Asia

Highlights The GOP can bolster its case for re-election in 2018 by passing tax cuts and rolling back regulation. With U.S. equity valuations stretched, prolonged uncertainty in Northeast Asia may be a catalyst for a pullback. The global economic outlook is brightening and will be a tailwind for U.S. economic growth and equities. Rising wage pressure will be another headwind for EPS growth in 2018, although wages appear quite benign at the moment. Wages are not always a good leading indicator for the inflation cycle. Indeed, sometimes upturns in wage growth lags that of consumer prices. Feature Safe haven assets caught a bid last week while risk assets sold off as investors weighed geopolitical tensions in Northeast Asia and more uncertainty over fiscal policy in Washington. Last week's U.S. economic data highlighted the disconnect between a tighter labor market and a lack of wage pressures. Meanwhile, the data suggest that growth outside the U.S. is accelerating. Nonetheless, history shows that investors should be patient while waiting for an upturn in inflation. Next Up: Tax Cuts The GOP will deliver on tax cuts this year despite disarray at the White House and an incompetent Congress, but fiscal stimulus may fail to live up to its hype. Furthermore, a fiscal lift from infrastructure spending is unlikely anytime soon. Republicans need a win ahead of the 2018 mid-term elections and they have already laid the groundwork for tax reform via the budget reconciliation process. Moreover, cutting taxes is easier to justify politically than removing an entitlement program (i.e. Obamacare). Tax rates probably will not be lowered by as much as originally promised because conservative Republicans in the House will demand "revenue offsets" to pay for tax cuts. Internal GOP battles over how to fund tax cuts could spill over into some tension regarding raising the debt ceiling. However, it is in neither political party's interests to create another "fiscal cliff" out of thin air. The GOP needs Democratic votes to pass this legislation in the Senate and the Democratic leadership has indicated it is willing to support it. At what price? House Minority leader Nancy Pelosi and Senate Minority leader Chuck Schumer may link the debt ceiling and spending bill to tax reform, and push for the tax cuts to extend to the middle class and to be revenue neutral. There is a chance that both parties will agree to temporarily eliminate the debt ceiling, perhaps beyond the 2018 mid-term elections. In any event, we expect a last minute resolution to both the U.S. debt ceiling and the potential government shutdown in September. Thus, there should be no lasting impact on financial markets from the debt ceiling debate. Turning to government regulation, the NFIB survey shows that small businesses are pleased with the Trump administration's attack on red tape. President Trump has made progress on slowing regulation and is on track to enact one-tenth the amount of economically significant regulation1 passed by the Obama administration (Chart 1). By this metric, Trump is even more frugal than Reagan. Trump and the GOP-held Congress have rolled back Obama-era rules and delayed others. Still, regulatory change is slow to impact the economy and it may take years for the regulatory rollback to provide any meaningful lift to growth. Accordingly, the "Trump Put"2 is still in place. U.S. politics will remain a mess for much of the year, delaying any progress on populist economic policies that would have buoyed U.S. nominal GDP growth and given the Fed a reason to hike interest rates more aggressively (Chart 2). Chart 1Trump Has Had Success In Slowing Regulation Still Waiting For Inflation Still Waiting For Inflation Chart 2The Trump Put The Trump Put The Trump Put Bottom Line: Trump will not be impeached until after the 2018 mid-term election, and only then if the Democrats manage to take control of the House. The GOP can bolster its case for re-election in 2018 by passing tax cuts and rolling back regulation. The intensifying Mueller investigation and White House incompetence will only fuel the "Trump Put", which has been positive for U.S. equities, neutral for Treasuries, and bad for the dollar, all else equal. A significant uptick in inflation could overwhelm the "Trump Put" and spark a dollar rally. As such, investors should focus on inflation prospects rather than on White House politics. Fire And Fury Investors are on high alert and with the Q2 earnings season over, may look beyond the positive news on corporate profits for direction. Our colleagues in the BCA Geopolitical Strategy service have long maintained that Northeast Asia is ripe for economic/political risk.3 The underlying driver of uncertainty on the Korean Peninsula is the Sino-American rivalry. China is an emerging "great power" that threatens the global dominance of the U.S. and its allies. The immediate consequence is mounting friction in China's periphery. That is why Taiwan, the South China Sea, and North Korea, are all heating up. North Korea's regime is highly unpredictable as evidenced by events in the past few weeks. In that sense, it is more significant than the other "proxy battles" between the U.S. and China. In essence, North Korea is no longer merely an object of satire. A new round of negotiations over North Korea's nuclear and missile programs is about to begin. The potential for a military conflict is high unless diplomacy succeeds in convincing North Korea to freeze its weapons programs. The events on the Korean peninsula are unfolding as we expected they would. North Korea has a history of rational action. It wants a nuclear deterrent and a peace treaty, but not a regime change. The U.S. has forsworn regime change as an intention and China has recommitted to new sanctions. South Korea is pro-engagement. Moreover, we are seeing the U.S. establish a credible military as part of the "arc of diplomacy," comparable to U.S.-Iran relations 2010-15. Bottom Line: We do not expect a pre-emptive strike by the U.S. on North Korea, as the constraints to conflict are extremely high and not all diplomatic options have been exhausted. Nonetheless, with U.S. equity valuations stretched, prolonged uncertainty in the region may be a catalyst for a pullback. A Rosy Global Picture The global economic outlook is brightening and will be a tailwind for U.S. economic growth and equities. Global real GDP estimates continue to move higher, a welcome departure from years past when estimates slid relentlessly lower (Chart 3). Since the start of 2017, global GDP estimates for this year have increased from 2.8% to 3%, while 2018 forecasts have accelerated from 2.7% to 2.9%. This upward trajectory has occurred despite a recalibration by many major central banks away from accommodative policies. Aggressive central bank actions or escalating tensions in Northeast Asia, or both, may halt the improving growth forecasts. Falling oil prices would also challenge a quickening of global growth, but our view is that oil prices will move higher in the coming months.4 Chart 3Global Growth Estimates Accelerating Despite Stalled U.S. Growth Global Growth Estimates Accelerating Despite Stalled U.S. Growth Global Growth Estimates Accelerating Despite Stalled U.S. Growth Global leading indicators are on the upswing (Chart 4). The BCA Global Leading Indicator Index (excluding the U.S.) in July 2017 was the strongest since 2010 when it slowed after a sharp rebound from the global financial crisis. The increase in growth still has room to run. Admittedly, the LEI's diffusion index has dipped below 50%. It would be a warning sign for global growth if the diffusion index does not soon turn up. Nominal global GDP growth is speeding up, boosted by improving consumer and business confidence, rising capital spending and declining policy uncertainty (Chart 5). The global economic surprise index is also climbing, which provides additional support. Investors may be concerned that the global PMIs have peaked (Chart 6), but they remain at levels consistent with above-trend GDP growth and we see no reason why they should drop below 50. Chart 4LEIs Pointing Higher LEIs Pointing Higher LEIs Pointing Higher Chart 5Supports For Global Growth In Place Supports For Global Growth In Place Supports For Global Growth In Place Chart 6Global Economic Activity Brightening bca.usis_wr_2017_08_14_c6 bca.usis_wr_2017_08_14_c6 Industrial production (IP) overseas is expanding nearly twice as fast as in the U.S. (Chart 5). This suggests that U.S. economic activity will be pulled up by foreign demand. A stronger dollar (as much as a 10% appreciation in the next year) may dampen U.S. exports and earnings, but this will be more a problem for 2018 than 2017. Bottom Line: Improving economic activity outside the U.S. is a tailwind for both U.S. economic growth and profits of U.S. firms with significant business abroad. Solid foreign demand will help the economy hit the Fed's GDP target and also support additional, but gradual, tightening by the central bank. Stay overweight U.S. equities and remain short duration. Waiting For Wages Rising wage pressure will be another headwind for EPS growth in 2018, although wages appear quite benign at the moment. Both primary and secondary indicators point to a tighter U.S. labor market. The July jobs report (released in early August) was yet another sign that the slack in the jobs market is vanishing.5 Data released last week on job openings (JOLTS) and the National Federation of Independent Business (NFIB) further supported this trend, and indicated that the labor market may tighten even more. Job openings rose to a new all-time high along with BCA's quit rate less layoffs indicator (Chart 7). The hire rate remained at a cycle peak. The NFIB data was equally impressive, with hiring plans and job openings surging in July. Small businesses are also finding it increasingly difficult to find quality labor. (Chart 7, panel 4) The strength in the labor market has not yet translated into accelerating wages, but patience is required. The July NFIB survey noted that "while a tight job market may point to higher wages and rising consumer spending down the road, which is also good for small businesses, the current expansion efforts by small business owners are being choked by their difficulties in hiring and keeping workers." The NFIB's compensation plans (Chart 7) provided quantitative support for the group's qualitative assessment. However, the latest readings on labor compensation from the Q2 productivity report, the tepid July average hourly earnings data and the Atlanta Fed wage tracker suggest that the labor market is still not tight enough to generate much wage pressure (Chart 8). Chart 7Widespread Evidence That##BR##Labor Market Is Tightening Widespread Evidence That Labor Market Is Tightening Widespread Evidence That Labor Market Is Tightening Chart 8Not Much Wage##BR##Pressure Yet Not Much Wage Pressure Yet Not Much Wage Pressure Yet Inflation And Long-Expansion Dynamics That said, wages are not always a good leading indicator for the inflation cycle. Indeed, sometimes upturns in wage growth lag that of consumer prices. In previous research we split U.S. post-1950 economic cycles into three sets based on the length of the expansion phase: short (about 2 years), medium (4-6 years) and long (8-10 years). What distinguishes short from medium and long expansions is the speed at which the most cyclical parts of the economy accelerated, and the time it took unemployment to reach a full employment level. Long expansions were characterized by a drawn-out rise in the cyclical parts of the economy and a very slow return to full employment, similar to what has occurred since the Great Recession. Chart 9 compares the current cycle to the average of two of the long cycles (the 1980s and the 1990s). We excluded the long-running 1960s expansion because the Fed delayed far too long and fell well behind the inflation curve. We define the 'late cycle' phase to be the time period from when the economy first reached full employment to the subsequent recession (shaded portions in Chart 9). The average late-cycle phase for these two expansions lasted almost four years, highlighting that reaching full employment does not necessarily mean that a recession is imminent. Inflation pressures are slower to emerge in 'slow burn' recoveries, allowing the Fed to proceed slowly. The Fed waited an average of 25 months to tighten policy after reaching full employment in these two long expansions, in part because core CPI inflation was roughly flat. The result was an extended late-cycle phase that was very rewarding for equity investors because the economy and earnings continued to grow. Of course, inflation eventually did turn higher, signaling the beginning of the end for the expansion and equity bull phase. In Chart 10, we compare the core PCE inflation rate in the current cycle with the average of the previous two long expansion episodes (the inflection point for inflation in the previous cycles are aligned with June 2017 for comparison purposes). The other panels in the chart highlight that, in the 1980s and 1990s, wage growth gave no warning that an inflation upturn was imminent. Indeed, wages were a lagging indicator of consumer price inflation. Chart 9Labor Market, Inflation And Stocks##BR##In The Long 80's & 90's Expansions Labor Market, Inflation And Stocks In The Long 80's & 90's Expansions Labor Market, Inflation And Stocks In The Long 80's & 90's Expansions Chart 10In The 80's & 90's Wage Growth##BR##Gave No Early Warning On On Inflation In The 80s & 90s Wage Growth Gave No Early Warning On On Inflation In The 80s & 90s Wage Growth Gave No Early Warning On On Inflation Market commentators often assume that inflation is driven exclusively by "cost push" effects, such that the direction of causation runs from wage pressure to price pressure. However, causation runs in the other direction as well. Households see rising prices and then demand better wages to compensate for the added cost of living. Chart 11Leading Indicators Of Inflation##BR##In "Slow Burn" Recoveries Leading Indicators Of Inflation In "Slow Burn" Recoveries Leading Indicators Of Inflation In "Slow Burn" Recoveries This is not to say that we should totally disregard wage information. But it does suggest that we must keep an eye on a wider set of data. Indicators that provided some leading information for inflation in the previous two long cycles are shown in Chart 11. To this list we would also add the St. Louis Fed's Price Pressure index, which is not shown in Chart 11 because it does not have enough history. All of these indicators have moved higher over the past 18 months, after bottoming at extremely low levels in 2015 and early 2016. However, they have all pulled back to some extent in recent months. This year's pipeline inflation "soft patch" continued into July, according to last week's release of the Producer Price Index. The easing in cost pressures at the producer level has been broadly based (i.e. one cannot blame special factors). These indicators suggest that consumer price inflation, according to either the CPI or the PCE, will struggle to rise in the next few months. The July CPI report revealed another tepid 0.1% monthly rise in the core price index, while the year-over-year rate remained at 1.7%. Rising prices for health care goods and services were offset by price declines for new and used cars. The diffusion index for the CPI moved up to the zero line in July, indicating that disinflation was a little less broadly based in the month. Bottom Line: Our base case is that core PCE inflation edges higher in the coming months, which will be enough for the FOMC to justify a rate hike in December. We also expect that inflation will be high enough in 2018 for the Fed to hike rates by more than is discounted in the bond market. Nonetheless, the warning signs of an inflation upturn are mixed at best. It would flatter our stocks-over-bonds recommendation if we are wrong on the inflation outlook, but our short duration stance would not be profitable in this case. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Office of Information and Regulatory Affairs (OIRA) of Office of Management and Budget (OMB): https://www.reginfo.gov/public/do/eAgendaMain and https://www.reginfo.gov/public/do/eoCountsSearchInit?action=init 2 Please see Geopolitical Strategy Weekly Report, "How Long Can The Trump Put Last" dated June 14, 2017, available at gps.bcaresearch.com. 3 Please see Geopolitical Strategy Weekly Report, "North Korea: Beyond Satire, dated April 18, 2017, available at gps.bcaresearch.com. 4 Please see Commodity & Energy Strategy Weekly Report, "KSA's Tactics Advance OPEC' 2.0's Agenda," dated August 10, 2017, available at ces.bcaresearch.com. 5 Please see U.S. Investment Strategy Weekly Report, "Stay The Course" dated August 7, 2017, available at usis.bcaresearch.com.

Highlights The rise in the yen sparked by the verbal confrontation between the U.S. and North Korea is creating an opportunity to buy USD/JPY. The DXY is set to stabilize and may even rebound, removing a key support for the yen. The U.S. economy is showing signs of strength, and the bond market is expensive, a backup in yields is likely. Rising U.S. bond yields should be poisonous for the yen Until higher bond yields cause an acute selloff in risks assets, an opportunity to buy USD/JPY is in place for investors. Feature After benefiting from the U.S. dollar's generalized weakness, the yen has received a renewed fillip thanks to the rising tensions between North Korea and the U.S. If the U.S. were indeed to unleash "fire and fury" on North Korea, safe-haven currencies like the yen or Swiss franc would obviously shine. While the verbal saber-rattling will inevitably continue, our colleagues Marko Papic and Matt Gertken - head and Asia specialist respectively of our Geopolitical Strategy service - expect neither the U.S. nor North Korea to go to war. Historically, North Korea has behaved rationally, and it only wants to use the nuclear deterrent as a bargaining chip. Meanwhile, the U.S does not want to invest the time, energy, and money required to enact a regime change in that country. Additionally, China is already imposing sanctions on Pyongyang, and Moon Jae-in, South Korea's new president, wants to appease its northern neighbor. With cooler heads ultimately likely to prevail, will the yen rally peter off, or should investors position themselves for additional USD/JPY weakness? We are inclined to buy USD/JPY at current levels. DXY: Little Downside, Potential Upside Most of the weakness in USD/JPY since July 10 has been a reflection of the 3.7% decline in the DXY between that time and August 2nd. However, the dollar downside is now quite limited and could even reverse, at least temporarily. The dollar is currently trading at its deepest discount since 2010 to our augmented interest rate parity model, based on real interest rate differentials - both at the long and short-end of the curve - as well as global credit spreads and commodity prices (Chart I-1). Crucially, the euro, which accounts for 58% of the dollar index, is its mirror image, being now overvalued by two sigma, the most since 2010 (Chart I-2). Confirming these valuations, investors have now fully purged their long bets on the USD, and are most net-long the euro since 2013. Chart I-1DXY Is Cheap... DXY Is Cheap... DXY Is Cheap... Chart I-2...But The Euro Is Not ...But The Euro Is Not ...But The Euro Is Not Valuations are only an indication of relative upside and downside; the macro economy dictates the directionality. While U.S. financial conditions have eased this year, they have tightened in Europe, resulting in the biggest brake on euro area growth relative to the U.S. in more than two years (Chart I-3). This is why euro area stocks have eradicated their 2017 outperformance against the S&P 500, why PMIs across Europe have begun disappointing, and why the euro area economic surprise index has rolled over - especially when compared to that of the U.S. The improvement in U.S. economic activity generated by easing financial conditions also has implications for the dollar. As Chart I-4 illustrates, the gap between the U.S. ISM manufacturing index and global PMIs has historically led the DXY by six months or so. This gap currently points to a sharp appreciation in the dollar. Chart I-3Easing Versus Tightening FCI Easing Versus Tightening FCI Easing Versus Tightening FCI Chart I-4PMIs Point To USD Rally PMIs Point To USD Rally PMIs Point To USD Rally If the dollar were indeed to stop falling, let alone appreciate, this would represent a hurdle for the yen to overcome, especially as the outlook for U.S. bond yields is pointing up. Bottom Line: Before North Korea grabbed the headlines, the USD/JPY selloff was powered by a weakening dollar. However, the dollar has limited downside from here. It is trading at a discount to intermediate-term models, while macroeconomic momentum is moving away from the euro area and toward the U.S. - a key consequence of the tightening in European financial conditions vis-à-vis the U.S. Additionally, the strong outperformance of the U.S. ISM relative to the rest of the world highlights that the dollar may even be on the cusp of experiencing significant upside. The Key To A Falling Yen: Treasury Yields Upside An end to the fall in the USD is important to end the downside in USD/JPY. However, rising Treasury yields are the necessary ingredient to actually see a rally in this pair. We are optimistic that U.S. bond yields can rise from current levels. The U.S. job market remains very strong. The JOLTS data this week was unequivocal on that subject. Not only are there now 6.2 million job openings in the U.S., but the ratio of unemployed to openings has hit its lowest level since the BLS began publishing the data, suggesting there is now a limited supply of labor relative to demand. Additionally, the number of unfilled jobs is nearly 30% greater than it was at its 2007 peak, pointing to an increasingly tighter labor market. We could therefore see an acceleration in wage growth going into the remainder of this business cycle, even if structural factors like the "gig-economy", the increasing role of robotics, or even the now-maligned "Amazon" effect limit how high wage growth ultimately rises. The Philips curve, when estimated using the employment cost index and the level of non-employment among prime-age workers, still holds (Chart I-5). Thus, a tight labor market in conjunction with continued job-creation north of 100,000 a month should put upward pressure on wages. Even when it comes to average hourly earnings, glimmers of hope are emerging. Our diffusion index of hourly wages based on the industries covered by the BLS cratered when wage growth slowed over the past year. However, it has hit historical lows and is beginning to rebound - a sign that average hourly earnings should also reaccelerate (Chart I-6). Chart I-5The Philips Curve Still Works Fade North Korea, And Sell The Yen Fade North Korea, And Sell The Yen Chart I-6Even AHE Are Set To Re-Accelerate Even AHE Are Set To Re-Accelerate Even AHE Are Set To Re-Accelerate The job market is not the only source of optimism, as U.S. capex should continue to be accretive to growth. Despite vanishing hopes of aggressive deregulation, the NFIB small business survey picked up this month. Even more importantly, various capex intention surveys as well as the CEO confidence index point to continued expansion of corporate investment (Chart I-7). Healthy profit growth is providing both the necessary signal and the source of funds to engage in this capex. This will continue to lift the economy. This is essential to our bond and our yen views, as it points to higher U.S. inflation. In itself, economic activity is not enough to generate higher prices. However, when this happens as aggregate capacity utilization in the economy is becoming tight, inflation emerges. As Chart I-8 shows, today, our composite capacity utilization indicator - based on both labor market conditions and the traditional capacity utilization measure published by the Federal Reserve - is in "no-slack" territory, a condition historically marked by bouts of inflation. Chart I-7U.S. Capex To Boost Growth Further U.S. Capex To Boost Growth Further U.S. Capex To Boost Growth Further Chart I-8No Slack Plus Growth Equals Inflation No Slack Plus Growth Equals Inflation No Slack Plus Growth Equals Inflation The recent increase to a three-year high in the "Reported Price Changes" component of the NFIB survey corroborates this picture, also pointing to an acceleration in core inflation (Chart I-9). But to us, the most telling sign that inflation will soon re-emerge is the behavior of the U.S. velocity of money. For the past 20 years, changes in velocity - as measured by the ratio of nominal GDP to the money of zero maturity - have lead gyrations in core inflation, reflecting increasing transaction demand for money. Today, the increase in velocity over the past nine months points to a rebound in core inflation by year-end (Chart I-10). Chart I-9The Pricing Behavior Of Small Businesses ##br##Points To An Inflation Pick Up The Pricing Behavior Of Small Businesses Points To An Inflation Pick Up The Pricing Behavior Of Small Businesses Points To An Inflation Pick Up Chart I-10Reaching Escape ##br##Velocity Reaching Escape Velocity Reaching Escape Velocity Expecting higher inflation is not the same thing as expecting higher interest rates and bond yields. However, we believe this time, higher inflation will result in higher yields. First, the Fed wants to push interest rates higher. Fed Chairwoman Janet Yellen and her acolytes have been very clear about this, with the "dot plot" anticipating rates to rise to 2.9% by the end of 2019. While the Fed's preference and reality can be at odds, this is currently not the case. Our Fed monitor continues to be in the "tighter-policy-needed" zone. While it is undeniable that it is doing so by only a small margin, higher inflation - as we expect - would only push this indicator higher. Moreover, the diffusion index of the components of the Fed monitor is already pointing toward an improvement in this policy gauge (Chart I-11). Chart I-11The Fed Monitor Will Pick Up The Fed Monitor Will Pick Up The Fed Monitor Will Pick Up Second, the Fed may have increased rates, and the spread between U.S. policy rates and the rest of the world may have widened, but the dollar has weakened this year. This counterintuitive result highlights that the Fed's effort has had little impact in tightening liquidity conditions. In fact, as we have mentioned, because of the lower dollar and higher asset prices, financial conditions have eased, suggesting liquidity remains plentiful. As such, like in 1987 or 1994, this is only likely to re-invigorate the Fed in its confidence that it can hike rates further, as liquidity conditions remain massively accommodative. Third, beyond the Fed's reaction function, what also matters are investors' expectations. At the time of writing, investors only expect 45 basis points of rate hikes over the upcoming 24 months, which is a reasonable expectation only if inflation does not move back toward the Fed's 2% target. However, our work clearly points toward higher inflation by year end. In a fight between the Fed's "dot plot" and the OIS curve, right now, we would take the side of the Fed. Fourth, it is not just 2-year interest rate expectations that seems mispriced, based on our view on U.S. growth, inflation, and the Fed. U.S. Treasury yields are also trading at a 36 basis points discount to the fair-value model developed by our U.S. Bond Strategy sister service (Chart I-12). Continued good news on the job front and an uptick in inflation would likely do great harm to Treasury holders. Finally, the oversold extreme experienced by the U.S. bond market in the wake of the Trump victory has been purged. While we are not at an oversold extreme, our Composite Technical Indicator never punched much into overbought territory during the Fed tightening cycle from 2004 to 2006 (Chart I-13). Moreover, with no more stale shorts, an upswing in U.S. economic and inflation surprises should help put upward pressure on U.S. bond yields. Confirming the intuition laid out above, the copper-to-gold ratio, a measure of growth expectations relative to reflation, has now broken out - despite the North Korean risks. In the past, such a development signaled higher yields (Chart I-14). With this in mind, let's turn to the yen itself. Chart I-12U.S. Bonds Are##br## Too Expensive U.S. Bonds Are Too Expensive U.S. Bonds Are Too Expensive Chart I-13Stale Shorts Have Been Purged, ##br##But Overbought Conditions Are Unlikely Stale Shorts Have Been Purged, But Overbought Conditions Are Unlikely Stale Shorts Have Been Purged, But Overbought Conditions Are Unlikely Chart I-14Where The Copper-To-Gold Ratio Goes, ##br## So Do Bond Yields Where The Copper-To-Gold Ratio Goes, So Do Bond Yields Where The Copper-To-Gold Ratio Goes, So Do Bond Yields Bottom Line: The U.S. economy looks healthy. The labor market is strong, and capex continues to offer upside. Because capacity utilization is tight and money velocity is accelerating, inflation should begin surprising to the upside through the remainder of 2017. With the market pricing barely two more hikes over the course of the next 24 months and U.S. bonds trading richly, such an economic backdrop should result in higher U.S. bond yields. Yen At Risk, Even If Volatility Rises JGB yields have historically displayed a low beta to global bond yields. As a result, when global bond yields rise, the yen tends to weaken. USD/JPY is particularly sensitive to yield upswings driven by actions in the Treasury market. This contention is even truer now than it has been. The Bank of Japan is targeting a fixed yield curve slope and does not want to see JGB yields rise much above 10 basis points. With the paucity of inflation experienced by Japan - core-core inflation is in a downtrend, ticking in at zero, courtesy of tightening financial conditions on the back of a stronger yen - this policy remains firmly in place. Emerging signs of weakness in Japan highlight that the BoJ is likely to remain wedded to this policy, even as Shinzo Abe's popularity hits a low for his current premiership. The recent fall in the leading indicator diffusion index suggests that industrial production - which has been a bright spot - is likely to roll over in the coming months (Chart I-15). This means the improvement in capacity utilization will end, entrenching already strong deflationary pressures in Japan. This only reinforces the easing bias of the BoJ, and truncates any downside for Japanese bond prices. Chart I-15The Coming Japanese IP Slowdown The Coming Japanese IP Slowdown The Coming Japanese IP Slowdown In short, while JGB yields might still experience some downside when global yields fall, they will continue to capture none of the potential upside. This makes the yen even more vulnerable to higher Treasury yields than it was before. Hence, based on our view on U.S. inflation and yields, USD/JPY is an attractive buy at current levels. But what if the rise in U.S. bond yields causes a correction in risk assets, especially EM ones? Again, monetary policy differences and the trend in yields will dominate. As Chart I-16 illustrates, USD/JPY has a much stronger correlation with dynamics in the bond markets than it has with EM equity prices. Chart I-16Yen: More Like Bonds Than Anything Else Yen: More Like Bonds Than Anything Else Yen: More Like Bonds Than Anything Else Chart I-17USD/JPY Falls Only When EM Selloffs Are So Acute That They Cause Bond Rallies USD/JPY Falls Only When EM Selloffs Are So Acute That They Cause Bond Rallies USD/JPY Falls Only When EM Selloffs Are So Acute That They Cause Bond Rallies Moreover, as the experience of the past three years illustrates, only once EM selloffs become particularly acute does USD/JPY weaken (Chart I-17). Essentially, the EM selloff has to be so severe that it threatens the Fed's ability to tighten policy, and therefore causes U.S. bond yields to fall. It is very possible that a rise in Treasury yields will ultimately generate this outcome, but in the meantime the rise in U.S. bond yields should create a tradeable opportunity to buy USD/JPY. Bottom Line: With Japan still in the thralls of deflation and the BoJ committed to fight it, JGB yields have minimal upside. Therefore, higher Treasury yields are likely to do what they do best: cause USD/JPY to rally. This might ultimately lead to a selloff in EM stocks, but in the meanwhile, a playable USD/JPY rally is likely to emerge. Thus, we are opening a long USD/JPY trade this week. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The U.S. labor market continues to strengthen, with the JOLTS Survey's Job Openings and Hires both ticking up. The NFIB Survey also shows signs of strength as the Business Optimism Index steadied at lofty levels, coming in at 105.2. Unit labor costs disappointed, but this supports U.S. equities. Nonfarm productivity also outperformed, pointing to improving living standards. U.S. data has turned around, with data surprises improving relative to the euro area. These dynamics are likely to prompt a resumption of the greenback's bull market. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Look Ahead, Not Back - June 9, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Euro area data has been mixed: German current account underperformed, with both exports and imports contracting on a monthly rate, and underperforming expectations. The trade balance, however, outperformed; German industrial production failed to meet expectations, even contracting on a monthly basis; Italian industrial production outperformed both on a monthly and yearly rate, but remains well below capacity European data has begun to show the pain inflicted by tightening financial conditions. Relative to the U.S., the economic surprise index has rolled over. If this trend continues, EUR/USD will struggle to appreciate more this year, and may even weaken if U.S. inflation can improve. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data has been negative in Japan: Labor cash earnings yearly growth went from 0.6% in May to a contraction of 0.4% in June, underperforming expectations. Machinery orders yearly growth fell down sharply, contracting at a 5.2% rate and underperforming expectations. The Japanese economy continues to show signs of weakness, which means that the Bank of Japan will not let 10-year JGB yields rise above 10 basis points. In an environment of rising U.S. bond yields this will cause the yen to fall. However the question remains: Could a selloff in EM prompted by a rising dollar help the yen? This should not be the case, at least for now, as the yen is much more correlated with U.S. bond yields than it is with EM stock prices. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: BRC like-for-like retail sales yearly growth came in at 0.9%, outperforming expectations. However, the RICS Hosing Price Balance - a crucial bellweather for the British economy - came in at 1%, dramatically underperforming expectations. Also, the trade balance underperformed expectations, falling to a 12 billion pounds deficit for the month of June as exports sagged. As we mentioned on our previous report, we expect the pound to suffer in the short term, as the high inflation produced by the fall in the pound following the Brexit vote is starting to weigh on consumers. Furthermore, house prices are also suffering, and could soon dip into negative territory. All of these factors will keep the BoE off its hawkish rhetoric for longer than priced by the markets. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 AUD gains are reversing as the U.S. dollar rebounds from a crucial support level. This has also occurred due to mixed Chinese and Australian data: Chinese trade balance beat expectations, however, both exports and imports underperformed; Chinese inflation underperformed expectations; Australian Westpac Consumer Confidence fell to -1.2% from 0.4% in August; This is largely in line with our view that the rally in AUD was would only create a better shorting opportunity. Underlying structural and fundamental issues will remain a headwind for the AUD for the remainder of the year. Iron ore inventories in China are also at an all-time high, which paints a dim picture for Australian mining and exports going forward. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 On Wednesday, the RBNZ left their Official Cash Rate unchanged at 1.75%. Overall, the bank signaled that it will continue its accommodative monetary policy for "a considerable period of time". Furthermore the RBNZ's outlook for inflation, specifically tradables inflation, remains weak. Finally, the bank also showed concern for the rise in the kiwi, stating that "A lower New Zealand Dollar is needed to increase tradables inflation and help deliver more balanced growth". Overall, we continue to be positive on the kiwi against the AUD. While the outlook for tradable-goods inflation might be poor, this is a variable determined by the global industrial cycle.. Being a metal producer, Australia is much more exposed to these dynamics than New Zealand, a food producer. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Data continues to look positive for Canada: Housing Starts increased by 222,300, beating expectations; Building permits also increased at a monthly pace of 2.5%, also beating expectations. CAD has experienced some downside as the stretched long positioning that emerged in the wake of the BoC's newfound hawkishness are being corrected. While we expect the CAD to outperform other commodity currencies, based on rate differentials and oil outperformance, USD/CAD should is likely to trend higher as U.S. inflation bottoms. EUR/CAD should trend lower by the end of this year as euro positioning reverts. As a mirror image, CAD/SEK may appreciate based on the same dynamics. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Last week we highlighted the possibility of a correction in EUR/CHF, given that it had reached highly overbought levels. This prediction turned out to be accurate, as EUR/CHF fell by almost 2% this week, as tensions between North Korea and the United States continue to escalate. Meanwhile on the economic front, Switzerland continues to show a tepid recovery: Headline inflation went from 0.2% in June to 0.3% in July, just in line with expectations. The unemployment rate continues to be very low at 3.2%, also coming in according to expectations. Inflation, house prices and various economic indicators are all ticking up, however, the economic recovery is still too weak to cause a major shift in monetary policy. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 The krone has fallen this week against the U.S. dollar, even as oil prices have remained relatively flat. This highlights a key theme we have mentioned before: USD/NOK is more sensitive to rate differentials than it is to oil prices. We expect these rate differentials to continue to widen, as the Norwegian economy remains weak, and inflation will likely remain below the Norges Bank target in the coming years. On the other hand, U.S. yields are set to rise, as a tight labor market will eventually lift wages higher and thus increase rate expectations. Meanwhile EUR/NOK, which is much more sensitive to oil prices than USD/NOK, will keep going down, as inventory drawdowns caused by the OPEC cuts should continue pushing up Brent prices. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Data in Sweden was mixed: New Orders Manufacturing yearly growth fell from 7.3% to 4.4%. Industrial production yearly growth increased from 7.5% in May to 8.5% in June, outperforming expectations. The Swedish economy continues to exhibit signs of strong inflationary pressures. Overall we continue to be bullish on the krona, particularly against the euro, as the exit of Stefan Ingves at the end of this year should give way for a more hawkish governor, who would respond to the strength in the economy with a more hawkish stance. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017Xx Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

Highlights Strong corporate earnings growth will drown out worries about North Korea. Stay cyclically overweight global equities. Underlying wage growth in the U.S. is stronger than the official data suggest. Surveys point to a further acceleration in U.S. wages, as do pay gains at the lower end of the income distribution. Labor's share of income will resume its cyclical recovery. This will lead to more consumer spending, and ultimately, higher price inflation. Wage growth elsewhere in the world will also pick up as labor slack declines. Global fixed-income investors should underweight duration and increase exposure to inflation-linked securities. Feature Focus On Corporate Earnings, Not Korea Chart 1EPS Estimates Have Remained ##br##Resilient This Year EPS Estimates Have Remained Resilient This Year EPS Estimates Have Remained Resilient This Year Global equities dropped over the past few days on the back of rising risks of conflict in the Korean peninsula. Our geopolitical strategists believe that neither the U.S. nor North Korea will launch a preemptive strike.1 Despite its bluster, North Korea has a history of rational action. It wants a nuclear deterrent and a peace treaty. The U.S. has forsworn regime change as a policy goal. China has recommitted to new sanctions and the South is pro-engagement. This raises the likelihood that a diplomatic solution will be found. Unfortunately, getting from here (open hostilities) to there (negotiated solution) will take time, which leaves the door open to increased market volatility. Nevertheless, we expect any selloff to be short-lived, owing to the positive earnings picture. More than anything else, strong profit growth has underpinned the cyclical bull market in stocks, and we expect this to remain the case over the coming months. More than 80% of S&P 500 companies have reported Q2 results. Based on these preliminary numbers, EPS appears to have increased by 11% over the previous year, marking the fourth consecutive quarter of margin expansion. The strength has been broad based, with all eleven sectors reporting positive growth. U.S. earnings estimates for both 2017 and 2018 have remained steady since January, bucking the historic pattern of downward revisions throughout the course of the year (Chart 1). The picture is even more impressive outside the U.S., where earnings estimates continue to move higher. The Euro STOXX 600 is now expected to deliver EPS growth of 12.6% this year. EPS of stocks listed on the Japanese Topix is expected to rise 14.8% this year and 7.3% next year, giving them an attractive 2018E P/E of 13.6. We recommend overweighting euro area and Japanese stocks over their U.S. counterparts in currency-hedged terms. EM stocks have seen the strongest positive earnings revisions this year. We continue to worry about some of the structural headwinds facing emerging markets (high debt levels, poor governance, etc.). However, the cyclical picture remains more upbeat. Chinese H-shares remain our favorite EM market, trading at just 7.5 times 2017 earnings estimates. The U.S. Labor Market Gets A JOLT, But Where's The Wage Growth? The Job Openings and Labor Turnover Survey (JOLTS) released on Tuesday provided more good news about the state of the U.S. labor market (Chart 2). The number of job openings rose to 6.2 million in June. There are now 28% more unfilled jobs in the U.S. than at the prior peak in April 2007. The number of unemployed workers per job opening fell to 1.1, the lowest level in the history of the series. One might think that with numbers like these, wage growth would be skyrocketing. Yet, it is not. While monthly average hourly wages did surprise to the upside in the June payrolls report, the year-over-year change remained stuck at 2.5%. This week's productivity report showed that compensation per hour increased by only 1% in Q2 relative to the same period in 2016. Other measures of wage growth generally point to some softening this year (Chart 3). Chart 2More Good News For The U.S. Labor Market More Good News For The U.S. Labor Market More Good News For The U.S. Labor Market Chart 3U.S. Wage Growth Remains Soft U.S. Wage Growth Remains Soft U.S. Wage Growth Remains Soft Many commentators regard the lackluster pace of wage inflation - coming at a time when the unemployment rate has fallen below its 2007 lows - as a "mystery" that needs to be solved. As we argue in this report, there is less to this mystery than meets the eye. Properly measured, underlying wage growth in the U.S. has been rising for some time, and may actually be stronger than the "fundamentals" warrant. Wage inflation elsewhere in the world is more subdued. However, this is largely because progress towards restoring full employment has been slower outside the U.S. Is Wage Growth Being Mismeasured? How can U.S. wage growth be characterized as "strong" when it is still so weak by historic standards? Part of the answer has to do with that old bugbear: measurement error. Low-skilled workers have been re-entering the labor force en masse over the past few years, after having deserted it during the Great Recession. This has put downward pressure on average wages, arithmetically leading to slower wage growth. Most of the official wage series, including the Employment Cost Index, do not adjust for this statistical bias.2 In a recent research report, economists at the San Francisco Fed concluded that "correcting for worker composition changes, wages are consistent with a strong labor market that is drawing low-wage workers into full-time employment."3 In addition to cyclical factors, demographic shifts have depressed official measures of wage inflation. Historically, population aging has pushed up average wages because older workers tend to earn more than younger ones. The retirement of millions of well-paid baby boomers over the past few years has reversed this trend, at least temporarily. Chart 4 shows that the median age of employed workers has fallen for the past three years, the first time this has happened since the 1970s. Weak Productivity Growth Dragging Down Wages Unfortunately, there is more to the story than measurement error. Today's young workers are not better skilled or educated than those of previous generations. This, along with other factors that we have discussed extensively in past reports, has dragged down productivity growth.4 Nonfarm productivity has increased at an average annualized pace of less than 1% over the past few years, down from 3% in the early 2000s (Chart 5). Slower productivity growth gives firms less scope to raise wages. In fact, for all the talk about how wages are stagnant, real wages have risen by more than productivity since 2014. This has pushed labor's share of income off its post-recession lows. Chart 4Median Age Of Workers No Longer Rising Median Age Of Workers No Longer Rising Median Age Of Workers No Longer Rising Chart 5Real Wages Have Increased Faster ##br##Than Productivity Over The Past Few Years Real Wages Have Increased Faster Than Productivity Over The Past Few Years Real Wages Have Increased Faster Than Productivity Over The Past Few Years It remains to be seen whether the structural downtrend in the share of income going to labor will be reversed. One can make compelling arguments for both sides of the issue.5 But over a cyclical horizon of one-to-two years, it is highly likely that labor's share will rise. Labor's share of income is fairly procyclical. It increased significantly in the late 1990s and rose again in the years leading up to the Great Recession. Considering how low unemployment is today, it is not unreasonable to assume that it will maintain its cyclical uptrend. If so, this will lead to more consumer spending, and ultimately, higher inflation. Surveys Point To Faster Wage Growth... Surveys such as those conducted by the National Federation of Independent Business, Duke University/CFO Institute, National Association for Business Economics, and various regional Federal Reserve banks suggest that employers are becoming increasingly willing to raise compensation in order to fill vacancies (Chart 6). Workers, in turn, are becoming more choosy. This can be seen in an improving assessment of job availability and a rising quits rate. Both of these measures lead wage growth (Chart 7). Chart 6ASurveys Show Employers More Willing To Raise Compensation Surveys Show Employers More Willing To Raise Compensation Surveys Show Employers More Willing To Raise Compensation Chart 6BSurveys Show Employers More Willing To Raise Compensation Surveys Show Employers More Willing To Raise Compensation Surveys Show Employers More Willing To Raise Compensation Chart 7Workers Are Feeling More Confident Workers Are Feeling More Confident Workers Are Feeling More Confident ...As Do Wage Gains Among Low-Income Workers Median weekly earnings of low-income workers have accelerated this year, even as wage gains among higher-income workers have hit an air pocket (Chart 8). For example, restaurant workers have seen pay hikes of nearly 5% this year, up from 1% in 2014. Wage growth among lower-income workers tends to be less noisy than for higher-income workers. The incomes of better-paid workers are often influenced by bonuses and other variables that may be driven more by industry-specific or economy-wide profit trends rather than labor slack per se. Less-skilled workers are usually the first to get fired and the last to get hired. Thus, wage pressures at the lower end of the skill distribution often coincide with an overheated labor market. This makes the trend in lower-income wages a more reliable gauge of underlying labor market slack. Wage Inflation Will Slowly Pick Up As Global Slack Diminishes We expect U.S. wage growth to rise over the next few quarters by enough to allow the Fed to raise rates in line with the dots. However, a more rapid acceleration - one that forces the Fed to raise rates aggressively - is improbable, at least over the next 12 months. This is mainly because the relationship between domestic labor market slack and wage growth is not as tight as it once was. Trade unions have less clout these days, which means it takes longer for a tight labor market to produce larger negotiated pay hikes. The labor market has also become less fluid, as evidenced by the structural decline in both the rate of job creation and job destruction (Chart 9). Wages tend to adjust more slowly when there is less hiring and firing going on. Chart 8Better Pay For Low-Wage Earners: ##br##A Sign Of A Tighter Labor Market Better Pay For Low-Wage Earners: A Sign Of A Tighter Labor Market Better Pay For Low-Wage Earners: A Sign Of A Tighter Labor Market Chart 9Structural Declines In Job Creation##br## And Destruction Structural Declines In Job Creation And Destruction Structural Declines In Job Creation And Destruction Perhaps most importantly, an increasingly globalized workforce has given firms the ability to move production abroad in response to rising wages at home. This suggests that wage growth in the U.S. is unlikely to increase significantly until falling unemployment begins to push up wages abroad. Wage Growth Around The World For now, wage growth in America's trading partners remains subdued. Euro area wage inflation is stuck between 1% and 1.5%, although with important regional variations (Chart 10). Wage inflation has accelerated to over 2% in Germany, but is still close to zero in Italy and Spain. Considering that unemployment in both countries remains well above pre-recession levels, it will be difficult for the ECB to tighten monetary policy to any great degree over the next few years. Japanese wage growth has picked up since 2010, but is still below the level consistent with the BoJ's 2% inflation target (Chart 11). Wage inflation is likely to ratchet higher over the next few years, now that the ratio of job openings-to-applicants has risen to the highest level since 1974 (Chart 12). In a sign of the times, Yamato Transport, Japan's largest parcel delivery company, recently told Amazon that it would not be able to make same-day deliveries due to a shortage of available drivers. Chart 10Euro Area Wage Growth Remains ##br##Weak Outside Of Germany Euro Area Wage Growth Remains Weak Outside Of Germany Euro Area Wage Growth Remains Weak Outside Of Germany Chart 11Modest Pickup In Japanese Wages Modest Pickup In Japanese Wages Modest Pickup In Japanese Wages Wage growth in Canada has actually declined since 2014. However, that is likely to change given that the unemployment rate has fallen close to nine-year lows. Falling unemployment rates should also boost wage inflation in the U.K., Australia, and New Zealand. Chinese wage growth also remains brisk. Chart 13 shows that urban household future income confidence has picked up notably of late, as growth has improved and the labor market has tightened. Chart 12Job Openings Ratio Will Push Wages Higher Job Openings Ratio Will Push Wages Higher Job Openings Ratio Will Push Wages Higher Chart 13Optimism Over The Labor Market In China Optimism Over The Labor Market In China Optimism Over The Labor Market In China Faster Wage Growth Will Ultimately Lead To Higher Inflation Chart 14The Decline In Inflation Expectations ##br##Have Weighed On Wage Growth The Decline In Inflation Expectations Have Weighed On Wage Growth The Decline In Inflation Expectations Have Weighed On Wage Growth Going forward, the combination of falling labor slack abroad and an overheated labor market at home will cause U.S. wage inflation to increase more rapidly starting in the second half of 2018. This will be a break from the past. Lower longer-term inflation expectations have tempered nominal wage growth over the past eight years (Chart 14). Both market-based inflation expectations and inflation expectations 5-to-10 years out in the University of Michigan's survey have fallen by about half a point since the financial crisis. The recent decline in headline CPI inflation from 2.7% in February to 1.6% in June may also explain why wage growth has dipped this year even as payroll gains have rebounded. Rising wage growth could begin to feed on itself. As we have discussed before, the Phillips curve tends to steepen once an economy reaches full employment (Chart 15). If the unemployment rate falls from 7% to 6%, this is unlikely to have a huge effect on wages. But if it falls from 4.5% to 3.5%, the effect could be substantial. A recent Fed paper concluded that "evidence strongly suggests a non-linear effect of slack on wage growth and core PCE price inflation that becomes much larger after labor markets tighten beyond a certain point."6 The implication is that once inflation does start rising, it could rise more quickly than investors (or the Fed) expect. Concluding Thoughts The past three U.S. recessions were all caused by the unravelling of financial sector and asset market excesses: The housing bust lay the groundwork for the Great Recession; the collapse of dotcom stocks ushered in the 2001 recession; and the failure of hundreds of banks during the Savings and Loan crisis paved the way for the 1990-91 recession. Unlike the last few recessions, the next one may end up being more akin to those of 1960s, 70s, and 80s. Those earlier recessions were generally triggered by aggressive Fed rate hikes in the face of an overheated economy and rising inflation (Chart 16). Chart 15The Phillips Curve Appears To Be Non-Linear What's The Matter With Wages? What's The Matter With Wages? Chart 16Are We Heading Towards A "Retro-Recession"? Are We Heading Towards A "Retro-Recession"? Are We Heading Towards A "Retro-Recession"? The good news is that neither wage nor price inflation is likely to soar over the next 12 months. This means that the bull market in global equities can continue for a while longer. The bad news is that complacency about inflation risk is liable to cause central bankers to fall increasingly behind the curve. Rising inflation will force the Fed to pick up the pace of rate hikes in the second half of 2018. This is likely to lead to a stronger dollar and higher Treasury yields. The resulting tightening in U.S. financial conditions could trigger a recession in 2019 or 2020. Investors should remain overweight risk assets for now, but prepare to scale back exposure next summer. Peter Berezin, Global Chief Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Geopolitical Strategy Special Report titled "North Korea: Beyond Satire," dated April 19, 2017. 2 Unlike the widely followed average hourly wage series published every month in the payrolls report, the quarterly Employment Cost Index (ECI) does control for shifts in the weights of different industries in total employment. Thus, an increase in the relative number of low-paid hospitality workers would depress average hourly wages, but would not affect the ECI. Nevertheless, the ECI does not control for the possibility that the composition of the workforce within industries may change over time. The Atlanta Fed's Wage Tracker does overcome this bias because it uses the same sample of workers from one period to the next. However it, too, is subject to a number of methodological problems. 3 Mary C. Daly, Bart Hobijn, and Benjamin Pyle, "What's Up with Wage Growth?" FRBSF Economic Letter 2016-07 (March 7, 2016). 4 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016; and The Bank Credit Analyst Special Report, "Taking Off The Rose-Colored Glasses: Education and Growth In The 21st Century," February 24, 2011. 5 Please see Global Investment Strategy Special Report, "Is Slow Productivity Growth Good Or Bad For Bonds?" dated May 31, 2017; and The Bank Credit Analyst Special Report, "Rage Against The Machines: Is Technology Exacerbating Inequality?" dated June, 2014. 6 Jeremy Nalewaik, "Non-Linear Phillips Curves With Inflation Regime-Switching," Federal Reserve Board, Finance and Economics Discussion Series 2016-078 (August 2016). Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Feature There have been two major milestones in China's financial market liberalization in recent months. In June, MSCI Inc. moved to include Chinese domestic A shares in its widely followed world and emerging market equity indices. In July, regulators in Hong Kong and on the Mainland jointly launched the "bond connect" program, allowing foreign investors easier access to China's massive onshore bond market.1 The immediate impact of these measures will likely be muted, but they mark China's continued efforts to deregulate capital account transactions, opening up Chinese domestic financial assets that a mere few years ago were still completely isolated from the rest of the world. Over the years, we have published and periodically updated our Research Note, "China Shop," as a practical guide for investors looking for exposure to Chinese assets. The guide has come a long way since its first edition more than a decade ago, when investing in China was extremely difficult and very limited for foreigners, and we were struggling to find the best "China play" proxies. Over the years, various indexes, tracker funds and derivatives have been established outside China, making investing in Chinese equities a lot easier and more straightforward. The China ETF universe not only covers broad market indexes but also specific sectors and different market caps, allowing for discretionary sector allocations and investment styles for China-focused portfolios (Box 1). Box 1 A Primer On Chinese Stocks A shares are stocks traded on the Shanghai and Shenzhen stock exchanges. These shares are denominated and traded in RMB, and are restricted to local investors and Qualified Foreign Institutional Investors (QFII). B shares are Chinese companies traded on the Shanghai and Shenzhen stock exchanges. This equity class was originally open to foreign investors only, but was made available to domestic investors in 2001. These stocks are denominated in the Chinese currency but traded in U.S. dollars on the Shanghai Stock Exchange and in Hong Kong dollars on the Shenzhen Stock Exchange. H shares are mainland-registered state-owned companies listed in Hong Kong and denominated in Hong Kong dollars. The term N shares refers to stocks listed on the New York Stock Exchange. Red Chips are stocks listed on the Hong Kong Exchange. These companies are usually domiciled outside China but have at least 30% of their stakes held by state-owned organizations or provincial and municipal governments of China. P Chips refer to shares of companies which are majority-owned by entrepreneurs from China and derive the bulk of their revenues in the mainland. These companies are typically incorporated in offshore tax havens and are listed in Hong Kong and other major exchanges outside of China. Since our last update a year ago, the China ETF universe that we've been tracking has continued to evolve, with a few interesting developments. The number of ETFs on our list witnessed the first decline since it was created about 10 years ago. Two new ETFs have been added to the list since our last update, but 16 have been suspended or de-listed (Appendix Below). This means the Chinese ETF boom in recent years has entered a period of "consolidation." It also means that global investors' appetite for Chinese assets has been rather weak. Investors' weak appetite for Chinese assets is also reflected in the constant net withdrawals from these China-related ETFs - a remarkable development considering the sharp rally in Chinese equities, both domestic and investable, since early 2016. Total assets under management (AUM) of these ETFs have increased slightly so far this year compared with a year ago. However, the increases have been entirely due to price increases (Chart 1). Indeed, net capital flows have constantly been negative since 2013, according to our calculations. Investors' lukewarm attitude toward Chinese ETFs stands in stark contrast to other EM bourses. AUMs of EM equity ETFs have been chasing the market rally to new records of late (Chart 2). It appears that investors, especially smaller retail investors, have remained highly uncomfortable with China's macro conditions, despite improving growth figures, and have been left out of the bull market. This could be a contrarian sign that Chinese equities are underweighted and under owned - confirmed by depressed equity multiples. Chart 1Constant Negative Fund Flows To China ETFs China Shop: Calling Foreign Investors China Shop: Calling Foreign Investors Chart 2China ETFs: Out Of Favor China ETFs: Out Of Favor China ETFs: Out Of Favor Looking forward, the Chinese ETF universe will continue to expand, and the recent market liberalization efforts will likely lead to increasing supplies of ETFs focused on the Chinese onshore bond market. Despite cyclical swings in both economic growth and financial markets, it is almost a sure bet that foreign ownership in Chinese assets will grow over time. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Embracing Chinese Bonds," dated July 6, 2017, available at cis.bcaresearch.com. Appendix Broad Market China Shop: Calling Foreign Investors China Shop: Calling Foreign Investors China Shop: Calling Foreign Investors China Shop: Calling Foreign Investors By Market Cap - A Share China Shop: Calling Foreign Investors China Shop: Calling Foreign Investors By Market Cap - Investible China Shop: Calling Foreign Investors China Shop: Calling Foreign Investors By Sector - A Share China Shop: Calling Foreign Investors China Shop: Calling Foreign Investors By Sector - Investible China Shop: Calling Foreign Investors China Shop: Calling Foreign Investors Leveraged Plays China Shop: Calling Foreign Investors China Shop: Calling Foreign Investors Currency China Shop: Calling Foreign Investors China Shop: Calling Foreign Investors Fixed Income - Mainland China Shop: Calling Foreign Investors China Shop: Calling Foreign Investors Fixed Income - Offshore China Shop: Calling Foreign Investors China Shop: Calling Foreign Investors Cyclical Investment Stance Equity Sector Recommendations

Highlights Dear Clients, We are publishing a Special Report prepared by my colleague Jonathan LaBerge who examines the case for allocating capital to EM stocks within a global equity portfolio. I hope you will find this report insightful. Best regards, Garry Evans The relative performance of emerging market equities is challenging the downward trend channel that has been in place for the past seven years. This has led to renewed interest in EM from global investors, and warrants a revisit of the role of emerging market equities within a global equity portfolio. While EM recorded the highest regional equity return last cycle (2002-07), they were surprisingly not the "ideal" regional equity market in an efficient portfolio allocation. Recently, several compositional changes within the EM equity universe give the appearance of much lower commodity exposure than is truly the case. But EM equities will still be correlated with broad commodities prices because the later reflect Chinese growth dynamics. Cyclical indicators for China's economy suggest that the broad trend in commodities prices is likely to be lackluster over the coming year, at best. Consequently, EM stocks offer a poor risk/return profile, justifying an underweight stance within a global equity portfolio. Feature Chart I-1Change In Trend, Or Another Failed Rally? Change In Trend, Or Another Failed Rally? Change In Trend, Or Another Failed Rally? In U.S. dollar terms, the relative performance of emerging market (EM) stocks has been in an uptrend for over 18 months, and now appears to be challenging the downward trend channel that has been in place for the past seven years (Chart I-1). This has led to a renewed interest in EM, particularly among global investors. This report takes the recent outperformance of EM stocks as an opportunity to revisit their past and future contribution to a global equity portfolio, and what this might mean for an allocation to EM equities over the coming year. We conclude that EM's return behavior during the last economic cycle (2002-2007), its continued link to commodities prices, and China's growth dynamics all contribute to a poor risk/return profile for EM over the coming year. Barring compelling signs of a durable commodity bull market, investors should underweight EM stocks within a global equity portfolio. EM Equities In A Global Context: Some Historical Perspective When examining whether emerging markets are attractive from the perspective of global equity allocation, a starting point is to analyze the fundamental drivers of regional earnings. One major driver of global earnings over the past 20 years has been commodities prices; Chart I-2 highlights how 12-month forward EPS for stocks in all major regions have been correlated with commodities since the late-1990s. Chart I-2ACommodities Prices Are Correlated With Earnings... Commodities Prices Are Correlated With Earnings... Commodities Prices Are Correlated With Earnings... Chart I-2B...Even In Developed Markets ...Even In Developed Markets ...Even In Developed Markets This can be largely explained by the fact that commodities tend to be a pro-cyclical asset class. However, the super cycle in commodities prices in the 2000s not only bolstered the earnings of global resource companies, it also powered earnings growth for export-oriented industrials as well as domestic demand plays in commodity-producing countries. Chart I-3Strong Correlation Between ##br##Commodities And EM Strong Correlation Between Commodities And EM Strong Correlation Between Commodities And EM Emerging markets were among the largest beneficiaries of the commodity boom; net commodity-exporting countries made up roughly 45% of EM market capitalization throughout the last economic cycle, whereas stocks in the resource sector made up between 25-30% of the index by weight. Unsurprisingly, the relative performance of EM stocks closely tracked commodities prices over this period (Chart I-3). But despite this, EM was surprisingly not the "ideal" regional equity market last cycle within an active portfolio, even though it had the highest return. Chart I-4A presents a scatterplot of annualized regional equity volatility and return from 2002 - 2007, measured in US$ terms. The chart also shows the ex-post Modern Portfolio Theory (MPT) efficient frontier, with Chart I-4B presenting the efficient regional allocation at each point along the frontier. Chart I-4AEmerging Market Stocks Had The Highest Return Last Cycle... Global Equity Allocation: The Underwhelming Case For EM Global Equity Allocation: The Underwhelming Case For EM Chart I-4B...But Were Only The Favored Market For High-Risk Portfolios Global Equity Allocation: The Underwhelming Case For EM Global Equity Allocation: The Underwhelming Case For EM Chart I-5From 2002-2007, Earnings Drove More ##br##Of The Rally In DCM Than EM From 2002-2007, Earnings Drove More Of The Rally In DCM Than EM From 2002-2007, Earnings Drove More Of The Rally In DCM Than EM While the charts show that the efficient allocation to emerging market stocks did rise to a maximum of 100% during the last economic cycle, it did not become the dominant region until the portfolio became considerably more volatile than the global equity benchmark. Indeed, Chart I-4B shows that developed commodity markets (DCM) were the preferred commodity play for most of the efficient frontier, owing to their superior performance in risk-adjusted terms. This risk-adjusted outperformance may have occurred because DCM returns last cycle were driven more by earnings than by multiple expansion; Chart I-5 highlights that EM stock prices benefitted from multiple expansion last cycle by outpacing forward earnings, versus the opposite in the case of DCM. Since the onset of the U.S. recession in 2008, Chart I-6A and Chart I-6B highlight that the ex-post efficient portfolio has been much more skewed than during the last economic cycle. The charts show that the frontier since 2008 has been extremely short, with efficient allocations only accruing to three countries with typically defensive stock markets: the U.S., Japan, and Switzerland, with a heavy bias towards the former. From the perspective of a global equity portfolio, this historical review leads to two conclusions: 1) investors should not allocate to EM unless they are bullish on commodities prices and, 2) if investors are bullish towards commodities, developed commodity markets have historically been a better risk-adjusted bet than emerging markets as a commodity play. Chart I-6ASince 2008, The Efficient Frontier Has Been Highly Skewed... Global Equity Allocation: The Underwhelming Case For EM Global Equity Allocation: The Underwhelming Case For EM Chart I-6B...Towards Defensive Markets (Mostly The U.S.) Global Equity Allocation: The Underwhelming Case For EM Global Equity Allocation: The Underwhelming Case For EM Chart I-7These Trends Give The False Appearance ##br##Of Lower EM Commodity Exposure These Trends Give The False Appearance Of Lower EM Commodity Exposure These Trends Give The False Appearance Of Lower EM Commodity Exposure EM And Commodities Prices: Has The Relationship Really Changed? More recently, a narrative has developed in the market that EM stocks are now far less sensitive to commodities prices than used to be the case. Proponents of this theory point to the following changes in the composition of emerging market equity benchmarks: First, the market capitalization weight of net commodity exporting countries has fallen precipitously since the onset of the collapse in oil prices in 2014 (Chart I-7, panel 1). On average, net commodity exporters made up between 40-45% of EM equity market cap from 2000 to 2013, but their share now stands at 27%. Second, Chart I-7, panel 2, shows that the market cap weight of resource sectors (energy plus materials) in emerging markets has fallen from roughly 30% to 14% over the past five years, a trend that pre-dated the decline in the share of net commodity exporters. Third, the enormous rise in the market capitalization of technology companies as a share of total EM market cap has been specifically cited by many market participants (Chart I-7, panel 3), especially since EM is now heavily overweight the tech sector relative to the global average. Broadly speaking, a fourth compositional change within the EM equity benchmark generally captures all of the shifts noted above, and is the focus of our remaining analysis below: the rise in the weight of emerging Asia as a share of overall EM (Chart I-7, panel 4). Among emerging markets, net commodity exporters tend to be located outside of Asia (with the exception of Indonesia and Malaysia), and emerging Asia accounts for essentially all of EM tech market cap. Consequently, investors who argue that EM equities have largely or fully decoupled from commodities prices are essentially arguing that emerging Asian equities are far less affected by changes in commodity markets than they used to be. This idea is deeply flawed, as shown below: Based on export share, Chart I-8 highlights that emerging Asia is far more economically exposed to China than developed markets and EM ex-Asia. While China is gradually becoming more of a services-oriented economy, Chart I-9 highlights that the sum of primary industry (raw material extraction), secondary industry (manufacturing and construction), and real estate services still account for over half of China's economic activity, well above that of industrialized nations such as the U.S. This underscores that emerging Asia's trade exposure to China is fundamentally rooted in economic activity that is closely linked to commodity demand. Chart I-8Emerging Asia Has High ##br##Trade Exposure To China Emerging Asia Has High Trade Exposure To China Emerging Asia Has High Trade Exposure To China Chart I-9Chinese Growth Still Largely ##br##Reflects Industrial Activity Chinese Growth Still Largely Reflects Industrial Activity Chinese Growth Still Largely Reflects Industrial Activity Within the commodity-linked segment of China's economy, Chart I-10 shows that there is little evidence of a weaker relationship between output and commodities prices. Simple regression analysis underscores that the Li Keqiang index, a growth proxy for China's industrial sector, is strongly linked to the year-over-year % change in spot commodities prices since the beginning of the commodity bull market, and that this relationship has in fact been increasing in strength over time. In addition, Chart I-11 underscores that China remains by far the largest consumer of base metals globally. Demand in the global oil market is considerably more diversified than the market for base metals, but China is the second-largest end market for oil (14% of global oil consumption), and accounted for over a quarter of the growth in total oil demand in 2016.1 Chart I-10Moderating Chinese Growth Will ##br##Be Negative For Commodities Moderating Chinese Growth Will Be Negative For Commodities Moderating Chinese Growth Will Be Negative For Commodities Chart I-11China Is By Far The Most Important ##br##End Market For Base Metals China Is By Far The Most Important End Market For Base Metals China Is By Far The Most Important End Market For Base Metals Finally, Chart I-12 shows a regression model between forward earnings expectations for emerging Asia and commodities prices, both at the overall index level and even for the financial sector (which, along with real estate, accounts for almost 25% of emerging Asian market capitalization). The fit for both models is extremely strong and, similar to the increasing strength of the Li Keqiang / commodity price relationship, the chart shows that commodities prices have begun to lead the growth in forward earnings, when the relationship used to be much more coincident. Chart I-12Emerging Asian Earnings Are Strongly ##br##Correlated With Commodities Prices Emerging Asian Earnings Are Strongly Correlated With Commodities Prices Emerging Asian Earnings Are Strongly Correlated With Commodities Prices The bottom line for investors is that Charts I-8-12 show emerging Asian economies are strongly linked economically to China, and that China remains the dominant driver of aggregate commodity demand. This means that while EM stocks may not have as much direct commodity exposure as they used to, they will continue to experience a high correlation with commodities prices because that the latter will be driven by swings in China's business cycle. In brief, Chinese growth fluctuations are instrumental to emerging Asia's economic and equity market performance. This is the rationale behind the very strong link between earnings expectations for emerging Asia and commodities prices: the latter reflect cyclical variations in the Chinese economy. EM Stocks: A Lackluster Bet Given The Outlook For Commodities Our earlier discussion of EM's historical contribution to a global equity portfolio revived elements of Modern Portfolio Theory (MPT), at least from an ex-post perspective. Ex-ante, investors need to make judgements about the likely risk, return, and cross-correlation of an asset when assessing its likely contribution to a diversified portfolio. Regarding the latter factor, Chart I-13 highlights that EM's correlation with global ex-EM has actually fallen quite substantially over the past year, which is a potential argument in the minds of some investors in favor of an increased allocation to EM. When recalling the lessons from Modern Portfolio Theory, most investors tend to focus on the key insight that lowly-correlated assets are valuable from the perspective of constructing a portfolio with an attractive risk/return profile. While this is true, many investors often forget that this is only valid given an expectation of a positive return. The efficient allocation to an asset that has a strongly negative correlation with other assets but has a negative return expectation is basically zero. This means that global investors eying an increased allocation to emerging markets should be squarely focused on EM equities' absolute performance, which as we have highlighted above are likely to be closely linked to commodity returns. Over the coming 6-12 months, Chart I-14 paints an uninspiring picture for commodities prices based on two measures of China's money supply. In turn, interest rates lead money growth and the rise in the former over the past nine months heralds further deceleration in the latter. This implies that the Chinese economy will likely continue to moderate, which is negative for the broad trend in commodities prices. Chart I-13A Significant Decline, But Focus On Return ##br##Expectations, Not Correlation A Significant Decline, But Focus On Return Expectations, Not Correlation A Significant Decline, But Focus On Return Expectations, Not Correlation Chart I-14Interest Rates And Money Growth Paint ##br##A Poor Picture For Commodities Interest Rates And Money Growth Paint A Poor Picture For Commodities Interest Rates And Money Growth Paint A Poor Picture For Commodities As noted above, China's share of the global oil market is much lower than that of base metals, and we do not expect China's oil demand to shrink even if its industrial sector slumps. But from the perspective of allocating to EM equities within a global portfolio, Table I-1 highlights that broad spot commodity price indexes tend to be more relevant predictors of forward earnings growth than energy prices alone. This means that a rise in oil prices (were it to occur for idiosyncratic supply reasons) might be positive for major oil producers such as Russia,2 but is unlikely to provide a broad-based catalyst for EM stocks. Table I-1Explanatory Power Of Commodity Price Indexes In Modeling ##br##12-Month Forward Earnings Per Share Growth (2002-2016) Global Equity Allocation: The Underwhelming Case For EM Global Equity Allocation: The Underwhelming Case For EM Finally, our analysis above has focused on the fundamental drivers of EM stocks, and has shown how DM investors are likely to have little basis to be bullish about emerging markets earnings over the coming 6-12 months. Chart I-15 highlights how this is also true about the potential for EM multiple expansion relative to their global peers. The chart shows that periods of relative EM multiple expansion have, like relative earnings expectations, tended to be associated with rising commodities prices, implying that a significant re-rating of EM equities is unlikely over the coming year. This is in addition the fact that EM stocks are neither cheap nor expensive in absolute terms,3 meaning that there is less room for multiple expansion in EM than many investors believe. Chart I-15No Relative Multiple Expansion ##br##Without Rising Commodities Prices No Relative Multiple Expansion Without Rising Commodities Prices No Relative Multiple Expansion Without Rising Commodities Prices Investment Conclusions In terms of gauging the contribution of EM equities to a global equity portfolio, this report has highlighted the following points: While EM stocks had the highest return of any regional equity market during the last economic cycle (2002-2007), this return profile was accompanied by an outsized degree of volatility. For all but the riskiest portfolios, developed commodity markets were preferred as a commodity play over emerging markets. Several compositional changes within the EM equity universe give the outward appearance of much lower commodity exposure, but this exposure has merely become indirect. While EM's weight towards net commodity exporters and resource sectors has declined, this has shifted benchmark exposure to emerging Asia which has significant economic exposure to China and its industrial sector (the dominant driver of global commodities prices). As such, share prices in EM overall and emerging Asia in particular will still be strongly correlated with commodities prices even given the region's significant weight towards the technology sector.4 Cyclical indicators for China's economy suggest that broad commodity price gains over the coming year are likely to be lackluster, at best (and may very well be negative). Even if global oil prices were to rise, this is unlikely to provide a broad-based catalyst for EM stocks if industrial metals prices relapse, as we expect. These conclusions underscore that it is highly unlikely emerging market stocks will sustainably decouple from commodities prices over the cyclical investment horizon, and that the uptrend in EM relative performance since early-2016 has likely been driven significantly by expectations of further China's growth acceleration and commodity gains. In our judgement, these circumstances have created a poor risk/return profile for emerging market equities, justifying an underweight stance within a global equity portfolio over the coming year. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Source: BP Statistical Review of World Energy, June 2017. 2 Note that we recommend an overweight stance towards Russian equities within an EM equity portfolio. 3 Please refer to the Emerging Markets Strategy Weekly Report titled, "EM Equity Valuations Revisited," dated March 29, 2017, link available on page 15. 4 For a further discussion of the impact of the technology sector on the relative performance of emerging market stocks, please see Emerging Markets Strategy Weekly Report titled, "Can Tech Drive EM Stocks Higher?" dated May 17, 2017, link available on page 15.

Highlights Dear Clients, We are publishing a Special Report prepared by my colleague Jonathan LaBerge who examines the case for allocating capital to EM stocks within a global equity portfolio. I hope you will find this report insightful. Best regards, Arthur Budaghyan The relative performance of emerging market equities is challenging the downward trend channel that has been in place for the past seven years. This has led to renewed interest in EM from global investors, and warrants a revisit of the role of emerging market equities within a global equity portfolio. While EM recorded the highest regional equity return last cycle (2002-07), they were surprisingly not the "ideal" regional equity market in an efficient portfolio allocation. Recently, several compositional changes within the EM equity universe give the appearance of much lower commodity exposure than is truly the case. But EM equities will still be correlated with broad commodities prices because the latter reflect Chinese growth dynamics. Cyclical indicators for China's economy suggest that the broad trend in commodities prices is likely to be lackluster over the coming year, at best. Consequently, EM stocks offer a poor risk/return profile, justifying an underweight stance within a global equity portfolio. Feature Chart I-1Change In Trend, Or Another Failed Rally? Change In Trend, Or Another Failed Rally? Change In Trend, Or Another Failed Rally? In U.S. dollar terms, the relative performance of emerging market (EM) stocks has been in an uptrend for over 18 months, and now appears to be challenging the downward trend channel that has been in place for the past seven years (Chart I-1). This has led to a renewed interest in EM, particularly among global investors. This report takes the recent outperformance of EM stocks as an opportunity to revisit their past and future contribution to a global equity portfolio, and what this might mean for an allocation to EM equities over the coming year. We conclude that EM's return behavior during the last economic cycle (2002-2007), its continued link to commodities prices, and China's growth dynamics all contribute to a poor risk/return profile for EM over the coming year. Barring compelling signs of a durable commodity bull market, investors should underweight EM stocks within a global equity portfolio. EM Equities In A Global Context: Some Historical Perspective When examining whether emerging markets are attractive from the perspective of global equity allocation, a starting point is to analyze the fundamental drivers of regional earnings. One major driver of global earnings over the past 20 years has been commodities prices; Chart I-2 highlights how 12-month forward EPS for stocks in all major regions have been correlated with commodities since the late-1990s. Chart I-2ACommodities Prices Are Correlated With Earnings... Commodities Prices Are Correlated With Earnings... Commodities Prices Are Correlated With Earnings... Chart I-2B...Even In Developed Markets ...Even In Developed Markets ...Even In Developed Markets This can be largely explained by the fact that commodities tend to be a pro-cyclical asset class. However, the super cycle in commodities prices in the 2000s not only bolstered the earnings of global resource companies, it also powered earnings growth for export-oriented industrials as well as domestic demand plays in commodity-producing countries. Chart I-3Strong Correlation Between ##br##Commodities And EM Strong Correlation Between Commodities And EM Strong Correlation Between Commodities And EM Emerging markets were among the largest beneficiaries of the commodity boom; net commodity-exporting countries made up roughly 45% of EM market capitalization throughout the last economic cycle, whereas stocks in the resource sector made up between 25-30% of the index by weight. Unsurprisingly, the relative performance of EM stocks closely tracked commodities prices over this period (Chart I-3). But despite this, EM was surprisingly not the "ideal" regional equity market last cycle within an active portfolio, even though it had the highest return. Chart I-4A presents a scatterplot of annualized regional equity volatility and return from 2002 - 2007, measured in US$ terms. The chart also shows the ex-post Modern Portfolio Theory (MPT) efficient frontier, with Chart I-4B presenting the efficient regional allocation at each point along the frontier. Chart I-4AEmerging Market Stocks Had The Highest Return Last Cycle... Global Equity Allocation: The Underwhelming Case For EM Global Equity Allocation: The Underwhelming Case For EM Chart I-4B...But Were Only The Favored Market For High-Risk Portfolios Global Equity Allocation: The Underwhelming Case For EM Global Equity Allocation: The Underwhelming Case For EM Chart I-5From 2002-2007, Earnings Drove More ##br##Of The Rally In DCM Than EM From 2002-2007, Earnings Drove More Of The Rally In DCM Than EM From 2002-2007, Earnings Drove More Of The Rally In DCM Than EM While the charts show that the efficient allocation to emerging market stocks did rise to a maximum of 100% during the last economic cycle, it did not become the dominant region until the portfolio became considerably more volatile than the global equity benchmark. Indeed, Chart I-4B shows that developed commodity markets (DCM) were the preferred commodity play for most of the efficient frontier, owing to their superior performance in risk-adjusted terms. This risk-adjusted outperformance may have occurred because DCM returns last cycle were driven more by earnings than by multiple expansion; Chart I-5 highlights that EM stock prices benefitted from multiple expansion last cycle by outpacing forward earnings, versus the opposite in the case of DCM. Since the onset of the U.S. recession in 2008, Chart I-6A and Chart I-6B highlight that the ex-post efficient portfolio has been much more skewed than during the last economic cycle. The charts show that the frontier since 2008 has been extremely short, with efficient allocations only accruing to three countries with typically defensive stock markets: the U.S., Japan, and Switzerland, with a heavy bias towards the former. From the perspective of a global equity portfolio, this historical review leads to two conclusions: 1) investors should not allocate to EM unless they are bullish on commodities prices and, 2) if investors are bullish towards commodities, developed commodity markets have historically been a better risk-adjusted bet than emerging markets as a commodity play. Chart I-6ASince 2008, The Efficient Frontier Has Been Highly Skewed... Global Equity Allocation: The Underwhelming Case For EM Global Equity Allocation: The Underwhelming Case For EM Chart I-6B...Towards Defensive Markets (Mostly The U.S.) Global Equity Allocation: The Underwhelming Case For EM Global Equity Allocation: The Underwhelming Case For EM Chart I-7These Trends Give The False Appearance ##br##Of Lower EM Commodity Exposure These Trends Give The False Appearance Of Lower EM Commodity Exposure These Trends Give The False Appearance Of Lower EM Commodity Exposure EM And Commodities Prices: Has The Relationship Really Changed? More recently, a narrative has developed in the market that EM stocks are now far less sensitive to commodities prices than used to be the case. Proponents of this theory point to the following changes in the composition of emerging market equity benchmarks: First, the market capitalization weight of net commodity exporting countries has fallen precipitously since the onset of the collapse in oil prices in 2014 (Chart I-7, panel 1). On average, net commodity exporters made up between 40-45% of EM equity market cap from 2000 to 2013, but their share now stands at 27%. Second, Chart I-7, panel 2, shows that the market cap weight of resource sectors (energy plus materials) in emerging markets has fallen from roughly 30% to 14% over the past five years, a trend that pre-dated the decline in the share of net commodity exporters. Third, the enormous rise in the market capitalization of technology companies as a share of total EM market cap has been specifically cited by many market participants (Chart I-7, panel 3), especially since EM is now heavily overweight the tech sector relative to the global average. Broadly speaking, a fourth compositional change within the EM equity benchmark generally captures all of the shifts noted above, and is the focus of our remaining analysis below: the rise in the weight of emerging Asia as a share of overall EM (Chart I-7, panel 4). Among emerging markets, net commodity exporters tend to be located outside of Asia (with the exception of Indonesia and Malaysia), and emerging Asia accounts for essentially all of EM tech market cap. Consequently, investors who argue that EM equities have largely or fully decoupled from commodities prices are essentially arguing that emerging Asian equities are far less affected by changes in commodity markets than they used to be. This idea is deeply flawed, as shown below: Based on export share, Chart I-8 highlights that emerging Asia is far more economically exposed to China than developed markets and EM ex-Asia. While China is gradually becoming more of a services-oriented economy, Chart I-9 highlights that the sum of primary industry (raw material extraction), secondary industry (manufacturing and construction), and real estate services still account for over half of China's economic activity, well above that of industrialized nations such as the U.S. This underscores that emerging Asia's trade exposure to China is fundamentally rooted in economic activity that is closely linked to commodity demand. Chart I-8Emerging Asia Has High ##br##Trade Exposure To China Emerging Asia Has High Trade Exposure To China Emerging Asia Has High Trade Exposure To China Chart I-9Chinese Growth Still Largely ##br##Reflects Industrial Activity Chinese Growth Still Largely Reflects Industrial Activity Chinese Growth Still Largely Reflects Industrial Activity Within the commodity-linked segment of China's economy, Chart I-10 shows that there is little evidence of a weaker relationship between output and commodities prices. Simple regression analysis underscores that the Li Keqiang index, a growth proxy for China's industrial sector, is strongly linked to the year-over-year % change in spot commodities prices since the beginning of the commodity bull market, and that this relationship has in fact been increasing in strength over time. In addition, Chart I-11 underscores that China remains by far the largest consumer of base metals globally. Demand in the global oil market is considerably more diversified than the market for base metals, but China is the second-largest end market for oil (14% of global oil consumption), and accounted for over a quarter of the growth in total oil demand in 2016.1 Chart I-10Moderating Chinese Growth Will ##br##Be Negative For Commodities Moderating Chinese Growth Will Be Negative For Commodities Moderating Chinese Growth Will Be Negative For Commodities Chart I-11China Is By Far The Most Important ##br##End Market For Base Metals China Is By Far The Most Important End Market For Base Metals China Is By Far The Most Important End Market For Base Metals Finally, Chart I-12 shows a regression model between forward earnings expectations for emerging Asia and commodities prices, both at the overall index level and even for the financial sector (which, along with real estate, accounts for almost 25% of emerging Asian market capitalization). The fit for both models is extremely strong and, similar to the increasing strength of the Li Keqiang / commodity price relationship, the chart shows that commodities prices have begun to lead the growth in forward earnings, when the relationship used to be much more coincident. Chart I-12Emerging Asian Earnings Are Strongly ##br##Correlated With Commodities Prices Emerging Asian Earnings Are Strongly Correlated With Commodities Prices Emerging Asian Earnings Are Strongly Correlated With Commodities Prices The bottom line for investors is that Charts I-8-12 show emerging Asian economies are strongly linked economically to China, and that China remains the dominant driver of aggregate commodity demand. This means that while EM stocks may not have as much direct commodity exposure as they used to, they will continue to experience a high correlation with commodities prices because that the latter will be driven by swings in China's business cycle. In brief, Chinese growth fluctuations are instrumental to emerging Asia's economic and equity market performance. This is the rationale behind the very strong link between earnings expectations for emerging Asia and commodities prices: the latter reflect cyclical variations in the Chinese economy. EM Stocks: A Lackluster Bet Given The Outlook For Commodities Our earlier discussion of EM's historical contribution to a global equity portfolio revived elements of Modern Portfolio Theory (MPT), at least from an ex-post perspective. Ex-ante, investors need to make judgements about the likely risk, return, and cross-correlation of an asset when assessing its likely contribution to a diversified portfolio. Regarding the latter factor, Chart I-13 highlights that EM's correlation with global ex-EM has actually fallen quite substantially over the past year, which is a potential argument in the minds of some investors in favor of an increased allocation to EM. When recalling the lessons from Modern Portfolio Theory, most investors tend to focus on the key insight that lowly-correlated assets are valuable from the perspective of constructing a portfolio with an attractive risk/return profile. While this is true, many investors often forget that this is only valid given an expectation of a positive return. The efficient allocation to an asset that has a strongly negative correlation with other assets but has a negative return expectation is basically zero. This means that global investors eying an increased allocation to emerging markets should be squarely focused on EM equities' absolute performance, which as we have highlighted above are likely to be closely linked to commodity returns. Over the coming 6-12 months, Chart I-14 paints an uninspiring picture for commodities prices based on two measures of China's money supply. In turn, interest rates lead money growth and the rise in the former over the past nine months heralds further deceleration in the latter. This implies that the Chinese economy will likely continue to moderate, which is negative for the broad trend in commodities prices. Chart I-13A Significant Decline, But Focus On Return ##br##Expectations, Not Correlation A Significant Decline, But Focus On Return Expectations, Not Correlation A Significant Decline, But Focus On Return Expectations, Not Correlation Chart I-14Interest Rates And Money Growth Paint ##br##A Poor Picture For Commodities Interest Rates And Money Growth Paint A Poor Picture For Commodities Interest Rates And Money Growth Paint A Poor Picture For Commodities As noted above, China's share of the global oil market is much lower than that of base metals, and we do not expect China's oil demand to shrink even if its industrial sector slumps. But from the perspective of allocating to EM equities within a global portfolio, Table I-1 highlights that broad spot commodity price indexes tend to be more relevant predictors of forward earnings growth than energy prices alone. This means that a rise in oil prices (were it to occur for idiosyncratic supply reasons) might be positive for major oil producers such as Russia,2 but is unlikely to provide a broad-based catalyst for EM stocks. Table I-1Explanatory Power Of Commodity Price Indexes In Modeling ##br##12-Month Forward Earnings Per Share Growth (2002-2016) Global Equity Allocation: The Underwhelming Case For EM Global Equity Allocation: The Underwhelming Case For EM Finally, our analysis above has focused on the fundamental drivers of EM stocks, and has shown how DM investors are likely to have little basis to be bullish about emerging markets earnings over the coming 6-12 months. Chart I-15 highlights how this is also true about the potential for EM multiple expansion relative to their global peers. The chart shows that periods of relative EM multiple expansion have, like relative earnings expectations, tended to be associated with rising commodities prices, implying that a significant re-rating of EM equities is unlikely over the coming year. This is in addition the fact that EM stocks are neither cheap nor expensive in absolute terms,3 meaning that there is less room for multiple expansion in EM than many investors believe. Chart I-15No Relative Multiple Expansion ##br##Without Rising Commodities Prices No Relative Multiple Expansion Without Rising Commodities Prices No Relative Multiple Expansion Without Rising Commodities Prices Investment Conclusions In terms of gauging the contribution of EM equities to a global equity portfolio, this report has highlighted the following points: While EM stocks had the highest return of any regional equity market during the last economic cycle (2002-2007), this return profile was accompanied by an outsized degree of volatility. For all but the riskiest portfolios, developed commodity markets were preferred as a commodity play over emerging markets. Several compositional changes within the EM equity universe give the outward appearance of much lower commodity exposure, but this exposure has merely become indirect. While EM's weight towards net commodity exporters and resource sectors has declined, this has shifted benchmark exposure to emerging Asia which has significant economic exposure to China and its industrial sector (the dominant driver of global commodities prices). As such, share prices in EM overall and emerging Asia in particular will still be strongly correlated with commodities prices even given the region's significant weight towards the technology sector.4 Cyclical indicators for China's economy suggest that broad commodity price gains over the coming year are likely to be lackluster, at best (and may very well be negative). Even if global oil prices were to rise, this is unlikely to provide a broad-based catalyst for EM stocks if industrial metals prices relapse, as we expect. These conclusions underscore that it is highly unlikely emerging market stocks will sustainably decouple from commodities prices over the cyclical investment horizon, and that the uptrend in EM relative performance since early-2016 has likely been driven significantly by expectations of further China's growth acceleration and commodity gains. In our judgement, these circumstances have created a poor risk/return profile for emerging market equities, justifying an underweight stance within a global equity portfolio over the coming year. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Source: BP Statistical Review of World Energy, June 2017. 2 Note that we recommend an overweight stance towards Russian equities within an EM equity portfolio. 3 Please refer to the Emerging Markets Strategy Weekly Report titled, "EM Equity Valuations Revisited," dated March 29, 2017, link available on page 15. 4 For a further discussion of the impact of the technology sector on the relative performance of emerging market stocks, please see Emerging Markets Strategy Weekly Report titled, "Can Tech Drive EM Stocks Higher?" dated May 17, 2017, link available on page 15.

Highlights The Mueller investigation is part of the "Trump Put;" General White House disarray and congressional incompetence combine to produce Goldilocks conditions for U.S. equities; Mexico's frontrunner in the upcoming elections, Andres Manuel Lopez Obrador, is no Chavez; Malaysian political risks are overstated, the ruling Barisan Nasional has pushed through painful reforms; With economic growth stabilizing, cheap valuations, and overstated political risks, Malaysia could be an intriguing investment opportunity. Feature This week, we turn to two emerging markets: Mexico and Malaysia. Our approach to EMs is to look for opportunities where politics may emerge as the alpha amidst appealing valuations. We rely on our sister strategy, BCA's Emerging Market Strategy, for fundamental analysis, to which we then add our political research. We find it striking that these two EMs are the very two that stood to suffer the most should U.S. Congress have passed a border adjustment tax (Chart 1). Not only have the Republicans forsworn the border tax, but these countries will benefit from other trends, as we explain below. Before we dive into Malaysia and Mexico, however, a short note on the latest developments in the White House is in order. Clients from St. Louis, Missouri to Auckland, New Zealand are asking us the same question this summer: when does the Mueller investigation become a headwind for the SPX? Chart 1Vulnerability To U.S. Import Tariffs And Border Adjustment Taxes Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Update On Emerging Markets: Malaysia, Mexico, And The United States Of America The "Trump Put" Continues Our answer is that Special Counsel Robert Mueller's investigation may already be a tailwind to the U.S. equity market. The investigation, along with general White House disarray and congressional incompetence, makes up the ongoing "Trump Put."1 The American political imbroglio has combined with decent earnings and steady global growth to produce Goldilocks conditions for U.S. equities, while simultaneously weakening the USD and supporting Treasuries. The political fulcrum upon which all these assets turn is the failure of the Trump administration to deliver its promised fiscal stimulus (Chart 2). Tax reform, which was supposed to be the main vehicle of such stimulus, is increasingly looking like it will fail to live up to its hype. We still think it will pass, for three broad reasons: Chart 2Handcuffed Trump The Most Likely Scenario Handcuffed Trump The Most Likely Scenario Handcuffed Trump The Most Likely Scenario Trump's low popularity remains an albatross around the neck of GOP candidates in the November 2018 elections, with potentially ominous results. Our simple "line-of-best-fit" model between a Republican president's approval rating and the GOP's midterm performance produces a 38-seat loss in the upcoming election (Chart 3). Republicans need a legislative win and need it fast. The House has laid the groundwork for tax reform, passing the FY2018 budget resolution with reconciliation instructions focused on tax legislation. This means that the Obamacare replace and repeal effort has until October 1 to be resolved.2 Investors are conflating replacing and repealing Obamacare with tax reform. The former is an entitlement program, the latter a more popular measure that Republicans have always tried to move through Congress. It is very rare for U.S. policymakers to successfully reduce or remove an entitlement program. Cutting, even reforming, taxes is easier to justify politically. Chart 3The Clock Is Ticking For The GOP On Tax Reform Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Although we still maintain that tax reform, or mere tax cuts, will happen, they are unlikely to be as stimulative as originally advertised. Corporate and household tax rates are unlikely to be lowered by as much as originally touted. That is because Republicans in the House will demand "revenue offsets" to accomplish rate reduction, yet they have already lost key offsets like Obamacare repeal and the border adjustment tax.3#fn_3 The White House could change all that by using its considerable political capital among conservative grassroots voters and the bully pulpit to get fiscally conservative Republicans in the House to move a stimulative tax reform through Congress. But, as we noted two weeks ago, factional fighting in the White House and an ineffective chief of staff are considerable hurdles.4 A few days after we published that report, President Trump replaced Reince Priebus with retired General and Homeland Security Secretary John Kelly. While Kelly is likely to introduce some discipline into the White House, we doubt he will make the executive more effective in cajoling House Representatives to toe the administration's line on tax reform. This is because Kelly adds no legislative experience to a White House that is already quite low on it by recent historical standards (Chart 4). Chart 4Trump Administration Is On The Low End Of Congressional Experience Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Additionally, the Trump Administration continues to drag its feet on presidential appointments, hurting the effectiveness of the executive. Only 220 appointments had been sent to the Senate by July 19, compared to the average 309 during the same time period by the previous four presidents (Chart 5). The Senate is very slow in confirming the candidates, perhaps because of their unorthodox backgrounds and resumes. The average time to confirm a Trump nominee is 45 days, which is astonishing given that the Senate is controlled by Republicans. Chart 5The Trump Administration Is Dragging Its Feet On Appointments Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Update On Emerging Markets: Malaysia, Mexico, And The United States Of America In addition to the ineffectiveness of the White House, investors fret that the ongoing Mueller investigation, which has just impaneled a grand jury, could undercut the rally in risk assets. By summoning a grand jury Mueller can subpoena documents and obtain testimony of witnesses under oath. Doing so will accelerate the investigation and perhaps take it down new avenues. For example, the Kenneth Starr investigation initially focused on the suicide of deputy White House counsel Vince Foster and the Whitewater real estate investments by Bill Clinton. But the trail led elsewhere. Ultimately, the "Starr Report" alleged that Clinton lied under oath regarding his extramarital affair with Monica Lewinsky. Impeachment proceedings ensued. That said, we are sticking with our conclusion from May that investors should look through any risk of impeachment or indictment for President Trump, at least as long as Republicans hold the House of Representatives (i.e., at least until the midterms in 2018).5 In particular, there are three main reasons to fade any near-term equity market volatility: President Mike Pence - Under both impeachment rules and the 25th amendment, the U.S. president would be replaced by the vice president. Vice President Pence's approval rating largely tracks that of President Trump and is in the 40% area, but investors should note that he once stood at nearly 60% during the campaign (Chart 6). As such, the worst-case scenario for investors in the event of a post-midterm impeachment is that Trump is replaced by Pence, an orthodox Republican, and that Pence has to deal with a split Congress. And that is not bad! It would grind reforms to a halt, but at least tax reform would be out of the way by then. Midterm Election - If the Trump White House becomes engulfed in scandal, Republicans in the House will fear losing their majority. Yes, the partisan drawing of electoral districts - "gerrymandering" - has reduced the number of competitive U.S. House districts from 164 in 1998 to 72 in 2016 (Chart 7). But the Democrats managed to win the House in 2006 and the Republicans managed to take it back in 2010, so there is no reason the roles cannot be reversed yet again. However, this is not a risk, it is an opportunity. It will motivate the GOP in Congress to lock in tax and health care reform well ahead of the midterm elections. Counter-Revolution - With Trump embattled and facing impeachment, the market may let out a sigh of relief because it would mark a clear defeat of populist politics in the U.S. Much as with electoral outcomes in Europe, investors may want to cheer the defeat of an unorthodox, anti-establishment movement in the U.S. As such, we would push against any "Russia scandal"-induced volatility in the U.S. markets, at least until the midterm election. We think the market would digest the volatility and realize that Trump's impeachment, were it to occur after midterm elections, would not arrest the Republican agenda before the midterms. After all, the GOP has waited over 15 years to make Bush-era tax cuts permanent and the opportunity to do so may evaporate within the next 12 months. In addition, given the performance of high tax-rate S&P 500 equities (Chart 8), investors appear to have already discounted the failure of meaningful tax reform in the market. This means that the "Trump Put" is in full effect: investors are bidding up risk assets not because they expect something to happen (tax reform, fiscal stimulus, financial deregulation, etc.), but because they expect nothing to happen (no fiscal stimulus, no fast Fed rate hikes, no onerous regulation for businesses, etc.). Chart 6Could Be Worse ##br##Than Pence Could Be Worse Than Pence Could Be Worse Than Pence Chart 7Gerrymandering Reduces##br## Competitive House Seats Gerrymandering Reduces Competitive House Seats Gerrymandering Reduces Competitive House Seats Chart 8Investors No Longer##br## Expect Tax Reform Investors No Longer Expect Tax Reform Investors No Longer Expect Tax Reform What about the long term? A scandal-ridden White House, escalating leaks against the administration, and a mounting bureaucratic revolt against the executive cannot be good for the U.S., can they? The news flow out of Washington increasingly looks like news from Ankara, Brasilia, or Pretoria. There are two diametrically opposed directions the U.S. can take. The first is deepening polarization and policy gridlock that leads to President Trump being replaced by an even greater bout of populism in 2020 or 2024. We described this scenario recently in a pessimistic note about the coming social unrest in America.6 The alternative is that Democrats and Republicans in Congress (particularly the Senate), representing the country's elites, decide to work together on legislation. Both parties recently united to pass veto-proof sanctions on Russia with a 98-2 vote that has bound the executive to future review by Congress. And some green shoots of bipartisanship appeared over the past two weeks on tax reform and even on health care. It is too soon to say which path American policymakers will take. Investors may have to wait until after the midterm election for genuine cooperation. But it would be very positive for the U.S. economy and prospects of reform if genuine bipartisanship emerged as a reaction to the incompetence, scandal, nationalism, and populism of the White House. Bottom Line: The intensifying Mueller investigation and ongoing White House incompetence will only further fuel the "Trump Put." This is positive for U.S. equities, neutral for bonds, and bad for the dollar, ceteris paribus. A significant pickup in inflation could overwhelm the "Trump Put" and cause the dollar to rally. As such, investors should focus on inflation prospects more than politics in the White House. What If Mexico Builds A Wall First? For every action, there is an equal and opposite reaction. The election of President Donald Trump, an unabashed nationalist who campaigned on an anti-immigrant platform, is spurring the campaign of Andres Manuel Lopez Obrador, also known as AMLO, in the upcoming July 1, 2018 elections in Mexico. Obrador has been a left-wing firebrand of Mexican politics for years. He was the Head of Government of Mexico City (essentially the city's mayor) from 2000 to 2005 and contested a close election against Felipe Calderon in 2006, which he narrowly lost. He lost the 2012 election by a much wider margin, but still came second to current president Enrique Pena Nieto of the Institutional Revolutionary Party (PRI). Obrador's election campaign calls for a confrontational attitude towards President Trump, the renegotiation of NAFTA, an increase to farm subsidies, and limitations on foreign investment in Mexico. He has said that he would reverse the opening of the energy sector to foreign investment through a referendum, but that he is in favor of public-private partnerships in the sector. That said, his left-wing firebrand persona is more PR than substance. In 2012, for example, he also campaigned on cutting government expenditure and ending monopolies - not exactly Chavista credentials. Nonetheless, he quit the left-leaning Party of the Democratic Revolution (PRD) to form a more left-wing movement. Obrador's new party, the National Regeneration Movement (MORENA), did well in the 2015 midterms and is currently leading in the polls ahead of the 2018 election (Chart 9). MORENA also did well in the State of Mexico, a PRI stronghold and Nieto's home state, in the June 4 election. The ruling PRI held the state for 90 years and is accused of election-rigging in order to, only narrowly, defeat an unknown MORENA candidate this year. Chart 9MORENA Has Lead In The Polls Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Given that the election is a year away, it is too soon to make a forecast. Nonetheless, it is clear that Obrador is the frontrunner for the presidency. There are three reasons why his election may be an over-hyped risk: The Congress: For much of Mexico's twentieth century history, the president was essentially a dictator due to the one-party rule of PRI. In the twenty-first century, however, Congress has become plural, forcing the president to cooperate with the body or see his reforms stalled. Given recent elections (Chart 10), it is highly unlikely that Obrador would have a congressional majority behind him, thus forcing him to temper his policies. Chart 10Mexico's Rising Political Plurality Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Update On Emerging Markets: Malaysia, Mexico, And The United States Of America The PAN-PRD Alliance: An unlikely alliance of the conservative National Action Party (PAN) and the center-left PRD has emerged as a reaction to the rise of MORENA in the polls. (These two parties have a history of cooperating against PRI presidents.) The two parties come from completely opposite ideological spectrums, but successfully joined forces in several state elections in 2016. It is unlikely that the two parties will unify sufficiently to field a single candidate - they failed to do so in the June 4 State of Mexico elections - but they may get enough votes to form a plurality in Congress. Mexicans do not lean left: Unlike most of Latin America, Mexico is a conservative country. Most Mexicans either think of themselves as centrist or lean right (Chart 11). While our data stops in 2015, the historical trend is clear: Mexico is a right-leaning country. As such, it is highly unlikely that AMLO will be able to manipulate the country's democratic institutions - which have been strengthened over the past twenty years - to turn Mexico into Venezuela. Chart 11Mexicans Lean Right Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Update On Emerging Markets: Malaysia, Mexico, And The United States Of America We would therefore fade any politically induced volatility in Mexican assets. Next year, investors should prepare to "sell the rumor and buy the news" (you read that right), as Mexican election fever grips the markets. Given current macroeconomic fundamentals, an entry point in Mexican assets may develop if they sell off ahead of the election - but they are not a buy at the moment. BCA's Emerging Market Strategy has pointed out in a recent report that:7 Inflation is well above the central bank's target and is broad based (Chart 12). Notably, wage growth is elevated (Chart 13). Given meager productivity growth, unit labor costs - calculated as wage-per-hour divided by productivity (output-per-hour) - are rising. This will depress companies' profit margins and make them eager to hike selling prices. This will, in turn, prevent inflation from falling and, consequently, hamper Banxico's ability to cut rates for now. Chart 12Inflation is Above Target Inflation is Above Target Inflation is Above Target Chart 13Wage Inflation Is High Wage Inflation Is High Wage Inflation Is High Meanwhile, the impact of higher interest rates will continue filtering through the economy. High interest rates entail a further slowdown in money and credit growth and, hence, in domestic demand. Both consumer spending and capital expenditure by companies are set to weaken a lot (Chart 14). This will weigh on corporate profits and share prices. Even though non-oil exports and manufacturing output are accelerating (Chart 15), non-oil exports - which make about 30% of GDP - are not large enough to offset the deceleration in domestic demand from monetary tightening. That said, the positive for Mexico is that the Mexican peso remains cheap (Chart 16) and may rally against other EM currencies. Our EM strategists suggest that investors should overweight MXN versus ZAR and BRL. Chart 14Domestic Demand to Buckle Domestic Demand to Buckle Domestic Demand to Buckle Chart 15Exports are Robust Exports are Robust Exports are Robust Chart 16Peso is Cheap Peso is Cheap Peso is Cheap If EM currencies depreciate or oil prices drop, it would be difficult to see MXN rally against the USD. However, MXN should outperform other currencies, especially given that political risks in Mexico are far lower than they are in Brazil and South Africa. Bottom Line: The Mexican markets may get AMLO-fever in 2018. Obrador is a clear frontrunner in the election to be held a year from now. However, AMLO will face off against constitutional, political, and societal constraints. As such, we would fade any politically induced risks in Mexican markets. Go strategically long MXN versus BRL and ZAR and look for an entry point into Mexican risk assets over the next 12 months. Malaysia: Hold Your Nose And Buy We have been broadly bearish on Malaysia since August 2015, but the upcoming elections - due by August 2018, but we expect to occur sooner rather than later - are likely to cause the markets to re-price Malaysian assets (Chart 17). The country's fundamentals are not rosy, and it remains vulnerable to a slowdown in China, a drop in commodities prices, and bad loans. Nevertheless, its underperformance is late, and this fact, combined with the political outlook, suggests that it will outperform for a while. Malaysia is in the midst of a long saga of party polarization that began amid the Asian Financial Crisis, when Prime Minister Mahathir Mohamad ousted his ambitious deputy, Anwar Ibrahim. Both men hailed from the dominant party of the country's ethnic Malay majority: the United Malay National Organization (UMNO), which is the center of Barisan Nasional (BN). The BN is a multi-ethnic coalition that has held power in one form or another since independence in 1957. Anwar went on to lead the reformasi (reform) movement, creating an opposition coalition of strange bedfellows: his own urban Malay People's Justice Party (PKR), the ethnic Chinese DAP, and the Islamist PAS. In the 2008 general elections, the opposition shocked the BN, depriving it of a two-thirds super-majority for the first time since 1969. In the 2013 general elections, the opposition won the popular vote, though BN retained control of parliament due to inherent advantages in the electoral system (Chart 18). Hence the past two elections, particularly the last one in 2013, have shaken the political system to the core. Since the 2013 shock, the opposition has had its sights set on the 2018 election, and a series of blows to the Najib government have given cause for hope. First, exports and commodity prices plunged from 2014 to 2016, damaging the economy and giving the opposition a grand opportunity to attack the administration (Chart 19). Second, Najib was personally implicated in a massive scandal involving 1MDB, a sovereign wealth fund that Najib helped create and from which he allegedly embezzled $700 million (!). Street protests emerged in 2015 and suddenly Najib faced a revolt from the old guard within his own party (including Mahathir himself). Chart 17Malaysian Underperformance Is Late Malaysian Underperformance Is Late Malaysian Underperformance Is Late Chart 18Opposition Threatens UMNO's Dominance Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Chart 19Commodities Should Help Malaysian Exports Commodities Should Help Malaysian Exports Commodities Should Help Malaysian Exports The problem for the opposition, however, is timing. The 2008 election occurred before the worst of the global financial crisis had been felt; the 2013 election occurred before the full impact of the commodity bust; and now the ruling coalition's fortunes are recovering in time for the upcoming election - which, of course, the prime minister schedules to his advantage. Thus, the opposition once again faces an uphill battle in this election cycle: The Malaysian economy has beaten expectations, growing by 5.6% in the first quarter of 2017, the fastest rate in two years. This was driven mainly by exports and the manufacturing sector (Chart 20). Money supply growth is strong while the credit impulse has bottomed and is approaching positive territory (Chart 21). The 1MDB scandal has mostly dissipated. Najib publicly confessed that the $700 million found in his personal account was a donation from a foreign government, and Saudi Arabian authorities confirmed this, prompting Najib to return the money. Malaysia's attorney general, anti-corruption commission, and central bank have all cleared Najib of wrongdoing, and his popular support has recovered from the fever pitch of the scandal in 2015-16, as demonstrated by the net-gain for BN in by-elections since 2013, and the fact that the BN saw its share of seats rise from 27% to 37% in the 2016 Sarawak State Assembly elections. This state's local elections have tended to foreshadow national elections, and it has the largest representation of any state in the national parliament (31/222). The opposition is split. Najib has courted the Islamist opposition party, PAS, peeling it away from the opposition coalition. Without PAS, the opposition falls from 89 seats in parliament to 71 seats, which is 41 shy of a majority. Even in the best case scenario for the opposition in the upcoming election, in which the opposition holds all seats from 2013 and Bersatu gains all of UMNO's seats in Kedah and Johor, the opposition would still fall 16 seats shy of a majority. Chart 20Growth Is Strong Growth Is Strong Growth Is Strong Chart 21Credit Cycle Is Picking Up Credit Cycle Is Picking Up Credit Cycle Is Picking Up Bottom Line: Our baseline case holds that Najib and BN will retain control of the government in the upcoming election on the back of the fading scandal, economic recovery, and a shrewd practice of dividing political enemies. What Does A Najib Win Mean? Is a Najib/BN victory positive for Malaysian risk assets? We think so, at least relative to other EMs. While Malaysia would benefit in the long run from breaking the BN's monopoly over parliament, the immediate consequence of an opposition victory would be confusion as the various opposition parties have widely divergent interests ... and zero governing experience. On the other hand, Najib's government has undertaken some significant reforms, expanded infrastructure, and improved government finances, making his corrupt and pseudo-authoritarian government not as market unfriendly as one might expect: As a result of weak commodities, cuts in subsidies, and the introduction of a goods and services tax (GST) and a tourism tax, Malaysia's fiscal deficit has improved from 5.5% in 2013, when Najib took office, to 3.1% today (Chart 22). The government is on a path to close the deficit by the end of the decade. The GST has allowed the government to reduce its dependency on oil revenues. Non-tax revenues, which include oil royalties, have decreased from 35% in 2010 to only 20% of total revenue, while indirect taxes (which include GST) have increased from 17% to 28% of revenue (Chart 23, top three panels). There are plans to increase the goods covered by the GST in the near future. The government has cut subsidies in fuel and cooking gas, taking advantage of low oil prices. The government had also eliminated subsidies in cooking oil and sugar. Subsidies as a percent of total expenditures have declined from almost 20% in 2014 to only 9% today (Chart 23, bottom panel). The government has expanded infrastructure, completing a mass rail transit extension in Kuala Lumpur, connecting the two East Malaysian states of Sabah and Sarawak via a 2,000 km highway, and attracting Chinese investment from the One Belt One Road program. The latter entails China building an East Coast Rail Link to connect the west and east coasts. Upon completion, this link will enable shippers to circumvent the port of Singapore and reach the South China Sea in a shorter time period. Chart 22Austerity Works Austerity Works Austerity Works Chart 23Tax Reforms Paid Off Tax Reforms Paid Off Tax Reforms Paid Off One perceived drawback of Najib's government is that in order to stay in power, he has had to court the Islamist PAS party, as mentioned above, specifically by allowing it to promote aspects of shariah law in the country's parliament. However, Malaysia is not at risk of being swept away by an imaginary rising tide of Islamic extremism. The country is very diverse, and Malay Muslims make up only a little more than half of the population. Malaysians are highly religious, but they are also highly tolerant, as they have lived among other races and religions since independence (Chart 24). Moreover, Islam is regulated and bureaucratized in Malaysia, which discourages the emergence of charismatic, anti-establishment religious leaders and the development of extremist movements. Finally, the government has an absolute need to win votes both in the Borneo states of Sabah and Sarawak, which have sizable Christian and non-Malay populations (adding up to more than half), and in the population centers of Kuala Lumpur and Penang. This means that it is not likely to allow PAS (or other Islamist movements) to go too far. Chart 24Malaysians Are Tolerant Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Bottom Line: Najib's government is corrupt and has authoritarian leanings, but has improved its management of the economy and public finances, and is not getting out of control with Islamism or populism. We would not expect a sustained market sell off in the face of a BN victory in upcoming polls. By contrast, if the opposition coalition wins a majority, it offers the long-term promise of a more inclusive and competitive political system that would be good for Malaysia, but would bring greater policy uncertainty in the short term. The opposition would likely have a low probability of achieving major reforms, as the BN party-state conglomerate would fight tooth and nail against it. A positive knee-jerk market response to an opposition win - on the expectation that "regime change" raises the probability of pro-market reforms - would likely be ephemeral. Investment Conclusion A key internal risk to the Malaysian economy stems from the country's fairly sizable debt, which may eventually become unsustainable. Yet at the moment, household and government debt are both rolling over even as growth is improving (Chart 25). A key external risk stems from China. Chinese politics are likely to shift from a tailwind for Chinese growth - fiscal stimulus and the need for stability ahead of the National Party Congress - to a headwind, as stimulus subsides and reforms are rebooted in 2018.8 We do not expect China's investment in Malaysia to fall sharply, since it is tied to a broad, long-term, strategic plan; nor do we see Malaysia as overexposed to Chinese imports or tourism. Nevertheless, Malaysia would suffer to some extent, and it is indirectly vulnerable as Malaysian exports to ASEAN and tourists from ASEAN are significant, and ASEAN would suffer from a Chinese slowdown. In short, China is a risk, albeit not as direct or major as one might think. The Malaysian ringgit has already become the best-performing currency this year. Yet this recent appreciation has not come near to reversing the currency's roughly 20% depreciation since 2014. A cheap currency, combined with robust external demand, should be a tailwind for Malaysian exports and the broader economy (Chart 26). Moreover, the rising price of key Malaysian exports like energy and palm oil should be positive for Malaysian equities (Chart 27). Chart 25Debt Is High, But Is Rolling Over Debt Is High, But Is Rolling Over Debt Is High, But Is Rolling Over Chart 26Cheap Currency Is A Tailwind For Exports Cheap Currency Is A Tailwind For Exports Cheap Currency Is A Tailwind For Exports Chart 27Commodities Support Equity Prices Commodities Support Equity Prices Commodities Support Equity Prices At the same time, valuations are attractive. Malaysian equities have underperformed the EM universe and its ASEAN peers since 2013 (see Chart 17 above). Malaysian equities have lost considerable value relative to their EM peers, and are trading at a discount relative to ASEAN peers. Compared to historical valuations, Malaysian equities are also trading at a discount (Chart 28 A and B). Chart 28aMalaysia Is Cheap Compared To Peers... Malaysia Is Cheap Compared To Peers... Malaysia Is Cheap Compared To Peers... Chart 28b...And Its Historical Valuation ...And Its Historical Valuation ...And Its Historical Valuation Bottom Line: The likely start of a new credit cycle, improving government finances, a persistently cheap currency, and the likelihood of an acceptable policy status quo should put a tailwind behind Malaysian risk assets. We recommend going long Malaysian equities relative to their EM peers. Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Stephan Gabillard, Senior Analyst Emerging Markets Strategy stephang@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "How Long Can The 'Trump Put' Last?" dated June 14, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," dated May 31, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Will Congress Pass The Border Adjustment Tax?," dated February 8, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 7 Please see BCA Emerging Market Strategy Weekly Report, "The Case For A Major Top In EM," dated July 12, 2017, available at ems.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com.

Highlights Investors are becoming less concerned about China's growth outlook, but there is no sign of euphoria. Monitor three risk factors that could disrupt the positive growth outlook and the bull market in Chinese stocks. For now, the risks appear reasonably contained, and the lack of a complacency in the marketplace means it is too early to bet against the herd. Remain positive and stay invested. Feature The latest purchasing managers surveys released early this week confirm that the Chinese economy remains buoyant. The manufacturing and service PMIs from both official and private sources remain comfortably in expansionary territory, and there are no signs of a material deterioration from the readings of the sub-indices. Improving growth also appears to be reflected in the stock market. Chinese investable equities have rallied by over 30% so far this year, beating the major global and EM benchmarks (Chart 1). Despite the improvement in the growth numbers and the rally in stock prices, there is no sign of euphoria among investors with respect to China. On the contrary, Chinese stocks' multiples are still among the lowest of the major global bourses (Chart 2). Importantly, ETFs investing in Chinese assets are still witnessing net redemptions: China-focused ETFs listed in the U.S. and Hong Kong have been witnessing constant net capital outflows since 2013 (Chart 3). Even in the first half of this year, these ETFs have continued to lose capital despite rising stock prices - which means retail investors have not participated in the rally. Attractive valuations and lack of "irrational exuberance" suggest the rally in Chinese investable stocks should have further to run. Chart 1Chinese Equities Have Outperformed... Chinese Equities Have Outperformed... Chinese Equities Have Outperformed... Chart 2...But Still With Much Lower Multiples ...But Still With Much Lower Multiples ...But Still With Much Lower Multiples Chart 3... And Net ETF Redemptions China: What Could Go Wrong? China: What Could Go Wrong? Overall, we remain positive on both Chinese equities and the economy's cyclical outlook, and see limited downside risks in the near term, as discussed in detail in recent weeks.1 However, as growth and stock market performance have been largely in line with our expectations, it is always useful to reflect on risk factors. We see three potential risks that could upset the economy and the ongoing rally in Chinese stocks that need to be closely monitored. Will The Trump Wildcard Strike Again? There are increasing signs that tensions between the U.S. and China are on the rise again after a period of relative tranquility. The first round of U.S.-China Comprehensive Economic Dialogue (CED) resulted in no material progress or concrete plans to improve bilateral trade imbalances. U.S. President Donald Trump has continued to pull "China hawks" into his trade policy team, naming Dennis Shea, well known for being highly critical of China's trade practices, as deputy U.S. Trade Representative. Furthermore, the U.S. State Department recently approved a major weapon package to Taiwan, the first arms sales to the Island since 2015. More recently, President Trump has openly accused China of not helping deal with the North Korea nuclear issue after the country tested an intercontinental ballistic missile (ICBM) that it claims can reach continental America. In addition, the Trump administration is reportedly planning trade measures to force Beijing to crack down on intellectual-property theft and ease requirements that American companies share advanced technologies to gain entry to the Chinese market. Overall, it is widely viewed that the brief "honeymoon" in U.S.-China relations following the April Summit between the leaders of the two countries has decisively ended, and the odds for protectionism tactics against Chinese products have increased. The "Trump wildcard" has always been a key risk with respect to our outlook for China2 - the latest developments suggest this risk remains firmly in place. President Trump and his inner circle appear genuinely convinced that punitive tactics could solve the country's chronic trade deficit. Moreover, President Trump has been increasingly bogged down by domestic policy, and he may lash out on the international front in an effort to boost his popularity. Furthermore, the U.S. President has few legal constitutional constraints to using tariffs against trade partners, giving him maneuvering room. From a big-picture perspective, the conflict between the U.S. and China has deep ideological and geopolitical roots, which are even harder to deal with than trade issues. Chart 4Steel Is No Longer Relevant For ##br##U.S.-China Trade China: What Could Go Wrong? China: What Could Go Wrong? Nonetheless, we maintain our guarded optimism that unilateral protectionism measures will not materially undermine Chinese exports, at least in the near term. On the U.S. side, even though President Trump has toughened his rhetoric on China and trade issues of late, it is still far less extreme compared to the promises he made on the campaign trail, in which he pledged to slap a 45% tariff on all imports from China and to label the country a currency manipulator on "day one." So far, the U.S. administration has mainly been focusing on specific industries, particularly steel, rather than broad-based tariffs, the impact of which should be marginal. For example, China accounts for only 3% of American steel imports. Sales to the U.S. account for less than 1% of China's massive steel output (Chart 4). In other words, steel appears to be a highly symbolic sector in Trump's trade policy, but the real impact on China-U.S. trade is negligible. On the Chinese side, the authorities have hard-drawn redlines on political and sovereign issues, but have much greater flexibility on trade-related issues. Chinese officials understand that the country's large surplus with the U.S. puts it at a near-term disadvantage in a trade war, and therefore will likely cave to pressure from the U.S. Moreover, the sectors that President Trump has been complaining about, namely steel and some other base metals, are the same sectors the Chinese government wants to restrict. Therefore, China will not fight for its own "out of favor" industries to disrupt the broader picture in exports. Taken together, President Trump's trade policy has once again become unpredictable, and some punitive measures on specific products appear likely in the near term. However, we still assign low odds of a drastic escalation in trade frictions, and we expect the Chinese authorities to refrain from tit-for-tat retaliation that could lead to a trade war. Protectionism risks, however, will remain a long-term structural issue that complicates the global trade and growth outlook. Deflationary Pressures And The Risk Of Policy Overkill? Chart 5Headline CPI Is Set To Drop Further Headline CPI Is Set To Drop Further Headline CPI Is Set To Drop Further A key feature of the Chinese economy is strong disinflationary/deflationary pressures, despite robust growth and job creation. Headline inflation to be released next week will likely once again surprise to the downside, mainly due to food prices (Chart 5). Wholesale prices of agricultural products have weakened substantially in recent months, pointing to sharply lower food CPI. Core CPI remains around 1%, underscoring incredibly low inflationary pressures. The key challenge for the Chinese authorities is figuring out how to manage economic policies to achieve the delicate balance between growth and disinflation/deflation. We have long viewed that one of the critical reasons behind China's sharp growth deterioration between 2012 and 2015 was a policy mistake, in which the authorities allowed monetary conditions to tighten dramatically. We are hopeful that the authorities have realized the cost of policy overkill, and will avoid similar mistakes down the road, but the risk certainly cannot be dismissed entirely. For now, we see low odds of policy overkill that could lead to price deflation and negative growth surprises. First, as growth has improved, some policy tightening is warranted. The authorities recently reported that the economy added 7.35 million new jobs in the first half of the year, far exceeding the government's target, pushing the registered urban unemployment rate to 3.95%, the lowest in recent years. In fact, the People's Bank of China may still be behind the curve, meaning that further tightening is simply a "catch-up" and is not immediately restrictive. Chart 6Another Sharp Rally ##br##In The Trade Weighted RMB is Unlikely Another Sharp Rally In The Trade Weighted RMB is Unlikely Another Sharp Rally In The Trade Weighted RMB is Unlikely Second, a major factor behind China's drastic tightening in monetary conditions in previous years was the sharp rally in the trade-weighted RMB, which appreciated by almost 30% between mid-2011 and early/late 2015 - a massive deflationary shock to Chinese exporters (Chart 6). Looking forward, it is extremely unlikely that the PBoC will allow the RMB to rise by a similar magnitude anytime soon. Finally, from investors' perspective, producer output prices are more important to watch for pricing power and profitability. On this front, PPI inflation has also rolled over and will likely continue to downshift, but will not turn to outright deflation in our view. It is important to note that the sharp decline in producer prices in previous years was due to a multi-year deterioration in Chinese growth, which has historically been an anomaly. The only other period in China's post-reform history with falling PPI happened in the late 1990s in the aftermath of the Asian crisis (Chart 7). In other words, falling PPI only occurs under rather extreme growth difficulties. Our model suggests that PPI inflation may decelerate to 3% by year end. Our PPI diffusion index, which measures the percentage of industrial sectors experiencing rising prices, suggests the majority of sectors are still witnessing higher prices both compared with previous months and a year ago (Chart 8). We are monitoring the PPI diffusion index closely to heed a leading signal on corporate pricing power and overall deflationary pressures in the corporate sector. Chart 7Producer Prices: A Historical Perspective Producer Prices: A Historical Perspective Producer Prices: A Historical Perspective Chart 8PPI Watch PPI Watch PPI Watch Bottom Line: A policy mistake of overtightening by the Chinese authorities remains a key threat to the near-term growth outlook, but is not our base case scenario. The Resumption Of The Dollar Bull Market? The U.S. dollar has rapidly dropped out of favor among global investors. The dollar index has fallen by 10% so far this year, the weakest among the major currencies. The weak U.S. dollar has provided a Goldilocks scenario for both the Chinese economy and financial markets: a weaker dollar depreciates the RMB in trade-weighted terms, which is reflationary for the Chinese economy. For investors, the broad dollar weakness also alleviates downward pressure on the CNY/USD, and a stable CNY/USD in turn reduces investors' anxiety on China's macro conditions, pushing up stock prices. This Goldilocks scenario could once again be disrupted if the dollar bull market resumes, and the positive feedback loop goes into reverse. A stronger dollar tends to strengthen the trade-weighted RMB, which is bad news for exporters. Meanwhile, it could rekindle downward pressure on the CNY/USD, re-intensifying domestic capital outflows, which could be viewed as a sign of China's macro troubles. Fears of an economic hard landing would quickly resurface. In our view, Chinese stocks are more vulnerable if the dollar's strength resumes, but the real damage on the broader economy should not be material. It is highly unlikely that Chinese policymakers would allow the trade-weighted RMB to rise alongside the dollar, and will tighten capital account controls to stop domestic capital flight. Chinese equities will suffer in this scenario, as investors' risk aversion increases. However, so long as the Chinese economy and corporate profits do not suffer a major relapse, the rally in stocks should eventually resume. All in all, the three risk factors should be closely monitored in the coming months, especially if investors become increasingly comfortable with the Chinese growth outlook. For now, the risks appear reasonably contained, and the lack of a complacency in the marketplace means it is too early to bet against the herd. We remain positive on Chinese growth, and favor Chinese equites both in absolute terms and against global/EM benchmarks. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Reports, "China Outlook: A Mid-Year Revisit", dated July 13, 2017, "Rising Odds Of PBoC Rate Hikes", dated July 20, 2017, and Special Report, "Focusing On Chinese Money Supply", dated July 27, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China: The 2017 Outlook, And The Trump Wildcard", dated January 12, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

This week we are sending you two Special Reports (both included in this document) that were previously published in the May and June editions of The Bank Credit Analyst. Both reports discuss the long-term outlook for global bond yields. The first report emphasizes the importance of demographics and the second focuses on the outlook for productivity growth. We are also sending a Weekly Report published jointly by our Global Fixed Income Strategy and U.S. Bond Strategy services. Highlights The fundamental drivers of the low rate world are considered by many to be structural, and thus likely to keep global equilibrium bond yields quite depressed by historical standards for years to come. However, some of the factors behind ultra-low interest rates have waned, while others have reached an inflection point. The age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool. Global investment needs will wane along with population aging, but the majority of the effect on equilibrium interest rates is in the past. In contrast, the demographic effects that will depress desired savings are still to come. The net impact will be bond-bearish. Moreover, the massive positive labor supply shock, following the integration of China and Eastern Europe into the world's effective labor force, is over. Indeed, this shock is heading into reverse as the global working-age population ratio falls. This may improve labor's bargaining power, sparking a shift toward using more capital in the production process and thereby placing upward pressure on global real bond yields. It is too early to declare globalization dead, but the neo-liberal trading world order that has been in place for decades is under attack. This could be inflationary if it disrupts global supply chains. Anti-globalization policies could paradoxically be positive for capital spending, at least for a few years. As for China, the fundamental drivers of its savings capacity appear to rule out a return to the days when the country was generating a substantial amount of excess savings. Technological advance will remain a headwind for real wage gains, but at least the transition to a world that is less labor-abundant will boost workers' ability to negotiate a larger share of the income pie. We are not making the case that real global bond yields are going to quickly revert to pre-Lehman averages. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations for bond yields are too low. Investors should have a bond-bearish bias on a medium- and long-term horizon. Feature In the September 2016 The Bank Credit Analyst, we summarized the key drivers behind the major global macroeconomic disequilibria that have resulted in deflationary pressure, policy extremism, dismal productivity, and the lowest bond yields in recorded history (Chart I-1). The disequilibria include income inequality, the depressed wage share of GDP, lackluster capital spending, and excessive savings. Chart I-1Global Disequilibria Beware Inflection Points In The Secular Drivers Of Global Bonds Beware Inflection Points In The Secular Drivers Of Global Bonds The fundamental drivers of the low bond yield world are now well documented and understood by investors. These drivers generally are considered to be structural, and thus likely to keep global equilibrium bond yields and interest rates at historically low levels for years to come according to the consensus. Based on discussions with BCA clients, it appears that many have either "bought into" the secular stagnation thesis or, at a minimum, have adopted the view that growth headwinds preclude any meaningful rise in bond yields. However, bond investors might have been lulled into a false sense of security. Yields will not return to pre-Lehman norms anytime soon, but some of the factors behind the low-yield world have waned, while others have reached an inflection point. Most importantly, the age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool. We have reached the tipping point. Equilibrium real bond yields will gradually move higher as a result. But before we discuss what is changing, it is important to review the drivers of today's macro disequilibria. Several of them predate the Great Financial Crisis, including demographic trends, technological advances, and the integration of China's massive workforce and excess savings into the global economy. Ultra-Low Rates: How Did We Get Here? (A) Demographics And Global Savings The so-called Global Savings Glut has been a bullish structural force for bonds for the past couple of decades. We won't go through all of the forces behind the glut, but a key factor is population aging in the advanced economies. Ex-ante desired savings rose as baby boomers entered their high-income years. The Great Financial Crisis only served to reinforce the desire to save, given the setback in the value of boomers' retirement nest eggs.1 The corporate sector also began to save more following the crisis. Chart I-2Global Shifts In The Saving ##br##And Investment Curves Beware Inflection Points In The Secular Drivers Of Global Bonds Beware Inflection Points In The Secular Drivers Of Global Bonds Even more importantly, the surge in China's trade surplus since the 1990s had to be recycled into the global pool of savings. While China's rate of investment was very high, its propensity to save increased even faster, resulting in a swollen external surplus and a massive net outflow of capital. Other emerging economies also made the adjustment from net importers of capital to net exporters following the Asian crisis in the late 1990s. By leaning into currency appreciation, these countries built up huge foreign exchange reserves that had to be recycled abroad. In theory, savings must equal investment at the global level and real interest rates shift to ensure this equilibrium (Chart I-2). China's excess savings, together with a greater desire to save in the developed countries, represented a shift in the saving schedule to the right. The result was downward pressure on global interest rates. (B) Demographics And Global Capital Spending Demographics and China's integration also affected the investment side of the equation. A slower pace of labor force growth in the developed countries resulted in a permanently lower level of capital spending relative to GDP. Slower consumer spending growth, as a result of a more moderate expansion in the working-age population, meant a reduced appetite for new factories, malls, and apartment buildings. Chart I-3 shows that the growth rate of global capital spending that is required to maintain a given capital-to-output ratio has dropped substantially, due to the dramatic slowdown in the growth of the world's working-age population.2 Keep in mind that this estimate refers only to the demographic component of investment spending. Actual capital expenditure growth will not be as weak as Chart I-3 suggests because firms will want to adopt new technologies for competitive or environmental reasons. Nonetheless, the point is that the structural tailwind for global capex from the post-war baby boom has disappeared. Chart I-3Demographics Are A Structural Headwind For Global Capex Beware Inflection Points In The Secular Drivers Of Global Bonds Beware Inflection Points In The Secular Drivers Of Global Bonds (C) Labor Supply Shock And Global Capital Spending While the working-age population ratio peaked in the developed countries years ago, it is a different story at the global level (Chart I-4). The integration of the Chinese and Eastern European workforces into the global labor pool during the 1990s and 2000s resulted in an effective doubling of global labor supply in a short period of time. Relative prices must adjust in the face of such a large boost in the supply of labor relative to capital. The sudden abundance of cheap labor depressed real wages from what they otherwise would have been, thus incentivizing firms to use more labor and less capital at the margin. The combination of slower working-age population growth in the advanced economies and a surge in the global labor force resulted in a decline in desired global capital spending. In terms of Chart I-2, the leftward shift of the investment schedule reinforced the impact of the savings impulse in placing downward pressure on global interest rates. (D) Labor Supply Shock And Income Inequality The wave of cheap labor also aggravated the trend toward greater inequality in the advanced economies and the downward trend in labor's share of the income pie (Chart I-5). Chart I-4Working-Age Population Ratios Have Peaked Working-Age Population Ratios Have Peaked Working-Age Population Ratios Have Peaked Chart I-5Labor Share Of Income Has Dropped Labor Share Of Income Has Dropped Labor Share Of Income Has Dropped In theory, a surge in the supply of labor is a positive "supply shock" that benefits both developed and developing countries. However, a recent report by David Autor and Gordon Hanson3 highlighted that trade agreements in the past were incremental and largely involved countries with similar income levels. The sudden entry of China to the global trade arena, involving a massive addition to the effective global stock of labor, was altogether different. The report does not argue that trade has become a "bad" thing. Rather, it points out that the adjustment costs imposed on the advanced economies were huge and long-lasting, as Chinese firms destroyed entire industries in developed countries. Chart I-6Hollowing Out Hollowing Out Hollowing Out The lingering adjustment phase contributed to greater inequality in the major countries. Management was able to use the threat of outsourcing to gain the upper hand in wage negotiations. The result has been a rise in the share of income going to high-income earners in the Advanced Economies, at the expense of low- and middle-income earners (Chart I-6). The same is true, although to a lesser extent, in the emerging world. Greater inequality, in turn, has weighed on aggregate demand and equilibrium interest rates because a larger share of total income flowed to the "rich" who tend to save more than the low- and middle-income classes. (E) The Dark Side Of Technology Advances in technology also contributed to rising inequality. In theory, new technologies hurt some workers in the short term, but benefit most workers in the long run because they raise national income. However, there is evidence that past major technological shocks were associated with a "hollowing out" or U-shaped pattern of employment. Low- and high-skilled employment increased, but the proportion of mid-skilled workers tended to shrink. Wages for both low- and mid-skilled labor did not keep up with those that were highly-skilled, leading to wider income disparity. Today, technology appears to be resulting in faster, wider and deeper degrees of hollowing-out than in previous periods of massive technological change. This may be because machines are not just replacing manual human tasks, but cognitive ones too. A recent IMF report made the case that technology and global integration played a dominant role in labor's declining fortunes. Technology alone explains about half of the drop in the labor share of income in the developed countries since 1980.4 Falling prices for capital goods, information and communications technology in particular, have facilitated the expansion of global value chains as firms unbundled production into many tasks that were distributed around the world in a way that minimized production costs. Chart I-7 highlights that the falling price of capital goods in the advanced economies went hand-in-hand with rising participation in global supply chains since 1990. Falling capital goods prices also accelerated the automation of routine tasks, contributing especially to job destruction in the developed (high-wage) economies. In other words, firms in the developed world either replaced workers with machinery in areas where technology permitted, or outsourced jobs to lower-wage countries in areas that remained labor-intensive. Both trends undermined labor's bargaining power, depressed labor's share of income, and contributed to inequality. The effects of technology, global integration, population aging and China's economic integration are demonstrated in Chart I-8. The world working-age-to-total population ratio rose sharply beginning in the late 1990s. This resulted in an upward trend in China's investment/GDP ratio, and a downward trend in the G7. The upward trend in the G7 capital stock-per-capita ratio began to slow as a result, before experiencing an unprecedented contraction after the Great Recession and Financial Crisis. Chart I-7Economic Integration And ##br##Falling Capital Goods Prices Economic Integration And Falling Capital Goods Prices Economic Integration And Falling Capital Goods Prices Chart I-8Macro Impact Of ##br##Labor Supply Shock Macro Impact Of Labor Supply Shock Macro Impact Of Labor Supply Shock The result has been a deflationary global backdrop characterized by demand deficiency and poor potential real GDP growth, both of which have depressed equilibrium global interest rates over the past 20 to 25 years. Transition Phase It would appear easy to conclude that these trends will be with us for another few decades because the demographic trends will not change anytime soon. Nonetheless, on closer inspection the global economy is transitioning from a period when cyclical economic pressures and all of the structural trends were pushing equilibrium interest rates in the same direction, to a period in which the economic cycle is becoming less bond-friendly and some of the secular drivers of low interest rates are gradually changing direction. First, the massive labor supply shock of the past few decades is over. The world working-age population ratio has peaked according to United Nations estimates. This ratio is already declining in the major advanced economies and is in the process of topping out in China. The absolute number of working-age people will shrink in China and the G7 countries over the next five years, although it will continue to grow at a low rate for the world as a whole (Chart I-9). Unions are unlikely to make a major comeback, but a backdrop that is less labor-abundant should gradually restore some worker bargaining power, especially as economies regain full employment. The resulting upward pressure on real wages will support capital spending as firms substitute toward capital and away from (increasingly expensive) labor. Consumer demand will also receive a boost if inequality moderates and the labor share of income begins to rise. Globalization On The Back Foot Second, it is too early to declare globalization dead, but the neo-liberal trading world order that has been in place for decades is under attack. Global exports appear to have peaked relative to GDP and average tariffs have ticked higher (Chart I-10). The World Trade Organization has announced that the number of new trade restrictions or impediments outweighed the number of trade liberalizing initiatives in 2016. The U.K. appears willing to sacrifice trade for limits to the free movement of people. The new U.S. Administration has ditched the Trans-Pacific Partnership (TPP) and is threatening to impose punitive tariffs on some trading partners. Chart I-9Working-Age Population To Shrink In G7 And China Working-Age Population To Shrink in G7 and China Working-Age Population To Shrink in G7 and China Chart I-10Globalization Peaking? Globalization Peaking? Globalization Peaking? Anti-globalization policies could paradoxically be positive for capital spending, at least for a few years. If the U.S. were to impose high tariffs on China, for example, it would make a part of the Chinese capital stock redundant overnight. In order for the global economy to produce the same amount of goods and services as before, the U.S. and other countries would need to invest more. Any unwinding of globalization would also be inflationary as it would disrupt international supply chains. Demographics And Saving: From Tailwind To Headwind... Chart I-11Income And Consumption By Age Cohort Income And Consumption By Age Cohort Income And Consumption By Age Cohort Third, the impact of savings in the major advanced economies and China on global interest rates will change direction as well. In the developed world, aggregate household savings will come under downward pressure as boomers increasingly shift into retirement. Economists are fond of employing the so-called life-cycle theory of consumer spending. According to this theory, consumers tend to smooth out lifetime spending by accumulating assets during the working years in order to maintain a certain living standard after retirement. The U.N. National Transfer Accounts Project has gathered data on spending and labor income by age cohort at a point in time. Chart I-11 presents the data for China and three of the major advanced economies. The data for the advanced economies suggest that spending tends to rise sharply from a low level between birth and about 15 years of age. It continues to rise, albeit at a more modest pace, through the working years. Other studies have found that consumer spending falls during retirement. Nonetheless, these studies generally include only private spending and therefore do not include health care that is provided by the government. The data presented in Chart I-11 show that, if government-provided health care is included, personal spending rises sharply toward the end of life. The profile is somewhat different in China. Spending rises quickly from birth to about 20 years of age, and is roughly flat thereafter. Indeed, consumption edges lower after 75-80 years of age. These data allow us to project the impact of changing demographics on the average household saving rate in the coming years, assuming that the income and spending profiles shown in Chart I-11 are unchanged. We start by calculating the average saving rate across age cohorts given today's age structure. We then recalculate the average saving rate each year moving forward in time. The resulting saving rate changes along with the age structure of the population. The results are shown in Chart I-12. The saving rates for all four economies have been indexed at zero in 2016 for comparison purposes. The aggregate saving rate declines in all cases, falling between 4 and 8 percentage points between 2016 and 2030. Germany sees the largest drop of the four countries. Chart I-12Aging Will Undermine Aggregate Saving Aging Will Undermine Aggregate Saving Aging Will Undermine Aggregate Saving The simulations are meant to be suggestive, rather than a precise forecast, because the savings profile across age cohorts will adjust over time. Moreover, governments will no doubt raise taxes to cover the rising cost of health care, providing a partial offset in terms of the national saving rate.5 Nonetheless, the simulations highlight that the major economies are past the point where the baby boom generation is adding to the global savings pool at a faster pace than retirees are drawing from it. The age structure in the major advanced economies is far enough advanced that the rapid increase in the retirement rate will place substantial downward pressure on aggregate household savings in the coming years. It is well known that population aging will also undermine government budgets. Rising health care costs are already captured in our household saving rate projection because the data for household spending includes health care even if it is provided by the public sector. However, public pension schemes will also be a problem. To the extent that politicians are slow to trim pension benefits and/or raise taxes, public pension plans will be a growing drain on national savings. Could younger, less developed economies offset some of the demographic trends in China and the Advanced Economies? Numerically speaking, a more effective use of underutilized populations in Africa and India could go a long way. Nevertheless, deep-seated structural problems would have to be addressed and, even then, it is difficult to see either of these regions turning into the next "China story" given the current backlash against globalization and immigration. ...And The Capex Story Is Largely Behind Us Demographic trends also imply less capital spending relative to GDP, as discussed above. In terms of the impact on global equilibrium interest rates, it then becomes a race between falling saving and investment rates. Some analysts point to the Japanese experience because it is the leading edge in terms of global aging. Bond yields have been extremely low for many years even as the household saving rate collapsed, suggesting that ex-ante investment spending shifted by more than ex-ante savings. Nonetheless, Japan may not be a good example because the deterioration in the country's demographics coincided with burst bubbles in both real estate and stocks that hamstrung Japanese banks for decades. A series of policy mistakes made things worse. Economic theory is not clear on the net effect of demographics on savings and investment. The academic empirical evidence is inconclusive as well. However, a detailed IMF study of 30 OECD countries analyzed the demographic impact on a number of macroeconomic variables, including savings and investment.6 They estimated separate demographic effects for the old-age dependency ratio and the working-age population ratio. Applying the IMF's estimated model coefficients to projected changes in both of these ratios over the next decade suggests that the decline in ex-ante savings will exceed the ex-ante drop in capex requirements by about 1 percentage point of GDP. This is a non-trivial shift. Moreover, our simulations highlight that timing is important. The outlook for the household saving rate depends on the changing age structure of the population and the distribution of saving rates across age cohorts. Thus, the average saving rate will trend down as populations continue to age over the coming decades. In contrast, the impact of demographics on capital spending requirements is related to the change in the growth rate of the working-age population. Chart I-13 once again presents our estimates for the demographic component of capital spending. The top panel presents the world capex/GDP ratio that is necessary to maintain a constant capital/output ratio, and the bottom panel shows the change in that ratio. The important point is that the downward adjustment in world capex/GDP related to aging is now largely behind us because most of the deceleration in the growth rate of the working-age population is done. This is in contrast to the household saving rate adjustment where all of the adjustment is still to come. China Is Transitioning Too China must be treated separately from the developed countries because of its unique structural issues. As discussed above, household savings increased dramatically beginning in the mid-1990s (Chart I-14). This trend reflected a number of factors, including: Chart I-13Demographics And Capex Requirements Beware Inflection Points In The Secular Drivers Of Global Bonds Beware Inflection Points In The Secular Drivers Of Global Bonds Chart I-14China's Savings Rates Have Peaked... China's Savings Rates Have Peaked... China's Savings Rates Have Peaked... the rising share of the working-age population; a drop in the fertility rate, following the introduction of the one-child policy in the late 1970s that allowed households to spend less on raising children and save more for retirement; health care reform in the early 1990s required households to bear a larger share of health care spending; and job security was also undermined by reform of the state-owned enterprises (SOE) in the late 1990s, leading to increased precautionary savings to cover possible bouts of unemployment. These savings tailwinds have turned around in recent years and the household saving rate appears to have peaked. China's contribution to the global pool of savings has already moderated significantly, as measured by the current account surplus. The surplus has withered from about 9% in 2008 to 2½% in 2016. A recent IMF study makes the case that China's national saving rate will continue to decline. The IMF estimates that for every one percentage-point rise in the old-age dependency ratio, the aggregate household saving rate will fall by 0.4-1 percentage points. In addition, the need for precautionary savings is expected to ease along with improvements in the social safety net, achieved through higher government spending on health care. The household saving rate will fall by three percentage points by 2021 according to the IMF (Chart I-15). Competitive pressure and an aging population will also reduce the saving rates of the corporate and government sectors. Chart I-15...Suggesting That External Surplus Will Shrink ...Suggesting That External Surplus Will Shrink ...Suggesting That External Surplus Will Shrink Of course, investment as a share of GDP is projected to moderate too, reflecting a rebalancing of the economy away from exports and capital spending toward household consumption. The IMF expects that savings will moderate slightly faster than investment, leading to a narrowing in the current account surplus to almost zero by 2021. A lot of assumptions go into this type of forecast such that we must take it with a large grain of salt. Nonetheless, the fundamental drivers of China's savings capacity appear to rule out a return to the days when the country was generating a substantial amount of excess savings. Moreover, a return to large current account surpluses would likely require significant currency depreciation, which is a political non-starter given U.S. angst over trade. The risk is that China's excess savings will be less, not more, in five year's time. Tech Is A Wildcard It is extremely difficult to forecast the impact of technological advancement on the global economy. We cannot say with any conviction that the tech-related effects of "hollowing out", "winner-take-all" and the "skills premium" will moderate in the coming years. Nonetheless, these effects have occurred alongside a surge in the world's labor force and rapid globalization of supply chains, both of which reinforced the erosion of employee bargaining power. Looking ahead, technology will still be a headwind for some employees, but at least the transition from a world of excess labor to one that is more labor-scarce will boost workers' ability to negotiate a larger share of the income pie. We will explore the impact of technology on productivity, inflation, growth, and bond yields in a companion report to be published in the next issue. Conclusion: The main points we made in this report are summarized in Table I-1. All of the structural factors driving real bond yields were working in the same (bullish) direction over the past 30-40 years. Looking ahead, it is uncertain how technological improvement will affect bond prices, but we expect that the others will shift (or have already shifted) to either neutral or outright bond-bearish. Table I-1Key Secular Drivers Beware Inflection Points In The Secular Drivers Of Global Bonds Beware Inflection Points In The Secular Drivers Of Global Bonds No doubt, our views that globalization and inequality have peaked, and that the labor share of income has bottomed, are speculative. These factors may not place much upward pressure on equilibrium yields. Nonetheless, it seems likely that the demographic effect that has depressed capital spending demand is well advanced. We see it shifting from a positive factor for bond prices to a neutral factor in the coming years. It is also clear that the massive positive labor supply shock is over, and is heading into reverse as the global working-age population ratio falls. This may improve labor's bargaining power and the resulting boost consumer spending will be negative for bonds. This may also spark a shift toward using more capital in the production process and thereby place additional upward pressure on global real bond yields. Admittedly, however, this last point requires more research because theory and empirical evidence on it are not clear. Perhaps most importantly, the aging of the population in the advanced economies has reached a tipping point; retirees will drain more from the pool of savings than the working-age population will add to it in the coming years. We have concentrated on real equilibrium bond yields in this report because it is the part of nominal yields that is the most depressed relative to historical norms. The inflation component is only a little below a level that is consistent with central banks meeting their 2% inflation targets in the medium term. There is a risk that inflation will overshoot these targets, leading to a possible surge in long-term inflation expectations that turbocharges the bond bear market. This is certainly possible, as highlighted by a recent Global Investment Strategy Quarterly Strategy Outlook.7 Pain in bond markets would be magnified in this case, especially if central banks are forced to aggressively defend their targets. Please note that we are not making the case that real global bond yields will quickly revert to pre-Lehman averages. It will take time for the bond-bullish structural factors to unwind. It will also take time for inflation to gain any momentum, even in the United States. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations suggest that investors have adopted an overly benign view on the outlook for yields. For example, implied real short-term rates remain negative until 2021 in the U.S. and 2026 in the Eurozone, while they stay negative out to 2030 in the U.K. (Chart I-16). We doubt that short-term rates will be negative for that long, given the structural factors discussed above. Another way of looking at this is presented in Chart I-17. The market expects the 10-year Treasury yield in ten years to be only slightly above today's spot yield, which itself is not far above the lowest levels ever recorded. Market expectations are equally depressed for the 5-year forward rate for the U.S. and the other major economies. Chart I-16Market Expects Negative Short-Term Rates For A Long Time Market Expects Negative Short-Term Rates For A Long Time Market Expects Negative Short-Term Rates For A Long Time Chart I-17Forward Rates Very Low Vs. History Forward Rates Very Low Vs. History Forward Rates Very Low Vs. History The implication is that investors should have a bond-bearish bias on a medium- and long-term horizon. Mark McClellan, Senior Vice President The Bank Credit Analyst MarkM@bcaresearch.com 1 It is true that observed household savings rates fell in some of the advanced economies, such as the United States, at a time when aging should have boosted savings from the mid-1990s to the mid-2000s. This argues against a strong demographic effect on savings. However, keep in mind that we are discussing desired (or ex-ante) savings. Ex-post, savings can go in the opposite direction because of other influencing factors. As discussed below, global savings must equal investment, which means that shifts in desired capital spending demand matter for the ex-post level of savings. 2 Arithmetically, if world trend GDP growth slows by one percentage point, then investment spending would need to drop by about 3½ percentage points of GDP to keep the capital/output ratio stable. 3 David H. Autor, David Dorn, and Gordon H. Hanson, "The China Shock: Learning from Labor Market Adjustment to Large Changes in Trade," Annual Review of Economics, Vol. 8, pp. 205-240 (October 2016). 4 Please see "Understanding The Downward Trend In Labor Income Shares," Chapter 3 in the IMF World Economic Outlook (April 2017). 5 In other words, while the household savings rate, as defined here to include health care spending by governments on behalf of households, will decline, any associated tax increases will blunt the impact on national savings (i.e. savings across the household, government and business sectors). 6 Jong-Won Yoon, Jinill Kim, and Jungjin Lee, "Impact Of Demographic Changes On Inflation And The Macroeconomy," IMF Working Paper no. 14/210 (November 2014). 7 Please see Global Investment Strategy, "Strategy Outlook: Second Quarter 2017: A Three Act Play," dated March 31, 2017, available at gis.bcaresearch.com. Is Slow Productivity Growth Good Or Bad For Bonds? Productivity growth has declined in most countries. This appears to be a structural problem that will remain with us for years to come. In theory, slower productivity growth should reduce the neutral rate of interest, benefiting bonds in the process. In reality, countries with chronically low productivity growth typically have higher interest rates than faster growing economies. The passage of time helps account for this seeming paradox: Slower productivity growth tends to depress interest rates at the outset, but leads to higher rates later on. The U.S. has reached an inflection point where weak productivity growth is starting to push up both the neutral real rate and inflation. Other countries will follow. The implication for investors is that government bond yields have begun a long-term secular uptrend. The market is not at all prepared for this. Slow Productivity Growth: A Structural Problem Productivity growth has fallen sharply in most developed and emerging economies (Chart II-1). As we argued in "Weak Productivity Growth: Don't Blame The Statisticians," there is little compelling evidence that measurement error explains the productivity slowdown.1 Yes, the unmeasured utility accruing from free internet services is large, but so was the unmeasured utility from antibiotics, indoor plumbing, and air conditioning. No one has offered a convincing explanation for why the well-known problems with productivity calculations suddenly worsened about 12 years ago. Chart II-1Productivity Growth Has Slowed In Most Major Economies Beware Inflection Points In The Secular Drivers Of Global Bonds Beware Inflection Points In The Secular Drivers Of Global Bonds If mismeasurement is not responsible for the productivity slowdown, what is? Cyclical factors have undoubtedly played a role. In particular, lackluster investment spending has curtailed the growth in the capital stock (Chart II-2). This means that today's workers have not benefited from the improvement in the quality and quantity of capital to the same extent as previous generations. However, the timing of the productivity slowdown - it began in 2004-05 in most countries, well before the financial crisis struck - suggests that structural factors have been key. These include: Waning gains from the IT revolution. Recent innovations have focused more on consumers than businesses. As nice as Facebook and Instagram are, they do little to boost business productivity - in fact, they probably detract from it, given how much time people waste on social media these days. The rising share of value added coming from software relative to hardware has also contributed to the decline in productivity growth. Chart II-3 shows that productivity gains in the latter category have been much smaller than in the former. Chart II-2The Great Recession Hit ##br##Capital Stock Accumulation The Great Recession Hit Capital Stock Accumulation The Great Recession Hit Capital Stock Accumulation Chart II-3The Shift Towards Software Has ##br##Dampened IT Productivity Gains The Shift Towards Software Has Dampened IT Productivity Gains The Shift Towards Software Has Dampened IT Productivity Gains Slower human capital accumulation. Globally, the fraction of adults with a secondary degree or higher is increasing at half the pace it did in the 1990s (Chart II-4). Educational achievement, as measured by standardized test scores in mathematics and science, is edging lower in the OECD, and is showing very limited gains in most emerging markets (Chart II-5). Test scores tend to be much lower in countries with rapidly growing populations (Chart II-6). Consequently, the average level of global mathematical proficiency is now declining for the first time in modern history. Chart II-4The Contribution To Growth ##br##From Rising Human Capital Is Falling Beware Inflection Points In The Secular Drivers Of Global Bonds Beware Inflection Points In The Secular Drivers Of Global Bonds Chart II-5Math Skills Around The World Beware Inflection Points In The Secular Drivers Of Global Bonds Beware Inflection Points In The Secular Drivers Of Global Bonds Decreased creative destruction. The birth rate of new firms in the U.S. has fallen by half since the late 1970s and is now barely above the death rate (Chart II-7). In addition, many firms in advanced economies are failing to replicate the best practices of industry leaders. The OECD reckons that this has been a key reason for the productivity slowdown.2 Chart II-6The Best Educated EMs Have The Worst Demographic Outlooks Beware Inflection Points In The Secular Drivers Of Global Bonds Beware Inflection Points In The Secular Drivers Of Global Bonds Chart II-7Secular Decline In U.S. Firm Births Secular Decline In U.S. Firm Births Secular Decline In U.S. Firm Births Productivity Growth And Interest Rates Investors typically assume that long-term interest rates will converge to nominal GDP growth. All things equal, this implies that faster productivity growth should lead to higher interest rates. Most economic models share this assumption - they predict that an acceleration in productivity growth will raise the rate of return on capital and incentivize households to save less in anticipation of faster income gains.3 Both factors should cause interest rates to rise. The problem is that these theories do not accord with the data. Chart II-8 shows that interest rates are far higher in regions such as Africa and Latin America, which have historically suffered from chronically weak productivity growth. In contrast, rates are lower in regions such as East Asia, which have experienced rapid productivity growth. One sees the same negative correlation between interest rates and productivity growth over time in developed economies. In the U.S., for example, interest rates rose rapidly during the 1970s, a decade when productivity growth fell sharply (Chart II-9). Chart II-8Emerging Markets: Interest Rates Tend To ##br##Be Higher Where Productivity Growth Is Weak Beware Inflection Points In The Secular Drivers Of Global Bonds Beware Inflection Points In The Secular Drivers Of Global Bonds Chart II-9U.S. Interest Rates Soared In ##br##The 1970s While Productivity Swooned U.S. Interest Rates Soared In The 1970s While Productivity Swooned U.S. Interest Rates Soared In The 1970s While Productivity Swooned Two Reasons Why Slower Productivity Growth May Lead To Higher Interest Rates There are two main reasons why slower productivity growth may lead to higher nominal interest rates over time: Slower productivity growth may eventually lead to higher inflation; Slower productivity growth may deplete national savings, thereby raising the neutral real rate of interest. We discuss each reason in turn. Reason #1: Slower Productivity Growth May Fuel Inflation Most economists agree that chronically weak productivity growth tends to be associated with higher inflation. Even Janet Yellen acknowledged as much, noting in a 2005 speech that "the evidence suggests that the predominant medium-term effect of a slowdown in trend productivity growth would likely be higher inflation."4 In theory, the causation between productivity and inflation can run in either direction: Weak productivity gains can fuel inflation while high inflation can, in turn, undermine growth. With respect to the latter, economists have focused on three channels: First, higher inflation may make it difficult for firms to distinguish between relative and absolute price shocks, leading to suboptimal resource allocation. Second, higher inflation may stymie capital accumulation because investors typically pay capital gains taxes even when the increase in asset values is entirely due to inflation. Third, high inflation may cause households and firms to waste time and effort on economizing their cash holdings. There are also several ways in which slower productivity growth can lead to higher inflation. For example, sluggish productivity growth may increase the likelihood that a country will be forced to inflate its way out of any debt problems. In addition, central banks may fail to recognize structural declines in productivity growth in real time, leading them to keep interest rates too low in the errant belief that weak GDP growth is due to inadequate demand when, in fact, it is due to insufficient supply. There is strong evidence that this happened in the U.S. in the 1970s. Chart II-10 shows that the Fed consistently overestimated the size of the output gap during that period. Chart II-10The Fed Continuously Overstated ##br##The Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s Reason #2: Slower Productivity Growth May Deplete National Savings, Leading To A Higher Neutral Real Rate Imagine that you have a career where your real income is projected to grow by 2% per year, but then something auspicious happens that leads you to revise your expected annual income growth to 20%. How do you react? If you are like most people, your initial inclination might be to celebrate by purchasing a new car or treating yourself to a lavish vacation. As such, your saving rate is likely to fall at the outset. However, as the income gains pile up, you might find yourself running out of stuff to buy, resulting in a higher saving rate. This is particularly likely to be true if you grew up poor and have not yet acquired a taste for conspicuous consumption. Now consider the opposite case: One where you realize that your income will slowly contract over time as your skills become increasingly obsolete. The logic above suggests that your immediate reaction will be to hunker down and spend less - in other words, your saving rate will rise. However, as time goes by and the roof needs to be changed and the kids sent off to college, you may find it hard to pay the bills - your saving rate will then fall. The same reasoning applies to economy-wide productivity growth. When productivity growth increases, household savings are likely to decline as consumers spend more in anticipation of higher incomes. Meanwhile, investment is likely to rise as firms move swiftly to expand capacity to meet rising demand for their products. The combination of falling savings and rising investment will cause real rates to increase. As time goes by, however, it may become increasingly difficult for the economy to generate enough incremental demand to keep up with rising productive capacity. At that point, real rates will begin falling. The historic evidence is consistent with the notion that higher productivity growth causes savings to fall at the outset, but rise later on. Chart II-11 shows that East Asian economies all had rapid growth rates before they had high saving rates. China is a particularly telling example. Chinese productivity growth took off in the early 1990s. Inflation accelerated over the subsequent years, while the country flirted with current account deficits - both telltale signs of excess demand. It was not until a decade later that the saving rate took off, pushing the current account into a large surplus, even though investment was also rising at the time (Chart II-12). Chart II-11Asian Tigers: Growth Took Off First, ##br##Followed By Higher Savings Asian Tigers: Growth Took Off First, Followed By Higher Savings Asian Tigers: Growth Took Off First, Followed By Higher Savings Chart II-12China: Productivity Growth Accelerated, ##br##Then Savings Rate Took Off China: Productivity Growth Accelerated, Then Savings Rate Took Off China: Productivity Growth Accelerated, Then Savings Rate Took Off Today, Chinese deposit rates are near rock-bottom levels, and yet the household sector continues to save like crazy. This will change over time. The working-age population has peaked (Chart II-13). As millions of Chinese workers retire and begin to dissave, aggregate household savings will fall. Meanwhile, Chinese youth today have no direct memory of the hardships that their parents endured. As happened in Korea and Japan, the flowering of a consumer culture will help bring down the saving rate. Meanwhile, sluggish income growth in the developed world will make it difficult for households to save much. Population aging will only exacerbate this effect. As my colleague Mark McClellan pointed out in last month's edition of The Bank Credit Analyst, elderly people in advanced economies consume more than any other age cohort once government spending for medical care on their behalf is taken into account (Chart II-14).5 Our estimates suggest that population aging will reduce the household saving rate by five percentage points in the U.S. over the next 15 years (Chart II-15). The saving rate could fall as much as ten points in Germany, leading to the evaporation of the country's mighty current account surplus. As saving rates around the world begin to fall, real interest rates will rise. Chart II-13China's Very High Rate Of National Savings ##br##Will Face Pressure From Demographics China's Very High Rate Of National Savings Will Face Pressure From Demographics China's Very High Rate Of National Savings Will Face Pressure From Demographics Chart II-14Income And Consumption By Age Cohort Income And Consumption By Age Cohort Income And Consumption By Age Cohort Chart II-15Aging Will Reduce Aggregate Savings Aging Will Reduce Aggregate Savings Aging Will Reduce Aggregate Savings The Two Reasons Reinforce Each Other The discussion above has focused on two reasons why chronically low productivity growth could lead to higher interest rates: 1) weak productivity growth could fuel inflation; and 2) weak productivity growth could deplete national savings, leading to higher real rates. There is an important synergy between these two reasons. Suppose, for example, that weak productivity growth does eventually raise the neutral real rate. Since central banks cannot measure the neutral rate directly and monetary policy affects the economy with a lag, it is possible that actual rates will end up below the neutral rate. This would cause the economy to overheat, resulting in higher inflation. Thus, if the first reason proves to be true, it is more likely that the second reason will prove to be true as well. The Technological Wildcard So far, we have discussed productivity growth in very generic terms - as basically anything that raises output-per-hour. In reality, the source of productivity gains can have a strong bearing on interest rates. Economists describe innovations that raise the demand for labor relative to capital goods as being "capital saving." Paul David and Gavin Wright have argued that the widespread adoption of electrically-powered processes in the early 20th century serves as "a textbook illustration of capital-saving technological growth."6 They note that "Electrification saved fixed capital by eliminating heavy shafts and belting, a change that also allowed factory buildings themselves to be more lightly constructed." In contrast, recent technological innovations have tended to be more of the "labor saving" than "capital saving" variety. Robotics and AI come to mind, but so do more mundane advances such as containerization. Marc Levinson has contended that the widespread adoption of "The Box" in the 1970s completely revolutionized international trade. Nowadays, huge cranes move containers off ships and place them onto waiting trucks or trains. Thus, the days when thousands of longshoremen toiled in the great ports of Baltimore and Long Beach are gone.7 If technological progress is driven by labor-saving innovations, real wages will tend to grow more slowly than overall productivity (Chart II-16). In fact, if technological change is sufficiently biased in favour of capital (i.e., if it is extremely "labor saving"), real wages may actually decline in absolute terms (Chart II-17). Owners of capital tend to be wealthier than workers. Since richer people save more of their income than poorer people, the shift in income towards the former will depress aggregate demand (Chart II-18). This will result in a lower neutral rate. Chart II-16U.S.: Real Wages Have Been ##br##Lagging Productivity Gains U.S.: Real Wages Have Been Lagging Productivity Gains U.S.: Real Wages Have Been Lagging Productivity Gains Chart II-17Examples Of Capital-Biased ##br##Technological Change Beware Inflection Points In The Secular Drivers Of Global Bonds Beware Inflection Points In The Secular Drivers Of Global Bonds It is difficult to know if the forces described above will dissipate over time. Productivity growth is largely a function of technological change. We like to think that we are living in an era of unprecedented technological upheavals, but if productivity growth has slowed, it is likely that the pace of technological innovation has also diminished. If so, the impact that technological change is having on such things as the distribution of income and global savings - and by extension on interest rates - could become more muted. To use an analogy, the music might remain the same, but the volume from the speakers could still drop. Capital In A Knowledge-Based Economy Labor-saving technological change has not been the only force pushing down interest rates. Modern economies are transitioning away from producing goods towards producing knowledge. Companies such as Google, Apple, and Amazon have thrived without having to undertake massive amounts of capital spending. This has left them with billions of dollars in cash on their balance sheets. The price of capital goods has also tumbled over the past three decades, allowing companies to cut their capex budgets (Chart II-19). Chart II-18Savings Heavily Skewed ##br##Towards Top Earners Savings Heavily Skewed Towards Top Earners Savings Heavily Skewed Towards Top Earners Chart II-19Falling Capital Goods Prices Have Allowed ##br##Companies To Slash Capex Budgets Falling Capital Goods Prices Have Allowed Companies To Slash Capex Budgets Falling Capital Goods Prices Have Allowed Companies To Slash Capex Budgets In addition, technological advances have facilitated the emergence of "winner-take-all" industries where scale and network effects allow just a few companies to rule the roost (Chart II-20). Such market structures exacerbate inequality by shifting income into the hands of a few successful entrepreneurs and business executives. As noted above, this leads to higher aggregate savings. Market structures of this sort could also lead to less aggregate investment because low profitability tends to constrain capital spending by second- or third-tier firms, while the worry that expanding capacity will erode profit margins tends to constrain spending by winning companies. The combination of higher savings and decreased investment results in a lower neutral rate. As with labor-saving technological change, it is difficult to know how these forces will evolve over time. The growth of winner-take-all industries has benefited greatly from globalization. Globalization, however, may be running out of steam. Tariffs are already extremely low in most countries, while the gains from further breaking down the global supply chain are reaching diminishing returns (Chart II-21). Perhaps more importantly, political pressures for greater income distribution, trade protectionism, and stronger anti-trust measures are likely to intensify. If that happens, it may be enough to reverse some of the downward pressure on the neutral rate. Chart II-20A Winner-Take-All Economy A Winner-Take-All Economy A Winner-Take-All Economy Chart II-21The Low-Hanging Fruits Of ##br##Globalization Have Been Picked The Low-Hanging Fruits Of Globalization Have Been Picked The Low-Hanging Fruits Of Globalization Have Been Picked Investment Conclusions Is slow productivity growth good or bad for bonds? The answer is both: Slow productivity growth is likely to depress interest rates at the outset, but is liable to lead to higher rates later on. The U.S. has likely reached the inflection point where slow productivity is going from being a boon to a bane for bonds. Chart II-22 shows that the U.S. output gap would be over 8% of GDP had potential GDP grown at the pace the IMF projected back in 2008. Instead, it is close to zero and will likely turn negative if growth remains over 2% over the next few quarters. Other countries are likely to follow in the footsteps of the U.S. Chart II-22Output Gap Has Narrowed Thanks ##br##To Lower Potential Growth Output Gap Has Narrowed Thanks To Lower Potential Growth Output Gap Has Narrowed Thanks To Lower Potential Growth To be clear, productivity is just one of several factors affecting interest rates - demographics, globalization, and political decisions being others. However, as we argued in our latest Strategy Outlook, these forces are also shifting in a more inflationary direction.8 As such, fixed-income investors with long-term horizons should pare back duration risk and increase allocations to inflation-linked securities. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 2 Dan Andrews, Chiara Criscuolo, and Peter N. Gal,"The Best versus the Rest: The Global Productivity Slowdown, Divergence across Firms and the Role of Public Policy," OECD Productivity Working Papers, No. 5 (November 2016). 3 Consider the widely-used Solow growth model. The model says that the neutral real rate, r, is equal to (a/s) (n + g + d), where a is the capital share of income, s is the saving rate, n is labor force growth, g is total factor productivity growth, and d is the depreciation rate of capital. All things equal, an increase in g will result in a higher equilibrium real interest rate. The same is true in the Ramsey model, which goes a step further and endogenizes the saving rate within a fully specified utility-maximization framework. In this model, consumption growth is pinned down by the so-called Euler equation. Assuming that utility can be described by a constant relative risk aversion utility function, the Euler equation states that consumption will grow at (r-d)/h where d is the rate at which households discount future consumption and h is a measure of the degree to which households want to smooth consumption over time. In a steady state, consumption increases at the same rate as GDP, n+g. Rearranging the terms yields: r=(n+g)h+d. Notice that both models provide a mechanism by which a higher g can decrease r. In the Solow model, this comes from thinking about the saving rate not as an exogenous variable, but as something that can be influenced by the growth rate of the economy. In particular, if s rises in response to a higher g, r could fall. Likewise, in the Ramsey model, a higher g could make households more willing to forgo consumption today in return for higher consumption tomorrow (equivalent to a decrease in the rate of time preference, d). This, too, would translate into a lower neutral rate. 4 Janet L. Yellen, "The U.S. Economic Outlook," Presentation to the Stanford Institute of Economic Policy Research, February 11, 2005. 5 Please see The Bank Credit Analyst, "Beware Inflection Points In The Secular Drivers Of Global Bonds," April 28, 2017, available at bca.bcaresearch.com. 6 Paul A. David, and Gavin Wright,"General Purpose Technologies And Surges In Productivity: Historical Reflections On the Future Of The ICT Revolution," January 2012. 7 Marc Levinson, "The Box: How the Shipping Container Made the World Smaller and the World Economy Bigger," Princeton University Press, 2006. 8 Please see Global Investment Strategy, "Strategy Outlook Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com.

Highlights The recent "abnormal" weakness in both M1 and M2 is due to various one-off factors. Removing these factors, Chinese money supply growth rates have been largely stable. Money and credit growth is currently slower than historical norms, but is far from alarming. The one-off factors have created enormous noise in Chinese money and credit numbers in recent years, rendering the effectiveness of various money "impulse" indicators. As the Chinese financial sector becomes more diversified and financial intermediation less bank-centric, the significance of money supply will diminish over time. It is increasingly important to take a broader view on the overall economy than solely relying on money and credit numbers to make a judgment on China's business cycle. Feature China's growth figures have mostly surprised to the upside in recent months, with one disconcerting exception: a deceleration in money supply. M1 money growth, after a sharp spike in 2015-2016, has slowed considerably. Broad M2 appears even more worrisome, decelerating to 9.4% in June, a record low since the data became available in the early 1980s. Historically, growth rates of monetary aggregates have been excellent leading indicators for the Chinese economy. In this vein, the downturn in money supply clearly raises a red flag and deserves closer scrutiny. The Alphabet Soup Of Money Supply Chart 1Three Layers Of Money Supply Three Layers Of Money Supply Three Layers Of Money Supply The People's Bank of China (PBoC) reports three measures of money supply that differ in terms of liquidity, i.e. the ease to make payments (Chart 1). M0, or the most liquid form of money supply, consists of bank notes and coins in circulation. M1 adds demand deposits of enterprises and government entities on top of M0, which is China's narrow money supply that can be readily used to make payments. The broader M2, besides M1, also includes deposits from households, savings deposits from enterprises, government entities and non-bank financial institutions. As China's funding channels have become increasingly diversified in recent years, the PBoC has been considering even broader aggregates, dubbed "M2 plus" or M3, to incorporate new financial instruments, though no such measures have been published yet. Chinese M0 has historically demonstrated strong seasonal patterns associated with the Chinese Spring Festival (Chart 2). Typically demand for cash increases sharply during the holiday season for shopping and gifting, and the PBoC injects fresh cash into circulation ahead of the festival, and withdraws it afterwards. Chinese M0 growth has been downshifting in recent years, and the trend is set to continue going forward, especially as Chinese consumers increasingly adopt mobile-payment tools. Empirically, there has been little correlation between M0 and economic variables. Conventional monetary economics suggests that the growth of broader money supply is an important variable in predicting the outlook for the business cycle and inflation. The reasons behind the predictive power of money supply, however, have not been entirely clear. Some have attributed it to the "transaction motive" - if the corporate sector anticipates improvement in the business cycle, it increases holdings of liquid assets so that it can take quicker action to expand. Others, however, suggest that companies may also increase holdings of liquid assets as "precautionary move" - when businesses and households feel insecure about the growth outlook, they will hold on to more liquid assets as a safeguard against unexpected setbacks, and postpone investments and expenditures. Regardless, empirically Chinese M1 has been tightly linked with numerous economic and financial variables over the past two decades (Chart 3). We suspect the linkage is likely driven by bank loans, which in turn are driven by the authorities' monetary and credit policies. Easing monetary and credit policies encourage bank lending, which replenishes the corporate coffers to expand, and vice versa. Chart 2Not Much Economic Information In M0 Not Much Economic Information In M0 Not Much Economic Information In M0 Chart 3M1 As A Leading Indicator M1 As A Leading Indicator M1 As A Leading Indicator Therefore, M1 and bank lending have historically largely been in sync (Chart 4). In this vein, the recent divergence is a glaring exception: M1 accelerated sharply since early 2015 and has decelerated notably since mid-last year, while credit growth has been largely stable. The divergence, in our view, is likely due to the local government "debt swap" program that debuted in early 2015, when local governments were allowed to issue municipal bonds to pay back the liabilities borrowed by "local government financing vehicles (LGFVs)."1 Chart 5 shows a dramatic increase in outstanding "muni bonds" in early 2015, coinciding with a sharp increase in M1. We suspect the proceeds of muni-bond issuance were temporarily parked on LGFVs' balance sheets, boosting M1. Subsequently, the cash hoard has been gradually withdrawn to retire maturing loans, while muni bond issuances have moderated, leading to a slowdown in M1 growth. Chart 4M1 And Bank Credit M1 And Bank Credit M1 And Bank Credit Chart 5M1 Was Boosted By Muni-Bond Issuance M1 Was Boosted By Muni-Bond Issuance M1 Was Boosted By Muni-Bond Issuance The important point here is that the sharp swings in M1 growth since early 2015 likely reflect exogenous one-off factors rather than real changes in credit flows and business activity. Therefore, the latest slowdown in M1 is likely noise rather than a signal for impending growth deceleration. A Closer Look At M2 Chinese M2 is the broadest measure of Chinese money supply that includes cash in circulation and various forms of deposits in commercial banks. The scope of M2 has been gradually evolving over time. In 2001, investors' deposits in brokerage accounts were included in M2, and in October 2011 it was further expanded to cover non-bank financial institutions' (NBFI) deposits in commercial banks as well as households' deposits in their "housing provident fund" accounts. Both moves led to abrupt changes in the M2 growth rate. Chart 6M2 And Bank Credit M2 And Bank Credit M2 And Bank Credit As deposits and loans are by far the largest items on each side of commercial banks' balance sheets, historically China's M2 growth rate has tracked bank loans closely, as they both reflect changes in commercial banks' balance sheets. However, there are two episodes of notable divergences between these two variables (Chart 6). In the late 1990s, in the aftermath of the Asian financial crisis, Chinese commercial banks were reluctant to lend amid a deflationary shock, and the government opened the fiscal tap on infrastructure investments through bond issuances, which kept money supply largely stable. More recently, Chinese M2 has decelerated sharply since early 2016 to a new record low. Credit growth, on the other hand, has also drifted lower but has remained considerably more buoyant. A closer look at the component of M2 sheds lights on the recent divergence between money and credit. In its current form, M2 includes cash in circulation, deposits from non-financial sectors (households, enterprises and government agencies) and NBFIs (Chart 7), accounting for 4%, 80% and 10% of M2, respectively. Importantly, even though NBFI deposits with commercial banks only account for 10% of total M2, they have been much more volatile, creating greater swings in the overall monetary aggregates. NBFI deposits increased dramatically between 2014 and 2015, have slowed sharply since early 2016 and have actually been contracting in recent months. Indeed, the contraction in NBFI deposits has contributed to the lion's share of the recent M2 slowdown. Excluding NBFI deposits, the other two components of M2 have also moderated in recent months, but are not nearly as alarming (Chart 8). Chart 7Closer Look At M2 Closer Look At M2 Closer Look At M2 Chart 8Boom-Bust In NFIB Deposits Distorted M2 Growth Boom-Bust In NFIB Deposits Distorted M2 Growth Boom-Bust In NFIB Deposits Distorted M2 Growth In other words, the dramatic swings in NBFI deposits have distorted the M2 statistics in recent years. The massive increase in NBFI deposits in previous years stoked up concerns among the Chinese authorities about financial excesses that triggered the regulatory and liquidity crackdown - and their recent contraction is the intended consequence of the government's policy tightening efforts. This, in fact, is one of the key reasons that the PBoC's liquidity tightening appears to have de-escalated of late.2 What Does It All Mean? We are usually unwilling to bore clients with the technical details of economic data, preferring instead to focus on the big picture. However, understanding the intricacies is of critical importance in understanding the recent "abnormal" developments in China's money supply. Still, several big-picture observations can be made. First, the recent "abnormal" weakness in both M1 and M2 is due to various one-off factors. Removing these factors, Chinese money supply growth rates have been largely stable, albeit slower than historical norms, as overall economic growth has downshifted. Meanwhile, various credit measures - both bank lending and "total social financing" - have also been steady (Chart 9). More importantly, longer-term loans to households and businesses have accelerated notably since early this year, which likely underscores improvement in capital spending. In short, there are no signs that the economy is facing an immediate material downturn. Second, the one-off factors in Chinese money and credit data in recent years have had a particularly large impact on various money "impulse" indicators, which attempt to measure changes in money and credit flows, simply because even if these one-off factors are marginal to the total outstanding amount of money stock, they could easily overwhelm the "flows" in any given timeframe. In recent years Chinese money and credit numbers have been frequently distorted by these factors, such as the muni bond-debt swap program, market-intervention by the Chinese government to rescue the stock market collapse in 2015, and the boom-bust in financial excesses in the interbank market. All of these factors have created enormous noise in money and credit numbers, but the impact on the real economy should be much less dramatic. Chart 9Credit Growth Has Been Largely Stable Credit Growth Has Been Largely Stable Credit Growth Has Been Largely Stable Chart 10M1 Is No Longer An Important##br## Leading Indicator For The US M1 Is No Longer An Important Leading Indicator For The US M1 Is No Longer An Important Leading Indicator For The US Third, a closer look at China's monetary statistics suggests that money and credit growth has been in a gradual downtrend in recent years. This confirms our view that China's growth recovery since early 2016 was to a greater extent due to significant improvement in monetary conditions rather than a massive increase in money and credit stimuli.3 On this front, growth improvement will likely push the authorities to tighten, creating economic headwinds going forward.4 We maintain our positive assessment on China's cyclical outlook, but the PBoC policy and the country's overall monetary conditions need to be closely monitored. Finally, the predictive power of money and credit for business cycles is contingent on the role a country's banking system plays in the economy. For example, money supply was a reliable leading indicator for the U.S. economy before the 1980s, but its correlation to the business cycle has become increasingly weaker in the past several decades, as capital markets have become more developed and the dominance of banks has been reduced (Chart 10). Currently, Chinese banks still plays a far more important role in the economy than their American counterparts, and therefore, "counting the money" remains critical. However, as the Chinese financial sector becomes more diversified and financial intermediation less bank-centric, the significance of money supply will diminish over time. In fact, bank lending currently accounts for about 70% of "total social financing," down from about 90% a decade ago. For investors, it is increasingly important to take a broader view on the overall economy than solely relying on money and credit numbers to make a judgment on China's business cycle. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "A Game Changer?" dated March 31, 2015, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Chinese Financial Tightening: Passing The Phase Of Maximum Strength", dated June 22, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "A Chinese Slowdown: How Much Downside?" dated June 8, 2017, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report, "Rising Odds Of PBoC Rate Hikes", dated July 20, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations