Asia

Highlights Financial market volatility in general and FX market volatility in particular is set to increase because of the following three factors: Rising U.S. inflation will make the Federal Reserve increasingly hawkish, and the European Central Bank is moving away from maximum accommodation; The Chinese economy is not accelerating; And geopolitical tensions are growing. While EM and commodity currencies will suffer, safe havens like the yen and Swiss franc will benefit. The euro may correct at first, but it remains on an upward trajectory. Feature Chart I-1Low And High Growth Sentiment##br## Are Linked Low And High Growth Sentiment Are Linked Low And High Growth Sentiment Are Linked A defining feature of global financial markets over the past two years has been the outright collapse of volatility. However, in late January the VIX rebounded, recording readings not seen since 2015. Currency volatility also hit three-year lows before the same wake-up call, causing a sharp but temporary increase in FX volatility. It is important to understand whether this recent rebound in volatility was just a blip or a symptom of something more profound - a sign that volatility is back on an uptrend and will continue to rise as it did from 1996 to 2002, or again from 2007 to 2009. This matters because volatility is an important determinant of FX returns. High-yielding carry currencies perform well when volatility is low. While low-yielding funding currencies like the Swiss franc or the yen suffer in periods of calm, their returns improve once volatility rises. Moreover, low-volatility environments are often associated with buoyant expectations about global growth among international investors (Chart I-1). Thus, a return of volatility could fray the edges of global growth sentiment, which is currently ebullient. This would hurt EM and commodity currencies. Our view is that volatility is making a comeback as global monetary policy is becoming less accommodative, China's path is becoming rockier and global geopolitical risks are rising. These dynamics will hurt EM and commodity currencies, while at the margin, help safe-haven currencies like the yen and Swiss franc. Monetary Policy In DM Economies Monetary policy in the advanced economies is not yet tight, but is moving away from the large accommodation implemented in the wake of the Great Financial Crisis. Historically, a removal of accommodative policy tends to be associated with rising volatility, especially in the FX space. The link is not that clear-cut though. Policy tightening tends to lead to higher volatility. However, it only does so once we enter the latter innings of the business cycle. Only when inflation begins to gain enough momentum to force the Fed to increase rates fast enough to raise the specter that policy will soon begin to hurt growth, does volatility start rising durably. We are getting closer to this moment in the U.S. The U.S. is increasingly showing signs of late-stage business expansion. For one, the yield curve has flattened to 53 basis points. This level of slope has historically been associated with full employment and rising wage pressures. Surveys corroborate this picture. The NFIB survey of U.S. small businesses shows that the gap between the difficulties of finding qualified labor versus demand problems is close to record highs. This normally marks rising wage pressures, the hallmark of full employment (Chart I-2). Moreover, the ISM manufacturing survey shows that companies are paying more for the price of their inputs and experiencing delays with suppliers. Normally, this also describes a late-cycle environment marked with rising inflationary pressures (Chart I-3). Chart I-2Late Cycle Dynamics##br## In The U.S. Late Cycle Dynamics In The U.S. Late Cycle Dynamics In The U.S. Chart I-3Firms Are Facing Budding##br## Inflationary Pressures Firms Are Facing Budding Inflationary Pressures Firms Are Facing Budding Inflationary Pressures Other variables are generally pointing toward an acceleration of U.S. inflation. Because aggregate U.S. capacity utilization - which incorporates both labor market conditions and the Fed's own capacity utilization measure - highlights a notable absence of slack, and because the change in the velocity of money in the U.S. is accelerating, our models forecast a sustained uptick in U.S. core inflation to 2% and above (Chart I-4). U.S. CPI excluding food and energy data for February is also pointing toward budding inflationary pressures. While the annual core inflation rate was flat compared to January, the annualized three-month rate of change has surged to 3%. The muted year-on-year comparison is being depressed by some base effect. In 2017, inflation started to weaken significantly in March. Therefore, beginning in March 2018, consumer price inflation in the U.S. will likely accelerate more noticeably than it has until now. Shelter inflation too is moving from a headwind to a tailwind. Shelter inflation represents 42% of the core CPI basket, and it has been on a decelerating trend for 14 months. However, the model developed by our U.S. Bond Strategy colleagues shows that U.S. shelter inflation is now set to start bottoming (Chart I-5, top panel). Chart I-4Core Inflation Will Rise Core Inflation Will Rise Core Inflation Will Rise Chart I-5Other Inflationary Pressures Other Inflationary Pressures Other Inflationary Pressures Core goods prices are also regaining some vigor. This is not much of a surprise. The strength of the global economy along with the weakness of the U.S. dollar have filtered through to higher import prices. Historically, import prices tend to lead core goods prices in the U.S. (Chart I-5, bottom panel). We could see rising inflationary pressures on the services front as well. The employment cost index - the cost component used to compute unit labor costs - is still displaying a tight positive correlation with the employment-to-population ratio for prime-age workers (Chart I-6). BCA estimates that employment gains above 123,000 new jobs a month will push this ratio up, and consequently labor costs. But as Chart I-7 illustrates, the strength in the Conference Board Leading Credit Index highlights that employment growth in the U.S. is likely to remain robust. This suggests the key driver of service inflation - wages - will continue to improve. Chart I-6Wages Will Keep Rising... The Return Of Macro Volatility The Return Of Macro Volatility Chart I-7...As Employment Growth Will Stay Strong ...As Employment Growth Will Stay Strong ...As Employment Growth Will Stay Strong Thus, it seems the stars are already aligning to foment a rise in U.S. core CPI. The Trump administration throwing in some large-scale fiscal stimulus into the mix is only akin to throwing fuel on a fire. Accordingly, we expect the Fed to upgrade its interest rate forecasts for 2019. Markets are not yet ready for this scenario, anticipating only five rate hikes between now and the end of 2019. Thus, the most important central bank for setting the global cost of capital will likely surprise in a hawkish fashion over the coming 21 months. But what about the other big DM central bank, the ECB? The ECB too has begun to remove monetary accommodation, as it has started to taper its purchases of securities. It aims to be done this in September. Moreover, the narrowing gap between the unemployment rate and NAIRU in the euro area points to budding inflationary pressures (Chart I-8). This would argue that the ECB will begin lifting interest rates toward the summer of 2019. In fact, the shadow policy rate for the euro area has already begun to turn higher (Chart I-9), suggesting European policy is already starting to move away from its accommodative extremes. This combination is very important for volatility. As Chart I-10 illustrates, the average shadow policy rate for the U.S., the euro area, the U.K., and Japan leads financial markets and FX volatility. While Japanese rates may remain at low levels, the path for Europe and the U.S. is clearly up, suggesting volatility will rise. Chart I-8Growing Wage Pressures In Europe Growing Wage Pressures In Europe Growing Wage Pressures In Europe Chart I-9ECB Policy Is Already Less Accommod ECB Policy Is Already Less Accommod ECB Policy Is Already Less Accommod Chart I-10Tighter Global Policy Leads To Higher Volatility Tighter Global Policy Leads To Higher Volatility Tighter Global Policy Leads To Higher Volatility Bottom Line: The U.S. is increasingly displaying symptoms that its business cycle expansion is at an advanced stage. With inflationary pressures growing more intense, the Fed will need to ratchet up its tightening path. The ECB too has begun removing accommodation. This means that two of the three most important price setters for the cost of money are either fully tightening policy or beginning to remove accommodation. This has historically marked the point when global financial market volatility begins to rise. China Uncertainty China is another factor pointing toward a rise in global financial volatility. China has exerted a benign influence on global growth from the second half of 2016 and through most of 2017. In response to a large easing in monetary conditions and a hefty dose of fiscal stimulus, Chinese growth had until recently regained vigor, with the Li Keqiang index - our preferred measure of Chinese industrial activity - swinging from -2.6 sigma to 0.5 sigma in 15 months. A key gauge of Chinese activity - the average of the new orders and backlog of order subcomponents of the PMIs surveys - captured these dynamics very well. This indicator also explains the gyrations in various measures of asset markets volatility well (Chart I-11). Currently, it points to a rise in global financial market volatility. Going forward, the key question for investors is whether or not Chinese orders continue to deteriorate, flagging a further rise in volatility. We are inclined to say yes. Chinese monetary conditions have continued to deteriorate, and administrative measures to slow down the growth of total social financing are starting to bite. Chart I-12 shows that the issuance of bonds by small financial intermediaries has slowed significantly. Based on this message, the early slowdown in total debt growth should continue over the coming months. Optimists about China often highlight that this should have a limited impact on economic activity. After all, 62% of fixed asset investments in China are financed by internally generated funds. However, the biggest problem for China is the misallocation of capital. As Chart I-13 shows, construction as a percentage of total capex has been linked to population growth. However, after 2008, these two series decoupled: population growth has been stagnating while construction activity has been skyrocketing, despite a slowdown in the rate of migration from rural to urban areas. This suggests that post-2008, China has been building too many structures. Chart I-11China To Affect ##br##Volatility China To Affect Volatility China To Affect Volatility Chart I-12Administrative Tightening Will ##br##Weigh On Chinese Credit Administrative Tightening Will Weigh On Chinese Credit Administrative Tightening Will Weigh On Chinese Credit Chart I-13After The GFC, Chinese ##br##Construction Took Off After The GFC, Chinese Construction Took Off After The GFC, Chinese Construction Took Off When capital is misallocated, even if the share of debt financing is low, tight monetary conditions and administrative measures to limit excesses in the economy can bite sharply. This raises the risk that Chinese growth will not pick up much going forward, and that in fact, capex and industrial activity will struggle. Jonathan LaBerge, who writes BCA's Chinese Investment Strategy, has built a list of some of the key indicators he follows to track the evolution of the Chinese economy. Table I-1 shows that all but the Caixin/Markit manufacturing PMI index are in a downtrend, and that 11 out of the 14 variables have been deteriorating in recent months.1 Moreover, as Chart I-14 illustrates, the strength in the Caixin PMI is likely to be an aberration. When the spread between the Caixin and the official measure is as wide as it currently is, the following quarters tend to be followed by a fall in the average of the two series. Table I-1No Convincing Signs Of An Impending##br## Upturn In China's Economy The Return Of Macro Volatility The Return Of Macro Volatility Chart I-14The Caixin PMI Is Probably##br## The Noise, Not The Signal The Caixin PMI Is Probably The Noise, Not The Signal The Caixin PMI Is Probably The Noise, Not The Signal We would therefore expect Chinese economic momentum to slow further. Since Chinese policymakers still want to engineer some deleveraging, the Chinese industrial sector will decelerate. This will contribute to the rise in financial market volatility for the remainder of the business cycle, especially as global monetary policy in the G-10 is becoming less accommodative. Bottom Line: The Chinese economy contributed to low levels of volatility in financial markets from 2016 to late 2017. However, China still suffers from a large misallocation of capital, which is making its economy vulnerable to both monetary and administrative tightening. With most key gauges of Chinese economic activity still pointing south, industrial activity could deteriorate further. This will contribute to a rise in global financial market volatility, especially as DM central banks are removing monetary accommodation. Rising Geopolitical Tensions The last factor pointing toward rising financial market volatility are growing global geopolitical tensions. As Marko Papic has highlighted in BCA's Geopolitical Strategy service, the world's unipolar moment under the umbrella of U.S. dominance is over. The world is increasingly becoming a multi-polar environment, where multiple powers vie for local dominance. As the early 20th century and the 1930s showed, when the world becomes multi-polar, geopolitical risks rise (Chart I-15). Chart I-15Geopolitical Risk Is The Outcome Of Global Multipolarity Geopolitical Risk Is The Outcome Of Global Multipolarity Geopolitical Risk Is The Outcome Of Global Multipolarity Today's increasingly multi-polar world may not be headed for an imminent global war, but tensions are likely to increase. This means policies could become more erratic. Additionally, domestic politics are under stain as well. Rising inequality and social stagnation in the U.S. are fomenting public discontent (Chart I-16). Moreover, U.S. citizens are not champions of free trade; in fact, they view unfettered trade with a rather suspicious eye, as do the citizens of Italy, Japan or France (Chart I-17). Chart I-16The U.S. Is Unequal And Ossified The Return Of Macro Volatility The Return Of Macro Volatility Chart I-17America Belongs To The Anti-Globalization Bloc The Return Of Macro Volatility The Return Of Macro Volatility Practically, this means tensions such as those experienced two weeks ago around the imposition of tariffs on steel and aluminum imports into the U.S. are likely to continue. The White House is already discussing the possibility of imposing a 15% tariff on Chinese imports to the U.S. totaling US$60 billion. As we highlighted last week, alleged intellectual property theft by China will likely remain a hot-button topic that could result in painful sanctions, prompting swift retaliation by Beijing. Additionally, NAFTA negotiations are not over, pointing to continued headline risk in the space. Moreover, relations with Russia are tense, and the Iran deal looks increasingly fraught with uncertainty. These two spots could easily morph into yet another source of risk. Bottom Line: The global geopolitical environment has become a multi-polar system - an environment historically prone to serious tensions. The rise of populism in the U.S. only makes this risk more salient, especially with respect to global trade. As a result, the threat of a trade war, especially between the U.S. and China, is increasing. This means shocks to global trade and global growth could become more frequent. This will likely create another source of financial market volatility, compounding the impact of economic fundamentals like global monetary policy and China's economic risks. Investment Implications Carry trades should fare especially poorly in this environment, as they abhor rising volatility.2 Hence, the performance of EM high-yielders like the BRL, TRY, and ZAR could progressively deteriorate. Moreover, because rising volatility often hurts economic sentiment, this increase in volatility could weigh on growth-sensitive currencies like the KRW in the EM space or the AUD and the NZD in the DM space. The SEK would normally suffer when global growth sentiment deteriorates. Yet this time may play out differently. Swedish short rates are -0.5%, making the SEK a funding currency. If carry trades do suffer, the need to buy back funding currencies could put a bid under the SEK. In this context, the JPY and the CHF could be the great winners. Both currencies have been used as funding vehicles. Moreover, both Switzerland and Japan sport outsized net international investment positions equal to 126% and 65% of their respective GDPs. If volatility does rise, some Swiss and Japanese investors will likely repatriate funds from abroad, generating purchases of yen and Swiss francs in the process. Moreover, from an empirical perspective, both these currencies continue to react well when global volatility spikes. Chart I-18The Euro Is Vulnerable To Higher Vol The Euro Is Vulnerable To Higher Vol The Euro Is Vulnerable To Higher Vol However, both Japan and Switzerland are still experiencing weak inflation. The BoJ and the SNB will therefore try to lean against currency strength caused by exogenous volatility shocks. The JPY and the CHF could be caught between these forces. The currency depreciation these central banks try to engineer will be occasionally interrupted by sharp rallies when financial market volatility spikes. This means that monetary policy in these two countries will have to stay extremely accommodative. For now, it is still too early to bet against the yen's current strength. Finally, the impact of rising volatility on the euro's outlook is more nebulous. The euro is neither a carry currency nor a funding currency, but it generally appreciates when global growth sentiment improves. Thus, since long positioning in the euro is very stretched, a renewed spike in volatility would likely hurt the euro, especially as European economic surprises are plummeting relative to the U.S. (Chart I-18). Nonetheless, this pain will be a temporary phenomenon. The euro is still cheap, and one of the factors driving global volatility higher is the ECB abandoning its accommodative monetary policy stance. Moreover, as terminal interest rate expectations in Europe are still well below their historical average relative to the U.S., there is still ample room for investors to upgrade their assessment of where the European policy rate will end up vis-à-vis the U.S. at the end of the cycle. Bottom Line: Any negative impact of rising global financial markets volatility will be felt most acutely by carry and growth-sensitive currencies like the BRL, TRY, ZAR, AUD, and KRW. Contrastingly, funding currencies underpinned with large positive net international investment positions such as the JPY and the CHF will be beneficiaries. The impact on the euro may be negative at first, as speculators are massively long the euro despite a collapse in euro area economic surprises. However, the long-term impact should prove to be more muted as the euro's fundamentals are still improving. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China And The Risk Of Escalation", dated March 7,2018, available at cis.bcaresearch.com. 2 Please see Foreign Exchange Strategy Special Report, titled "Carry Trades: More than Pennies And Steamrollers", dated May 6, 2016, available at fes.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 U.S. data was generally positive for the dollar: Headline and core CPI came in line with expectations, growing at 2.2% and 1.8% annually, respectively; NFIB Business Optimism Index was hit 107.6, beating expectations of 107.1; Continuing jobless claims came in at 1.879 million, beating the expected 1.9 million; Initial jobless claims came in line with expectations at 226,000; However, retail sales came in weaker than expected, contracting by 0.1% monthly. Despite this generally positive tone to the data, the dollar was still soft this week. However, downward momentum has slowed, paving the way for a short-term counter trend rally. This is consistent with a global growth slowdown. Report Links: Are Tariffs Good Or Bad For The Dollar? - March 9, 2018 The Dollar Deserves Some Real Appreciation - March 2, 2018 Who Hikes Again? - February 9, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 European data was disappointing: Industrial production contracted in monthly terms by 1% and also grew at only 2.7% yearly, less than the expected 4.7% pace; German CPI grew at a 1.4% yearly pace, with the harmonized index growing by 1.2%, both in line with expectations. In a speech on Wednesday, President Draghi clarified that "monetary policy will remain patient, persistent and prudent" as there is still a need for "further evidence that inflation dynamics are moving in the right direction". As global growth is downshifting, the euro could experience a significant correction before resuming its bull market. Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: Machinery orders yearly growth came in at 2.9%, outperforming expectations. However, domestic corporate goods inflation surprised to the downside, coming in at 2.5%. Moreover, the tertiary industry Index month-on-month growth also underperformed expectations, coming in at -0.6%. Finally, labor cash earnings yearly growth came in line with expectations at 0.7%. Last Friday, the BoJ decided to leave its interest rate benchmark unchanged at 0.1%. In its minutes, the board members shared the view that CPI will reach their 2% in fiscal 2019. Overall, we expect that rising global interest rates will cause a rise in currency volatility. This will result in a positive environment for the yen for now, but one that could prevent Japanese inflation from hitting that 2% objective in 2019. Report Links: The Yen's Mighty Rise Continues... For Now - February 16, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Industrial production yearly growth underperformed expectations, coming in at 1.6%. Manufacturing production also underperformed expectations, coming in at 2.7%. However, the trade balance outperformed expectations, coming in at -3.074 billion pounds. The pound has been relatively flat this week against the U.S. dollar. Overall, we believe that the upside to the British pound against the dollar is limited, as there are already 40 basis points of interest rate hikes priced for the BoE this year. Given that inflation is set to ease following last year's rally in the pound, it is unlikely that the pound will raise rates more than what is currently priced. Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Australian data was mixed: Home loans fell by 1.1%; Investment lending for homes increased by 1.1%; The NAB Confidence survey declined to 9 from 11 but was in line with expectations; The NAB Conditions survey increased to 21, outperforming expectations; The Westpac Consumer Confidence increased from -2.3% to 0.2%. Elevated Household debt and the absence of wage growth are still at the forefront of Australian policymaker's minds. The RBA is reluctant to raise rates in order to avoid a deflationary spiral which would set the economy back severely. The AUD will most likely suffer this year because of this. Report Links: Who Hikes Again? - February 9, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been negative: The current account surprised to the downside, coming in at -2.7% of GDP. Moreover, GDP yearly growth also underperformed expectations, coming in at 2.9%. However, it did improve from last quarter growth of 2.7%. Finally, Food Price Index monthly growth decline from last month, coming in at -0.5%. The New Zealand dollar has been flat this week against the U.S. dollar. We believe that NZD/USD and NZD/JPY are likely to suffer moving forward, as financial markets volatility is set to rise in the coming months due to the rise in global interest rates and the possibility of a slowdown in China. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Canadian employment figures remain strong, with the ADP employment change coming in at 39,700, above the 10,700 experienced last month. Canada's export growth should improve further as the White House is adding large amounts of fiscal stimulus in the U.S. economy, Canada's largest trading partner. This will help the BoC stick to its hiking path. However, risks are high. While Canada has so far been able to avoid the U.S. steel and aluminum tariffs, NAFTA negotiations still remain a danger for the Canadian economy. Furthermore, the housing market still remains overheated and the debt load is at risk of spiraling when mortgages begin to be refinanced at higher rates. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 The SNB left its reference rate unchanged at -0.75%. The Swiss central bank reiterated that the negative rates as well as foreign exchange intervention "remain essential". Moreover, the SNB decreased its inflation forecast for this year form 0.7% to 0.6%. The SNB also changed its forecast for 2019 from 1.1% to 0.9%. Overall, the SNB is likely to maintain a very dovish stance, given the headwinds to Swiss inflation. This will continue to put upward pressure on EUR/CHF. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been positive: Headline inflation surprised to the upside, coming in at 2.2%. It also increased from 1.6% the previous month. Meanwhile, core inflation also outperformed expectations, coming in at 1.4%. It also increased from 1.1% the previous month. USD/NOK has depreciated by roughly 1.4% this week. On Thursday, the Norges Bank left its policy rate unchanged at 0.5%. In its monetary policy report the central bank highlighted that the outlook for the Norwegian economy suggests that "it will soon be appropriate to raise rates". Overall, we believe that the krone is likely to outperform other commodity currencies, given that there are only 18 basis points priced for the next 12 months, which is less than is warranted given the strength of the economy and BCA's outlook for oil prices in 2018. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 While Swedish inflation came in line with expectations, with consumer prices growing at a 0.7% monthly pace and a 1.6% yearly pace, Sweden's unemployment came in at a much lower level than anticipated. The krona is finally strengthening after EUR/SEK traded above the critical 10.00 level. This trend should continue as the euro weakens from overbought levels. Furthermore, the eventual resurgence of inflation in Sweden will propel the SEK to stronger levels as markets reprice the Riksbank's likely policy path. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Several economic and financial market indicators point to a budding downtrend in Chinese capital spending and its industrial sector. The recent underperformance of global mining, chemicals and machinery/industrials corroborate that capital spending in China is starting to slump. Shipments-to-inventory ratios for Korea and Taiwan also point to a relapse in Asian manufacturing. This is occurring as our global growth sentiment proxy sits on par with previous peaks, and investor positioning in EM and commodities is overextended. Stay put on EM. Markets with currency pegs to the U.S. dollar, such as the Gulf states and Hong Kong, will face tightening local liquidity. Share prices in these markets have probably topped out. Feature On the surface, EM equities, currencies and local bond and credit markets are still trading well. However, there are several economic indicators and financial variables that herald negative surprises for global and Chinese growth. In particular: China's NBS manufacturing PMI new orders and backlogs of orders have relapsed in the past several months. Chart I-1 illustrates the annual change in new orders and backlogs of orders to adjust for seasonality. The measure leads industrial profits, and presently foreshadows a slowdown going forward. Furthermore, the average of NBS manufacturing PMI, new orders, and backlog orders also points to a potential relapse in industrial metals prices in general as well as mainland steel and iron ore prices (Chart I-2). The message from Charts I-1 and I-2 is that the recent weakness in iron ore and steel prices could mark the beginning of a downtrend in Chinese capital spending. While supply cuts could limit downside in steel prices, it would be surprising if demand weakness does not affect steel prices at all.1 Chart I-1China: Slowdown Has Further To Run China: Slowdown Has Further To Run China: Slowdown Has Further To Run Chart I-2Industrial Metals Prices Have Topped Out Industrial Metals Prices Have Topped Out Industrial Metals Prices Have Topped Out Although China's money and credit have been flagging potential economic weakness for a while, the recent manufacturing PMI data from the National Bureau of Statistics finally confirmed an impending deceleration in industrial activity and ensuing corporate profit disappointment. Our credit and fiscal spending impulses continue to point to negative growth surprises in capital spending. The latter is corroborated by the weakening Komatsu's Komtrax index, which measures the average hours of machine work per unit in China (Chart I-3). In both Korea and Taiwan, the overall manufacturing shipments-to-inventory ratios have dropped, heralding material weakness in both countries' export volumes (Chart I-4). Chart I-3Signs Of Weakness In Chinese Construction Signs Of Weakness In Chinese Construction Signs Of Weakness In Chinese Construction Chart I-4Asia Exports Are Slowing Asia Exports Are Slowing Asia Exports Are Slowing Notably, global cyclical equity sectors that are leveraged to China's capital spending such as materials, industrials and energy have all recently underperformed the global benchmark (Chart I-5). Some of their sub-sectors such as machinery, mining and chemicals have also begun to underperform (Chart I-6). Chart I-5Global Cyclicals Have ##br##Begun Underperforming... Global Cyclicals Have Begun Underperforming... Global Cyclicals Have Begun Underperforming... Chart I-6...Including Machinery ##br##And Chemical Stocks ...Including Machinery And Chemical Stocks ...Including Machinery And Chemical Stocks Among both global and U.S. traditional cyclicals, only the technology sector is outperforming the benchmark. However, we do not think tech should be treated as a cyclical sector, at least for now. In brief, the underperformance of global cyclical equity sectors and sub-sectors following last month's equity market correction corroborate that China's capital spending is beginning to slump. Notably, this is occurring as our global growth sentiment proxy rests on par with its previous apexes (Chart I-7). Previous tops in this proxy for global growth sentiment have historically coincided with tops in EM EPS net revisions, as shown in this chart. Chart I-7Global Growth Sentiment: As Good As It Gets Global Growth Sentiment: As Good As It Gets Global Growth Sentiment: As Good As It Gets All told, we may be finally entering a meaningful slowdown in China that will dampen commodities prices and EM corporate earnings. The latter are still very strong but EPS net revisions have rolled over and turned negative again (Chart I-8). Chart I-8EM EPS Net Revisions Have Plummeted EM EPS Net Revisions Have Plummeted EM EPS Net Revisions Have Plummeted EM share prices typically lead EPS by about nine months. In 2016, EM stocks bottomed in January-February, yet EPS did not begin to post gains until December 2016. Even if EM corporate profits are to contract in the fourth quarter of this year, EM share prices, being forward looking, will likely begin to wobble soon. Poor EM Equity Breadth There is also evidence of poor breadth in the EM equity universe, especially compared to the U.S. equity market. First, the rally in the EM equally-weighted index - where all individual stocks have equal weights - has substantially lagged the market cap-weighted index since mid 2017. This suggests that only a few large-cap companies have contributed a non-trivial share of capital gains. Second, the EM equal-weighted stock index's and EM small-caps' relative share prices versus their respective U.S. counterparts have fallen rather decisively in the past six weeks (Chart I-9, top and middle panels). While the relative performance of market cap-weighted indexes has not declined that much, it has still rolled over (Chart I-9, bottom panel). We compare EM equity performance with that of the U.S. because DM ex-U.S. share prices themselves have been rather sluggish. In fact, DM ex-U.S. share prices have barely rebounded since the February correction. Third, EM technology stocks have begun underperforming their global peers (Chart I-10). This is a departure from the dynamics that prevailed last year, when a substantial share of EM outperformance versus DM equities was attributed to EM tech outperformance versus their DM counterparts and tech's large weight in the EM benchmark. Chart I-9EM Versus U.S. Equities: Relative ##br##Performance Is Reversing EM Versus U.S. Equities: Relative Performance Is Reversing EM Versus U.S. Equities: Relative Performance Is Reversing Chart I-10EM Tech Has Started ##br##Underperforming DM Tech EM Tech Has Started Underperforming DM Tech EM Tech Has Started Underperforming DM Tech Finally, the relative advance-decline line between EM versus U.S. bourses has been deteriorating (Chart I-11). This reveals that EM equity breadth - the advance-decline line - is substantially worse relative to the U.S. Chart I-11EM Versus U.S.: Relative Equity Breadth Is Very Poor EM Versus U.S.: Relative Equity Breadth Is Very Poor EM Versus U.S.: Relative Equity Breadth Is Very Poor Bottom Line: Breadth of EM equity performance versus DM/U.S. has worsened considerably. This bodes ill for the sustainability of EM outperformance versus DM/U.S. We continue to recommend an underweight EM versus DM position within global equity portfolios. Three Pillars Of EM Stocks EM equity performance is by and large driven by three sectors: technology, banks (financials) and commodities. Table I-1 illustrates that technology, financials and commodities (energy and materials) account for 66% of the EM MSCI market cap and 75% of MSCI EM total (non-diluted) corporate earnings. Therefore, getting the outlook of these sectors right is crucial to the EM equity call. Table I-1EM Equity Sectors: Earnings & Market Cap Weights EM: Disguised Risks EM: Disguised Risks Technology Four companies - Alibaba, Tencent, Samsung and TSMC - account for 17% of EM and 58% of EM technology market cap, respectively. This sector can be segregated into hardware tech (Samsung and TSMC) and "new concept" stocks (Alibaba and Tencent). We do not doubt that new technologies will transform many industries, and there will be successful companies that profit enormously from this process. Nevertheless, from a top-down perspective, we can offer little insight on whether EM's "new concept" stocks such as Alibaba and Tencent are cheap or expensive, nor whether their business models are proficient. Further, these and other global internet/social media companies' revenues are not driven by business cycle dynamics, making top-down analysis less imperative in forecasting their performance. We can offer some insight for technology hardware companies such as Samsung and TSMC. Chart I-12 demonstrates that semiconductor shipment-to-inventory ratios have rolled over decisively in both Korea and Taiwan. In addition, semiconductor prices have softened of late (Chart I-13) Together, this raises a red flag for technology hardware stocks in Asia. Chart I-12Asia's Semiconductor Industry Asia's Semiconductor Industry Asia's Semiconductor Industry Chart I-13Semiconductor Prices: A Soft Spot? Semiconductor Prices: A Soft Spot? Semiconductor Prices: A Soft Spot? Finally, Chart I-14 compares the current run-up in U.S. FANG stocks (Facebook, Amazon, Netflix and Google) with the Nasdaq mania in the 1990s. An equal-weighted average stock price index of FANG has risen by 10-fold in the past four and a half years. Chart I-14U.S. FANG Stocks Now ##br##And 1990s Nasdaq Mania U.S. FANG Stocks Now And 1990s Nasdaq Mania U.S. FANG Stocks Now And 1990s Nasdaq Mania A similar 10-fold increase was also registered by the Nasdaq top 100 stocks in the 1990s over eight years (Chart I-14). While this is certainly not a scientific approach, the comparison helps put the rally in "hot" technology stocks into proper historical perspective. The main take away here is that even by bubble standards, the recent acceleration in "new concept" stocks has been too fast. That said, it is impossible to forecast how long any mania will persist. This has been and remains a major risk to our investment strategy of being negative on EM stocks. In sum, there is little visibility in EM "new concept" tech stocks. Yet Asia's manufacturing cycle is rolling over, entailing downside risks to tech hardware businesses. Putting all this together, we conclude that it is unlikely that EM tech stocks will be able to drive the EM rally and outperformance in 2018 as they did in 2017. Banks We discussed the outlook for EM bank stocks in our February 14 report,2 and will not delve into additional details here. In brief, several countries' banks have boosted their 2017 profits by reducing their NPL provisions. This has artificially boosted profits and spurred investors to bid up bank equity prices. We believe banks in a number of EM countries are meaningfully under-provisioned and will have to augment their NPL provisions. The latter will hurt their profits and constitutes a major risk for EM bank share prices. Energy And Materials The outlook for absolute performance of these sectors is contingent on commodities prices. Industrial metals prices are at risk of slower capex in China. The mainland accounts for 50% of global demand for all industrial metals. Oil prices are at risk from traders' record-high net long positions in oil futures, according to CFTC data (Chart I-15, top panel). Traders' net long positions in copper are also elevated, according to the data from the same source (Chart I-15, bottom panel). Hence, it may require only some U.S. dollar strength and negative news out of China for these commodities prices to relapse. Chart I-15Traders' Net Long Positions In ##br##Oil And Copper Are Very Elevated Traders' Net Long Positions In Oil And Copper Are Very Elevated Traders' Net Long Positions In Oil And Copper Are Very Elevated How do we incorporate the improved balance sheets of materials and energy companies into our analysis? If and as commodities prices slide, share prices of commodities producers will deflate in absolute terms. However, this does not necessarily mean they will underperform the overall equity benchmark. Relative performance dynamics also depend on the performance of other sectors. Commodities companies could outperform the overall equity benchmark amid deflating commodities prices if other equity sectors drop more. In brief, the improved balance sheets of commodities producers may be reflected in terms of their relative resilience amid falling commodities prices but will still not preclude their share prices from declining in absolute terms. Bottom Line: If EM bank stocks and commodities prices relapse as we expect, the overall EM equity index will likely experience a meaningful selloff and underperform the DM/U.S. benchmarks. Exchange Rate Pegs Versus U.S. Dollar With the U.S. dollar depreciating in the past 12 months, pressure on exchange rate regimes that peg their currencies to the dollar has subsided. These include but are not limited to Hong Kong, Saudi Arabia and the United Arab Emirates (UAE). As a result, these countries' interest rate differentials versus the U.S. have plunged (Chart I-16). In short, domestic interest rates in these markets have risen much less than U.S. short rates. This has kept domestic liquidity conditions easier than they otherwise would have been. However, maneuvering room for these central banks is narrowing. In Hong Kong, the exchange rate is approaching the lower bound of its narrow band (Chart I-17). As it touches 7.85, the Hong Kong Monetary Authority (HKMA) will have no choice but to tighten liquidity and push up interest rates. Chart I-16Markets With U.S. Dollar Peg: ##br##Policymakers' Maneuvering Window Is Closing Markets With U.S. Dollar Peg: Policymakers' Maneuvering Window Is Closing Markets With U.S. Dollar Peg: Policymakers' Maneuvering Window Is Closing Chart I-17Hong Kong: Interest ##br##Rates Are Heading Higher Hong Kong: Interest Rates Are Heading Higher Hong Kong: Interest Rates Are Heading Higher In Saudi Arabia and the UAE, the monetary authorities have used the calm in their foreign exchange markets over the past year to not match the rise in U.S. short rates (Chart I-18A and Chart I-18B). However, with their interest rate differentials over U.S. now at zero, these central banks will have no choice but to follow U.S. rates to preserve their currency pegs.3 Chart I-18ASaudi Arabian Interest Rates Will Rise The UAE Interest Rates Will Rise The UAE Interest Rates Will Rise Chart I-18BThe UAE Interest Rates Will Rise Saudi Arabian Interest Rates Will Rise Saudi Arabian Interest Rates Will Rise If U.S. interest rates were to move above local rates in Saudi Arabia and the UAE, those countries' currencies will come under considerable depreciation pressure because capital will move from local currencies into U.S. dollars. Hence, if U.S. short rates move higher, which is very likely, local rates in these and other Gulf countries will have to rise if their exchange rate pegs are to be preserved. Neither the Hong Kong dollar nor Gulf currencies are at risk of devaluation. The monetary authorities there have enough foreign currency reserves to defend their respective pegs. Nevertheless, the outcome will be domestic liquidity tightening in the Gulf's and Hong Kong's banking system. In addition, potentially lower oil prices will weigh on Gulf bourses and China's slowdown will hurt growth and equity sentiment in Hong Kong. All in all, equity markets in Gulf countries and Hong Kong have probably seen their best in terms of absolute performance. Potential negative external shocks and higher interest rates due to Fed tightening have darkened the outlook for these bourses. Bottom Line: Local liquidity in Gulf markets and Hong Kong is set to tighten. Share prices in these markets have probably topped out. However, given these equity markets have massively underperformed the EM equity benchmark, they are unlikely to underperform when the overall EM index falls. Hence, we do not recommend underweighting these bourses within an EM equity portfolio. For asset allocators, a neutral or overweight allocation to these bourses is warranted. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report "China's "De-Capacity" Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017; the link is available on page 16. 2 Please see Emerging Markets Strategy Special Report "EM Bank Stocks Hold The Key," dated February 14, 2018; the link is available on page 16. 3 Please see BCA's Frontier Markets Strategy Special Report "United Arab Emirates: Domestic Tailwinds, External Headwinds," dated March 12, 2018. The link is available on fms.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

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

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

Highlights Chinese domestic stocks have materially lagged their investable peers over the past three years, due to the legacy effects of an enormous, policy-driven bubble in 2014-2015. While A-shares have worked off some of this speculative bubble and multiples are no longer extreme, the outlook for earnings is uninspiring and the valuation discount offered by domestic stocks is modest, at best. Investors should maintain a neutral stance towards Chinese A-shares over the coming 6-12 months, but should remain alert to any improvements in China's housing market and especially any easing monetary policy, as they may signal a potential upgrade catalyst. Finally, we note that the negative perception of Chinese domestic stocks by many global investors does not appear to be justified by the data. A-shares have a place within a regional equity portfolio, and should not be ignored when the right cyclical conditions present themselves. Feature Since last October we have written extensively about the character and magnitude of the economic slowdown in China, and what it means for both Chinese import growth as well as earnings growth for the MSCI China Index (our investable benchmark). Chart 1Disappointing Relative Performance ##br##From A-Shares Disappointing Relative Performance From A-Shares Disappointing Relative Performance From A-Shares We have focused our investment strategy discussions on investable stocks because domestic A-shares have underperformed our investable benchmark by a significant margin over the past three years (Chart 1). In this week's report we take a closer look at the reasons for this underperformance, and review the outlook for A-shares over the coming 6-12 months. We conclude that the case for A-shares is currently uninspiring over the cyclical investment horizon, warranting a neutral stance for now. However, we also note that the negative perception of China's domestic stocks among some global investors, that it is a "casino" market untethered from fundamentals, is not supported by the data. This underscores that A-shares deserve a place within a regional equity portfolio, and should be favored when cyclical conditions warrant it. 2014-2015: A Policy-Driven Bubble In Domestic Stocks The drivers of A-share underperformance over the past few years can be traced back to events that occurred in 2014/2015, when A-shares rose 160% over the course of 12 months (Chart 2). Following several years of poor performance in the domestic stock market, Chinese policymakers began a push in 2014 to encourage retail investors to buy A-shares. This policy was part of a plan to help reduce what the government saw as a massive flow of savings towards investments that were excessively speculative in nature (such as wealth management products and China's property market), as well as to support a market that authorities hoped would become a more prominent target of international investors. This push involved lowering transaction and account opening fees, lowering margin debt restrictions, and using state media to wage a campaign to encourage equity ownership.1 Chart 3 highlights that the authorities' efforts initially worked at boosting stock prices, by showing the strong relationship between the MSCI China A Onshore index and margin debt linked to the Shanghai and Shenzhen stock exchanges. But this experiment ultimately ended badly, and domestic stock prices and margin debt began to crash in the summer of 2015. In total, the MSCI China A Onshore index fell roughly 50% from June 2015 to January 2016, nearly rivaling the total decline experienced by the S&P 500 during the 2007-2009 global financial crisis. Chart 22014/2015 Was A Policy-Driven Bubble ##br##In Domestic Stocks 2014/2015 Was A Policy-Driven Bubble In Domestic Stocks 2014/2015 Was A Policy-Driven Bubble In Domestic Stocks Chart 3Easing Margin Debt Restrictions ##br##Had An Enormous Impact Easing Margin Debt Restrictions Had An Enormous Impact Easing Margin Debt Restrictions Had An Enormous Impact While domestic stocks have risen by an impressive 30% (12.5% annualized) since they troughed in early-2016, they have underperformed their investable peers (both overall and excluding technology) over the same period. This disappointing relative performance has caused many global investors to question whether they should bother investing in A-shares, and under what conditions, if any, should they favor domestic stocks over investable equities. A-Share Value No Longer Extreme... The narrative of a policy-driven bubble in 2014-2015 suggests that extreme overvaluation is the root cause of the recent underperformance of domestic Chinese equities. Chart 4 shows that this is indeed the case, by presenting the 12-month forward P/E ratio for MSCI China (our investable benchmark), MSCI China A Onshore, and All Country World. Chinese equities, both investable and domestic, were deeply discounted relative to global stocks in late-2014, reflecting the multi-year Chinese economic slowdown that began in mid-2010. But the government's campaign to encourage domestic stock ownership caused the A-share multiple to more than double in 12 months, and to exceed that of global stocks. Chart 4The Underperformance Of A-Shares, As Told By Multiples The Underperformance Of A-Shares, As Told By Multiples The Underperformance Of A-Shares, As Told By Multiples The multiple of investable equities also rose due to the campaign, but by a much smaller magnitude. It began to fall in mid-2015 alongside the domestic stock multiple but bottomed before the end of the year in response to signs that China's economy was about to enter the upswing of a mini economic cycle. The following 2 years saw investable equities re-rate significantly as China's economy recovered, whereas the still-elevated domestic market multiple simply trended sideways. But the bottom line for investors is that A-shares have worked off a good portion amount of the overvaluation that was caused by the policy-driven bubble of 2014-2015, meaning that their risk-reward profile has materially improved. ...But The Outlook For Domestic Stocks Is Uninspiring Given that domestic equities have largely closed their valuation gap relative to investable stocks, shouldn't investors be overweight the former? In our view, there are several factors currently arguing against an overweight stance towards A-shares: While we acknowledge the improvement in relative valuation, multiples at a level similar to the overall investable market are not cheap enough to make domestic stocks look highly attractive, given that the latter are no longer cheap themselves versus the global benchmark. We noted in our February 15 Weekly Report that investable technology stocks have been responsible for pushing our relative composite valuation indicator for China into overvalued territory over the past year,2 and we recommended in that report that investors continue to maintain their Chinese equity exposure on an ex-tech basis (which are considerably cheaper in relative terms). Given the fact that China's economy is slowing, and given that the corporate sector has substantially increased its leverage over the past decade, we believe that Chinese equities should be priced at some discount relative to global stocks. Chart 5 suggests that this discount is modest, at best. Chart 5 shows that domestic stocks are modestly cheap versus the global benchmark according to earnings and book value, but are expensive according to cash flow and dividends. While gaps of these kinds have existed in the past, the fact that cash-based measures have been lagging more accrual-based measures since 2013 raises the odds of a problem with earnings quality in the domestic market. This is a topic that we hope to revisit in the coming months, but for now it reinforces the view that the valuation discount applied to A-shares (versus global) is likely insufficient. Chart 6 presents a forecast for A-share earnings per share growth in U.S. dollars, based on its relationship with the Li Keqiang index. The chart shows that while a significant earnings contraction is not in the cards, the growth rate may fall to zero over the coming 6-12 months. This, in conjunction with only a minor valuation discount relative to global stocks, paints an uninspiring cyclical outlook for A-shares over the coming year. Chart 5The Current Valuation Discount Applied To A-Shares Is Modest, At Best The Current Valuation Discount Applied To A-Shares Is Modest, At Best The Current Valuation Discount Applied To A-Shares Is Modest, At Best Dispelling The Myth Of The "Casino" Market While we find the cyclical outlook for A-shares to be lackluster, the fact that valuation has improved significantly since mid-2015 is an important development from the perspective of regional equity allocation. From our perspective, A-shares should be on the radar screen of global investors as a potential market to favor if the opportunity presents itself, even if the cyclical conditions do not currently warrant an overweight stance. Besides the issue of regulated investability, one reason why global investors tend to overlook domestic Chinese stocks is the perception that A-shares are largely a "casino" market. Admittedly, the decision by policymakers in 2014 to effectively engineer a bubble in domestic stocks did not help to dispel this perspective. However, a closer examination of this question highlights that domestic Chinese equities are, while relatively volatile, hardly untethered from fundamentals at the broad index level. First, Chart 6 below highlighted that there is a close correlation between the Li Keqiang index and the growth rate of A-share trailing earnings. Earnings quality issues aside (the risk of which can be managed by assigning a valuation discount), this certainly does not suggest that A-share returns are more likely to be random than other stock markets. Second, as we noted in a September Special Report,3 the gap in the volatility of A-shares relative to other markets is slowly declining (Chart 7). More recently, the decline in A-share volatility appears to be due to the involvement of China's "national team", i.e. purchases by state-owned financial institutions that are designed to reduce the oscillation of daily price changes, and that began in the wake of the 2015 selloff with the goal of stabilizing the stock market. In the developed world, this type of government interference in financial markets is viewed with deep suspicion and is often referred to in the financial media as being necessary for the government to "prop up" its stock market to avoid an inevitable decline. Chart 6An Uninspiring Domestic Equity Earnings Outlook An Uninspiring Domestic Equity Earnings Outlook An Uninspiring Domestic Equity Earnings Outlook Chart 7A-Shares Are Relatively Volatile, But The Gap Is Narrowing A-Shares Are Relatively Volatile, But The Gap Is Narrowing A-Shares Are Relatively Volatile, But The Gap Is Narrowing But Chart 6 highlights how this is misleading: the recovery in A-share earnings that has occurred since 2015 is clearly legitimate given the mini-cycle upswing, meaning that China's "national team" has, at worst, prevented a sharp decline in an elevated multiple over the past two years. It is difficult to see this as anything but a genuine attempt at managing the workout process of a market that underwent a major shock, quite similar in concept to what the Federal Reserve did in the U.S. during the first few years of the subpar economic recovery. From our perspective, as long as this buying remains counter-cyclical and does not somehow interfere with the link between the economy and underlying earnings growth, this should argue in favor a global investor allocation to A-shares (via a lower equity risk premium), not against it. Third, a "casino" market that truly ignores fundamentals and is based heavily on herd-following behavior should rank as highly inefficient from the perspective of the Efficient Markets Hypothesis (EMH). We test whether the A-share market falls into this category by looking for two telltale signs of an inefficient market: whether past returns carry significant information about future returns, and whether simple technical trading rules can lead to outsized profits. Tables 1 and 2 present our findings: in Table 1, we show the F-statistic and R-squared of a second-order autoregression for several regional markets (higher numbers = less efficient), and in Table 2 we show the "win rate" of a trend following rule that buys stocks in the following month if the closing index price at the end of the prior month is above its 9-month moving average (higher win rate = less efficient). Table 1China's Domestic Market Is Less Inefficient Than It Used To Be A-Shares: Stay Neutral, For Now A-Shares: Stay Neutral, For Now Table 2Simple Technical Rules Don't Earn Outsized Profits In The A-Share Market A-Shares: Stay Neutral, For Now A-Shares: Stay Neutral, For Now The tables show that while there is some evidence to suggest that the A-share market has been relatively inefficient on average compared with other stock markets since the beginning of the last decade, this gap has been significantly reduced over the past few years. To us, this is a compelling sign that A-shares deserve a place within a global equity portfolio and should be favored when cyclical conditions warrant it. Investment Conclusions The ongoing economic slowdown in China means that the earnings outlook for domestic Chinese equities is uninspiring. When coupled with a modest (at best) valuation discount relative to global stocks, this suggests that global investors should have a neutral allocation to A-shares over the coming 6-12 months. However, the observable link between China's economy and domestic equity earnings growth means that investors should be looking to increase their allocation to A-shares on any signs of a pickup in Chinese economic activity. In particular, Chart 8 highlights that domestic stocks appear more likely to lead corporate bond spreads and housing market indicators than investable stocks are, suggesting that any significant easing in monetary policy or a continued improvement in the housing market could act as a potential catalyst to upgrade A-shares even within the context of a benign growth slowdown in China's industrial sector. Chart 8A-Shares Better Lead The Housing Market##br## And Domestic Corporate Bond Spreads A-Shares Better Lead The Housing Market And Domestic Corporate Bond Spreads A-Shares Better Lead The Housing Market And Domestic Corporate Bond Spreads As a final point, even if A-shares were to become a more attractive investment at some point in the future, investability remains somewhat of a challenge for some investors. Over the years, BCA's China Investment Strategy service has published and periodically updated our Research Note, "China Shop," as a practical guide for investors looking for exposure to Chinese assets. Our most recent edition, published last August, has a simple list of ETFs that investors can use to gain exposure to the domestic market when the right conditions present themselves.4 But for investors who wish to rank these ETFs based on a proprietary BCA methodology, or who want to easily compare key metrics such as liquidity, legal structure, constituents, sector exposure, performance, etc, BCA's Global ETF Strategy service has a new tool that will greatly assist the process. Effective mid-February, our Global ETF Strategy team launched a new completely redesigned interactive website, along with a Special Report that reviewed how investors can make the most of the matching engine at the heart of the platform (as well as how to best profit from the entire Global ETF Strategy service).5 Given the issues surrounding investability in China's domestic equity market, we highly recommend that any clients who are potentially interested in allocating to A-shares read the report, and take note of this unique, time-saving service. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 "China's State Media Join Brokerages Saying Buy Equities", Bloomberg News, September 4, 2014. 2 Please see China Investment Strategy Weekly Report, "After The Selloff: A View From China", dated February 15, 2018, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report, "A Stock Market With Chinese Characteristics", dated September 21, 2017, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Research Note, "China Shop: Calling Foreign Investors", dated August 10, 2017, available at cis.bcaresearch.com. 5 Please see Global ETF Special Report, "A User's Guide To Global ETF Strategy", dated February 14, 2018, available at etf.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Bond Strategy: The investment backdrop is broadly evolving the way that we forecasted in our 2018 Outlook, thus we continue to maintain our core strategic recommendations. Maintain below-benchmark portfolio duration and overweight global corporate debt versus government bonds (focused on the U.S.). Look to reverse that positioning sometime during the latter half of 2018 after global inflation increases and central banks tighten policy more aggressively. Japan Corporates: Japanese companies are in excellent financial shape, according to our new Japan Corporate Health Monitor. Although softening Japanese growth and a firming yen may prevent an outperformance of Japanese corporate debt in the coming months. Feature "I love it when a plan comes together." - Hannibal Smith, Leader of The A-Team Many investors likely came down with serious case of a sore neck last week, given the head-turning headlines that came out: Chart 1A Pause In The 'Inflation Scare' A Pause In The 'Inflation Scare' A Pause In The 'Inflation Scare' U.S. President Donald Trump announcing a blanket tariff on metals imports, then exempting some important countries (Canada, Mexico, Australia) only days later. Trump agreeing to an unprecedented meeting with North Korean leader Kim Jong Un on the nuclear issue, only to have the White House press secretary later announce that no meeting would take place without North Korean "concessions". The European Central Bank (ECB) hawkishly altering its forward guidance to markets at the March monetary policy meeting, but then having that immediately followed by dovish comments from ECB President Mario Draghi. The strong headline number on the February U.S. employment report blowing away expectations, but the soft readings on wages suggesting that the Fed will not have to move more aggressively on rate hikes. For bond markets in particular, the ECB announcement and the U.S. Payrolls report were most important. Investors had been growing worried about a more hawkish monetary policy shift in Europe or the U.S. This was especially true in the U.S. after the previous set of employment data was released in early February showing a pickup in wage inflation that could force the Fed to shift to a more hawkish stance. That created a spike in Treasury yields and the VIX and a full-blown equity market correction. Since then, inflation expectations have eased a bit and market pricing of future Fed and ECB moves has stabilized, helping to bring down volatility and supporting some recovery in global equity markets (Chart 1). With all of these "tape bombs" hitting the news wires, investors can be forgiven for re-thinking their medium-term investment strategy in light of the changing events. We think it is more productive to check if the initial expectations on which that strategy was based still make sense. On that note, the developments seen so far this year fit right in with the key themes we outlined in our 2018 Outlook, which we will review in this Weekly Report. The Critical Points From Our Outlook Still Hold Up In a pair of reports published last December, we translated BCA's overall 2018 Outlook into broad investment themes (and strategic implications) for global fixed income markets. We repeat those themes below, with our updated assessment on where we currently stand. Theme #1: A more bearish backdrop for bonds, led by the U.S.: Faster global growth, with rebounding inflation expectations, will trigger tighter overall global monetary policy. This will be led by Fed rate hikes and, later in 2018, ECB tapering. Global bond yields will rise in response, primarily due to higher inflation expectations. ASSESSMENT: UNFOLDING AS PLANNED, BUT WATCH INFLATION EXPECTATIONS. Economic growth is still broadly expanding at a solid pace, as evidenced by the elevated levels of the OECD leading economic indicator and our global manufacturing PMI (Chart 2). The U.S. is clearly exhibiting the strongest growth momentum looking at the individual country PMIs (bottom panel), while there is a more mixed picture in the most recent readings in other countries and regions. Importantly, all of the manufacturing PMIs remain well above the 50 line indicating expanding economic activity. Last week's U.S. Payrolls report for February showed that great American job creation machine can still produce outsized employment gains with only moderate wage inflation pressures, even in an economy that appears to be at "full employment". The +313k increase in jobs, which included upward revisions to both of the previous two months of a combined +54k, generated no change in the U.S. unemployment rate which stayed unchanged at 4.1% with the labor force participation rate increasing modestly (Chart 3). Chart 2U.S. Growth Leading The Way U.S. Growth Leading The Way U.S. Growth Leading The Way Chart 3The Fed Can Still Hike Rates Only 'Gradually' The Fed Can Still Hike Rates Only 'Gradually' The Fed Can Still Hike Rates Only 'Gradually' The wage data was perhaps the most important part of the report, given that the spike in global market volatility seen last month came on the heels of an upside surprise in U.S. average hourly earnings (AHE) for January. There was no follow through of that acceleration in February, with the year-over-year growth rate of AHE slowing back to 2.6% from 2.9%, reversing the previous month's increase (middle panel). The immediate implication is that the Fed does not have to start raising rates faster or by more than planned. That pullback in U.S. wage growth, combined with the continued sluggishness of inflation in the other developed economies and the sideways price action seen in global oil markets, does suggest that inflation expectations may struggle to be the main driver of higher global bond yields in the near term. Overall nominal bond yields are unlikely to decline, however, as real yields are slowly rising in response to faster global growth and markets pricing in tighter monetary policy in response (Chart 4). Chart 4Real Yields Rising Now,##BR##Inflation Expectations Will Rise Again Later Real Yields Rising Now, Inflation Expectations Will Rise Again Later Real Yields Rising Now, Inflation Expectations Will Rise Again Later We have not seen enough evidence to cause us to change our view on inflation expectations moving higher over the course of 2018, particularly with BCA's commodity strategists now expecting oil prices to trade between $70-$80/bbl in the latter half of 2018.1 One final point: it is far too soon to determine if the protectionist trade leanings of President Trump will alter the current trajectory of global growth and interest rates. The implication is that investors should not change their overall planned investment strategy for this year at this juncture. Theme #2: Growth & policy divergences will create cross-market bond investment opportunities: Global growth in 2018 will become less synchronized compared to 2016 & 2017, as will individual country monetary policies. Government bonds in the U.S. and Canada, where rate hikes will happen, will underperform, while bonds in the U.K. and Australia, where rates will likely be held steady, will outperform. ASSESSMENT: UNFOLDING AS PLANNED. As shown in Chart 2, the big coordinated upward move in global growth seen in 2017 is already starting to become less synchronized in 2018. Recent readings on euro area growth have softened a bit while, more worryingly, a growing list of Japanese data is slowing. U.K. data remains mixed, while the Canadian economy is showing few signs of cooling off. China's growth remains critical for so many countries, including Australia, but so far the Chinese data is showing only some moderation off of last year's pace. Net-net, the data seen so far this year is playing out according to our 2018 Themes - better in the U.S. and Canada, softer in the U.K. and Australia. We are sticking to our view that the rate hikes currently discounted by markets in the U.S. and Canada will be delivered, but that there will be little-to-no monetary tightening in the U.K. and Australia (Chart 5). Theme #3: The most dovish central banks will be forced to turn less dovish: The ECB and Bank of Japan (BoJ) will both slow the pace of their asset purchases in 2018, in response to strong domestic economies and rising inflation. This will lead to bear-steepening of yield curves in Europe, mostly in the latter half of 2018. The BoJ could raise its target on JGB yields, but only modestly, in response to an overall higher level of global bond yields. ASSESSMENT: UNFOLDING AS PLANNED, ALTHOUGH WE NOW EXPECT NO BoJ MOVE TO TAKE PLACE THIS YEAR. Both central banks have already dialed back to pace of the asset purchases in recent months. This is in addition to the Fed beginning its own process of reducing its balance sheet by not rolling over maturing bonds in its portfolio. Growth of the combined balance sheet of the "G-4" central banks (the Fed, ECB, BoJ and Bank of England) has been slowing steadily as a result (Chart 6). The ECB continues to contribute the greatest share of that aggregate "G-4" liquidity expansion, although that is projected to slow over the balance of 2018 as the ECB moves towards a full tapering of its bond buying program by the end of the year (top panel). Chart 5Not Every Central Bank##BR##Will Deliver What's Priced Not Every Central Bank Will Deliver What's Priced Not Every Central Bank Will Deliver What's Priced Chart 6Risk Assets Are##BR##Exposed To ECB Tapering Risk Assets Are Exposed To ECB Tapering Risk Assets Are Exposed To ECB Tapering Barring a sudden sharp downturn in the euro area economy, the ECB is still on track for that taper. We have been expecting a signaling of the taper sometime in the summer, likely after the ECB gains even greater confidence that its inflation target can be reached within its typical two-year forecasting horizon. That story will not be repeated in Japan, however, where core inflation is still struggling to stay much above 0% and economic data is softening. We see very little chance that the BoJ will make any alterations of its current policy settings - with negative deposit rates and a target of 0% on the 10-year JGB yield - this year, as we discussed in a recent Special Report.2 We continue to expect a diminishing liquidity tailwind for global risk assets over the rest of 2018 (bottom two panels). Theme #4: The low market volatility backdrop will end through higher bond volatility: Incremental tightening by central banks, in response to faster inflation, will raise the volatility of global interest rates. This will eventually weigh on global growth expectations over the course of 2018, and create a more volatile backdrop for risk assets in the latter half of the year. ASSESSMENT: UNFOLDING AS PLANNED. We saw a sneak preview of how this theme would play out during that volatility spike at the beginning of February, triggered by only a brief blip up higher in U.S. wage inflation. With a more sustained increase in realized global inflation likely to develop within the next 3-6 months, a return to that world of high volatility is still set to unfold in the latter half of 2018, in our view. After reviewing our four investment themes for 2018 in light of the latest news, we conclude that the themes are largely playing out. Therefore, we will continue to stick with the investment strategy conclusions for this year that were derived from those themes (Table 1):3 Table 1A Pro-Risk Recommended Portfolio In H1/2018, Looking To Get Defensive Later In The Year Sticking With The Plan Sticking With The Plan 2018 Model Bond Portfolio Positioning: Target a moderate level of portfolio risk, with below-benchmark duration and overweights on corporate credit versus government debt. These allocations will shift later in the year as central banks shift to a more restrictive monetary policy stance and growth expectations for 2018 become more uncertain. Chart 7Tracking Our Recommendations Tracking Our Recommendations Tracking Our Recommendations 2018 Country Allocations: Maintain underweight positions in the U.S., Canada and the Euro Area, keeping a moderate overweight in low-beta Japan, and add small overweights in the U.K. and Australia (where rate hikes are unlikely). The year-to-date performance of the main elements of our model bond portfolio are shown in Chart 7. All returns are shown on a currency-hedged basis in U.S. dollars. Our country underweights are shown in the top panel, our country overweights in the 2nd panel, our credit overweights in the 3rd panel and our credit underweights in the bottom panel. The broad conclusion is that our best performing underweight is the U.S. and best performing overweight is Japan. All other country allocations are essentially flat on the year (in currency-hedged terms). Our call to overweight corporate debt vs. government debt, focused on the U.S., has performed well, but mostly through our overweight stance on U.S. high-yield. Bottom Line: The investment backdrop is broadly evolving the way that we forecasted in our 2018 Outlook, thus we continue to maintain our core strategic recommendations. Maintain below-benchmark portfolio duration and overweight global corporate debt versus government bonds (focused on the U.S.). Look to reverse that positioning sometime during the latter half of 2018 after global inflation increases and central banks tighten policy more aggressively. Introducing The Japan Corporate Health Monitor Japan's relatively small corporate bond market has not provided much excitement for non-Japanese investors over the years. Japanese companies have always been highly cautious when managing leverage on their balance sheets, and have traditionally relied heavily on bank loans, rather than bond issuance, for debt financing. The result is a corporate bond market with far fewer defaults and downgrades compared to other developed economies, with much lower yields and spreads as well. Due to its small size, poor liquidity and low yields/spreads, we have not paid much attention to Japanese corporate debt in the past. Thus, we don't have the same kinds of indicators available to us for Japanese corporate bond analysis as we have in the U.S., euro area or U.K. One such indicator is the Corporate Health Monitor (CHM) to assess the financial health of corporate issuers.4 We are changing that this week by adding a Japan CHM to our global CHM suite of indicators. In other countries, we have both top-down and bottom-up versions of the CHM. The former uses GDP-level data on income statements and balance sheets to determine the individual ratios that go into the CHM (a description of the ratios is shown in Table 2), while the latter uses actual reported financial data at the individual firm level which is aggregated into the CHM. Table 2Definitions Of Ratios##BR##That Go Into The CHM Sticking With The Plan Sticking With The Plan Consistent and timely data availability is an issue for building a top-down CHM, as there is no one source of top-down data on the corporate sector. Some data is available from the BoJ or the Ministry of Finance, or even from international research groups like the OECD, but not all are presented using a consistent methodology. Some data is only available on an annual basis, which significantly diminishes the usefulness of a top-down CHM as a timely indicator for bond investment. Thus, we focused our efforts on only building a bottom-up version of a Japan CHM, using publically available financial information released with higher frequency (quarterly). We focused on non-financial companies (as we do in the CHMs for other countries) and exclude non-Japanese issuers of yen-denominated corporate bonds. In the end, we used data on 43 companies for our bottom-up CHM. By way of comparison, there are only 36 individual issuers in the Bloomberg Barclays Japan Corporate Bond Index that fit the same description of non-financial, non-foreign issuers, highlighting the relatively tiny size of the Japanese corporate bond market. Our new Japan bottom-up CHM is presented in Chart 8. The overall conclusions are the following: Japanese corporate health is in overall excellent shape, with the CHM being in the "improving health" zone for the full decade since the 2008 Financial Crisis. Corporate leverage has steadily declined since 2012, mirroring the rise in company profits and cash balances over the same period. Return on capital is currently back to the pre-2008 highs just below 6%, although operating margins remain two full percentage points below the pre-2008 highs. Interest coverage and the liquidity ratio are both at the highest levels since the mid-2000s, while debt coverage is steadily improving. The overall reading from the CHM is one of solid Japanese creditworthiness and low downgrade and default risks. It is no surprise, then, that corporate bond spreads have traded in a far narrower range than seen in other countries. In Chart 9, we present the yield, spread, return and duration data for the Bloomberg Barclays Japanese Corporate Bond Index. We also show similar data for the Japanese Government Bond Index for comparison. Japanese corporates have a much lower index duration than that of governments, which reflects the greater concentration of corporate issuance at shorter maturities. Chart 8The Japan Corporate Health Monitor The Japan Corporate Health Monitor The Japan Corporate Health Monitor Chart 9The Details Of Japan Corporate Bond Index The Details Of Japan Corporate Bond Index The Details Of Japan Corporate Bond Index Japanese corporates currently trade at a relatively modest spread of 36bps over Japanese government debt, although that spread only reached a high of just over 100bps during the 2008 Global Financial Crisis - a much lower spread compared to U.S. and European debt of similar credit quality. That is likely a combination of many factors, including the small size of the Japanese corporate market and the relatively smaller level of interest rate volatility in Japan versus other countries. Given the dearth of available bond alternatives with a positive yield in Japan, the "stretch for yield" dynamic has created a demand/supply balance that is very favorable for valuations - especially given the strong health of Japanese issuers. Chart 10Japan Corporates Do Not Like A Rising Yen Japan Corporates Do Not Like A Rising Yen Japan Corporates Do Not Like A Rising Yen It remains to be seen how the market will respond to a future economic slowdown in Japan, which may be starting to unfold given the recent string of sluggish data. On that note, the performance of the Japanese yen bears watching, as the currency has a positive correlation to Japanese corporate spreads (Chart 10). The linkage there could be a typical one of risk-aversion, where the yen goes up as risky assets selloff. Or it could be linked to growth expectations, where markets begin to price in the impact on Japanese growth and corporate profits from a stronger currency. Given our view that the BoJ is highly unlikely to make any changes to its monetary policy settings this year, the latest bout of yen strength may not last for much longer. For now, given the link between the yen and Japanese credit spreads, we would advise looking for signs that the yen is rolling over before considering any allocations to Japanese corporate debt. Bottom Line: Japanese companies are in excellent financial shape, according to our new Japan Corporate Health Monitor. Although softening Japanese growth and a firming yen may prevent an outperformance of Japanese corporate debt in the coming months. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst Ray@bcaresearch.com 1 Please see BCA Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Getting Comfortable With Higher Prices", dated February 22nd 2018, available at ces.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Special Report, "What Would It Take For The Bank Of Japan To Raise Its Yield Target?", dated February 13th 2018, available at gfis.bcareseach.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "Our Model Bond Portfolio In 2018: A Tale Of Two Halves", dated December 19th 2017, available at gfis.bcaresearch.com. 4 For a summary of all of our individual country CHMs, including a description of the methodology, please see the BCA Global Fixed Income Strategy Weekly Report, "BCA Corporate Health Monitor Chartbook: No Improvement Despite A Strong Economy", dated November 21st 2017, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Sticking With The Plan Sticking With The Plan Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

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

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

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

We examined emerging market equity valuations as an asset class in Part 1 of this Special Report published on January 24; the link is available on page 18. The conclusions of the report were: That EM stocks are about one standard deviation above their fair value; Compared with DM equities, EM stocks are not cheap - their relative valuations are neutral. This follow-up report looks at individual country valuations to identify valuation opportunities within the EM equity universe. Composite Multiples Indicator (CMI) The Composite Multiples Indicator is an equal-weighted average of the following multiples: Trailing P/E ratio Forward P/E ratio Price-to-cash earnings (PCE) ratio Price-to-book value (PBV) ratio Price-to-dividend ratio. As we have argued for some time, looking at market cap-weighted equity valuation ratios for EM indexes is misleading. The basis is that some large-cap-weighted sectors optically look cheap for distinct reasons - including but not limited to low NPL provisions for banks, poor corporate governance among SOEs and high cyclicality and uncertainty over the outlook for commodities prices for energy and materials companies. Moreover, other segments such as certain technology stocks and private well-run companies command extremely high multiples. Therefore, as in Part 1, we focus on various valuation measures that are not market cap-weighted. Specifically, for each country's available sub-sectors, we calculate the following measures for each of the five multiples referred to above: 20% trimmed-mean ratio - this excludes the top 10% and bottom 10% sub-sectors - i.e., it removes outliers and then calculates an equal-weighted average. Median ratio takes the median value of sub-sectors; Equal-weighted ratio assigns an equal weight to each sub-sector regardless of market cap. Then, we standardize individual aggregates - the 20% trimmed-mean, the median and equal-weighted sub-sector ratios. Based on these three aggregates, we compute a Composite Multiples Indicator (CMI) for each country. Chart I-1 demonstrates the ranking of equity markets according to CMI. Based on these aggregate CMIs, India, Indonesia, the Philippines, Thailand and Chile are the most expensive, while Russia, Turkey, Colombia, Korea and Mexico are the cheapest. Chart I-1Equity Valuation Ranking Based On Multiples EM Equity Valuations (Part II) EM Equity Valuations (Part II) Appendix 1 on page 14 shows the aggregate CMI for the largest EM bourses in absolute terms. Among the above-mentioned five ratios, the most critical one in our opinion is the price-to-cash earnings. MSCI defines cash earnings as earnings per share including depreciation and amortization as reported by the company - i.e. depreciation and amortization expenses are added to calculate cash earnings. While this measure is not pertinent for banks, for non-financial companies it is the best proxy measure of operating cash flow. Hence, cash earnings are a superior measure of earnings power. Notably, when calculating the median, 20% trimmed-mean and equal-weighted ratios for all sub-sectors, the impact of banks is largely eliminated, as banks are just one sub-sector among about 50 others. Table I-1Ranking Based On Price-To-Cash ##br##Earnings Ratio EM Equity Valuations (Part II) EM Equity Valuations (Part II) The point is not that banks are unimportant, but rather that bank valuations should be dealt with separately. We reiterated the importance of banks and their profits in the EM universe and discussed why in certain EM countries banks' reported profits should be taken with a grain of salt in our February 14, 2018 Weekly Report; the link is available on page 18. Banks, somewhat more than other businesses, can substantially manipulate their profits by raising or lowering provisions for bad assets, leaving current multiple levels misleading. Table I-1 shows the ranking based on the average price-to-cash earnings ratio. According to this ranking, the most attractive markets are Poland, Russia, the Czech Republic, Turkey, Hungary and Korea. By contrast, the least attractive are India, Indonesia, the Philippines, South Africa, Brazil and China. A CMI can be thought of as a cyclical valuation measure, while the cyclically adjusted P/E (CAPE) ratio is a structural valuation measure. Investors with time horizons longer than three years should put meaningful weight on CAPE ratios. The latter is, however, not useful for investment horizons that are 12-18 months or less. The CAPE ratio is a structural valuation indicator because it derives the secular trend in corporate earnings and computes the P/E ratio based on the latter. Hence, the cyclical earnings trajectory is ignored. In contrast, CMIs do not incorporate such an adjustment. Hence, they can be considered as a cyclical valuation measure. By combining cyclical (CMI) and structural (CAPE) valuation measures, we produced Chart I-2. It plots each country's CAPE ratio on the X axis and CMI on the Y axis. According to these metrics, Russia, Turkey, Korea, Colombia and Mexico are cheap. On the flip side, India, Thailand, the Philippines and Indonesia are expensive. Chart I-2Cyclical Versus Structural Valuation Ratios EM Equity Valuations (Part II) EM Equity Valuations (Part II) Adjusting Multiples For Local Interest Rates Equity multiples differ across countries because of a variety of factors. One of the most crucial factors defining the equilibrium of equity multiples are domestic nominal interest rates. Chart I-3 plots local currency government bonds on the X axis and the latest values for CMI on the Y axis. As expected, there is a loose inverse relationship between bond yields and equity multiples: lower bond yields are typically consistent with relatively higher multiples, and vice versa. Chart I-3Composite Multiples & Local Interest Rates EM Equity Valuations (Part II) EM Equity Valuations (Part II) The bourses that falls outside the main cluster can be regarded as being out of equilibrium valuation. The markets that fall into the left-bottom corner of the chart are relatively cheap. These include Russia, Korea, Taiwan, Central Europe, Malaysia, Colombia and Mexico. On the other end of the spectrum, India, Indonesia, the Philippines, Brazil and South Africa stand out as expensive. As we argued above, the price-to-cash earnings ratio is somewhat superior to other multiples. This is why another useful matrix to consider is the comparison of the average price-to-cash earnings ratio with nominal local bond yields, as shown in Chart I-4. According to these metrics, central European bourses are among the cheapest. Russia, Korea, Taiwan, Thailand and Malaysia are also attractive. Chart I-4Price-To-Cash EPS & Local Interest Rates EM Equity Valuations (Part II) EM Equity Valuations (Part II) Finally, taking into account both price-to-cash earnings ratios and nominal domestic bond yields, the most expensive equity markets are India, Indonesia, the Philippines, South Africa and Brazil. Investment Conclusions Valuation of any asset class is an art rather than science. Having examined various cyclical and structural equity valuation measures and having incorporated local interest rates, we can draw the following conclusions: Chart I-5EMS's Fully-Invested Equity Portfolio ##br##Performance Versus The Benchmark EMS's Fully-Invested Equity Portfolio Performance Versus The Benchmark EMS's Fully-Invested Equity Portfolio Performance Versus The Benchmark Within the EM equity universe, Russia, central Europe and Korea stand out as the cheapest. There is also relative value in Turkey, Colombia and Mexico. India, Indonesia and Philippines are the most expensive markets. South Africa and Brazil are still somewhat expensive. Neutral valuations prevail in China, Taiwan, Peru and Chile. In China, the cheapness of banks is offset by elevated valuations of technology/new economy stocks. Our recommended country allocation within EM equities takes into consideration not only valuations but also many other parameters such as cyclical and structural outlooks for each economy, macro policies, banking system health, politics, currency and interest rate trends and other factors that we have visibility on. As such, we might recommend underweighting some markets that may look cheap, and overweighting others that appear expensive because of factors other than valuation. Our current overweights are Taiwan, Korean technology, Russia, central Europe, India, Thailand and Chile. Our underweights are Turkey, Malaysia, Brazil, South Africa and Peru. We are neutral on China, non-tech Korea, Mexico, the Philippines, Colombia and Indonesia. Finally, Chart I-5 illustrates that our fully invested EM equity model portfolio has outperformed the EM benchmark by 57% since its initiation in May 2008. This translate into 450 basis points of compounded outperformance per year. More importantly, such outperformance has been achieved with very low volatility. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com Indonesia: Weighing The Pros And Cons Chart II-1Indonesian Stock Prices: ##br##Relative & Absolute Indonesian Stock Prices: Relative & Absolute Indonesian Stock Prices: Relative & Absolute Indonesian stocks have underperformed the emerging market (EM) equity benchmark considerably since early 2016, and may well be approaching the final stages of underperformance. Yet the jury is still out on the timing of a potential reversal (Chart II-1, top panel). In absolute U.S. dollar terms, Indonesian share prices are flirting with their previous highs, which will likely become a major resistance level (Chart II-1, bottom panel). Banks hold the key for this bourse, as they account for 40% of the MSCI Indonesia index and 27% of the Jakarta Composite Index. Their earnings also make up 48% of the MSCI index's total earnings. Indonesian bank share prices have rallied significantly in the past two years, but the underpinnings of this advance are questionable for reasons we elaborate on below. Cyclical Vulnerabilities... Indonesia's macro vulnerability arises from two sources: balance of payment (BoP) dynamics and banking system health. We will review the nation's BoP vulnerability only briefly, as we have frequently discussed the outlook for commodities prices, the U.S. dollar and fund flows to EM in our weekly reports. In short, we expect Chinese growth to decelerate meaningfully this year, which will likely cause commodities prices to fall significantly (Chart II-2). Falling commodities prices will in turn create headwinds for Indonesia. Notably, commodities account for around 35% of Indonesia's total exports. Chart II-3 further illustrates that changes in Indonesia's trade balance have historically been correlated with swings in its equity market. Chart II-2Indonesia's Coal Exports ##br##To China And Coal Prices Indonesia's Coal Exports To China And Coal Prices Indonesia's Coal Exports To China And Coal Prices Chart II-3Trade Balance Is ##br##A Threat To Share Prices Trade Balance Is A Threat To Share Prices Trade Balance Is A Threat To Share Prices We now explore the vulnerability of Indonesian bank stocks in greater detail. Banks: Dubious Profit Recovery While earnings of listed Indonesian banks have rebounded, this recovery is of poor quality and is likely unsustainable. This, along with banks' elevated equity valuations, make the outlook for their share prices negative. The top panel of Chart II-4 shows that banks' net interest income - a measure of a bank's ability to grow organically - has declined. This has occurred because bank loan growth has been sluggish and net interest margins have narrowed (Chart II-4, middle and bottom panel). Yet, banks have reported dramatic acceleration in profit growth in the past six months. This has been achieved through the lowering of non-performing loan (NPL) provisions (Chart II-5). Chart II-4Strong Bank Earnings: ##br##Not From Organic Growth... Strong Bank Earnings: Not From Organic Growth... Strong Bank Earnings: Not From Organic Growth... Chart II-5...But From Lowering Provisions ...But From Lowering Provisions ...But From Lowering Provisions Lowering provisions to boost profits is an unsustainable strategy for Indonesian banks, in our opinion. Chart II-6 shows that NPLs are too low when one considers the steep rise in leverage that has occurred since 2010. Chart II-6Private Credit Has Risen A Lot ##br##Since 2010, Yet NPLs Are Still Low Private Credit Has Risen A Lot Since 2010, Yet NPLs Are Still Low Private Credit Has Risen A Lot Since 2010, Yet NPLs Are Still Low Indonesian banks have benefited meaningfully from the rally in commodities prices in the past two years. Higher resource prices have not only slowed the formation of new NPLs but have also made some old NPLs current. However, if our negative view on commodities prices plays out, these loans may become non-performing again. Further, Indonesian commercial banks were also aided by the financial authority's (OJK) decision to relax credit restructuring rules in August 2015. This relaxation allowed banks to restructure some of the troubled loans on their balance sheets in a more favorable manner, allowing them to reduce provisions. The temporary relaxation expired in August 2017, and banks now have to revert to the previous and more rigorous methods of accounting for troubled loans. Altogether, the above developments will cause NPLs and provisions to rise anew. Importantly, the sum of NPLs and special-mention loans1 (SMLs) for Indonesia's largest seven banks stand at 6.6% (2.7% NPL + 3.9% SMLs). Taking India's experience as a roadmap for Indonesia, SMLs will ultimately become non-performing, and the workout of NPLs and SMLs could drag on for years. For example, the ratio of NPLs and stressed loans in India has now reached 12.2% of total loans for the whole banking system. We also believe Indonesian banks are under-provisioned. Provisions for bad loans at Indonesia's seven largest commercial banks stand at only 3.8% of total loans. In comparison, the sum of NPLs and SMLs makes up a 6.6% share of total loans. Odds are that Indonesian commercial banks will soon be forced to raise provisions, which will materially hit their profit growth. Chart II-7 shows that if banks in Indonesia were to raise provisions by 35% in 2018 - which would take them back to early 2017 levels - then banks' annual operating profit growth would drop from 21% to zero. This is a major threat to bank share prices.2 Chart II-7As Banks' NPL Provisions Rise, ##br##Bank Stocks Could Fall As Banks' NPL Provisions Rise, Bank Stocks Could Fall As Banks' NPL Provisions Rise, Bank Stocks Could Fall Furthermore, having rallied significantly in the past two years or so, Indonesian commercial banks' valuations are elevated. The price-to-book value (PBV) for the nation's banks that are included in the MSCI equity index stands at 2.8. Bottom Line: The recent profit recovery for Indonesia's commercial banks is unsustainable, and primarily driven by opportunistic reductions in provisions. ...But Room To Pursue Accommodative Policies Despite the cyclical challenges facing the Indonesian economy and banks, the authorities have accrued enough firepower that allows them to pursue counter-cyclical policies. First, Indonesia's central bank, Bank Indonesia (BI), used strong global growth and robust trade as an opportunity to accumulate foreign exchange reserves. This has provided BI with significant ability to defend the rupiah as and when it comes under depreciation pressure from slowing exports growth and potential capital outflows. Notably, BI has bought foreign exchange reserves more rapidly than the central banks of other vulnerable economies such as South Africa, Malaysia, Turkey and Brazil (Chart II-8). As a result, the rupiah has not appreciated at all in the past 12 months, and has lagged other EM currencies. We consider this a positive sign as there will be less downside risk if the external environment worsens and EM exchange rates depreciate. Second, the Ministry of Finance has curbed government spending in the past two to three years (Chart II-9) at a time when strong global growth and rising commodities prices have been supporting Indonesia's overall growth. Chart II-8Bank Indonesia's Foreign ##br##Reserves Accumulation Bank Indonesia's Foreign Reserves Accumulation Bank Indonesia's Foreign Reserves Accumulation Chart II-9Government Has Been Prudent Indonesia's Government Has Been Prudent Indonesia's Government Has Been Prudent Consequently, the government's deposits at both the central bank and commercial banks have been rising rapidly (Chart II-10). This will allow the government to increase its expenditures without resorting to new borrowing. Because of these counter-cyclical policies, especially tight fiscal policy, the domestic demand recovery has been very muted (Chart II-11). On the flip side, and going forward, if the government raises expenditures, Indonesian domestic demand will be relatively resilient - even as and when commodities prices fall. Low inflation will also allow the authorities to stimulate when needed. Chart II-10Government Has Substantial Firepower Government Has Substantial Firepower Government Has Substantial Firepower Chart II-11Domestic Demand Recovery Has Been Muted Domestic Demand Recovery Has Been Muted Domestic Demand Recovery Has Been Muted On the whole, counter-cyclical monetary and fiscal policies will offset some of the potential external shocks that will emanate from slowing Chinese growth and falling commodities prices. This is positive for Indonesia's relative stock market performance going forward. Investment Conclusions For now, we recommend maintaining a neutral allocation to Indonesian equities. One or a combination of the following will likely lead us to upgrade this bourse to overweight: First, as and when the initial phase of commodities price declines transpires, and commodities currencies depreciate. This is a primary risk, and we will be more comfortable upgrading Indonesia if this scenario partially plays out. Second, Indonesia's relative performance vis-à-vis EM appears to be inversely related to the relative performance of Chinese stocks against that same benchmark (Chart II-12). It is hard to find scientific or even intuitive arguments behind this relationship, but it seems that portfolio flows have been rotating between Chinese and Indonesian bourses. Chart II-12Investors Rotating Between Chinese ##br##And ASEAN/Indonesian Equities Investors Rotating Between Chinese And ASEAN/Indonesian Equities Investors Rotating Between Chinese And ASEAN/Indonesian Equities Given this relationship, we would be looking for Chinese stocks to begin underperforming and equity flows rotating to Indonesia to feel confident in the potential reversal of the latter's underperformance. In short, we will be looking at the market's momentum as confirmation of our view before upgrading this bourse. Last week we reviewed our recommended allocation to EM local bonds and advocated a neutral position in Indonesian domestic bonds. This strategy remains intact. Prudent macro policies will act to offset a potential external shock to the Indonesian currency and local bonds. Indonesian sovereign credit also warrants a neutral allocation at present, with a possible upgrade on potential spread-widening. For currency traders, we continue to recommend a long PLN / short IDR trade. This is a bet on rising inflation and interest rates in central Europe on the one hand, and a negative view on commodities and fund flows to EMs on the other. As a part of our strategy of betting on depreciation in EM/commodities currencies, we are also maintaining our short IDR/long U.S. dollar position. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Special mention loans (SML) are stressed loans that are not yet non-performing. 2 Notably, annual provision growth averaged 40% between 2015 and 2016 when banks were facing declining commodities prices and rising NPLs. Appendix 1: Composite Multiples Indicators Chart III-1, Chart III-2, Chart III-3, Chart III-4 Chart III-1 CHART 1 CHART 1 Chart III-2 CHART 2 CHART 2 Chart III-3 CHART 3 CHART 3 Chart III-4 CHART 4 CHART 4 Equity Recommendations Fixed-Income, Credit And Currency Recommendations