Currencies

Highlights The latest round of tariffs on U.S. imports from China confirms that the Trump administration's confrontation with China goes beyond the mid-term elections. Desynchronization between the U.S. and China/EM growth foreshadows dollar appreciation. The latter is the right medicine for the global economy for now. A stronger dollar is required to redistribute growth and inflation away from the U.S. and towards the rest of the world. China needs a weaker currency to offset deflationary pressures stemming from domestic deleveraging and trade tariffs. For EM ex-China, the dollar rally is painful, but it is the right medicine in the long run. It will bring about the unraveling of excesses within their economies. Feature The global economy presently finds itself between two strong and opposing crosscurrents: robust growth and mounting inflationary pressures in the U.S. on the one hand, and weakening Chinese growth on the other. Desynchronization between China/EM and the U.S. has been our theme since April 2017.1 Although this theme has become evident and to a certain degree priced into the markets, we believe it is not yet time to abandon it. Before exploring this analysis in greater depth, we will address the issue of whether strong U.S. demand will reverse the slowdown in the global trade cycle, and update our thoughts on the trade wars. Global Trade And Trade Wars Our leading indicators for global trade do not herald a reversal in the global exports slowdown. Chart I-1 demonstrates that the ratio of risk-on versus safe-haven currencies2 leads global export volumes by several months, and it does not yet flag any improvement. Chart I-1Risk-On / Safe-Haven Currency Ratio As An Indicator Of Global Trade Risk-On / Safe-Haven Currency Ratio As An Indicator Of Global Trade Risk-On / Safe-Haven Currency Ratio As An Indicator Of Global Trade In addition, Taiwanese exports of electronic products lead the global trade cycles by a couple of months, and they are currently pointing to further deceleration in world exports (Chart I-2). It seems extremely robust U.S. domestic demand growth has not prevented a slowdown in global trade in general and EM exports in particular. The reason for this is that many developing countries' shipments to China are larger than their exports to the U.S., as illustrated in Table I-1. Chart I-2Taiwanese Electronics Exports##br## Slightly Lead Global Exports Taiwanese Electronics Exports Slightly Lead Global Exports Taiwanese Electronics Exports Slightly Lead Global Exports Table I-1Many Emerging Economies##br## Sell More To China Than To The U.S. Desynchronization Compels Currency Adjustments Desynchronization Compels Currency Adjustments The latest decision by the U.S. administration to impose a 10% tariff on $200 billion of imports from China and increase this rate to 25% starting January 1, 2019 confirms that the Trump administration's confrontation with China goes beyond the mid-term elections. The true intention of the U.S. is to contain China's geopolitical rise to preserve its global hegemony. These episodes of import tariffs will likely mark the beginning of a much longer and drawn-out geopolitical confrontation. Our colleagues at BCA's Geopolitical Strategy service have been noting for several years that a U.S.-China confrontation is unavoidable.3 In this vein, it is not clear to us why global growth-sensitive and China-leveraged plays in financial markets have rallied in recent days on the new tariff announcement. We can think of two reasons: (1) markets expect China to stimulate domestic demand aggressively to counter tariffs; and (2) gradually rising U.S. import tariffs will boost global trade in the near term, as companies front load their production and shipments before the 25% tariff rate takes hold. On the first point, there has so far been no major new fiscal stimulus announced in China. We detailed fiscal numbers in our August 23 report,4 and there have been no changes since. As to liquidity easing - which has been material - our assessment is that it is likely to be overwhelmed by ongoing regulatory tightening on banks and shadow banking. In short, lingering credit excesses and regulatory tightening will hamper the monetary transmission mechanism from lower interest rates to faster credit growth. So far, money growth in China remains very weak (Chart I-3). Chart I-3China's Narrow Money And EM Stocks China's Narrow Money And EM Stocks China's Narrow Money And EM Stocks On the second point, we cannot rule out a moderate and temporary improvement in global trade due to various technical factors. Yet, any rally rooted in this will prove to be short-lived and fleeting. Bottom Line: Escalating tariffs on U.S. imports from China will reinforce the tectonic macro shifts that have been in place since early this year: it will lift U.S. inflation slightly and weigh on Chinese growth. Rising U.S. Inflation U.S. core inflation is accelerating and moving above the Federal Reserve's soft target of 2%. This will substantially narrow the Fed's maneuvering room to respond to the turmoil in EM and weakening growth outside the U.S. Chart I-4 demonstrates that an equally weighted average of various core consumer inflation measures for the U.S. has been markedly accelerating. The components of this core inflation aggregate are presented in Chart I-5 and include: trimmed mean CPI, trimmed mean PCE, market-based core PCE and median CPI. Besides, the U.S. labor market is super tight, and employee compensation growth will continue to rise. This will put downward pressure on corporate profit margins and will push businesses to consider passing on their rising costs to consumers. Provided wage growth will continue accelerating and the job market and confidence both remain strong, odds are that companies will be able to raise their selling prices. Chart I-4U.S. Inflation Is Rising... U.S. Inflation Is Rising... U.S. Inflation Is Rising... Chart I-5...Based On Various Core Measures ...Based On Various Core Measures ...Based On Various Core Measures Weakening Chinese Growth Growth continues to weaken in China. In particular: The aggregate freight index (transport by railway, highway, waterway, and aviation) is sluggish and the measure of Air China's freight continues to downshift (Chart I-6). The strength in China's residential property market since 2015 has partially been due to the central bank providing very cheap financing directly to housing via its Pledged Supplementary Lending (PSL) scheme. We have argued in the past that this represents nothing less than monetization of excess housing inventories directly by the People's Bank of China.5 This has boosted property prices and sales, supporting the economy over the past two years. Having met the objective of reducing housing inventories, the PBoC has lately reduced the amount of PSL. Provided changes in PSL flows have led both housing prices and sales volumes, it is reasonable to expect a relapse in new sales in the next six months or so (Chart I-7). Chart I-6China: A Slowdown In Freight Indicators China: A Slowdown In Freight Indicators China: A Slowdown In Freight Indicators Chart I-7China: Housing Sales To Roll Over Soon China: Housing Sales To Roll Over Soon China: Housing Sales To Roll Over Soon Our main theme in China has been and remains shrinking construction activity - both infrastructure and property building. This is the primary rationale for our negative view on commodities prices as well as weakness in mainland aggregate imports. Chart I-8 illustrates property construction activity is already contracting. Headline fixed asset investment in real estate has been held up by booming land purchases, yet equipment purchases as well as construction and installation have been shrinking (Chart I-8). Capital expenditures for all industries, including construction and installation, purchase of equipment and instruments - but excluding land values - are also very weak (Chart I-9). Chart I-8China: Property Investment##br## Excluding Land Is Contracting China: Property Investment Excluding Land Is Contracting China: Property Investment Excluding Land Is Contracting Chart I-9China: Overall Capex##br## Is Very Weak China: Overall Capex Is Very Weak China: Overall Capex Is Very Weak   Interestingly, our proxy for marginal propensity to spend6 by Chinese companies leads global industrial metals prices, and continues pointing to more downside (Chart I-10). With respect to oil, Chinese oil import growth has downshifted considerably (Chart I-11) implying that global oil prices have been mostly propped up by supply concerns. Chart I-10Chinese Companies' Propensity##br## To Spend And Metal Prices Chinese Companies' Propensity To Spend And Metal Prices Chinese Companies' Propensity To Spend And Metal Prices Chart I-11China: A Slowdown##br## In Oil Imports China: A Slowdown In Oil Imports China: A Slowdown In Oil Imports Currency Markets As A Rebalancing Mechanism Pressures from growth desynchronization between the U.S. and China and trade wars continue to build. Left unchecked, these imbalances will enlarge and culminate into a bust. A release valve is needed to diffuse these accumulating pressures. Currency and bond markets often act as such - they move to rebalance the global economy and amend economic excesses. Odds are that exchange rates will continue to act as a rebalancing conduit. A stronger dollar is the right medicine for the global economy at the moment. A stronger dollar is required to redistribute growth away from the U.S. and towards the rest of the world. In particular, dollar appreciation is needed to cap budding U.S. inflationary pressures. China needs a weaker currency to offset deflationary pressures stemming from domestic deleveraging and trade tariffs. In turn, a stronger greenback will cause capital outflows from EM and compel the unraveling of excesses within the developing economies. While the result will be painful growth retrenchment for EM in the medium term, cheapened currencies and deleveraging (an unwinding of credit excesses) will ultimately create a foundation for stronger and healthier growth in the years ahead. As to the question of why the dollar would rally in the face of widening twin deficits, we have the following remarks. In a world where growth and inflation are scarce (i.e., in a deflationary milieu), a wider current account deficit and higher inflation - signs of robust domestic demand - will attract capital, ultimately lifting a country's currency. By contrast, in a world of strong growth and intensifying inflationary pressures, twin deficits and higher inflation will cause a country's currency to depreciate. Our assessment is that the global economic backdrop is still more deflationary than inflationary, despite intensifying inflationary pressures in the U.S. Therefore, twin deficits and inflation in the U.S. will be at a premium. That and the fact that the Federal Reserve is willing to continue tightening are conducive for dollar appreciation. As we have argued in previous reports, the U.S. dollar is not cheap,7 but it is not particularly expensive either. In fact, odds are it will get much more expensive before topping out. Bottom Line: Beyond any possible short-term countertrend moves, the path of least resistance for the U.S. dollar is up, and for the RMB and EM currencies, down. As these adjustments within the currency markets endure, EM risk assets will stay under selling pressure and underperform their developed market counterparts.   Indonesia: At The Whims Of Foreign Portfolio Flows 20 September 2018   The Indonesian currency has reached a two- decade low, and equities and bonds have sold off considerably. Is it time to turn positive on the nation's financial markets? Our bias remains that this selloff is not over and stocks, bonds as well as the currency have more downside. The basis is that Indonesia's balance of payments (BoP) will continue to deteriorate. Indonesia has been very reliant on volatile foreign portfolio flows to fund its current account deficit (Chart II-1). Not surprisingly, a reversal in foreign portfolio inflows to emerging markets (EM) has hurt this country's financial markets. We expect international capital flows to EM to be lackluster, which will continue to weigh on Indonesia's capital account. In the meantime, Indonesia's current account deficit is likely to widen in the months ahead. First, export revenues will begin rolling over on the back of lower copper and palm oil prices. Together, these commodities account for 13% of Indonesian exports. Second, the ongoing slowdown in China may eventually weigh on thermal coal prices. This commodity makes up another 12% of exports. Third, Indonesian imports remain very robust. Overall, a widening current account/trade deficit is typically negative for both share prices and the rupiah (Chart II-2). Chart II-1Indonesia: Foreign ##br##Portfolio Flows Are Key Indonesia: Foreign Portfolio Flows Are Key Indonesia: Foreign Portfolio Flows Are Key Chart II-2Deteriorating Trade Balance ##br##Is Bearish For Equities Deteriorating Trade Balance Is Bearish For Equities Deteriorating Trade Balance Is Bearish For Equities To prevent further currency depreciation, the government announced it will curb certain imports by raising tariffs.While this policy may succeed in limiting imports, it will also raise inflation by pushing prices of imported goods higher. This will allow inefficient domestic producers to stay in business. Higher inflation is fundamentally negative for the currency and local bonds. The above dynamics are making Indonesia's macro outlook increasingly toxic because Bank Indonesia (BI) will probably need to tighten monetary policy further in order to stabilize the rupiah and restrain inflation. Crucially, the BI's objective is to maintain rupiah stability in order to keep inflation tame. Further, Perry Warjiyo, the current governor of BI, has highlighted his preference for setting decisive and preemptive policies. Indonesia's central bank has already raised interest rates, and more hikes are likely if the currency continues depreciating - as we expect. On top of rate hikes, the BI will continue to deplete its foreign exchange reserves to defend the rupiah. Chart II-3 shows that foreign exchange reserve selling by the BI is shrinking local banking system liquidity (commercial bank reserves at the central bank) and lifting domestic interbank rates. In turn, higher local rates will cause bank loan growth to slow, hurting domestic demand. The latter will be very negative for profit growth and share prices because the Indonesian stock market is heavily dominated by banks and other domestic plays. The outlook for Indonesian banks is crucial for the performance of the Indonesian bourse, given they account for 42% of total MSCI market cap. Unfortunately, banks still rest on shaky foundations: Chart II-3Selling FX Reserves = Higher Interbank Rates Selling FX Reserves = Higher Interbank Rates Selling FX Reserves = Higher Interbank Rates Chart II-4Net Interest Margins Will Keep Compressing Net Interest Margins Will Keep Compressing Net Interest Margins Will Keep Compressing Not only will demand for loans slump as borrowing costs rise, but banks' net interest margins will also continue to compress (Chart II-4). Weaker growth and higher interest rates will also lead to a considerable rise in non-performing loans (NPLs), and cause banks' provisioning levels to spike. Higher provisions will hurt their earnings (Chart II-5). Notably, banks have boosted their profits substantially in the past two years by reducing their provisions. This process is set to reverse very soon. Finally, a word on overall equity valuations is warranted. Despite the correction that has taken place, this bourse is not yet trading at compelling valuation levels neither in absolute nor in relative terms (Chart II-6). Chart II-5Downside Ahead For Banks' Shares Downside Ahead For Banks' Shares Downside Ahead For Banks' Shares Chart II-6Indonesian Bourse Isn't Cheap Indonesian Bourse Isn't Cheap Indonesian Bourse Isn't Cheap Bottom Line: The rupiah will remain under selling pressure. This in turn will create a toxic macro mix of higher inflation, rising borrowing costs and weaker domestic demand. We recommend investors keep an underweight position in Indonesian stocks as well as local and sovereign bonds within their respective EM dedicated portfolios. We are also maintaining our short positions in the rupiah versus the U.S. dollar and on 5-year local currency bonds. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Footnotes 1 Please see Emerging Markets Strategy Weekly Report, "Toward A Desynchonized World?" dated April 26, 2017, the link is available at ems.bcaresearch.com. 2 Relative total return (carry included) of four equally weighted EM (ZAR, RUB, BRL and CLP) and three DM (AUD, NZD and CAD) commodities currencies versus an equally weighted average of two safe-haven currencies - the Japanese yen and Swiss franc. 3 Please see Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 28, 2018, the link is available at gps.bcaresearch.com. 4 Please see Emerging Markets Strategy Weekly Report, "EM: Do Not Catch A Falling Knife," dated August 23, 2018, the link is available at ems.bcaresearch.com. 5 Please see Emerging Markets Strategy Special Report, "China Real Estate: A Never-Bursting Bubble?" dated April 6, 2018, the link is available at ems.bcaresearch.com. 6 Calculated as a ratio of corporate demand deposits to time deposits. Rising demand deposits relative to time (savings) deposits entail that companies are gearing up to spend /invest money and vice versa. 7 Please see Emerging Markets Strategy Special Report, "The Dollar: Will The U.S. Invoke A "Nuclear" Option?" dated August 30, 2018, the link is available at ems.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The Trump administration's decision to effectively tariff the second round of imports at 25% materially raises the odds of another significant uptick in Chinese financial market volatility. Even if China ramps up its stimulus efforts in response, the lesson of the 2014-2016 episode is that investors are likely to wait for earnings clarity before buying stocks aggressively. Stay neutral China, at best, relative to global stocks, and overweight low-beta sectors within the investable equity universe. We have a contrarian view about Chinese corporate bonds, and recommend holding a long but diversified position over the coming 6-12 months. Feature Chart 1The RMB Is Acting As A "Panic Barometer" ##br##For Domestic Stocks The RMB Is Acting As A "Panic Barometer" For Domestic Stocks The RMB Is Acting As A "Panic Barometer" For Domestic Stocks The Trump administration finally announced its decision this week on the second round of tariffs on Chinese imports, essentially applying a 25% rate. While the rate will initially start at 10%, it will rise to 25% by the end of the year, and the administration has threatened to immediately seek public consultation on tariffs on all remaining imports from China if the country retaliates against the second round (which was announced yesterday). With news reports having suggested that China would reject new trade talks merely if the second round moves forward, the prospect of a breakthrough in negotiations seems dim, at best. We have highlighted in past reports that the RMB has acted as a panic barometer for domestic equities (Chart 1), as evidenced by the recent spike in the correlation between the two. During this period, the percent decline in CNY-USD seems to have closely followed the magnitude of proposed tariffs as a percent of Chinese exports to the U.S., as would be implied in a simple open economy model with flexible exchange rates. Based on this framework, Chart 2 suggests that the RMB may come under considerable further market pressure, even if investors only assume a 10% rate on the third round of tariffs. A break above the psychologically-important level of 7 for USD-CNY appears likely barring a major intervention from the PBOC, suggesting that a meaningful uptick in Chinese financial market volatility is forthcoming. Chart 2USDCNY = 7 Is Likely To Be Breached Barring Strong Action From The PBOC USDCNY = 7 Is Likely To Be Breached Barring Strong Action From The PBOC USDCNY = 7 Is Likely To Be Breached Barring Strong Action From The PBOC Stimulus To The Rescue? Given that Chinese policymakers have signaled their willingness to stimulate in response to a negative external environment, some investors have argued that China is actually about to enter a mini-cycle upswing. For now, two points suggest that this conclusion is premature: A 10% tariff rate on all remaining imports from China would imply close to $90 billion in tariffs collected, once the second round rate rises to 25%. As noted above, a simple equilibrium exchange rate framework would imply material further weakness in the RMB to counter protectionism of this magnitude. Besides heralding a further selloff in Chinese stocks, this could lead to competitive currency devaluation amongst China's largest trading partners, a "beggar-thy-neighbor" policy that tends to exacerbate rather than alleviate shocks to aggregate demand. As we have noted numerous times over the past year, China's old economy was slowing in the lead up to the U.S./China trade war, and it is not yet clear whether the announced stimulus will generate enough "lift" to convince investors that the low in economic activity is behind them. Chart 3 shows that the August rise in adjusted total social financing as a share of GDP was extremely muted, and that there is no sign yet of a pickup in government spending. Even if China ramps up its stimulus efforts in response to this week's decision from the Trump administration, Chart 4 highlights an important point for investors: there was a considerable lag between a policy response and the low in stock prices during the 2014-2016 episode (a lag that may re-occur today). The chart shows that despite an ongoing depreciation in the RMB and a rebound in our BCA leading indicator for the Li Keqiang index, Chinese stock prices continued to decline for several months. This gap was caused by a lagged decline in earnings, and underscores that investors may ignore the current efforts by policymakers to stabilize the economy until clarity on the stability of earnings presents itself. Chart 3No Sign Yet Of##br## Major Stimulus No Sign Yet Of Major Stimulus No Sign Yet Of Major Stimulus Chart 4History Suggests Investors Need Both ##br##Stimulus And Earnings Clarity History Suggests Investors Need Both Stimulus And Earnings Clarity History Suggests Investors Need Both Stimulus And Earnings Clarity And for now, several signs point to potentially material downside risk for earnings: While the now considerably larger shock from U.S. tariffs has yet to impact the Chinese economy, trailing earnings growth has already peaked and has recently fallen below its trend (Chart 5, panel 1). Despite the recent deceleration in trailing earnings growth and the sharp decline in stock prices, analysts' 12-month forward growth estimates remain quite elevated (Chart 5, panel 2). This suggests that forward earnings could be vulnerable to a decline above and beyond what occurs to trailing earnings, as a full 1/3rd of the increase in the former since late-2015 has been due to very significant shift in growth expectations. The rise in trailing earnings over the past few years appears to be stretched, based the trend in profit margins (Chart 6). The chart highlights that 12-month trailing earnings have well surpassed sales since late-2016, causing margins to rise to their highest level on record and raising the risk of a significant mean-reversion in response to a meaningful economic shock. Net earnings revisions have done a good job at predicting inflection points in forward earnings growth over the past decade, and have recently fallen into negative territory (Chart 7). Chart 5Lofty Earnings Growth Expectations ##br##Are A Risk To Stocks Lofty Earnings Growth Expectations Are A Risk To Stocks Lofty Earnings Growth Expectations Are A Risk To Stocks Chart 6The Earnings Recovery Has Been Partly ##br##Reliant On A Margin Expansion The Earnings Recovery Has Been Partly Reliant On A Margin Expansion The Earnings Recovery Has Been Partly Reliant On A Margin Expansion Chart 7Earnings Revisions Herald ##br##Slowing Earnings Momentum Earnings Revisions Herald Slowing Earnings Momentum Earnings Revisions Herald Slowing Earnings Momentum It is true that some of the above-average levels for profit margins and 12-month forward growth expectations can be explained by the substantial rise in the share of the tech sector in the MSCI China index, whose constituents are significantly more profitable than ex-tech stocks, may have better longer-term growth prospects, and may be more immunized from the trade war with the U.S. Still, Chart 8 illustrates the high earnings hurdle rate for tech stocks over the coming year. Bottom-up analysts continue to expect tech stocks to grow their earnings more than 20% over the next 12 months, despite: Chart 8Are Chinese Tech Stocks Going To Be##br## Able To Grow Earnings 20+%? Are Chinese Tech Stocks Going To Be Able To Grow Earnings 20+%? Are Chinese Tech Stocks Going To Be Able To Grow Earnings 20+%? A poor economic outlook that is likely to impact consumer spending (even if households "outperform" the business sector), and The fact that tech sector net earnings revisions have fallen deeply into negative territory (panel 2). How should investors allocate capital within China in the middle of a trade war with the U.S? First, despite the fact that Chinese stocks have already fallen significantly from their early-January high, it is clearly too early to bottom fish either domestic or investable stocks. Stay neutral China, at best, relative to global stocks. Second, investors should certainly favor low-beta sectors within the Chinese equity universe. Currently, our low-beta equity portfolio includes industrials, telecom services health care, utilities, and consumer staples, but we update the portfolio weights at the end of every month. Third, as discussed below, investors should ignore the very bearish narrative towards Chinese corporate bonds, and hold a long but diversified position over the coming 6-12 months. Bottom Line: The Trump administration's decision to effectively tariff the second round of imports at 25% materially raises the odds of another significant uptick in Chinese financial market volatility. Even if China ramps up its stimulus efforts in response, the lesson of the 2014-2016 episode is that investors are likely to wait for earnings clarity before buying stocks aggressively. Stay neutral China, at best, relative to global stocks, and overweight low-beta sectors within the investable equity universe. Chinese Corporate Bonds: A Contrarian Long Our analysis of the earnings risk facing equities suggests that it is probably still too early to buy Chinese stocks, but in our (contrarian) view there is still one pro-cyclical asset that investors should favor: Chinese corporate bonds. Headlines about defaults in China's corporate bond market continue to appear in the financial press, with concerns most recently focused on low recovery rates of defaulted issues.1 We last wrote about Chinese corporate bonds in June,2 and took a contrarian (i.e. optimistic) stance towards the market. In the meantime, our long China onshore corporate bond trade has continued to gain ground, and an analysis of the inferred credit rating of the market actually strengthens our conviction to stay long. One key element of the bearish narrative towards Chinese corporate bonds is the fact that investment-grade issues in the market are trading like junk. Table 1 highlights that this is largely true: the table presents the spread-inferred credit rating of the four major rating categories of the ChinaBond Corporate Bond Index, and shows that AAA bonds are trading on the border of equivalent maturity investment- and speculative-grade bonds in the U.S. Bonds rates AA+/AA/AA- in China are trading between lower-B and high-CAA, which is firmly in speculative-grade territory. However, in our view market participants are making a mistake when they assume that de-facto junk ratings on Chinese corporate bonds will translate into U.S. junk-style default rates on bonds over the coming 6-12 months (or, frankly, beyond). Chart 9 presents an estimate of the market-implied default rate for the four rating categories shown in Table 1, and suggests that investors are pricing in roughly a 1% default rate for AAA-rated corporate bonds and a 4-5% default rate for AA+/AA/AA-. Table 1Chinese Corporate Bonds Are Trading##br## Like Speculative-Grade Issues Investing In The Middle Of A Trade War Investing In The Middle Of A Trade War Chart 9Allowing Market-Implied Default Rates##br## To Occur Would Be A Huge Policy Error Allowing Market-Implied Default Rates To Occur Would Be A Huge Policy Error Allowing Market-Implied Default Rates To Occur Would Be A Huge Policy Error There are two important factors to consider when gauging the validity of these expectations: Based on Moody's most recent Annual Default Study, the market's current expectations for Chinese corporate bond defaults are actually above the average historical one-year default rates for their inferred credit ratings. Average default rates almost never actually occur over a given 12-month period. Chart 10 highlights that default rates in the U.S. have a binary distribution that is almost entirely determined by whether the economy is in recession (not just slowing down). The late-1980s and the post-2015 environment have been exceptions to this rule, which in large part can be explained by industry-specific events (namely, a surge of energy-sector defaults due to a collapse in the price of oil). But the key point is that investors are likely to overestimate the actual default rate over a given 12 month period when assuming an average historical rate, unless the economy shifts from an expansion to an outright recession over the period. From our perspective, the combination of the market's default expectations and the fact that China is easing suggests an outright long position in Chinese corporate bonds is warranted over the coming year. In our judgement, there is simply no way that policymakers can allow default rates on the order of what is being priced in to occur, as it would constitute an enormous policy mistake that would risk destabilizing the financial system at a time when officials are attempting to counter the looming shock to the export sector. In fact, we doubt that China's typical policy of gradualism when liberalizing its economy and financial markets would allow default rates to rise from 0% to 5% over a year in any economic environment, particularly the current one. As a final point, Chart 11 highlights why a significant rise in the default rate is required in order for investors to lose money on Chinese corporate bonds. The chart shows the 12-month breakeven spread for the ChinaBond AA- Corporate Bond index, unadjusted for default. The breakeven spread represents the rise in yields that would be required for investors to lose money over a 12-month horizon (i.e. the yield change that exactly erases the income return from the position), assuming no defaults. Chart 10"Average" Default Rates ##br##Do Not Really Occur "Average" Default Rates Do Not Really Occur "Average" Default Rates Do Not Really Occur Chart 11A 2% Rise In Yields From Tighter Policy Is Not##br## Going To Occur Over The Coming Year A 2% Rise In Yields From Tighter Policy Is Not Going To Occur Over The Coming Year A 2% Rise In Yields From Tighter Policy Is Not Going To Occur Over The Coming Year The chart shows that AA- bond yields would have to rise approximately 215 bps over the coming year before investors suffer a negative total return, which would be an enormous rise that has a near-zero probability of occurring due of tighter monetary policy. As such, defaults (or the pricing of default risk) remains the only real credible source of potential capital loss from these bonds over the coming year. Our bet, with high conviction, is that holders of Chinese corporate bonds hold a put option that will prevent this from occurring. Bottom Line: Fade investor concerns about rising defaults, and stay long Chinese corporate bonds over the coming 6-12 months. We acknowledge that idiosyncratic risk is likely to be elevated for this asset class, and we recommend that investors take a diversified, portfolio approach when investing in China's corporate bond market. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 For example, please see "In China, Less Than 20% Defaulted Bonds Have Been Paid Back" by Bloomberg News, August 27, 2018 2 Pease see China Investment Strategy Weekly Report "A Shaky Ladder", dated June 13, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights The USD remains supported by fundamentals, especially now that its late-2016 excesses have been purged. Solid U.S. growth contrasts with weaker growth in the rest of the world, which will incentivize further inflows into the U.S. dollar. Despite this positive cyclical view, the tactical outlook remains risky for dollar bulls. In the immediate term, the euro will benefit from easing Italian tensions and as well as from the dollar's correction, but its six-month outlook remains poor. The AUD could also rebound right now, but any such rally should be used to build further short positions. Feature After a furious rally from February to August, the dollar has been weakening since the middle of last month. Since July, we have been worried that the dollar could stage a bit of a correction,1 but we remained committed to the view that ultimately the greenback would rise further in 2018. It is now time to review whether this thesis still holds. BCA believes that the USD's correction could run through the fall, but that the final quarter of 2018 should still prove a rewarding period for dollar bulls. Ultimately, policy divergences will remain a crucial support for the dollar, especially as EM weakness continues to affect the distribution of growth across the globe. USD: Not Yet Extended The dollar ultimately follows the path implied by its fundamental drivers - whether they are interest rate spreads, growth and inflation differentials, relative equity prices, or even relative money-supply growth. However, the path taken by the USD around its drivers is rather wide, and the dollar regularly overshoots and undershoots the equilibrium implied by the aggregation of all these fundamentals (Chart I-1). Academics call this the "band of agnosticism." Chart I-1The Dollar To Follow Fundamentals Higher The Dollar To Follow Fundamentals Higher The Dollar To Follow Fundamentals Higher This cycle was no exception. BCA's Fundamentals Index for the dollar hooked up in 2011, a move associated with a turning point in the greenback itself. However, the dollar remained in undershoot territory for many years. Then suddenly, in 2014, the coiled spring was released and the dollar surged higher, moving above its "band of agnosticism" in 2015 - a moved exacerbated by the sudden rally that followed the election of Donald Trump in November 2016. Once the dollar had become over-loved, over-owned and expensive, it also became vulnerable. The pick-up in global growth that was so evident in 2017 caused a serious correction in this vulnerable currency. However, the selloff had a positive impact: U.S. growth, interest rates, equities and so on continued to move favorably, and the dollar is now positioned to rebound anew, having purged its most egregious excesses. The global economic backdrop is also positive for the dollar. For one, the theme of monetary divergences is still at play. Boosted by a healthy banking sector, healthy household balance sheets and an untimely fiscal stimulus of 1.7% of GDP, U.S. growth has hit 2.8%, well above potential. Moreover, growth has been above potential for eight years, and now U.S. capacity utilization is at its tightest level since the late 1980s. Historically, so large an absence of slack has been linked to higher U.S. interest rates (Chart I-2). Yet interest rate markets are pricing in roughly four increases over the next 24 months, even as Lael Brainard warned that the Federal Reserve could move beyond the hikes implied by its own forecast, the "dot plots." Chart I-2Tight Capacity Utilization Implies Higher U.S. Rates... Tight Capacity Utilization Implies Higher U.S. Rates... Tight Capacity Utilization Implies Higher U.S. Rates... The U.S. economy continues to fare well, as U.S. real interest rates remain 60 basis points below neutral rates and the yield curve has yet to invert. However, U.S. rates matter for the rest of the world as well. There, the picture is less pretty. EM dollar debt stands near record levels (Chart I-3). Hence, EM financial conditions have been hit by the combined assault of higher U.S. rates and an appreciating dollar. Nowhere is this clearer than when looking at the interplay between U.S. bond yields and the South African rand or AUD/JPY, a cross highly correlated to EM currencies. This cycle, rising U.S. bond yields have most often been associated with a rising ZAR or a rising AUD/JPY (Chart I-4). However, this time around, as was the case during the May 2013 Taper Tantrum, rising bond yields are linked to these pro-cyclical currency pairs falling. This suggests that rising yields are not reflecting global growth anymore, and are in fact restrictive for the rest of the world, even if they are not a problem for the U.S. Chart I-3... Which Will Hurt EM Economies ... Which Will Hurt EM Economies ... Which Will Hurt EM Economies Chart I-4Higher U.S. Rates Now Hurt Global Growth Higher U.S. Rates Now Hurt Global Growth Higher U.S. Rates Now Hurt Global Growth This inference is underpinned by the decline in BCA's U.S. Financial Liquidity Index, which heralds additional weakness in global growth and commodity prices (Chart I-5). Already we are seeing symptoms of the malaise. Japanese foreign machine tool orders are contracting, and BCA's Asian Leading Economic Indicator is in deep contraction (Chart I-6). Chart I-5Dollar Liquidity Is A Problem For Growth Dollar Liquidity Is A Problem For Growth Dollar Liquidity Is A Problem For Growth Chart I-6Signs That Global Growth Is Already Suffering Signs That Global Growth Is Already Suffering Signs That Global Growth Is Already Suffering A rising fed funds rate and falling ex-U.S. growth is likely to continue to support the dollar. The dollar loves nothing more than falling global growth. The U.S. economy has low exposure to global trade and to the global industrial sector, and therefore when global growth slows, the U.S. economy is relatively insulated from foreign shocks. This means that U.S. rates of return do not suffer as much as foreign ones. This is even truer in the rare instances when global growth slows while U.S. economic activity continues to power ahead, especially when artificially inflated by untimely fiscal stimulus. This is a characterization of the current environment. Hence, money will continue to flow into the U.S. economy on a two- to three-quarter horizon. In fact, portfolio flows into the U.S. remain well below the levels that prevailed during the previous decade (Chart I-7). The current account deficit is also smaller, hence, if net foreign portfolio flows can increase due to the attraction of higher U.S. rates of return, the U.S. balance of payments will move into a greater surplus, creating a strong underpinning for the dollar. This positive cyclical backdrop for the greenback is not without impediments. Most crucially are the short-term dynamics. Since July, we have been warning clients that a tactical correction in the dollar was likely. While EUR/USD has indeed rebounded, most other currencies have displayed rather tepid performances. This does not mean that the tactical risks to the dollar have abated. Quite the opposite, they are rising. As Chart I-8 illustrates, a large buildup in dollar longs has materialized, yet the G10 economic surprise index is making a trough. Moreover, the diffusion index of the BCA Global Leading Economic indicator is also stabilizing. Additionally, USD /CNY has failed to make new highs and the Turkish central bank just raised rates to 24% - which if Argentina is any guide is likely to provide only temporary relief for the TRY. This means that a period of risk-on sentiment in EM could emerge. Stretched dollar positioning, a temporary stabilization in global growth and EM inflows could precipitate a serious correction in the dollar. Chart I-7Dollar Favorable Flows Dollar Favorable Flows Dollar Favorable Flows Chart I-8Tactical Risks To The Dollar Tactical Risks To The Dollar Tactical Risks To The Dollar Bottom Line: The dollar is still supported by potent cyclical tailwinds. The U.S. economy is roaring and at full employment, yet global growth is suffering because global liquidity conditions are deteriorating. Higher rates of return in the U.S. will therefore attract additional capital, supporting the greenback in the process. Despite this positive cyclical backdrop, the short-term outlook is murkier. Speculators have aggressively bought the dollar, leaving them vulnerable to any positive surprises in global growth, even temporary ones. Fade The Euro Rebound The euro has benefited from the cool-off in Italian politics. The populist Five Star Movement / Lega Nord coalition is backing away from a budget confrontation with Brussels, as Giovanni Tria, Italy's minister of finance, wants a 2% budget deficit, while Deputy Prime Minister Matteo Salvini is arguing for a 2.9% budget hole - well south of the 6% levels touted during the campaign. As a result, the spread between Italian BTPs and German bunds has fallen from 193 basis points at the beginning of the month to 150 basis points this week (Chart I-9). Since gyrations in Italian spreads reflect the evolution of the perceived probability that the euro area will fall apart, the fall in the spreads has implied a fall in the euro area-breakup risk premium. This has created a boon for the euro. Another support for the euro emerged yesterday. At his press conference, European Central Bank President Mario Draghi divulged that the ECB has curtailed its growth forecast for 2018 and 2019, but not its inflation forecast. In fact, Draghi went as far as mentioning that his confidence that euro area inflation would move back to target in the medium term has increased. There is no denying that the inflationary backdrop has improved as European wages and labor costs have indeed starting to recover (Chart I-10). However, the picture is not that straightforward. The lagged impact of the previous fall in euro area inflation relative to the U.S. is likely to continue to be felt in EUR/USD moving forward, as has been the case over the past 10 years (Chart I-11). Chart I-9The Euro Area Break Up Risk Premium Is Declining The Euro Area Break Up Risk Premium Is Declining The Euro Area Break Up Risk Premium Is Declining Chart I-10Rising Euro Area Labor Costs Rising Euro Area Labor Costs Rising Euro Area Labor Costs Chart I-11Relative Inflation Backdrop Is Still Euro Bearish Relative Inflation Backdrop Is Still Euro Bearish Relative Inflation Backdrop Is Still Euro Bearish This risk is compounded by developments in China. As we have often argued, the growth differential between the euro area and China can largely be explained by growth dynamics in China. As Chart I-12 illustrates, when Chinese monetary conditions tighten, or when China's marginal propensity to consume - as approximated by the gap between M1 and M2 - declines, this often leads to underperformance of European economic activity relative to the U.S. Chart I-12AChinese Economy Still Hurting Euro Area Vs U.S. (I) Chinese Economy Still Hurting Euro Area Vs U.S. (I) Chinese Economy Still Hurting Euro Area Vs U.S. (I) Chart I-12BChinese Economy Still Hurting Euro Area Vs U.S. (II) Chinese Economy Still Hurting Euro Area Vs U.S. (II) Chinese Economy Still Hurting Euro Area Vs U.S. (II) Today, Chinese monetary conditions have improved somewhat as the Chinese authorities try to combat the shock to the Chinese economy created by the growing trade war between the U.S. and China. However, Matt Gertken, BCA's Geopolitical Strategy service's expert on Chinese policy, believes that Chinese policymakers do not intent to actually cause economic growth to pick up. Indeed, they are committed to reform and deleveraging, and only want to limit downside to the Chinese economy.2 Thus, the large growth gap between the U.S. and the euro area is here to stay. As markets absorb news of Chinese stimulus, EUR/USD could rebound toward 1.19, but we are inclined to fade such a rebound. For one, the growth and inflation gap between the U.S. and the euro area remains euro bearish. Additionaly BCA's Central Bank Monitor for the Fed clearly points toward the need to tighten U.S. monetary policy, while our indicator for the ECB points to the need to maintain an extremely loose policy setting in Europe (Chart I-13). With the euro still trading above its intermediate-term fair value estimate (Chart I-14), beyond any short-term rally the euro still possesses ample downside in the fourth quarter. As such, we would use the current rebound in the euro as an opportunity to buy the dollar once again. Chart I-13The U.S. Needs More Tightening, Europe Does Not The U.S. Needs More Tightening, Europe Does Not The U.S. Needs More Tightening, Europe Does Not Chart I-14The Euro Possesses Downside The Euro Possesses Downside The Euro Possesses Downside Bottom Line: Falling risk premia in Italy, a pick-up in European wages and signs of stimulus in China are creating some support under the euro. However, European growth and inflation are set to continue to lag well behind the U.S. as China's stimulus is not designed to reverse its deleveraging campaign and boost growth, but instead to limit downside to growth created by the U.S.-China trade war. Hence, we will use the current rebound in the euro and correction in the USD to buy the greenback again in the coming weeks. What's Going On Down Under? In recent months, the Australian economy has managed to generate some impressive numbers on the employment front. However, until recently this was not enough to prompt investors to push the AUD higher. In fact, as recently as Monday, AUD/USD was trading at 0.71. Investors are skeptical about the Australian economy's underlying strength. The NAB Business Confidence for the Next Period has weakened sharply, while mortgage approvals and house prices have also sagged. This suggests that new orders, employment and consumption could follow lower (Chart I-15). This represents a big problem for the Aussie, as our central bank monitor for the Reserve Bank of Australia is already in "easing required" territory (Chart I-16). The RBA will therefore not be able to hike rates any time soon, despite the fact that U.S. interest rates are currently in an uptrend. As such, interest rate differentials between Australia and the U.S. will continue to deteriorate. Chart I-15Australia Is Set To Slowdown Australia Is Set To Slowdown Australia Is Set To Slowdown Chart I-16China And Australia Are Joined At The Hip China And Australia Are Joined At The Hip China And Australia Are Joined At The Hip Moreover, Australia has been hit directly by the decline in Chinese industrial activity. As Chart I-17 illustrates, Australian exports are a direct function of China's Li-Keqiang index. This has two implications. First, the current rebound in the Li-Keqiang index suggests that investors could bid up the AUD with great alacrity if the USD were to correct further, a thesis we espouse. However, since we do not anticipate the rebound in the Li-Keqiang indicator to have much longevity, nor do we anticipate the greenback's correction to morph into a bear market, this also means that we would use any rebound in the AUD to sell more of it. Beyond China, EM at large still constitutes a risk for AUD/USD. Arthur Budaghyan, our Chief EM strategist, argues that the period of weakness in EM assets has further to run. Our views on the U.S. dollar, on declining global liquidity and on Chinese policy corroborate this assessment. If EM economies slow further, the still-elevated expected long-term growth rate in EM earnings could decline further as well. Since growth expectations on EM EPS are indicative of expected interest rates and terms-of-trade for Australia, this also suggests that the AUD could suffer significant downside in the coming quarters (Chart I-18). Finally, the AUD remains a pricey currency. AUD/USD continues to trade significantly above its purchasing-power-parity fair value, and the real trade-weighted AUD remains above its long-term average (Chart I-19). As such, the AUD does not possess the required valuation cushion to make it a buy in this challenging context. Chart I-17RBA ##br##Cannot Hike RBA Cannot Hike RBA Cannot Hike Chart I-18EM Has Yet To Be Fully Re-Rated, ##br##And So Does The AUD EM Has Yet To Be Fully Re-Rated, And So Does The AUD EM Has Yet To Be Fully Re-Rated, And So Does The AUD Chart I-19No Valuation Cushion##br## In The AUD No Valuation Cushion In The AUD No Valuation Cushion In The AUD Bottom Line: The Australian economy has posted some solid employment numbers, but the trends in business confidence and the housing market augur poorly. Australian monetary policy will have to remain very loose. Moreover, since China's stimulus is likely to be limited, any rebound in the AUD on the back of a dollar correction should be faded, especially as the Aussie does not offer any valuation cushion. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Time To Pause And Breathe", dated July 6, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report, titled "China: How Stimulating is The Stimulus?", dated August 24, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Recent data in the U.S. has been mixed: Average hourly earnings growth outperformed expectations significantly, coming in at 2.9%. Moreover, nonfarm payrolls also surprised to the upside, coming in at 201 thousand, but this was mitigated by large downward revisions to the previous two months. Additionally initial jobless claims surprised positively, coming in at 203 thousand. However, core inflation underperformed expectations, coming in at 2.2%. Finally, DXY has been flat for the past couple of weeks. We continue to be bullish on the dollar on a cyclical basis, as inflationary pressures will continue to accumulate in the U.S., causing the fed to hike more than expected, particularly in 2019. Moreover, high U.S. borrowing cost will likely weigh on global growth, giving an additional boost to the dollar, as the U.S. has a lower beta than other DM economies to the global economic cycle. Report Links: The Dollar And Risk Assets Are Beholden To China’s Stimulus - August 3, 2018 Rhetoric Is Not Always Policy - July 27, 2018 Time To Pause And Breathe - July 6, 2018 Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The Euro Recent data in the euro area has been negative: Both headline and core inflation surprised to the downside, coming in at 2% and 1% respectively. Moreover, industrial production yearly growth also surprised to the downside, coming in at -0.1%. Finally, retail sales yearly growth also underperformed expectations, coming in at 1.1%. EUR/USD has been flat the past two weeks. Yesterday, however the market rallied as the ECB confirmed that it expects to wind down its bond-buying program. Nevertheless, it also lowered growth forecast for this year and next. We continue to believe that the euro will have downside until the end of the year, as a policy and regulatory tightening in China will weigh on the global industrial cycle, to which Europe is highly levered. Report Links: Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn’t Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 The Yen Recent data in Japan has been mixed: Tokyo ex fresh food inflation outperformed expectations, coming in at 0.9%. Moreover, overall household spending yearly growth also surprised positively, coming in at 0.1%. However, labor cash earnings yearly growth underperformed expectations substantially, coming in at 1.5%. Finally, Markit Services PMI surprised to the downside, coming in at 51.5. USD/JPY has been flat the past couple of weeks. Overall, we are bullish on the yen against the euro and the commodity currencies, as the tightening in monetary policy in the U.S. as well as in China should create a risk off environment where safe heavens like the yen benefits and cyclical currencies suffer. Report Links: Rhetoric Is Not Always Policy - July 27, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 British Pound Recent data in the U.K. has been mixed: Average hourly earnings yearly growth excluding and including bonuses both came in above expectations, at 2.9% and 2.6% respectively. Moreover, Markit Services PMI also outperformed expectations, coming in at 54.3. However, industrial production surprised to the downside, coming in at 0.9%. Finally, nationwide housing prices yearly growth also surprised negatively, coming in at 2%. GBP/USD has rallied by roughly 0.5% the past couple of weeks. We believe that the pound could have some short term upside, as positioning continues to be significantly bearish. That being said, we are bearish on the pound on a cyclical basis, particularly against the yen. At this moment, the pound does not appear to have much of a geopolitical risk premium embedded in its price. Thus, any turbulence in the Brexit negotiations could result in significant downside for the GBP. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Australian Dollar Recent data in Australia has been mixed: Gross domestic product yearly growth came in above expectations, at 3.4%. However, building permits month-on-month growth surprised to the downside, coming in at -5.2%. Finally, the RBA Commodity Index SDR yearly growth surprised positive, coming in at 6.7%. After a bout of pronounced weakness, AUD/USD has been flat for the past couple of weeks. We believe that the Australian dollar has further downside particularly against the yen and the dollar. Australia's economy is very sensitive to the Chinese industrial cycle, as iron ore is Australia's main commodity export. However, the overleveraged industrial complex is precisely the economic sector where Chinese policymakers want to rein in credit excesses. This will curb industrial activity in China, and hurt the economies of commodity supplies like Australia. Report Links: What Is Good For China Doesn’t Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 New Zealand Dollar Recent data in New Zealand has been mixed: Retail sales and retail sales ex autos yearly growth both outperformed expectations, coming in at 1.1% and 1.4% respectively. Moreover, the trade balance also surprised to the upside, coming in at -4.4 billion dollars/ However, the terms of trade Index underperformed expectations, coming in at 0.6%. NZD/USD has fallen by roughly 0.8% against the dollar for the past couple of weeks. We continue to be bearish on kiwi on a cyclical basis. The combination of high U.S. rates and deleveraging in China will weigh on carry currencies like the NZD. Furthermore, we also hold a bearish view on a structural basis, given that the new government has vowed to curb immigration and add an unemployment mandate to the RBNZ, both developments which are negative for the currency. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Canadian Dollar Recent data in Canada has been mixed: Both core and headline inflation outperformed expectations, coming in at 1.6% and 3% respectively. Moreover, manufacturing shipments month-on-month growth also outperformed expectations, coming in at 1.1%. However, retail sales month-on-month growth surprised to the downside, coming in at -0.2%. USD/CAD has been flat for the past couple of weeks. We are short this cross as a hedge to our dollar bullish view, as inflationary pressures in Canada remain strong. Moreover, the CAD will continue to outperform the AUD, as the divergence between Canada's and Australia's main export markets- China and the U.S. - will persist. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Swiss Franc Recent data in Switzerland has been mixed: Gross domestic product yearly growth outperformed expectations, coming in at 3.4%. The SVME PMI also surprised to the upside, coming in at 64.8. However, the KOF leading indicator surprised negatively, coming in at 100.3. Finally, real retail sales growth also underperformed expectations, coming in at -0.3%. EUR/CHF has risen by roughly 0.5% this past two weeks. We continue to be bearish on the franc on a long-term basis, as inflationary pressures in Switzerland are still too weak for the SNB to remove its accommodative monetary policy, or stop its currency intervention. That being said, the CHF could experience some short term upside if the sell-off in emerging markets continues. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Norwegian Krone Recent data in Norway has been mixed: Both headline and core inflation outperform expectations, coming in at 3.4% and 1.9%. Moreover, the Labour Force survey also surprised to the upside, coming in at 3.9%. However, retail sales growth underperformed expectations, coming in at 0.7%. USD/NOK has fallen by nearly 2% over the last two weeks. We are bullish on the NOK against other commodity currencies like the AUD and the NZD. This is because oil will likely outperform within the commodity space. After all, Our commodity strategist have explained at length why political risk in Iraq and Venezuela could cause a shortage of supply in the oil markets, while Chinese deleveraging in the industrial sector will weigh on base metal demand. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Swedish Krona Recent data in Sweden has been mixed: Retail sales yearly growth surprised to the downside, coming in at -1.2%. However, consumer confidence outperformed expectations, coming in at 102.6. The krona has been the best performing currency during the past two weeks, with USD/SEK falling by roughly 2% over this period. At the moment we continue to be bullish USD/SEK, as the krona is the most sensitive currency to the dollar's strength. However, on a longer term basis, we believe that inflationary pressures in Sweden will ultimately force the Riskbank to hike more than the market expects, providing support for the SEK. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights A sovereign debt default in Argentina is unlikely in the next 12 months, the primary reason being IMF financing. The peso and the stock market appear close to two standard deviations cheap. Consequently, it makes sense to argue that financial market adjustments in Argentina are probably advanced, and investors should avoid temptation to become more bearish. However, we are not yet comfortable taking unhedged bets. For fixed income and currency investors, we recommend the following relative positions: short Brazilian / long Argentine sovereign credit, and long Argentine peso / short Brazilian real. Feature Chart I-1The Argentine Peso Is Cheap The Argentine Peso Is Cheap The Argentine Peso Is Cheap Argentine financial markets have plunged dramatically, and the question is whether the country is heading into another sovereign default. Argentina has defaulted eight times and devalued its currency many times in the past 60 years. Hence, odds of a government debt default cannot be dismissed lightly. This is also a valid question, given that Argentina's foreign currency public debt stands at $220 billion, and that after the latest currency devaluation, it is equal to 71 % of GDP. Total public (foreign and local currency) debt stands at 87% of GDP. Yet, our assessment is that a sovereign debt default is not likely in the next 12 months because of IMF financing. The latter will be ready to increase the size of its funding to Argentina's current government, if needed, for both political and economic reasons. The IMF has a good working relationship with Argentine President Mauricio Macri's government, which is packed with orthodox economists who share the IMF's philosophies. Besides, the U.S. administration will welcome IMF financial support for Argentina, as it will not want the latter country to request credit lines from China, like it did under its previous government. Given that a sovereign debt default is likely to be avoided in the next 12 months before Macri's current term expires, should investors buy Argentine financial assets? On one hand, the currency seems to have become quite cheap - Chart I-1 illustrates that the peso's real effective exchange rate has plunged close to 40% below its fair value. On the other hand, both the near-term domestic outlook and broader EM dynamics remain risky. What Went Wrong? Argentina's woes this year have been due to excessive reliance on foreign financing as well as tardy fiscal tightening. The government had been delaying crucial fiscal tightening due to political considerations. Further, it used its access to global capital markets last year to raise an immense amount of foreign funds to finance its ballooning fiscal deficit. In particular, portfolio net inflows amounted to $35 billion in 2017 amid the buying frenzy in emerging markets (Chart I-2). Meantime, net FDI inflows were meager. The outstanding amount of portfolio debt securities and portfolio equity investment owned by foreigners has risen sharply since Macri's government came to power in December 2015 (Chart I-3). The most recent data points on this chart are as of the end of March 2018. Hence, they do not incorporate security liquidations that have occurred by foreigners since that time. Chart I-2Argentina: Heavy Reliance On##br## Foreign Portfolio Flows Argentina: Heavy Reliance On Foreign Portfolio Flows Argentina: Heavy Reliance On Foreign Portfolio Flows Chart I-3Securities Holdings By Foreigners Have ##br##Surged Since Macri's Election Securities Holdings By Foreigners Have Surged Since Macri's Election Securities Holdings By Foreigners Have Surged Since Macri's Election In brief, Macri's government relied on plentiful global portfolio flows into EM to finance the country's large fiscal deficit in 2016 and 2017. As soon as foreign portfolio inflows into EM reversed, Argentina immediately began to feel the punch. Some commentators blame the central bank for excessive money printing, and have recommended Argentina dollarizing its economy: i.e., adopting the U.S dollar.1 These accusations and recommendations are misplaced and misguided. In the short term, commercial banks have expanded their loans aggressively in the past 18 months (Chart I-4). This is what has contributed to the peso's plunge. The central bank was late to hike interest rates accommodating this credit binge and the collapse in the exchange rate value was the price to be paid for this mistake. From a structural perspective, however, local currency broad money (M3) supply in Argentina is not excessive at all. It is equal to mere 24% of GDP, which is a very low ratio compared to Turkey's 52%, Brazil's 90% and China's 240% (Chart I-5). Therefore, there has structurally been no excessive money creation. Chart I-4Private Credit Boom This Year Private Credit Boom This Year Private Credit Boom This Year Chart I-5Money Supply Is Not Excessive In Argentina Money Supply Is Not Excessive In Argentina Money Supply Is Not Excessive In Argentina The currency meltdown can be attributed to persistent hyperinflation that makes residents reluctant to hold and save in pesos. Inflation is a structural problem in Argentina, and it is not due to excessive demand, but rather due to lack of supply. Structural supply deficiency - the inability of the economy to produce goods and services efficiently - is the primary reason for structurally high inflation and large current account deficits. Each time demand recovers in Argentina, it can only be satisfied by ballooning imports and a widening current account deficit since domestic production/supply is weak. Chronic supply deficiency can be cured by structural reforms, though it will take years to show progress. It cannot be solved by fiscal and monetary policies within a year or two. Painful Adjustments Are In The Making In near term, the currency will remain volatile but over the next six months, it will likely find a floor because of the following. First, the nation's foreign debt obligations (FDO) will drop from $68 billion this year to $40 billion in 2019 (Chart I-6, top panel). This will alleviate pressure on the balance of payments that has been severe this year. Therefore, the outlook for foreign funding should improve over the next year. The negotiated new tranche from the IMF of about $30-35 billion will cover a considerable portion of Argentina's foreign funding needs over the next 16 months. If more funding is required, the IMF will likely provide it as well. Second, in the past year the government has already been reducing its primary fiscal spending - i.e. excluding interest payments on public debt (Chart I-7). The crisis has forced Macri's government to slash public expenditures more aggressively. In recent weeks alone the government announced cuts in several government ministries and raised taxes on exports of agricultural goods. Overall, the primary deficit target for 2019 has been revised in from -1.3% of GDP to a balanced budget (Chart I-8). Chart I-6Argentina: Lower Foreign Debt ##br##Obligations Due Next Year Argentina: Lower Foreign Debt Obligations Due Next Year Argentina: Lower Foreign Debt Obligations Due Next Year Chart I-7Argentina: Government Spending Has##br## Been Substantially Curtailed Argentina: Government Spending Has Been Substantially Curtailed Argentina: Government Spending Has Been Substantially Curtailed Chart I-8Argentina: No Primary ##br##Fiscal Deficit In 2019 Argentina: No Primary Fiscal Deficit In 2019 Argentina: No Primary Fiscal Deficit In 2019 The key risk to this target is government revenues that may underwhelm because the economy is in a major recession. If this occurs, additional spending cuts are likely. This is bad for the economy, but if the government implements these expenditure cuts it will be positive for the currency and government creditors. Third, the current account and trade balances will improve in the next 12 months as the peso's plunge and higher interest rates are already crashing domestic demand and imports (Chart I-9). Imports of both consumer and capital goods are already plunging, and total imports will likely drop by at least 30-35% in the next 12 months (Chart I-10). Finally, given the peso's 50% plunge this year, inflation is set to surge. Based on the regression of inflation on the exchange rate, consumer price inflation could reach 55% by year end (Chart I-11). This will impair household purchasing power - erode their income in real terms - as the government will likely maintain the growth ceiling of 13% for minimum wages in 2018. The minimum wage serves as a benchmark for wage negotiations nationwide. In real terms, wage diminution will reinforce a contraction in consumer spending. Chart I-9Argentina: Current Account Balance ##br##Was Unsustainably Wide Argentina: Current Account Balance Was Unsustainably Wide Argentina: Current Account Balance Was Unsustainably Wide Chart I-10Argentina: Imports Are##br## Set To Plummet Argentina: Imports Are Set To Plummet Argentina: Imports Are Set To Plummet Chart I-11Argentina: Inflation Will Surge##br## To About 50% Argentina: Inflation Will Surge To About 50% Argentina: Inflation Will Surge To About 50% In a nutshell, the unfolding crash in domestic demand will cap inflation next year. Bottom Line: A dramatic domestic demand retrenchment (a major recession) along with lower foreign debt obligations in 2019 will reduce the country's foreign funding requirements next year. Besides, the IMF will likely disburse the remaining $35 billion in the next 16 months. It will, in our opinion, also be disposed to providing additional funding to avoid a public debt default in Argentina in the next 12 months at least. In this vein, investors should be asking whether the peso and asset prices have become sufficiently cheap to warrant bottom-fishing. What Is Priced In? There is little doubt that economic growth and corporate profits in Argentina will be disastrous in the months ahead. Nevertheless, financial markets have already crashed and investors should be looking to make a judgment on whether the peso, equities and sovereign credit are cheap enough to warrant bottom-fishing. We have the following observations: Currency: The peso is about 40% below its fair value, according to our valuation model (Chart 1 on page 1). This model is built using the real effective exchange rate (REER) based on consumer and producer prices. Previous episodes of devaluation drove the peso's REER 40-55% below its fair value. Hence, there still could be up to 15% of downside in the REER or in the peso's total return adjusted for carry. However, from a big-picture perspective, the peso may not be too far from bottoming in real inflation-adjusted terms. This does not mean that the nominal exchange rate will appreciate. It entails that the peso will bottom in real terms or adjusted for the carry (on a total return basis). Stocks: The aggregate Argentine equity index has plunged by 60% in dollar terms, and bank stocks have dropped by 75% in dollar terms. As a result, our cyclically adjusted P/E ratio has fallen to 5 for the overall bourse and to 3 for bank stocks (Chart I-12A & Chart I-12B). Chart I-12AOverall Equities Are Cheap... Overall Equities Are Cheap... Overall Equities Are Cheap... Chart I-12B... As Are Bank Stocks ...As Are Bank Stocks ...As Are Bank Stocks Yet there might be a tad more downside before these cyclically-adjusted P/E ratios reach two standard deviations below their fair value. Furthermore, if we were to compare the magnitude of the crash in Argentine share prices relative to the Asian crisis (specifically, Thailand and Korea), there seems to be further downside in Argentine equities (Chart I-13). Sovereign credit: Argentine sovereign credit spreads have reached 850 basis points (Chart I-14, top panel), which is 450 basis points wider than the spread for the aggregate EM benchmark (Chart I-14, bottom panel), but they are still well below their 2013 highs. Clearly valuations are not yet sufficiently attractive in the credit space to warrant bottom-fishing. However, assuming our call that the IMF will do everything to preclude a public debt default, at least in the next 12 months, sovereign credit spreads may not widen excessively from current levels. Chart I-13There Is More Downside When Compared With Asian Crisis There Is More Downside When Compared With Asian Crisis There Is More Downside When Compared With Asian Crisis Chart I-14Sovereign Credit Spreads: Absolute And Relative To EM Sovereign Credit Spreads: Absolute And Relative To EM Sovereign Credit Spreads: Absolute And Relative To EM Investment Conclusions The peso and stock market appear close to two standard deviations cheap. Consequently, it makes sense to argue that financial market adjustments in Argentina are probably advanced, and that investors should avoid the temptation to become more bearish. For investors who own the currency, stocks, or sovereign credit, and can withstand further volatility, it likely makes sense to stay the course. Even though the economy has entered yet another major recession, investors should keep in mind that financial markets are forward looking and may have already priced in a major economic contraction. In the equity space, we will wait before recommending a long position in the overall market or in bank stocks, as disastrous corporate profits could produce a final down leg in share prices. Our negative view on EM risk assets also argues for being patient. In the sovereign credit space, we are not yet comfortable taking a unhedged absolute bet, and continue to recommend maintaining the following relative position: short Brazilian / long Argentine sovereign credit (Chart I-15). Chart I-15Argentina Versus Brazil: Sovereign Credit Spreads Argentina Versus Brazil: Sovereign Credit Spreads Argentina Versus Brazil: Sovereign Credit Spreads Relative to Argentina, Brazil's financial markets are expensive at a time when Brazil's macro fundamentals and politics are problematic. We discussed our view on Brazil in detail in our July 27, 2018 Special Report,2 and will not repeat it here. Our recommendation - from January 16th 2017 - of buying Argentine long-dated local currency bonds has incurred large losses. We are closing this position and opening a new trade going long the peso to earn the high carry at the front end of the curve. The high carry could provide enough downside protection. Yet we do not have strong conviction as to whether the peso has reached an ultimate bottom. Therefore, we recommend a relative currency trade: long Argentine peso / short Brazilian real. This trade has a 35% positive carry, and certainly the selloff in the Argentine peso is far more advanced than that of the real. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Analyst andrijav@bcaresearch.com 1 Please refer to Wall Street Journal article entitled: Argentina Needs to Dollarize, dated September 10th 2018. 2 Please see BCA Emerging Markets Strategy Special Report, "Brazil: Faceoff Time," dated July 27, 2018, available on page 18. South African Rand: Engulfed In A Downward Spiral? 13 September 2018 Chart II-1Risks Are To The Downside For The Rand Risks Are To The Downside For The Rand Risks Are To The Downside For The Rand From the beginning of 2016 to early 2018, the South African rand enjoyed various tailwinds: rising metal prices, an improving trade balance, strong foreign portfolio inflows and lastly, hopes that the new president Ramaphosa would implement structural reforms, in turn enhancing the country's structural backdrop. These tailwinds have turned into headwinds since early this year and seem likely to persist. Hence, we believe the rand will remain in a downward spiral for now. First and foremost, metal prices have been under serious downward pressure. Typically, they correlate with the South African rand. Chart II-1 illustrates our new indicator for the rand, which is calculated as the annual growth rate in metal prices minus South Africa's broad money (M3) impulse. When the indicator drops below zero, like it has done recently, the rand tends to sell-off. In short, the bear market in the rand is not yet over. The broad money impulse in this indicator serves as a proxy for underlying domestic demand, and hence, import growth. Also, we use the average of the Goldman Sachs industrial and precious metal price indexes for metal prices. The latter is used as a proxy for export growth. Worryingly, not only export prices are plummeting but export volumes are also weak and mining production is contracting (Chart II-2). As a result, the trade and current account deficits will widen again. Chart II-3 illustrates that the rand depreciates when the annual change in trade balance turns down. It will be difficult for South Africa to finance its widening trade and current account deficits given the poor global backdrop and the slowing fund flows to EM. Since 2013, foreign capital inflows have by and large been comprised of volatile portfolio inflows rather than stable foreign direct investments (Chart II-4). Presently, the gap between the two stands at its widest in history. Additionally, foreign ownership of domestic bonds remains extremely elevated. Our big picture view is that the liquidation in EM financial markets will persist and foreign investors in South African domestic bonds will be under pressure to reduce their holdings or hedge their currency risk exposure. Chart II-2Mining Output ##br##Is Shrinking Mining Output Is Shrinking Mining Output Is Shrinking Chart II-3Trade Balance Momentum Points ##br## To Currency Depreciation Trade Balance Momentum Points To Currency Depreciation Trade Balance Momentum Points To Currency Depreciation Chart II-4Excessive Reliance On ##br##Foreign Portfolio Inflows Excessive Reliance On Foreign Portfolio Inflows Excessive Reliance On Foreign Portfolio Inflows Politics served as a justification for investors to buy South African risk assets at the start of the year. We downplayed that optimism back then and still remain negative on politics today. Ramaphosa has recently endorsed a constitutional change that would allow the confiscation of land without compensation. Whether this policy will actually materialize and get implemented is impossible to know. That said, as outlined in our June 28 2017 Special Report entitled South Africa: Crisis of Expectations,3 our fundamental political analysis suggests that the median voter in South Africa will continue favoring populism. As such, populist policies are likely to continue being proposed to appease the ANC base, and some of them might be implemented. Constant pressure on the ANC from South Africa's far-left political party Economic Freedom Fighters, before next year's election, entails a very low likelihood that painful structural reforms will be enacted. As such, the productivity outlook will remain poor for now. On the fiscal front, there has been little to no improvement since Ramaphosa assumed office in February of this year (Chart II-5). In terms of valuation, South African risk assets are not particularly attractive at the moment. The rand is not very cheap (Chart II-6) and neither are equities (Chart II-7). Odds are that the rand will become as cheap as in 2015 based on its real effective exchange rate - before a bottom is reached. Chart II-5There Has Been No Improvement##br## In Fiscal Accounts There Has Been No Improvement In Fiscal Accounts There Has Been No Improvement In Fiscal Accounts Chart II-6The Rand Will Likely Get ##br##Cheaper Before It Bottoms The Rand Will Likely Get Cheaper Before It Bottoms The Rand Will Likely Get Cheaper Before It Bottoms Chart II-7South African Equities##br## Are Not Cheap Yet South African Equities Are Not Cheap Yet South African Equities Are Not Cheap Yet Putting all these factors together, the path of least resistance for South African risk assets is down. We recommend EM dedicated equity and fixed-income (both local currency and sovereign credit) investors to maintain an underweight allocation on South Africa. We also continue recommending shorting general retailer stocks. For currency traders, we suggest maintaining the following trades: short ZAR vs. USD and short ZAR vs. MXN. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 3 Please see BCA Emerging Markets Strategy & Geopolitical Strategy Special Report, "South Africa: Crisis Of Expectations," dated June 28, 2017, available at ems.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The U.S. midterm elections are far less investment-relevant than consensus holds; Trump will increase the pressure on China and Iran regardless of the likely negative election results for the GOP; The Iranian sanctions, civil conflict in Iraq, and other oil supply issues are the real geopolitical risk; Despite the tentative good news on Brexit, political uncertainty in the U.K. makes now a bad time to buy the pound; Go long Brent crude / short S&P 500; long U.S. energy / tech equities; long JPY / short GBP. Feature The U.S. political cycle begins in earnest after Labor Day. Understandably, we have noticed an uptick in client interest, with a steady stream of questions and conference call requests about U.S. politics. Generally, our forecast remains unchanged since our April net assessment of the upcoming midterm election.1 Democrats have a slightly better than 60% probability of winning the House of Representatives, with a solid 45% probability of taking the Senate, and rising. The latter is astounding, given that the "math" of the Senate rotation is against the Democrats. Our bias toward a Democratic victory is based on current polling (Chart 1) and President Trump's woeful approval rating (Chart 2). There are a lot of other moving parts, however, and we will update them next week in detail. Chart 1GOP Trails In Polls, But It Is Still Close GOP Trails In Polls, But It Is Still Close GOP Trails In Polls, But It Is Still Close Chart 2Trump's Approval Rating Lines The GOP Up For Steep Losses Fade The Midterms, Not Iraq Or Brexit Fade The Midterms, Not Iraq Or Brexit But why, dear client, should you care? Do the midterms really matter for investors? History suggests that they tend to be a bullish catalyst for the stock market (Chart 3). Will this time be any different? The two bearish narratives hanging over markets have to do with the Democrats foiling President Trump's pro-business policy and impeaching him. The former would purportedly have a direct impact on earnings by stymieing Trump's pluto-populist agenda, while the latter would presumably force Trump to seek relevance abroad - through an aggressive foreign policy or trade policy. We think both concerns are without merit. First, by taking over the House of Representatives, the Democrats will not be able to stop or reverse the president's economic agenda. Trump's deregulation will continue, given that regulatory affairs are the sole prerogative of the executive branch of government. Tax cuts will not be reversed, given that Democrats have no chance of gaining a 60-seat, filibuster-proof, majority in the Senate, and would not have a two-thirds majority in each chamber to override Trump's veto. As for fiscal stimulus, it is highly unlikely that the party of the $15 minimum wage and "Medicare for all" would seek to impose fiscal discipline on the nation. As far as the market is concerned, President Trump has accomplished all he needed to accomplish. Gridlock is perfectly fine, which is why a divided Congress has not stopped bull markets in the past (Chart 4). And should the Republicans somehow retain Congress, the result would be a "more of the same" rally. Chart 3Midterm U.S. Elections Tend To Be Bullish... Fade The Midterms, Not Iraq Or Brexit Fade The Midterms, Not Iraq Or Brexit Chart 4... Even Those That Produce Gridlock Fade The Midterms, Not Iraq Or Brexit Fade The Midterms, Not Iraq Or Brexit What about impeachment? Well, what about it? As we have illustrated in our net assessment of the impeachment risk, the Senate is not likely to convict Trump, so markets can look through it, albeit with bouts of volatility (Chart 5A & 5B).2 Chart 5AMarkets Can Rally Through Impeachment... Markets Can Rally Through Impeachment... Markets Can Rally Through Impeachment... Chart 5B...Despite Volatility ...Despite Volatility ...Despite Volatility To this our clients counter: "But Trump is different!" According to this theory, President Trump would respond to the threat of impeachment by becoming unhinged and seeking relevance abroad through an aggressive foreign and trade policy. But can he be more aggressive than ... Threatening nuclear war with North Korea; Re-imposing an oil embargo against Iran - and thus unraveling the already shaky equilibrium in the Middle East; Imposing tariffs on half, possibly all, U.S. imports from China; Threatening additional tariffs on U.S. allies like Canada, the EU, and Japan? More aggressive than that? We are agnostic towards the upcoming midterm elections. We already have a deeply alarmist view towards U.S. foreign policy posture vis-à-vis Iran3 and U.S. trade policy vis-à-vis China,4 both of which we have articulated at length. The midterm elections factor very little in our analysis of either. As such, they are a non-diagnostic variable. The outcome of the vote is a red herring. President Trump will seek relevance abroad whether or not his Republican Party holds the House and Senate. In fact, we believe that the midterms are a distraction. Investors have already forgotten about Iran (Chart 6), at a time when global oil spare capacity is falling (Chart 7). BCA's Commodity & Energy Strategy is forecasting Brent to average $80/bbl in 2019, but prices would easily reach $120/bbl in a case where all three pernicious scenarios occur (shale production bottlenecks, Venezuela export collapse, and Iran sanctions).5 Chart 6Nobody Is Paying Attention To Iranian Supply Risk! Nobody Is Paying Attention To Iranian Supply Risk! Nobody Is Paying Attention To Iranian Supply Risk! Chart 7Global Spare Capacity Stretched Thin Global Spare Capacity Stretched Thin Global Spare Capacity Stretched Thin These figures are alarming. But they could become even worse if our Q4 Black Swan - a Shia-on-Shia civil war in Iraq - manifests. The end of the U.S.-Iran détente has put the tenuous geopolitical equilibrium in Iraq on thin ice.6 Since our missive on this topic last week, the violence in Basra has intensified, with rioters setting the Iranian consulate alight. Investors were largely able to ignore the Islamic State insurgency in Iraq because it occurred in areas of the country that do not produce oil. A Shia-on-Shia conflict, however, would take place in Basra. This vital port exports 3.5 bpd. Any damage to its facilities, which is highly likely if Iran gets involved in the conflict, would instantly become the world's largest supply loss since the first Gulf War (Chart 8). Bottom Line: Our message to clients is that midterm elections are far less investment-relevant than is assumed. President Trump has already initiated aggressive foreign and trade policy. We expect the White House to intensify the pressure on Iran and China regardless of the outcome of the midterm election. And we also expect the Democratic Party to be unable to stop President Trump on either front, should it gain a majority in the House of Representatives. The truly underappreciated risk for investors is a massive oil supply shock in 2019 that comes from a combination of instability in Venezuela, aggressive U.S. enforcement of the oil embargo against Iran, and Iran's retaliation against such sanctions via chaos in Iraq. We are initializing a long Brent / short S&P 500 trade, as well as a long energy stocks / short tech trade, as hedges against this risk (Chart 9). Chart 8Civil Unrest In Basra Would Be Big Fade The Midterms, Not Iraq Or Brexit Fade The Midterms, Not Iraq Or Brexit Chart 9Two Hedges We Recommend Two Hedges We Recommend Two Hedges We Recommend Government Shutdown Is The One True Midterm-Related Risk There is a declining possibility of a government shutdown before the midterm - and a much larger possibility afterwards. It is well known that the election odds favor the Democrats, but if there were ever a president who would do something drastic to try to turn the tables, it would be Trump. A majority in the House gives Democrats the ability to impeach. While we think the Senate would acquit Trump of any impeachment articles, this view is based on stout Republican support. A "smoking gun" from Special Counsel Robert Mueller - comparable to Nixon's Watergate tapes - could still change things. Trump would rather avoid impeachment altogether. Trump could still conceivably try to upset the election by insisting on funding his promised "Wall" on the border. The Republicans want to delay the appropriations bill for the Department of Homeland Security, which would include any border security funding increases, until after the election (but before the new House sits in January). Trump has repeatedly threatened to reject his own party's plan, though he has recently backed off these threats. A shutdown ahead of an election would conventionally be political suicide - especially given the likely need for a federal response to Hurricane Florence. Moreover Trump's border wall is opposed by over half the populace. But Trump could reason that the greatest game changer would be a spike in turnout when his supporters hear that he is willing to stake the entire election on this key issue. Turnout is everything. The success of such a kamikaze run would hinge on the Senate. Assuming that Trump retained full Republican support to push through wall funding, as GOP incumbents frantically sought to end the shutdown, there would be 12 Democratic senators, in the broadest measure, who could conceivably be intimidated into voting with them (Table 1). These senators would have to decide on the spot whether they are safer running for office during a government shutdown or after having given Trump his wall. They may decide on the latter. Table 1A Government Shutdown Could Conceivably Intimidate Trump-State Democrats Fade The Midterms, Not Iraq Or Brexit Fade The Midterms, Not Iraq Or Brexit This would total 63 votes in the Senate, enough to invoke "cloture," ending debate, and hence break any Democratic filibuster against proposed wall funding. But this calculation is also extremely generous to Trump. More likely, at least four of the twelve senators would refuse to break rank: Debbie Stabenow of Michigan, Robert Menéndez of New Jersey, Sherrod Brown of Ohio, and Bob Casey of Pennsylvania. They would be averse to defecting from their party on such a consequential vote, even if eight of their colleagues were willing to do so.7 This is presumably why Mick Mulvaney, Trump's budget director, has already gone to Capitol Hill and "personally assured" the leading Republicans that Trump is not going to pursue a government shutdown.8 The legislative math doesn't really work. Nevertheless, there is still some chance that Trump - as opposed to any other president - will try this gambit. Especially as the loss of the House and potentially the Senate begins to appear "inevitable." After the midterm, of course, all bets are off. A lame duck Congress, or worse a Democratic Congress, will give President Trump all the reason he needs to grind things to a halt over his wall, with a view to 2020. The odds of a shutdown will shoot up. Do shutdowns matter for investors? Not really. S&P 500 returns tend to be flat for the first two weeks after a shutdown. Looking at eight past shutdowns, the average return was 1% fifteen days later, and 4.5% two months later. Bottom Line: We give a pre-election shutdown 10% odds due to Trump's unorthodoxy and desperate need to boost turnout among his voter base. Post-midterm election, a government shutdown is inevitable, unless congressional Republicans manage to convince President Trump to sign long-term appropriation bills before the election. Brexit: Is The Pound Pricing In Uncertainty? The U.K.-EU negotiations are entering their final, and thus most uncertain, phase. Our Brexit decision-tree looks messy and complicated (Diagram 1). While we believe that Prime Minister Theresa May has increased the probability of the sanguine "soft Brexit" outcome, there are plenty of pathways that lead to risk-off events. Diagram 1Brexit: Decision Tree And Conditional Probabilities Fade The Midterms, Not Iraq Or Brexit Fade The Midterms, Not Iraq Or Brexit Is the pound sufficiently pricing in this uncertainty? According to BCA's Foreign Exchange Strategy, which recently penned a special report on the subject, the answer is no.9 According to their long-term fair value model, the trade-weighted pound exhibits only a 3% discount - well within its historical norm (Chart 10). Chart 10Pound: A Much Smaller Discount On A Trade-Weighted Basis Pound: A Much Smaller Discount On A Trade-Weighted Basis Pound: A Much Smaller Discount On A Trade-Weighted Basis In order to assess the degree of political risk priced into the pound, one needs to isolate the risk of the U.K. leaving the EU. This is because all fair value models - including that of our FX team - are based on a potentially unrepresentative sample, one where the U.K. is part of the EU! The problem is that the traditional variables used to explain exchange rate movements were also greatly affected by the shock following the Brexit vote in June 2016. For example, looking at the behavior of British gilts, the FTSE, consumer confidence, and business confidence, one can see very abnormal moves occurring in conjunction with large fluctuations in the pound during the summer of 2016 (Chart 11A & 11B). Thus, if one were to regress the pound on these variables, one would not have observed a risk premium, even though the market was clearly very concerned with the geopolitical outlook for the U.K. Chart 11AAbnormal Moves Around The Brexit Vote... Abnormal Moves Around The Brexit Vote... Abnormal Moves Around The Brexit Vote... Chart 11B...Make It Hard To Spot Geopolitical Risk ...Make It Hard To Spot Geopolitical Risk ...Make It Hard To Spot Geopolitical Risk Our FX team therefore decided to try to explain the pound's normal behavior using variables that did not experience large abnormal moves in the direct aftermath of the British referendum. For GBP/USD (cable), the currency pair was regressed versus the dollar index and the British leading economic indicator (LEI). For EUR/USD, the currency pair was regressed against the trade-weighted euro and U.K. LEI. The reason for using the trade-weighted dollar and euro as explanatory variables is simple: it helps isolate the pound's movements from the impact of fluctuations in the other leg of the pair. Using the U.K. LEI helps incorporate the immediate outlook for U.K. growth and U.K. monetary policy into the pound's movement. The remaining error term was mostly a reflection of geopolitical risk.10 The results of the models are shown in Chart 12A & 12B. While the pound did show a geopolitical discount in the second half of 2016 (as evidenced by the abnormally large discount from the fundamental-based model), today the pound's pricing shows no geopolitical risk premium, whether against the dollar or the euro. This corroborates the message from the economic policy uncertainty index computed by Baker, Bloom, and Davis, which shows a very low level of economic policy uncertainty based on news articles (Chart 13). Chart 12ANo Geopolitical Risk Embedded... No Geopolitical Risk Embedded... No Geopolitical Risk Embedded... Chart 12B...In Today's Pound Sterling ...In Today's Pound Sterling ...In Today's Pound Sterling Chart 13Policy Uncertainty Index Muted Policy Uncertainty Index Muted Policy Uncertainty Index Muted Considering the thin risk premium embedded in the pound against both the dollar and the euro, GBP does not have much maneuvering room through the upcoming busy calendar. The problem for the pound is that the 5% net disapproval of Brexit among the British public remains smaller than the cohort of British voters who remain undecided (Chart 14). This means that domestic politics in the U.K. could remain a source of surprise, especially as Prime Minister Theresa May's polling remains tenuous (Chart 15). This raises the risk that Hard Brexiters end up controlling 10 Downing Street - despite their status as a minority within the ranks of Conservative MPs (Chart 16). Chart 14A Liability For Sterling A Liability For Sterling A Liability For Sterling Chart 15Theresa May's Tenuous Grip Theresa May's Tenuous Grip Theresa May's Tenuous Grip Chart 16Hard Brexiters Are A Minority Fade The Midterms, Not Iraq Or Brexit Fade The Midterms, Not Iraq Or Brexit With the global economic outlook already justifying a lower pound, especially versus the dollar, the pound seems to be too risky of an investment at this moment. It is true that positioning and sentiment towards cable are currently very depressed, raising the risk of a short-term rebound (Chart 17). This could particularly occur if the EU meeting in Salzburg in two weeks results in some breakthrough. Such an event would still not resolve May's domestic conundrum, which is why we would be inclined to fade any such rebound. Bottom Line: On a six-to-nine-month basis, it makes sense to short the pound against the dollar and the yen. Slowing global growth hurts the pound but also hurts the euro while benefiting the greenback and the yen. The political environment in Japan, in particular, supports this reasoning. As we have maintained, Shinzo Abe is not going to lose the September 20 leadership election for the ruling party (Chart 18).11 And the Trump administration is not going to wage a full-scale trade war against Japan. However, after the leadership poll, Abe will press ahead with his agenda to revise the constitution, which will initiate a controversial process and stake his fate on a popular referendum that is likely to be held next year. Chart 17Fade Any Short-Term Rebound Fade Any Short-Term Rebound Fade Any Short-Term Rebound Chart 18Abe Lives, But Yen Will Rise Fade The Midterms, Not Iraq Or Brexit Fade The Midterms, Not Iraq Or Brexit At the same time, Trump might try throwing some threats or jabs against Japan before his defense secretary and admirals are able to convince him that such actions subvert U.S. strategy against China. Therefore Japan-specific political risks are on the horizon, in addition to the ongoing trade war with China, which is already a boon for the yen. We are therefore initiating a long yen / short pound tactical trade. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Juan Manuel Correa, Senior Analyst juanc@bcaresearch.com Ekaterina Shtrevensky, Research Associate ekaterinas@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Will Trump Fail The Midterm?" dated April 18, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "The U.S. And China: Sizing Up The Crisis," dated July 11, 2018, available at gps.bcaresearch.com. 5 Please see BCA Commodity & Energy Strategy Weekly Report, "Trade, Dollars, Oil & Metals ... Assessing Downside Risk," dated August 23, 2018, available at ces.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Commodity & Energy Strategy Special Report, "Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply," dated September 5, 2018, available at gps.bcaresearch.com. 7 Please see Burgess Everett, "Key red-state Democrat sides with Trump on wall funding," Politico, August 8, 2018, available at www.politico.com, and Ali Vitali, "Vulnerable Senate Democrats embrace Trump's wall," NBC News, August 13, 2018, available at www.nbcnews.com. 8 Please see Niv Elis and Scott Wong, "Trump again threatens shutdown," The Hill, September 5, 2018, available at thehill.com. 9 Please see BCA Foreign Exchange Strategy Special Report, "Assessing The Geopolitical Risk Premium In The Pound," dated September 7, 2018, available at fes.bcaresearch.com. 10 To make sure the exercise was robust, Foreign Exchange Strategy tested the out-of-sample performance of the model. Reassuringly, the GBP/USD and EUR/GBP models showed great predictive power out-of-sample (see Appendix), while remaining significant and explaining 80% and 65% of the pairs' variations respectively. 11 Please see BCA Geopolitical Strategy Special Report, "Japan: Kuroda Or No Kuroda, Reflation Ahead," dated February 7, 2018, available at gps.bcaresearch.com. Appendix: Traditional Variables Are Of Little Use To Isolate A Geopolitical Risk Premium Chart 19 Out-Of-Sample Testing Of Model (I) Out-Of-Sample Testing Of Model (I) Chart 20 Out-Of-Sample Testing Of Model (II) Out-Of-Sample Testing Of Model (II) Geopolitical Calendar

Highlights Cable is cheap on a PPP basis. However, the discount does not reflect a geopolitical risk premium; it reflects the dollar's general expensiveness. In fact, when the British productivity picture is taken into account, the trade-weighted pound's discount appears rather modest. Our model specifically designed to capture the geopolitical risk premia in GBP/USD and EUR/GBP shows that investors are currently pricing in a very rosy political outlook in the U.K., and near certainty that a soft Brexit will materialize. We are not willing to bet that the path toward a soft Brexit will be easy. As a result, we would expect that if the GBP experiences any rebounds, they will prove short-lived, especially as the outlook for global growth outside the U.S. remains murky. Feature This fall will be a tumultuous time for the pound, as the Brexit process goes into full swing ahead of March 2019. While there remain many possible paths that the U.K.'s relationship with the rest of the EU could ultimately take, ranging from a complete reset of the relationship (i.e. a hard Brexit) to no Brexit at all, another unknown needs to be tackled: Is the GBP priced to adequately compensate investors for such heightened uncertainty? In this week's piece, we develop a simple model to try to ascertain whether geopolitical risk premium is currently present in the pound. We conclude that even though the pound seems cheap enough to compensate investors for the high degree of uncertainty surrounding the U.K.'s long-term economic outlook, this picture is deceiving. As a result, BCA remains concerned about the pound's cyclical outlook, especially against the euro. Is The Pound That Cheap? At first glance, it seems obvious that the pound is very cheap. Cable currently trades at a prodigious 20% discount to it purchasing power parity (PPP) estimate (Chart I-1). Such bargain-basement levels must be a reflection of the economic risks surrounding Brexit. Well, perhaps not. First, the pound may be trading at a large discount against the dollar, but the euro also trades well below its PPP fair value. In fact, when using PPP models, it is hard to dissociate the cheapness of the pound from the expensiveness of the U.S. dollar against its trading partners (Chart I-2). Thus, PPP models are not enough to gauge whether or not the pound is adequately compensating investors for inherent geopolitical risk. Chart I-1Is The Pound Cheap... Is The Pound Cheap... Is The Pound Cheap... Chart I-2U.S. Dollar And PPP ...Or Is The Dollar Expensive? U.S. Dollar And PPP ...Or Is The Dollar Expensive? U.S. Dollar And PPP ...Or Is The Dollar Expensive? Second, when one uses a slightly more sophisticated valuation approach, the discount of the pound seems much more muted than when one looks at PPP alone. Based on our proprietary long-term fair value model, the trade-weighted pound exhibits a much more muted discount of only 3% - well within the historical norm (Chart I-3). Chart I-3Pound: A Much Smaller Discount On A Trade-Weighted Basis Pound: A Much Smaller Discount On A Trade-Weighted Basis Pound: A Much Smaller Discount On A Trade-Weighted Basis What explains this disconnect is the U.K.'s poor productivity performance. In the world of exchange rate determination, there is a phenomenon called the Penn effect. It is an empirical observation - one not fully understood under a theoretical lens1 - which shows that countries with higher levels of productivity growth than their trading partners tend to experience an appreciation in their real exchange rates. As Chart I-4 illustrates, the U.K. is on the wrong side of this phenomenon, as its relative productivity has been falling in comparison to its trading partners. This factor has played an important role in dragging down the pound's fair value. This poor productivity performance has also had another pernicious effect: unit labor costs in the U.K. have risen much more sharply than in the majority of its important trading partners (Chart I-5). This hurts the pound's competitiveness and suggests that a simple PPP model based purely on producer prices might be missing the mark for the true fair value of the British currency - further supporting the message of our proprietary long-term valuation model. Chart I-4Negative Penn Effect For The Pound Negative Penn Effect For The Pound Negative Penn Effect For The Pound Chart I-5The U.K. Is Uncompetitive The U.K. Is Uncompetitive The U.K. Is Uncompetitive Even when these adjustments are taken into account, our model might still be missing the mark due to a very significant problem: All fair value models for the pound are now based on a potentially unrepresentative sample, one where the U.K. was part of the EU. Thus, another exercise is needed to evaluate the pound's geopolitical risk premium. Bottom Line: Based on simple PPP models, cable looks cheap and therefore may already embed a large geopolitical risk premium. However, this conclusion is misleading. A large share of the pound's undervaluation is not GBP-specific and instead simply mirrors the USD's premium to its fair value. Additionally, the U.K.'s poor productivity performance relative to its trading partners already provides an economic justification for a cheap pound. Thus, we need a different exercise to zero in on the degree of geopolitical discount present in the pound. Zeroing In On The Geopolitical Risk In order to assess the degree of political risk priced into the pound, one needs to isolate this risk. The problem is that the traditional variables used to explain exchange rate movements were also greatly affected by the shock following the Brexit vote in June 2016. For example, looking at the behavior of British gilts, the Footsie, consumer confidence or business confidence, one can see very abnormal moves occurring in conjunction with large fluctuations in the pound during the summer of 2016 (Chart I-6). Thus, if one were to regress the pound on these variables, one would not have observed a risk premium, even though the market was clearly very concerned with the geopolitical outlook for the U.K. Chart I-6ATraditional Variables Are Of Little Use To Isolate A Geopolitical Risk Premium (I) Traditional Variables Are Of Little Use To Isolate A Geopolitical Risk Premium (I) Traditional Variables Are Of Little Use To Isolate A Geopolitical Risk Premium (I) Chart I-6BTraditional Variables Are Of Little Use To Isolate A Geopolitical Risk Premium (II) Traditional Variables Are Of Little Use To Isolate A Geopolitical Risk Premium (II) Traditional Variables Are Of Little Use To Isolate A Geopolitical Risk Premium (II) We therefore decided to try to explain the pound's normal behavior using variables that did not experience large abnormal moves in the direct aftermath of the British referendum. Moreover, we wanted to keep the model simple, as simplicity permits us to better understand the pound's deviation from its predicted value. Practically, we settled on the following specification: for GBP/USD, we regressed the pair versus the dollar index and the British leading economic indicator. For EUR/GBP, we regressed the cross against the trade-weighted euro and the U.K. LEI. The reason for using the trade-weighted dollar and euro as explanatory variables is simple: it helps us isolate the pound's movements from the impact of fluctuations in the other leg of the pair. Using the U.K. LEI helps incorporate the immediate outlooks for U.K. growth and U.K. monetary policy into the pound's movement. The remaining error term was mostly a reflection of geopolitical risks. To make sure the exercise was robust, we then tested the out-of-sample performance of the model. Reassuringly, the GBP/USD and EUR/GBP models showed great predictive power out-of-sample (see Appendix), while remaining significant and explaining 80% and 65% of the pairs' variations, respectively. The results of the models are shown in Chart I-7, and they are startling. While the pound did show a geopolitical discount in the second half of 2016 (as evidenced by the abnormally large discount from our fundamental-based model), today the pound's pricing shows an absence of geopolitical risk premium, both against the dollar and against the euro. This corroborates the message from the uncertainty index computed by Baker Bloom and Davis, which shows a very low level of economic policy uncertainty based on language in the press (Chart I-8). Chart I-7ALittle Risk Premium In The Pound (I) Little Risk Premium In The Pound (I) Little Risk Premium In The Pound (I) Chart I-7BLittle Risk Premium In The Pound (II) Little Risk Premium In The Pound (II) Little Risk Premium In The Pound (II) This is particularly salient when compared to the euro, where the geopolitical risk premium is currently exaggerated. As Chart I-9 illustrates, the probability of a euro area breakup in the next five years priced into the bond market is at its highest level since the heyday of the euro area crisis in 2011 and 2012. However, this risk is currently overstated as investors have been frightened by the recent Italian elections. Yet, after a tumultuous beginning, the populist Five Star Movement / Lega Nord coalition is backing away from a budget confrontation with Brussels. Giovanni Tria, Italy's minister of finance, wants a 2% budget deficit while Deputy Prime Minister Matteo Salvini is arguing for a 2.9% budget hole - well south of the 6% levels touted during the campaign. Italians realize that life outside the euro area will not be a land of milk and honey. Chart I-8British Political Uncertainty Has Collapsed British Political Uncertainty Has Collapsed British Political Uncertainty Has Collapsed Chart I-9Investors Are Worries About The Euro Area Investors Are Worries About The Euro Area Investors Are Worries About The Euro Area Instead, the pound's cheapness reflects the weakness in the British LEI. This is a consequence of the deterioration in global economic activity. As Chart I-10 shows, the trade-weighted pound has been more sensitive to EM gyrations than the euro or the dollar. This is because total trade represents a stunning 40% of U.K. GDP, versus 37% for the euro area or 28% for the U.S. The U.K. is therefore highly sensitive to global economic conditions. Moreover, the tightening in global liquidity conditions that has contributed to the deterioration of the global growth outlook is itself particularly negative for the pound. The U.K. runs a current account deficit of 4% of GDP, and as FDI inflows into Great Britain have collapsed, the U.K. now runs a basic balance-of-payments deficit (Chart I-11). As such, it is highly dependent on global liquidity flows to finance its current account deficit. As a result, the recent weakness in the pound is more a function of global economic conditions than Brexit itself. Chart I-10The Pound Has Fallen Because of EM Risks... The Pound Has Fallen Because of EM Risks... The Pound Has Fallen Because of EM Risks... Chart I-11...And As Global Liquidity Has Tightened ...And As Global Liquidity Has Tightened ...And As Global Liquidity Has Tightened Bottom Line: After developing a more precise method for evaluating the size of the geopolitical risk premium embedded in the pound, we arrived at an interesting conclusion: There is currently no evidence of a risk premium at all. Instead, the pound's weakness reflects the expensiveness of the dollar, weakening global growth and deteriorating global liquidity conditions. In fact, it is the euro that currently suffers from an exaggerated geopolitical risk premium, as euro area bonds currently incorporate too-large of a break-up risk premium. Investment Implications Taking into account the thin risk premium embedded in the pound against both the dollar and the euro, the GBP does not have much maneuvering room through the fall season. The problem for the pound is that the 5% net disapproval of Brexit among the British public remains smaller than the cohort of British voters who remain undecided (Chart I-12). This means that domestic politics in the U.K. could remain a source of surprise, especially as Prime Minister Theresa May's polling remains tenuous (Chart I-13). This raises the risk that Hard Brexiters end up controlling 10 Downing Street - despite their status as a minority within Conservative MPs. This also raises the risk that Jeremy Corbyn, whose popularity is rising, could end up as British Prime Minister (Chart I-14). Both of these outcomes are worrisome. The pound is currently pricing in neither the risk of a hard Brexit, nor the risk of the U.K. being controlled by the most leftist government of any G10 nation since the election of Francois Mitterrand in France in 1981. Chart I-12More Undecided Voters Than ##br##Net Brexit Detractors More Undecided Voters Than Net Brexit Detractors More Undecided Voters Than Net Brexit Detractors Chart I-13A Risk To ##br##U.K. Stability... A Risk To U.K. Stabiity... A Risk To U.K. Stabiity... Chart I-14...Especially With Mitterand 2.0 ##br##Lurking In The Shadows ...Especially With Mitterand 2.0 Lurking In The Shadows ...Especially With Mitterand 2.0 Lurking In The Shadows Moreover, while Germany and EU chief negotiator Michel Barnier seem amenable to keeping the window of negotiations open for the ultimate form of Brexit during the transition period, it remains to be seen what kind of concessions London is willing to make on the free movement of people required to be granted access to the common market in goods. Additionally, the Northern Ireland border remains an unresolved issue. These factors increase the chances that negotiations with the EU will remain difficult. Hence, the implementation of the Chequers White Paper is far from certain, yet the pound currently seems to be priced for an absolute soft Brexit. With the global economic outlook already justifying a lower pound, especially versus the dollar, it therefore seems that the pound today is too risky an investment. It is true that positioning and sentiment in cable are currently very depressed, raising the risk of a short-term rebound (Chart I-15), especially if the EU meeting in Salzburg in two weeks shows an acquiescent EU. However, this will not remove Britain's domestic political problems. Hence, we would be inclined to fade any such rebound. Finally, it is unlikely that the Bank of England will be of much help to the pound either. The British LEI continues to slow, which not only drags the fair value of the pound lower, but also limits how fast the BoE can raise interest rates. Moreover, while British inflation surged as imported goods prices skyrocketed after the GBP plummeted in 2016, domestic prices have remained well behaved (Chart I-16). Thus, as the pass-through to inflation of the previous pound weakness dissipates, British inflation will decelerate further, limiting the upside for interest rates in the process. This combination is only made more binding for the BoE as the government is expected to exert some drag on growth as the British fiscal thrust will subtract 0.4%, 0.2%, and 0.2% to growth in 2018, 2019, and 2020, respectively (Chart I-17). Chart I-15There Is Room For A ##br##Countertrend GBP Rally U.K. XR There Is Room For The A Countertred GBP Rally U.K. XR There Is Room For The A Countertred GBP Rally Chart I-16Little Domestic ##br##Price Pressures Little Domestic Price Pressures Little Domestic Price Pressures Chart I-17Fiscal Drag ##br##Not Over Fiscal Drag Not Over Fiscal Drag Not Over On a six- to nine-month basis, it makes most sense to short the pound against the dollar and the yen, as slowing global growth hurts the pound but also hurts the euro while benefiting the greenback and the yen. However, on a longer-term basis, we would expect the break-up risk premium in the euro area to dissipate, which will boost the cheap euro in the process. This means that on investment horizons beyond one year, being long EUR/GBP still makes sense. Bottom Line: Since this year's pound weakness did not represent a swelling of the GBP's geopolitical risk premium but instead has been a reflection of poor global growth and liquidity, any hiccups in British politics could inflict considerable pain on cable. While the EU negotiations may progress positively, domestic British politics remain a big source of risk that investors are not being compensated to take on. As such, we are inclined to fade any rally in the pound. While the pound could weaken most against the dollar and the yen through the fall months, the longer-term outlook looks riskier against the euro. To be clear, the confidence interval around these views remains wide, as the British political situation remains very fluid. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Juan Manuel Correa, Senior Analyst juanc@bcaresearch.com Ekaterina Shtrevensky, Research Associate ekaterinas@bcaresearch.com 1 The Balassa-Samuelson effect has been cited as a potential explanation for this observation, but it still does not fully satisfy many theorists. Appendix Chart II-1Out-Of-Sample Testing Of Model (I) Assessing The Geopolitical Risk Premium In The Pound Assessing The Geopolitical Risk Premium In The Pound Chart II-2Out-Of-Sample Testing Of Model (II) Out-Of-Sample Testing Of Model (II) Out-Of-Sample Testing Of Model (II) Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The primary trend for both Chinese stock prices and CNY-USD remains captive to negative surprises related to the trade war between the U.S. and China. Considerable uncertainty remains on this front, but our outlook is that the situation is likely to get worse, not better. It remains too early to forecast a durable stabilization in the exchange rate. It is an open question whether the PBOC will be forced to change short-term interest rates in order to guide the currency in their preferred direction. There is some evidence to suggest that China can control both the interest and exchange rate should it choose to do so, but analyzing the issue is significantly complicated by the approach Chinese policymakers are using to manage the impossible trinity. There is room for Chinese short-term interest rates to rise modestly if the worst of the U.S./China trade war does not materialize. This would be consistent with the goal of avoiding significant releveraging of China's private sector. For now, investors should maintain no more than a benchmark allocation towards Chinese investable stocks within a global equity portfolio, and should continue to favor low-beta sectors within the investable universe. Feature We noted in our August 22 Weekly Report that the persistent weakness of the RMB appeared to be one important factor weighing on Chinese stocks, particularly the domestic market.1 We presented some tentative evidence that part of the decline in CNY-USD since mid-June has been policy-driven (despite the PBOC's statements that it had not been depreciating the currency), but also noted that the RMB had now likely fallen outside the comfort zone of policymakers. The PBOC's re-introduction of its "counter-cyclical factor" when fixing the yuan's daily mid-point supports this view, and suggests that monetary authorities are now aiming for a broadly stable exchange rate (or are aiming to limit further downside). Chart 1 highlights that there have been some, albeit modest, signs of success. Whether they succeed will, first and foremost, be largely determined by what appears to be an imminent decision by the Trump administration to levy tariffs on an additional $200 billion in imports from China. Our previous analysis of potential equilibrium levels for CNY-USD suggests that investors have already priced in the imposition of a second round of tariffs, but the key factor for markets will be whether the tariff rate applied is 10% or 25%. In the first case it is possible that the RMB has overshot to the downside; in the latter case, CNY-USD will very likely come under renewed pressure that would be difficult for the PBOC to fully counter. Chart 1Some Modest Signs Of Currency Stability Some Modest Signs Of Currency Stability Some Modest Signs Of Currency Stability Chart 2Interest Rate Differentials And CNY-USD: A Tight Link Interest Rate Differentials And CNY-USD: A Tight Link Interest Rate Differentials And CNY-USD: A Tight Link But an additional question is whether the PBOC will be forced to change short-term interest rates in order to guide the currency in their preferred direction. Both our Global Investment Strategy and Emerging Markets Strategy services have highlighted that USD-CNY has broadly tracked the one-year swap differential between the U.S. and China over the past few years (Chart 2). This suggests that, at a minimum, there is some link between the interbank market and the exchange rate, despite the fact that capital controls are still tight in the Chinese economy. It also seems to imply, ominously, that the PBOC may have to choose between potentially significant releveraging and a significant re-appreciation in the exchange rate. Revisiting The Impossible Trinity "With Chinese Characteristics" The exact nature of this interest/exchange rate link is difficult to analyze, because of how China has chosen to manage the "impossible trinity" following the August 2015 devaluation of the yuan. The upper portion of Chart 3 illustrates the standard view of the impossible trinity, which posits that policymakers must choose one side of the triangle, foregoing the opposite economic attribute. For example, most modern economies have chosen "B", allowing the free flow of capital and independent monetary policy by giving up a fixed exchange rate regime. Hong Kong has chosen "A", meaning that its monetary policy is driven by the Fed in exchange for a pegged exchange rate and an open capital account. Chart 3The Possible Trinity? Moderate Releveraging And Currency Stability: An Impossible Dream? Moderate Releveraging And Currency Stability: An Impossible Dream? China historically has chosen "C", an economy with a closed capital account, a fixed exchange rate, and independent monetary policy. There is no causal link between interest and exchange rates in the world of option C, but following the PBOC's move in 2015 towards a more market-oriented approach for the exchange rate, it was accused by many market participants of trying to pursue all three goals simultaneously. In short, market participants have not been able to clearly discern what option China has chosen following over the past few years. China, in effect, answered these criticisms by arguing that it was not bound by the standard view of the impossible trinity, but rather one "with Chinese characteristics". The lower portion of Chart 3 presents this theory, which posits that policymakers must distribute a 200% adoption rate among three competing choices. The chart depicts a possible scenario where policymakers are relatively tolerant of capital flow, partially adopting two measures in addition to fully independent monetary policy: quasi-floating exchange rates highly subject to the interest rate dynamics shown in Chart 2, and loosely enforced capital controls. The chart also shows what ostensibly occurred in response to significant capital flight in 2014 and 2015, i.e. a crackdown on capital control enforcement and a less market-driven exchange rate. To the extent that this framework still applies, Charts 4 - 7 suggest that this capital flow crackdown has not abated and that the PBOC may be able to prevent significant further weakness in the currency without dramatically raising interest rates: China tightened scrutiny on trade invoicing verifications in 2016 to crack down on "fake" international trades, such as imports from Hong Kong (local firms fabricated import businesses to move money offshore). Based on the recent trend, these restrictions remain in effect (Chart 4). In addition, quarterly net flows of currency and deposits, which turned sharply negative in Q3 2015, have risen back into positive territory (Chart 5). Chart 4Blocking Capital Leakage In Trade... Blocking Capital Leakage In Trade... Blocking Capital Leakage In Trade... Chart 5...And Cash ...And Cash ...And Cash Chart 6 presents Chinese foreign reserves measured in SDRs, and highlights that reserves have been stable for the better part of the past two years. This stability is in sharp contrast to the material decline that occurred in 2015, and is supportive of the view that China can control both the interest and exchange rate, should it choose to do so. Chart 7 highlights that there are a few precedents for a divergence between interbank rates and CNY-USD. One divergence in 2012-2013 is particularly noteworthy: CNY-USD trended higher, but interbank interest rates remained flat for some time. Crucially, this does not appear to have been driven by falling U.S. interest rates, as the 2-year Treasury yield had already fallen close to zero in 2011 and did not begin to rise until mid-2013. Chart 6China Has Stabilized Its ##br##Foreign Reserves China Has Stabilized Its Foreign Reserves China Has Stabilized Its Foreign Reserves Chart 7Short-Term Interest Rates And ##br## CNY-USD Have Diverged Before Short-Term Interest Rates And CNY-USD Have Diverged Before Short-Term Interest Rates And CNY-USD Have Diverged Before Interest Rates And Moderate Releveraging Despite the evidence presented in Charts 4 - 7, the bottom line is that it is not clear whether the PBOC would be forced to raise short-term interest rates (and by how much) if it chooses to stabilize the currency. Would doing so be a death-knell for the Chinese economy? In our view, the answer is no, unless the trade war does indeed metastasize further. We have argued that the magnitude of the decline in the 3-month repo rate has been excessive, and is not currently consistent with a moderately reflationary scenario. We have argued that the repo rate decline is a side-effect of the PBOC's heavy liquidity injections, which were more likely aimed at ensuring financial system stability against the backdrop of struggling small banks. Chart 8Lending Rates Will Decline Substantially ##br## If Repo Rates Don't Rise Lending Rates Will Decline Substantially If Repo Rates Don't Rise Lending Rates Will Decline Substantially If Repo Rates Don't Rise But the current level of liquidity support carries risks to the objective of controlling private-sector leveraging. Chart 8 suggests that unless the PBOC raises the benchmark lending rate (which would be interpreted very hawkishly by the market), the magnitude of the decline in the repo rate will push the weighted average lending back to its 2016 low (when the monetary authority had turned the policy dial to "maximum reflation"). Last week's Special Report explained in detail why this would carry significant risks to China's financial stability.2 We noted that most of the private sector leveraging that has occurred in China since 2010 has occurred on the balance sheet of state-owned enterprises (SOEs) and the household sector. While the household debt-to-GDP ratio is still low, it is rising rapidly and may accelerate even further if lending rates fall significantly. The picture for SOEs is even more dire: leverage is extremely elevated, and a comparison of adjusted return on assets to borrowing costs suggests that the marginal operating gain from debt has become negative. This suggests that further leveraging of SOEs could push them into a debt trap and/or shackle the monetary authority's ability to meaningfully raise interest rates. As such, it is actually our expectation that short-term interest rates will rise modestly following a 10% rate on the second round of tariffs (instead of 25%), or if it becomes clear that there will be no third round. If the trade war escalates, however, short-term interest rates would not be expected to rise at all, and the drive to control leverage could be downshifted yet again. Investment Conclusions Chart 9Stay Neutral Towards Chinese Stocks, ##br##And Favor Low-Beta Sectors Stay Neutral Towards Chinese Stocks, And Favor Low-Beta Sectors Stay Neutral Towards Chinese Stocks, And Favor Low-Beta Sectors What does this all mean for our view on the RMB, and what are the implications for Chinese stocks? For now, we can draw the following conclusions: The primary trend for both stock prices and the exchange rate remains captive to negative surprises related to the trade war between the U.S. and China. We would expect further financial market weakness in response to a 25% rate on the second round of tariffs, and especially if President Trump moves forward with plans to tariff the remaining $250 billion of imports from China (the "third round"). Conversely, a 10% second-round tariff rate, or convincing signs that there will be no third round, could soon put a floor under the RMB and stock prices. On this front, the lead-up to a possible meeting between Presidents Trump and Xi in November will be important to monitor. But for now, given our view that the trade war between the U.S. and China is likely to get worse, not better, it remains too early to forecast a durable stabilization in the exchange rate, and an overweight stance towards Chinese equities in absolute terms remains premature. A-shares are deeply oversold and we are watching closely for signs to time a reversal, relative to investable stocks (at least at first). Higher Chinese short-term interest rates are not necessarily negative for stock prices, as long as the rise is modest and not in the context of a further, material uptick in trade tensions between the U.S. and China. While a moderate releveraging scenario would clearly imply a weaker earnings growth outlook than if credit accelerated strongly, earnings growth is still positive and yet Chinese equities are 20-30% off of their 1-year high in local currency terms. Modestly higher interest rates, in the context of durable RMB stability and an end to the escalation of trade threats, is likely to be equity-positive. As we wait for more clarity on the trade outlook, we reiterate our core equity investment recommendations: Investors should maintain no more than a benchmark allocation towards Chinese investable stocks within a global equity portfolio, and should continue to favor low-beta sectors within the investable universe (Chart 9). As always, we will be monitoring developments related to the timing and magnitude of the upcoming export shock, as well as further policymaker responses continually over the coming weeks and months. Stay tuned! Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Pease see China Investment Strategy Weekly Report "In Limbo", dated August 22, 2018, available at cis.bcaresearch.com. 2 Pease see China Investment Strategy Special Report "Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging", dated August 29, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations