Asia

Feature EM risk assets refuse to sell off - regardless of new information and developments that historically would have caused these markets to tumble. Indeed, political turmoil and changes in Brazil and South Africa - two high-beta EM markets - have so far had limited impact on flows and market dynamics. Moreover, while our Reflation Confirming Indicator has rolled over, EM share prices have not reacted at all (Chart I-1). EM stocks have also decoupled with the equal-weighted average of global mining and energy equity indexes (Chart I-2). Chart 1Reflation Confirming Indicator And ##br##EM Stocks Reflation Confirming Indicator And EM Stocks Reflation Confirming Indicator And EM Stocks Chart 2Commodities Share Prices And ##br##EM Equities: Unsustainable Divergence Commodities Share Prices And EM Equities: Unsustainable Divergence Commodities Share Prices And EM Equities: Unsustainable Divergence We do not subscribe to the thesis that EM assets have permanently decoupled from both commodities and their domestic credit cycles, and that tried and tested indicators no longer work. Technology and social media share prices have been instrumental to this latest decoupling, as we wrote in last week's report.1 This group of stocks is in a full-blown mania phase, and it is hard to know when this will end. Yet, exponential price moves always occur at the end of a bull market, and are typically followed by bear markets. As we elaborated in last week's report, the investment call on social media and internet stocks is a bottom-up - not macro - call. Top-down analysis can add some value on the semiconductor cycle, and we suggested last week that it is likely topping out. This week new data releases support the thesis that Asian/global trade in general and the semiconductor cycle in particular are already decelerating. Korean exports data for the first 20 days of May, Japanese preliminary manufacturing PMI for May, and Taiwanese manufacturing output volume growth for April have all decelerated (Chart I-3). Finally, one technical piece of evidence that this rally is late is relative weakness in the equal-weighted MSCI equity indexes. In the EM space, the equally-weighted individual stock index has fared poorly against the EM market cap-weighted index since May 2016 (Chart I-4, top panel). In the U.S., the same measure of market breadth has deteriorated since December 2016 (Chart I-4, bottom panel). Chart 3Asia's Manufacturing Growth ##br##Is Already Decelerating Asia's Manufacturing Growth Is Already Decelerating Asia's Manufacturing Growth Is Already Decelerating Chart 4The EM And U.S. Equity Rally ##br##Has Been Driven By Large-Cap Stocks The EM And U.S. Equity Rally Has Been Driven By Large-Cap Stocks The EM And U.S. Equity Rally Has Been Driven By Large-Cap Stocks Bottom Line: EM financial markets are in the midst of irrational exuberance. The rally is late, but it is impossible to time the top. The forthcoming selloff will be large and protracted. Beware Of China's Budding Growth Slump Interest rates have risen in China sufficiently enough to cause a major growth slowdown in the mainland economy (Chart I-5). Liquidity tightening amid a lingering credit bubble could not be a more dangerous combination. In this context, financial markets are extremely complacent on EM/China plays. China's liquidity tightening continues, and is bound to create a decisive growth relapse in the months ahead, as well as dampen exports in countries that sell to China (Chart I-6). Chart 5China Growth To Slump China Growth To Slump China Growth To Slump Chart 6Exports To China To Slump Exports To China To Slump Exports To China To Slump Not only is the People's Bank of China (PBoC) guiding interest rates higher, but there is an ongoing regulatory crackdown on the financial system. Regulators are forcing banks to bring Wealth Management Products (WMPs) and other off-balance-sheet items onto their balance sheets. As a result, banks' capital adequacy and risk matrixes will deteriorate, and they will be forced to slow down credit creation. Chart 7EM Share Prices Ex. Tech Have Not Broken Out EM Share Prices Ex. Tech Have Not Broken Out EM Share Prices Ex. Tech Have Not Broken Out Remarkably, policymakers are determined to get things under control. According to The Wall Street Journal,2 key policymakers have issued strongly worded statements. "Strong medicine must be prescribed," said Guo Shuqing, chairman of the China Banking Regulatory Commission (CRBC), according to people familiar with the matter. "If the banking industry gets into a mess," he added, "I will resign." He was appointed as the head of the CRBC last October, and likely has a mandate from the President to tackle speculative excesses in the financial system. In its first quarter Monetary Policy Implementation Report,3 the PBoC repeatedly used the phrase "preventing bubbles." Besides, in his statements, the chairman of the PBoC has frequently emphasized the need to normalize credit growth and curb speculative activities. The former head of the insurance regulator, who has been "accommodating" and "tolerant" of risky activities by insurance companies, was jailed last fall for corruption. These are strong indications confirming that policymakers are determined to curb speculative financial activities. Provided how entrenched and large various speculative financial schemes and the credit bubble have become in China, it will be impossible to tackle speculative excesses without a slowdown in overall credit growth and associated harm to the real economy. This is not to say that policymakers are tightening with intentions to cause a growth collapse. Policymakers in all countries always tighten to cap inflation or credit excesses or normalize interest rates - i.e., they never tighten to cause a major shock to the real economy. This applies to Chinese policymakers at the moment, especially ahead of the party Congress later this year. That said, when the existing imbalances in the economy or financial system are sufficiently large, even minor tightening can cause a financial accident or growth relapse. It is not within policymakers' powers to predict or prevent it. They may alter their policy after the fact, but markets will sell off considerably beforehand. We do not know exactly how financial dynamics in China will evolve in the months ahead, but we are certain that the market consensus is too complacent and that EM asset prices are at major risk. Bottom Line: It is impossible to predict financial accidents (stress among specific institutions) but we are certain that China's credit growth and, consequently, capital spending are bound to slow considerably in the coming months. This bodes ill for producers of commodities and industrial goods both within and outside China. Accordingly, EM risk assets will suffer the most. As a final note, EM ex-technology share prices have not yet broken out and we do expect them to relapse from the current levels (Chart I-7). Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report titled, "Can Tech Drive EM Stocks Higher?," dated May 17, 2017, link available at ems.bcaresearch.com. 2 Lingling Wei and Chao Deng, "China's War on Debt Causes Stocks to Drop, Bond Yields to Shoot Up and Defaults to Rise," May 5, 2017, The Wall Street Journal. 3 Please refer to http://www.pbc.gov.cn/zhengcehuobisi/125207/125227/125957/3307990/3307409/index.html (In Chinese only). Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights U.S. fiscal stimulus will be priced back into markets; Northeast Asia is consumed with domestic politics for now; China's financial crackdown raises risks, but so far looks contained; South Korea's relief rally will lead to buyer's remorse; Japan's constitutional reforms portend more reflation. Feature The market has lost faith in U.S. fiscal stimulus. The bond market has given back all of the expectations of faster growth and higher inflation (Chart 1). Hopes of populist, budget-busting tax cuts appear to have been dashed by the Putin-gate scandal and alleged White House obstruction of justice. As a result, the DXY has fallen to pre-election levels, while the Goldman Sachs high tax-rate basket of equities has fallen to its lowest level relative to the S&P 500 since February 2016 (Chart 2). We continue to believe that tax reform, or just tax cuts, will happen this year or early next year and that the market will have to re-price fiscal stimulus and budget profligacy at some point this year.1 As such, we are not ready to close our tactical recommendations of going long the high-tax rate basket relative to S&P 500 (down 1.62% since April 5) or playing the 2-year / 30-year Treasury curve steepener (down 11.4 bps since November 1). Republicans in Congress will push through tax reforms or cuts for the sake of remaining competitive in the upcoming midterm elections. And we doubt their commitment to budget discipline. That said, it is not clear that the equity market needs tax reforms to continue its upward trajectory. The Atlanta Fed's GDPNow model is predicting growth of 4.1% in the second quarter while the NY Fed's Nowcast is forecasting 2.3%. BCA U.S. Equity Strategy's earnings model continues to predict continued healthy profit growth for the remainder of the year both in the U.S. and abroad (Chart 3).2 In fact, if expectations of stimulus in the U.S. fully dissipate, the USD will take a breather - giving global stocks a boost - and the Fed will be able to take it easy on tightening U.S. rates, easing global monetary conditions. Chart 1Market No Longer##br## Believes In Trump Stimulus... Market No Longer Believes In Trump Stimulus... Market No Longer Believes In Trump Stimulus... Chart 2...Or Trump ##br##Tax Cuts ...Or Trump Tax Cuts ...Or Trump Tax Cuts Chart 3Corporate Profit ##br##Outlook Still Strong Corporate Profit Outlook Still Strong Corporate Profit Outlook Still Strong Perhaps far more important for global and U.S. risk assets is global growth. And the fulcrum of global growth has been China's economic performance. As the only country willing to run pro-cyclical monetary and fiscal policy, China has had a disproportionate impact on global growth since 2008. As such, we turn this week to the geopolitics and politics of Northeast Asia. China: How Far Will Deleveraging Go? Chinese financial policy tightening caught the market by surprise this year. The running assumption was that policy would be fully accommodative in order to ensure stability ahead of the all-important nineteenth National Party Congress in October or November.3 However, it is possible that the assumption is flawed. First, as we have pointed out in the past, China does not have a record of proactive economic stimulus ahead of party congresses (Chart 4). Second, President Xi Jinping may be far more secure in his position than is understood. Chart 4Not Much Evidence Of Aggressive Stimulus Ahead Of Mid-Term Party Congresses In China Not Much Evidence Of Aggressive Stimulus Ahead Of Mid-Term Party Congresses In China Not Much Evidence Of Aggressive Stimulus Ahead Of Mid-Term Party Congresses In China The crackdown on the financial sector in recent months suggests that Xi's administration has a greater appetite for risk ahead of the party congress than is generally believed: The administration is continuing to tamp down on the property sector. The PBoC has drained liquidity and allowed interbank rates to rise (Chart 5). The China Banking Regulatory Commission (CBRC) has launched inspections and new regulations on wealth management products and the shadow lending sector. The China Insurance Regulatory Commission (CIRC) has imposed new restrictions, including preventing insurers from selling new policies. One can make a good case that these measures will be limited so as not to cause excessive disruption in the financial system. All of the key Communist Party statements, from Premier Li Keqiang's recent comments to those made by the economic leadership in December, at the beginning of this tightening cycle, have emphasized that stability remains the priority.4 The PBoC's measures have been marginal; other measures have mostly to do with supervision. Notable personnel changes affecting the top economic and financial government positions fall under preparations for the party congress and do not necessarily suggest a new ambitious policy initiative is under way.5 Moreover, the government has already stepped back a bit in the face of the liquidity squeeze. One of the signs of the PBoC's tighter stance was its discontinuation of its Medium-Term Lending Facility in January, but this has since been reinstated.6 And throughout May the PBoC has injected increasing amounts of liquidity into the interbank system, marking an apparent tactical shift (Chart 6). Furthermore, government spending is already growing again after a brief contraction. Chart 5People's Bank Tightens Marginally... People's Bank Tightens Marginally... People's Bank Tightens Marginally... Chart 6...But Keeps Interbank Rates On A Leash ...But Keeps Interbank Rates On A Leash ...But Keeps Interbank Rates On A Leash In light of these decisions, it seems policy tightening is intended not to be stringent but merely to keep the financial sector - especially the shadow banking sector - in check during a year in which the assumption is that regulators' hands are tied. After all, an unchecked expansion of leverage throughout the year could interfere with the stability imperative. There are two major risks to this view. First, there is the danger of unintended consequences: China is overleveraged: The fundamental problem for China is that there is too much leverage in the system and there has not been a bout of deleveraging for several years (Chart 7). Much of the leverage is off-balance sheet as a result of the rapid growth in shadow lending. There are complex and opaque webs of counterparty risk. When authorities crack down, they cannot be certain that their actions will not spiral out of control. Recently, heightened scrutiny of "mutual guarantees," a type of shadow lending between corporations, led to the default of a company in Shandong that prompted a local government bailout, and more such credit events have occured.7 Policymakers are human: It is a fallacy to assume that Chinese policymakers are omnipotent. The mishaps of 2015-16 put a point on this. A state-backed newspaper has recently reiterated that its "deleveraging" campaign is not finished - the government could accidentally push too far.8 The rise in bond yields has already inverted the yield curve, causing the five-year bond yield to rise higher than the ten-year (Chart 8). This is a red flag and warrants caution.9 Quick fixes have negative side-effects: China escaped the last round of financial jitters, in 2015-16, by using its time-tried technique of credit and fiscal spending to boost the property market and build infrastructure, while imposing draconian capital controls. The growth rebound came at the expense of more debt, less economic rebalancing, and less financial openness. Chart 7China Is Massively Overleveraged China Is Massively Overleveraged China Is Massively Overleveraged Chart 8China's Yield Curve Has Inverted China's Yield Curve Has Inverted China's Yield Curve Has Inverted Second, there is the risk that Xi Jinping's calculus ahead of the party congress is not knowable. It may well be the case that Xi's position in the party is strengthened by a disruptive financial crackdown. The party congress is already under way: The party congress runs all year; it is not merely a one-off event this fall. Senior party officials will come up with a list of candidates for promotion in June or July. Then the PSC and former PSC members will likely meet behind the scenes to hash out their final list, which the Central Committee will ratify in the fall. If financial jitters were supposed to be strictly avoided for the party congress, then the current crackdown would never have begun. The outcomes are uncertain: The negotiations for the Politburo and PSC are not a foregone conclusion no matter how well positioned Xi appears to be as the "core" of the Communist Party. A simple assessment of the current Politburo suggests that the factions are evenly balanced when it comes to the current Politburo members capable of filling the five positions on the new PSC. Two of these positions should go to President Xi's and Premier Li Keqiang's successors, likely to be of opposing factions, while there will probably be three remaining slots that will have to be divvied up among an equal number of candidates from the two main factions (Table 1). Xi may still need to win some battles for influence behind the scenes in order to stack the Central Committee, Politburo, and PSC with his people for 2017 and beyond.10 His anti-corruption campaign has slowed down but is not over (Chart 9). This is all the more imperative for him since his retirement could be rattled by future enemies, given that he has removed the longstanding impunity of former PSC members. Table 1Lineup Of New Politburo Standing Committee Yet To Take Shape - Factions Evenly Balanced Northeast Asia: Moonshine, Militarism, And Markets Northeast Asia: Moonshine, Militarism, And Markets Despite these risks, we still tend to think that for China, as for the world, political risks are overstated in 2017 and understated in 2018.11 If Xi deliberately courts instability this year, as opposed to merely staying vigilant over the financial sector, then it will mark a major break from the norms of Chinese politics. The true risk to China's stability - aside from the unintended consequences discussed above - arises after the party congress, when Xi's political capital is replenished and he can attempt to reboot his policy agenda. Previous presidents Hu Jintao and Jiang Zemin both launched reform pushes after their midterm congresses in 2007 and 1997, respectively. Hu's reform drive was cut short by the global financial crisis, while Jiang's was large-scale and disruptive and paved the way for a decade of higher potential GDP. Having consolidated power in the party, bureaucracy, and military, and tightened controls over the media, Xi Jinping will be in a position in 2018 to launch sweeping reforms should he choose to do so. Presumably these reforms would follow along the lines of those he outlined in the Third Plenum of the Eighteenth Central Committee back in 2013 - they would be pro-market reforms focused on raising productivity by transferring more wealth to households and SMEs at the expense of state-owned enterprises and local governments.12 To illustrate the process of structural reform, we have often used the notion of the "J-Curve" in Diagram 1. This shows that painful reforms deplete political capital, creating a "danger zone" for political leaders in which they lose popularity as economic pain hurts the public. Xi's work over the past five years to fight corruption and rebuild the party's public image have given him the ability to start the J-Curve process from a higher point than otherwise would have been the case. He will start at point D in the diagram, instead of point A, which means that the low point E may not embroil him as deeply in the danger zone of serious political instability as point B. Chart 9Embers Still Burning In ##br##Anti-Corruption Campaign Embers Still Burning In Anti-Corruption Campaign Embers Still Burning In Anti-Corruption Campaign Diagram 1The J-curve Of##br## Structural Reform Northeast Asia: Moonshine, Militarism, And Markets Northeast Asia: Moonshine, Militarism, And Markets But there is still no guarantee that he intends to expend his political capital in this way. The current round of financial tightening could be preliminaries for bigger moves next year - or it could be just another mini-cycle in the ongoing process of "managing" China's massive leverage. If China decides to execute a major deleveraging campaign, either now or next year, it will have a negative effect on global commodity demand (particularly base metals), on commodity exporters, on emerging markets in general, and ultimately on global growth. It would be beneficial for Chinese growth in the long run but negative in the short run, and in terms of Chinese domestic risk assets would open up opportunities for investors to favor "new (innovative) China" versus "old (industrial) China." Bottom Line: We remain long Chinese equities versus Taiwanese and Hong Kong equities for now, but are wary of any sign of doubling down on policy tightening in the face of more frequent and intense credit events. That would indicate that the Chinese leadership has a higher risk appetite than anyone expects and may be willing to induce serious financial disruption before the party congress. Korea: Drunk On Moonshine The Korean election is over and with it much of the heightened uncertainty that accompanied the impeachment and removal from office of President Park Geun-hye over the past year. The new president, Moon Jae-in of the Democratic Party, performed right around the polled expectations at 41% of the vote (Table 2). His competitor on the right wing, Hong Jun-pyo, outperformed expectations, though he still trailed well behind at 24%, giving Moon a large margin of victory by Korean standards that will help provide him with political capital (Chart 10). Table 2South Korean Presidential Election Results Northeast Asia: Moonshine, Militarism, And Markets Northeast Asia: Moonshine, Militarism, And Markets Chart 10Moon Will Have A Honeymoon Northeast Asia: Moonshine, Militarism, And Markets Northeast Asia: Moonshine, Militarism, And Markets Moon's election will bring relief to markets on both the domestic and geopolitical front. On the domestic front, he is proposing a series of policies that will cumulatively boost fiscal thrust and growth. On the geopolitical front, he will revive the "Sunshine Policy" (now "Moonshine Policy") of engagement with North Korea, reducing the appearance that the peninsula is slipping into war.13 The power vacuum in South Korea was a key driver of North Korea's belligerence in 2016, as the lead-up to South Korean elections has been in the past (Chart 11). South Korean presidents typically enjoy a substantial honeymoon period in which they are able to drive policy. The fact that the election occurred seven months early, as a result of the impeachment, gives Moon a notable boost to this period - he has seven months longer than he would have had before he faces any potential check from voters in the 2020 legislative elections. That is not to say that Moon has free rein. Ahn Cheol-soo's People's Party holds 40 seats in the National Assembly and is therefore in a "kingmaker" position - able to provide either the ruling Democratic Party or the fractured right-wing opposition with a majority of seats (Diagram 2). The People's Party is already criticizing Moon's call for increasing government spending by around 0.7% of GDP to fulfill his campaign pledges. True, the People's Party leans to the left and rose to power as a result of the median voter's shift to the left in the 2016's legislative elections. This may limit its ability to obstruct Moon's agenda at first. Nevertheless, it poses a substantial constraint on Moon's agenda through 2020. Chart 11Bull Market For##br## North Korean Threats Northeast Asia: Moonshine, Militarism, And Markets Northeast Asia: Moonshine, Militarism, And Markets Diagram 2Center-Left People's Party##br## Is The Korean Kingmaker Northeast Asia: Moonshine, Militarism, And Markets Northeast Asia: Moonshine, Militarism, And Markets Markets are relieved but not ebullient. The impeachment rally is over and eventually markets will realize that while Moon's agenda is pro-growth, it is not necessarily pro-corporate profits (Chart 12). He is promising to introduce a higher minimum wage, to convert temporary labor contracts into permanent ones, to increase social spending, and to toughen up labor and environmental regulation (Table 3). He has also appointed the so-called "chaebol sniper" as his point man in leading the reform of the country's chaebol industrial giants. On one hand, South Korea definitely needs corporate governance reform; on the other, the process will add uncertainty and Moon's approach may not be market-positive.14 Chart 12Relief Rally Likely To Disappoint Relief Rally Likely To Disappoint Relief Rally Likely To Disappoint Table 3South Korean President's Campaign Proposals Northeast Asia: Moonshine, Militarism, And Markets Northeast Asia: Moonshine, Militarism, And Markets To get an indication of what kind of impact Moon's economic agenda may have, it is helpful to compare that of his mentor, Roh Moo-hyun, president from 2002-7. Roh gave a boost to consumption, both government and private, and saw a relative drop off in fixed capital accumulation, which fits with the broad agenda of supporting workers and households and removing privileges for Korea's traditional export-oriented industrial complex (Chart 13). Roh proved very beneficial for the financial sector, wholesale and retail trade, and health and social work. Education and public administration received some support but were flat overall (Chart 14 A & B). If Moon follows in Roh's footsteps, he will be beneficial for the domestic-oriented economy. Chart 13South Korea's Left Wing##br## Boosts Domestic Consumption South Korea’s Roh Moo-Hyun Boosted Domestic Consumption South Korea’s Roh Moo-Hyun Boosted Domestic Consumption Chart 14ASouth Korea's Left Wing Boosts Finance,##br## Domestic Trade, And Health Care (I) South Korea’s Roh Moo-Hyun Boosted Finance, Domestic Trade, And Health Care (I) South Korea’s Roh Moo-Hyun Boosted Finance, Domestic Trade, And Health Care (I) Chart 14BSouth Korea's Left Wing Boosts Finance,##br## Domestic Trade, And Health Care (II) South Korea’s Roh Moo-Hyun Boosted Finance, Domestic Trade, And Health Care (II) South Korea’s Roh Moo-Hyun Boosted Finance, Domestic Trade, And Health Care (II) Abroad, the Moonshine Policy is likely to have some success, at least in the medium term. The Trump administration is pursuing a strategy comparable to the U.S.'s nuclear negotiations with Iran from 2011-15, in which it tries to rally a coalition to impose tougher sanctions on the rogue state with the purpose of entering into a new round of negotiations that will actually generate concrete results. The "arc of diplomacy" will take time to get going and could last several years - it is essentially a last-ditch effort to convince North Korea to pause its nuclear and missile advances. The tail risk of conflict on the Korean peninsula will be moved out to the end of this effort, perhaps around the end of Trump's term.15 Meanwhile, Moon is already patching up trade relations with China, according to reports, after the latter imposed sanctions on Korea for deploying the U.S. THAAD missile defense system (Chart 15). He will also seek joint infrastructure projects with China and Russia to connect the peninsula. China has a vested interest in Moon's success because it is attempting to demonstrate to the Trump administration that it is cooperating on North Korean security. Chart 15China Likely To Ease##br## Sanctions On South Korea China Likely To Ease Sanctions On South Korea China Likely To Ease Sanctions On South Korea Chart 16South Korean Inflation##br## And Credit Impulse Weak South Korean Inflation And Credit Impulse Weak South Korean Inflation And Credit Impulse Weak The geopolitical risk to markets is, first, that North Korea miscalculates the threshold of other nations' patience, continues with provocations, and eventually causes an incident that derails the new negotiations. This is possible given the North's record of belligerent acts and the fact that both the Trump administration and the Abe administration could cut diplomacy short in the face of a truly disruptive provocation for domestic political reasons. Second, there is a risk that Trump decides to escalate North Korean tensions again, whether to distract from domestic scandals or to reinforce the military deterrent in the event that China and South Korea appear to be giving North Korea a free pass in another round of useless talks. If Moon pursues a unilateral détente with North Korea, without adequate coordination with the U.S., and pushes for the removal of THAAD missiles, then the U.S. and South Korea are headed for a period of higher-than-normal alliance tensions that could become market-relevant.16 Bottom Line: We remain short KRW/THB. Core inflation and domestic demand remain weak in Korea, which reinforces the central bank's recent decision to stick to an accommodative monetary policy. Credit growth is cyclically weak, which reinforces the fact that rate cuts are still on the table (including the possibility of a surprise rate cut like in mid-2016) (Chart 16). Finally, the KRW has been relatively strong compared to the currencies of Korea's competitors (Chart 17). Chart 17South Korean Won Has Outpaced The Yuan And Yen South Korean Won Has Outpaced The Yuan And Yen South Korean Won Has Outpaced The Yuan And Yen In terms of equities, the top six chaebol have come under scrutiny, but Samsung has rallied despite lying at the center of the corruption scandal. The others have not performed well amid the economic slowdown. We see no opportunity at present to short the chaebol in relation to the broader market. Broadly, however, Moon's policies will add burdens to large internationally competitive industrials while boosting small and medium-sized enterprises. We also remain short the Korean ten-year government bond versus the two-year (see Chart 12, panel three, above). Moon's policy bent will subtract from a 1% budget surplus (2016) and worsen the long-term trajectory of the country's relatively low public debt (39% of GDP). Insofar as his foreign policy succeeds, it entails a larger future debt burden as a result of efforts to integrate with North Korea, which is relevant to long-term bonds well before reunification appears anywhere on the horizon. At bottom, we are structurally bearish South Korea because of rising headwinds both to U.S.-China relations and to the broader globalization process that has benefited South Korea so much in the recent past. Japan: Is Militarism The Final Act Of Abenomics? Japan has reached peak political capital under Shinzo Abe. The ruling Liberal Democratic Party, with its New Komeito coalition partner, continues to play in a totally different league from its competitors - there is no political alternative at the moment (Chart 18). The ruling party has a de facto two-thirds supermajority in both houses of the Diet. Abe himself is more popular than any recent prime minister, and has retained that popularity over a longer period of time (Chart 19). He has secured permission from his party to stay on as its president until 2021, though he faces general elections in December 2018 to stay on as prime minister. Chart 18Japan: Liberal Democrats Still Supreme Japan: Liberal Democrats Still Supreme Japan: Liberal Democrats Still Supreme Chart 19Shinzo Abe Remains The Man Of The Hour Northeast Asia: Moonshine, Militarism, And Markets Northeast Asia: Moonshine, Militarism, And Markets Political capital is a fleeting thing, so Abe must use it or lose it. This is why we have insisted that he would press forward rapidly with attempts to revise Japan's constitution, his ultimate policy goal, which he has now confirmed he will do. His proposed deadline is July 2020 for the new provisions coming into force.17 Constitutional revision is not only about enshrining the Japanese Self-Defense Forces (JSDF) so as to normalize the country's defense policy. It is also about Japan becoming an independent nation again, capable of forging its own destiny outside of the one foreseen by the American framers of the post-WWII constitution. Though Abe has specific constitutional aims, any change to the constitution will demonstrate that change is possible and break a taboo, advancing Abe's broader goal of nudging the Japanese public toward active rather than passive policies.18 Hence Japanese politics are about to heat up in a big way. Abe has already done a trial run in his passage of a new national security law in September 2015. This law allowed the government to reinterpret the constitution so as to achieve many of his chief military-strategic aims (e.g. allowing the JSDF to come to the aid of allies in "collective self-defense"). Over the course of that year, Abe's popularity flagged, as public opinion punished him for shifting attention away from the economic reflation agenda that got him elected so as to focus on his more controversial, hawkish security agenda (Chart 20). Nevertheless, Abe stuck to the security agenda, in the face of some of the largest protests in Japan's post-Occupation history, and managed to shift back to the economy in time to notch another big victory in the upper house elections of 2016. We expect a similar process to unfold this time, though with bigger stakes and far less of a chance that Abe can "pivot" again. Under no circumstances do we see him reversing the constitutional drive now that he has the rare gift of supermajorities in the Diet; rather, he is going to spend his political capital. After all, there is no telling what could happen in the 2018 election. What are the market implications of this agenda? There may be some hiccups in consumer and business sentiment as a result of the rise in activism, political opposition, and controversy that is already beginning and will intensify as the process gets under way. Abe will be accused of putting the economy on the backburner. Abenomics is already of questionable success (Chart 21) and it will come under greater criticism as Abe shifts attention elsewhere, especially if global headwinds gain strength. Chart 20Abe Loses Support When He Talks##br## Security Instead Of Economy Northeast Asia: Moonshine, Militarism, And Markets Northeast Asia: Moonshine, Militarism, And Markets Chart 21Abenomics: ##br##Progress Is Gradual Abenomics: Progress Is Gradual Abenomics: Progress Is Gradual However, we recommend investors fade this narrative and buy Japan. Abe's constitutional changes must receive a simple majority in a nationwide popular referendum in order to pass - and Abe does not clearly have what he needs at the moment (Chart 22). This means that he cannot, in reality, afford to put Abenomics on the back burner, but instead must err on the side of monetary dovishness, fiscal stimulus, and reflation in order to win support for the non-economic agenda. There has been virtually no talk of fiscal stimulus this year, yet the policy setting is conducive to increasing spending as necessary. The Bank of Japan has explicitly embraced a monetary regime designed to allow for greater "coordination" with fiscal policy (Chart 23).19 There is no reason whatsoever to believe Abe is backing away from this stance. (Incidentally, the next consumption tax hike is not slated until October 2019, and could be delayed again.) Geopolitics are also fairly supportive of the Abe administration. First, the Korean situation is currently alarming enough to help justify the constitutional changes yet not alarming enough to provoke outright conflict. Abe is also making headway toward a historic improvement of relations with Russia, allowing Japan's military to pivot from the north to the south and west (i.e. China and North Korea). The chief risk for Abe is if North Korea surprises on the dovish side and new international diplomatic efforts appear so fruitful as to reduce domestic support for remilitarization. China, South Korea, and possibly North Korea will encourage the latter dynamic, while drumming up global criticism of Japan for warmongering. Meanwhile Japan will try to remind the domestic public and the U.S. that North Korea remains a clear and present danger and tends to take advantage of negotiations. Given the relatively positive geopolitical backdrop for Abe, the biggest risk to his agenda is an exogenous economic shock. Even then, if that shock stems from China and causes Beijing to rattle-sabers as a domestic distraction, then it will benefit Abe's remilitarization agenda. What would hurt Abe is if global growth sags but China and North Korea lay low. It is too soon to say that they will do this, but it is unlikely. Trump is also a wild card whose threats of "tough" policy toward China and North Korea may reemerge in 2018, in time to help Japan make constitutional changes that the U.S. generally supports. Bottom Line: Go long Japan. While there is no correlation between Japan's defense-exposed equity sector performance and the current government's remilitarization efforts, there is a clear case to be made that nominal GDP and defense spending will both be going up as a result of constitutional and economic policies (Chart 24). Abe will double down on reflation for at least as long as is necessary to maintain popular approval of his government ahead of a historic constitutional referendum. Chart 22Revise The Constitution? Yes.##br## End Pacifism? Maybe. Northeast Asia: Moonshine, Militarism, And Markets Northeast Asia: Moonshine, Militarism, And Markets Chart 23Japanese Reflation ##br##Will Continue Japanese Reflation Will Continue Japanese Reflation Will Continue Chart 24Expect Higher Nominal##br## Growth And Defense Spending Expect Higher Nominal Growth And Defense Spending Expect Higher Nominal Growth And Defense Spending Housekeeping: Play Pound Strength Through USD, Not EUR We are closing our short EUR/GBP position, open since January 25, for a loss of 1.77%. This trade has largely been flat. We put it on as a way to articulate our view that Brexit political risks are overstated and that the pound bottomed on January 16. The political call was right, but the pound has largely moved sideways versus the euro since then. We maintain our short USD/GBP, which is up 4.63% since March 29, as a way to articulate the same view that Brexit (and the upcoming U.K. elections) are not a risk. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 2 Please see BCA Global Investment Strategy Weekly Report, "Trump Thumps The Markets," dated May 19, 2017, available at gis.bcaresearch.com. 3 The party congress, which occurs every five years and marks the "midterm" of President Xi Jinping's administration, will see a sweeping rotation of Communist Party officials, including on the Central Committee, the Politburo, and the Politburo Standing Committee (PSC). 4 Please see "China able to keep its financial markets stable, Premier Li says," Reuters, May 14, 2017, available at www.reuters.com. For the December meeting, see "China's monetary policy to be prudent, neutral in 2017," Xinhua, December 16, 2016, available at www.chinadaily.com. 5 Finance Minister Xiao Jie, Commerce Minister Zhong Shan, NDRC Chairman He Lifeng, and China Banking Regulatory Commission Chairman Guo Shuqing have all recently been appointed, but they replaced leaders due to retire as part of the party congress reshuffle. Only the new China Insurance Regulatory Commission Chairman Xiang Junbo and the new Director o f the National Bureau of Statistics Wang Baoan were replaced for reasons other than retirement, having been stung by the anti-corruption campaign. By March 2018 the world should have a better sense of Xi's economic and financial "team" for 2018-22. 6 Please see BCA China Investment Strategy Weekly Report, "China: Financial Crackdown And Market Implications," dated May 18, 2017, available at cis.bcaresearch.com. 7 Zouping government, in Shandong, intervened into the case of Qixing aluminum company's insolvency in order to transfer control to Xiwang, a corn oil and steel producer that had given a mutual guarantee to Qixing. The Zouping authorities arrested the son of Qixing's chairman to force the transfer. Please see "Bond Buyers Blacklist Some Chinese Provinces After Run Of Defaults," Bloomberg, April 26, 2017, available at www.bloomberg.com. 8 Please see "China Deleveraging To Continue As Goals Not Yet Achieved: State Paper," Reuters, May 17, 2017, available at www.reuters.com. 9 Please see BCA Emerging Markets Strategy Weekly Report, "Signs Of An EM/China Growth Reversal," dated April 12, 2017, available at ems.bcaresearch.com, and Global Investment Strategy Special Report, "The Signal From Commodities," dated May 19, 2017, available at gis.bcaresearch.com. 10 Xi may yet go after another big "tiger," Zeng Qinghong, the right-hand man of former President Jiang Zemin. 11 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated in 2018," dated April 12, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Special Report, "Reflections On China's Reforms," dated December 11, 2013, and "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com, and China Investment Strategy Special Report, "Tracking The Reform Progress," dated October 22, 2014, available at cis.bcaresearch.com. 13 "Moonshine Policy" is a phrase we regrettably did not coin, but we discussed its coming in BCA Geopolitical Strategy Weekly Report, "What About Emerging Markets?" dated May 3, 2017, and "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 14 Moon has nominated Kim Sang-jo, a professor of economics at Hansung University in Seoul, to head his Fair Trade Commission. Kim is a long-time advocate for shareholders against the family-controlled chaebol and led a prominent law suit against Samsung. Past efforts at reforming the chaebol led by Presidents Kim Dae-jung and Roh Moo-hyun focused on improving balance sheets, protecting minority shareholders' rights, limiting the total amount of investment, and improving corporate management and accountability. It remains to be seen how Moon (and Kim Sang-jo, assuming his nomination is confirmed) will proceed, but the effort will bring domestic challenges to the top industrial conglomerates' operating environment at least initially. 15 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 16 South Korea's special envoy Hong Seok-hyun claims that Trump told him at the White House that he will work closely with Moon and is willing to try engagement with Pyongyang, conditions permitting, though he is not interested in talks for the sake of talks. This fits with our view that the U.S. saber-rattling this year was designed to make the military option more credible before pursuing a new round of diplomacy. 17 Please see BCA Geopolitical Strategy "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, and Special Report, "Japan: The Emperor's Act Of Grace," dated June 8, 2016, available at gps.bcaresearch.com. 18 So, for instance, if it should happen that, over the course of the coming debates, Abe is forced to drop his proposed revisions to the pacifist Article 9, he may still achieve changes to the amendment-making procedure in Article 96. The latter would be even more important for Japan's future, since it would make it easier for Japan to change the constitution for whatever reason in the coming decades. 19 Please see BCA Geopolitical Strategy Monthly Report, "King Dollar: The Agent Of Righteous Retribution," dated October 12, 2016, available at gps.bcaresearch.com.

Dear Client, In addition to this Special Report, I am sending you our usual Weekly Report focusing on the market implications from the brewing crisis in the Trump White House. Best regards, Peter Berezin, Chief Global Strategist Highlights Chart 1Commodity Prices: A Halting Comeback Commodity Prices: A Halting Comeback Commodity Prices: A Halting Comeback Commodity prices have managed to stage a halting comeback over the past two weeks, but still remain well below their highs for the year. Concerns over the Chinese economy, a withdrawal of speculative demand, and strong supply growth have all weighed on commodity prices. All three of these forces should ebb over the coming months. This should provide a more benign cyclical backdrop for commodities and commodity-related investment plays. We went long the December 2017 Brent futures contract two weeks ago. The trade is up 7.8% since then. Stick with it. The cyclical recovery in commodity prices will benefit DM commodity currencies such as the CAD, AUD, and NOK. Go short EUR/CAD. Feature What's Been Weighing On Commodities? Commodity prices have managed to stage a halting comeback over the past two weeks, but still remain well below their highs for the year (Chart 1). We see three reasons why commodities have struggled to gain traction over the past few months: Fears that the Chinese economy is losing growth momentum have intensified. Traders have soured on the commodity complex, causing speculative demand to fizzle. Skepticism about OPEC's ability to maintain production discipline has been running high. All three of these forces should ebb over the coming months. This should provide a more benign cyclical backdrop for commodities and commodity-related investment plays. Global Growth: An Uneven Picture After a strong end to 2016, global growth so far this year has been mixed. The euro area has continued to hum along, with real GDP increasing by 2% in Q1 on an annualized basis. Japanese growth clocked in at 2.2% in Q1. This marked the fifth consecutive quarter of positive growth - the first time this has happened in 11 years! In contrast, U.K. growth slowed to 1.2% in Q1, while the U.S. registered a disappointing 0.7% growth print. As discussed in the Weekly Report that accompanies this Special Report, the U.S. economy is likely to bounce back over the remainder of the year, notwithstanding the ongoing soap opera that has become the Trump presidency. However, even if that happens, traders have become increasingly concerned that stronger U.S. growth will be offset by weaker growth in China. China Growth Risks Back In Focus All four Chinese purchasing manager indices fell in April (Chart 2). This week's data releases saw below-consensus growth in industrial production, retail sales, and fixed asset investment. Tighter financial conditions have contributed to the recent growth shortfall (Chart 3). The PBoC has drained excess liquidity over the past few months, causing overnight rates to rise. Corporate bond yields have surged while Chinese small cap stocks have taken it on the chin. The slowdown in Chinese growth is a cause for concern, but some perspective is in order. The economy began the year on a strong footing. Nominal GDP increased by 11.8% in Q1, compared with 9.6% in Q4 of 2016. Real GDP rose by 6.9% in the first quarter, comfortably above the government's target of 6.5%. A modest slowdown from these levels is not surprising. Most indicators point to an economy that is still expanding at a decent clip. Export growth is accelerating and our China team's model suggests that this will remain the case, thanks to solid global demand and a competitive RMB (Chart 4). America's latest anti-dumping measures on some Chinese steel products are irrelevant from a big picture point of view, as U.S. steel imports from China only account for a mere 1% of Chinese steel output. Chart 2China: PMIs Falling Across The Board China: PMIs Falling Across The Board China: PMIs Falling Across The Board Chart 3Financial Conditions Have Tightened In China Financial Conditions Have Tightened In China Financial Conditions Have Tightened In China Chart 4China: The Rebound In Exports Should Continue China: The Rebound In Exports Should Continue China: The Rebound In Exports Should Continue Meanwhile, fixed investment is benefiting from an upturn in the profit cycle. Chart 5 shows that excavator sales, railway freight traffic, and the PBoC's Entrepreneur Confidence Index - all leading indicators for Chinese capex - are surging. Even the housing market is well positioned to withstand some policy tightening. Land purchases by developers have rebounded and the most recent central bank survey showed that households' home-buying intentions jumped to an all-time high in the first quarter (Chart 6). Chart 5Positive Signs For Chinese Capex... Positive Signs For Chinese Capex... Positive Signs For Chinese Capex... Chart 6...And The Housing Market ...And The Housing Market ...And The Housing Market Efforts Focused On Containing Financial Risk Most of the government's tightening measures have been designed to reduce financial sector risks while inflicting as little collateral damage on the economy as possible. So far, this strategy appears to be working: While broad credit growth has slowed from a high of 25.7% in January 2016 to 15.5% in April of 2017, almost all of that was due to a deceleration in borrowing by non-bank financial institutions. The pace of lending to nonfinancial private borrowers and the government - the so-called "real economy" - has barely fallen from last year. In fact, medium- and long-term loans to the corporate sector, a key driver of overall capital spending, have accelerated (Chart 7). The inversion of the Chinese yield curve largely reflects these macroprudential measures. The spread between 10-year and 5-year government bond yields turned negative last week, the first time this has ever happened (Chart 8). Chart 7China: Credit Growth To The Real EconomyBarely Affected By Tightening Measures China: Credit Growth To The Real Economy Barely Affected By Tightening Measures China: Credit Growth To The Real Economy Barely Affected By Tightening Measures Chart 8Chinese Yield Curve Inversion Chinese Yield Curve Inversion Chinese Yield Curve Inversion Some pundits have interpreted this development as an omen of a coming recession. However, there is a less dramatic explanation: Up until recently, non-bank financial institutions have been issuing so-called wealth management products like crazy. According to Moody's, the outstanding value of these products soared from U.S. $72 billion in 2007 to $4.2 trillion in the first quarter of 2017. The crackdown on shadow banking has forced many participants to liquidate their positions which, in many cases, included substantial leveraged holdings of government bonds. Since 5-year bonds are less liquid than their 10-year counterparts, yields on the former have increased more than on the latter. The Commodity Connection While the data is sketchy, it appears that Chinese non-bank financial institutions have been major players in the commodities market. As funding to these institutions - and their clients - dried up, panic selling of commodity futures contracts ensued. This withdrawal of Chinese investment demand for commodity markets began at time when, globally, long speculative positions were highly elevated. Chart 9 shows that net long spec positions as a share of open interest for energy and industrial commodities reached the highest levels in over a decade earlier this year. Today, speculative positioning has returned to more normal levels. This reduces the risk of a further downdraft in commodity prices. At the same time, the Chinese authorities appear to be relaxing some of their earlier tightening measures. The PBoC re-started its Medium-Term Lending Facility (MLF) earlier this week. It also made the largest one-day cash injection into the financial system in nearly four months on Tuesday. This follows the release of stronger-than-expected credit numbers for April, as well as Premier Li Keqiang's call over the weekend for "striking a balance" between enhancing financial stability and maintaining growth. Adding to the newfound easing bias, general government fiscal spending is now recovering (Chart 10). Chart 9Commodities: Long Speculative Positions Returning To More Normal Levels Commodities: Long Speculative Positions Returning To More Normal Levels Commodities: Long Speculative Positions Returning To More Normal Levels Chart 10China: Fiscal Spending Is On The Mend China: Fiscal Spending Is On The Mend China: Fiscal Spending Is On The Mend Oil Supply Should Tighten Chart 11Oil Inventories Should Decline Oil Inventories Should Decline Oil Inventories Should Decline Tighter supply conditions in various parts of the commodity complex should reinforce the upward pressure on prices stemming from firming demand. This is especially true for crude oil. Saudi Arabia and Russia announced earlier this week that they will support an extension of output cuts through to March 2018. Despite a sharp recovery in shale output, BCA's energy strategists expect global production to increase by only 0.5 MMB/d in 2017 compared to 1.5 MMB/d growth in consumption. Consequently, oil inventories should fall over the remainder of this year. Inventory draws will continue through 2018, albeit at a slower pace than in 2017 (Chart 11). Larger-than-expected declines in U.S. oil inventories over the past two weeks, along with a steep reduction in the volume of oil held in tanker ships (so-called "floating storage"), suggest that this trend has already begun. Some Investment Implications Fading fears about a China slowdown and a tighter supply picture will lift commodity prices over the remainder of the year. We went long the December 2017 Brent futures contract two weeks ago. The trade is up 7.8% since then. We are targeting a further 10% in upside from current levels. The cyclical recovery in commodity prices will benefit the stocks and bonds of companies within the resource sector. It will also benefit DM commodity currencies such as the CAD, AUD, and NOK. In addition, rising commodity prices will provide a tailwind to emerging markets, although Fed rate hikes and the occasional political scandal (here's looking at you, Brazil!) will take some bloom off the rose. The prospect of higher commodity prices supports our recommendation to be overweight euro area stocks relative to U.S. equities. The IMF estimates that the European economy is three-times more sensitive to changes in EM growth than the U.S. (Chart 12).1 If higher commodity prices give emerging markets a boost, this will help Europe's large industrial exporting companies. Calculations by JP Morgan suggest that petrostate sovereign wealth funds hold five times more European equities than U.S. stocks, even though European stocks account for less than half the global market capitalization of U.S. stocks.2 These funds are especially exposed to European financials and consumer discretionary names. Higher oil prices would give them greater scope to add to their favorite positions. What about EUR/USD? The run-up in the euro over the past few weeks was partly driven by the unwinding of sizable short hedges that traders put on in the lead up to the French elections. At this point, euro positioning has moved from being highly bearish to broadly neutral. Going forward, fundamentals will play the dominant role. On the one hand, an outperforming euro area equity market should attract foreign capital into the region, giving the common currency a boost. On the other hand, interest rate differentials will continue to move in favor of the dollar. As we discussed last week, the Fed is likely to raise rates by more than the 38 basis points that markets are currently pricing in over the next 12 months.3 In contrast, the ECB is likely to stand pat, given that the rate of labor underutilization is still 18% in the euro area, 3.5 percentage points higher than in 2008 (Chart 13). If anything, rising inflation expectations in the euro area could cause real short-term rates to decline, putting downward pressure on the euro. Chart 12Europe Is More Sensitive To EM The Signal From Commodities The Signal From Commodities Chart 13Labor Market Slack In The Euro Area Remains High The Signal From Commodities The Signal From Commodities Our research indicates that real interest rate differentials are by far the most important drivers of currency returns over cyclical horizons of around 12 months. The decline in the dollar over the past few weeks has occurred alongside an increase in real rate differentials between the U.S. and its trading partners. Notably, two-year real rate differentials have widened by 47 basis points versus the euro area since the end of March, even though the dollar has actually weakened against the euro over this timeframe (Chart 14). Thus, a period of "catch-up strength" for the dollar is in order. We continue to expect EUR/USD to reach parity by the end of the year. With all this in mind, we are opening a new trade today: Short EUR/CAD (Chart 15). Chart 14Widening Real Rate Differentials Support The Dollar Widening Real Rate Differentials Support The Dollar Widening Real Rate Differentials Support The Dollar Chart 15Play The Cyclical Recovery In Oil Via The EUR/CAD Play The Cyclical Recovery In Oil Via The EUR/CAD Play The Cyclical Recovery In Oil Via The EUR/CAD Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see "IMF Multilateral Policy issue Report: 2014 Spillover Report," IMF, dated July 29, 2014. 2 Nikolaos Panigirtzoglou, Nandini Srivastava, Jigar Vakharia, and Mika Inkinen, "Flows & Liquidity," J.P.Morgan Global Asset Allocation (January 29, 2016). 3 Please see Global Investment Strategy Weekly Report, "The Fed's Dilemma," dated May 12, 2017, available at gis.bcaresearch.com.

Highlights Increased regulatory scrutiny on the domestic financial sector may continue to create some headline risks and financial volatility, but the real economic impact should be marginal. The recent regulatory crackdown has mainly caused liquidity issues in the domestic market rather than any sort of real growth issue. Chinese shares listed overseas will continue to grind higher. Domestic A shares will remain largely trendless. Domestic corporate bonds are starting to look attractive after the most recent panic selloff. Feature Chinese domestic stocks and bonds have taken a beating of late as the authorities ramped up scrutiny to rein in excesses in the country's financial sector. While it is warranted to control accumulated financial risk - especially associated with shadow banking activity - the "campaign" style administrative crackdown has caused widespread confusion and mini-panics among domestic investors. The actions and corresponding reactions illustrate the authorities' primitive control tools, which are increasingly at odds with the rapidly developing financial sector, and how blanket actions can spur undue financial volatility and provoke unintended consequences. For now, we expect the economic fallout to be limited, unless the financial crackdown causes further spikes in interest rates and a sudden halt in credit flows. Chinese shares listed overseas will continue to grind higher in the absence of a major policy mishap that short-circuits the broad growth improvement and the profit cycle upturn. Domestic A shares will remain largely trendless, while the more richly valued bubbly segments of the market will continue to deflate. Domestic corporate bonds are starting to look attractive after the most recent panic selloff. What Do They Want To Achieve? Policymakers' primary focus has been on cracking down on excessive speculation in financial markets and restricting lending activities that are not in compliance with legal and regulatory requirements. Financial sector deregulation in recent years has increasingly blurred the lines between banks, insurance companies, brokers and trust companies, and regulators are constantly challenged to monitor all the increasingly sophisticated moving parts. From the banking sector's point of view, regulators are concerned that lenders have been aggressively boosting their exposure to other banks and non-bank financial institutions instead of providing credit to the "real economy." Overall commercial banks' claims on other banks and non-bank financial institutions have increased from 12% of their total assets in 2006 to over 25% as of January 2017, while their liabilities to other banks and non-bank financial firms have increased from 7% to 12% (Chart 1). Smaller banks are even more dependent on interbank financing for loanable funds. Interbank transactions and repo activities account for about 14% of smaller lenders' total source of funding, compared with 2% for large banks (Chart 2). Some small banks regularly borrow at lower costs through the interbank market or use negotiable certificate of deposits to purchase "wealth management products" offering higher returns issued by other banks or financial institutions. The duration mismatch leads to constant pressure to roll over these short-term financial instruments. The increasing interdependence among the country's financial institutions also creates the risk of a chain reaction in the financial system should some type of credit event erupt. Chart 1Increasing Interdependence Among Financial Institutions China: Financial Crackdown And Market Implications China: Financial Crackdown And Market Implications The Chinese authorities have long regarded preventing systemic financial risk as a top priority, and the recent growth improvement has provided a window of opportunity for some housecleaning without a major adverse impact on the economy. Therefore, it is unlikely that regulators will back off from tightening regulatory supervision going forward. Overall, the authorities will continue to discourage overtrading within the financial system, and enforce full disclosure of off-balance-sheet items and shadow lending activities. The saving grace is that tightened macro prudential measures have already begun to curtail banks' aggressive expansion to non-bank financial institutions. Commercial banks' claims to these firms have slowed sharply since last year's peak (Chart 3). Meanwhile, the recent rise in interbank rates should also further discourage the perceived "risk-free" funding arbitrage to play the interest rate gap between long- and short-dated financial assets. All of this reduces the pressure of an escalation in the regulatory crackdown. Chart 2Smaller Banks Depend More On##br## Wholesale Funding Smaller Banks Depend More On Wholesale Funding Smaller Banks Depend More On Wholesale Funding Chart 3Banks' Exposure To Non-Bank Financial Firms ##br##Has Been Scaled Back Banks' Exposure To Non-Bank Financial Firms Has Been Scaled Back Banks' Exposure To Non-Bank Financial Firms Has Been Scaled Back Should Investors Be Concerned? In essence, banks' rising claims to other financial institutions means a lengthening of the credit intermediation channel, in which financing goes from credit providers through multiple layers of intermediaries to reach final borrowers in the real economy. In other words, banks, instead of lending directly to borrowers, channel loans to trust companies or securities brokers, who in turn transfer the funds to the real economy through "shadow banking" activities such as trust loans or various forms of "wealth management products", typically at higher rates. From this perspective, cracking down on lending excesses within the financial system in of itself should not have a material impact on credit flows to final corporate borrowers. In fact, streamlining the financial intermediation channel holds the promise of increasing accessibility to bank credit for the corporate sector and reducing its funding cost, which should benefit the overall economy in the long run. In the near term, liquidity tightening and the regulatory crackdown could push up interest rates and disrupt credit flows, which should be closely monitored to assess near-term negative impact on the economy. So far, the impact does not appear material. Chart 4Regulatory Crackdown ##br## Has Not Interrupted Credit Flows Regulatory Crackdown Has Not Interrupted Credit Flows Regulatory Crackdown Has Not Interrupted Credit Flows Interbank rates have increased by about 100 basis points across the board since the beginning of this year, and 10-year government bond yields have risen by 50 basis points - both of which pale in comparison to the significant improvement in overall business activity. Nominal GDP growth expanded by 11.8% in the first quarter, compared with 9.6% in Q4, 2016. Furthermore, the central bank early this week re-started its medium-term lending facility (MLF), which was designed to avoid liquidity overkill in the domestic financial sector. Overall, the risk of overtightening of liquidity is not high. The regulatory crackdown since early this year has not had a meaningful impact on credit expansion. Banks' claims to other financial institutions have slowed sharply, but overall loan growth has been rather stable. Importantly, medium- and long-term loans to the corporate sector, pivotal for overall capital spending, have in fact accelerated (Chart 4). In short, increased regulatory scrutiny on the domestic financial sector may continue to create some headline risks and financial volatility, but the real economic impact should be marginal. We expect the authorities to remain highly vigilant and avoid policy overkill. Reading Market Tea Leaves There have been some notable divergences among different classes of Chinese stocks (Chart 5). Chinext, the domestic small-cap venture board, has suffered heavy losses of late, while large-cap A shares have been much more resilient. Meanwhile, offshore Chinese shares have barely felt any pressure at all. H shares have moved higher of late, while Chinese firms listed in the U.S. have decisively broken out. The divergence between onshore and offshore Chinese stocks' performance confirms the recent regulatory crackdown has mainly caused liquidity issues in the domestic market rather than any sort of real growth issue. Barring major policy mistakes, we expect the Chinese economy to stay buoyant, as discussed in detail in our recent report.1 As such, a few investment conclusions can be drawn. Tighter liquidity will likely continue to place downward pressure on domestic stock prices, but the downside is limited by overall buoyant activity and improving profits. We expect the broad-A share market will remain narrowly range-bound. Overseas-listed Chinese shares are not subject to domestic liquidity constraints, and will likely continue to grind higher supported by growth improvement, profit recovery and low valuation multiples. The small-cap Chinext market has long been viewed as the more speculative segment of the domestic financial market, with higher multiples and greater volatility than large-cap A shares. As such, this market will remain vulnerable to domestic liquidity tightening. Even after the most recent selloff, the bourse's trailing price-to-earnings ratio and price-to-book ratio are still at 38.4 and 4.6, respectively, much higher than for broader onshore and offshore Chinese stocks. The recent selloff in the onshore corporate bond market has also been driven by liquidity pressure, which in our view is overdone. While it's true that economic acceleration justifies higher yields, corporate spreads have also widened sharply, which is at odds with the broad growth acceleration and profit recovery. In addition, after the most recent selloff, Chinese corporate spreads are significantly higher than in most other major markets (Chart 6). In the near term, tighter liquidity may continue to induce more selling pressure in the domestic bond market. Cyclically we expect Chinese corporate bond spreads to narrow. Chart 5Diverging Market Trends Diverging Market Trends Diverging Market Trends Chart 6The Sharp Spike In Chinese Corporate ##br##Spreads Is Overdone The Sharp Spike In Chinese Corporate Spreads Is Overdone The Sharp Spike In Chinese Corporate Spreads Is Overdone Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Has China's Cyclical Recovery Peaked?" dated May 5, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Unsurprisingly, OPEC 2.0's leadership agreed on the need to extend the coalition's 1.8mm b/d production-cutting agreement to end-March 2018. Leaders of the coalition - the energy ministers of the Kingdom of Saudi Arabia (KSA) and Russia - will recommend as much when the coalition meets next week in Vienna. Meanwhile, sequential production in U.S. shales during the first four months of the year is up just under 100k b/d, based on the EIA's latest estimates. This was led by surging Permian production. We expect shale-oil production growth to continue, and are revising our year-end 2017 light-tight-oil (LTO) production estimate for the four main shale-oil plays to 5.66mm b/d, up from our earlier assessment of 5.39mm b/d. We also are lifting our year-end 2018 estimate of shale production to 6.64mm b/d. This means December-to-December LTO production will increase ~ 1mm b/d by Dec/17 and by another ~1mm b/d by Dec/18. Energy: Overweight. As of last Thursday's close, we are long Dec/17 Brent $65/bbl calls vs. $45/bbl puts at -$1.16/bbl, and long Dec/17 vs. Dec/18 Brent at -$0.21/bbl. These positions were up 16.4% and 242.9%, respectively. Base Metals: Neutral. The physical deficit in zinc appears to be widening slightly, based on supply-demand estimates from the International Zinc Study Group. Usage totaled 2.282mm MT in Jan-Feb 2017 vs. refined production of 2.28mm MT. For 2016, usage was 13.89mm MT vs. supply of 12.67mm MT. Precious Metals: Neutral. Metal refiner Johnson Matthey expects a 790k oz. palladium deficit this year, up from a little over 160k oz. last year. Separately, the World Platinum Investment Council expects platinum supply to fall 2% this year to 7.33mm oz. Ags/Softs: Underweight. The USDA reported corn planting stood at 71% for the week ended May 14, vs. an average of 70% over the 2012 - 16 period. We remain bearish. Feature The determination of the leaders of OPEC 2.0 to clear the storage overhang could not have been made more clear, following comments earlier this week from KSA's and Russia's energy ministers the coalition's 1.8mm b/d production-cutting agreement would be extended to end-March 2018. This is three months beyond earlier speculation the deal would be extended to year-end 2017. Chart of the WeekBalances Chart Balances Chart Balances Chart Still, when dealing with a political organization of any sort - and OPEC 2.0 is nothing if not a political entity - our bias is to assume less-than-complete compliance with production cuts, and an earlier return to pre-agreement production levels than proffered by the leadership of the coalition. Hence, in our updated balances model (Chart of the Week), in addition to assuming higher U.S. production out of the shales, we have Russian production returning to a level just below 11.30mm b/d by October 2017, up roughly 150k b/d from the 11.15mm b/d we assume they'll be producing until the end of September. We also assume Iraq's production will move up to 4.45mm b/d (up 50k b/d) beginning in January, and that Iran will be steadily, yet slowly, increasing production by 5-10k b/d per month beginning this month. The only assumption we're making for staunch compliance to the OPEC 2.0 accord after our assumed extension to year-end 2017 at next week's Vienna meeting is that KSA and its GCC allies - Kuwait, Qatar, and the UAE - will continue to abide by their voluntary production cuts. This group has maintained solidarity on past production-management deals, we expect them to do so again in this round. Of course, the other members of the coalition could vote against this proposal next week, and instead decide to end the production deal in June under its original conditions. Or, they could agree to extend the deal, but only until year-end 2017. Regardless of whichever policy decisions are agreed to during next week's meeting, come November, when OPEC meets again, they might tweak/change those agreements to reflect their updated outlook at that time. Given this uncertainty, we believe the assumptions we've made are realistic, but we will be monitoring conditions closely so that we can modify our view quickly. Shale Coming On Strong Part of OPEC 2.0's desire to extend its deal likely is the improvement in the performance of shale-oil producers in the U.S. In its latest Drilling Productivity Report (DPR), the EIA noted that sequential production in the first four months of the year has risen ~ 100k b/d per month in the U.S. shales. This surge was led by higher Permian production, which accounted for ~ three-quarters of the increased output (Chart 2). Interestingly, rig-weighted production per rig dropped for the first time in April 2017, but it still is high at 732 b/d, down from 735 b/d in March. We will be watching this closely to see if it is the beginning of a trend of stagnating productivity amid a rapid expansion of industry activity. The resurgence in the shales can be seen in the year-on-year (yoy) growth in total production in the seven basins the EIA tracks, which broke back above 5.0mm b/d in February and crossed into positive yoy growth in March (Chart 3). Net, we expect 2017 global supply to average 97.65mm b/d, for an increase 610k b/d this year, and for demand to average 98.3mm b/d, for an increase of 1.5mm b/d. EM demand, which we proxy using non-OECD consumption, accounts for 1.27mm b/d of this year's global demand growth, and continues to lead overall growth in oil demand (Chart 4, panel 2). Of this, China and India account for 350k and 210k b/d, respectively, of the growth in EM demand. Chart 2Permian Basin Leads##br##U.S. Shale's Resurgence Permian Basin Leads U.S. Shale's Resurgence Permian Basin Leads U.S. Shale's Resurgence Chart 3Year-On-Year LTO Production##br##Breaks Out In 1Q17 Year-On-Year LTO Production Breaks Out In 1Q17 Year-On-Year LTO Production Breaks Out In 1Q17 Chart 4EM Growth Continues##br##To Lead Global Demand EM Growth Continues To Lead Global Demand EM Growth Continues To Lead Global Demand China, India Lead EM Oil Consumption Non-OECD countries represent more than 50% of global oil consumption. Indeed, within the ~1.6mm b/d global oil demand growth we expect for 2017 and again in 2018, slightly more than 87% of it comes from EM economies. Table 1 below shows the average yoy growth by year for different regions - DM and EM - and countries from 2011 to 2018. Over this period, almost all of the world's oil-demand growth comes from non-OECD countries. From 2011-2018, the average p.a. demand growth for non-OECD countries is 2.79%, while for OECD countries it is only 0.12%. Table 1EM Leads Oil-Demand Growth Balancing Oil-Shale's Resilience And OPEC 2.0's Production Cuts Balancing Oil-Shale's Resilience And OPEC 2.0's Production Cuts Looking more closely at the composition of the EM economies, we see that, on average, between 2010 and 2018 Chinese oil consumption accounts for 24% of non-OECD demand, while the Indian oil consumption represents 8.3%, for a combined total of 32.37% of non-OECD average consumption. These two countries alone contributed on average to around 50% of the world oil consumption growth from 2010 to 2018. China has been the fastest-growing oil market in the world since the early 2000s. However, since 2015, when it emerged as an important growth market on the world stage, India's consumption has been increasing at a faster pace than China's. One of the reasons for this likely is the desire of the Chinese government to resume its pivot to a more service-oriented economy, which is less commodity-intensive than the export-oriented economy dominated by heavy industry. India, meanwhile, is looking to increase its manufacturing output, lifting it from the low-teens to 25% of GDP by 2022 under Prime Minister Narendra Modi's "Make in India" campaign. This change in the composition of global oil-demand growth is reducing demand for residual fuel oil and distillates. Indeed, IEA data continues to show a steady decline in yoy consumption for these two types of fuel in China, with residual fuel oil consumption down 26.5% yoy in 2016, and gasoil and diesel (distillates) consumption down close to 3% yoy. By contrast, gasoline consumption, is up more than 8% yoy along with jet fuel and kerosene. LPG demand (propane and butane, along with other light ends) and ethane demand (a petrochemical feedstock) is surging, up 24% in 2016, according to the IEA. In relative terms, China will remain the main driver of global oil consumption. At ~ 12.5mm b/d, China's oil demand is close to three times as high than India's. However, India likely will surpass China in terms of its contribution to global oil demand growth in coming years. A combination of structural and policy-driven factors points toward a possible sustainable growth path for Indian oil consumption for the coming years (oil consumption per capita is increasing, as is vehicle usage, particularly motorcycles (Chart 5); and, the government's desire to increase the share of the manufacturing to 25% of GDP by 2022 will boost oil demand growth as well). Chart 5India Passenger Car Sales Are Soaring India Passenger Car Sales Are Soaring India Passenger Car Sales Are Soaring Recent studies assessing the "take-off" of an economy look at its per capita oil consumption in transportation, in particular, given that this sector accounts for more than half of the world's oil consumption (63% according to IEA Energy Statistics 2014). The theory boils down to the following: As income grows, a larger share of the population becomes vehicle owners. This is referred to as the "motorization" of an economy. In India, the transportation sector represents around 40% of total oil consumption.1 According to Sen and Sen (2016), the level of vehicle-ownership per capita is still low in India compared to other economies that have experienced similar take-offs. The government's targeted increase in manufacturing as a share of GDP to 25% under the "Make In India" program (from a current level of ~ 15%) would, according to the Sen and Sen (2016) formulation, lead to an increase in oil consumption. The "Make in India" campaign was launched in 2014 by Prime Minister Narendra Modi and aims to transform the country's manufacturing sector into a powerhouse for growth and employment. Other key objectives of this campaign include a target of 12-14% annual growth in the manufacturing sector, and the creation of 100 million new jobs by 2020 in the sector.2 In 2017Q1, India's liquid fuels consumption declined by 3% yoy. This decline was, for the most part, caused by the government's "demonetization" program, which was designed to streamline the economy and reduce rampant black-market transactions. The government chose to invalidate the 500- and the 1,000-rupee banknotes, the most-used currency denominations in the economy (around 86% of the total value of currency in circulation). This represented a huge shock to the average citizen, since it limited the purchasing power of a large part of the consumer economy for an extended period of time and impacted India's overall economic activity. Recent data show Indian oil and liquids consumption up 3% in April (yoy), and its money supply is almost back to its pre-demonetization levels, according to the EIA. This suggests economic activity and liquid-fuel consumption will get back to their previous levels. Bottom Line: We believe OPEC 2.0's deal will be extended at next week's Vienna meeting to March 2018. However, after September, we are expecting compliance to fall off meaningfully, leaving KSA and its allies as the only producers adhering to their voluntary cuts past year-end 2017. Even so, we expect the storage overhang to be worked off - mostly this year - but also into next. Even though U.S. shale production is surprising on the upside, the commitment of a majority of OPEC 2.0 to production cutbacks at least through September of this year will force the storage overhang to draw down by year end. KSA and its core allies will maintain production discipline to March 2018, which will keep storage from refilling too quickly during the seasonally weak consumption period in the first quarter next year. We continue to expect oil forward curves to backwardate by December 2017, and remain long Dec/17 Brent vs. short Dec/18 Brent. In addition, we remain long Dec/17 Brent $65/bbl calls vs. short Dec/17 Brent $45/bbl puts, expecting prices to rally toward $60/bbl by the time Brent delivers in December. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Assistant Commodity & Energy Strategy hugob@bcaresearch.com 1 Sen, Amrita; Anupama Sen (2016), "India's Oil Demand: On the Verge of 'Take-Off'?". Oxford Institute for Energy Studies. 2 Some of the recent policies to enhance the manufacturing growth include: Government subsidies of up to 25% for specific manufacturing sub-sectors; area-based incentives to increase the manufacturing development in key regions; allowances for companies that invest a predetermined amount in new plant and machinery; deductions for additional wages paid to new regular employees; deductions for R&D expenditures; and other incentives aimed at promoting the manufacturing sector and improving the India's ease of doing business to attract foreign direct investments. Please see http://www.makeinindia.com/article/-/v/direct-foreign-investment-towards-india-s-growth. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016 Balancing Oil-Shale's Resilience And OPEC 2.0's Production Cuts Balancing Oil-Shale's Resilience And OPEC 2.0's Production Cuts Balancing Oil-Shale's Resilience And OPEC 2.0's Production Cuts Balancing Oil-Shale's Resilience And OPEC 2.0's Production Cuts

Highlights The structural theme of overweighting technology stocks within the overall equity benchmark, and relative to other cyclical sectors such as commodities and machinery stocks, remains intact. However, in absolute terms, EM tech/semi share prices have become overbought and have already priced in a lot of good news. They will likely sell off soon due to the potential slowdown in the pace of semiconductor demand. Continue overweighting EM tech stocks, Taiwanese and Korean bourses within EM equity portfolios. We also reiterate our long-standing long tech / short materials strategy. Feature EM technology stocks have surged to all-time highs (Chart I-1, top panel), contributing significantly to the ongoing EM rally. In fact, excluding tech stocks, EM share prices have not yet surpassed a major technical hurdle, as shown in the bottom panel of Chart I-1. BCA's Emerging Markets Strategy (EMS) team has been recommending that investors overweight tech stocks since June 8, 2010. In our report titled, How To Play EM Growth In The Coming Decade,1 we contended that the structural bull market in commodities was over, and that in the coming decade (2010-2019) the winners would be health care and technology (Chart I-2). We also identified a potential mania candidate - i.e., a segment that was poised for exponential price gains. We reasoned that the fusion between technology and health care - health care equipment stocks - could experience exponential price moves. This strategy has paid off exceptionally well. Consistently, within the EM equity benchmark, we have been overweighting Taiwanese and Korean tech stocks since 2007 and 2010, respectively (Chart I-3). Chart I-1EM Tech Stocks Have ##br##Surged To All Time Highs EM Tech Stocks Have Surged To All Time Highs EM Tech Stocks Have Surged To All Time Highs Chart I-2EMS Strategy Since 2010: ##br##Long Tech / Short Materials EMS Strategy Since 2010: Long Tech / Short Materials EMS Strategy Since 2010: Long Tech / Short Materials Chart I-3Taiwanese & Korean Tech ##br##Stocks Relative To Overall EM Taiwanese & Korean Tech Stocks Relative To Overall EM Taiwanese & Korean Tech Stocks Relative To Overall EM After such enormous gains, a relevant question is whether technology share prices will continue to rally in absolute terms, boosting the EM equity benchmark, or whether their absolute performance and/or relative performance will roll over. Chart I-4EM Tech Stocks Are Overbought EM Tech Stocks Are Overbought EM Tech Stocks Are Overbought Before we proceed in laying out our analysis, a caveat is in order: we can offer thematic long-term views on various sectors, but investors should realize the investment calls on many technology, internet and social media companies are driven by bottom-up - not macro - views. From a top-down perspective, we can offer little insight on whether EM internet and social media stocks such as Alibaba, Tencent and Baidu are cheap or expensive, whether their business models are or are not proficient, or what their profit outlooks might be. The reason is that these and other global internet/social media companies' revenues are not driven by business cycle dynamics and top-down analysis is less imperative in forecasting their performance. In this report we will shed some light on the business cycle in the global/Asian semiconductor industry. The latter is subject to both business cycle swings as well as sector-specific factors. Again, sector-unique factors for the semi industry are also beyond our top-down approach. The five largest constituents of the EM MSCI tech sector are Samsung (4.3% of EM MSCI market cap), Tencent (4.0%), Taiwan Semiconductor Manufacturing Company (3.5%), Alibaba (3.0%), and Baidu (1.0%). Chart I-4 shows their share prices. In short, they have become a large part of the EM benchmark and are also extremely overbought, increasing the risk of correction. Technology's Structural Bull Market Is Intact... Even though EM tech prices have skyrocketed in both absolute and relative terms, odds are that the structural bull market has further to run. There are no structural excesses in the technology sector that would warrant a bust for now. Even in China, credit/leverage excesses are concentrated in the old industries, not among the tech and new economy segments. Demand for tech products in general and semiconductors in particular is not very dependent on the credit cycle in EM. In both developed market (DM) and EM economies, spending on many tech gadgets is contingent on income gains rather than credit growth. Our bearish view on EM/China growth is primarily due to our expectations of a credit downturn that will affect spending that is financed by credit. Investment expenditures driven by credit are much more important for commodities and industrial goods than technology products. While the share prices of technology and new economy companies are overbought and may be expensive, global/EM economic demand growth will be skewed toward new industries and technologies rather than commodities. In brief, the outlook for global tech spending remains positive, both cyclically and structurally. Having outperformed all other sectors by a large margin, the EM technology sector presently accounts for 26% of the EM MSCI benchmark, while at its previous structural peak in 2000 its market share stood at 22% (Chart I-5, top panel). During the 1999-2000 tech bubble, the U.S. and DM tech sector’s share of market cap reached 34% and 24% of the U.S. MSCI and DM MSCI benchmark market caps, respectively (Chart I-5, middle and bottom panels). Despite being stretched, it is possible that the technology sector's market cap will rise further before another structural top transpires. Hence, we are not yet ready to call the top in the tech's share of the overall market cap either in EM or DM. From a very long-term perspective (since 1960), the relative performance of the U.S. technology sector against the S&P 500 has not yet reached two standard deviations above its time trend, as it did in the year 2000 during the tech bubble. Conversely, the same measure for energy, materials and machinery stocks is not yet depressed enough to warrant a mean reversion bet (Chart I-6). Chart I-5Tech Stocks Market Cap Share ##br##Of Overall Equity Benchmarks Tech Stocks Market Cap Share Of Overall Equity Benchmarks Tech Stocks Market Cap Share Of Overall Equity Benchmarks Chart I-6Relative Performance Of ##br##U.S. Sectors Vs. S&P 500 Relative Performance Of U.S. Sectors Vs. S&P 500 Relative Performance Of U.S. Sectors Vs. S&P 500 Finally, secular leadership rotations within global equities typically occur during market downturns. Chart I-7 shows that commodities stocks and tech leadership changed in 2001 and 2008. It is possible that new sectoral leadership will emerge in global equities during the next bear market/severe selloff. However, it is too early to bet on it now. The current character of equity markets - which favors technology over commodities - will persist. Bottom Line: The structural theme of overweighting technology stocks within the overall equity benchmark and relative to other cyclical sectors such as resources/commodities and machinery stocks remains intact. ...But The Semi Cycle Upswing Is Advanced The semiconductors industry is cyclical, and as such business cycle analysis is pertinent here. The rest of the technology sector, however, is not correlated with overall business cycles. Therefore, there is little value that macro analysis can deliver on the outlook for non-semi tech areas. This is why this section is focused on semiconductors rather than the overall tech sector. There is no basis as to why semiconductor/tech cycles should correlate with commodities cycles. However, when they do, the amplitude of global business cycle fluctuations rises. Indeed, Asian exports and global trade tumbled in 2015 and have subsequently improved over the past 12 months for the following reason: the 2015 downturn and the ensuing recovery in the semiconductor cycle overlapped with similar swings in commodities and Chinese capital goods demand (Chart I-8). This has increased the amplitude of the global business cycle's swings in the past two years. Chart I-7Secular Leadership ##br##Rotation: Tech Vs. Energy Secular Leadership Rotation: Tech Vs. Energy Secular Leadership Rotation: Tech Vs. Energy Chart I-8Chinese Capital Goods Imports & ##br##Global Semiconductor Cycle Chinese Capital Goods Imports & Global Semiconductor Cycle Chinese Capital Goods Imports & Global Semiconductor Cycle We remain bearish on Chinese capital spending in general and construction in particular. This entails weaker demand for commodities and industrial goods. Yet we are not bearish on Chinese demand for semiconductors and tech devices. The semiconductor cycle has experienced a mini boom in the past 12-18 months. Demand for electronic products in the U.S. has been exceptionally strong (Chart I-9, top panel). Moreover, European production and sale of overall high-tech products as well as computer and electronic products have been robust (Chart I-9, bottom panel). In China, retail sales of communication appliances have also been extremely healthy (Chart I-10, top panel). By extension, the mainland's production of electronics has also boomed (Chart I-10, bottom panel). Chart I-9DM Demand For Tech Is Strong... DM Demand For Tech Is Strong... DM Demand For Tech Is Strong... Chart I-10...And So Is China's ...And So Is China's ...And So Is China's One soft spot for semi demand, however, could emanate from the global auto sector. U.S. auto sales have begun to contract, and auto production will likely shrink as well (Chart I-11, top panel). In addition, the growth rate of auto sales in both China and Europe may have reached a peak (Chart I-11, middle and bottom panels). Annual vehicle sales have reached 25 million units in China, and 17 million vehicles in both the U.S. and euro area. Overall global auto production is set to decelerate and this will weigh on semiconductor demand given that autos consume a lot of electronics. In addition, there are several other indications that suggest a mini-slowdown will likely transpire in the global semiconductor sector later this year: Taiwan's narrow money (M1) growth impulse has historically been correlated with the tech-heavy TSE index and has led export cycles (Chart I-12). This money impulse currently heralds a major top and relapse in both share prices and exports. Chart I-11Global Auto Production Global Auto Production Global Auto Production Chart I-12Taiwanese M1 Money Impulse Is Signaling A ##br##Growth Slowdown And Risk To Stocks Taiwanese M1 Money Impulse Is Signaling A Risk To Stocks Taiwanese M1 Money Impulse Is Signaling A Risk To Stocks The semiconductor shipments-to-inventory ratio has peaked in Korea and Taiwan (Chart I-13). This indicates that the best of the semi upswing may be behind us. Consistently, both global semiconductor producers' and semiconductor equipment stocks' forward EPS net revisions have already surged, and are elevated. This implies that a lot of earnings optimism has been priced in. Historically, when forward earning net revisions have reached these levels, global semi share prices have rolled over or entered a consolidation period (Chart I-14). Chart I-13Korea's & Taiwan's Semi ##br##Cycle Is Topping Out Korea's & Taiwan's Semi Cycle Is Topping Out Korea's & Taiwan's Semi Cycle Is Topping Out Chart I-14Semiconductors' Forward EPS ##br##Revisions Are Elevated Semiconductors' Forward EPS Revisions Are Elevated Semiconductors' Forward EPS Revisions Are Elevated Bottom Line: We expect a moderation in semi demand, but not recession. Semi share prices may react negatively to slower demand growth as the former have become extremely overbought and have already priced in a lot of good news. Investment Conclusions Semiconductor stocks have become overbought and a marginal slowdown in demand might be enough to cause a shake-out. The same is true for the overall tech sector. That said, we continue to recommend that investors overweight EM tech stocks, Taiwanese and Korean bourses within the EM equity portfolios. We also reiterate our long-standing long tech / short materials strategy. Remarkably, the KOSPI and Taiwanese TSE indexes - highly leveraged to semiconductors - have rallied to their previous highs (Chart I-15). In the past, they failed to break above these levels and we expect them to struggle again. If these equity indexes pull back and tech stocks correct, the overall EM stock index will roll over too. The rest of EM equity universe has much poorer fundamentals than tech companies. Financials and commodities sectors make 25% and 7% of the EM MSCI benchmark's market cap, respectively. The former is at risk from credit slowdown in EM and the latter is at a risk from lower commodities prices (Chart I-16). Chart I-15KOSPI & TSE Have Reached ##br##Major Resistances KOSPI & TSE Have Reached Major Resistances KOSPI & TSE Have Reached Major Resistances Chart I-16Industrial Metals ##br##Prices To Head Lower bca.ems_wr_2017_05_17_s1_c16 bca.ems_wr_2017_05_17_s1_c16 On the whole, we believe the recent divergence of EM risk assets from commodities prices and the EM/China credit cycles does not represent a structural regime shift in EM fundamentals, it rather reflects complacency in the marketplace. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Ayman Kawtharani, Associate Editor aymank@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Report titled, "How The Play Emerging Market Growth In The Coming Decade", dated June 8, 2010, available at ems.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlight Once-ebullient oil markets are overwrought. Fears that an economic slowdown in China will spill over into EM - the engine of global commodity demand growth - along with a very weak 1Q17 U.S. GDP performance, will keep oil markets focused on downside risks to prices. On the supply side, high-frequency inventory data from the U.S. suggests visible OECD stocks remain high, seemingly impervious to OPEC 2.0's best efforts to drain them. Steadily rising U.S. shale output also weighs on prices. Markets appear to be looking right through the choreographed comments on production cuts from leaders of OPEC 2.0, which suggest these cuts will definitely be extended to year-end 2017, and possibly into 2018. We doubt the demand picture is anywhere close to a fundamental downshift, expecting, instead, continued robust demand. We also expect the extension of OPEC 2.0's production cutbacks to year-end 2017 to significantly drain storage, even as shale output continues to grow. If anything, recent market action has presented an opportunity re-establish length, and to position for backwardation toward year-end. Energy: Overweight. The stop-loss on our Dec/17 Brent $45/bbl puts vs. $65/bbl calls was elected May 4/17, leaving us with a loss of $1.54/bbl (-327.7%). We are reinstating the position as of tonight's close, anticipating Brent will reach $60/bbl by year-end. We also stopped out of our Dec/17 Brent long vs. Dec/18 Brent short on May 4/17, with a $0.50/bbl loss (-263.2%). We will re-establish this position as well basis tonight's close. Base Metals: Neutral. LME and COMEX stock builds are keeping copper under pressure, offsetting possible renewed labor unrest. This is keeping us neutral. Precious Metals: Neutral. We were made long spot gold at $1230.25/oz basis last Thursday's close as a hedge against inflation risk, and a possible equities correction. Ags/Softs: Underweight. USDA data indicate a favorable start to the grain planting season. We remain bearish. Feature Softer Chinese PMIs spooked commodity markets, coming as they did on the heels of a very visible and much-reported weakening of base metals and iron ore prices emanating from Chinese markets (Chart of the Week).1 Financial markets fear weaker Chinese growth could presage weaker EM growth, which is the engine of commodity growth generally.2 With U.S. GDP coming in weak as well - registering a paltry growth of 0.7% in 1Q17 - markets started re-calibrating oil demand estimates for this year in light of still-high inventory levels. Adding to the market's agita, visible oil inventories in the OECD remain stubbornly high, thwarting OPEC 2.0's best efforts to drain them via their closely followed production cuts. By Wednesday of this week, this potent combination shaved some 9.6% off 1Q17 average prices, taking international benchmarks Brent and WTI below $50/bbl. Dubai prices have largely been spared similar carnage, as Gulf OPEC states continue to reduce supplies of heavier sour crude availabilities (Chart 2). Chart of the WeekChina PMIs Weaken As Monetary##BR##Conditions Tighten Slightly China PMIs Weaken As Monetary Conditions Tighten Slightly China PMIs Weaken As Monetary Conditions Tighten Slightly Chart 2Oil Prices##BR##In Retreat Oil Prices In Retreat Oil Prices In Retreat OPEC 2.0 Responds To Weaker Prices OPEC 2.0 - our moniker for the producer group comprised of OPEC, led by the Kingdom of Saudi Arabia (KSA), and non-OPEC, led by Russia - was not oblivious to these concerns. Indeed, earlier this week KSA Oil Minister Khalid al-Falih said the group would "do whatever it takes" to drain stocks and normalize global inventories (Chart 3). The OPEC 2.0 leadership is well aware that failure to do so would again expose these petro-states to the risk of a price collapse, as, absent production discipline, oil inventories once again would fill. This would force prices through producers' cash costs until enough production was knocked off-line to drain the storage overhang.3 Comments by leaders of OPEC 2.0 regarding the extension of its 1.8mm b/d production cuts this year and into next year are consistent with a strategy we laid out earlier, part of which includes the use of forward guidance to convince markets the supply side will tighten in the future.4 The other critical part of the strategy is for OPEC 2.0 to keep the front of the Brent curve at or below $60/bbl, using their own production, spare capacity and storage, and guiding to higher supply in the future, which would keep markets backwardated in 2018 once visible storage returns to five-year average levels. A persistent and deep backwardation - on the order of 10% p.a. - would, based on our modelling, slow the return of rigs to U.S. shale fields. In addition, the combination of a front-end forward curve capped at $60/bbl and persistent backwardation would keep depletion rates elevated, as cash-strapped producers - e.g., non-Gulf OPEC producers with high fiscal breakeven oil prices - are forced to forego maintenance capex. Taken together, this would give OPEC 2.0 a stronger hand in guiding prices - provided the coalition can hold together and maintain production discipline. We continue to expect an extension of the 1.8mm b/d OPEC 2.0 cuts will backwardate markets once inventories normalize later this year, even with strong growth from U.S. shales.5 Indeed, we expect this combination of fundamentals will clear the storage overhang by end-2017, and produce draws of more than 1mm b/d on average from April - December (Chart 4). Chart 3OPEC 2.0 Leaders KSA,##BR##Russia: "Whatever It Takes" OPEC 2.0 Leaders KSA, Russia: "Whatever It Takes" OPEC 2.0 Leaders KSA, Russia: "Whatever It Takes" Chart 4Steady Demand,##BR##Extended Cuts Will Drain Inventories Steady Demand, Extended Cuts Will Drain Inventories Steady Demand, Extended Cuts Will Drain Inventories Wobbly Oil Demand Is Transitory The 1Q17 demand-side scares emanating from China and the U.S. are transitory. Chart 5Fiscal And Infrastructure Spending##BR##Picked Up This Year In China Fiscal And Infrastructure Spending Picked Up This Year In China Fiscal And Infrastructure Spending Picked Up This Year In China Following their return from the mainland, our colleagues on BCA's China Investment Strategy desk note that monetary conditions still are fairly stimulative, and are unlikely to cause the economy to roll over.6 Most of the deterioration in economic growth results from a slowing in the depreciation of China's trade-weighted RMB, following a years-long appreciation from 2012 to 2015, which did dampen growth. In addition, while fiscal stimulus was reduced at the end of 2016, the government "quickly reversed course" as direct spending and investment in infrastructure picked up substantially (Chart 5). Our China Investment Strategy colleagues note China's fiscal spending is pro-cyclical - it increases as the economy improves and tax revenues increase. The government shows no sign of wanting to wind this down: "China's policy setting remains expansionary, a major departure from previous years when the Chinese economy was under the heavy weight of policy tightening while external demand also weakened. Looking forward, there is little chance that the Chinese authorities will commit similar policy mistakes that could lead to a major growth downturn. Barring a major policy mistake of aggressive tightening, Chinese growth should remain buoyant." The impact of Chinese demand on global oil demand is increasing, based on econometric work we've recently completed. From 2000 to end-April 2017, a 1% increase in Chinese oil demand has translated into a 0.64% ncrease in Brent prompt prices. During this period, the impact of non-OECD demand ex China was more than two times that of China's - a 1% increase there could be expected to lead to a 1.3% increase in Brent prices. China's impact on Brent prices in the post-GFC world more than doubled, while the impact of non-OECD demand ex-China increased marginally. Since the Global Financial Crisis, a 1% increase in China's oil consumption has produced a 1.4% increase in Brent prices, while a similar increase in EM ex-China has translated into a 1.8% increase in Brent prices.7 Turning to the U.S., we believe, along with the Fed, the weak patch in GDP in 1Q17 is transitory. Following the report on the quarter's weak 0.7% GDP growth, the U.S. Bureau of Labor Statistics surprised markets with a reading of 4.4% unemployment (U3 measure), and an equally impressive U6 measure of 8.6%, which takes it almost to pre-GFC levels. We expect robust U.S. labor-market conditions will keep demand for refined products in the U.S. robust, which will support oil prices there going forward. Globally, the U.S. EIA expects oil consumption will grow 1.6mm b/d this year - unchanged from last year. This is above our 1.4mm b/d estimate for the year. If the EIA's demand estimate is accurate, we can expect a sharper draw (+200k b/d) in global inventories than the average 860k b/d we currently are projecting, all else equal (Chart 4). This would lead to a sharper and earlier backwardation in prices that we currently expect. We will be re-estimating our balances model next week. Investment Implications We continue to expect the global storage overhang to clear by year-end, given the extension of OPEC 2.0's production cuts to at least year-end 2017. Wobbly demand is a transitory phenomenon, and we expect a recovery in the balance of the year. Given our expectation, we are re-establishing our long year-end Brent exposure, and are going short a $45/bbl Dec/17 Brent put vs. long a $65/bbl Dec/17 Brent call at tonight's close. We had a -$1.00/bbl stop-loss on this position, which was elected May 4/17 and resulted in a 1.54/bbl loss (-327.7%). We stopped out of our long Brent front-to-back position - long Dec/17 Brent vs. short Dec/18 Brent - in anticipation of backwardation. We also will be looking to re-establishing this position at tonight's closing levels, and for a good entry point to re-establish the same position in WTI. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Iron-ore (62% Fe) prices are down 33.5% after peaking this year at close to $91/MT in March. The LMEX base metals index is down 7.7% from its 2017 peak in February. Regular readers of Commodity & Energy Strategy will recall we've been bearish iron ore and steel for months, and have remained neutral base metals. Please see "China Commodity Focus: Supply Cuts, Environmental Restrictions Will Hit Metals," and "Copper's Price Supports Are Fading," in the January 19, and March 23, 2017, issues of Commodity & Energy Strategy. They are available at ces.bcaresearch.com. 2 In the May 5, 2017, issue of BCA Research's Foreign Exchange Strategy, our colleague Mathieu Savary notes, "The impulse to EM growth tends to emerge from China as Chinese imports have been the key fuel to boost exports, investments, and incomes across a wide swath of EM nations. Chinese developments suggest that Chinese growth, while not about to crater, may be slowing." Please see "The Achilles Heel of Commodity Currencies" in the May 5 FES, available at fes.bcaresearch.com. 3 Please see "OPEC 2.0 Cuts Will Be Extended Into 2017H2; Fade The Skew And Get Long Calls Vs. Short Puts," published by BCA Research's Commodity & Energy Strategy April 20, 2017, for a further discussion of the logic behind these cuts. 4 This aligns with a strategy we laid out last month, which uses forward guidance to convince markets to anticipate tighter supply further out the curve. By leading markets to anticipate lower crude oil availabilities in the future - while storage is drawing - OPEC 2.0 is setting the stage for forward curves to remain backwardated. Please see "The Game's Afoot In Oil, But Which One?" published April 6, 2017, in BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 5 "Backwardation" refers to a futures forward-price curve in which contracts for prompt delivery are higher than prices for deferred delivery. This indicates merchants and refiners are willing to pay more for a commodity delivered close in time versus in the future. It is the opposite of a "contango" curve, in which deferred prices exceed prompt prices. 6 Please see "Has China's Cyclical Recovery Peaked?" in BCA Research's China Investment Strategy Weekly Report published May 5, 2017. It is available at cis.bcaresearch.com. 7 These coefficients are all significant at less than 0.01. R2 coefficients of determination for these cointegrating regressions, which include the USD broad trade-weighted index (TWIB) all exceed 0.90, indicating that the USD TWIB and Brent prices share a common long-term trend, and that FX effects remain important in assessing oil prices. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016 Oil: Be Long, Or Be Wrong Oil: Be Long, Or Be Wrong Oil: Be Long, Or Be Wrong Oil: Be Long, Or Be Wrong

Highlights Shorting the RMB against the dollar is no longer a one-way bet. Investors should look to reduce bearish positions on the RMB going forward. The RMB is no longer overvalued. Therefore, any further decline will push the RMB deeper into undershoot territory, which is ultimately subject to mean reversion. The recent focus on China's low and falling reserve-to-M2 ratio largely reflects lopsided expectations on continued capital outflows and further RMB declines. The PBoC should have no difficulties maintaining control over the exchange rate with the country's massive current account surplus, low foreign currency debt and pervasive capital account control measures. Feature With widespread consensus among investors and market-watchers for the RMB to continue depreciating against the U.S. dollar, a key question is whether the seemingly unloved RMB could once again become appreciated. Indeed, the widely shared consensus a mere three years ago - that the RMB had nowhere to go but up - has now become a highly controversial rhetorical question. The current prevailing view is that the RMB is under intense downward pressure against the dollar, and the People's Bank of China (PBoC) is fighting an uphill battle in maintaining exchange rate stability. Some have gone even further, relating the RMB's ongoing weakness to "money printing" and "credit largess." According to these pundits, the country's mighty official foreign reserves pale in comparison to domestic capital flight, and the end game will have to be a substantial currency depreciation before a new equilibrium is re-established. Chart 1The RMB's Rollercoaster Ride The RMB's Rollercoaster Ride The RMB's Rollercoaster Ride In June 2013, amid the comfortable consensus that the RMB would perpetually rise against the dollar and the RMB "carry trade" was running amok, we published a Special Report titled "Is The RMB Still Undervalued?"1 We argued at the time that "the large valuation buffer for the RMB has mostly been eliminated," and that "there is a strengthening case for the RMB to fall against the greenback." Fast forward four years, the CNY/USD peaked in January 2014 and has since depreciated by about 15% (Chart 1). As the consensus on the RMB has now completely swung to the other extreme, it is time for a new reality check and some provocative rethinking. What Has Changed? With the benefits of hindsight, it is easy to spot what went wrong for the RMB as well as for the Chinese economy. In our 2013 Special Report, we concluded that "the dollar appears to be bottoming out from its structural bear market" and that "the Chinese central bank should guide the RMB lower versus the greenback in order to maintain a relatively stable exchange rate against a currency basket." In reality, the sharp dollar rally of 2014-'15 pushed up the trade-weighted RMB by another 10% and led to draconian tightening in China's monetary conditions - a major policy mistake that caused relentless deflationary pressure and growth woes. By the same token, the depreciation of the RMB since early 2016 has turned out to be a key reflationary force that has helped stabilize the Chinese economy. As far as the RMB is concerned, there have been a few important changes in the macro environment. Chart 2The Dollar: A Long Term Perspective The Dollar: A Long Term Perspective The Dollar: A Long Term Perspective First, the dollar's multi-year bull market has pushed the greenback up by 25% since 2014. The U.S. economy is currently a bright spot in the world, and the Federal Reserve appears to be the most determined to tighten among the major monetary authorities - two factors that are likely to maintain dollar bullishness. However, it is important to note that the sharp rally has already pushed the dollar close to two sigma above its long-term trend (Chart 2). The dollar may remain well bid in the near term, but another major up leg similar to the one in 2014-'15 is highly unlikely. Second, the valuation froth in the RMB accumulated in previous years has been squeezed out (Chart 3). The trade-weighted RMB has fallen back to its long-term trend line after a two-sigma overshoot. Its spot rate against the dollar has now dropped below our PPP model fair value estimate. In real effective terms, the RMB has also quickly swung back from overvalued territory. The increase in Chinese producer prices since September 2016 also suggests the RMB may have become cheap again. Third, the massive RMB "carry trade" has been largely unwound. Before 2014, the RMB's one-way ascendance attracted speculative "hot money" inflows to China in anticipation of both higher yields and further currency upside. Chinese companies also sharply ramped up borrowing in foreign currencies, mostly U.S. dollars, for lower rates and potential exchange rate gains. Both trends abruptly reversed as the RMB began to fall, with hot money fleeing and domestic borrowers rushing to pay back foreign currency obligations. Chart 4 shows the abnormal surge of the RMB "carry trade" before 2014 has essentially vanished. Chart 3The RMB Is No Longer Overvalued The RMB Is No Longer Overvalued The RMB Is No Longer Overvalued Chart 4The Unwinding Of The RMB "Carry Trade" The Unwinding Of The RMB "Carry Trade" The Unwinding Of The RMB "Carry Trade" Finally, the reflationary benefit of a weaker exchange rate on the Chinese economy has been proven since 2016, which in of itself rules out the possibility of an endless RMB decline. As the largest manufacturer and exporter in the world, a weaker RMB is good news for the Chinese industrial sector's pricing power, profit margins and overall business activity - unless broad protectionist backlash blocks the positive feedback loop.2 The bearish argument on the RMB fixating on Chinese credit, even if true, ignores the reflationary impact on a major part of the Chinese economy, which in turn puts a floor under its exchange rate. What's Intact? Meanwhile, some factors that were widely viewed in previous years as supportive for an ever-rising RMB have remained largely intact. China still runs by far the largest trade surplus in the world, amounting to an annualized US$ 500 billion. Chinese foreign reserves, although having fallen by US$ 1 trillion since their all-time peak, still accounts for almost 30% of the global total (Chart 5). In comparison, China's official hoarding of foreign assets accounted for about 15% of the world in 2005, when the RMB was de-pegged from the greenback and began a decade-long ascent. In addition, Chinese exporters have continued to gain global market share, currently accounting for about 14% of world exports, more than double 2005 levels. Meanwhile, it is fairly likely that China's recent export numbers have been under-reported, as exporters have hidden part of their overseas proceeds offshore in anticipation of further RMB declines. Overall, there is no evidence that the value of the RMB has hindered Chinese exporters' competitiveness. From a long-term perspective, a country's productivity growth relative to the rest of the world fundamentally determines its relative competitiveness in global trade, which in turn is the ultimate driving force behind its exchange rate (Chart 6). On all these fronts, China still compares favorably to other major countries. Chart 5China's Foreign Official ##br##Reserves Remain Massive China's Foreign Official Reserves Remain Massive China's Foreign Official Reserves Remain Massive Chart 6Relative Productivity Determines ##br##Export Sector Competitiveness Relative Productivity Determines Export Sector Competitiveness Relative Productivity Determines Export Sector Competitiveness Are China's Foreign Reserves Enough? Chart 7 shows that the ebbs and flows of China's foreign exchange reserves are tightly linked with the USD/CNY "risk reversal" indicator, defined as the implied volatility for call options minus the implied volatility for put options on the cross rate. Chinese foreign reserves have increased for three consecutive months, a sign of slower capital outflows and easing concerns surrounding the RMB. It remains to be seen whether this is a permanent shift or a temporary pause. A more important question is whether China's foreign reserves are large enough for the PBoC to maintain control over its exchange rate. Chart 7The RMB Risk Aversion And Capital Flows The RMB Risk Aversion And Capital Flows The RMB Risk Aversion And Capital Flows Central banks' precautionary holdings of foreign reserves are mainly to reduce the likelihood of balance-of-payments pressures. From this perspective, for a country running chronic and massive trade surpluses with minimal foreign currency debt, China should not hold large foreign reserves at all. This is also why its massive foreign reserve holdings were long regarded as wasteful before 2014 by both market participants and Chinese policymakers - and since 2014 as the RMB has weakened the exact opposite: as not enough. Based on traditional yardsticks for reserve adequacy such as coverage ratios for imports or short-term foreign currency debt, China's reserves are far more than adequate. The more recent focus has been on additional metrics proposed by the IMF, particularly the ratio of reserves relative to a country's broad money supply (M2). This ratio captures potential residents' capital flight through the liquidation of their highly liquid domestic assets, which reflects potential drains on the balance of payments. Chart 8 shows a sharp decline in China's reserves-to-M2 ratio in recent years. However, this does not mean that Chinese foreign reserves are insufficient for the following reasons. Historically China's reserve-to-M2 ratio has had no direct correlation with the broad RMB trend. China's reserve-to-M2 ratio peaked at 28% in 2008, long before the RMB peaked. At 13% currently, the ratio is comparable to 2005 when the RMB began to rise against the dollar. Globally speaking, there is no empirical evidence that a higher reserve-to-M2 ratio helps alleviate downward pressure on a country's exchange rate. Other major emerging countries such as Brazil, Russia and India have much higher reserve-to-M2 ratios than China, but their currencies have suffered brutal declines in recent years (Chart 9). In contrast, Japan's reserve-to-M2 ratio is comparable to China, but the Bank of Japan has been trying desperately to weaken the yen. Germany's ratio is even lower. Finally, China's pervasive capital account control measures and its largely state-controlled financial institutions are powerful tools to hinder capital outflows, and can be adjusted to accommodate changes in the marketplace. This further diminishes the usefulness of this ratio. Chart 8China's Reserves-To-M2 Ratio Has Been Falling... China's Reserves-To-M2 Ratio Has Been Falling... China's Reserves-To-M2 Ratio Has Been Falling... Chart 9...But Does It Matter? ...But Does It Matter? ...But Does It Matter? Overall, the recent focus on China's low and falling reserve-to-M2 ratio largely reflects lopsided expectations on continued capital outflows and further RMB declines. This has all but ignored the prospect for capital inflows. True, Chinese households and companies will likely continue to diversify into foreign assets. However, there is an equally compelling case that foreign demand for RMB-denominated assets will also increase going forward. For example, Chinese local bond yields, both sovereign and credit, are substantially higher than other major economies. Meanwhile, foreign ownership in Chinese bonds is practically non-existent compared with other bourses (Chart 10). It is almost a sure bet that foreign demand for RMB bonds will increase significantly, especially if market expectations on the RMB stabilize. Given how dramatic market expectations on the RMB have shifted in the past several years, this could come much sooner than many expect. Chart 10The Case For Increasing Foreign Demand##br## For RMB Bonds The Case For Increasing Foreign Demand For RMB Bonds The Case For Increasing Foreign Demand For RMB Bonds Investment Conclusions We are not making the case for an immediate resumption of a rising RMB. In the near term, the USD/CNY cross rate will continue to be dominated by the broad dollar trend, the upside of which may not yet be exhausted. However, the prevailing bearish consensus means that shorting the RMB against the dollar has become a very crowded trade. Meanwhile, our valuation models suggest the RMB is currently no longer overvalued. Therefore, any further decline will push the RMB deeper into undershoot territory, which is ultimately subject to mean reversion. Overall, we caution against being overly negative at the moment, and investors should begin to reduce bearish bets on the RMB going forward. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Special Report, "Is The RMB Still Undervalued?," dated June 12, 2013, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Reflecting On The Trump-Xi Summit," dated April 13, 2017 available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Please note that we are publishing a Special Report today titled "EM Local Bonds: Looking At Hedged Yields". Feature Commodities prices have plunged lately, even though the U.S. dollar, up until this past week, has been weak versus European currencies. Hence, the recent selloff in the commodities complex cannot be attributable to U.S. dollar strength. Something else has been at work. Furthermore, EM share prices and currencies have decoupled from both commodities prices and DM commodities currencies such as the AUD, NZD and the CAD (Chart I-1). Chart I-1Unsustainable Divergence Unsustainable Divergence Unsustainable Divergence Is this time different, and are we entering a new era in EM investing? We do not think so. This divergence is unsustainable and reflects irrational exuberance and fund flows into EM. The decoupling is already overstretched - although it could last another several weeks, it will not continue for much longer. We have the following observations: The commodities selloff has been very broad-based, and has been especially intense in commodities that are trading in China as well as those that are leveraged to Chinese growth (Chart I-2A & Chart I-2B). Such a simultaneous gap down in various commodities prices can be explained either by a decline in speculative long positions in commodities or weakness in real demand. It cannot be attributed to supply because the selloff has transpired at the same time across various commodities. Commodities' supply dynamics are idiosyncratic. China's central bank has been tightening liquidity, forcing deleveraging in the financial system. It is very plausible that this has led to an unwinding of long positions in commodities trading in China. Chart I-2AWidespread Carnage In Commodities Widespread Carnage In Commodities Widespread Carnage In Commodities Chart I-2BWidespread Carnage In Commodities Widespread Carnage In Commodities Widespread Carnage In Commodities China bulls would correctly argue that the selloff in commodities is indicative of a reduction in speculative trading activities - not in final demand. However, to be consistent, we should also accept that that the commodities rally in 2016 was not entirely due to demand improvement in China. Instead, it was at least partially due to speculative investment demand. It is impossible to quantify the magnitude of speculative activity in China's commodities markets, yet it has probably been a non-trivial force supercharging both last year's rally as well as the latest selloff. In regard to commodities demand from the real economy, China's growth has not yet turned decisively down. That said, the growth outlook is downbeat as credit growth downshifts in response to the ongoing policy tightening. Chart I-3 illustrates that the annual growth in the number and value of newly started projects has recently contracted. This heralds weaker demand for commodities, materials and capital goods in the months ahead. The surge in new projects launched last year marked the beginning of an upturn in industrial activity, and could well be indicative of a budding downtrend now. Besides, Chinese imports of industrial metals (excluding iron ore) has by and large been flat since 2010 (Chart I-4). The mainland's iron ore imports have been strong because inefficient/expensive domestic production has been shut down, leading to an increase in imports. Chart I-3China: Capital Spending To Slump Again China: Capital Spending To Slump Again China: Capital Spending To Slump Again Chart I-4China: No Growth In Industrial Metals' Imports China: No Growth In Industrial Metals' Imports China: No Growth In Industrial Metals' Imports Although China's oil imports have been strong (Chart I-5, top panel), underlying final demand has been weaker as there is evidence that the country has used imports of crude to increase inventories (Chart I-5, bottom panel). Provided that inventories are mean-reverting, such a large build-up in crude inventories poses a risk to China's oil demand and oil prices in the months ahead. Remarkably, the Brazilian real and South African rand have recently decoupled from the overall commodities price index and platinum prices, respectively (Chart I-6). These divergences represent a substantial departure from historical correlations. We cannot find any explanation other than the ongoing irrational exuberance in EM financial markets. Finally, signposts of potential growth deceleration are not only limited to the commodities complex. For example, Taiwanese narrow money (M1) impulse has decisively rolled over; it typically leads Taiwanese exports and correlates well with the equity market (Chart I-7). Chart I-5China's Oil Imports And An Inventories Proxy China's Oil Imports And An Inventories Proxy China's Oil Imports And An Inventories Proxy Chart I-6EM Commodity Currencies And Commodities Prices EM Commodity Currencies And Commodities Prices EM Commodity Currencies And Commodities Prices Chart I-7Taiwanese Export Growth And Equities Are At Risk Too Taiwanese Export Growth And Equities Are At Risk Too Taiwanese Export Growth And Equities Are At Risk Too Bottom Line: The recent decoupling between commodities prices and EM risk assets is unsustainable. This divergence reflects irrational exuberance that typically transpires around a major market top. While not chasing this rally has been painful, there is no point in doing so at current levels. We recommend investors maintain a negative stance on EM risk assets. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Duration: U.S. growth expectations have become overly pessimistic. A Q2 rebound will lead to higher global bond yields and a steeper U.S. Treasury curve. UST / Bund Spread: The extreme divergence between the European and U.S. economic surprise indexes is not sustainable, especially in the face of weakening Chinese economic data. The Treasury / Bund spread is biased wider in the near term, though could tighten in the second half of this year as the ECB shifts to a less accommodative policy. USD Hedging Costs: Declining hedging costs driven by interest rate differentials and negative basis swap spreads make international bond investment very attractive for U.S. investors. Feature Chart 1Global Recovery Will Persist Global Recovery Will Persist Global Recovery Will Persist The synchronized global recovery that took hold in the second half of 2016 has stalled so far this year. Measures of economic sentiment, such as the Global ZEW survey and our own Boom/Bust Indicator, have rolled over from high levels and global bonds have clawed back some of last year's lost returns (Chart 1). Year-to-date, the Bloomberg Barclays Global Government Bond index has returned +3%, after having lost more than 9% between the July trough in the Global ZEW index and the end of last year. In our view, a repeat of early 2016's global growth slowdown and bond market rally, which saw the Global ZEW index fall below zero and the Global Government Bond index return 11.6% in 2016H1, is not in the cards. The global economy is on much firmer footing than at this time last year. U.S. Growth: Past Peak Pessimism First quarter U.S. GDP growth was a disappointing 0.7%, but is poised to bounce back strongly in Q2. The volatile inventories component subtracted 0.9% from overall Q1 growth, harsh weather wreaked havoc on the March employment report and there continue to be problems with residual seasonality depressing first quarter GDP data.1 The outlook is much brighter moving forward. The latest employment report showed that the U.S. economy added a healthy 211k jobs in April and our model is pointing toward a further acceleration (Chart 2). Economic growth can be thought of as a combination of aggregate hours worked and labor productivity (Chart 3). With aggregate hours worked growing at 1.7% year-over-year and labor productivity growth having averaged 0.6% (annualized) per quarter since 2012, real U.S. GDP growth of around 2.3% seems like a reasonable forecast. Chart 2Labor Market Still Strong Labor Market Still Strong Labor Market Still Strong Chart 3Look For Above 2% Growth Look For Above 2% Growth Look For Above 2% Growth There is even some reason to suspect that labor productivity could strengthen during the next few quarters. A recent IMF paper2 attributed weak post-crisis productivity growth to a combination of structural and cyclical factors, but also noted that weak investment in physical capital may be responsible for lowering total factor productivity growth by nearly 0.2 percentage points per year in advanced economies during the post-crisis period. With leading indicators pointing to still further gains in fixed investment (Chart 3, bottom panel), we would not be shocked to see productivity growth enjoy a modest late-cycle rebound. Chart 4Stronger Productivity = Steeper Curve Stronger Productivity = Steeper Curve Stronger Productivity = Steeper Curve All else equal, a late-cycle rebound in productivity growth would slow the increase in unit labor costs. Unit labor costs are a combination of wages (compensation-per-hour) and productivity (output-per-hour), and have historically tracked changes in the slope of the U.S. yield curve (Chart 4). Faster wage growth tends to coincide with Fed tightening, and slower wage growth with Fed easing. For this reason, all wage measures perform reasonably well tracking changes in the yield curve. But unit labor costs perform best because they also incorporate productivity growth, and low productivity growth can flatten the yield curve by pulling down long-dated yields. Rapid increases in compensation-per-hour and muted productivity growth have combined to give the yield curve a strong flattening bias during the past several years. Any increase in productivity growth would slow the uptrend in unit labor costs relative to other wage measures, allowing the yield curve to steepen. In fact, we continue to recommend that investors position for a steeper U.S. yield curve by going long the 5-year Treasury note and shorting a duration-matched barbell consisting of the 2-year and 10-year notes. This trade produces positive returns when the 2/10 slope steepens (Chart 4, panel 3), but has also returned +19 bps since we initiated the position last December, even though the curve has flattened since then. The reason for the trade's strong performance in an unfavorable curve environment is that the 5-year yield had been unusually elevated compared to the rest of the curve. Our model of the 2/5/10 butterfly spread versus the 2/10 slope showed that the 5-year note was one standard deviation cheap on the curve as recently as mid-March (Chart 4, bottom panel). This undervaluation has mostly dissipated and the 5-year note now appears only slightly cheap. For our curve trade to outperform from here, it will likely require the 2/10 slope to steepen.3 Bottom Line: With weak Q1 GDP now in the rearview mirror, we are likely past the point of peak pessimism on U.S. growth. Expect global bond yields to rise and the U.S. yield curve to steepen as the economic data start to reflect an environment of above-trend growth, in the neighborhood of 2% - 2.5%. European Growth & The Risk From China While the U.S. data have disappointed in recent weeks, as evidenced by the U.S. Economic Surprise Index having dipped below zero (Chart 5), the European economy has consistently bested expectations (Chart 5, panel 2). As a result, the Treasury / Bund spread has narrowed from high levels during the past few months. In practice, economic surprise indexes tend to mean revert because positive data surprises beget increasingly optimistic expectations. Eventually, overly optimistic expectations become too high a hurdle and the data start to disappoint. In our view, U.S. expectations have become unduly pessimistic while the Eurozone surprise index appears overdue for a correction. Against this back-drop, we expect the Treasury / Bund spread to widen in the near term as the large divergence between the U.S. and European surprise indexes starts to narrow. Further making the case for a wider Treasury / Bund spread is the recent performance of the Chinese economy. Our Foreign Exchange Strategy service recently observed that growth differentials between the U.S. and Europe are highly correlated with indicators of Chinese growth.4 This should not be overly surprising since Europe trades more with China and other Emerging Markets than does the United States. Along those lines, the IMF has calculated that a 1% growth shock to Emerging Markets impacts European growth by nearly 40 basis points, while it impacts U.S. growth by only 10 basis points.5 The worry at the moment is that Chinese monetary conditions have started to tighten, and China's Manufacturing PMI is rolling over alongside weaker commodity prices. These trends usually coincide with the underperformance of Europe relative to the U.S. (Chart 6). Chart 5Surprise Indexes Will Converge Surprise Indexes Will Converge Surprise Indexes Will Converge Chart 6Look To China To Trade UST / Bund Spread Look To China To Trade UST / Bund Spread Look To China To Trade UST / Bund Spread Our China Investment Strategy service highlights the importance of the trade-weighted RMB as a driver of Chinese growth.6 The RMB's 30% appreciation between 2012 and 2015 applied a massive deflationary force to China's economy, while its more recent depreciation helped boost producer prices, enhance profit margins and reduce the real cost of funding (Chart 7). Chart 7Monetary Conditions ##br##Still Fairly Stimulative Monetary Conditions Still Fairly Stimulative Monetary Conditions Still Fairly Stimulative More recently, the pace of the RMB's depreciation has slowed and this likely explains the weakness in China's Manufacturing PMI and commodity prices. Our China strategists are quick to note that while the pace of RMB depreciation has slowed, it is still not appreciating, and real interest rates deflated by the producer price index remain negative. In other words, monetary conditions have become somewhat less stimulative, but they should still be supportive of further economic growth. Although the Chinese economic data are likely to moderate in the coming months, barring the major policy mistake of aggressive tightening, Chinese growth will avoid a collapse and remain reasonably buoyant. Similarly, we would also expect European growth expectations to soften in the coming months, but growth is very likely to remain above trend and the ECB is still on track to adopt a less accommodative policy stance over the next year. In the most likely scenario, a few hints will be given at the June ECB meeting, and then an announcement that asset purchases will be tapered in 2018 will be made at the September meeting. The market will correctly assume that rate hikes will follow the taper, and this re-pricing of rate expectations will open up a window in the second half of this year when the Treasury / Bund spread can tighten. However, it is still too soon to adopt this position. Bottom Line: The extreme divergence between the European and U.S. economic surprise indexes is not sustainable, especially in the face of weakening Chinese economic data. The Treasury / Bund spread is biased wider in the near term, though could tighten in the second half of this year as the ECB shifts to a less accommodative policy. U.S. Bond Investors Should Expand Their Borders Divergences that have opened up between U.S. short-term interest rates and short-term rates in other developed countries mean that U.S. bond investors now face much lower currency hedging costs. In addition, increasingly negative cross-currency basis swap spreads have become a permanent feature of the post-crisis investment landscape, and unless significant regulatory changes occur, we expect they are here to stay. Combined, both of these factors make it incredibly attractive for U.S. bond investors to swap their U.S. dollars for foreign currencies and invest in foreign government bonds. In this week's report we explain why this is an attractive trade for U.S. investors and why it will likely remain so for quite some time. What Is The Basis Swap Spread? An excellent definition of the cross-currency basis comes from the Bank for International Settlements (BIS) who define it as "the difference between the direct dollar interest rate in the cash market and the implied dollar interest rate in the [currency] swap market".7 In essence, the existence of a negative basis swap spread should mean that there is an opportunity to arbitrage the difference between interest rates in the cash market and implied interest rates in the currency swap market. However, post-crisis regulatory constraints on bank balance sheets appear to have made this arbitrage prohibitive. Banks are either unable or unwilling to arbitrage the basis swap spread back to zero, and this increases the cost of U.S. dollars in FX swap markets. As a quick example, we can calculate the 10-year German Bund yield hedged into U.S. dollars using currency forwards. Hedged yield = Unhedged yield - Cost of hedging Where: Cost of hedging = forward exchange rate / spot exchange rate In this case, we define the exchange rates as euros per 1 U.S. dollar. By covered interest rate parity, we can also calculate the cost of hedging as: Cost of hedging = (1 + euro interest rate + basis swap spread) / (1 + USD interest rate) Using current 3-month interest rates, this means that the cost of hedging from euros into U.S. dollars is: Cost of hedging = (1 - 0.36% - 0.3%) / (1 + 1.18%) = -1.82% This means that the 10-year German Bund yield rises from 0.42% to 2.24%, from the perspective of a U.S. dollar investor, after hedging the currency on a 3-month horizon. In other words, U.S. investors can significantly increase the average yield of their portfolios by lending U.S. dollars over short time horizons and investing the proceeds into non-U.S. bonds. In Chart 8 we show the difference this currency hedging makes for German, Japanese and French 10-year government bonds. Current hedged 10-year yields for all the major bond markets are also shown on page 13 of this report. But for how long can this trade continue? In short, it can continue for as long as U.S. short-term interest rates increase relative to non-U.S. short-term interest rates and for as long as basis swap spreads move further into negative territory. At the moment there is no widespread agreement on what drives the day-to-day fluctuations in the basis swap spread. The BIS has posited a model where dollar strength weakens the capital positions of bank balance sheets, causing them to back away from providing liquidity to the FX swap market, and leading to increasingly negative basis swap spreads (Chart 9, top panel). Chart 8Higher Yields Via Currency Hedging Higher Yields Via Currency Hedging Higher Yields Via Currency Hedging Chart 9Basis Swaps, Reserves And The Dollar Basis Swaps, Reserves And The Dollar Basis Swaps, Reserves And The Dollar Meanwhile, Zoltan Pozsar from Credit Suisse has identified a link between basis swap spreads and reserves on the Fed's balance sheet (Chart 9, bottom panel).8 Specifically, as the Fed winds down its balance sheet it will be draining cash reserves from the banking system and replacing them with Treasury securities. This could cause money to leave the FX swap market and flow into Treasuries. The result is less liquidity in the FX swap market and increasingly negative basis swap spreads. Interestingly, the run-up to the debt ceiling in the U.S. has presented a test of this view. To stay under the debt ceiling the U.S. Treasury department has drawn down its cash account at the Fed and removed T-bill supply from the market. The result has been a temporary increase in reserve balances. As the theory would have predicted, basis swap spreads have moved closer to zero as reserves have increased. Going forward, the Fed is very likely to start winding down its balance sheet later this year. In all likelihood this will serve to pressure basis swap spreads even further below zero. Meanwhile, short-term interest rates in the U.S. will probably continue to rise more quickly than in most other developed markets. This means that the cost of hedging should become increasingly negative for U.S. investors. In Chart 10 we show that as the cost of hedging becomes more negative, total returns from a USD-hedged position in German bunds tend to outpace total returns from a position in U.S. Treasuries. Similarly, Chart 11 shows that USD-hedged Japanese government bonds (JGBs) also tend to outperform U.S. Treasuries when the cost of hedging falls. Chart 10Hedging Costs & Bond Returns: Germany Hedging Costs & Bond Returns: Germany Hedging Costs & Bond Returns: Germany Chart 11Hedging Costs & Bond Returns: Japan Hedging Costs & Bond Returns: Japan Hedging Costs & Bond Returns: Japan We should note that the relationships between hedging costs and relative total returns shown in Charts 10 & 11 are not perfect, and there will be instances when Treasuries can outperform even if hedging costs continue to decline. However, in the long run, as long as short-term U.S. interest rates continue to rise more quickly than short-term interest rates in the Eurozone or Japan, and especially if the Fed's upcoming balance sheet contraction leads to more deeply negative basis swap spreads, then U.S. investors should continue to boost their yields by lending dollars and investing in bunds and JGBs. Bottom Line: Declining hedging costs driven by interest rate differentials and negative basis swap spreads make international bond investment very attractive for U.S. investors. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Our U.S. Investment Strategy service took up the issue of residual seasonality in a recent report. Please see U.S. Investment Strategy Weekly Report, "Spring Snapback?", dated April 24, 207, available at usis.bcaresearch.com 2 IMF Staff Discussion Note, "Gone with the Headwinds: Global Productivity", https://www.imf.org/en/Publications/Staff-Discussion-Notes/Issues/2017/04/03/Gone-with-the-Headwinds-Global-Productivity-44758 3 Our outlook for the U.S. yield curve was discussed in detail in a recent report. Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report, "ECB: All About China?", dated April 7, 2017, available at fes.bcaresearch.com 5 IMF Multilateral Policy Issues Report: 2014 Spillover Report https://www.imf.org/external/np/pp/eng/2014/062514.pdf 6 Please see China Investment Strategy Weeky Report, "Has China's Cyclical Recovery Peaked?", dated May 5, 2017, available at cis.bcaresearch.com 7 http://www.bis.org/publ/work592.pdf 8 https://ftalphaville.ft.com/2017/04/13/2187317/where-would-you-prefer-your-balance-sheet-banks-or-the-federal-reserve/ Fixed Income Sector Performance Recommended Portfolio Specification