leveraging in the corporate/financial sector Eliminate corruption and graft We argued that Chinese policymakers would have to set the pace of reforms to avoid a significant slowdown in the economy, but we noted that a policy mistake (moving too aggressively) could not be ruled out. We introduced the BCA China Reform Monitor as a way of tracking the intensity of the reforms, which was calculated as an equally-weighted average of the four "winner" sectors that emerged in the month following the Party Congress (energy, consumer staples, health care, and technology) relative to an equally-weighted average of the remaining seven sectors (Chart 10). In particular, we argued that a rise in the monitor that was driven by the underperformance of the denominator would be a warning sign that reforms had become too aggressive for the economy to withstand. Chart 10Reform, As A Broad Theme, Will Be Less Relevant In The Year Ahead Reform, As A Broad Theme, Will Be Less Relevant In The Year Ahead Reform, As A Broad Theme, Will Be Less Relevant In The Year Ahead Chart 10 highlights that the reform monitor rose for the first half of the year, driven by the gains of the numerator rather than losses in the denominator. The message of a sustainable pace of reforms, even against the backdrop of brewing trade tension, was consistent with the relative performance of Chinese stocks and was part of the reason we recommended staying overweight versus the global benchmark in Q1 and the majority of Q2.7 Since mid-June, however, the reform theme has been thrown into reverse: our reform monitor has declined, alongside absolute declines in both "winner" and "loser" sectors. The timing of this inflection point is clearly aligned with President Trump's announcement of the second round of tariffs. Given this, and our view that the U.S./China trade war is likely to get worse over the coming 6-12 months, it is likely that broad "reform" as an investment theme will be less relevant for the foreseeable future, at least relative to policymaker efforts to stabilize the economy. However, for several reasons, we view this as a pause in the theme, rather than an end: On the environmental front, Chart 11 highlights that China continues to pursue a clean air policy, at least in large population centers. Anti-pollution efforts are a signature policy of President Xi Jinping. They affect quality of life and ultimately the legitimacy of the regime, so they cannot be postponed entirely or indefinitely. Chart 11China Continues To Clamp Down On Air Quality China Continues To Clamp Down On Air Quality China Continues To Clamp Down On Air Quality Shifting China's growth model away from primary and secondary industry remains a long-term goal of policymakers. Chart 12 highlights that tertiary industry has already risen non-trivially as a share of GDP. This trend is also clearly visible in the electricity consumption data, which shows that residential and tertiary industry consumption has risen quite materially over the past several years. Chinese policymakers will clearly ease up on the brake over the coming year in terms of deleveraging, but it is far from clear that they will aim for another wave of aggressive private sector debt growth. We highlighted one key reason for this in a recent Special Report: comparing adjusted state-owned enterprise (SOE) return on assets to borrowing costs suggests that the marginal operating gain from debt has become negative for these firms (Chart 13). This implies that further aggressive leveraging of SOEs could push them into a debt trap. In fact, if policymakers do refrain from promoting a major private sector credit expansion over the coming year, that restraint will directly reflect the reform agenda. Chart 12Policymakers Continue To Emphasize A Transition Towards Services Policymakers Continue To Emphasize A Transition Towards Services Policymakers Continue To Emphasize A Transition Towards Services Chart 13SOEs Now Appear To Have A Negative Financial Gain From Debt SOEs Now Appear To Have A Negative Financial Gain From Debt SOEs Now Appear To Have A Negative Financial Gain From Debt Chart 14 highlights that while anti-corruption cases involving gifts and the improper use of public funds are off of their high from early this year, they remain elevated and are not trending lower. As a final point, Chart 15 shows that our long MSCI China environmental, social, and governance (ESG) leaders / short MSCI China trade has been negatively impacted by the pause in reform as an investment theme. While MSCI's ESG indexes aim to generate low tracking error relative to the underlying equity market of each country, technology companies are typically overrepresented in ESG indexes because of the low emissions nature of their business model. In China's case, we noted above that technology industry groups have fared poorly since mid-June, and panel 2 of Chart 15 shows that the underperformance of Chinese investable technology companies since mid-June lines up with the latest leg of ESG underperformance. Chart 14China's Anti-Corruption Drive Is Still In Effect China's Anti-Corruption Drive Is Still In Effect China's Anti-Corruption Drive Is Still In Effect Chart 15Favor ESG Leaders Again When The Reform Theme Reasserts Itself Favor ESG Leaders Again When The Reform Theme Reasserts Itself Favor ESG Leaders Again When The Reform Theme Reasserts Itself It remains unclear how much of tech's underperformance has been due to rich multiples versus concerns that the U.S. crackdown on Chinese technology transfer and intellectual property theft will negatively impact the market share of China's tech companies (via an opening of the market and a rise in the market share of foreign competitors). But we believe that the latter is a factor, and we recommend closing our long ESG leaders / short benchmark trade until "reform", both environmental and otherwise, reasserts itself as a driving factor for the Chinese equity market. Bottom Line: While it is likely paused rather than stalled, broad "reform" as an investment theme will be less relevant over the coming 6-12 months relative to policymaker efforts to stabilize the economy. We are closing our long ESG leaders / short benchmark trade at a loss of 5.5%. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Pease see China Investment Strategy Special Report "China: How Stimulating Is The Stimulus?" dated August 8, 2018, available at cis.bcaresearch.com. 2 Pease see China Investment Strategy Weekly Report "Investing In The Middle Of A Trade War", dated September 19, 2018, available at cis.bcaresearch.com. 3 Pease see China Investment Strategy Special Report "GICS Sector Changes: The Implications For China", dated September 26, 2018, available at cis.bcaresearch.com. 4 Pease see China Investment Strategy Weekly Report "Now What?", dated June 27, 2018, available at cis.bcaresearch.com. 5 Pease see Commodity & Energy Strategy Weekly Report "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl", dated September 20, 2018, available at ces.bcaresearch.com. 6 Pease see China Investment Strategy Special Report "China's Property Market: Where Will It Go From Here?", dated September 13, 2018, available at cis.bcaresearch.com. 7 The rapidly escalating trade war between China and the U.S. caused us to recommended putting Chinese stocks on downgrade watch at the end of March, and we recommended that investors cut their exposure to neutral on June 20. Pease see China Investment Strategy Weekly Report "Chinese Stocks: Trade Frictions Make For A Tenuous Overweight", dated March 28, 2018, and China Investment Strategy Special Report "Downgrade Chinese Stocks To Neutral", dated June 20, 2018, both available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Macro outlook: Global growth will continue to decelerate into early next year on the back of brewing EM stresses and an underwhelming policy response from China. Equities: Stay neutral for now, while underweighting EM relative to DM stocks. Within DM, overweight the U.S. in dollar terms. Bonds: Global bond yields may dip in the near term, but the longer-term path is firmly higher. Currencies: The dollar is working off overbought conditions, but will rebound into year-end. EM currencies will suffer the most. Commodities: Favor oil over industrial metals. Precious metals will also remain under pressure until the dollar peaks next year, before beginning a major bull run as inflation accelerates. Feature I. Economic Outlook The Fed Can Hike A Lot More If 2017 was the year of a synchronized global growth recovery, 2018 is turning out to be a year where desynchronization is once again the name of the game. The U.S. economy continues to fire on all cylinders, while much of the rest of the world is struggling to stay afloat. The divergence in economic outcomes has been mirrored in central bank policy. The Fed is now hiking rates once per quarter whereas most other major central banks are still sitting on their hands. How high can U.S. rates go? The answer is a lot higher than investors anticipate. Market participants currently expect the Fed funds rate to rise to 2.37% by the end of this year and 2.84% by the end of 2019. No rate hikes are priced in for 2020 and beyond. The Fed dots are somewhat higher than market expectations (Chart 1). The median dot rises to about 3.4% in 2020-21, but then falls back to 3% over the Fed's longer-run horizon. Both investors and the Fed have apparently bought into Larry Summers' secular stagnation thesis. They seem convinced that rates will not be able to rise above 3% without triggering a recession. While we have a lot of sympathy for Summers' thesis, it must be acknowledged that it is a theory about the long-term determinants of the neutral rate of interest. Over a shorter-term cyclical horizon, many factors can influence the neutral rate. Critically, as discussed last week, most of these factors are pushing it higher: Fiscal policy is extremely stimulative. The IMF estimates that the U.S. cyclically-adjusted budget deficit will reach 6.8% of GDP in 2019. In contrast, the euro area is projected to run a deficit of only 0.8% of GDP (Chart 2). The relatively more expansionary nature of U.S. fiscal policy is one key reason why the Fed can raise rates while the ECB cannot. Chart 1Markets Expect No Fed ##br##Hikes Beyond Next Year 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Chart 2Fiscal Policy Is More Expansionary ##br##In The U.S. Than In The Euro Area Fiscal Policy Is More Expansionary In The U.S. Than In The Euro Area Fiscal Policy Is More Expansionary In The U.S. Than In The Euro Area Credit growth has picked up. After a prolonged deleveraging cycle, private-sector nonfinancial debt is increasing faster than GDP (Chart 3). The recent easing in The Conference Board's Leading Credit Index suggests that this trend will continue (Chart 4). Chart 3U.S. Private-Sector Nonfinancial Debt Is Rising At Close To Its Historic Trend U.S. Private-Sector Nonfinancial Debt Is Rising At Close To Its Historic Trend U.S. Private-Sector Nonfinancial Debt Is Rising At Close To Its Historic Trend Chart 4U.S. Credit Growth Will Remain Strong U.S. Credit Growth Will Remain Strong U.S. Credit Growth Will Remain Strong Wage growth is accelerating. Average hourly earnings surprised on the upside in August, with the year-over-year change rising to a cycle high of 2.9%. This followed a stronger reading in the Employment Cost Index in the second quarter. A simple correlation with the quits rate suggests that there is plenty of upside for wage growth (Chart 5). Faster wage growth will put more money into workers' pockets who will then spend it. The savings rate has scope to fall. The personal savings rate currently stands at 6.7%, more than two percentage points higher than what one would expect based on the current level of household net worth (Chart 6). If the savings rate were to fall by two points over the next two years, it would add 1.5% of GDP to aggregate demand. Chart 5The Quits Rate Is Signaling Upside For Wage Growth The Quits Rate Is Signaling Upside For Wage Growth The Quits Rate Is Signaling Upside For Wage Growth Chart 6The Personal Savings Rate Has Room To Fall 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back A back-of-the-envelope calculation suggests that these cyclical factors will permit the Fed to raise rates to 5% by 2020, almost double what the market is discounting.1 An Absence Of Major Financial Imbalances Will Allow The Fed To Keep Raising Rates The past three recessions were all caused by financial market overheating rather than economic overheating. The 1991 recession was mainly the consequence of the Savings and Loan crisis, compounded by the spike in oil prices leading up to the Gulf War. The 2001 recession stemmed from the dotcom bust. The Great Recession was triggered by the housing bust. Today, it is difficult to point to any clear imbalances in the economy. True, housing activity has been weak for much of the year. However, unlike in 2006, the home vacancy rate stands near record-low levels (Chart 7). Tight supply will limit downside risks to both construction and home prices. On the demand side, low unemployment, high consumer confidence, and a rebound in the rate of new household formation should help the sector. Despite elevated home prices in some markets, the average monthly payment that homeowners must make to service their mortgage is quite low by historic standards (Chart 8). The quality of mortgage lending has also been very high over the past decade, which reduces the risk of a sudden credit crunch (Chart 9). Chart 7Low Housing Inventories Will Support Home Prices And Construction Low Housing Inventories Will Support Home Prices And Construction Low Housing Inventories Will Support Home Prices And Construction Chart 8Housing Affordabiity Is Not Yet Stretched Housing Affordabiity Is Not Yet Stretched Housing Affordabiity Is Not Yet Stretched Chart 9Mortgage Lenders Are Being Prudent Mortgage Lenders Are Being Prudent Mortgage Lenders Are Being Prudent Unlike housing debt, there are more reasons to be concerned about corporate debt. The ratio of corporate debt-to-GDP has risen to record-high levels. So-called "covenant-lite" loans now make up the bulk of corporate leveraged loan issuance. While there is no doubt that the corporate debt market is the weakest link in the U.S. financial sector, some perspective is in order. U.S. corporate debt levels are quite low by global standards. Corporate debt in the euro area is more than 30 points higher as a percent of GDP than in the United States (Chart 10). Moreover, the interest coverage ratio - EBIT divided by interest expense - for U.S. corporates is still above its historic average (Chart 11). While this ratio will fall as interest rates rise, this will not happen very quickly. Most U.S. corporate debt is at fixed rates and average maturities have been rising. This reduces both rollover risk and the sensitivity of debt-servicing costs to higher short-term rates. An increasing share of U.S. corporate debt is held by non-leveraged investors. Bank loans account for only 18% of nonfinancial corporate sector debt, down from 40% in 1980 (Chart 12). This is important, because what makes a spike in corporate defaults so damaging is not the direct impact this has on the economy, but the second-round effects rising defaults have on financial sector stability. Chart 10U.S. Corporate Debt Not That High By Global Standards U.S. Corporate Debt Not That High By Global Standards U.S. Corporate Debt Not That High By Global Standards Chart 11Interest Coverage Ratio Is Above Its Historic Average Interest Coverage Ratio Is Above Its Historic Average Interest Coverage Ratio Is Above Its Historic Average Chart 12Banks Have Been Reducing Their Exposure To The Corporate Sector Banks Have Been Reducing Their Exposure To The Corporate Sector Banks Have Been Reducing Their Exposure To The Corporate Sector In any case, we already had a dress rehearsal for what a corporate debt scare might look like. Credit spreads spiked in 2015. Default rates rose, but the knock-on effects to the financial system were minimal. This suggests that corporate America could handle a fair bit of monetary tightening without buckling under the pressure. The Fed And The Dollar If the Fed is able to raise rates substantially more than the market is discounting while most central banks cannot, the short-term interest rate spread between the U.S. and its trading partners is likely to widen. History suggests that this will produce a stronger dollar (Chart 13). Chart 13Historically, The Dollar Has Moved In Line With Interest Rate Differentials Historically, The Dollar Has Moved In Line With Interest Rate Differentials Historically, The Dollar Has Moved In Line With Interest Rate Differentials Some have speculated that the Trump administration will intervene in the foreign-exchange market in order to drive down the value of the greenback. We doubt this will happen, but even if such interventions were to occur, they would not be successful. Presumably, currency interventions would take the form of purchases of foreign exchange, financed through the issuance of Treasurys. The purchase of foreign currency would release U.S. dollars into the financial system, but the sale of Treasury securities would suck those dollars back out of the system. The net result would be no change in the volume of U.S. dollars in circulation - what economists call a "sterilized" intervention. Both economic theory and years of history show that sterilized interventions do not have lasting effects on currency values. The Fed could, of course, provide funding for the Treasury's purchases of foreign exchange, leading to an increase in the monetary base. This would be tantamount to an unsterilized intervention. However, such a deliberate attempt to weaken the dollar by expanding the money supply would fly in the face of the Fed's efforts to cool growth by tightening financial conditions. We highly doubt the Fed's current leadership would go along with this. Emerging Markets In The Crosshairs The combination of rising U.S. rates and a stronger dollar is bad news for emerging markets. Eighty percent of EM foreign-currency debt is denominated in dollars. Outside of China, EM dollar debt is now back to late-1990s levels, both as a share of GDP and exports (Chart 14). The wave of EM local-currency debt issued in recent years only complicates matters. If EM central banks raise rates to defend their currencies, this could imperil economic growth and make it difficult for local-currency borrowers to pay back their loans. Rather than hiking rates, some EM central banks may simply choose to inflate away debt. Consider the case of Brazil. The fiscal deficit stands at nearly 8% of GDP and government debt has soared from 60% of GDP in 2013 to 84% of GDP at present (Chart 15). Ninety percent of Brazilian sovereign debt is denominated in reais. The Brazilian government won't default on its debt per se. However, if push comes to shove, Brazil's central bank can always step in to buy government bonds, effectively monetizing the fiscal deficit. This could cause the real to weaken much more than it already has. Chart 14EM Dollar Debt Is High EM Dollar Debt Is High EM Dollar Debt Is High Chart 15Brazil's Perilous Fiscal Position Brazil's Perilous Fiscal Position Brazil's Perilous Fiscal Position Chinese Stimulus To The Rescue? When emerging markets last succumbed to pressure in 2015, China saved the day by stepping in with massive stimulus. Fiscal spending and credit growth accelerated to over 15% year-over-year. The government's actions boosted demand for all sorts of industrial commodities. The stimulus measures in 2015 followed an even greater wave of stimulus in 2009. While these stimulus measures invigorated China's economy and helped put a floor under global growth, they came at a price: China's debt-to-GDP ratio has swollen from 140% in 2008 to over 250% at present, which has endangered financial stability (Chart 16). Excess capacity has also increased. This can be seen in the dramatic rise in the capital-to-output ratio. It can also be seen in the fact that the rate of return on assets within the Chinese state-owned enterprise sector, which has been the main source of rising corporate leverage, has fallen below borrowing costs (Chart 17). Chart 16China: Debt And Capital Accumulation Went Hand In Hand China: Debt And Capital Accumulation Went Hand In Hand China: Debt And Capital Accumulation Went Hand In Hand Chart 17China: Rate Of Return On Assets Below Borrowing Costs For SOEs China: Rate Of Return On Assets Below Borrowing Costs For SOEs China: Rate Of Return On Assets Below Borrowing Costs For SOEs Chinese banks are being told that they must lend more money to support the economy, while ensuring that their loans do not turn sour. Unfortunately, that is becoming an impossible feat. The Chinese economy produces too much and spends too little. The result is excess savings, epitomized most clearly in a national savings rate of 46% (Chart 18). As a matter of arithmetic, national savings must be transformed either into domestic investment or exported abroad via a current account surplus. Now that the former strategy has run into diminishing returns, the Chinese authorities will need to concentrate on the latter. This will require a larger current account surplus which, in turn, will necessitate a relatively cheap currency. Above-average productivity growth has pushed up the fair value of China's real exchange rate over time. However, the currency still looks expensive relative to its long-term trend line (Chart 19). Pushing down the value of the yuan against the dollar will not be that difficult. Chart 20 shows that USD/CNY has moved broadly in line with the one-year swap spread between the U.S. and China. The spread was about 3% earlier this year. Today, it stands at only 0.6%. As the Fed continues to raise rates, the spread will narrow further, taking the yuan down with it. Chart 18China Saves A Lot China Saves A Lot China Saves A Lot Chart 19The RMB Is Still Quite Strong The RMB Is Still Quite Strong The RMB Is Still Quite Strong Chart 20USD/CNY Has Tracked China-U.S. Interest Rate Differentials USD/CNY Has Tracked China-U.S. Interest Rate Differentials USD/CNY Has Tracked China-U.S. Interest Rate Differentials Unlike standard Chinese fiscal/credit easing, a stimulus strategy focused on weakening the yuan would hurt other emerging markets by undermining their competitiveness in relation to China. A weaker yuan would also make it more expensive for Chinese companies to import natural resources, thus putting downward pressure on commodity prices. The Euro Area: Back In The Slow Lane After putting in a strong performance in 2017, the economy in the euro area has struggled to maintain momentum this year. Growth is still above trend, but the overall tone of the data has been lackluster at best, with the risks to growth increasingly tilted to the downside. Weaker growth in China and other emerging markets certainly has not helped. However, much of the problem lies closer to home. Bank credit remains the lifeblood of the euro area economy. The 12-month credit impulse - defined as the change in credit growth from one 12-month period to the next - tends to track GDP growth (Chart 21).2 Euro area credit growth accelerated over the course of 2017, but has been broadly stable this year. As a result, the credit impulse has fallen, taking GDP growth down with it. It will be difficult for euro area GDP growth to increase unless credit growth starts rising again. So far, there is little sign that this is about to happen. According to the latest euro area bank lending survey, while banks continue to ease standards for business loans, they are doing so at a slower pace than in the past. A net 3% of banks eased lending standards in the second quarter, compared to 8% in the first quarter. Loan demand growth has been fairly stable. This suggests that loan growth will remain positive, but is unlikely to increase much from current levels. Worries about the health of European banks will further constrain credit growth. European banks in general, and Spanish banks in particular, have significant exposure to the most vulnerable emerging markets (Chart 22). Chart 21Euro Area Credit Growth Has Flatlined Euro Area Credit Growth Has Flatlined Euro Area Credit Growth Has Flatlined Chart 22Spain Most Exposed To Vulnerable EMs 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Concerns about the ability of the Italian government to service its debt obligations will also restrain bank lending. Investors breathed a sigh of relief last month when the Italian government signaled a greater willingness to pare back next year's proposed budget deficit, in accordance with the dictates of the European Commission. Tensions remain, however, as evidenced by the fact that the ten-year spread between BTPs and German bunds is still 120 basis points higher than in April (Chart 23). The European political establishment is terrified of the rise in populism across the region and would love nothing more than to see Italy's populist parties implode. This means that any help from the ECB and the European Commission will only arrive once a full-fledged crisis is underway. Anyway, it is far from clear that a smaller budget deficit would actually translate into a lower government debt-to-GDP ratio. Like China, Italy also has a private sector that saves too much and spends too little. A shrinking population has reduced the need for firms to invest in new capacity. The prior government's pension cuts have also incentivized people to save more for their retirement. The result is a private sector savings-investment surplus that stood at 5% of GDP in 2017 compared to close to breakeven a decade ago (Chart 24). Chart 23Italian/Bund Spreads Signal Lingering Fiscal Strain Italian/Bund Spreads Signal Lingering Fiscal Strain Italian/Bund Spreads Signal Lingering Fiscal Strain Chart 24Italy: Private Sector Saves Too Much And Spends Too Little Italy: Private Sector Saves Too Much And Spends Too Little Italy: Private Sector Saves Too Much And Spends Too Little Unlike Germany, Italy cannot export its excess production because it does not have a hypercompetitive economy. Nor does it have the ability to devalue its currency to gain a quick competitiveness boost. This means that the Italian government has to absorb excess private-sector savings with its own dissavings - a fancy way of saying that it has to run a large budget deficit. This has effectively been Japan's strategy for over two decades. However, unlike Japan, Italy does not have a lender of last resort that can unconditionally buy government debt. This raises the risk that Italy's debt woes will resurface, either because the government abandons austerity measures, or because the lack of fiscal support causes nominal GDP to stagnate, making it all but impossible for the country to outgrow its debt burden. Receding Policy Puts The discussion above suggests that many of the "policy puts" that investors have relied on are in the process of having their strike price marked down to deeper out-of-the-money levels. Yes, the Fed will ease off on rate hikes if U.S. growth is at risk of stalling out completely. However, now that the labor market has reached full employment, the Fed will welcome modestly slower growth. Remember that there has never been a case in the post-war era where the three-month average of the unemployment rate has risen by more than a third of a percentage point without a recession taking place (Chart 25). The further the unemployment rate falls below NAIRU, the more difficult it will be for the Fed to achieve the proverbial soft landing. Chart 25Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Likewise, the "China stimulus put" - the presumption that most investors have that the Chinese authorities will launch a barrage of fiscal and credit easing at the first sign of slower growth - has become less reliable in light of the government's competing objectives namely reducing debt growth and excess capacity. The same goes for the "ECB put." Yes, the ECB will bail out Italy if the entire European project appears at risk. But spreads may need to blow out before the cavalry arrives. Meanwhile, just as the aforementioned policy puts are receding, new policy risks are rising to the fore, chief among them protectionism. We expect the trade war to heat up, with the Trump administration increasingly directing its ire at China. Trump's macroeconomic policies are completely at odds with his trade agenda. Fiscal stimulus will boost aggregate demand, which will suck in more imports. An overheated economy will prompt the Fed to raise rates more aggressively than it otherwise would, leading to a stronger dollar. All this will result in a wider trade deficit. What will Trump tell voters two years from now when he is campaigning in Michigan and Ohio about why the trade deficit has widened rather than narrowed under his watch? Will he blame himself or Beijing? No trophy for getting that answer right. II. Financial Markets Global Equities The combination of slower global growth, rising economic vulnerabilities outside the U.S., and a more challenging policy environment caused us to downgrade our view on global equities from overweight to neutral in June,3 while reiterating our preference for developed market equities relative to EM stocks. For now, we are comfortable with our bearish view towards emerging market stocks. While EM equities have cheapened, they are not yet at washed out levels (Chart 26). Bottom fishers still abound, as evidenced by the fact that the number of shares outstanding in the MSCI iShares Turkish ETF has almost tripled since early April (Chart 27). Chart 26EM Assets: Valuations Not Yet At Washed Out Levels EM Assets: Valuations Not Yet At Washed Out Levels EM Assets: Valuations Not Yet At Washed Out Levels Chart 27EM Bottom Fishers Still Abound EM Bottom Fishers Still Abound EM Bottom Fishers Still Abound At some point - probably in the first half of next year - investors will liquidate their remaining bullish EM bets. At that point, EM stocks will rebound. European and Japanese equities should also start to outperform the U.S., given their more cyclical nature. As far as the absolute direction of the S&P 500 is concerned, the next few months could be challenging. U.S. stocks have been able to decouple from those in the rest of the world, but this state of affairs may not last. Recall that the S&P 500 fell by 22% peak-to-trough between July 20 and October 8, 1998, in what otherwise was a massive bull market. We do not know if there is another Long-Term Capital Management lurking around the corner, but if there is, a temporary selloff in U.S. stocks may be hard to avoid. Such a selloff would present a buying opportunity over a horizon of 12-to-18 months. If we are correct that cyclical forces have lifted the neutral rate of interest, it will take a while for monetary policy to reach restrictive territory. This means that both fiscal and monetary policy will stay accommodative at least for the next 18 months. As such, the S&P 500 may not peak until 2020. Appendix A - Chart I presents a stylized diagram of where we think global equities are going. It incapsulates three phases: 1) a challenging period over the next six months, driven by EM weakness; 2) a blow-off rally in equities starting in the middle of next year; 3) and finally, a recession-induced bear market beginning in late-2020. Appendix B also presents our valuation charts, which highlight that long-term return prospects are better outside the United States. Fixed Income After advocating for a long duration strategy for much of the post-crisis recovery, BCA declared "The End Of The 35-Year Bond Bull Market" on July 5, 2016, the very same day that the 10-year U.S. Treasury yield hit a record closing low of 1.37%. Cyclically and structurally, we continue to expect U.S. bond yields to rise more than the market is discounting. As noted above, the Fed is underestimating how high rates will need to go before they reach restrictive territory. This means that the Fed will end up behind the curve in normalizing monetary policy, causing the economy to overheat and inflation to rise above the Fed's comfort zone. Chart 28Bond Sentiment Is Extremely Bearish Bond Sentiment Is Extremely Bearish Bond Sentiment Is Extremely Bearish Granted, the Fed is willing to tolerate a modest inflation overshoot. However, a core PCE reading above 2.3%, which is at the top end of the range of the Fed's own forecast, would prompt the Fed to expedite the pace of rate hikes. A bear flattening of the yield curve - a situation where long-term yields rise, but short-term rates go up even more - would be highly likely in that environment. Over a shorter-term horizon spanning the next six months, the outlook for yields is more benign. The combination of a stronger dollar, slower global growth, and flight-to-quality flows into the Treasury market from vulnerable emerging markets can cap yields. Add to this the fact that sentiment towards bonds is currently extremely bearish (Chart 28), and a temporary countertrend decline in yields becomes quite probable. Developed market bond yields in general are likely to follow the direction of U.S. yields, both on the upside and the downside, but in a more muted manner. Outside the periphery, euro area yields have less scope to fall in the near term given that they are already so low. European yields also have less room to rise once global growth bottoms next year because the neutral rate of interest is much lower in the euro area than in the United States. Ironically, a more dovish ECB would help reduce Italian bond yields, as higher inflation is critical for increasing Italian nominal GDP. Since labor market slack is still elevated in Italy, continued monetary stimulus would also lift wages in core Europe more than in Italy, helping to boost Italy's competitiveness relative to the rest of the euro area. Japanese yields have plenty of scope to rise over the long haul. An aging population is pushing more people into retirement, which will cause the national savings rate to fall further. A decline in the savings pool will increase the neutral rate of interest in Japan. Instead of raising the policy rate, the Japanese authorities will let the economy overheat, generating inflation in the process. This will cause the yield curve to steepen, particularly at the very long end (e.g., beyond 10 years) which is the part of the yield curve that is the least susceptible to the BoJ's yield curve control regime. We are positioned for this outcome through our short 20-year JGB/long 5-year JGB trade recommendation. Appendix A - Chart II shows our expectations for the major government bond markets over the coming years. Turning to credit markets, high-yield credit typically underperforms in the latter innings of business-cycle expansions, a period when the Fed is raising rates. Thus, while we do not think that U.S. corporate debt levels will be a major source of systemic financial risk for the broader economy, this is hardly a reason to be overweight spread-product. A more cautious stance towards credit outside the U.S. is also warranted. Currencies And Commodities The dollar is working off overbought conditions, but will rebound into year-end, as EM tensions intensify and hopes of a massive credit/fiscal-fueled Chinese stimulus package fizzle. EM currencies will weaken the most against the dollar over the next three-to-six months, but the euro and, to a lesser extent, the yen, will also come under pressure. Granted, the dollar is no longer a cheap currency, but if long-term interest rate differentials stay anywhere close to current levels, the greenback will remain well supported. Consider the dollar's value against the euro. Thirty-year U.S. Treasurys currently yield 3.20% while 30-year German bunds yield 1.12%, a difference of 208 basis points. Even if one allows for the fact that investors expect euro area inflation to be lower than in the U.S. over the next 30 years, EUR/USD would need to trade at a measly 82 cents today in order to compensate German bund holders for the inferior yield they will receive.4 We do not expect EUR/USD to get down to that level, but a descent into the $1.10-to-$1.12 range over the next six months is probable. Sterling will remain hostage to Brexit negotiations. It is impossible to know how talks will evolve, but our bias is to take a somewhat pound-positive view. The main reason is that support for Brexit has faded (Chart 29). Opinion polls suggest that if a referendum were held again, the "bremain" side would almost certainly prevail. Lacking public support for leaving the EU, it is unlikely that British negotiators could simply walk away from the table. This reduces the odds of a "hard Brexit" outcome. Indeed, a second referendum that leads to a "no-Brexit" verdict remains a distinct possibility. The combination of slower global growth and a resurgent dollar is likely to hurt commodity prices. Industrial metals are more vulnerable than oil. China consumes around half of all the copper, nickel, aluminum, zinc, and iron ore produced around the world (Chart 30). In contrast, China represents less than 15% of global oil demand. Chart 29When Bremorse Sets In When Bremorse Sets In When Bremorse Sets In Chart 30China Is A More Dominant Consumer Of Metals Than Oil China Is A More Dominant Consumer Of Metals Than Oil China Is A More Dominant Consumer Of Metals Than Oil The supply backdrop for oil is also more favorable than for metals. Not only are Saudi Arabia and Russia maintaining production discipline, but U.S. sanctions against Iran threaten to weigh on global crude supply. Further reduction in Venezuela's oil output, as well as potential disruptions to Libyan or Iraqi exports, could also boost oil prices. The superior outlook for oil over metals means we prefer the Canadian dollar relative to the Aussie dollar. While AUD/CAD has weakened in recent months, the Aussie dollar is still somewhat expensive against the loonie based on our long-term valuation model (Chart 31). We also see an increasing chance that Canada will negotiate a revamped trade deal with the U.S., as Trump focuses his attention more on China. Should this happen, it will remove the NAFTA break-up risk discount embedded in the Canadian dollar. Finally, a few words on precious metals. Precious metals typically struggle during periods when the dollar is appreciating (Chart 32). Consequently, we would not be eager buyers of gold or other precious metals until the dollar peaks, most likely around the middle of next year. As inflation starts to accelerate in late-2019 and in 2020, gold will finally move decisively higher. Chart 31Canadian Dollar Still Somewhat Cheap Versus The Aussie Dollar Canadian Dollar Still Somewhat Cheap Versus The Aussie Dollar Canadian Dollar Still Somewhat Cheap Versus The Aussie Dollar Chart 32Gold Won't Shine Until The Dollar Peaks Gold Won't Shine Until The Dollar Peaks Gold Won't Shine Until The Dollar Peaks Appendix A - Chart III and Chart IV present an illustration of where the major currencies and commodities are heading. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Depending on which specification of the Taylor rule one uses, a one percent of GDP increase in aggregate demand will increase the neutral rate of interest by half a point (John Taylor's original specification) or by a full point (Janet Yellen's preferred specification). Fiscal policy is currently about 3% of GDP too stimulative compared to a baseline where government debt-to-GDP is stable over time. Assuming a fiscal multiplier of 0.5, fiscal policy is thus boosting aggregate demand by 1.5% of GDP. Nonfinancial private credit has increased by an average of 1.5 percentage points of GDP per year since 2016. Assuming that every additional one dollar of credit increases aggregate demand by 50 cents, the revival in credit growth is raising aggregate demand by 0.75% of GDP, compared to a baseline where credit-to-GDP is flat. The labor share of income has increased by 1.25% of GDP from its lows in 2015. Assuming that every one dollar shift in income from capital to labor boosts overall spending on net by 20 cents, this would have raised aggregate demand by 0.25% of GDP. Lastly, if the personal savings rate falls by two points over the next two years, this would raise aggregate demand by 1.5% of GDP. Taken together, these factors are boosting the neutral rate by anywhere from 2% (Taylor's specification) to 4% (Yellen's specification). This is obviously a lot, and easily overwhelms other factors such as a stronger dollar that may be weighing on the neutral rate. 2 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. Euro area private-sector credit growth accelerated from -2.6% in May 2014 to 3.1% in March 2017, but has been broadly flat ever since. Hence, the credit impulse has dropped. 3 Please see Global Investment Strategy Special Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 20, 2018. 4 For this calculation, we assume that the fair value for EUR/USD is 1.32, which is close to the IMF's Purchasing Power Parity (PPP) estimate. The annual inflation differential of 0.47% is based on 30-year CPI swaps. This implies that the fair value for EUR/USD will rise to 1.52 after 30 years. If one assumes that the euro reaches that level by then, the common currency would need to trade at 1.52/(1.0208)^30=0.82 today. Appendix A Appendix A Chart IMarket Outlook: Equities 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Appendix A Chart IIMarket Outlook: Bonds 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Appendix A Chart IIIMarket Outlook: Currencies 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Appendix A Chart IVMarket Outlook: Commodities 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Appendix B Appendix B Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Appendix B Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Appendix B Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Appendix B Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Macro outlook: Global growth will continue to decelerate into early next year on the back of brewing EM stresses and an underwhelming policy response from China. Equities: Stay neutral for now, while underweighting EM relative to DM stocks. Within DM, overweight the U.S. in dollar terms. Bonds: Global bond yields may dip in the near term, but the longer-term path is firmly higher. Currencies: The dollar is working off overbought conditions, but will rebound into year-end. EM currencies will suffer the most. Commodities: Favor oil over industrial metals. Precious metals will also remain under pressure until the dollar peaks next year, before beginning a major bull run as inflation accelerates. Feature I. Economic Outlook The Fed Can Hike A Lot More If 2017 was the year of a synchronized global growth recovery, 2018 is turning out to be a year where desynchronization is once again the name of the game. The U.S. economy continues to fire on all cylinders, while much of the rest of the world is struggling to stay afloat. The divergence in economic outcomes has been mirrored in central bank policy. The Fed is now hiking rates once per quarter whereas most other major central banks are still sitting on their hands. How high can U.S. rates go? The answer is a lot higher than investors anticipate. Market participants currently expect the Fed funds rate to rise to 2.37% by the end of this year and 2.84% by the end of 2019. No rate hikes are priced in for 2020 and beyond. The Fed dots are somewhat higher than market expectations (Chart I-1). The median dot rises to about 3.4% in 2020-21, but then falls back to 3% over the Fed's longer-run horizon. Both investors and the Fed have apparently bought into Larry Summers' secular stagnation thesis. They seem convinced that rates will not be able to rise above 3% without triggering a recession. While we have a lot of sympathy for Summers' thesis, it must be acknowledged that it is a theory about the long-term determinants of the neutral rate of interest. Over a shorter-term cyclical horizon, many factors can influence the neutral rate. Critically, most of these factors are pushing it higher: Fiscal policy is extremely stimulative. The IMF estimates that the U.S. cyclically-adjusted budget deficit will reach 6.8% of GDP in 2019. In contrast, the euro area is projected to run a deficit of only 0.8% of GDP (Chart I-2). The relatively more expansionary nature of U.S. fiscal policy is one key reason why the Fed can raise rates while the ECB cannot. Chart I-1Markets Expect No Fed Hikes Beyond Next Year October 2018 October 2018 Chart I-2Fiscal Policy Is More Expansionary In ##br##The U.S. Than In The Euro Area Fiscal Policy Is More Expansionary In The U.S. Than In The Euro Area Fiscal Policy Is More Expansionary In The U.S. Than In The Euro Area Credit growth has picked up. After a prolonged deleveraging cycle, private-sector nonfinancial debt is increasing faster than GDP (Chart I-3). The recent easing in The Conference Board's Leading Credit Index suggests that this trend will continue (Chart I-4). Chart I-3U.S. Private-Sector Nonfinancial Debt Is ##br##Rising At Close To Its Historic Trend U.S. Private-Sector Nonfinancial Debt Is Rising At Close To Its Historic Trend U.S. Private-Sector Nonfinancial Debt Is Rising At Close To Its Historic Trend Chart I-4U.S. Credit Growth Will Remain Strong U.S. Credit Growth Will Remain Strong U.S. Credit Growth Will Remain Strong Wage growth is accelerating. Average hourly earnings surprised on the upside in August, with the year-over-year change rising to a cycle high of 2.9%. This followed a stronger reading in the Employment Cost Index in the second quarter. A simple correlation with the quits rate suggests that there is plenty of upside for wage growth (Chart I-5). Faster wage growth will put more money into workers' pockets who will then spend it. The savings rate has scope to fall. The personal savings rate currently stands at 6.7%, more than two percentage points higher than what one would expect based on the current level of household net worth (Chart I-6). If the savings rate were to fall by two points over the next two years, it would add 1.5% of GDP to aggregate demand. Chart I-5The Quits Rate Is Signaling Upside For Wage Growth The Quits Rate Is Signaling Upside For Wage Growth The Quits Rate Is Signaling Upside For Wage Growth Chart I-6The Personal Savings Rate Has Room To Fall October 2018 October 2018 A back-of-the-envelope calculation suggests that these cyclical factors will permit the Fed to raise rates to 5% by 2020, almost double what the market is discounting.1 An Absence Of Major Financial Imbalances Will Allow The Fed To Keep Raising Rates The past three recessions were all caused by financial market overheating rather than economic overheating. The 1991 recession was mainly the consequence of the Savings and Loan crisis, compounded by the spike in oil prices leading up to the Gulf War. The 2001 recession stemmed from the dotcom bust. The Great Recession was triggered by the housing bust. Today, it is difficult to point to any clear imbalances in the economy. True, housing activity has been weak for much of the year. However, unlike in 2006, the home vacancy rate stands near record-low levels (Chart I-7). Tight supply will limit downside risks to both construction and home prices. On the demand side, low unemployment, high consumer confidence, and a rebound in the rate of new household formation should help the sector. Despite elevated home prices in some markets, the average monthly payment that homeowners must make to service their mortgage is quite low by historic standards (Chart I-8). The quality of mortgage lending has also been very high over the past decade, which reduces the risk of a sudden credit crunch (Chart I-9). Chart I-7Low Housing Inventories Will Support ##br##Home Prices And Construction Low Housing Inventories Will Support Home Prices And Construction Low Housing Inventories Will Support Home Prices And Construction Chart I-8Housing Affordabiity Is Not Yet Stretched Housing Affordabiity Is Not Yet Stretched Housing Affordabiity Is Not Yet Stretched Chart I-9Mortgage Lenders Are Being Prudent Mortgage Lenders Are Being Prudent Mortgage Lenders Are Being Prudent Unlike housing debt, there are more reasons to be concerned about corporate debt. The ratio of corporate debt-to-GDP has risen to record-high levels. So-called "covenant-lite" loans now make up the bulk of corporate leveraged loan issuance. While there is no doubt that the corporate debt market is the weakest link in the U.S. financial sector, some perspective is in order. U.S. corporate debt levels are quite low by global standards. Corporate debt in the euro area is more than 30 points higher as a percent of GDP than in the United States (Chart I-10). Moreover, the interest coverage ratio - EBIT divided by interest expense - for U.S. corporates is still above its historic average (Chart I-11). While this ratio will fall as interest rates rise, this will not happen very quickly. Most U.S. corporate debt is at fixed rates and average maturities have been rising. This reduces both rollover risk and the sensitivity of debt-servicing costs to higher short-term rates. Chart I-10U.S. Corporate Debt Not That High By Global Standards U.S. Corporate Debt Not That High By Global Standards U.S. Corporate Debt Not That High By Global Standards Chart I-11Interest Coverage Ratio Is Above Its Historic Average Interest Coverage Ratio Is Above Its Historic Average Interest Coverage Ratio Is Above Its Historic Average An increasing share of U.S. corporate debt is held by non-leveraged investors. Bank loans account for only 18% of nonfinancial corporate sector debt, down from 40% in 1980 (Chart I-12). This is important, because what makes a spike in corporate defaults so damaging is not the direct impact this has on the economy, but the second-round effects rising defaults have on financial sector stability. In any case, we already had a dress rehearsal for what a corporate debt scare might look like. Credit spreads spiked in 2015. Default rates rose, but the knock-on effects to the financial system were minimal. This suggests that corporate America could handle a fair bit of monetary tightening without buckling under the pressure. The Fed And The Dollar If the Fed is able to raise rates substantially more than the market is discounting while most central banks cannot, the short-term interest rate spread between the U.S. and its trading partners is likely to widen. History suggests that this will produce a stronger dollar (Chart I-13). Chart I-12Banks Have Been Reducing Their ##br##Exposure To The Corporate Sector Banks Have Been Reducing Their Exposure To The Corporate Sector Banks Have Been Reducing Their Exposure To The Corporate Sector Chart I-13Historically, The Dollar Has Moved ##br##In Line With Interest Rate Differentials Historically, The Dollar Has Moved In Line With Interest Rate Differentials Historically, The Dollar Has Moved In Line With Interest Rate Differentials Some have speculated that the Trump administration will intervene in the foreign-exchange market in order to drive down the value of the greenback. We doubt this will happen, but even if such interventions were to occur, they would not be successful. Presumably, currency interventions would take the form of purchases of foreign exchange, financed through the issuance of Treasurys. The purchase of foreign currency would release U.S. dollars into the financial system, but the sale of Treasury securities would suck those dollars back out of the system. The net result would be no change in the volume of U.S. dollars in circulation - what economists call a "sterilized" intervention. Both economic theory and years of history show that sterilized interventions do not have lasting effects on currency values. The Fed could, of course, provide funding for the Treasury's purchases of foreign exchange, leading to an increase in the monetary base. This would be tantamount to an unsterilized intervention. However, such a deliberate attempt to weaken the dollar by expanding the money supply would fly in the face of the Fed's efforts to cool growth by tightening financial conditions. We highly doubt the Fed's current leadership would go along with this. Emerging Markets In The Crosshairs The combination of rising U.S. rates and a stronger dollar is bad news for emerging markets. Eighty percent of EM foreign-currency debt is denominated in dollars. Outside of China, EM dollar debt is now back to late-1990s levels, both as a share of GDP and exports (Chart I-14). The wave of EM local-currency debt issued in recent years only complicates matters. If EM central banks raise rates to defend their currencies, this could imperil economic growth and make it difficult for local-currency borrowers to pay back their loans. Rather than hiking rates, some EM central banks may simply choose to inflate away debt. Consider the case of Brazil. The fiscal deficit stands at nearly 8% of GDP and government debt has soared from 60% of GDP in 2013 to 84% of GDP at present (Chart I-15). Ninety percent of Brazilian sovereign debt is denominated in reais. The Brazilian government won't default on its debt per se. However, if push comes to shove, Brazil's central bank can always step in to buy government bonds, effectively monetizing the fiscal deficit. This could cause the real to weaken much more than it already has. Chart I-14EM Dollar Debt Is High EM Dollar Debt Is High EM Dollar Debt Is High Chart I-15Brazil's Perilous Fiscal Position Brazil's Perilous Fiscal Position Brazil's Perilous Fiscal Position Chinese Stimulus To The Rescue? When emerging markets last succumbed to pressure in 2015, China saved the day by stepping in with massive stimulus. Fiscal spending and credit growth accelerated to over 15% year-over-year. The government's actions boosted demand for all sorts of industrial commodities. The stimulus measures in 2015 followed an even greater wave of stimulus in 2009. While these stimulus measures invigorated China's economy and helped put a floor under global growth, they came at a price: China's debt-to-GDP ratio has swollen from 140% in 2008 to over 250% at present, which has endangered financial stability (Chart I-16). Excess capacity has also increased. This can be seen in the dramatic rise in the capital-to-output ratio. It can also be seen in the fact that the rate of return on assets within the Chinese state-owned enterprise sector, which has been the main source of rising corporate leverage, has fallen below borrowing costs (Chart I-17). Chart I-16China: Debt And Capital ##br##Accumulation Went Hand In Hand China: Debt And Capital Accumulation Went Hand In Hand China: Debt And Capital Accumulation Went Hand In Hand Chart I-17China: Rate Of Return On Assets ##br##Below Borrowing Costs For SOEs China: Rate Of Return On Assets Below Borrowing Costs For SOEs China: Rate Of Return On Assets Below Borrowing Costs For SOEs Chinese banks are being told that they must lend more money to support the economy, while ensuring that their loans do not turn sour. Unfortunately, that is becoming an impossible feat. Chart I-18China Saves A Lot China Saves A Lot China Saves A Lot The Chinese economy produces too much and spends too little. The result is excess savings, epitomized most clearly in a national savings rate of 46% (Chart I-18). As a matter of arithmetic, national savings must be transformed either into domestic investment or exported abroad via a current account surplus. Now that the former strategy has run into diminishing returns, the Chinese authorities will need to concentrate on the latter. This will require a larger current account surplus which, in turn, will necessitate a relatively cheap currency. Above-average productivity growth has pushed up the fair value of China's real exchange rate over time. However, the currency still looks expensive relative to its long-term trend line (Chart I-19). Pushing down the value of the yuan against the dollar will not be that difficult. Chart I-20 shows that USD/CNY has moved broadly in line with the one-year swap spread between the U.S. and China. The spread was about 3% earlier this year. Today, it stands at only 0.6%. As the Fed continues to raise rates, the spread will narrow further, taking the yuan down with it. Chart I-19The RMB Is Still Quite Strong The RMB Is Still Quite Strong The RMB Is Still Quite Strong Chart I-20USD/CNY Has Tracked China-U.S. Interest Rate Differentials USD/CNY Has Tracked China-U.S. Interest Rate Differentials USD/CNY Has Tracked China-U.S. Interest Rate Differentials Unlike standard Chinese fiscal/credit easing, a stimulus strategy focused on weakening the yuan would hurt other emerging markets by undermining their competitiveness in relation to China. A weaker yuan would also make it more expensive for Chinese companies to import natural resources, thus putting downward pressure on commodity prices. The Euro Area: Back In The Slow Lane After putting in a strong performance in 2017, the economy in the euro area has struggled to maintain momentum this year. Growth is still above trend, but the overall tone of the data has been lackluster at best, with the risks to growth increasingly tilted to the downside. Weaker growth in China and other emerging markets certainly has not helped. However, much of the problem lies closer to home. Bank credit remains the lifeblood of the euro area economy. The 12-month credit impulse - defined as the change in credit growth from one 12-month period to the next - tends to track GDP growth (Chart I-21).2 Euro area credit growth accelerated over the course of 2017, but has been broadly stable this year. As a result, the credit impulse has fallen, taking GDP growth down with it. It will be difficult for euro area GDP growth to increase unless credit growth starts rising again. So far, there is little sign that this is about to happen. According to the latest euro area bank lending survey, while banks continue to ease standards for business loans, they are doing so at a slower pace than in the past. A net 3% of banks eased lending standards in the second quarter, compared to 8% in the first quarter. Loan demand growth has been fairly stable. This suggests that loan growth will remain positive, but is unlikely to increase much from current levels. Worries about the health of European banks will further constrain credit growth. European banks in general, and Spanish banks in particular, have significant exposure to the most vulnerable emerging markets (Chart I-22). Chart I-21Euro Area Credit Growth Has Flatlined Euro Area Credit Growth Has Flatlined Euro Area Credit Growth Has Flatlined Chart I-22Spain Most Exposed To Vulnerable EMs October 2018 October 2018 Concerns about the ability of the Italian government to service its debt obligations will also restrain bank lending. Investors breathed a sigh of relief last month when the Italian government signaled a greater willingness to pare back next year's proposed budget deficit, in accordance with the dictates of the European Commission. Tensions remain, however, as evidenced by the fact that the ten-year spread between BTPs and German bunds is still 120 basis points higher than in April (Chart I-23). The European political establishment is terrified of the rise in populism across the region and would love nothing more than to see Italy's populist parties implode. This means that any help from the ECB and the European Commission will only arrive once a full-fledged crisis is underway. Anyway, it is far from clear that a smaller budget deficit would actually translate into a lower government debt-to-GDP ratio. Like China, Italy also has a private sector that saves too much and spends too little. A shrinking population has reduced the need for firms to invest in new capacity. The prior government's pension cuts have also incentivized people to save more for their retirement. The result is a private sector savings-investment surplus that stood at 5% of GDP in 2017 compared to close to breakeven a decade ago (Chart I-24). Chart I-23Italian/Bund Spreads Signal Lingering Fiscal Strain Italian/Bund Spreads Signal Lingering Fiscal Strain Italian/Bund Spreads Signal Lingering Fiscal Strain Chart I-24Italy: Private Sector Saves Too Much And Spends Too Little Italy: Private Sector Saves Too Much And Spends Too Little Italy: Private Sector Saves Too Much And Spends Too Little Unlike Germany, Italy cannot export its excess production because it does not have a hypercompetitive economy. Nor does it have the ability to devalue its currency to gain a quick competitiveness boost. This means that the Italian government has to absorb excess private-sector savings with its own dissavings - a fancy way of saying that it has to run a large budget deficit. This has effectively been Japan's strategy for over two decades. However, unlike Japan, Italy does not have a lender of last resort that can unconditionally buy government debt. This raises the risk that Italy's debt woes will resurface, either because the government abandons austerity measures, or because the lack of fiscal support causes nominal GDP to stagnate, making it all but impossible for the country to outgrow its debt burden. Receding Policy Puts The discussion above suggests that many of the "policy puts" that investors have relied on are in the process of having their strike price marked down to deeper out-of-the-money levels. Yes, the Fed will ease off on rate hikes if U.S. growth is at risk of stalling out completely. However, now that the labor market has reached full employment, the Fed will welcome modestly slower growth. Remember that there has never been a case in the post-war era where the three-month average of the unemployment rate has risen by more than a third of a percentage point without a recession taking place (Chart I-25). The further the unemployment rate falls below NAIRU, the more difficult it will be for the Fed to achieve the proverbial soft landing. Chart I-25Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Likewise, the "China stimulus put" - the presumption that most investors have that the Chinese authorities will launch a barrage of fiscal and credit easing at the first sign of slower growth - has become less reliable in light of the government's competing objectives namely reducing debt growth and excess capacity. The same goes for the "ECB put." Yes, the ECB will bail out Italy if the entire European project appears at risk. But spreads may need to blow out before the cavalry arrives. Meanwhile, just as the aforementioned policy puts are receding, new policy risks are rising to the fore, chief among them protectionism. We expect the trade war to heat up, with the Trump administration increasingly directing its ire at China. Trump's macroeconomic policies are completely at odds with his trade agenda. Fiscal stimulus will boost aggregate demand, which will suck in more imports. An overheated economy will prompt the Fed to raise rates more aggressively than it otherwise would, leading to a stronger dollar. All this will result in a wider trade deficit. What will Trump tell voters two years from now when he is campaigning in Michigan and Ohio about why the trade deficit has widened rather than narrowed under his watch? Will he blame himself or Beijing? No trophy for getting that answer right. II. Financial Markets Global Equities The combination of slower global growth, rising economic vulnerabilities outside the U.S., and a more challenging policy environment caused us to downgrade our view on global equities from overweight to neutral in June,3 while reiterating our preference for developed market equities relative to EM stocks. For now, we are comfortable with our bearish view towards emerging market stocks. While EM equities have cheapened, they are not yet at washed out levels (Chart I-26). Bottom fishers still abound, as evidenced by the fact that the number of shares outstanding in the MSCI iShares Turkish ETF has almost tripled since early April (Chart I-27). Chart I-26EM Assets: Valuations Not Yet At Washed Out Levels EM Assets: Valuations Not Yet At Washed Out Levels EM Assets: Valuations Not Yet At Washed Out Levels Chart I-27EM Bottom Fishers Still Abound EM Bottom Fishers Still Abound EM Bottom Fishers Still Abound At some point - probably in the first half of next year - investors will liquidate their remaining bullish EM bets. At that point, EM stocks will rebound. European and Japanese equities should also start to outperform the U.S., given their more cyclical nature. As far as the absolute direction of the S&P 500 is concerned, the next few months could be challenging. U.S. stocks have been able to decouple from those in the rest of the world, but this state of affairs may not last. Recall that the S&P 500 fell by 22% peak-to-trough between July 20 and October 8, 1998, in what otherwise was a massive bull market. We do not know if there is another Long-Term Capital Management lurking around the corner, but if there is, a temporary selloff in U.S. stocks may be hard to avoid. Such a selloff would present a buying opportunity over a horizon of 12-to-18 months. If we are correct that cyclical forces have lifted the neutral rate of interest, it will take a while for monetary policy to reach restrictive territory. This means that both fiscal and monetary policy will stay accommodative at least for the next 18 months. As such, the S&P 500 may not peak until 2020. Appendix A - Chart I presents a stylized diagram of where we think global equities are going. It incapsulates three phases: 1) a challenging period over the next six months, driven by EM weakness; 2) a blow-off rally in equities starting in the middle of next year; 3) and finally, a recession-induced bear market beginning in late-2020. Appendix B also presents our valuation charts, which highlight that long-term return prospects are better outside the United States. Fixed Income After advocating for a long duration strategy for much of the post-crisis recovery, BCA declared "The End Of The 35-Year Bond Bull Market" on July 5, 2016, the very same day that the 10-year U.S. Treasury yield hit a record closing low of 1.37%. Cyclically and structurally, we continue to expect U.S. bond yields to rise more than the market is discounting. As noted above, the Fed is underestimating how high rates will need to go before they reach restrictive territory. This means that the Fed will end up behind the curve in normalizing monetary policy, causing the economy to overheat and inflation to rise above the Fed's comfort zone. Granted, the Fed is willing to tolerate a modest inflation overshoot. However, a core PCE reading above 2.3%, which is at the top end of the range of the Fed's own forecast, would prompt the Fed to expedite the pace of rate hikes. A bear flattening of the yield curve - a situation where long-term yields rise, but short-term rates go up even more - would be highly likely in that environment. Over a shorter-term horizon spanning the next six months, the outlook for yields is more benign. The combination of a stronger dollar, slower global growth, and flight-to-quality flows into the Treasury market from vulnerable emerging markets can cap yields. Add to this the fact that sentiment towards bonds is currently extremely bearish (Chart I-28), and a temporary countertrend decline in yields becomes quite probable. Chart I-28Bond Sentiment Is Extremely Bearish Bond Sentiment Is Extremely Bearish Bond Sentiment Is Extremely Bearish Developed market bond yields in general are likely to follow the direction of U.S. yields, both on the upside and the downside, but in a more muted manner. Outside the periphery, euro area yields have less scope to fall in the near term given that they are already so low. European yields also have less room to rise once global growth bottoms next year because the neutral rate of interest is much lower in the euro area than in the United States. Ironically, a more dovish ECB would help reduce Italian bond yields, as higher inflation is critical for increasing Italian nominal GDP. Since labor market slack is still elevated in Italy, continued monetary stimulus would also lift wages in core Europe more than in Italy, helping to boost Italy's competitiveness relative to the rest of the euro area. Japanese yields have plenty of scope to rise over the long haul. An aging population is pushing more people into retirement, which will cause the national savings rate to fall further. A decline in the savings pool will increase the neutral rate of interest in Japan. Instead of raising the policy rate, the Japanese authorities will let the economy overheat, generating inflation in the process. This will cause the yield curve to steepen, particularly at the very long end (e.g., beyond 10 years) which is the part of the yield curve that is the least susceptible to the BoJ's yield curve control regime. Appendix A - Chart II shows our expectations for the major government bond markets over the coming years. Turning to credit markets, high-yield credit typically underperforms in the latter innings of business-cycle expansions, a period when the Fed is raising rates. Thus, while we do not think that U.S. corporate debt levels will be a major source of systemic financial risk for the broader economy, this is hardly a reason to be overweight spread-product. A more cautious stance towards credit outside the U.S. is also warranted. Currencies And Commodities The dollar is working off overbought conditions, but will rebound into year-end, as EM tensions intensify and hopes of a massive credit/fiscal-fueled Chinese stimulus package fizzle. EM currencies will weaken the most against the dollar over the next three-to-six months, but the euro and, to a lesser extent, the yen, will also come under pressure. Granted, the dollar is no longer a cheap currency, but if long-term interest rate differentials stay anywhere close to current levels, the greenback will remain well supported. Consider the dollar's value against the euro. Thirty-year U.S. Treasurys currently yield 3.20% while 30-year German bunds yield 1.12%, a difference of 208 basis points. Even if one allows for the fact that investors expect euro area inflation to be lower than in the U.S. over the next 30 years, EUR/USD would need to trade at a measly 82 cents today in order to compensate German bund holders for the inferior yield they will receive.4 We do not expect EUR/USD to get down to that level, but a descent into the $1.10-to-$1.12 range over the next six months is probable. Sterling will remain hostage to Brexit negotiations. It is impossible to know how talks will evolve, but our bias is to take a somewhat pound-positive view. The main reason is that support for Brexit has faded (Chart I-29). Opinion polls suggest that if a referendum were held again, the "bremain" side would almost certainly prevail. Lacking public support for leaving the EU, it is unlikely that British negotiators could simply walk away from the table. This reduces the odds of a "hard Brexit" outcome. Indeed, a second referendum that leads to a "no-Brexit" verdict remains a distinct possibility. The combination of slower global growth and a resurgent dollar is likely to hurt commodity prices. Industrial metals are more vulnerable than oil. China consumes around half of all the copper, nickel, aluminum, zinc, and iron ore produced around the world (Chart I-30). In contrast, China represents less than 15% of global oil demand. Chart I-29When Bremorse Sets In When Bremorse Sets In When Bremorse Sets In Chart I-30China Is A More Dominant Consumer Of Metals Than Oil China Is A More Dominant Consumer Of Metals Than Oil China Is A More Dominant Consumer Of Metals Than Oil The supply backdrop for oil is also more favorable than for metals. Not only are Saudi Arabia and Russia maintaining production discipline, but U.S. sanctions against Iran threaten to weigh on global crude supply. Further reduction in Venezuela's oil output, as well as potential disruptions to Libyan or Iraqi exports, could also boost oil prices. The superior outlook for oil over metals means we prefer the Canadian dollar relative to the Aussie dollar. While AUD/CAD has weakened in recent months, the Aussie dollar is still somewhat expensive against the loonie based on our long-term valuation model (Chart I-31). We also see an increasing chance that Canada will negotiate a revamped trade deal with the U.S., as Trump focuses his attention more on China. Should this happen, it will remove the NAFTA break-up risk discount embedded in the Canadian dollar. Finally, a few words on precious metals. Precious metals typically struggle during periods when the dollar is appreciating (Chart I-32). Consequently, we would not be eager buyers of gold or other precious metals until the dollar peaks, most likely around the middle of next year. As inflation starts to accelerate in late-2019 and in 2020, gold will finally move decisively higher. Chart I-31Canadian Dollar Still Somewhat ##br##Cheap Versus The Aussie Dollar Canadian Dollar Still Somewhat Cheap Versus The Aussie Dollar Canadian Dollar Still Somewhat Cheap Versus The Aussie Dollar Chart I-32Gold Won't Shine Until The Dollar Peaks Gold Won't Shine Until The Dollar Peaks Gold Won't Shine Until The Dollar Peaks Appendix A - Chart III and Chart IV present an illustration of where the major currencies and commodities are heading. Peter Berezin Chief Global Strategist Global Investment Strategy September 28, 2018 Next Report: October 25, 2018 1 Depending on which specification of the Taylor rule one uses, a one percent of GDP increase in aggregate demand will increase the neutral rate of interest by half a point (John Taylor's original specification) or by a full point (Janet Yellen's preferred specification). Fiscal policy is currently about 3% of GDP too stimulative compared to a baseline where government debt-to-GDP is stable over time. Assuming a fiscal multiplier of 0.5, fiscal policy is thus boosting aggregate demand by 1.5% of GDP. Nonfinancial private credit has increased by an average of 1.5 percentage points of GDP per year since 2016. Assuming that every additional one dollar of credit increases aggregate demand by 50 cents, the revival in credit growth is raising aggregate demand by 0.75% of GDP, compared to a baseline where credit-to-GDP is flat. The labor share of income has increased by 1.25% of GDP from its lows in 2015. Assuming that every one dollar shift in income from capital to labor boosts overall spending on net by 20 cents, this would have raised aggregate demand by 0.25% of GDP. Lastly, if the personal savings rate falls by two points over the next two years, this would raise aggregate demand by 1.5% of GDP. Taken together, these factors are boosting the neutral rate by anywhere from 2% (Taylor's specification) to 4% (Yellen's specification). This is obviously a lot, and easily overwhelms other factors such as a stronger dollar that may be weighing on the neutral rate. 2 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. Euro area private-sector credit growth accelerated from -2.6% in May 2014 to 3.1% in March 2017, but has been broadly flat ever since. Hence, the credit impulse has dropped. 3 Please see Global Investment Strategy Special Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 20, 2018. 4 For this calculation, we assume that the fair value for EUR/USD is 1.32, which is close to the IMF's Purchasing Power Parity (PPP) estimate. The annual inflation differential of 0.47% is based on 30-year CPI swaps. This implies that the fair value for EUR/USD will rise to 1.52 after 30 years. If one assumes that the euro reaches that level by then, the common currency would need to trade at 1.52/(1.0208)^30=0.82 today. APPENDIX A APPENDIX A CHART IMarket Outlook: Equities October 2018 October 2018 APPENDIX A CHART IIMarket Outlook: Bonds October 2018 October 2018 APPENDIX A CHART IIIMarket Outlook: Currencies October 2018 October 2018 APPENDIX A CHART IVMarket Outlook: Commodities October 2018 October 2018 APPENDIX B Long-Term Return Prospects Are Slightly Better Outside The U.S. October 2018 October 2018 Long-Term Return Prospects Are Slightly Better Outside The U.S. October 2018 October 2018 Long-Term Return Prospects Are Slightly Better Outside The U.S. October 2018 October 2018 Long-Term Return Prospects Are Slightly Better Outside The U.S. October 2018 October 2018 II. Is It Time To Buy Value Stocks? Per the most commonly referenced growth and value indexes, growth has been outperforming value for over 11 years, the longest stretch in the history of the series. Growth's extended winning streak has split investors into two camps: those who believe that value is finished because of overexposure and shortened investor timeframes, and those who are trying to identify the point at which reversion to the mean will ensue. In this Special Report, we argue that the traditional off-the-shelf indexes are poor proxies for true value. Their methodology strays quite far from the principles enumerated by Benjamin Graham, the father of value investing, and Fama and French, the researchers who demonstrated that lower-priced stocks have outperformed over time. The headline S&P 500 indexes currently differentiate between growth and value stocks using simplistic metrics that introduce considerable sector bias, reducing the difference between growth and value to a binary choice between Tech and Financials. Using tools developed by BCA's Equity Trading Strategy service, we create sector-neutral U.S. value and growth indexes that correct for the off-the-shelf indexes' flaws, and broaden the range of metrics Fama and French employed to make style distinctions. The ETS-derived indexes appear to better distinguish between value and growth stocks. The ETS value-versus-growth portfolio beat its Fama and French counterpart by four percentage points annually over its 22-year life. We join our custom value and growth indexes to Fama and French's to study the impact of macro variables on relative style performance over time for the purpose of gaining insight into the most opportune points to shift between styles. Relative style performance has not corresponded consistently or robustly enough with the business cycle, inflation, interest rates, or broad market direction to support reliable style-decision rules. We find that monetary policy settings, as defined by our stylized fed funds rate cycle, are a consistently reliable predictor of relative style performance. Per the fed funds rate cycle, tight policy is most conducive to value outperformance. From this perspective, value's decade-long slump is not a surprise, given that the ultra-accommodative tide has been lifting all boats. There is no rush to increase value exposure while policy remains easy, but investors should look to load up on value once policy becomes tight, using the metrics in our ETS model to identify true value stocks. We expect that the policy inflection will occur sometime in the second half of 2019, or the first half of 2020. Growth stocks have been on a tear for the longest stretch in the history of the series, based on the most commonly referenced growth and value indexes, even if their gains haven't yet matched the magnitude of the 1990s (Chart II-1). It is no surprise, then, that growth stocks are as expensive as they have ever been, outside of the tech-bubble era in the late 1990s. Many investors are thus wondering if the next "big trade" is to bet on an extended reversion to the mean during which value regains the ground it has given up. Chart II-1A Lost Decade For Value Stocks A Lost Decade For Value Stocks A Lost Decade For Value Stocks In this Special Report, we argue that the traditional off-the-shelf indexes are not very good at differentiating growth from value stocks. Trends in relative performance have much more to do with sector performance than intrinsic value, making the indexes a poor proxy for investors who are truly interested in selecting stocks based on their value and growth profiles. We create U.S. value and growth indexes that are unaffected by sector performance, using stock selection software provided by BCA's Equity Trading Strategy service. The results will surprise readers who are used to dealing with canned measures of value and growth. What Is Value Investing? Value investing principles have been around at least since the days when Benjamin Graham was a money manager himself. Style investing has been a part of the asset-management lexicon for four decades. Yet there is no universally agreed-upon definition of a value stock versus a growth stock. Based on our reading of Graham's Intelligent Investor, we submit that an essential element of value investing is the identification of stocks that are temporarily trading below their intrinsic value. The temporary drag may persist for a while - stock markets can remain oblivious to fundamentals for extended stretches - but it is ultimately expected to dissipate. Value investing is a play on negative overreaction or neglect, and dedicated value investors have to be contrarians, not to mention contrarians with strong stomachs. The temporary nature of undervaluation is a recurring theme in Graham's book. The stock market's ever-present proclivity toward overreaction ensures a steady supply of value opportunities: "The market is always making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks.1" "[W]hen an individual company ... begins to lose ground in the economy, Wall Street is quick to assume that its future is entirely hopeless and it should be avoided at any price.2" "[T]he outstanding characteristic of the stock market is its tendency to react excessively to favorable and unfavorable influences.3" Graham viewed security analysis as the comparison of an issue's market price to its intrinsic value. He advised buying stocks only when they trade at a discount to intrinsic value, offering an investor a "margin of safety" that should guard against significant declines. His favorite measure for assessing intrinsic value was a sober, objective estimate of average future earnings, grossed-up by an appropriate multiple. A low price-to-average-earnings ratio was the linchpin of his margin-of-safety mantra. Decades after Graham's heyday, University of Chicago professors Eugene Fama and Kenneth French bestowed the academy's seal of approval on value investing. Their landmark 1992 paper found that low price-to-book ("P/B") stocks consistently and convincingly outperformed high P/B stocks.4 Several "growth" and "value" indexes have been developed over the years, but they bear no more than a passing resemblance to Graham's, and Fama and French's, work. It is important to realize that the off-the-shelf indexes are far from an ideal proxy for the value factor that Fama & French tried to isolate. Traditional Growth And Value Indexes Are Wanting The off-the-shelf growth and value indexes shown in Chart II-1 all share similar cyclical profiles, with only small differences in long-term returns. Given the similarity of the indexes, we will focus on Standard & Poor's/Citigroup methodology for the purposes of this report.5 The headline S&P 500 indexes currently differentiate between growth and value stocks using the following metrics: 3-year growth rates in EPS, 3-year growth rates in sales-per-share, and 12-month price momentum; along with valuation yardsticks including price-to-book, price-to-earnings, and price-to-sales. Companies with higher growth rates in earnings and sales, and better price momentum, are classified as growth stocks, while those with lower valuation multiples are considered value stocks. Several stocks are cross-listed in both indexes, which is baffling and counterproductive for an investor seeking to implement a rigorous style tilt.6 Table II-1 contains a summary of the current sector breakdowns for the S&P 500 Growth and Value indexes. Table II-2 sheds light on each index's aggregate geographical and U.S. business cycle exposure, the former of which is based on our U.S. Equity Strategy service's judgment. Table II-1Current S&P 500 Style Index Exposures October 2018 October 2018 Table II-2The Value Index Has Less Global ##br##And Late Cyclical Exposure October 2018 October 2018 Growth is currently heavily weighted in Health Care, Technology and Consumer Discretionary sectors, while value has a high concentration of Financials, Energy and Consumer Staples (Table II-1). Table II-2 shows that the growth index has a clear current bias toward sectors with global economic exposure that typically outperform the broad equity market late in the business cycle. The value benchmark flips growth's global/domestic exposure, and has slightly more exposure to defensive sectors, while splitting its cyclical exposure evenly between early and late cyclicals. Sector Dominance Unfortunately, the reigning methodology creates a major problem - shifts in the relative performance of growth and value indexes are dominated by sector performance. Financials' higher debt loads, and banks' low-margin operations, depress their multiples relative to nonfinancial firms. Thus, Financials hold permanent residency in the off-the-shelf value indexes. Conversely, Tech stocks perennially account for an outsized proportion of most growth indexes' market cap. Value-versus-growth boils down to a binary choice between Financials and Tech.7 The growth/value price ratio has closely tracked the Technology/Financials price ratio since the late 1990s (Chart II-2, top panel). The correlation was much less evident before 1995, when Tech stocks accounted for a much smaller share of market capitalization. Chart II-3 demonstrates that the positive correlation between growth/value and Tech has steadily climbed over the decades to almost 1, while the correlation with Financials has become increasingly negative (currently at -0.75). Chart II-2The S&P 500 Style Indexes Merely Mimic Relative Sector Performance The S&P 500 Style Indexes Merely Mimic Relative Sector Performance The S&P 500 Style Indexes Merely Mimic Relative Sector Performance Chart II-3Style Capture Style Capture Style Capture In contrast, the Fama/French approach, which focuses exclusively on price-to-book while ensuring equal representation for large- and small-market-cap stocks, appears much less affected by sector skews; the growth/value index created from their data has not tracked the Tech/Financials ratio, even after 1995 (Chart II-2, second panel). Moreover, note that the extended downward trend in the Fama/French growth/value ratio is consistent with other academic research that shows that value stocks outperform growth over the long-term. The off-the-shelf indexes show the opposite, but that is because they are merely tracking the long-term outperformance of Tech relative to Financials. The bottom line is that the standard indexes incorporate flawed measures of growth and value that limit their usefulness for true style investing. Conventional Wisdom With respect to style investing and the economic cycle, the prevailing conventional wisdom holds that: Inflation - Growth stocks perform best during times of disinflation and persistently low inflation, whereas value stocks perform best during periods of accelerating inflation; Interest Rates - Periods of high and rising interest rates favor value stocks at the expense of growth; and Business Cycle - It is believed that growth stocks outperform value during recessions, because the latter tend to be more highly leveraged to the economic cycle than their growth counterparts. According to the conventional view, value stocks shine in the early and middle phases of a business cycle expansion. Growth stocks return to favor again in the late states of an expansion, when investors begin to worry about the pending end to the business cycle and are looking for reliable and consistent earnings growth. Do the traditional measures of growth and value corroborate this conventional wisdom? Chart II-4 shows that the S&P value/growth index and headline CPI inflation have both trended lower since the early 1980s, but there has been no tendency for value to outperform when inflation rises. Value has shown some tendency to outperform during rising-rate phases since the mid-1980s, but the relationship with the level of the fed funds rate is stronger than its direction, as we discuss below. The growth-over-value relationship with the business cycle is complicated by the tech bubble in the late 1990s, which heavily distorted relative sector performance. The Citigroup measure of growth began to outperform very late in the cycle and through the subsequent recession in some business cycles (1979-1981, 1989-1991, and 2007-2009; Chart II-5). The early and middle parts of the cycles, however, were a mixed bag. Chart II-4Spiting The Conventional Wisdom Spiting The Conventional Wisdom Spiting The Conventional Wisdom Chart II-5No Consistent Relationship With The Business Cycle No Consistent Relationship With The Business Cycle No Consistent Relationship With The Business Cycle The bottom line is that there appears to be some rough correspondence between the Citigroup index and the interest rate and growth cycles, but it is too variable to point to reliable rules for shifting between styles. Ultimately, determining the direction of the growth and value indexes is more about forecasting relative Tech and Financials performance than it is about identifying cheap stocks. A Better Value Approach We identify four broad shortcomings of off-the-shelf value indexes: They exclusively use trailing multiples, a rear-view mirror metric. They rely on simple price-to-book multiples, which flatter serial acquirers. They rely entirely on reported earnings, which are an imperfect proxy for cash flow. A share of stock ultimately represents a claim on its issuer's future cash flows. They make no attempt to place relative metrics into historical context. Without a mechanism to compare a particular segment's valuation relative to its history, structurally low-multiple stocks will be over-represented and structurally high-multiple stocks will be under-represented. BCA's Equity Trading Strategy (ETS) platform provides a way of differentiating value from growth stocks that avoids these problems. The web-based platform uses 24 quantitative factors to rank approximately 10,000 individual stocks in 23 countries. Users can rank and score individual equities to support a broad set of investment strategies and apply macro and sector views to single-name investments. The ETS approach has an impressive track record. Historically, the top decile of stocks ranked using the "BCA Score" methodology has outperformed stocks in the bottom decile by over 25% a year. The overall BCA Score includes all 24 factors when ranking stocks, but to develop our custom value index, we use only the five valuation measures in the ETS database: trailing P/E, forward P/E, price-to-tangible-book, price-to-sales and price-to-cash flow. Every quarter we rank the stocks within each of the 11 sectors based on an equally-weighted composite of the five valuation measures. Note that we are using the data to rank stocks only against other stocks in the same sector. We calculate the total return from owning the top 30% of stocks by value in each sector. We do the same with the bottom 30% and refer to this as our "growth" index.8 We then compute an equally-weighted average of the total returns for the growth indexes across the 11 sectors. We do the same for the value indexes. By comparing stock valuation only to other stocks in the same sector, this approach avoids the sector composition problem suffered by the off-the-shelf measures. Chart II-6 compares the ETS value/growth total return index to the Fama/French value/growth index. Data limitations preclude comparing the two measures before 1996, but the ETS index confirms the Fama/French result that value trumps growth over the long term. The ETS index follows a similar cyclical profile to the Fama/French index from 1997 to 2009, rising and falling in tandem. The two series subsequently diverge: per the criteria ETS uses to identify value and construct an index, lower-priced stocks have outperformed higher-priced ones for most of this expansion, while the Fama/French methodology suggests the reverse. Chart II-6The ETS Model Builds On Fama And French's Work The ETS Model Builds On Fama And French's Work The ETS Model Builds On Fama And French's Work By avoiding sector composition problems and using a wider variety of value measures, the ETS approach appears to be a superior measure of value. An investor that consistently over-weighted value stocks according to the ETS approach would have outperformed someone who did the same using the Fama methodology by an annual average of four percentage points from 1996 to 2018. The history of our ETS index only covers two recessions, limiting our ability to gauge its performance vis-Ã -vis a variety of macro factors, so we extend the ETS index back to 1926 using the Fama/French index. While joining two indexes with different methodologies is less than ideal, we feel the drawbacks are outweighed by the benefit of observing growth and value relative performance across more business cycles. The top panel of Chart II-7 shows U.S. real GDP growth, shaded for recessions. The bottom panel presents our extended ETS value/growth index, shaded for declines of more than 10%. The shaded periods overlap in many, but not all, cycles (indicated by circles in the chart). That is, growth stocks have tended to outperform during economic downturns, although this is not a hard-and-fast rule. Chart II-7No Hard-And-Fast Relationship With The Business Cycle... No Hard-And-Fast Relationship With The Business Cycle... No Hard-And-Fast Relationship With The Business Cycle... Value-over-growth relative returns exhibit some directionality with the overall equity market when looking at corrections (peak-to-trough declines of at least 10%, as shaded in the top panel of Chart II-8), though it should be noted that it is nearly impossible to flag a correction in advance. The relationship weakens when considering bear markets, i.e. peak-to-trough declines of at least 20%, which can be forecast with at least some reliability.9 The bottom panel is the same as in Chart II-7; the extended ETS index, shaded for periods of significant value stock underperformance. The correspondence between the shaded periods is hardly perfect, and there does not appear to be a practical style exposure message, even if an investor could call corrections in advance. Chart II-8...And Market Directionality Has Been An Imperfect Guide Over The Last 50 Years ...And Market Directionality Has Been An Imperfect Guide Over The Last 50 Years ...And Market Directionality Has Been An Imperfect Guide Over The Last 50 Years Valuation Relative valuation also provides some useful information on positioning, though it is not always timely. Chart II-9 presents an aggregate valuation measure for the stocks in our value index relative to that of the stocks in our growth index. Value stocks are expensive relative to growth when the valuation indicator is above +1 standard deviation, and value is cheap when the indicator is less than -1 standard deviation. Historically, investors would have profited if they had over-weighted value stocks when the valuation indicator reached the threshold of undervaluation, although subsequent outperformance was delayed by as much as a year in two episodes. In contrast, the valuation indicator is not useful as a 'sell' signal for value stocks because they can remain overvalued for long periods. Value was overvalued relative to growth for much of the time between 2009 and 2016. Value stocks have cheapened since then, although they have yet to reach the undervaluation threshold. The Fed Funds Rate Cycle While relative style performance may generally lean in one direction or another in conjunction with the business cycle, inflation, interest rates, or broad equity-market performance, there are no hard-and-fast rules. It is difficult to formulate any sort of rotation view between styles, and history does not inspire confidence that any such rule would generate material outperformance. The monetary policy backdrop offers a path forward. We have found the fed funds rate cycle offers a consistent guide to equity and bond returns in other contexts, and our Global ETF Strategy service has found a robust link between the policy cycle and equity factor performance.10 We segment the fed funds rate cycle into four phases, based on whether or not the Fed is hiking or cutting rates, and whether policy is accommodative or restrictive (Chart II-10). Our judgment of the state of policy is derived from comparing the fed funds rate to our estimate of the equilibrium fed funds rate, the policy rate that neither encourages nor discourages economic activity. Chart II-9Sizeable Undervaluation Flags Turning ##br##Points, But You May Have To Wait A While Sizeable Undervaluation Flags Turning Points, But You May Have To Wait A While Sizeable Undervaluation Flags Turning Points, But You May Have To Wait A While Chart II-10The Fed Funds Rate Cycle October 2018 October 2018 As defined by Fama and French, value stocks outperform growth stocks by a considerable margin when monetary policy is restrictive (Table II-3 and Chart II-11, top panel). Considering value and growth stocks separately, both perform extremely well when policy is easy (Chart II-11, second panel), but growth stocks barely advance when policy is tight, falling far behind their value counterparts. A strategy for generalist investors may be to seek out value exposure when policy is tight, while investing without regard to styles when it is easy. Table II-3The State Of Monetary Policy Is The ##br##Best Guide To Style Performance October 2018 October 2018 Chart II-11The State Of Monetary Policy Drives Style Performance The State Of Monetary Policy Drives Style Performance The State Of Monetary Policy Drives Style Performance Investment Conclusions: U.S. equity sectors that have traditionally been considered "growth" have outperformed value sectors for an extended period. The long slump has led some investors to argue that value investing is finished, killed by a combination of overexposure and short-term performance imperatives. Other investors see value's long drought as an anomaly, and are looking for the opportune time to bet on a reversal. We are in the latter camp. The difficulty lies in finding an indicator that reliably leads value stocks' outperformance. Most macro measures are unhelpful, though broad market direction offers some insight, as stocks with low price-to-book multiples have outperformed their high-priced peers by a wide margin during bear markets. Bear markets aren't the most useful timing guide, however, because one only knows in retrospect when they begin and end. The monetary policy backdrop holds the most promise as a practical guide. Although our determination of easy or tight policy turns on the modeled estimate of a concept and should not be looked to for absolute precision, it has provided a timely, reliable guide to value outperformance. We expect the relationship will persist because of the cushion provided by less demanding multiples. Earnings and multiples surge when policy is easy, lifting all boats. It is only when policy is tight, and the tide is going out, that the margin of safety offered by lower-priced stocks yields the greatest benefit. Per our estimate of the equilibrium fed funds rate, we are still firmly ensconced within Phase I of the policy rate cycle, and expect that we will remain there until sometime in the second half of 2019. We therefore expect that value, in Fama and French terms, will continue to underperform growth for another year. The clock is ticking for growth, though, as the expansion is in its latter stages and building inflation pressures will likely force the Fed to take a fairly hard line in this rate-hiking cycle. Once monetary policy turns restrictive, investors should hunt for value candidates using a range of valuation metrics, and combine them in a sector-neutral way, as we have via our Equity Trading Strategy service's model. Mark McClellan Senior Vice President The Bank Credit Analyst Doug Peta Senior Vice President U.S. Investment Strategy 1 Graham, Benjamin, The Intelligent Investor, Harper Collins: New York, 2005, p. 97. 2 Ibid, p. 15. 3 Ibid, p. 189. 4 Fama, Eugene F. and French, Kenneth R., "The Cross-Section of Expected Stock Market Returns," The Journal of Finance, Volume 47, Issue 2 (June 1992), pp. 427-465. 5 S&P currently brands its Growth and Value Indexes as S&P 500 Dow Jones Indexes, but Citigroup has the longest history of compiling S&P 500 Growth and Value Indexes, beginning in 1975, so we join the Citigroup S&P 500 style indexes to the Standard & Poor's series to obtain the maximum style-index history. We use the terms Citigroup and S&P interchangeably. 6 The Pure Value and Pure Growth indexes include only the top quartile of value and growth stocks, respectively, with no overlap between indexes, and are therefore better gauges of true style investing. 7 The Tech-versus-Financials cast of the indexes endures because all of the other sectors, ex-regulated Telecoms and Utilities, which account for too little market cap to make a difference, regularly move between the indexes as their fundamental fortunes, and investor appetites, wax and wane. The current Early Cyclical/Late Cyclical/Defensive profiles are not etched in stone and should be expected to shift, perhaps considerably, over time. 8 We created a second growth index by taking the top 30% of stocks ranked by earnings momentum. However, it made little difference to the results, so we will use the bottom 30% of stocks by value as our measure of "growth" for the purposes of this report, consistent with Fama/French methodology. 9 Please see The Bank Credit Analyst. September 2017, available on bca.bcaresearch.com 10 Please see the May 17, 2017 Global ETF Strategy Special Report, "Equity Factors And The Fed Funds Rate Cycle," available at getf.bcaresearch.com. III. Indicators And Reference Charts Our equity indicators continue to signal that caution is warranted, but U.S. profits remain potent enough to drown out scattered negative messages. Our Monetary Indicator remains at the low end of a multi-year range, suggesting that liquidity conditions have tightened. Our Composite Technical Indicator is in no-man's land, not far above the zero line that marks a sell signal, but coming close to issuing a buy signal by crossing above its 9-month moving average. Our Composite Sentiment Indicator is in a healthy position that suggests that the current level of investor optimism is sustainable. On the other hand, not one of our Willingness-to-Pay (WTP) Indicators is moving in the right direction. The U.S. version is still weak and slowly getting weaker; the European one has flat-lined; and our Japanese WTP extended its decline, albeit from a high level. Our Revealed Preference Indicator (RPI) for stocks continues to issue a sell signal. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Momentum remains out of sync with valuation and policy, underlining the idea that caution is warranted. On balance, our indicators continue to suggest that the underlying supports of the U.S. equity bull market are eroding. Surging U.S. profits are papering over the cracks, and may still have some legs. Earnings surprises are at an all-time high, and the net revisions ratio remains elevated. The 10-year Treasury yield's march higher is due to run out of steam. Valuation (slightly cheap) and technicals (oversold by almost 2 standard deviations) imply that a countertrend pullback is not too far around the corner. Beyond a near-term correction, though, complacency about inflation and the Fed's ability to hike rates to at least the level of the FOMC voters' median projection points to looming capital losses. The dollar is quite expensive on a purchasing power parity basis, and its long-term outlook is not constructive, but policy and growth divergences with other major economies will likely keep the wind at its back in the near term. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys And Valuations U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Doug Peta Senior Vice President U.S. Investment Strategy