Asia

Highlights Seasonal environmental restrictions on Chinese aluminum output are due to ease going into spring, which will restore some of the output taken off line when inefficient smelters were shuttered last year. Global demand likely will slow later this year, largely because we expect GDP growth in China, which accounts for more than half of global aluminum consumption, to moderate in 2H18. In addition, expected U.S. tariffs and quotas will limit imports and revive output in that market. This will contribute to the easing of a tight global balance, and take some of the pressure off prices, but we do not expect a significant move lower. We remain neutral. Energy: Overweight. Our long Dec/18 $65/bbl Brent calls vs. short Dec/18 $70/bbl calls - recommended last week on the back of our updated price forecast - closed with a 3.1% gain on Tuesday. We took profits on our long 4Q19 $55/bbl Brent puts vs. short 4Q19 $50/bbl Brent puts, realizing a 20.7% gain since it was recommended January 18, 2018. Base Metals: Neutral. We are expecting a secular increase in aluminum supplies this year, on the back of Chinese environmental policies and more difficult global trading conditions. Precious Metals: Gold markets awaited Fed Chair Powell's Humphrey-Hawkins testimony beginning Tuesday, as vice chair for financial supervision, Randal Quarles, warned U.S. economic growth could exceed expectations the day before. Ags/Softs: Underweight. Argentina's drought looks like it will stress that country's grain harvests, and tighten markets at the margin. Feature Chart of the WeekAluminum In Large Deficit Last Year Aluminum In Large Deficit Last Year Aluminum In Large Deficit Last Year Easing of winter supply restrictions in China, as well as tighter controls on U.S. aluminum imports, will dominate the aluminum market in the near term. In both cases, the net effect likely will be an increase in global supply. The latter would also support aluminum's price in the U.S. market - as measured by the U.S. Midwest premium. These events will ease the global physical deficit in aluminum, which last year came in at its widest since 1995 (Chart of the Week). The current tight conditions are driven by Beijing's elimination of overcapacity, which, along with environmental reform policies implemented last year, led to a reduction in China's output. The price dynamics that dominated the aluminum market over the past couple years will shift as a result. This already can be seen in the behavior of prices on the LME and the SHFE: LME prices have been gyrating around $2,200/MT, while SHFE prices have dipped by more than 5% since the beginning of the year. Unwinding China's Supply-Side Policies? At first blush, it may not be apparent China's primary aluminum production sector experienced significant changes last year. After stalling at 1% year-on-year (y/y) growth in 2016, output grew 1.2% y/y in 2017, a sharp deceleration from the 16% y/y average growth rates registered between 2010 and 2015. However, the annual gain masked a 10% y/y increase in output in 1H17, which was almost completely reversed by the negative impacts of China's environmental policies and its efforts to eliminate overcapacity. These policy-led initiatives ultimately caused output to fall 7% y/y in 2H17 (Chart 2). The resulting 1 mm MT of production cuts in the second half of last year reflects China's 2017 supply-side policies. Beijing's strategy is two-fold: Chart 2Sharp Fall In 2H17 Output From China ... Sharp Fall In 2H17 Output From China ... Sharp Fall In 2H17 Output From China ... Eliminate outdated and unlicensed capacity by forcing it to close. This has removed an estimated 3-4 mm MT of annual capacity. The policy targets capacity lacking proper building and expansion permits, as well as the smelters that do not meet strict environmental standards. However, not all the shutdowns are permanent. Among this shuttered capacity is 2 mm MT of outdated smelter capacity belonging to China Hongqiao, which the company plans to replace with new capacity.1 The other major supply-side policy implemented by Beijing last year is a restriction on smelter activity during the mid-November to mid-March period. As is the case in the steel sector, this winter-curtailment policy seeks to reduce pollution during the smog-prone winter months. Aluminum smelters in the cities targeted in the winter plan were ordered to cut output by ~ 30% during this period. This policy is expected to be an annually recurring event until 2020. However, while 3 mm MT of annualized capacity would have been closed during the winter if the full 30% curtailment target had been met, reports surfaced in mid-December that compliance was low, and suggested only ~ 0.6 mm MT of capacity (just 20% of the goal, or 6% of the curtailment target) had been closed.2 The total aluminum annual capacity affected by both the winter environmental curtailments and capacity-reduction policies implemented last year could potentially reach 7 mm MT. China's total smelting capacity was a reported 40 mm MT in 2016. Lower Chinese Production ... And Consumption On a year-on-year basis, global primary aluminum production has been falling since August. This is, for the most part, true on a month-on-month basis, as well. The 12-month moving average for global aluminum production peaked in July, and has been coming down consistently since then. Although 2017 production came in higher than the previous year, this is due to a ~ 6% y/y increase in the first half, which preceded a ~ 4% y/y decline in output in the second half of the year. These dynamics are driven by China, which accounts for 55% of global primary production. Chinese firms raised primary output in 1H17, which was followed by a sharp contraction in 2H17. Chinese primary aluminum production peaked in June, recording an all-time record of 2.98 mm MT before falling in the subsequent months. On the other hand, primary production from the rest of the world has remained largely unchanged over the past two years, at 26 mm MT. Data from the International Aluminum Institute shows month-on-month production increases in China in December and January; however, output is still lower vs. the same period a year earlier. Chinese production drove global aluminum production higher in the past, but falling output from the world's leading producer now is causing global primary aluminum supply to contract. The impact of China's supply curtailments has been muted by lower demand for the metal (Chart 3). Again, lower consumption has been driven by the top-demand market - China - which typically consumes ~ 55% of the primary metal. Chinese primary consumption and production each came down by more than 1 mm MT y/y in the second half of last year. Falling aluminum demand in China is consistent with a slowdown in Chinese automobile production as well as fixed asset investments in infrastructure and transportation (Chart 4). Furthermore, China's scrap aluminum imports increased in 2H17, reflecting a preference for the secondary metal as the price of primary aluminum increased. Chart 3... Coincided With Falling Chinese Consumption ... Coincided With Falling Chinese Consumption ... Coincided With Falling Chinese Consumption Chart 4Slowdown In Chinese Demand Slowdown In Chinese Demand Slowdown In Chinese Demand A Divergence In Global Dynamics ... Despite the improved balance in China, the global primary aluminum balance in the rest of the world recorded a large deficit last year - the largest since 1995 (Chart 5). While both consumption and production in China came down by more than 1 mm MT in 2H17, consumption in the rest of the world increased by ~ 0.4 mm MT, even as production remained largely unchanged. This tightened the global market, as more stringent aluminum production policies in China meant that there was no flooding of Chinese aluminum to ease the deficit. In fact, the world excluding China deficit is the largest at least since the World Bureau of Metal Statistics (WBMS) started collecting data in 1995. ... Is Reflected In Inventory Dynamics This also coincides with rising aluminum stocks on the Shanghai Futures Exchange and falling inventory on the LME. In fact, Chinese aluminum imports have been falling and were down almost 30% y/y in 2H17. At the same time, Chinese net exports picked up slightly (Chart 6). Chart 5Record Aluminum Deficit Outside China Record Aluminum Deficit Outside China Record Aluminum Deficit Outside China Chart 6Chinese Net Exports On The Rise Chinese Net Exports On The Rise Chinese Net Exports On The Rise In response to lower output, LME inventories have been falling since 2Q14, and they continued their descent last year, ending 2017 at roughly the same level as mid-2008. On the other hand, stocks at the SHFE have been rising steeply since the beginning of last year and are at record highs (Chart 7). Whether the tight global market fundamentals will persist depends on whether China's outdated capacity cuts prove to be temporary or permanent. Chart 7Dynamics Reflected In Stock Changes Dynamics Reflected In Stock Changes Dynamics Reflected In Stock Changes U.S. Tariffs And Quotas Would Offset Tight Markets In what appears to be an effort to revive U.S. aluminum and steel production, the U.S. Commerce Department launched an investigation into these domestic industries late last year. Last month, Commerce proposed tariffs and quotas that would impact all aluminum imports with the exception of aluminum scrap and aluminum powders. There appear to be two main objectives of this investigation: 1. Increase capacity utilization in the U.S. aluminum and steel industries; and 2. Penalize China for subsidizing its aluminum sector at the expense of those in other countries. Among the Commerce proposals: 1. A 7.7% tariff on all aluminum imports to the U.S. 2. A 23.6% tariff on all aluminum imports from certain countries, while other countries would be subject to quotas equal to 100% of their 2017 exports to the U.S.3 3. A quota on all aluminum imports from other countries equal to a maximum of 86.7% of their 2017 exports to the U.S. In a memo issued last week, the U.S. Department of Defense expressed its support for the targeted tariffs (option 2 above), as well as a recommendation to postpone action on the aluminum sector. President Trump has until April 19 to make a decision on the aluminum recommendations. While he may not stick to the exact details outlined in the three options, our Geopolitical Strategists expect him to go through with implementing protectionist measures to limit aluminum imports. U.S. production of primary aluminum is at its lowest level since 1951 (Chart 8). To reach the 80% target of smelter capacity utilization envisioned by Commerce, the U.S. will have to add ~ 0.67 mm MT of supply. This represents just ~ 1.16% of world supply in 2016. Imports currently make up 90% of U.S. primary aluminum consumption. Chart 8U.S. Producers Took A Big Hit U.S. Producers Took A Big Hit U.S. Producers Took A Big Hit In fact, even if this amount of aluminum was supplied domestically in the U.S. last year, the world aluminum market would have remained in deficit. Furthermore, this additional supply would pale in comparison to the cuts China has already implemented in its aluminum sector last year. China's primary production in the August to December period last year came in 1.15 mm MT below the same period in 2016. Annual smelter capacity in the U.S. is estimated to be a combined 1.82 mm MT. Of this capacity, Alcoa has 0.34 mm MT of idle capacity, Century Aluminum has 0.27 mm MT, while ARG International's Missouri plant has 0.27 mm MT of idle capacity. U.S. producers have started communicating plans to restart idled capacity. According to Century Aluminum's CEO, the company's eastern Kansas operation, which shuttered more than half of its production, could ramp output at one of its smelters to full capacity of up to 0.27 mm MT by early next year. Similarly, Alcoa has committed to partially restarting production at its Warwick, Indiana, facility, which would bring 0.16 mm MT of capacity online by the second quarter of this year. However, imports are not the sole reason output in the U.S. aluminum sector is falling. High power costs also have contributed, but this is not addressed in the Department of Commerce's report. In any case, we would not be surprised to witness an increase in aluminum imports by U.S. consumers before a final decision is made. If import controls do in fact fall into place, prices in the U.S. - as reflected by the U.S. Midwest transaction premium - will likely increase. Bottom Line: Supply- and demand-side developments, mostly in China, which accounts for more than half of global production and consumption, will combine to ease a global supply deficit this year. Expected U.S. tariffs and quotas will limit imports and revive output in that market. This will take some pressure off prices, but, we do not expect levels to move significantly lower. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see "China Hongqiao says to cut 2 mln T/year of outdated aluminum capacity," published on August 2, 2017, available at reuters.com. 2 Please see "Aluminum Under Pressure After China Smog Cutbacks Fall Short," published on December 20, 2017, available at reuters.com. 3 The countries noted are China, Hong Kong, Russia, Venezuela, and Vietnam. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Global Aluminum Deficit Set To Ease Global Aluminum Deficit Set To Ease Trades Closed in 2018 Summary of Trades Closed in 2017 Global Aluminum Deficit Set To Ease Global Aluminum Deficit Set To Ease

Highlights The political path of least resistance leads to fiscal profligacy - in the U.S. and beyond. The response to populism is underway. The U.S. midterm election is market-relevant. Gridlock between the White House and Congress does, in fact, weigh on equity returns, after controlling for macro variables. The Democratic Party's chances of taking over Congress have fallen, but remain 50% in the House of Representatives. A divided House and Senate is the worst combination for equities, but macro factors matter most. China is clearly rebooting its "reform" agenda as Xi Jinping becomes an irresistible force. We remain long H-shares relative to EM, for now. Emerging markets - including an improved South Africa - will suffer as politics become a tailwind for U.S. growth and a headwind for Chinese growth. Feature The bond market has been shocked into action this month by the twin realizations that the Republican-held Congress is not as incompetent as believed and that the Republican Party is not as fiscally conservative as professed. When combined with steady U.S. wage growth and rising inflation expectations (Chart 1), our core 2018 theme - that U.S. politics would act as an accelerant to growth - has been priced in by the bond market with impressive urgency.1 The tax cuts alone were not enough to wake the bond market. First, the realization that a tax cut would pass Congress struck markets in late October, when it became increasingly clear that the $1.5 trillion Tax Cuts And Jobs Act would indeed pass the Senate. Second, the bill's passage along strict party lines - including the slimmest of margins in the Senate thanks to reconciliation rules - convinced investors that there would be no further compromises down the pipeline. The real game changer was the realization that the political path of least resistance leads towards profligacy. This happened with the signing into law of the February 9 two-year budget compromise (the Bipartisan Budget Act of 2018) that will see fiscal spending raised by around $380 billion.2 The deal failed to gain the support of a majority of Republicans in the House, despite House Speaker Paul Ryan's support, but 73 Democrats crossed the aisle to ensure its passage. They did so despite a lack of formal assurances that the House would consider an immigration bill. The three-day shutdown in late January has forced Democrats, who largely took the blame, to assess whether they care more about preserving their liberal credentials on fiscal policy or immigration policy. The two-year budget agreement is a testament to their concern for the former. The deal will see the budget deficit most likely rise to about 5.5% of GDP in FY2019, up from 3.3% in last year's CBO baseline forecast (Chart 2). Chart 1Rising U.S. Inflation Expectations Rising U.S. Inflation Expectations Rising U.S. Inflation Expectations Chart 2Fiscal Policy Gets Expansive Fiscal Policy Gets Expansive Fiscal Policy Gets Expansive Adding to the newly authorized fiscal spending could be a congressional rule-change that reintroduces earmarks - leading to a potential $20 billion additional spending per year. There is also a 10-year infrastructure plan that could see spending increase by another ~$200 billion over the next decade. The new budget compromise, combined with last year's tax cuts, will massively increase U.S. fiscal thrust beyond the IMF's baseline (Chart 3). The IMF's forecast, done before the tax cuts were passed, suggested that fiscal thrust would contract by about 0.5% of GDP this year, and would only slightly expand in 2019. Now we estimate that fiscal thrust will be a positive 0.8% of GDP in 2018 and 1.3% in 2019. These figures are tentative because it is not clear exactly how much of the spending will take place this year versus 2019 and 2020. Our colleague Mark McClellan, author of BCA's flagship The Bank Credit Analyst, has stressed that the impact on GDP growth will be less than these figures suggest because the economic multipliers related to tax cuts are less than those for spending.3 Our theme that the political path of least resistance will lead to profligacy is not exclusive to the U.S. After all, populism is not exclusive to the U.S, with non-centrist parties consistently capturing around 16% of the electoral vote in Europe (Chart 4). Chart 3The Budget Deal And Tax Cuts##br## Will Expand U.S. Fiscal Thrust Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China Chart 4Populism Will Fuel Fiscal##br##Spending Beyond The U.S. Populism Will Fuel Fiscal Spending Beyond The U.S. Populism Will Fuel Fiscal Spending Beyond The U.S. Policymakers are not price-setters in the political marketplace, but price-takers. The price-setter is the median voter, who we believe has swung to the left when it comes to economic policy in developed markets after a multi-year, low-growth, economic recovery.4 Broadly speaking, investors should prepare for higher fiscal spending globally on the back of this dynamic. Aside from the U.S., the populist dynamic is evident in the world's third (Japan), fourth (Germany), and sixth (the U.K.) largest economies. Japan may have started it all, as a political paradigm shift in 2011-12 spurred a historic reflationary effort.5 Geopolitical pressure from China and domestic political pressures on the back of an extraordinary rise in income inequality, and natural and national disasters, combined to create the political context that made Abenomics possible. While the fiscal arrow has somewhat disappointed - particularly when PM Shinzo Abe authorized the 2014 increase in the consumption tax - Japan has still surprised to the upside on fiscal thrust (Chart 5). On average, the IMF has underestimated Japan's fiscal impulse by 0.84% since the beginning of 2012. Investors often understate the ability of centrist, establishment policymakers to rebrand anti-establishment policies - whether on fiscal spending or immigration - as their own. In January 2015, we asked whether "Abenomics Is The Future?"6 We concluded that rising populism in Europe would require a policy response not unlike the policy mix favored by Tokyo. Today, the details of the latest German coalition deal between the formally fiscally conservative Christian Democratic Union (CDU) and the center-left Social Democratic Party (SDP) means that even Germany has now succumbed to the political pressure to reflate. The CDU has agreed to fork over the influential ministry of finance to the profligate SPD and apparently spend an additional 46 billion euros, over the duration of the Grand Coalition, on public investment and tax cuts. Finally, in the U.K., the end of austerity came quickly on the heels of the Brexit referendum, the ultimate populist shot-across-the-bow. The new Chancellor of the Exchequer, Philip Hammond, announced a shift away from austerity almost immediately, scrapping targets for balancing the budget by the end of the decade. The change in rhetoric has carried over to the new government, especially after the Labour Party pummeled the Tories on austerity in the lead up to the June 2017 election. The bond market action over the past several weeks suggests that investors have not fully appreciated the political shifts underway over the past several years. Bond yields had to "catch up" to the political reality essentially over the course of February. However, the structural upward trajectory is now in place. The end of stimulative monetary policy will accelerate the rise in bond yields. Quantitative easing programs have soaked up more than the net government issuance of the major economies. Chart 6 shows that the flow of the major economies' government bonds available for the private sector to purchase was negative from 2015-2017. This flow will now swing to the positive side as fiscal spending necessitates greater issuance and as central banks withdraw demand. Real interest rates may therefore be higher to the extent that government bonds will have to compete with private-sector issuance for available savings. Chart 5Japan's Abenomics Leads The Way To More Spending Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China Chart 6Lots Of Bonds Hitting The Private Market Lots Of Bonds Hitting The Private Market Lots Of Bonds Hitting The Private Market Bottom Line: The U.S. electorate chose the populist, anti-establishment Donald Trump as president with unemployment at a multi-decade low of 4.6%. The message from the U.S. election, and the rise of anti-establishment parties in Europe, is that the electorate is restless, even with the post-Great Financial Crisis recovery now in its ninth year. Policymakers have heard the message, loud and clear, and are adjusting fiscal policy accordingly. Over the course of the next quarter, BCA's Global Investment Strategy expects the rapid rise in bond yields to peter out, but investors should use any bond rallies as an opportunity to reduce duration risk. BCA's House View calls for the 10-year Treasury yield to finish the year at about 3.25%.7 Our U.S. bond strategists expect the end-of-cycle level of the nominal 10-year Treasury yield to be between 3.3% and 3.5%.8 Does The U.S. Midterm Election Matter? The three-day government shutdown that ended on January 22 has hurt the chances of the Democratic Party in the upcoming midterm election. The Democrats' lead in the generic congressional ballot has gone from a high of 13% at the end of 2017 to just 9% today (Chart 7). As Chart 8 illustrates, this generic ballot has some predictive quality. However, it also suggests that for Democrats, the lead needs to be considerably larger than for Republicans to generate the type of seat-swing needed to win a majority in the House of Representatives in 2018. Chart 7Democrats Have Lost Some Steam Democrats Have Lost Some Steam Democrats Have Lost Some Steam Chart 8Democrats Need Big Polling Lead To Win Majority Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China There are three reasons for this built-in advantage for the Republican Party in recent midterm elections. First, the Republicans dominate the rural vote, which tends to be overrepresented in any electoral system that draws electoral districts geographically. Second, redistricting - or gerrymandering - has tended to favor the Republican Party in the past several elections. While the Supreme Court has recently struck down some of the most egregiously drawn electoral districts, the overall impact of gerrymandering since 2010 overwhelmingly favors the GOP. Third, midterm elections tend to have a lot lower voter turnout than general elections, which hurts the Democrats who rely on the youth and minority vote. Both constituencies tend to shy away from participation in the midterm election. Does the market care who wins the House and Senate? On the margin, yes. If the current GOP control of the White House, House of Representatives, and Senate were to be broken, markets might react negatively. It is often stated that gridlock has a positive effect on stock prices, as it reduces the probability of harmful government involvement in the economy and financial markets. However, research by our colleague Jonathan LaBerge, which we have recently updated, suggests otherwise. After controlling for the macro environment, gridlock between the White House and Congress is actually associated with modestly lower equity market returns.9 This conclusion is based on the past century of data. For most of that period, polarization has steadily risen to today's record-setting levels (Chart 9). As such, the negative impact of gridlock could be higher today. Table 1 illustrates the impact of four factors on monthly S&P 500 price returns. The first two columns demonstrate the effect on returns of recessions and tightening monetary policy, respectively, whereas the last two columns measure the effects of executive/legislative disunity and reduced uncertainty in the 12-months following presidential and midterm elections.10 The table presents the beta of a simple regression based on dummy variables for each of the four components (t-statistics are shown in parentheses). Chart 9U.S. Polarization Has Risen For 60 Years U.S. Polarization Has Risen For 60 Years U.S. Polarization Has Risen For 60 Years Table 1Divided Government Is, In Fact, Bad For Stocks Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China As expected, the macro context has a much larger impact on stock returns than politically driven effects. The impact of political gridlock is shown to be negative regardless of timeframe. The takeaway for equity investors is that, contrary to popular belief, political gridlock is not positive for stock prices after controlling for important macro factors. Absolute results are similarly negative, with the average monthly S&P 500 returns considerably larger during periods of unified executive and legislative branches (Chart 10). Intriguingly, the less negative constellation of forces is when the president faces a unified Congress ruled by the opposing party. We would reason that such periods force the president to compromise with the legislature, which constitutionally has a lot of authority over domestic policy. The worst outcome for equity markets, by far, is when the president faces a split legislature. In these cases, we suspect that uncertainty rises as neither party has to take responsibility for negative policy outcomes, making them more likely. Chart 10A Unified Congress Is A Boon For Stocks Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China In the current context, gridlock could lead to greater political volatility. For example, a Democratic House of Representatives would begin several investigations into the Trump White House and could potentially initiate impeachment proceedings against the president. But as we pointed out last year, impeachment alone is no reason to sell stocks.11 The Democrats would not have the ability to alter President Trump's deregulatory trajectory - which remains under the purview of the executive - nor would they be likely to gain enough seats to repeal the tax cut legislation. Yet given President Trump's populist bias, center-left Democrats could find much in common with the president on spending. This would only reinforce our adage that the political path of least resistance will tend towards profligacy. The only thing that President Trump and the Democrats in Congress will find in common, in other words, will be to blow out the U.S. budget deficit. Bottom Line: The chances of a Democratic takeover following the midterm elections have fallen, but remain at 50% for the House of Representatives. A gridlocked Congress is mildly negative for equity markets, taking into consideration that macro variables still dominate. Nonetheless, investors should ignore the likely higher political volatility and focus on the fact that President Trump and the Democrats are not that far apart when it comes to spending. China: The Reform Reboot Is Here And It Is Still Winter He told us not to believe the people who say it's spring in China again. It's still winter. - Anonymous Chinese government official referring to Liu He, the top economic adviser.12 The one risk to the BCA House View of a structural bond bear market - at least in the near term - is a peaking of global growth and a slowdown in emerging markets. The EM economies, which normally magnify booms in advanced economies, particularly in latter stages of the economic cycle, are currently experiencing a relative contraction in their PMIs (Chart 11). BCA Foreign Exchange Strategy's "carry canary" indicator - which shows that EM/JPY carry trades tend to lead global industrial activity - is similarly flashing warning signs (Chart 12).13 Chart 11EM Economies Underperforming EM Economies Underperforming EM Economies Underperforming Chart 12Yen Carry Trades Signal Distress Yen Carry Trades Signal Distress Yen Carry Trades Signal Distress At the heart of the divergence in growth between EM and DM is China. Beijing has been tightening monetary conditions as part of overall structural reform efforts, causing a sharp deceleration in the Li Keqiang index (Chart 13). In addition, the orders-to-inventories ratio has begun to contract, import volumes are weak, and export price growth is slowing sharply (Chart 14). Chart 13Li Keqiang Index Surprises Downward Li Keqiang Index Surprises Downward Li Keqiang Index Surprises Downward Chart 14China's Economy Weakens... China's Economy Weakens... China's Economy Weakens... The Chinese slowdown is fundamentally driven by politics. Last April we introduced a checklist for determining whether Chinese President Xi Jinping would "reboot" his reform agenda during his second term in office. We define "reform" as policies that accelerate the transition of China's growth model away from investment-driven, resource-intensive growth. Since then, political and economic events have supported our thesis. Most recently, interbank lending rates have spiked due to China's new macro-prudential regulations and monetary policy (Chart 15), and January's total credit growth clocked in at an uninspiring 11.2% (Chart 16). Tight credit control in the first calendar month typically implies that credit expansion will be limited for the rest of the year (Chart 17). A strong grip on money and credit growth is entirely in keeping with the three-year "battle" that Xi Jinping has declared against systemic financial risk.14 Chart 15...While Policy Drives Up Interbank Rates ...While Policy Drives Up Interbank Rates ...While Policy Drives Up Interbank Rates Chart 16January Credit Growth Disappoints... January Credit Growth Disappoints... January Credit Growth Disappoints... Chart 17... And January Credit Is The Biggest Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China In short, we have just crossed the 50% threshold on our checklist, confirming that China is indeed rebooting its reform agenda (Table 2). Going forward, what matters is the intensity and duration of the reform push. Three events at the start of the Chinese New Year suggest that the market will be surprised by both. Table 2How Do We Know China Is Reforming? Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China First, the National People's Congress (NPC), which convenes March 5, is reportedly planning to remove term limits for the president and vice-president, thus enabling Xi Jinping to remain as president well beyond March 2023. Xi was already set up to be the most powerful man in China's politics through the 2020s,15 so we do not consider this a material change in circumstances: the material change occurred last October when "Xi Thought" received the status of "Mao Zedong Thought" in the Communist Party's constitution and reshaped the Politburo to his liking. The point is that Xi's position is irresistible which means that his policies will have greater, not lesser, effectiveness as party and state bureaucrats scramble to enact them faithfully.16 Chart 18Crackdown On Shadow Lending Has Teeth Crackdown On Shadow Lending Has Teeth Crackdown On Shadow Lending Has Teeth Second, the Communist Party is reportedly convening its "Third Plenum" half a year early this year - that is, in late February and early March, just before the annual legislative meeting that begins March 5. This is a symbolic move. The third plenum is known as the "reform plenum," and this year is the fortieth anniversary of the 1978 third plenum that launched China's market reform and opening up to the global economy under Deng Xiaoping. However, the last time China convened a third plenum - in 2013 when Xi first announced his agenda - the excitement fizzled as implementation proved to be slow.17 As we have repeatedly warned clients, China's political environment has changed dramatically since 2013: the constraints to painful structural reforms have fallen.18 If the third plenum is indeed held early, some key decisions on reform initiatives will be made as we go to press, and any that require legislative approval will receive it instantly when the National People's Congress convenes on March 5.19 This will be a "double punch" that will supercharge the reform agenda this year. It is precisely the kind of ambition that we have been expecting. Third, one of the most important administrative vehicles of this new reform push, the Financial Stability and Development Commission (FSDC), has just made its first serious move.20 On February 23, China's top insurance regulator announced that it is taking control of Anbang Insurance Group for one year, possibly two, in order to restructure it amid insolvency and systemic risks. Anbang's troubles are idiosyncratic and have received ample media attention since June 2017.21 Nevertheless, China's government has just seized a company with assets over $300bn. Clearly the crackdown on the shadow financial sector has teeth (Chart 18). Anbang's case will reverberate beyond the handful of private companies involved in shadow banking and highly leveraged foreign acquisitions abroad. Beijing's focus is systemic risk, not merely innovative insurance products. The central government is scrutinizing state-owned enterprises (SOEs) and local governments as well as a range of financial companies and products. We provide a list of reform initiatives in Table 3. Table 3China Is Rebooting Economic Reforms Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China What is the cumulative effect of these three developments? Basically, they raise the stakes for Xi's policies dramatically this year. If Xi makes himself president for life, and yet this year's third plenum is as over-hyped and under-delivered as in 2013, then we would expect China's economic future to darken rapidly. China will lose any pretext of reform just as the United States goes on the offensive against Beijing's mercantilism. It would be time to short China on a long-term time line. However, it would also spell doom for our positive U.S. dollar outlook and bearish EM view. If, on the other hand, Xi Jinping couples his power grab with renewed efforts to restructure China's economy and improve market access for foreigners, then he has a chance of deleveraging, improving China's productivity, and managing tensions with the U.S. This is the best outcome for investors, although it would still be negative for Chinese growth and imports, and hence EM assets, this year. The next political indicator to watch is the March 5 NPC session. This legislative meeting will be critical in determining what precise reforms the Xi administration will prioritize this year. The NPC occurs annually but is more important this year than usual because it installs a new government for the 2018-23 period and will kick off the new agenda. In terms of personnel, there is much speculation (Table 4).22 Investors should stay focused on the big picture: four months ago, the news media focused on Xi Jinping's Maoist thirst for power and declared that all reform efforts were dead in the water. Now the press is filled with speculation about which key reformer will get which key economic/financial position. The big picture is that Xi is using his Mao-like authority in the Communist Party to rein in the country's economic and financial imbalances. His new economic team will have to establish their credibility this year by remaining firm when the market and vested interests push back, which means more policy-induced volatility should be expected. Table 4China's New Government Takes Shape At National People's Congress Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China The risk is that Beijing overcorrects, not that reforms languish like they did in 2015-16. Our subjective probability of a policy mistake remains at 30%, but we expect that the market will start to price in this higher probability of risk as the March political events unfold. As Liu He declared at Davos, China's reforms this year will "exceed the international community's expectations."23 The anti-corruption campaign is another important factor to monitor. In addition to any major economic legislation, the most important law that the NPC may pass is one that would create a new nationwide National Supervisory Commission, which will expand the Communist Party's anti-corruption campaign into every level of the state bureaucracy. In other words, an anti-corruption component is sharpening the policy effectiveness of the economic and financial agenda. In the aforementioned Anbang case, for instance, corporate chief Wu Xiaohui was stung by a corruption probe in June 2017 and is being tried for "economic crimes" - now his company and its counterparty risks are being restructured. The combination of anti-corruption campaign and regulatory crackdown has the potential to cause significant risk aversion among financial institutions, SOEs, and local governments. Add in the ongoing pollution curbs, and any significant SOE restructuring, and Chinese policy becomes a clear source of volatility and economic policy uncertainty this year that the market is not, as yet, pricing (Chart 19). On cue, perhaps in anticipation of rising domestic volatility, China has stopped updating its home-grown version of the VIX (Chart 20). Chart 19Market Expects No Political Volatility Yet Market Expects No Political Volatility Yet Market Expects No Political Volatility Yet Chart 20Has China Halted Its Version Of The VIX? Has China Halted Its Version Of The VIX? Has China Halted Its Version Of The VIX? We would not expect anything more than a whiff, at best, of policy easing at the NPC this March. For instance, poverty alleviation efforts will require some fiscal spending. But even then, the point of fiscal spending will be to offset credit tightness, not to stimulate the economy in any remarkable way. Monetary policy may not get much tighter from here, as inflation is rolling over amid the slowdown (Chart 21),24 but anything suggesting a substantial shift back to easy policy would be contrary to our view. More accommodative policy at this point in time would suggest that Xi has no real intention of fighting systemic risk and - further - that global growth faces no significant impediment from China this year. In such a scenario, the dollar could fall further and EM would outperform. We expect the contrary. We are long DXY and short EUR/JPY. We remain overweight Chinese H-shares within emerging markets, but we will close this trade if we suspect either that reform is a fig leaf or that authorities have moved into overcorrection territory. Otherwise, reform is a good thing for Chinese firms relative to EM counterparts that have come to rely on China's longstanding commodity- and capital-intensive growth model (Chart 22). Chart 21Monetary Policy May Not Tighten From Here Monetary Policy May Not Tighten From Here Monetary Policy May Not Tighten From Here Chart 22Tighter-Fisted China Will Hit EM Tighter-Fisted China Will Hit EM Tighter-Fisted China Will Hit EM Bottom Line: Xi Jinping has rebooted China's economic reforms. The new government being assembled is likely to intensify the crackdown on systemic financial risk. Reforms will surprise to the upside, which means that Chinese growth is likely to surprise to the downside amidst the current slowdown, thus weighing on global growth at a time when populism provides a tailwind to U.S. growth. What It All Means For South Africa And Emerging Markets We spent a full week in South Africa last June and came back with these thoughts about the country's economy and the markets:25 The main driving force behind EM risk assets, year-to-date, has been U.S. TIPS yields and the greenback (Chart 23). Weak inflation data and policy disappointments as the pro-growth, populist, economic policy of the Trump Administration stalled have supported the ongoing EM carry trade. The actual emerging market growth fundamentals and politics are therefore unimportant. Chart 23Weak Inflation And Dollar Drove EM Assets Weak Inflation And Dollar Drove EM Assets Weak Inflation And Dollar Drove EM Assets Chart 24Market Likes Ramaphosa, Unlike Zuma Market Likes Ramaphosa, Unlike Zuma Market Likes Ramaphosa, Unlike Zuma In the near term, South African politics obviously do matter. Markets have cheered the election of Cyril Ramaphosa to the presidency of the African National Congress (ANC), a stark contrast to the market reaction following his predecessor's ascendancy to the same position (Chart 24). However, the now President Ramaphosa's defeat of ex-President Jacob Zuma's former cabinet minister and ex-wife, Nkosazana Dlamini-Zuma was narrow and has split the ANC down the middle. On one side is Ramaphosa's pragmatic wing, on the other is Dlamini-Zuma's side, focused on racial inequality and social justice. Chart 25Chronic Youth Unemployment Chronic Youth Unemployment Chronic Youth Unemployment Chart 26Few Gains In Middle Class Population Few Gains In Middle Class Population Few Gains In Middle Class Population For now, the ANC bureaucracy has served as an important circuit-breaker that will limit electoral choices in the 2019 election to the pro-market Ramaphosa, centrist Democratic Alliance, and radical Economic Freedom Fighters. From investors' perspective, this is a good thing. After all, it is clear that if the South African median voter had her way, she would probably not vote for Ramaphosa, given that the country is facing chronic unemployment (Chart 25), endemic corruption, poor healthcare infrastructure, and a desire for aggressive, and targeted, redistributive economic policies. South Africa stands alone amongst its EM peers when it comes to its tepid rise in the middle class as a percent of the population (Chart 26) and persistently high income inequality (Chart 27). We see no evidence that the electorate will welcome pro-market structural reforms. Chart 27Inequality Remains Very High Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China Nonetheless, Ramaphosa's presidency is a positive given the recent deterioration of South Africa's governance, which should improve as the new regime focuses on fighting corruption and restructuring SOEs. Whether Ramaphosa will similarly have the maneuvering room to correct the country's endemically low productivity (Chart 28) and still large twin deficits (Chart 29) is another question altogether. Chart 28A Distant Laggard In Productivity A Distant Laggard In Productivity A Distant Laggard In Productivity Chart 29Twin Deficits A Structural Weakness Twin Deficits A Structural Weakness Twin Deficits A Structural Weakness Will investors have time to find out the answer to those latter questions? Not if our core thesis for this year - that politics is a tailwind to U.S. growth and a headwind to Chinese growth - is right. In an environment where the U.S. 10-year Treasury yield is rising, DXY stabilizes, and Chinese economy slows down, commodities and thus South African assets will come under pressure. As our colleague Arthur Budaghyan, BCA's chief EM strategist, recently put it: positive political developments are magnified amid a benign external backdrop. Conversely, in a negative external environment, positive political transformations can have limited impact on the direction of financial markets. Bottom Line: Markets are cheering Ramaphosa's ascendancy to the South African presidency. We agree that the development is, all other things being equal, bullish for South Africa's economy and assets. However, the structural challenges are vast and we do not see enough political unity in the ANC to resolve them. Furthermore, we are not sure that the global macro environment will remain sanguine for long enough to give policymakers the time for preemptive structural reforms. To reflect the potential for a positive political change and forthcoming orthodox macro policies, we are closing our recommendation to bet on yield curve steepening in South Africa, which has been flat since initiation on June 28, 2017. However, we will maintain our recommendation to buy South African 5-year CDS protection and sell Russian, even though it has returned a loss of 17.08 bps thus far. We expect that Russia will prove to be a low-beta EM play in the next downturn, whereas South Africa will not be so lucky. On a different note, we are booking gains of 2525bps on our short Venezeulan vs. EM 10-yr sovereign bonds, as our commodity team upgrades its oil-price forecast for this year. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 2 Please see the Congressional Budget Office, "Bipartisan Budget Act of 2018," February 8, 2018, available at www.cbo.gov. 3 Please see BCA The Bank Credit Analyst Monthly Report, "March 2018," dated February 22, 2018, available at bca.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Japan's Political Paradigm Shift: Investment Implications," dated December 21, 2012, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Monthly Report, "Is Abenomics The Future?" dated February 11, 2015, available at gps.bcaresearch.com. 7 Please see BCA Global Investment Strategy Weekly Report, "A Structural Bear Market In Bonds," dated February 16, 2018, available at gis.bcaresearch.com. 8 Please see BCA U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds," dated February 20, 2018, available at usbs.bcaresearch.com. 9 Please see BCA U.S. Investment Strategy Weekly Report, "A Party On The QE2," dated November 8, 2010, available at usis.bcaresearch.com. 10 We include the last factor in the regression because it could be that the market responds positively in the post-election period, irrespective of the election outcome, simply because political uncertainty is diminished. 11 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 12 Please see Tom Mitchell, "Xi's China: The Rise Of Party Politics," Financial Times, July 25, 2016, available at ft.com. See also BCA Geopolitical Strategy and China Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at www.bcaresearch.com. 13 "Carry Canary" indicator tracks the performance of EM/JPY carry trades. These trades short the Japanese Yen and long an emerging market currency with a high interest rate (Brazilian real, Russian ruble, or South African rand), and as such they are highly geared to a positive global growth back-drop. Please see BCA Foreign Exchange Strategy Weekly Report, "The Yen's Mighty Rise Continues ... For Now," dated February 16, 2018, available at fes.bcaresearch.com. 14 The other two battles are against pollution and poverty. 15 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Weekly Report, "Xi Jinping: Chairman Of Everything," dated October 25, 2017, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Monthly Report, "Reflections On China's Reforms," in "The Great Risk Rotation - December 2013," dated December 11, 2013, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 19 Consider that the standard political calendar would have called for Xi to make personnel adjustments at the second plenum (which was held in January), then to formalize those personnel changes at the legislature in March, and then to announce reform initiatives at the third plenum in the fall, leaving implementation until late in the year or even March 2019. Instead, all of this will be done by March of this year, leaving the rest of the year for implementation. 20 The Financial Stability and Development Commission was created last July at an important financial gathering that occurs once every five years. We dubbed it a "Preemptive Dodd Frank" at the time because of China's avowed intention to use it to tackle systemic financial risk. Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. The FSDC's purpose is to coordinate the People's Bank of China with the chief financial regulators - the banking, insurance, and securities regulatory commissions (CBRC, CIRC, and CSRC) and the State Administration of Foreign Exchange (SAFE). There is even a possibility under discussion (we think very low probability of happening) that the FSDC will preside above the central bank - though the precise organizational structure will remain unclear until it is formalized, probably during the March legislative session. 21 Anbang is part of a group of companies, including Foresea, Fosun, HNA, Ping An, and Dalian Wanda, that have been targeted over the past year for shady financial doings, corruption, excessive debt, and capital flight. In particular, Anbang was integral to the development of universal life products, which have been highly restricted since last year. These were not standard insurance products but risky short-term, high-yield shadow investment products. Investors could redeem them easily so there was a risk that purchasers could swamp insurance companies with demands for paybacks if investment returns fell short. This would leave insurance companies squeezed for cash, which in turn could shake other financial institutions. The systemic risk not only threatened legitimate insurance customers but also threatened to leave insurance companies unable to make debt payments on huge leveraged buyouts that they had done abroad. Anbang and others had used these and other shadow products to lever up and then go on a global acquisition spree, buying assets like insurance subsidiaries, hotels, and media/entertainment companies. The targeted firms are also in trouble with the central government for trying to divest themselves of China's currency at the height of the RMB depreciation and capital flight of 2015. They were using China's shadow leverage to springboard into Western assets that would be safe from RMB devaluation and Chinese political risk. The government wants outward investment to go into China's strategic goals (such as the Belt and Road Initiative) instead of into high-profile, marquee Western assets and brands. 22 Particularly over whether Xi Jinping's right-hand man, Liu He, will be appointed as the new central bank governor, to replace long-serving Governor Zhou Xiaochuan, and/or whether he will replace Vice Premier Ma Kai as chairman of the FSDC. It is important whether Liu He takes the place of central banker or chief reformer because those roles are so different. Making him PBoC chief would keep a reformer at the helm of a key institution at an important point in its evolution, but will raise questions about who, if anyone, will take charge of structural reform. Giving him the broader and more ad hoc role of Reformer-in-Chief would be reminiscent of Zhu Rongji at the historic NPC session in March 1998, i.e. very optimistic for reforms. Of course, Liu He is not the only person to watch. It is also important to see what role former anti-corruption czar Wang Qishan gets (for instance, leading U.S. negotiations) and whether rising stars like bank regulator Guo Shuqing are given more authority (he is a hawkish reformer). 23 Please see Xie Yu and Frank Tang, "Xi picks team of problem solvers to head China's economic portfolios," South China Morning Post, dated February 21, 2018, available at www.scmp.com. 24 Please see BCA China Investment Strategy Weekly Report, "Seven Questions About Chinese Monetary Policy," dated February 22, 2018, available at cis.bcaresearch.com. 25 Please see BCA Geopolitical Strategy Special Report, "South Africa: Crisis Of Expectations," dated June 28, 2017, available at gps.bcaresearch.com.

Feature China's foreign reserves have been subject to heavy scrutiny over the past few years. The country's multi-trillion-dollar official reserve assets, long viewed by both Chinese officials and the global investment community as an unproductive use of resources, suddenly became a lifeline for China's exchange rate stability following the August 2015 devaluation of the RMB. China's official reserves currently stand at roughly US$3.2 trillion, a massive drawdown from the US$4 trillion all-time peak reached in 2014. Over the years, BCA's China Investment Strategy service has run a series of Special Reports tracking the composition of China's foreign asset holdings.1 This year's update comes at a time when investors have become comfortable with the view that China has succeeded at stemming capital outflow, but headlines suggest that investors continue to scrutinize China's official reserves to assess any potential impact on U.S. Treasury yields.2 Today's report takes a close look at the U.S. Treasury International Capital (TIC) system data and various other sources to check the evolution of China's official reserves and foreign assets. As we have noted in previous versions of this report, there are some important caveats. First, Chinese holdings of U.S. assets reported by the TIC are not entirely held by the People's Bank of China in its official reserves. Some assets, particularly corporate bonds and equities, may be held by Chinese institutional investors. Meanwhile, it is well known that in recent years China has been using offshore custodians in some European countries, the usual suspects being Belgium, Luxembourg and the U.K., which disguises the true situation of the country's official reserve holdings. Finally, China's large conglomerates owned by the central government also hold vast amounts of foreign assets, or "shadow reserves". With these caveats, this week's report reveals some important developments in the past year: While China's official reserves have risen in U.S. dollar terms, the growth rate in SDR-denominated reserves remains modestly negative (Chart 1). This suggests that the recovery of the former has been due to a currency revaluation effect, and that a material easing in capital controls is not likely over the coming 6-12 months even if China has succeeded in stabilizing its reserve level. China still holds the largest amount of foreign reserves in the world, but its global share has dropped to about 40%, down from a peak of over 50% in 2014. Relative to mid-2016, the TIC data show Chinese holdings of U.S. assets have increased as a share of the country's total foreign reserves (Table 1). This flies in the face of concerns that Beijing is predisposed to slowing or stopping the purchase of U.S. Treasurys, and has occurred in spite of the currency revaluation effect that we noted above, which would have the tendency of boosting the share of holdings of non-U.S. assets. Indeed, measured in SDRs, China's holdings of non-U.S. assets since mid-2016 have fallen by a larger magnitude than holdings of U.S. assets. Table 1Chinese Foreign Exchange Reserves Demystifying China's Foreign Assets Demystifying China's Foreign Assets Chinese holdings of U.S. Treasurys have trended sideways since August 2017, but holdings of some other countries suspected to be China's overseas custodians have turned up or continued to rise (Chart 2). This likely means that Chinese holdings of U.S. assets are larger than reflected in the TIC data. Chart 1China Has Stabilized Its Reserve Level China Has Stabilized Its Reserve Level China Has Stabilized Its Reserve Level Chart 2U.S. Treasurys: How Much Does China Really Hold? U.S. Treasurys: How Much Does China Really Hold? U.S. Treasurys: How Much Does China Really Hold? China's holdings of U.S. risky assets have increased since mid-2016, after they were disproportionately liquidated in 2015/2016 as part of its reserve stabilization efforts, perhaps due to reduced political sensitivity when compared with selling U.S. Treasurys. Given that increasing the expected returns of the country's foreign assets has been a long-run policy goal, it will be interesting to see whether China's holdings of U.S. risky assets increase significantly over the coming year. The effect of the restrictions that China has placed on outward direct investment are evident in several places: slower growth in direct investment abroad as a share of total international position assets (relative to portfolio investment and overseas loans), a sharp re-orientation in outward investment towards "strategic" industries rather than "trophy" investments in tourism and entertainment, and an outright reduction in investment in Belt & Road Initiative (BRI)-related countries, despite the strategic importance of the initiative. While we expect a pickup in the growth rate of outward investment over the coming 6-12 months, we doubt that the increase will be sharp. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com 1 Please see China Investment Strategy Special Report, "Demystifying China's Foreign Assets", dated December 15, 2016, available at cis.bcaresearch.com. 2 Please see "China Officials Are Said To Be Wary Of Treasuries, Sparking Drop", dated January 10, 2018, Bloomberg News. China's official data shows that the country's total holdings of international assets have risen to around US$6.7 trillion last year, including foreign exchange reserves, direct investment, overseas lending and holdings of bonds and equities. Official reserves have declined sharply since 2016, and other holdings have increased steadily. Reserves assets dropped below half of total foreign assets in 2016, and their share continued to fall last year. In contrast, portfolio investment and overseas loans have gained significantly both in value terms and as a share of the country's total foreign assets. Chart 3 Chart 3 Chart 3 Chart 4 Chart 4 Chart 4 Despite the sharp decline, international investment positions by Chinese nationals, public and private combined, are still much more heavily concentrated in official reserve assets compared with other major economies. In other major creditor countries, outward direct and portfolio investment accounts for a much larger share of international assets than reserves. Official reserves in the U.S. are negligible. China's official reserves give the PBOC resources to maintain exchange rate stability, but they also lower the expected returns of the country's foreign assets. Encouraging domestic entities to acquire overseas assets directly has been a long-run policy. However, Chinese authorities became alarmed by the pace of Chinese nationals' overseas investment during the acute phase of capital outflow, and have continued to take restrictive measures to limit some projects. Chart 5 Demystifying China's Foreign Assets Demystifying China's Foreign Assets Our calculations shows that Chinese total holdings of U.S. assets reached US$1.62 trillion at the end of November 2017, including Treasurys, government agency bonds, corporate bonds, stocks and non-Treasury short-term custody liabilities of U.S. banks to Chinese official institutions, based on the TIC data (Table 1). Treasurys still account for the majority of the country's total holdings of U.S. assets, while corporate bonds and stocks are relatively insignificant. China's holdings of U.S. assets as a share of total reserves declined between the global financial crisis and 2014, but the trend has since reversed. The share of U.S. asset holdings currently accounts for 52% of Chinese official reserves, compared with a peak of over 70% in the early 2000s and a trough of 46% in 2014. China's overall holdings of foreign exchange reserves (including U.S. assets) declined massively in early 2016, and the recovery in level terms is entirely due to a currency revaluation effect. The U.S. dollar carries a 41.73% weight in the SDR (Special Drawing Rights of the International Monetary Fund), and it accounts for about 63% of total foreign reserves managed by global central banks. In our view, these two measures should be viewed as relevant benchmarks to gauge China's desired level of holdings of U.S. dollar-denominated assets in its official reserves. Chart 6 Chart 6 Chart 6 Chart 7 Chart 7 Chart 7 Long-term assets (defined as having a maturity greater than one year) make up the overwhelming majority of China's holdings of U.S. assets. Most of these long-term assets are in the form of government and agency bonds, corporate bonds and stocks. Chinese holdings of short-term U.S. assets have been negligible in recent years. During the global financial crisis in 2008/09, China massively increased its holdings of short-term U.S. assets, amid a global drive of "flight to liquidity" at the height of the crisis. Chart 8 Chart 8 Chart 8 Chart 9 Chart 9 Chart 9 In terms of risk classification, the majority of Chinese holdings of U.S. assets are risk-free assets, including Treasurys and government agency bonds. China's holdings of these assets have plateaued in recent years. As a share of China's total reserves, U.S. risk-free assets currently account for about 45%, down from about 65% in 2003. Meanwhile, the accumulation of U.S. risky assets has stabilized after a sharp drop in 2016. Changes in U.S. risky asset holdings largely reflect changes in equities, with corporate bonds steadily accounting for about 0.6% of total foreign assets. Chart 10 Chart 10 Chart 10 Chart 11 Chart 11 Chart 11 China currently holds US$1.18 trillion of Treasurys, which account for over 83.8% of total Chinese holdings of U.S. risk-free assets, or 37.7% of total Chinese foreign reserves. Notably, Treasurys as a share of Chinese foreign reserves have been relatively stable, ranging between 30% and 40% over the past decade. This may be the comfort zone for the Chinese authorities' asset allocation to U.S. government paper. China's holdings of U.S. government agency bonds have been roughly flat over the past year following a pickup from 2014-2016. Still, China's agency bond holdings are significantly lower than at their peak prior to the U.S. subprime debacle. Their share in Chinese foreign reserves has declined to 8% from a peak of close to 30% in 2008. Chart 12 Chart 12 Chart 12 Chart 13 Chart 13 Chart 13 Almost all of China's holdings of Treasurys are parked in long-term paper (with duration of more than one year). China's possession of short-term Treasurys has been negligible in recent years, but picked up fractionally in late 2016 (likely as part of the PBOC's increase in cash holdings to deal with capital outflows). Short-term Treasurys accounted for as high as 2.5% of Chinese reserves during the last U.S. expansion, yet remain essentially at zero today despite several rate hikes from the Fed. Chart 14 Chart 14 Chart 14 Chart 15 Chart 15 Chart 15 Chinese holdings of risky U.S. assets - corporate bonds and equities - account for 7% of China's total foreign reserves, a non-trivial decline from its peak of over 10% in 2015. The decline was mainly due to the sudden drop of holdings of equities is holding currently standing at about USD 200 billion. Chart 16 Chart 16 Chart 16 Chart 17 Chart 17 Chart 17 China remains the largest foreign creditor to the U.S. government. Chinese holdings of U.S. Treasurys account for about 10% of total outstanding U.S. government bonds, or around 19% of total foreign holdings of U.S. Treasurys, according to our calculation. About 51% of outstanding U.S. Treasurys are held by foreigners. China is also one of the largest foreign holders of U.S. of agency bonds. While its holdings only accounts for 3% of total outstanding agency bonds, they account for around 22% of the total held by foreigners. About 12% of agency and GSE-backed securities are currently held by foreigners. Chart 18 Chart 18 Chart 18 Chart 19 Chart 19 Chart 19 The flow of Chinese outward direct investment remains high, reaching US$270 billion in 2017, although investment slowed in dollar terms relative to 2016 by a small margin. Total overseas direct investments amount to US$ 1.7 trillion. China's overseas investments have been heavily concentrated in resource-rich regions and industries. Cumulatively, the energy sector alone accounts for almost half of China's total overseas investments, followed by transportation infrastructure, real estate and base metals, which clearly underscores China's demand for commodities. The overseas investments in property dropped about 26% in 2017 compared to the years before. China's outbound investment was originally led by state-owned enterprises. More recently, private Chinese enterprises have become more active in overseas investments and acquisitions. Chart 20 bca.cis_sr_2018_02_28_c20 bca.cis_sr_2018_02_28_c20 Chart 21 Demystifying China's Foreign Assets Demystifying China's Foreign Assets Chart 22 Demystifying China's Foreign Assets Demystifying China's Foreign Assets The U.S. remained one of the largest targets for Chinese investments in 2017, following Switzerland and the U.K. Investment in Switzerland was buoyed by the acquisition of a Swiss agribusiness firm, which has significant long-term implications for food security in China. Consistent with the breakdown in outbound investment by industry, Chinese investments in resource rich countries, such as Australia, Canada and Brazil have recently been much more muted. There is an outright reduction in investment in Belt & Road Initiative (BRI) related countries, despite the strategic importance of the initiative. Corporate China's interest in the global resource space has waned in the past year, with total investment in the energy and metals industries having peaked in 2016. There has been a dramatic increase in investment in the agriculture, finance and logistics industries. These investment deals are mainly driven by state-owned enterprises. Recent increases in investment in tourism and entertainment industries have decreased, which may reflect cautiousness on the part of the Chinese government in the wake of the sharp decline in foreign reserves that occurred in 2015 (and the massive overseas investments by private enterprises in recent years). Chart 23, 24 Demystifying China's Foreign Assets Demystifying China's Foreign Assets Chart 25 Chart 25 Chart 25 Cyclical Investment Stance Equity Sector Recommendations

Highlights Following the establishment of an interest rate corridor system in 2015, the 1-week interbank repo rate is the new de jure policy rate in China. However, the massive rise in interbank repo rate spreads that has occurred over the past 18 months means that the 3-month repo rate has become the new de facto policy rate. This is the key rate that investors should be watching in order to predict the impact of monetary policy on average or effective interest rates in the real economy. Roughly 3/4ths of the tightening in monetary policy that has occurred since late-2016 has actually been regulatory/macro-prudential in nature. This raises the possibility that interbank spreads may rise outside of the central bank's comfort zone, but the PBOC appears to have the appropriate tools to respond to such an event. Concerns that rising inflation and a recent surge in monthly bank lending may spur tighter monetary policy over the coming 6-12 months are a red herring. Recent trends in the Chinese economy are more consistent with the need to ease monetary policy than the need to tighten. Investors should continue to maintain cyclical exposure to investable Chinese stocks, excluding the tech sector. Feature We examined the question of how to judge the stance of China's monetary policy in a Weekly Report published last month.1 In today's Special Report we answer seven questions about China's monetary policy framework, in order to clarify the transmission mechanism between the PBOC's interest rate corridor and the real economy and to help investors understand how to measure and track changes to the Chinese monetary policy landscape. Today's report makes several important conclusions. First, it underscores that while the 1-week interbank repo rate is the new de jure policy rate in China, a sharp rise in interbank spreads that began in late-2016 has caused the 3-month rate to become the de facto policy rate. This is the key rate that investors should be watching in order to predict the impact of monetary policy on average or effective interest rates in the real economy. Second, it highlights that roughly 3/4ths of China's monetary policy tightening since late-2016 has actually been caused by macro-prudential changes made by the PBOC, rather than due to direct interest rate hikes. Third, while the PBOC's rhetoric about inflation and the recent pickup in bank loans ostensibly suggests that further tightening is forthcoming, the reality is that recent trends in the Chinese economy are more consistent with the need to ease monetary policy than the need to tighten. From the perspective of investment strategy, our analysis continues to suggest that investors should maintain cyclical exposure to investable Chinese stocks excluding the tech sector. We outlined how the outlook for monetary policy fits into our "decision tree" for Chinese stocks in our first report of the year,2 and we continue to expect that the PBOC will refrain from significant further tightening over the coming 6-12 months. Our answers to the seven questions below should provide investors with a strong sense of how to predict potential inflection points in Chinese monetary policy, and whether it remains supportive of our recommended investment strategy over the coming year. Q: What is the PBOC's new policy framework, and how does it differ from the bank's traditional monetary policy tools? A: The PBOC has established a corridor system similar to that of many other countries, and now aims to control market-based interest rates as opposed to the old system of regulated interest rates. Chart 1China's Policy Rate: New Vs Old China's Policy Rate: New Vs Old China's Policy Rate: New Vs Old The PBOC's long, ongoing effort to liberalize its interest rate environment reached a new stage in mid-2015, when the central bank shifted to a corridor system similar to that observed in several other countries. Like in other nations, the objective of the corridor is to guide short-term interest rates towards a particular policy rate, which since late-2016 has been officially recognized as the 1-week interbank repo rate. Chart 1 illustrates this corridor, which is bounded by the PBOC's 1-week reverse repo rate on the lower end and by the 1-week standing lending facility rate on the upper end. The chart also shows the benchmark lending rate, which is China's "old" policy rate. For global investors who are more familiar with U.S. monetary policy, this corridor is conceptually equivalent to the target range for the federal funds rate, with the 1-week interbank repo rate acting as the effective fed funds rate. The key difference between China's old and new monetary policy framework is that the former is based heavily on regulated interest rates (and changes in the reserve requirement ratio), whereas the latter rests on manipulating market-based interest rates using a variety of tools. China's "old" policy tools still exist and may be employed if Chinese policymakers wish to rapidly shift the monetary policy stance. But more importantly, they continue to influence the monetary environment in a way that is important for investors to understand, even if they are not the day-to-day focus of policymakers (see next question). Q: What is the relationship between the new PBOC policy rate and the old one? A: The PBOC's corridor system influences 3-month interbank repo rates, which directly impact how many loans are issued at an interest rate above the old, benchmark policy rate (and by what magnitude). Chart 1 highlighted that the midpoint of the PBOC's interest rate corridor has been consistently and meaningfully below that of the old benchmark lending rate over the past two years, but the adoption of the corridor system did not instantly ease monetary policy in China. The reason is that the vast majority of loans in China are issued at rates above the benchmark rate, and the link between the PBOC's old and new monetary policy framework appears to be how the interbank market influences the breadth and depth of this loan rate premium above the old benchmark. Chart 2A Strong Link Between 3-Month Repo Rates ##br##And Economy-Wide Rates A Strong Link Between 3-Month Repo Rates And Economy-Wide Rates A Strong Link Between 3-Month Repo Rates And Economy-Wide Rates Chart 2 highlights that there is a strong (and leading) relationship between changes in China's 3-month interbank repo rate and 1) changes in the percentage of loans issued above the benchmark rate and 2) the changes in the gap between the weighted-average interest rate and the benchmark rate. While the 1-week interbank repo rate has only increased by around 50 bps since late-2016, the 3-month rate has risen about 200 bps, which explains the extent of the rise in the share of loans issued at above-benchmark rates and the rise in average interest rates relative to the benchmark. This relationship is crucial for investors to understand, since we noted in our January 18 Weekly Report that the midpoint of the 2014-2016 range for average interest rates represents our best estimate of the threshold between easy and tight monetary policy in China.3 Charts 1 and 2 also underscore another very important point: while the 1-week interbank repo rate is the new de jure policy rate, the 3-month rate is the new de facto policy rate as long as interbank repo spreads remain elevated. Q: Why have 3-month interbank repo rates risen so much relative to the 1-week rate? Is this a sign of serious interbank stress? A: No, the rise has been intentionally caused by changes in macro-prudential policy. But the rise in spreads has made up a significant portion of monetary tightening in China since late-2016. By the standards of developed markets, China's interbank repo spreads are extraordinarily high. Chart 3 presents China's 3-month / 1-week interbank repo spread since the PBOC established its new monetary policy framework versus the U.S. 3-month / 1-week LIBOR and repo rate spreads. During the worst of the U.S. subprime financial crisis, these spreads peaked at 182 and 105 bps, respectively. By contrast, China's repo rate spread currently stands at 200 bps. Part of this difference is likely explained by the fact that repos in China tend to be conducted on a 'pledged' basis (where ownership of the collateral remains with the cash borrower but is pledged to the lender),4 but we strongly doubt that it explains a majority of the difference given how low Chinese interbank repo spreads were prior to Q4 2016. Chart 3Chinese Repo Rate Spreads Are Outsized##br## Compared With The U.S. Chinese Repo Rate Spreads Are Outsized Compared With The U.S. Chinese Repo Rate Spreads Are Outsized Compared With The U.S. As there are no other signs of an outright banking crisis in China, it follows that China's interbank repo spreads have risen due to a distortion in the market. We reject expectations of further increases in the interest rate corridor as an explanation, given that the rise in spreads has occurred at what is still the short-end of the interbank repo market and that it has persisted for more than a year in the face of very minor changes to the corridor. It is difficult to judge the ultimate cause of the rise in repo spreads with a high degree of confidence, because it began in late-November 2016 when global financial markets were in a high state of flux. Government bond yields rose globally following the U.S. election in early-November in response to (ultimately validated) expectations of stimulative fiscal policy from the Trump administration, and the 1-week repo rate itself was rising during the period. But to us, two pieces of evidence suggest that the rise in interbank repo spreads was caused by the PBOC's decision to include banks' off-balance sheet holdings of wealth management products into its macro-prudential assessment (MPA): The Timing of the MPA Decision: While the PBOC's inclusion of WMPs in its MPA only began in the first quarter of 2017, news that the PBOC had begun a trial of the program broke in mid-November, in advance of the sharp rise in spreads.5 The Rise In 7-Day Depository / Non-Depository Repo Spreads: Chart 4 shows the difference between the 7-day interbank repo rate for all financial institutions and that for depository corporations only (the latter being the new, de jure policy rate). The chart shows that the spread between these two same-maturity rates began a significant uptrend around the same time that the 3-month / 1-week repo spread started to rise. Since non-depository financial institutions appear to have been more active in issuing WMPs over the past several years, this rise in 7-day depository / non-depository repo spreads is consistent with a liquidity squeeze (in anticipation of an upcoming MPA "stress test") among heavy issuers of WMPs. Chart 4Repo Rate Spreads Have Risen ##br##Due To Shadow Banking Crackdown Repo Rate Spreads Have Risen Due To Shadow Banking Crackdown Repo Rate Spreads Have Risen Due To Shadow Banking Crackdown While the rise in the 3-month / 1-week interbank repo spread does therefore appear to represent a "liquidity event" that is squeezing some Chinese banks, it does not seem to meet the description of real banking "stress". True financial system stress tends to occur when banks become wary of lending to each other due to solvency concerns, whereas the current rise in interbank spreads has occurred entirely due to regulatory changes (i.e. the Xi administration's crackdown on shadow banking). As such, while the rise in spreads undoubtedly represents tighter monetary policy, we have already incorporated this development into our framework for China's economy and its financial markets and see no reason to make any changes to our recommended investment strategy unless interbank spreads were to rise sharply further from here. Q: What can the PBOC do to control interbank spreads if they rise significantly from current levels? A: It can use open market operations to inject liquidity into the banking system. Our discussion above highlights that most of the tightening in Chinese market interest rates that has occurred since late-2016 has been regulatory in nature rather than due to direct increases in the PBOC's new policy rate. In fact, since the 3-month interbank repo rate has risen approximately 200 bps because of a 150 bps rise in 3-month / 1-week repo spreads, then it would appear that a full 75% of China's recent monetary policy tightening is attributable to the PBOC's decision to crack down on WMP issuance and shadow lending more generally. This undoubtedly showcases the potential for macro-prudential policies to significantly influence monetary policy in China, but it also raises the question of whether the crackdown may unintentionally tighten financial conditions by more than the PBOC expects. For example, while the PBOC likely knew that increasing its scrutiny over WMPs would impact the interbank market, it is not likely that they were able to predict the magnitude of the impact with any precision. Chart 5The PBOC Has Ample Room ##br##To Inject Liquidity If Needed The PBOC Has Ample Room To Inject Liquidity If Needed The PBOC Has Ample Room To Inject Liquidity If Needed Chart 5 presents one monetary policy tool that the PBOC can use to try to reduce spreads in the interbank repo market were they to rise outside of the central bank's comfort zone. The chart shows the rolling 1-year net liquidity injection into the banking system from the PBOC's open market operations (OMOs), and highlights that the period of rising interbank repo spreads has generally corresponded with declining net liquidity injections. In fact, the chart shows that the PBOC injected no net liquidity into the banking system in 2017, which likely increased the magnitude of the rise in interbank repo spreads. More recently, net liquidity injections have fallen quite sharply, but this appears to have been caused by the PBOC's use of a different policy tool, the Contingent Reserve Arrangement, to inject a substantial amount of liquidity to help meet cash demand during the Chinese New Year. In short, while it is possible that interbank repo spreads could rise significantly and unexpectedly from current levels, the fact that spreads have been elevated but stable over the past year when the PBOC injected no net liquidity into the banking system suggests that monetary authorities should be able to reign in any outsized rise back to levels within the central bank's comfort zone. Q: Is the PBOC likely to tighten aggressively further to control inflation? A: No. The PBOC specifically noted in their latest monetary policy report that inflation needs to be "closely watched", so further tightening to control inflation cannot be ruled out. However, several observations suggest that the risk of aggressive further tightening to control inflation is moderate at most: We have highlighted in past reports that Chinese core consumer prices have recently been correlated with past values of the Li Keqiang index, which has declined meaningfully from its high early last year (Chart 6). The most recent inflation release suggests that the rate of appreciation in core prices is indeed rolling over, suggesting that inflationary pressure is set to ease (rather than intensify) over the coming 6-12 months. Chart 7 presents the BCA China Regional CPI Diffusion Index, which is made up of headline inflation data from 31 first-level administrative divisions. The index is shown alongside overall headline inflation, and while it does confirm that there has been some increase in inflation pressure, the index has not decisively risen above the boom/bust line. Chart 8 illustrates the measure of household inflation expectations that the PBOC cited along with headline CPI. While it is true that the measure has increased, it has done so from a below-median level, and the relationship shown in the chart suggests that further increases would be needed simply to have headline CPI accelerate. Given that headline inflation is 150 bps below the central bank's stated target, it appears that the PBOC is exaggerating the risk of an inflationary breakout to maintain hawkish rhetoric as part of its efforts to reduce the presence of moral hazard in financial markets and the real economy.6 Chart 6Ebbing Inflationary Risk Ebbing Inflationary Risk Ebbing Inflationary Risk Chart 7No Decisive Outbreak No Decisive Outbreak No Decisive Outbreak Chart 8Rising, But From A Low Level Rising, But From A Low Level Rising, But From A Low Level To be clear, we agree that the PBOC will likely raise its interest rate corridor (potentially significantly) further if core inflation re-accelerates and the disinflationary impact of food & energy prices dissipates. However, we see low odds of such a scenario over the coming 6-12 months barring a material re-acceleration of the economy. Q: Does the spike in new RMB loans in January raise the risk of further monetary tightening? A: No. Credit trends in the Chinese economy are more consistent with the need to ease than the need to tighten. Chart 9 shows the monthly increase in new RMB loans, which rose massively in January. Some market commentators have suggested that the January increase in this series carries special significance for loan growth over the remainder of the year, and that the rise suggests that further monetary tightening is forthcoming. But a closer examination of the data highlights that these concerns are unfounded. Panel 2 of Chart 9 shows the domestic bank loan component of total social financing, which is nearly identical to the new RMB loans series shown in panel 1. When presented as the YoY growth rate of a stock rather than a monthly flow,7 it is clear that bank loan growth did not meaningfully accelerate in January. In fact, Chart 10 shows that the YoY growth rate of total social financing (adjusted for equity and municipal bond issuance) continues to decelerate, highlighting that credit trends in the Chinese economy are more consistent with the need to ease monetary policy rather than tighten. Chart 9A Sharp MoM Rise... A Sharp MoM Rise... A Sharp MoM Rise... Chart 10...But Not In YoY Terms ...But Not In YoY Terms ...But Not In YoY Terms Q: What market-based indicators can investors use to tell if Chinese monetary policy is becoming restrictive? A: Watch the correlation between the 3-month interbank repo rate and China's relative sovereign CDS spread vs Germany. Chart 11A Market-Based Indicator ##br##Of The Restrictiveness Of Monetary Policy A Market-Based Indicator Of The Restrictiveness Of Monetary Policy A Market-Based Indicator Of The Restrictiveness Of Monetary Policy Besides a generalized selloff in Chinese risky financial assets, one warning sign that investors can use to monitor whether monetary policy has become restrictive is the rolling 1-year correlation between the 3-month interbank repo rate and the relative sovereign CDS spread between China and a large, fiscally sound developed economy (such as Germany). Despite the fact that actual sovereign credit risk in China is extremely low, Chart 11 shows that the relative CDS spread has acted as a good bellwether for growth conditions in the Chinese economy. It shows that the correlation between this spread and the 3-month interbank repo rate was initially positive in late-2016 (representing concern on the part of investors that monetary policy is restrictive), but has since come back down into negative territory. Interestingly, the correlation was consistently positive from mid-2011 to mid-2014, when average lending rates averaged 7% or higher and the benchmark lending rate exceeded the IMF's Taylor Rule estimate by about 1%.8 So while this is but one measure that we will be tracking, it's performance over the past several years as an indicator for restrictive policy appears to accord with our ex-post understanding of the impact of monetary conditions on the Chinese economy. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Monetary Tightening In China: How Much Is Too Much?" dated January 18, 2018, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "The 'Decision Tree' For Chinese Stocks", dated January 4, 2018, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "Monetary Tightening In China: How Much Is Too Much?" dated January 18, 2018, available at cis.bcaresearch.com. 4 For more information on the structure of China's repo market, please see "The Chinese Interbank Repo Market" by Ross Kendall and Jonathan Lees, Reserve Bank of Australia Bulletin, June 2017. 5 "China's tightened rules on wealth management products having little effect", Cathy Zhang, South China Morning Post, November 17, 2016 6 Please see our January 25 webcast for our geopolitical team's perspective on the potential impact of Governor Xiaochuan's approaching retirement on the PBOC's policy bias: https://gps.bcaresearch.com/webcasts/index/178# 7 We cumulate the social financing series using the best available estimates of the initial starting point of each component series. 8 Please see China Investment Strategy Weekly Report, "Monetary Tightening In China: How Much Is Too Much?" dated January 18, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Despite having the largest negative return of major markets during the global equity market correction, China's investable stock selloff appears to be normal after controlling for its risk characteristics. Taken together, the association between the global correction and volatility/valuation should be viewed as a sharp reduction in complacency in the market. Several factors make us cautious about China's outsized tech sector exposure in a world of reduced complacency. We recommend that investors retain cyclical exposure to investable Chinese stocks while neutralizing exposure to the tech sector. Feature Chart 1An Average Size, But Very Rapid, ##br##Global Selloff An Average Size, But Very Rapid, Global Selloff An Average Size, But Very Rapid, Global Selloff Global equities have sold off quite sharply since the end of January, having declined a total of 9% in US$ terms from their January 26 high to last Friday's close (Chart 1). BCA addressed the rout in a Special Report last week,1 and noted that strong economic growth and positive earnings surprises are likely to keep the global equity bull market intact, a view largely supported by this week's stock market behavior. Still, the report also highlighted that investors need to adjust to the fact that realized volatility is likely to sustainably rise, even if forward-looking volatility measures (such as the VIX in the U.S.) are currently too elevated. More generally, we equate the return of volatility with a reduction in complacency, and in this week's report we explore the implications of lower complacency for investors with an overweight allocation towards Chinese equities. Our judgement is that the complacency risk for China's ex-tech equity market is low, but that the same cannot be said for China's technology stocks. We conclude by recommending two trades that investors can employ to retain cyclical exposure to investable Chinese stocks, but with a neutralized exposure to the tech sector. Normal Underperformance For China Chart 2At First China Appears To Be Among ##br##The Worst Performers... After The Selloff: A View From China After The Selloff: A View From China At first blush, China's investable stock market fared quite poorly during the global stock market correction. Chart 2 lists 21 major country stock markets by the magnitude of their decline in US$ terms and highlights that China's selloff ranks at the very top of the list. But a simple comparison of stock market performance is misleading, as it fails to adjust for the different degrees of riskiness that are normally observed across global equity markets. For example, it is well known that emerging market equities have tended to be high beta relative to global stocks over the past decade, and we noted in a recent Special Report that Chinese investable stocks have become high beta even relative to emerging markets. In order to properly compare the performance of these markets during the global stock market selloff, we rely on the concept of "abnormal return" that is often employed in event study analysis. This approach involves calculating a counterfactual "normal" return for each market based on its rolling 1-year alpha and beta versus global stocks prior to the selloff, and then comparing it to the actual return. This difference, the "abnormal return" of each market, is shown in Chart 3, which highlights that China's performance during the selloff was perfectly normal after controlling for its risk characteristics. In fact, Chart 3 shows that many equity markets outperformed on a risk-adjusted basis, highlighting that the magnitude of the selloff in global stocks could actually have been worse. As for the underlying cause of the selloff, we showed in last week's Special Report that a crowded "short volatility" trade was undoubtedly a driving force: Chart 4 highlights that net long speculative positions on the VIX had fallen to a new low over the past six months, a circumstance that has now completely reversed. But Chart 5 shows that valuation also appears to have been a factor contributing to the selloff, by presenting the abnormal returns shown in Chart 3 as a function of the difference between the market's 12-month forward P/E and that of the global benchmark. While the fit is somewhat loose, the chart confirms that markets with higher (lower) forward P/E ratios were more likely to have negative (positive) abnormal returns over the two-week period. Chart 3...But Not After Adjusting##br## For Riskiness After The Selloff: A View From China After The Selloff: A View From China Chart 4The Low-Vol Trade Contributed ##br##To The Speed Of The Selloff... The Low-Vol Trade Contributed To The Speed Of The Selloff... The Low-Vol Trade Contributed To The Speed Of The Selloff... Taken together, the association between the selloff and volatility/valuation should be viewed as a sharp reduction in complacency in the market. While this does not necessarily bode poorly for global equities over the coming 6-12 months, there are some potential implications to explore for China's investable stock market. Chart 5...But Valuation Was Also A Factor After The Selloff: A View From China After The Selloff: A View From China Complacency Risk And Chinese Stocks The sharp reversal in global markets raises the question of whether Chinese equities are complacent about some looming risk. The obvious candidate for complacency risk in China would be focused on its economy, and the potential for a more substantial economic slowdown than is currently expected by market participants. However, we are unconvinced that Chinese ex-tech stocks are somehow neglecting the risks facing China's economy over the coming year. First, we have noted in previous reports that Chinese investable ex-tech stocks are extremely cheap versus global ex-tech stocks, highlighting that investors have priced in a degree of structural risk. Second, recent economic data releases from China do not suggest that the pace of the ongoing economic slowdown is accelerating, suggesting that there is no basis to expect a severe downturn over the coming year. But we acknowledge that the same cannot be said for China's tech sector. While Chinese tech stocks are not stretched on a technical basis (either versus the investable benchmark or versus global tech stocks), several observations make us cautious about China's outsized tech exposure in a world of reduced complacency: First, the growth rates of IBES 12-month trailing and forward earnings growth for global technology stocks are currently at the 80th and 85th percentiles, respectively (Chart 6). This suggests that a substantial amount of fundamental improvement has already been priced in to global tech stocks, raising the risk of earnings disappointment over the coming year. Given that China's tech sector weight (42%) is considerably above that of the global benchmark (18%), a global tech selloff would cause China's investable stock market to underperform even if Chinese tech performance is in line with that of the global tech sector. Second, relative to global technology stocks, the growth rates of China's 12-month trailing and forward earnings growth are also quite elevated, at the 80th and 70th percentiles, respectively (Chart 6 panel 2). This suggests that the tech earnings exuberance observed globally is even worse in China. Third, Chart 7 highlights that China's tech sector has been responsible for pushing our relative composite valuation indicator for China into overvalued territory over the past year. Relative to global ex-tech, China's ex-tech stocks are still significantly cheap; relative to global tech, China's tech stocks are significantly overvalued. Last, we have noted in past reports that China's tech sector appears to be a domestic consumer play, and thus unlikely to significantly underperform over the coming year. However, we also noted in last week's report on China's housing market that the optimism of the consumer sector may be somewhat unfounded if it is based on expectations of future gains in employment and/or income.2 While we do not expect a broad-based retracement in China's consumer sector, even a moderate decline in consumer confidence could spark a non-trivial selloff in Chinese tech stocks given the stretched fundamental picture highlighted above. Chart 6Tech Earnings Growth##br## Is Significantly Stretched Tech Earnings Growth Is Significantly Stretched Tech Earnings Growth Is Significantly Stretched Chart 7Tech Stocks Have Pushed China ##br##Into Overvalued Territory Tech Stocks Have Pushed China Into Overvalued Territory Tech Stocks Have Pushed China Into Overvalued Territory Investment Recommendations Given our observations about the complacency risk facing Chinese tech sector stocks, we are making the following changes to our investment recommendations: We are closing our overweight MSCI China Free versus the emerging markets benchmark trade for a 31% relative return. This has been a core trade for BCA's China Investment Strategy service and has provided investors with significant outperformance since its initiation in May 2012. We are opening two new trades as a replacement for the closed China / EM position: 1) long MSCI China investable ex-technology / short MSCI All Country World ex-technology, and 2) long MSCI China investable value / short All Country World value. These two new trades are a slight variation of a single theme, which is to retain cyclical exposure to investable Chinese stocks while neutralizing exposure to the tech sector. While style indexes such as value and growth normally do not have such a stark sector orientation, Chart 8 highlights that the relative performance of China value vs global value looks very similar to our internally-calculated ex-technology indexes for both markets. This is because MSCI's China growth index is almost entirely made up of tech sector stocks, meaning that a relative value play effectively mimics an ex-tech position. As a final point, we noted above that it is difficult to see how Chinese ex-tech equities are complacent about the ongoing slowdown in China's economy. Chart 9 supports this view by presenting a model for China's investable ex-tech 12-month trailing earnings in US$ terms, based on the Li Keqiang index. The model fit has been tight over the past decade, and is currently forecasting roughly 10% earnings growth over the coming year. This would clearly represent a significant deceleration from current levels, but it is still a decent earnings result that signals Chinese ex-tech stocks are attractive on a risk/reward basis given the sizeable valuation discount that is levied on China relative to global stocks. Chart 8China Ex-Tech And Value:##br## Similar Performance Vs Global China Ex-Tech And Value: Similar Performance Vs Global China Ex-Tech And Value: Similar Performance Vs Global Chart 9Positive Ex-Tech Earnings Growth Likely, ##br##Even With A Slowing Economy Positive Ex-Tech Earnings Growth Likely, Even With A Slowing Economy Positive Ex-Tech Earnings Growth Likely, Even With A Slowing Economy We remain alert to the possibility of a further, more pronounced slowdown in China's economy, but barring that Chinese ex-tech stocks appear to be a solid buy over the coming 6-12 months. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "The Return Of Vol", dated February 6, 2018, available at gis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Is China's Housing Market Stabilizing?", dated February 8, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights The trajectory of EM bank profits and share prices will be critical to sustain the EM equity rally. Rising U.S. bond yields will push up EM local bond yields. This, along with poor quality of banks' earnings, will likely halt EM banks' stock rally. We reiterate our strategic equity position: short EM banks / long U.S. banks. The same strategy can be replicated in credit markets. In China, bank loan data are no longer indicative of aggregate lending to all segments of the economy. Banks' total claims, total assets, and money aggregates have all slowed. The Korean won is making a major top. Short it against an equal-weighted basket of the U.S. dollar and yen. Feature Chart I-1Rising U.S. Bond Yields = Higher EM Local ##br##Bond Yields And Lower Bank Stocks Rising U.S. Bond Yields = Higher EM Local Bond Yields And Lower Bank Stocks Rising U.S. Bond Yields = Higher EM Local Bond Yields And Lower Bank Stocks The key financial market variables with respect to the outlook for emerging markets (EM) are commodities prices, the U.S. dollar and EM bank share prices. We have written extensively on the former two, and today we elaborate on the third pillar: the importance of banks/financial stocks to the EM aggregate equity index. First, surging U.S. Treasurys yields point to higher EM local currency bond yields (Chart I-1, top panel). In turn, EM banks' share performance inversely correlates with EM local bond yields (Chart I-1, bottom panel). Altogether, this heralds lower EM bank share prices. Second, financials make up 24.4% of the MSCI EM equity market cap, with banks accounting for 18% out of the 24.4%. Hence, financials/banks' price fluctuations are critical to the EM equity benchmark. Importantly, financials' earnings accounts for 33.6% of EM listed companies earnings. By contrast, technology accounts for 27.6% of the EM market cap, but only 23.3% of EM total earnings (Table I-1). As to the EM technology sector, it is heavily skewed toward four large companies: Tencent, Alibaba, Samsung and TSMC. The latter two have already shown considerable weakness, with Samsung breaking down below its 200-day moving average (Chart I-2). Analyses on the former two companies are beyond the realm of macro research. What's more, these stocks are extremely overbought and probably expensive. If the rest of EM goes down, these two stocks are not likely to preclude it from happening. Third, banks in China, Turkey, Indonesia, Malaysia and Brazil have been boosting their reported EPS by reducing their provisions outright or the pace of provisioning. Table I-1EM Equity Sectors: Earnings & Market Cap Weights EM Bank Stocks Hold The Key EM Bank Stocks Hold The Key Chart I-2Is EM Tech Hardware Breaking Down? Is EM Tech Hardware Breaking Down? Is EM Tech Hardware Breaking Down? For various reasons, we believe these reductions in provisions are unjustified. In China, Turkey and Malaysia, NPLs are too low to begin with: the more accurate measures of NPLs are probably much higher in these banking systems given the magnitude and duration of the preceding credit boom (Chart I-3 and Chart I-4). Chart I-3China: Banks' Provisions Are Inadequate bca.ems_wr_2018_02_14_s1_c3 bca.ems_wr_2018_02_14_s1_c3 Chart I-4Turkey And Malaysia: ##br##Falling Provisions Are Untenable Turkey And Malaysia: Falling Provisions Are Untenable Turkey And Malaysia: Falling Provisions Are Untenable In Brazil and Indonesia, the recent weakness in nominal GDP growth - shown inverted on the chart - does not justify the outright reduction in the level of net new NPL provisions (Chart I-5). In short, some EM banks have inflated their EPS in recent quarters by reducing provisioning for bad loans. This suggests that their EPS quality is poor, and their profit recovery is unsustainable. Bottom Line: EM bank share prices have reached their previous high but are unlikely to break above that level, in our opinion (Chart I-6). Chart I-5Brazil And Indonesia: Declining ##br##Provisions Are Unsustainable Brazil And Indonesia: Declining Provisions Are Unsustainable Brazil And Indonesia: Declining Provisions Are Unsustainable Chart I-6EM Bank Share Prices ##br##Are Facing Resistance EM Bank Share Prices Are Facing Resistance EM Bank Share Prices Are Facing Resistance We reiterate our strategic call of being short EM banks and long U.S. bank stocks. The relative share price performance of EM versus U.S. banks has been inversely correlated with U.S. bond yields (Chart I-7). Chart I-7Rising U.S. Bond Yields = ##br##EM Banks Underperformance Rising U.S. Bond Yields = EM Banks Underperformance Rising U.S. Bond Yields = EM Banks Underperformance If our view on higher U.S. bond yields materializes, odds are that EM bank share prices will relapse considerably versus U.S. banks. Traders should consider implementing this trade. Credit investors can replicate the same strategy in credit markets. Strategy Considerations Investor sentiment remains bullish on risk assets in general and emerging markets in particular. The buy-on-dips mentality is well entrenched. Amid such investor consensus, it is important to consider alternative scenarios. Presently, the relative performance of Swiss versus global non-financial stocks is sitting on its long-term moving average (Chart I-8). Odds of a rebound in the relative performance of Swiss non-financial stocks from such oversold levels are fairly high. As and when the latter begin outperforming their global peers, it might entail a negative outlook for global bourses in general and cyclical equity sectors in particular. The basis is that Swiss non-financial stocks are defensive in nature, as pharmaceuticals and consumer staples account for a large portion of the total market cap. Not surprisingly, the previous bottoms in Swiss non-financials' relative performance versus global non-financials coincided with major tops in global equity bull markets. For now, the risk-reward for global stocks is unattractive, and the outlook for EM relative performance is extremely poor. Notably, relative manufacturing PMI trends favor DM over EM stocks (Chart I-9). Chart I-8Swiss Stocks Are At Critical Juncture: ##br##What Does It Mean For Global Equities? Swiss Stocks Are At Critical Juncture: What Does It Mean For Global Equities? Swiss Stocks Are At Critical Juncture: What Does It Mean For Global Equities? Chart I-9EM Relative To DM: PMIs And Share Prices EM Relative To DM: PMIs And Share Prices EM Relative To DM: PMIs And Share Prices Besides, as we discussed at great length in our recent report,1 EM equity valuations are on par with DM when adjusted for sector weights and sub-sectors with outlier valuation ratios. Our stance remains that EM risk assets will face a perfect storm this year for two reasons: Strong U.S. growth will cause U.S. inflation to rise, and the selloff in U.S. bonds has further to run. Higher U.S. interest rates should support the U.S. dollar and weigh on EM risk assets that have benefited disproportionally from the search for yield; While China's growth has slowed only moderately, our forward-looking leading indicators continue to point to further deceleration. A combination of these two tectonic shifts will amount to a perfect storm for EM risk assets in 2018. We explore these two issues in greater detail below. U.S. Inflation, The Fed And The U.S. Dollar We have the following observations on current U.S. economic dynamics: Fiscal stimulus is arriving at a time when growth is already robust, and the labor market is tight. This will likely produce higher inflation. Inflation does not need to surge to make a difference in financial markets. It would be fair to say investors have become complacent and financial markets are still pricing in a goldilocks scenario. Therefore, even a moderate rise in core inflation readings along with some anecdotal evidence that companies are able to raise prices will lead to further re-pricing in U.S. interest rate expectations. Higher U.S. interest rates pose a risk to EM, which have benefited considerably from the search for yield. EM currencies, domestic bonds and credit markets have so far held up well, despite the considerable rise in U.S. bond yields (see Chart I-1 on page 1). Based on this, it is tempting to argue that EM will be immune to rising U.S. interest rate expectations. Nevertheless, we believe this EM resilience has occurred because fund flows to EM remain very robust. These flows are often backward looking. Odds are that 10-year U.S. Treasury yields will move well north of 3%. Such a considerable rise in yields will weigh on EM risk assets. It is essential to realize that the positioning in EM stocks, local bonds and credit is more elevated today than it was before the 2015 downturn. Finally, Chart I-10 illustrates that U.S. banks' excess reserves at the Federal Reserve have started to drop. In recent years the periods of reserve declines have coincided with a strong U.S. dollar, yet the latest drop in banks' excess reserves has not yet produced a meaningful rally in the greenback (the dollar is shown inverted in Chart I-10). The Fed's ongoing tapering efforts and the U.S. Treasury's replenishment of its account at the Fed are bound to produce further reductions in banks' excess reserves. Based on the latter's correlation with the exchange rate, this should support the greenback. Notably, the U.S. dollar is fairly valued, according to our most favored valuation measure: the unit labor cost-based real effective exchange rate (Chart I-11). This takes into account both wages and productivity, and hence gauges competitiveness much better than real effective exchange rate measures that rely on consumer and producer prices. Chart I-10Shrinking U.S. Banks Excess ##br##Reserves = Stronger U.S. Dollar Shrinking U.S. Banks Excess Reserves = Stronger U.S. Dollar Shrinking U.S. Banks Excess Reserves = Stronger U.S. Dollar Chart I-11The U.S. Dollar Is Not Expensive The U.S. Dollar Is Not Expensive The U.S. Dollar Is Not Expensive Finally, tax cuts are supply side reforms, and they are typically bullish for the currency. Bottom Line: A combination of stronger growth, rising interest rate expectations, neutral valuations and oversold conditions should help the U.S. dollar to rebound. The rally in the U.S. exchange rate versus EM currencies will be pronounced if China's growth slows, as we expect it to. Making Sense Of Chinese Data China's slowdown has so far been moderate. However, in any economy a downturn almost always begins with a moderation in growth. That, however, is not sufficient reason to conclude that the growth slump will be benign or short-lived. Judgement on the duration and magnitude of a slowdown should be based on the existence of major macro imbalances, or lack thereof. Given that China has enormous money, credit and property market excesses/imbalances and policy has been tightening, we believe that growth disappointments will be non-trivial and more substantive than the market consensus currently expects. The following corroborate the case for a deepening growth slump ahead: The annual change in the manufacturing new orders-to-inventory ratio from the National Bureau of Statistics points to a relapse in Caixin's manufacturing PMI as well as steel, iron ore and coal prices (Chart I-12). This indicator also heralds a decline in analysts' EPS net revisions for all Chinese stocks (Chart I-13). Chart I-12China: An Impending Slowdown China: An Impending Slowdown China: An Impending Slowdown Chart I-13China: EPS Net Revisions Have Peaked China: EPS Net Revisions Have Peaked China: EPS Net Revisions Have Peaked While some economic data like imports for January were strong, it is important to realize that this January had a few more working days compared with January 2017 due to the Chinese New Year falling in February this year. Although the same seasonal adjustment should be applied to money and credit data, there are other critical dimensions specific to the credit data that investors should be aware of. Banks' loans to companies and households - widely watched by the investment community - was very strong in January relative to the previous month. However, loan and most of other data in China should be seasonally adjusted. The annual growth rate in RMB bank loans is still very robust at 13.2% (Chart I-14, top panel). However, the growth rates of banks' total assets, total claims and broad money have all dropped close to 10% or below (Chart I-14). The disparity between bank loans on the one hand and their claims and assets on the other is due to the following: In China's banking statistics, banks' loans to non-bank financial institutions - such as financial trusts, investment corporations, insurance, financial leasing companies and auto-financing companies, and loan companies - are not included in banks' loan data. Hence, bank loan data do not reveal the banks' full impact on the economy. By extending credit to non-bank financial institutions, banks have expanded their balance sheets without exceeding their loan quotas. In short, banks have funded shadow banking and by extension the real economy and speculative investment schemes but have done so via non-bank financial institutions. In addition, banks have also bought a lot of corporate and local government bonds that are not considered loans. Overall, bank loans have been understating the degree of the banking system's credit expansion. In the past year, regulators have been forcing banks to reduce their lending to non-bank financial institutions. With this channel of balance sheet expansion restricted (Chart I-15, top panel), banks are probably resorting to more traditional loans to expand their balance sheets and earn income. Chart I-14China: Bank Loans, ##br##Assets And Total Claims China: Bank Loans, Assets And Total Claims China: Bank Loans, Assets And Total Claims Chart I-15China: Bank Lending To Shadow ##br##Banking Is Being Curtailed China: Bank Lending To Shadow Banking Is Being Curtailed China: Bank Lending To Shadow Banking Is Being Curtailed In short, one needs to look at banks' aggregate claims on all entities - companies, households, non-bank financial institutions and governments - to assess whether their lending to the economy is slowing or accelerating. Chart I-16China: Structure Of Bank Assets China: Structure Of Bank Assets China: Structure Of Bank Assets Consistent with the ongoing regulatory clampdown, banks' claims on non-bank financial institutions - so called shadow banking - have plummeted in the past 12 months after expanding 50-70% annually for several years in a row (Chart I-15, top panel). The bottom three panels of Chart I-15 indicate that the annual growth rates of banks' claims on companies, household and the government have either already decelerated or are slowing now. Their respective shares in banks' total assets are displayed in Chart I-16. While banks' RMB loans remain the largest category of assets, the importance of other claims has risen. Bottom Line: Several leading indicators continue pointing to an impending slowdown in the mainland's economy. Bank loan data is no longer indicative of total bank assets expansion/aggregate lending to all segments in the economy. Broader measures - such as banks' total claims, assets and money aggregates - have decelerated considerably. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Korea: A Major Top In The Won The Korean won is vulnerable on several fronts: Its real effective exchange rate based on unit labor costs is well above its historical mean (Chart II-1, top panel). Importantly, based on this same measure, the won is very expensive versus the Japanese yen (Chart II-1, bottom panel). The manufacturing cycle has already weakened in Korea (Chart II-2). Chart II-1The Won Is Expensive The Won Is Expensive The Won Is Expensive Chart II-2Korea's Manufacturing Is Weakening Korea's Manufacturing Is Weakening Korea's Manufacturing Is Weakening Japanese exports in U.S. dollar terms are starting to outperform Korean ones (Chart II-3), suggesting that Korean exporters might be losing market share to their Japanese rivals. Furthermore, manufacturing inventories are rising sharply in Korea but not in Japan (Chart II-4). Relative manufacturing inventory trends also favor the yen versus the won (Chart II-4, bottom panel). Chart II-3Relative Exports: Korea Versus Japan Relative Exports: Korea Versus Japan Relative Exports: Korea Versus Japan Chart II-4Manufacturing Inventories: Korea And Japan Manufacturing Inventories: Korea And Japan Manufacturing Inventories: Korea And Japan The won's appreciation has depressed Korea's export prices in local-currency terms. In Japan, on the other hand, local-currency export prices are holding better. Interestingly, the relative export price trend in U.S. dollars points to the won's depreciation versus the yen (Chart II-5). Korean non-financial stocks have broken below their 200-day moving average, which corroborates that corporate profitability is deteriorating (Chart II-6). Korean equities have been among the world's worst-performing bourses year-to-date. Chart II-5Export Prices: Korea And Japan Export Prices: Korea And Japan Export Prices: Korea And Japan Chart II-6Korean Non-Financial Stocks Are Cracking Korean Non-Financial Stocks Are Cracking Korean Non-Financial Stocks Are Cracking In addition, the correction in Korean stocks commenced before the recent plunge in the S&P 500. This highlights that the relapse in Korean share prices was not only due to the contagion from the U.S. equity selloff. Finally, the technical profile of the won points to a major top. Chart II-7 shows that the won is facing multi-year technical resistance versus the U.S. dollar. Chart II-7KRW/USD Exchange Rate: ##br##A Long-Term Technical Profile KRW/USD Exchange Rate: A Long-Term Technical Profile KRW/USD Exchange Rate: A Long-Term Technical Profile Investment Conclusions We have been short the Korean won versus the Thai baht since October 19, 2016 and this trade has produced a 7.3% gain. We recommend closing this trade and shorting the won versus an equally-weighted basket of the U.S. dollar and yen. The rationale to short the KRW versus this basket is to hedge against a possible near-term U.S. dollar selloff if China is forced to revalue the RMB further, as we discussed in February 7, 2018 report.2 In regards to equities, we are closing our long KOSPI / short Nikkei trade with a 1% loss since April 26, 2017. Within the EM universe, we continue recommending a neutral allocation to Korean stocks excluding technology. Despite their recent underperformance, EM-dedicated managers should continue overweighting Korean tech stocks. The reasoning behind this is that the potential currency depreciation will help their corporate profitability as tech shipments are not exposed to Chinese capital spending. The latter will be the epicenter of negative growth surprises in our opinion. Finally, Korean local bond yields will soon top out as the deflationary pressures from a stronger currency become more evident in the economy. Korean bonds will outperform U.S. Treasurys on a currency-hedged basis. 1 Please refer to Emerging Markets Strategy Special Report, titled "EM Equity Valuations (Part I)," dated January 24, 2018, the link is available on page 19. 2 Please refer to Emerging Markets Strategy Weekly Report, titled "A Regime Shift?," dated February 7, 2018, the link is available on page 19. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The recent house price weakness in Tier 1 markets likely reflects past economic "information", and does not suggest that a more pronounced slowdown is forthcoming. In fact, while it is too soon to conclude that China's housing sector is about to enter a significant upturn, there are several signs of a potential pickup in activity that should be closely monitored. These signs suggest that, at a minimum, the risk of a material housing downturn has somewhat eased. This is consistent with an overweight stance towards Chinese investable stocks within an emerging market or global equity portfolio. The enormous rise in Chinese investable real estate stocks over the past year reflects a significant improvement in fundamentals and a re-rating from deeply depressed levels. Our Sector Alpha Portfolio suggests that cutting exposure is not yet warranted, but investors should tighten their stops given now lofty earnings expectations over the coming year. Feature We presented our framework for tracking the end of China's mini-cycle in an October 2017 Weekly Report,1 and noted at that time that a weakening housing market was a trend that needed to be monitored. We argued that a moderation in house price appreciation was all but inevitable given the magnitude of the boom over the prior 2 years, and was not concerning in isolation. But we also highlighted that home sales and prices were a key bellwether of the efficacy of policymakers' reflationary efforts over the course of the recent mini-cycle, and that an eventual stabilization of the pace of decline would be an important signal confirming the benign nature of China's economic slowdown. Chart 1A Sharp Decline In Tier 1 House Prices A Sharp Decline In Tier 1 House Prices A Sharp Decline In Tier 1 House Prices The rate of appreciation in Chinese house prices has moderated further since we wrote our October report (Chart 1), with prices in Tier 1 markets (Beijing, Shanghai, Guangzhou, and Shenzhen) having recently decelerated to 0%. In this week's report we provide a brief update on China's housing market, and whether recent house price weakness is consistent with our benign slowdown view. We conclude that the softness in house prices, even in Tier 1 markets, has occurred due to the ongoing economic slowdown and does not likely reflect new information about the condition of the Chinese economy. In fact, while it is too soon to conclude that China's housing sector is about to enter a significant upturn, there are several signs of a potential pickup in activity that should be closely monitored. A Stylized View Of China's Housing Cycle Chart 2 presents a stylized description of the sequencing of China's housing market cycles since 2010, at the onset of China's "new normal" period of decelerating economic growth. Chart 3 presents these dynamics directly and illustrates the lag structure that has prevailed over the period. Chart 2A Stylized View Of China's Housing Market Dynamics: 2010 - Present Is China's Housing Market Stabilizing? Is China's Housing Market Stabilizing? Chart 3Residential Floor Space Sold And House Price Diffusion Indexes Lead ##br##Other Housing Market Data Residential Floor Space Sold And House Price Diffusion Indexes Lead Other Housing Market Data Residential Floor Space Sold And House Price Diffusion Indexes Lead Other Housing Market Data The charts highlight how residential floor space sold has tended to lead other major housing market data in China over the past several years, closely followed by house price diffusion indexes and the year-over-year house price index for Tier 1 markets. These series are, in turn, followed by residential floor space started, the growth rate of house prices in Tier 2 & 3 markets, and finally by land purchased for overall real estate development. Charts 2 & 3 present two noteworthy observations: While Tier 1 house prices have tended to lead prices in Tier 2 and Tier 3 markets, they themselves tend to be preceded by other important housing market series. The extent of the recent decline in Tier 1 house prices seems to simply be the mirror image of the enormous boom that occurred in late-2015 / early-2016, when prices rose over 30% year-over-year. Given the significant slowdown in floor space sold that has occurred since mid-2016, and the enormous rise in prices that preceded it, it seems reasonable to conclude that the recent price weakness in Tier 1 markets likely reflects past economic "information". The more salient question for investors is what developments are likely to occur in China's housing market over the coming year, and what investment strategy conclusions emerge from the outlook. The Cyclical Outlook For Chinese Housing While it is too soon to conclude that China's housing sector is about to enter a significant upturn, there are several signs of a potential pickup in activity that should be closely monitored: Charts 2 & 3 highlight that residential floor space sold has had the best leading properties of the overall housing market cycle in China over the past several years, and there has been a modest pickup in this series since October (Chart 4). Admittedly, there have been two false starts in this series since mid-2016, so it is too early to tell from this data alone that China's housing market activity is about to pick up significantly. However, there has also been a notable improvement in our BCA China 70-City House Price Diffusion Index (Chart 5), which measures the share of cities with accelerating year-over-year house prices. We flagged the previous sharp decline in this measure in our October report, but the recent rebound has resulted in a complete round-trip from last summer's levels. Official diffusion indexes, based on the number of cities with positive month-over-month price gains, are also well above the boom/bust line and have not deteriorated to the same extent as our index has over the past year. Chart 4A Modest Pickup##br## In Housing Sales Volume A Modest Pickup In Housing Sales Volume A Modest Pickup In Housing Sales Volume Chart 5A Notable Pickup##br## In Our House Price Diffusion Index A Notable Pickup In Our House Price Diffusion Index A Notable Pickup In Our House Price Diffusion Index The recent pickup in house prices may be linked to the rolling back of purchase restrictions in some cities, but the correlation is far from perfect. For example, Shijiazhuang, Xiamen, Changsha, Xi'an, and Lanzhou have all been cited in various news reports as having adjusted their housing policies, but none of these markets have experienced a pickup in house price appreciation. We will be watching for more compelling signs over the coming months that local housing market deregulation is the root cause of the recent pickup in our diffusion index. The easing in "for sale" floor space inventory to sales over the past two years has reduced some of the housing overhang, which may cause a moderate boost to new housing construction. Chart 6 highlights that the ratio of residential floor space started to sold has fallen significantly over the past few years, as inventories have been drawn down. Since most of the economic impact from housing comes through the construction process, a pickup in floor space started could shift the growth outlook for China in a positive direction. On the negative side, while survey data suggests that Chinese consumers are upbeat and are looking to buy a home (Chart 7), other indicators suggest that this pickup in interest may be occurring due to unfounded optimism about future employment and/or income. First, we have highlighted in several reports over the past months that the Li Keqiang index is falling (driven significantly by monetary tightening, including rising mortgage rates), which suggests that China's business cycle is shifting down, not up. This clearly raises the risk that income and employment growth with downshift with it. Second, Chart 8 highlights that the employment components of the official manufacturing and services PMIs have stagnated again, after having picked up in 2016 and early-2017. Third, Chart 9 illustrates that while per capita disposable income growth for urban households did pick up during the same period as the employment PMIs, it may be in the process of peaking (especially given the weak Q4 print). Chart 6An Easing In Inventories May Boost##br## New Housing Construction An Easing In Inventories May Boost New Housing Construction An Easing In Inventories May Boost New Housing Construction Chart 7Chinese Consumers ##br##Are Upbeat... Chinese Consumers Are Upbeat... Chinese Consumers Are Upbeat... Chart 8...But Employment Prospects Aren't Great... ...But Employment Prospects Aren't Great... ...But Employment Prospects Aren't Great... Chart 9...And Neither Is Recent Income Growth ...And Neither Is Recent Income Growth ...And Neither Is Recent Income Growth Investment Strategy Implications The first investment strategy implication is that our analysis is consistent with a benign view of the ongoing economic slowdown in China, which supports an overweight stance towards Chinese investable stocks within an emerging market or global equity portfolio. While it is too soon to conclude that housing is about to enter a significant upturn, the risk of a material housing downturn has somewhat eased. Second, a potential pickup in China's housing sector raises the question of whether construction-related sectors are poised to significantly outperform China's investable benchmark over the coming year. We recently closed our long investable building materials / short investable benchmark trade as part of a stringent trade review process, based on the view that a significant upturn in the housing market was far from guaranteed. Our analysis in this report supports that decision, as signs of a significant pickup are tentative at best. However, we will be actively looking to re-open the trade at some point over the coming months were we to observe compelling evidence that a significant acceleration in housing construction is imminent. Third, signs of a potential inflection point in China's housing market would normally be positive for the investable real estate stocks, but the outlook for this sector is clouded by its massive outperformance over the past year. We last wrote about real estate stocks in a September Weekly Report,2 and argued that a positive re-rating from extremely discounted levels had further to run. Indeed, our composite valuation indicator highlights that real estate stocks have merely become fairly valued over the past year (Chart 10), despite a 95% US$ price return in 2017. While this underscores that there has been a major fundamental improvement for Chinese investable real estate companies, Chart 11 highlights that these stocks are now priced for another year of 20-30% EPS growth, which may be a tall order unless a very substantial pickup in Chinese housing market activity materializes. Chart 10Chinese Real Estate Stocks ##br##Are Not Overvalued... Chinese Real Estate Stocks Are Not Overvalued... Chinese Real Estate Stocks Are Not Overvalued... Chart 11...But They Are At Risk Of ##br##An Earnings Disappointment ...But They Are At Risk Of An Earnings Disappointment ...But They Are At Risk Of An Earnings Disappointment For now, the BCA China Investable Sector Alpha Portfolio that we introduced in our January 11 Special Report continues to support an overweight stance towards the investable real estate sector (Table 1),3 and we are reluctant to recommend that investors cut their exposure to these stocks. Still, tight stops may be warranted, especially if the recent pickup in residential floor space sold proves to be fleeting. Table 1Our Investable Sector Alpha Portfolio Still Favors Real Estate Stocks Is China's Housing Market Stabilizing? Is China's Housing Market Stabilizing? Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Tracking The End Of China's Mini-Cycle", dated October 12, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Chinese Real Estate: Which Way Will The Wind Blow?", dated September 28, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report, "China: No Longer A Low-Beta Market", dated January 11, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights The end of the low volatility regime could mark a leadership change in global equities away from EM to DM. The near-term risk to our negative stance on EM risk assets is a scenario where Beijing allows RMB appreciation to head off major protectionist threats from the U.S. This could delay the U.S. dollar rally and support EM risk assets. The EM and commodities equity rallies might be facing formidable technical resistances. These equity segments have to break out these technical resistances decisively to confirm the sustainability of the bull market. Feature Global stocks have corrected, and volatility measures have surged. The low volatility regime appears to have come to a decisive end. Even though in the short run volatility measures could well decline after their steep surge of the past week, the cyclical outlook points to higher volatility relative to last year. Financial markets are likely to be re-priced to adjust to the end of this low-volatility period. This entails more stress, and an additional selloff in risk assets. Periods of low volatility historically sow the seeds of their own reversal. Investors tend to embrace high-risk strategies amid low volatility, and take on more leverage. As a result, market excesses and froth arise, increasing the market's vulnerability in the event of a reversal. The latest period of low volatility lasted for more than a year, and no doubt facilitated the build-up of froth and excesses in global financial markets. Chart I-1 illustrates that the aggregate volatility measure of various financial markets was at its lows of the past 12 years before surging in recent days. Chart I-1Rising Volatility Coincides With A U.S. Dollar Rally Rising Volatility Coincides With A U.S. Dollar Rally Rising Volatility Coincides With A U.S. Dollar Rally What does rising volatility mean for emerging market (EM) relative performance vis a vis developed markets (DM)? It is primarily contingent on the U.S. dollar. If the U.S. dollar rebounds along with the rise in volatility, as it has done in the past (Chart I-1), EM equities will commence underperforming DM bourses. If the U.S. dollar fails to rebound and drifts lower, EM stocks are likely to outperform DM equities. With respect to exchange rates, we believe one of the major driving forces for currencies is the relative growth trajectory. The latter can be approximated by relative equity market performance in local currency terms. Chart I-2 shows that U.S. share prices - of both large and small caps - have been outperforming their global counterparts in local currency terms. Persisting periods of outperformance of U.S. stocks versus their global peers eventually, albeit sometimes with a considerable time lag, instigates a stronger trade-weighted U.S. dollar. U.S. large-cap share prices are making new highs versus their global peers in local currency terms. This entails that the selloff in the broad trade-weighted dollar is at a very late stage. The dollar rebound is a missing trigger for EM relative equity outperformance to reverse. A Risk To Our View: The U.S. Dollar One risk to our negative stance on EM risk assets and our recommendation of underweighting EM versus DM is the continuation of the U.S. dollar selloff. The greenback has been trading very poorly despite jitters in global equity markets. The recent surge in the RMB versus the U.S. dollar may be indicative that the Chinese authorities are tolerating RMB appreciation to defuse a threat of major protectionist measures from the U.S. (Chart I-3). If the RMB continues to appreciate versus the greenback, Asian and other EM currencies will stay well supported, and EM outperformance will persist. Chart I-2U.S. Relative Equity Outperformance ##br##Warrants A Stronger Dollar U.S. Relative Equity Outperformance Warrants A Stronger Dollar U.S. Relative Equity Outperformance Warrants A Stronger Dollar Chart I-3Will Beijing Tolerate A Stronger RMB? Will Beijing Tolerate A Stronger RMB? Will Beijing Tolerate A Stronger RMB? We suspect that Chinese policymakers are reluctantly allowing the RMB to appreciate. Indeed, Chinese policymakers have been both vocal and public about their understanding of Japan's experience with deleveraging, and specifically the mistake made by Japanese policymakers of allowing the yen to appreciate in the early 1990s. As most know, deflationary forces stemming from the combined effects of deleveraging and currency appreciation set off a formidable deflationary adjustment in Japan in the 1990s. Given Japan's experience, our conjecture is that Chinese policymakers would rather opt for a stable-to-mildly weaker currency. This has been one of the cornerstones of our bullish bias on the U.S. dollar versus emerging Asian currencies. If China allows the RMB to appreciate further versus the U.S. dollar, a potential U.S. dollar rally versus EM currencies will be delayed. In turn, this will likely allow EM equity, currency and credit markets to outperform their DM peers. That said, a strong currency will add to the ongoing policy tightening in China. The cumulative impact of this policy tightening combined with currency appreciation will weigh on China's growth later this year. As such, our fundamental thesis on China-slowdown is still valid in the medium term. However, political interference in the currency markets could delay EM risk assets' response to it. Bottom Line: The near-term risk to our negative stance on EM risk assets is a scenario where Beijing allows further RMB appreciation to head off potentially major protectionist threats from the U.S. May 2006 Redux? The current riot in global stocks resembles the May 2006 correction to a certain extent. Back in the spring of 2006, then Federal Reserve Chairman Ben Bernanke had just taken the helm at the Fed. Global growth was strong, the U.S. dollar was selling off, and global share prices were surging and overbought. Chart I-4May 2006 And Now: EM Stocks, ##br##U.S. Bond Prices And U.S. Dollar May 2006 And Now: EM Stocks, U.S. Bond Prices And U.S. Dollar May 2006 And Now: EM Stocks, U.S. Bond Prices And U.S. Dollar In May-June 2006, markets sold off because of the then-prevailing narrative that Chairman Bernanke would be too dovish and would allow U.S. inflation to get out of hand. U.S. bond yields spiked, inflicting particular damage on EM. It seems that February 2018 may play out like May 2006. It will not be exactly the same, but there are enough similarities to draw parallels: Global growth is robust, inflationary pressures are accumulating. DM bond yields are rising and the greenback is selling off. The new Fed Chairman, Jerome Powell, just took over the reins at the Fed, and there are growing odds that U.S. inflation will soon begin to rise, justifying more Fed rate hikes. Chart I-4 illustrates the similarities between financial market dynamics in 2005-2006 and now. If we take 2006 as a guide, we can infer that the selloff is not yet over. In a matter of only five weeks EM share prices plunged by 25% in U.S. dollar terms, and the S&P 500 dropped by 7%. From a big-picture perspective, the May 2006 selloff was a sharp correction in a bull market that lasted for another year or so. Importantly, the 25% plunge in EM share prices that took place in 2006 occurred despite EM corporate profit growth expanding at a double-digit rate in 2006-'07. All that said, the 2006 selloff marked an important regime shift in the global economic landscape - the rate of U.S. growth peaked in the second quarter 2006, and began to decelerate. We believe that the current equity market riot will likely mark a bottom in U.S. inflation and the beginning of a slowdown in China. The U.S. Bond Market Selloff Is Not Over... Yet The selloff in the U.S./DM bond markets has not yet run its course: The U.S. inflation model - constructed by our colleagues in the Foreign Exchange Strategy service and based on U.S. capacity utilization and broad money supply - is pointing to higher inflation in the months ahead (Chart I-5). U.S. bond yields will likely move higher as forthcoming inflation prints validate our expectations for higher U.S. inflation. Fiscal stimulus amid robust growth and a tight labor market in the U.S. as well as record-high optimism among consumers and businesses have created fertile ground for rising inflation. The weak dollar of the past 12 months will also manifest in rising inflationary pressures. The U.S. bond term premium is still extremely low. Yet, budding uncertainty over inflation and the gradual end of QE programs in DM, will likely cause the U.S. bond term premium to rise from current depressed levels. Finally, simple DM bond markets technicals are still pointing to higher yields ahead (Chart I-6). Chart I-5U.S. Core Inflation Set To Rise U.S. Core Inflation Set To Rise U.S. Core Inflation Set To Rise Chart I-6U.S. Bond Yields: The Path ##br##Of Least Resistance Is Up U.S. Bond Yields: The Path Of Least Resistance Is Up U.S. Bond Yields: The Path Of Least Resistance Is Up Overall, the path of least resistance for DM bond yields is up. This will make EM local currency bond yields less attractive versus DM and especially versus U.S. Treasurys. Yield differentials between EM and the U.S. are already at a 10-year low (Chart I-7). Low risk premiums on EM local bonds and rising global financial market volatility suggest that flows to EM fixed income markets will slow over the course of this year. That said, near-term risks still remain due to the massive inflows that previously went into EM funds, and might not have been deployed yet. China's Tightening And Pending Slowdown It is not unusual for an equity market riot to begin with inflation and high-interest-rate fears and then culminate with a growth scare - with a rebound in between. 2018 may shape up to fit this pattern. Global equity markets seem to be immersed with inflation and policy tightening in the U.S. - and potentially in China. At some point, share prices could well stage a rebound but then relapse again as materially slower Chinese growth spills over to global trade.1 We have discussed our view on China and its spillover effect on EM in past reports, and will not reiterate our views and analysis here. We will only bring to clients' attention that manufacturing production volume in Asia has already been weakening for a couple of months (Chart I-8). Chart I-7EM Local Currency Bonds Over ##br##U.S. Treasurys: Yield Differential U.S. Bond Yields: The Path Of Least Resistance Is Up EM Local Currency Bonds Over U.S. Treasurys: Yield Differential U.S. Bond Yields: The Path Of Least Resistance Is Up EM Local Currency Bonds Over U.S. Treasurys: Yield Differential Chart I-8Asia's Manufacturing ##br##Production Growth Is Slowing Asia's Manufacturing Production Growth Is Slowing Asia's Manufacturing Production Growth Is Slowing Leadership changes in the equity markets occur amid selloffs. Hence, it is reasonable to expect a leadership shift within global equity market sectors and countries as well as currency markets. One major equity leadership shift could be that EM begins underperforming DM. A combination of rising U.S. inflation and bond yields and a slowdown in China are negative for EM financial markets, especially relative to DM ones. Reading Markets' Tea Leaves It remains to be seen how much further this selloff in global equities will last and whether this is the beginning of a major downtrend in EM risk assets. It is impossible to have perfect foresight. To help investors in their portfolio decisions, we combine our fundamental analysis with tools that assist us in forecasting business cycles as well as various chart patterns that may be indicative of the market's potential trajectory. The following charts illustrate that the EM and commodities equity rally may be facing formidable technical resistance. These equity markets have to break out decisively through these technical resistance lines to confirm the sustainability of the bull market. Global energy stocks have corrected after reaching their long-term moving average (Chart I-9, top panel). The latter served as a floor in the 2008 crash. It was a key technical level in the 2014-'15 bear market that did not hold up and was followed by a collapse in crude prices. Similarly, global steel stocks are exhibiting the same pattern (Chart I-9, bottom panel). Relative performance of emerging Asian share prices versus the global equity benchmark is also at a similar critical juncture (Chart I-10, top panel). Chart I-9Global Energy And Steel Stocks: ##br##A Technical Resistance Global Energy and Steel Stocks: A Technical Resistance Global Energy and Steel Stocks: A Technical Resistance Chart I-10Select EM Equity Markets ##br##Are Facing A Critical Test Select EM Equity Markets Are Facing A Critical Test Select EM Equity Markets Are Facing A Critical Test Finally, Brazilian share prices in U.S. dollar terms have also reached a crucial technical threshold (Chart I-10, bottom panel). Bottom Line: Share prices of a few equity sectors and markets that are imperative to the EM equity outlook are at important technical junctures. Failure to break above these technical resistance lines will corroborate our negative stance on EM/China growth and related financial markets. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 We elaborated the relationship between China/EM and DM growth in November 29, 2017 Emerging Markets Strategy Weekly Report, the link is available on page 12. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Japan's reflationary economic policies will be reinforced ahead of the constitutional referendum; The Bank of Japan is a long way from a 2% inflation overshoot; Fiscal thrust will continue to surprise to the upside; Wage law revisions are significant and, on net, inflationary; Go long JPY/EUR as a tactical play on the countertrend yen rally. Feature Despite a 8.5% selloff in Japanese equities over the past week amid the global equity pullback, Japan's underlying economic growth is strong. The unemployment rate has collapsed to 2.8%, the economy is humming along at an impressive 2.1% clip, and inflationary pressures are building at last. A variety of indicators - from sentiment surveys to household incomes to manufacturing output - attest to the fact that "Abenomics" is keeping the fire well lit (Chart 1). Before the pullback began, investors were wondering whether the BoJ's reduction of long-term government bond purchases signaled that a less dovish turn in monetary policy was underway (Chart 2). BoJ Governor Haruhiko Kuroda tried to quiet these rumors by reiterating the need to keep current, easy monetary policy in place. The latest financial shakeup reinforces this message. Chart 1Japan's Macro Fundamentals Are Strong Japan's Macro Fundamentals Are Strong Japan's Macro Fundamentals Are Strong Chart 2The BoJ Has Cut Back Asset Purchases The BoJ Has Cut Back Asset Purchases The BoJ Has Cut Back Asset Purchases Over the long run, the BoJ's moves, and "Abenomics" in general, should be assessed from the perspective of Japan's broader geopolitical revival.1 Prime Minister Shinzo Abe needs reflation to continue for a range of reasons. Policymakers are not constrained by inflation; rather, inflation is constrained by the yen, global growth, and the increasing danger of a Chinese policy mistake. The BoJ Will Not Betray Abenomics Japan's strong consumer and business confidence, white-hot economic growth, and multi-year equity rally have stemmed from three factors: positive fiscal thrust, an EM rebound, and a weak yen.2 As a result, real interest rates have fallen (Chart 3), prompting the BoJ to downgrade its quantitative and qualitative easing policy (QQE). But cutting back bond-buying does not mean that the BoJ is removing accommodative policy. The central bank stopped targeting the quantity of asset purchases when it introduced its "yield curve control" policy in September 2016. Yield curve control ensures that long-term JGB yields stay around 0%, with a de facto cap of 10 basis points that can be adjusted as needed. Therefore the gross amount of asset purchases is arbitrary; it only needs to be sufficient to achieve the yield target. In fact, the BoJ's official annual target of asset purchases, 80 trillion yen, was until recently well above the annual net issuance of JGBs at 35 trillion yen (Chart 4). Fiscal policy, while surprising upward as expected, has not produced the volumes of new bond issuance that would be necessary to justify such a lofty target. Hence the BoJ can reduce bond-buying without turning more hawkish. As for inflation, the core price level has only barely begun to perk up (Chart 5) - and that has occurred after five years of reflationary efforts, which, in turn, followed a sea change in Japanese politics. Prime Minister Abe came to power by declaring war on deflation, putting Governor Kuroda in charge of the BoJ, and seeking a broad-based revival of Japan from the "lost decades" of the 1990s and 2000s. Neither Abe nor Kuroda can afford to remove accommodation too soon and snatch defeat from the jaws of victory. Chart 3Real Interest##br## Rates Have Fallen Real Interest Rates Have Fallen Real Interest Rates Have Fallen Chart 4Bond Purchases Had ##br##Exceeded New Issuances Bond Purchases Had Exceeded New Issuances Bond Purchases Had Exceeded New Issuances Chart 5Weak Yen, Easier Financial ##br##Conditions Pushed Up Inflation Weak Yen, Easier Financial Conditions Pushed Up Inflation Weak Yen, Easier Financial Conditions Pushed Up Inflation Kuroda has repeatedly stressed that he will allow inflation to "overshoot" the 2% target before normalizing policy.3 While it is possible that he will step down when his first term ends on April 8, it is neither required nor probable. We highly doubt that he will. Further, the likeliest candidates to replace him are those that would maintain policy continuity.4 Hence the wind-down of QQE does not portend any additional moves away from easy policy. Any such moves would drive the yen upward, and neither Kuroda nor his acolytes at the BoJ can allow yen strength to undermine their quest to whip deflation. Bottom Line: The BoJ's yield curve control framework will remain intact even if the quantity of asset purchases remains much smaller. No leadership change at the BoJ will alter this new monetary policy framework. With the Fed and other central banks in the midst of rate-hike cycles, and the ECB winding down its QE, the persistent dovishness of the BoJ will act as a depressant on the yen as it experiences upward pressure from abroad. Policy Is Inflationary... Significant inflationary pressures are building in Japan, and reflationary policy will be resolute in the face of any headwinds. First, Abe's political career depends on maintaining the economic revival. His most treasured policy objective - reforming the Japanese constitution to revise the pacifist Article Nine and clear the legal path for the normalization of the country's military - ultimately requires a majority vote in a popular referendum.5 This is no easy task. Abe will almost certainly win the leadership poll within the Liberal Democratic Party in September this year, but he may not wait till then to try to push a constitutional amendment through the Diet. The tentative plan is to present a bill in March and proceed to the national referendum in late 2018. Certainly it is imperative for him to secure two-thirds majority votes in each chamber before the House of Councillors elections in July 2019, since that event puts his near-supermajority in the upper house at risk (Chart 6). The constitutional referendum could coincide with that vote or precede it, but Abe wants the process finished before the 2020 Tokyo summer Olympics. It will be a stretch but it is feasible. Chart 6Abe Has A Virtual Supermajority In Both Houses, Necessary For Constitutional Change Japan: Kuroda Or No Kuroda, Reflation Ahead Japan: Kuroda Or No Kuroda, Reflation Ahead Chart 7A Popular Referendum Will Be Very Close Japan: Kuroda Or No Kuroda, Reflation Ahead Japan: Kuroda Or No Kuroda, Reflation Ahead Opinion polls have consistently showed the public almost evenly split on the topic of revising Article Nine, with the hawkish advocates of revision usually trailing dovish opponents (Chart 7). While Abe's approval rating ranges in the high forties, his constitutional tinkering has similar, sub-50% levels of support. Pacifism runs deep in Japan. The LDP and New Komeito ruling coalition has not won more than 47% of the popular vote in the 2012, 2014, and 2017 general elections (Chart 8). And it has never scored above 50% in popular opinion polls over the course of Abe's term (Chart 9). Chart 8Abe's Coalition Has Not Won 50% Of The Vote... Japan: Kuroda Or No Kuroda, Reflation Ahead Japan: Kuroda Or No Kuroda, Reflation Ahead Chart 9...Nor Polled Above 50% In Popular Opinion ...Nor Polled Above 50% In Popular Opinion ...Nor Polled Above 50% In Popular Opinion Abe will not have forgotten Italy's former Prime Minister Matteo Renzi, who gambled his political career on controversial constitutional reforms in 2016 only to fall from power when he lost the popular referendum. More to the point, Abe knows that large-scale protests - bigger than those he faced in 2015 - could attend his final push to secure the constitutional revision. After all, Abe's grandfather, Nobusuke Kishi, faced mass protests in 1960 and was forced to resign upon concluding a new Treaty of Mutual Cooperation and Security with the United States. This was a consequential update to the "U.S.-Japan Security Treaty" that enabled Japan to build up de facto military forces despite its pacifist constitution. Kishi fell from power even though he had presided over a rapid expansion of real GDP and real wages and a steep drop in unemployment (Chart 10). True, Japan was a very different place in 1960. At that time, the Cold War was raging, and a large and restless youth population energized the protests. Today's youth are complacent and outnumbered by comparison. Nevertheless, Kishi did not need to put his treaty to a popular vote, unlike Abe's constitutional revisions. His grandson has a higher threshold to overcome. It follows that Japan will maintain dovish monetary policy and will continue to outperform conventional estimates of fiscal thrust (Chart 11).6 Abe's decision to abandon the goal of achieving a primary balance budget surplus by 2020 is a clear indication of this policy direction.7 Chart 10Treaty Protests In 1960 Despite Strong Economy Treaty Protests In 1960 Despite Strong Economy Treaty Protests In 1960 Despite Strong Economy Chart 11Fiscal Thrust Surprises To Upside Japan: Kuroda Or No Kuroda, Reflation Ahead Japan: Kuroda Or No Kuroda, Reflation Ahead Wages will be a decisive factor in Abe's economic success.8 Wage growth has remained in the black for most of his term, marking a contrast with the past twenty years of at best sporadic and short-lived wage rises (Chart 12). This is likely to continue. In this spring's "shunto" negotiations between businesses and unions, both the Abe administration and Keidanren, the top business group, are asking for 3% wage increases. The biggest union, Rengo, is only asking for one percentage point more.9 Abe has dedicated the current Diet session, beginning January 22, to "work-style reforms" that should be, on net, positive for wage growth.10 He wants to remove disparities between regular and irregular workers, particularly regarding wages, training opportunities, and welfare benefits. He also wants to impose limits on the workweek - putting a cap on the average 80-hour workweek of Japan's full-time workers so as to force companies to hire more irregular workers on a full-time basis (and to encourage employed people to have children). Companies that raise wages by 3% or more will see a cut in the corporate tax rate from around 30% to 25%. Economic conditions should push wages up regardless of central government policies. The jobs-to-applicants ratio is at the highest level since 1990. The labor participation rate is 60.8%, with female participation at 51.3%, up from 47.8% when Abe took power in 2012. Neither does the adoption of robotics, for which Japan is famous, counteract the tight labor market and inflationary consequences over time.11 In short, wages and core inflation should rise as long as the economic expansion is not derailed. As our colleague Peter Berezin of BCA's Global Investment Strategy has shown, the Phillips Curve will eventually kick in - and it even looks like Japan (Chart 13)!12 Chart 12Wage Growth Is The Key To Abe's Success Wage Growth Is The Key To Abe's Success Wage Growth Is The Key To Abe's Success Chart 13The Phillips Curve In Japan Looks Like Japan Japan: Kuroda Or No Kuroda, Reflation Ahead Japan: Kuroda Or No Kuroda, Reflation Ahead Bottom Line: A growing economy with real wage growth is Abe's only hope not only of beating deflation but also of getting his planned constitutional amendments over the line. Reflationary policy is essential to his legacy and vision of reviving Japan. ... But Not Too Inflationary Still, fiscal thrust is hardly going to explode unless an economic slowdown calls for it. Despite Abe's adoption of a twenty first-century "Takahashi Plan," i.e. simultaneous monetary and fiscal expansion, his administration's fiscal spending has remained relatively restrained. Strong revenue growth has actually improved the primary balance (Chart 14). Until very recently, Abe's "fiscal arrow" has disappointed his cheerleaders - he even raised the consumption tax from 5% to 8% in 2014, undermining his pro-growth fiscal packages. By law Abe is required to raise the consumption tax again, from 8% to 10%, in October 2019. In the latest election he campaigned on using the proceeds of this tax increase to expand social spending.13 Of course, he reserves the option of postponing this decision if he should deem a tax hike detrimental to the economic recovery (or to his odds of revising the constitution). But this flexibility means that any and all inflationary pressures in 2018-19 will increase under the shadow of a statutorily scheduled slug to consumer spending. There are also some constraints on wage growth. First, the reforms are intended to liberalize the labor market, which means their effects are not likely to be exclusively inflationary. "Performance" metrics that put less emphasis on seniority and working overtime, insofar as they are successful, could weigh on wage growth, at least initially. Second, Japan is starting to allow immigration - the number of foreign workers hit a record of 1.28 million total in October 2017 (Chart 15).14 This trend runs contrary to Japan's long status as the least hospitable destination for migrants in the developed world. The influx is apparently not limited to construction workers for the 2020 Olympics, as manufacturing is still the sector with the largest number of foreign workers. The Abe administration is committed to breaking the mold in the name of pro-growth structural reform and immigration is a meaningful change, albeit still in its early stages. Given existing labor market tightness and rising labor costs for companies, we expect this trend to outrun expectations, nudging up labor force growth and at least mildly counteracting wage rises, especially in low-skill sectors.15 Chart 14Primary Balance Improves On Growth Japan: Kuroda Or No Kuroda, Reflation Ahead Japan: Kuroda Or No Kuroda, Reflation Ahead Chart 15Japan Finally Allowing Immigration Japan: Kuroda Or No Kuroda, Reflation Ahead Japan: Kuroda Or No Kuroda, Reflation Ahead Bottom Line: Inflation will continue building if the global economy continues expanding and additional fiscal thrust and wage hikes are added to Japan's negative output gap, tight labor market, and rock-bottom unemployment rate. Nevertheless Japan is far from runaway inflation, and fiscal and labor market policies are nuanced. The BoJ's desired inflation overshoot is still a long way off. China And EM Pose Deflationary Risks Meanwhile deflationary forces lurk in China and emerging markets, which have been key factors in Japan's recent economic outperformance. Japan's trade exposure to China is substantial: The latter accounts for 18% of Japan's total exports, 2.7% of Japan's GDP (Chart 16). At the moment, Japanese manufacturing appears resilient in the face of China's slowdown, especially relative to the "newly industrialized" Asian neighbors. But Chinese Premier Li Keqiang's famous proxy for economic activity is closely correlated with Japanese export growth, and it is slowing. China's monetary conditions and credit and fiscal spending impulse - key leading indicators - also bode ill for Japanese exports (Chart 17). Chart 16Japan Exposed To Chinese Economy Japan Exposed To Chinese Economy Japan Exposed To Chinese Economy Chart 17China Policy Will Hit Japan Directly China Policy Will Hit Japan Directly China Policy Will Hit Japan Directly Beijing has so far tightened policy into the slowdown. It is adding new financial, environmental, and property sector regulations while expanding its anti-corruption campaign into finance, industry, and local government.16 Central government regulatory discipline - and reforms meant to reduce capital and energy intensity - will weigh on China's monetary and credit growth, capex, capital and commodity imports, and hence EM as a whole (Chart 18). And EM ex-China accounts for a further 25% of Japanese exports. In other words, Chinese reforms will bite in 2018-19 and thus encourage Japan to maintain loose fiscal and monetary policy. Recent market turbulence may add to this predicament as it is not easy for China to abandon its newly launched economic reforms - meaning China may ease policy too late if conditions worsen. We put the risk of a policy induced mistake in China at 30%. There are also significant geopolitical risks in East Asia that could cause headwinds to Japan's economy. China's strategic challenge is the key driver of Japan's attempts to revive its economy (including through higher military spending) and normalize its military operations (Chart 19). With Japan re-arming, China and Japan could easily suffer a breakdown in diplomatic relations - and China has already shown the willingness to use sanctions to punish Japan when strategic spats occur.17 Frictions over the Koreas or Taiwan could also encourage safe-haven flows into the yen. In short, Abe and Kuroda must be prepared for any eventuality, which is another reason to expect policy to stay looser for longer. Chart 18China Policy Will Hit Japan Via EM China Policy Will Hit Japan Via EM China Policy Will Hit Japan Via EM Chart 19Strategic Tensions Still A Serious Risk Strategic Tensions Still A Serious Risk Strategic Tensions Still A Serious Risk Bottom Line: Japan's exposure to both China and EM ex-China makes it vulnerable to growth wobbles as China intensifies reforms. Meanwhile Japan's constitutional revisions and remilitarization could spark a spat with China. These are compelling reasons for policymakers to stay the course with loose monetary and fiscal policies. Investment Recommendations In the short run, we would suggest clients go long JPY/EUR. The euro is expensive relative to fair value and purchasing-power-parity models (Chart 20). And investor positioning is skewed heavily in favor of the euro versus the yen (Chart 21).18 Chart 20EUR/JPY Is Expensive EUR/JPY Is Expensive EUR/JPY Is Expensive Chart 21Skewed Positioning In EUR/JPY Skewed Positioning In EUR/JPY Skewed Positioning In EUR/JPY We are closing our long USD/JPY for a loss of 3.23%. In the long run, as long as global growth holds up, any yen rally is likely to be a countertrend one, as a stronger yen will exert deflationary pressures and reinforce persistent, easy policy. Japanese policymakers have little need to fear inflation; they will focus on nurturing the country's economic and strategic rebound. Therefore, investors need not worry about the BoJ pulling the rug out from under the equity and bond markets. While BCA's House View favors Japanese equities over the U.S., BCA Geopolitical Strategy's China view prevents us from sharing this conviction in 2018. We would favor U.S. equities, which are low-beta and poised for continued strong earnings growth due to tax cuts and growth. The big risk for Japanese equities comes if China's central government makes a policy mistake and "overcorrects," triggering a precipitous drop in Chinese imports. We put a 30% subjective probability to such a scenario given the difficulty of reforming the financial sector in a highly leveraged economy. The yen would rally on safe-haven flows and Japanese markets would sell off. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Japan's Political Paradigm Shift: Investment Implications," dated December 21, 2012, available at gps.bcaresearch.com. 2 Please see BCA Foreign Exchange Strategy Weekly Report, "Yen: QQE Is Dead! Long Live YCC!" dated January 12, 2018, available at fes.bcaresearch.com. 3 See for example Haruhiko Kuroda, "Quantitative and Qualitative Monetary Easing and Economic Theory," speech at the University of Zurich, Bank of Japan, November 13, 2017, available at www.boj.or.jp. 4 Technically, Kuroda's term ends on April 8, 2018 but he can be reappointed by the prime minister for another five-year term. Please see "Experts say Haruhiko Kuroda likely to remain at BOJ helm despite failures," Japan Times, October 7, 2017, available at www.japantimes.co.jp. Both of Kuroda's deputies, Hiroshi Nakaso and Kikuo Iwata, as well as other possible successors (Masayoshi Amamiya, Etsuro Honda, and Takatoshi Ito) are dovish candidates likely to maintain continuity with his policies if at the BoJ helm. Nobuchika Mori is the only potential exception but it is still not clear that he would deviate from Abe's and Kuroda's framework if given the top job. 5 Please see BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016; and Special Report, "Japan: The Emperor's Act Of Grace," dated June 8, 2016, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. 7 Abe abandoned the 2020 budget target while campaigning in the general election of October 2017 and has stuck with his higher spending proposals. 8 Please see BCA Geopolitical Strategy Monthly Report, "King Dollar: The Agent Of Righteous Retribution," dated October 12, 2016, available at gps.bcaresearch.com. 9 Please see "Japan business lobby seconds call for 3% pay hikes," Nikkei Asian Review, January 17, 2018, available at asia.nikkei.com. 10 Abe is attempting to amend the Labor Standards Law. Please see Heizo Takenaka, "A prologue to work-style reforms," Japan Times, January 30, 2018, available at www.japantimes.co.jp. 11 Despite labor shortages, Japanese firms are using robots less often. Also, companies with high technology and robot usage are actually companies that tend to pay higher wages, contrary to popular belief. Please see BCA's The Bank Credit Analyst Special Report, "The Impact Of Robots On Inflation," dated January 25, 2018, available at bca.bcaresearch.com. 12 Please see BCA Global Investment Strategy, "Three Tantalizing Trades - Four Months On," dated January 19, 2018, available at gis.bcaresearch.com. 13 Abe reiterated his plans for more social spending, for instance on expanded child care support and free preschool education, in his policy speech ahead of the opening Diet session this year. Please see "Abe delivers policy speech," NHK, January 22, 2018, available at www3.nhk.or.jp. 14 Please see "Number of Foreign Workers in Japan at Record High," NHK, January 26, 2018, available at www3.nhk.or.jp. 15 Please see "Japan quietly accepting foreign workers -- just don't call it immigration," Japan Times, November 3, 2016, available at www.japantimes.co.jp 16 Please see BCA Geopolitical Strategy Special Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, "Does It Pay To Pivot To China?" dated July 5, 2017, available at gps.bcaresearch.com. 18 For full discussion, see footnote 2 above. Geopolitical Calendar

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