Economic Growth

Highlights Strengthening income growth is apparent in DM and EM trade volumes, real wages in the U.S., and industrial commodity prices, chiefly oil and copper. This indicates inflation at the consumer level will move higher in the near future, most likely in 2H2018. We believe 10-year U.S. Treasury Inflation-Indexed securities (TIPS) trading below 0.52 do not reflect the risk of higher inflation and are, therefore, going long at tonight's close. Energy: Overweight. Crude oil prices rallied 4.6% this week, following the OPEC 2.0 meeting in St. Petersburg. Although ministers did not announce additional cuts to the 1.8mm b/d agreed at the end of last year, Saudi Energy Minister Khalid al-Falih said the Kingdom would reduce August exports to 6.6mm b/d, which is more than 300k b/d below May's level, the latest month for which data are available from JODI. Given strong global demand, if this export reduction persists - and if others join the Kingdom - it would speed the drawdown in global inventories. Base Metals: Neutral. Copper pushed through $2.80/lb on the COMEX, a level not seen since May 2015. Underlying strength in EM economic activity - seen most recently in global trading activity (discussed below) - and a weaker USD are supporting base metals. Precious Metals: Neutral. Gold fell below $1,257/oz earlier this week, and was trading ~ $1,250/oz going to press Wednesday. We remain long gold as a portfolio hedge; the position is up 1.7% since it was initiated on May 4, 2017. Ags/Softs: Underweight. Harsh weather is impacting grains. The USDA rated 62% of the U.S. corn crop in the 18 states comprising 92% of total output good or excellent last week, down from 76% in 2016. For beans, the split was 58% last week vs. 71% last year. Feature The expansion in global trade that began toward the end of last year continues, which, based on our modeling, indicates inflation at the consumer level likely will move higher in the short run (Chart of the Week). Trade expansion, particularly in EM economies, is consistent with rising incomes, which, all else equal, will keep industrial commodities - oil and copper, in particular - well supported, given income and demand for these commodities are closely aligned.1 These fundamentals dovetail with other indications of stronger growth, particularly in DM economies, where trade volumes also are growing (Chart 2). In the U.S., for example, wage growth continues to outpace inflation, and monetary conditions remain benign (Chart 3). Our colleagues at BCA Research's Global Investment Strategy believe the Fed actually may be behind the curve in reacting to nascent inflationary pressures emerging in the U.S.2 Chart of the WeekRising EM Trade Volumes Consistent##BR##With Higher U.S. CPI Inflation Rising EM Trade Volumes Consistent With Higher U.S. CPI Inflation Rising EM Trade Volumes Consistent With Higher U.S. CPI Inflation Chart 2DM Trade Volumes Are Expanding##BR##At ~ 5% Pace ... DM Trade Volumes Are Expanding At ~ 5% Pace ... DM Trade Volumes Are Expanding At ~ 5% Pace ... Chart 3U.S. Labor Market Tightening,##BR##Financial Conditions Remain Loose U.S. Labor Market Tightening, Financial Conditions Remain Loose U.S. Labor Market Tightening, Financial Conditions Remain Loose Trade Growth Supports Higher Inflation U.S. CPI is highly correlated with EM trade volumes (imports and exports) as shown in the Chart of the Week. In recent research into inflation and trade, we also showed EM oil demand and world base metals demand are highly correlated with EM trade volumes.3 Chart 4EM Trade Volumes##BR##Continue To Strengthen Growth EM Trade Volumes Continue To Strengthen Growth EM Trade Volumes Continue To Strengthen Growth EM import growth continues to expand at a faster pace than DM growth (Chart 4). Year-on-year (yoy) EM import growth came in at 7.7%, a full 2 percentage points above DM growth. This is not to minimize DM growth - it finally broke out of its lethargy in May with a sharp advance of close to 6%, which will lift the trend rate of growth (the 12-month moving average, or 12mma) higher going forward. EM export growth in May was only slightly above DM growth for the month - 5.4% yoy vs. 5.2% yoy. These stout monthly trade performances will, in the next few months, offset the lethargic growth seen in EM and DM prior to the expansion begun at the end of 2016, as weaker monthly performance falls off the trend calculations. Over the year ended in May, within EM markets the annual trend in imports (the 12mma to May 2017) has barely grown more than 1% yoy, dragged down by a 6% contraction in the Middle East and Africa (MEA) and a 2.1% contraction in Latin American growth. The trend in EM - Asia's imports is up, rising 3.2% over the same period. For the year ended in May, imports into central and Eastern Europe were mostly flat; however, since November 2016, the trend turned sharply positive with 3.3% yoy growth. The trend in export volumes is expanding for in MEA and Latin America economies - 3.5% yoy trend growth (12mma) in MEA, and 4.4% growth in Latin America, which is slightly higher than the overall 2.2% rate of trend growth in EM exports. Still, lower oil and commodity prices, along with reduced volumes are curtailing an income recovery in these regions. Central and Eastern Europe's rate of export expansion leads EM generally at close to 4% yoy trend growth. Favor Gold And TIPS Ahead Of Higher Inflation As the labor market tightens and real-wage growth continues to outpace productivity growth, we expect U.S. inflation to pick up. Growth in trade volumes also will support growth in EM oil demand and world base metal demand, as noted above. This will feed into U.S. core PCE, the Fed's preferred inflation gauge (Chart 5). As we've highlighted in the past, there is very strong co-movement among these variables: We've found that, all else equal, a 1% increase in the non-OECD oil demand implies an increase in the core PCE of slightly less than 50bp. If the trend in overall EM trade volumes persists, the likelihood we will be increasing our estimate of non-OECD oil consumption for 2H17 and 2018 increases. U.S. CPI and EM trade volumes show similar co-movement properties, as the Chart of the Week shows. A 1% increase in EM import volumes translates into a 0.53% increase in the U.S. CPI, while a 1% increase in EM export volumes implies a 0.49% increase in the CPI. EM import volumes over the January - May 2017 interval have been growing at slightly more than 8% yoy, while exports have been growing at slightly more than 3%. Continued strength in the EM trade data implies U.S. CPI could grow well above what's currently being priced in inflation markets and by Fed policymakers. This leads us to favour gold and TIPS as inflation hedges. If we do get a larger-than-expected move in the U.S. CPI, gold should respond well. The modelling depicted in Chart 6 shows a 1% increase in the CPI translates into a 4.1% increase in gold. Chart 5Core PCE Will Pick Up##BR##As Commodity Demand Grows Core PCE Will Pick Up As Commodity Demand Grows Core PCE Will Pick Up As Commodity Demand Grows Chart 6Gold Will Pick Up##BR##Larger-Than-Expected CPI Moves Gold Will Pick Up Larger-Than-Expected CPI Moves Gold Will Pick Up Larger-Than-Expected CPI Moves For this reason we recommend getting long U.S. Treasury Inflation-Protected Securities (TIPS), which will appreciate as the U.S. CPI moves higher.4 We will be getting long as of tonight's close. We remain long low-risk calls spreads in Dec/17 WTI and Brent - long $50/bbl strikes vs. short $55/bbl strikes. We are up 39.3% and 32.9% on the Brent and WTI positions, respectively, from last week, and 47.2% and 89.2% since inception. U.S. Monetary Policy Remains A Huge Risk To EM Trade As we've noted in the past, U.S. monetary policy can have an outsized effect on EM trade volumes. In an update of an earlier model using U.S. M2 and the broad trade-weighted USD (TWIB), we find a 1% increase in the broad trade-weighted USD translates into a 1.1% drop in EM imports, while a 1% increase in U.S. M2 (broad money) implies an 85bp increase in EM imports (Chart 7).5 Chart 7EM Trade Volumes Highly Sensitive##BR##To U.S. Monetary Policy EM Trade Volumes Highly Sensitive To U.S. Monetary Policy EM Trade Volumes Highly Sensitive To U.S. Monetary Policy This demonstrates the feedback loop we've identified between U.S. monetary policy and EM trade. EM trade volumes affect inflation at a global level. We've found inflation in the U.S., EU and China to be co-integrated - i.e., these price gauges all follow the same long-term trend. Inflation and inflation expectations drive Fed policy, which drives the price formation of the USD - i.e., the FX rates included in the USD TWIB - and affect Fed policy on M2. These U.S. monetary variables, in turn, affect EM trade volumes. And so it goes ... Too-aggressive a tightening by the Fed as it normalizes its interest-rate policy regime could destabilize EM economies - either via too-sharp an appreciation in the USD TWIB, a larger-than-expected deceleration in M2 growth, or both - and negatively affect trade flows. At the end of the day, this would redound to the detriment of the U.S. economy, as the different feedback mechanisms kick in. This says the Fed's policy doesn't just affect the U.S. economy, or that EM economies essentially are on their own in the policy tools they deploy to adjust to Fed innovations. Like it or not, the Fed has to consider these types of feedback loops in its decision-making, since the Open Market Committee will be dealing with the fallout of its earlier policies. Bottom Line: EM trade volumes continue to grow yoy, continuing the trend that began at the end of last year. This performance, coupled with a tightening labor market in the U.S. and a still-loose financial backdrop, raises the odds inflation will exceed what's currently priced into market and Fed expectations. We are getting long U.S. 10-year TIPS at tonight's close, and remain long gold as a strategic portfolio hedge. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 The income elasticity for industrial commodities in EM economies is ~ 1.0, according to the OECD. Please see "The Price of Oil - Will It Start Rising Again?" OECD Economics Department Working Paper No. 1031, p. 6 (2013). 2 Please see BCA's Global Investment Strategy Weekly Report titled "Are Central Banks Behind The Curve Or Ahead Of It?," published on July 21, 2017. It is available at gis.bcaresearch.com. Among other things, the Global Investment Strategy team notes labor-market slack is dissipating, real wages are increasing, and easier financial conditions are spurring credit growth. Our colleagues note, "The prospect of stronger growth over the next few quarters implies that the unemployment rate is likely to fall below 4% early next year, possibly breaking through the 2000 low of 3.8%." BCA's Global Investment Strategy believes U.S. inflation could move higher by 2H18. 3 Please see BCA Commodity & Energy Strategy Weekly Reports titled "EM Trade Volumes Continue Trending Higher, Supporting Metals" and "Strong EM Trade Volumes Will Support Oil," published June 29, and June 8, 2017. Both are available at ces.bcaresearch.com. 4 U.S. TIPS increase in value as the Consumer Price Index (CPI) rises, and fall in value as the index declines. Please see "TIPS: Rates & Terms" on the UST's TreasuryDirect web page (https://www.treasurydirect.gov/indiv/research/indepth/tips/res_tips_rates.htm). 5 This model covers 2000 to the present, using monthly data. The R2 for the cointegrating regression is 0.96. These variables do not explain EM exports, which are not cointegrated with U.S. monetary variables. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade And Commodity Data Point To Higher Inflation Trade And Commodity Data Point To Higher Inflation Commodity Prices and Plays Reference Table Trade And Commodity Data Point To Higher Inflation Trade And Commodity Data Point To Higher Inflation Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights To shed light on the dichotomies that have surfaced in China's money and credit variables, we have calculated a new credit-money. This new measure is currently corroborating a very downbeat outlook for Chinese growth and China-related plays. We do not mean that investors should put all of their faith in this new measure. Yet, other measures of money and credit such as M1, M2 and banks' total assets all point to an impending deceleration in economic growth in China. While many global investors take for granted that the central government will underwrite credit risk in the entire economy, the top leadership in Beijing is sending the opposite message, at least for now. A new fixed income trade: pay Czech / receive Polish 10-year swap rates. Feature Chart I-1China: A Business Cycle Top Is In The Making China: A Business Cycle Top Is In The Making China: A Business Cycle Top Is In The Making Typically, the phrase 'Follow The Money' is used in the investment community to advise in favor of chasing investment flows. Today, we use this phrase in the context of not following investor crowds, per se, but money growth - especially in China. Judging from market actions and elevated inflows into EM assets and investable Chinese stocks, we can infer that investor consensus on China/EM is rather bullish. In the meantime, China's money/credit growth is sending a bearish signal. Investors should heed the downbeat message from Chinese money/credit and not chase EM risk assets higher. To reconcile the different messages from various measures of Chinese money and credit aggregates (more on the differences below), we calculated a new measure of money/credit creation - commercial banks' total credit (referred to below as banks' credit-money). Banks' credit/-oney is the sum of commercial banks' claims on companies, households, non-bank financial institutions, and all levels of government, as well as commercial banks'' and PBoC's foreign assets. Also, we deduct government deposits at the central bank (see below for the rationale). This measure, a de-facto aggregate of credit/money originated by banks and the PBoC, is computed using the asset side of banks' balance sheets. The key message from this report is that mainland banks' credit-money growth has already decelerated meaningfully, and points to a considerable slump in China's business cycle and imports in the months ahead (Chart I-1). Notably, banks' credit-money growth is at the lowest level of the past 10 years, excluding the Lehman crisis. It is also well below 2015 lows when the economy was acutely struggling. Exploring Money And Credit Dichotomies In China There has lately been a puzzling divergence between the growth rates of banks' credit-money, M2, and total social financing (TSF) (Chart I-2). Chart I-2Dichotomy Among Various Credit And Money Aggregates In China Dichotomy Among Various Credit And Money Aggregates In China Dichotomy Among Various Credit And Money Aggregates In China In 2016, banks' credit-money growth accelerated to 20%, while the pick-up in M2, and bank loan growth was modest. At the same time, TSF and corporate and household credit growth was largely flat. Lately, M1 growth has slowed, M2 and banks' total asset growth have dropped to all-time lows, while banks' loan and total social financing have remained flat. So, what is the true picture of money and credit growth in China? What are these critical variables telling us about the growth outlook? Our measure of banks' credit-money should by and large match broad money (M2) because the former is calculated by adding up various assets, and the latter by aggregation of various liabilities. Indeed, both were correlated well in the past, but decoupled in 2013 (Chart I-3, top panel). There has been another money/credit paradox: banks' credit-money on the one hand, and TSF and banks' RMB loans on the other, also have decoupled since 2013 (Chart I-3, middle and bottom panels). Overall, neither M2 nor TSF and banks' RMB loans mirrored the surge in banks' money-credit origination in 2015 and 2016, as portrayed in Chart I-3. We have been relying on the M2 and TSF aggregates published by China's central bank. Their tame readings in 2016 were the main reason we underestimated the duration and magnitude of China's economic recovery in the past year or so, as well as its impact on the rest of EM and commodities. As to components of banks' credit-money, Chart I-4 demonstrates that the deceleration has been due to the claims on non-financial organizations (companies), non-bank financial institutions and government. In brief, the slowdown has been broad-based; only claims on households continue expanding at a robust rate of 25% from a year ago (Chart I-4, bottom panel). Chart I-3M2 And Total Social Financing Have Not ##br##Reflected Money Created by Banks M2 And Total Social Financing Have Not Reflected Money Created by Banks M2 And Total Social Financing Have Not Reflected Money Created by Banks Chart I-4Individual Components Of Commercial ##br##Banks' Money Origination Individual Components Of Commercial Banks' Money Origination Individual Components Of Commercial Banks' Money Origination We suspect burgeoning financial engineering in China, credit shenanigans, and the non-encompassing nature of the People's Bank of China's broad money (M2) calculation along with the local government debt swap conducted in 2015 have all distorted credit and money data in recent years, producing the above dichotomies. To shed light on these dichotomies and calculate what has been true money/credit origination in China, we have revisited the basics of money and credit creation and have attempted to make sense of the data and the underlying trends. Overall, we have the following observations and comments: New nominal purchasing power in any economy is created by banks when they originate new loans. Hence, measuring properly the amount of new credit/money origination is of paramount importance to forecasting business cycle dynamics in any country. As we argued in our trilogy of Special Reports on Money, Credit and Savings, banks do not need savings or deposits to originate loans.1 They simultaneously create an asset (a loan) and a liability (a deposit) when extending credit to a borrower, which creates purchasing power in the economy. Importantly, there is no need for someone to save (i.e., forego consumption) in order for a bank to create a new loan / originate new money. In the case of China, commercial banks have an enormous amount of deposits - not because households and companies save a lot but because the banking system altogether has originated a lot of credit/money. The household and national savings rates quoted by economists refer to excess production/overcapacity in the real economy and not deposits in the banking system. We have discussed this issue in the past2 and will revisit it in future reports. The restraining factors for banks to originate new credit/money are their capital, regulations, loan demand, and liquidity - but not deposits. Liquidity is banks' excess reserves at the central bank. Commercial banks create deposits but they cannot engender reserves at the central bank, i.e., liquidity. Only the central bank can expand or shrink the amount of liquidity/reserves commercial banks hold with it. Finally, commercial banks do not lend their reserves; they use the reserves to settle transactions with other banks. In turn, central banks do not create new money/purchasing power unless they lend to or buy assets from governments and non-bank entities or issue currency. Central banks have a monopoly over the creation of bank reserves and currency in circulation - high-powered money. A liquidity crunch at a bank occurs when a bank runs out of excess reserves at the central bank, and it cannot borrow/attract additional reserves. Nowadays, many central banks targeting interest rates supply reserves and lend to commercial banks unlimited amounts of reserves on demand to assure interbank rates stay close to their policy target rate. Therefore, in such settings one can infer that banks are not restrained by liquidity to produce new money/expand their assets. In the case of China, the PBoC's claims on banks have skyrocketed - they have surged by 4.5-fold since 2014 (Chart I-5) - entailing that the former has supplied a lot of liquidity to commercial banks. Such liquidity expansion by the PBoC has in turn allowed banks to create tremendous amounts of new money (new purchasing power). To put the amount of money/credit originated by Chinese commercial banks in context, we have calculated the ratio of their credit/money stock to China's nominal GDP and global nominal GDP (Chart I-6). Chart I-5The PBoC Has Injected A Lot Of##br## Liquidity/Reserves Into The System The PBoC Has Injected A Lot Of Liquidity/Reserves Into The System The PBoC Has Injected A Lot Of Liquidity/Reserves Into The System Chart I-6Chinese Banks' Colossal ##br##Money Creation Chinese Banks' Colossal Money Creation Chinese Banks' Colossal Money Creation The broad measure of banks' credit/money created presently stands at 250% of Chinese GDP and 32% of global GDP, or US$29 trillion. The latter compares with the U.S. Wilshire 5000 equity market cap of US$ 26 trillion at a time when American share prices are at all-time highs, and the median P/E ratio is at a record high as well. In 2016 alone, Chinese banks' originated RMB 21 trillion, or US$1.7 trillion in new money-credit. Since January 2009, when the credit boom commenced, mainland commercial banks have cumulatively generated RMB 141 trillion, or US$21.12 trillion, of new money/credit. Banks create new money/deposits when they lend or acquire assets. Exceptions are when banks lend to the central bank or to other commercial banks. In those circumstances, a bank draws on its reserves at the central bank, and no new money - and by extension purchasing power - is created. Fluctuations in reserves/liquidity affect purchasing power in an economy indirectly rather than directly. Expanding reserves/liquidity encourage banks money/credit creation and vice versa. In China, commercial banks' excess reserves at the PBoC are presently contracting and stand at historically low level relative to outstanding stock of credit/money (Chart I-7). This is one of the reasons why banks have been scaling back their credit/money origination. Chart I-7China: Banks' Liquidity/##br##Excess Reserves Are Thin China: Banks' Liquidity/Excess Reserves Are Thin China: Banks' Liquidity/Excess Reserves Are Thin The fiscal authorities play a unique role in money creation. Because of the authorities typically have accounts at both the central bank and commercial banks, they can alter the money supply by shifting deposits back and forth between their accounts at the central bank and commercial banks. By transferring deposits from a commercial bank to the central bank, the fiscal authorities can destroy money; by the same token, they can create money by doing the opposite. This is why when computing Chinese banks' credit-money aggregate we have deducted from the credit/money aggregate government deposits at the PBoC. Finally, there is a difference between credit-money originated by banks, and non-bank credit. Non-banks are financial intermediaries that transfer existing deposits into credit. By doing so they do not create new purchasing power. When banks lend or acquire various assets, they do generate new purchasing power - i.e., they create new deposits that did not exist before. This is why banks are not financial intermediaries. This is true for any country and financial system. For more detailed analysis on the difference between banks and non-banks, please refer to the linked paper.3 When examining leverage in the system, one should consider bank and non-bank credit. Yet, when looking to gauge the outlook for growth and inflation, one should consider new credit/money originated by banks. The purpose of this report is to examine and compute new credit-money that determine nominal economic growth in China rather than discuss leverage even though they are often interlinked. Therefore, we are focused on new credit-money originated by banks, and not on the amount of and changes in leverage in the economy. Bottom Line: Whether one prefers M2, banks' total assets or our new measure of banks' credit/money, the message is by and large the same: money-credit growth is slowing and is very weak. Credit-Money And Business Cycle Chart I-8Comparing Two Impulse Indicators Comparing Two Impulse Indicators Comparing Two Impulse Indicators How good is the bank credit-money in terms of being an indicator for China's business cycle? We have one caveat to mention before we illustrate its relevance: Banks' credit-money is a stock variable, and our goal is to gauge business cycle trends - i.e., changes in flow variables such as output, capital spending, profits and imports. Also, the first derivative of a stock variable is a flow, while the second derivative of a stock variable is a change in its flow. Therefore, we have calculated credit/money impulse as the second derivative of outstanding credit/money, or a change in annual change, to align it with the growth rate of flow variables. The following illustrates that banks' credit-money impulse has been an extremely good leading indicator for many economic and financial variables. The new impulse of banks' credit-money has since 2014 diverged from the nation's credit and fiscal impulse (Chart I-8). Nevertheless, the new credit-money impulse leads numerous business cycle variables such as nominal GDP, producer prices, electricity output, machinery sales, freight volumes, and manufacturing PMI (Chart I-9A and Chart I-9B). Chart I-9AChina's Growth To Decelerate A Lot (II) China's Growth To Decelerate A Lot (I) China's Growth To Decelerate A Lot (I) Chart I-9BChina's Growth To Decelerate A Lot (I) China's Growth To Decelerate A Lot (II) China's Growth To Decelerate A Lot (II) Not surprisingly, this impulse also leads property sales and starts as well as construction nominal GDP (Chart I-10). This impulse often precedes swings in the LMEX industrial metals index and iron ore prices (Chart I-11). Further, it is also a reasonably good indicator for EM EPS growth (Chart I-11, bottom panel). As discussed above, banks' new credit-money creation determines nominal - not real - growth. Chart I-10China: Property / Construction ##br##Are At A Major Risk China: Property / Construction Are At A Major Risk China: Property / Construction Are At A Major Risk Chart I-11Downbeat Message For Industrial ##br##Metals And EM Profits Downbeat Message For Industrial Metals And EM Profits Downbeat Message For Industrial Metals And EM Profits By expanding their assets, banks generate new purchasing power, but they do not have any control over whether this new purchasing power is used to boost real output or prices. The recovery of the past 12 months have in some cases boosted prices more than volumes. It might be that China is inching closer to an inflation inflection point. We are not saying that China has runaway inflation at the moment, but persistent enormous overflow of money-credit will inevitably produce higher inflation. If inflation does indeed rise materially, policymakers will have no choice but to tighten. Monetary tightening will be devastating for an economy with already high leverage. Bottom Line: The new measure of banks' credit-money is currently corroborating a very downbeat outlook for Chinese growth and China-related plays. Beijing's Priorities And Investment Implications It is generally believed in the global investment community that China's authorities will not allow the economy to slump - they will boost credit/money growth and fiscal spending to ensure solid growth. It is true that no government wants to see their economy crumble, and China is no exception. However, there are several reasons to expect growth to slump considerably before the government responds: The central bank has been guiding interest rates higher across the entire yield curve. Short-term interbank rates (7-day Interbank Fixing Rate) and 5-year AA domestic corporate bond yields have risen by about 100 and 200 basis points, respectively, since November 2016. In addition, financial regulators are clamping down on off-balance-sheet and fancy financial engineering practices of banks and other financial institutions. Monetary policy works with a time lag, and the current tightening along with the government's regulatory clampdown will impact economic growth in the months ahead. The sharp deceleration in banks' credit/money confirms this. Even though interest rates have recently stopped rising, the damage to banks' credit/money growth has been done as shown in Chart I-12. Business activity is lagging money/credit and will be next to suffer. The central government in Beijing has largely lost control over credit creation/leverage build-up since 2009. The top leadership in Beijing did not want credit to explode and speculative behavior to profligate. Two recent articles by Caixin news agency (links are in footnote4) corroborate that Beijing is unhappy with credit creation and allocation practices prevailing in the financial system as well as among SOEs and local governments. The top leadership appears decisive, at least for now, in clamping down on ballooning credit/money growth and the ensuing misallocation of capital and bubbles. Interestingly, while many global investors take for granted that the central government will underwrite credit risk in the entire economy, or at least among state-owned companies, Beijing is sending the opposite message for now. True, when an economy and financial system crumbles, the central government will undoubtedly step in. However, investors do not want to be on the long side of China-related markets when this occurs. Buying opportunities may occur at that point, but for now the risk-reward profile is extremely poor. The authorities in Beijing tolerated colossal money/credit creation and misallocation of capital when growth in the advanced economies was extremely feeble. Now, with DM economies expanding at a solid pace and China's growth having recovered, they are comfortable tightening. As for the resulting investment strategy conclusions, it is too late to chase this rally in EM risk assets and other China-related assets. We do not mean that investors should put all of their faith in our new measure of China's credit/money. Yet, other measures of money and credit such as M1, M2 or banks' total assets all point to an impending deceleration in economic growth in China. In EM ex-China, narrow (M1), broad money and private credit growth have been and remain lackluster (Chart I-13). As China's growth and imports slump, the majority of EM economies will be materially affected. Chart I-12China: Interest Rates And Money Creation China: Interest Rates And Money Creation China: Interest Rates And Money Creation Chart I-13EM Ex-China: Subdued Money / Credit Growth EM Ex-China: Subdued Money / Credit Growth EM Ex-China: Subdued Money / Credit Growth There is no change in our overall investment strategy. Specific country recommendations and positions across all asset classes are always presented at the end of our reports, presently on pages 18-19. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Caitlynn Qi Zeng, Research Assistant caitlynnz@bcaresearch.com Central Europe: A New Fixed-Income Trade In a Special Report titled Central Europe: Beware Of An Inflation Outbreak from June 21st 2017 - the link is available on page 20, we argued that labor shortages in central Europe have been pushing up wage growth, generating genuine inflationary pressures. The Polish, Czech and Hungarian economies are overheating, warranting imminent monetary policy tightening. We elaborated on the reasons why this is happening in that report and as such we will not go through it in detail again here. Based on this theme, our primary investment recommendation was in the currency market: go long the PLN and CZK versus the euro and/or EM currencies. This recommendation remains intact. Today we recommend a new trade based on the same theme: pay Czech / receive Polish 10-year swap rates (Chart II-1). The negative 143 basis points yield gap between Czech and Polish 10-year swap rates is unsustainable and it will mostly close for the following reasons: The relative output gap between the Czech Republic and Poland is showing that the Czech economy is overheating faster than in Poland (Chart II-2). This will eventually lead to inflation rising faster in Czech Republic than in Poland as per Chart II-2. Markedly, relative trend in headline inflation warrants shrinking swap spread between Czech and Polish swap rates (Chart II-3). In effect, the Czech National Bank (CNB) will be forced to hike rates at a faster pace and more than the National Bank of Poland (NBP). The CNB has been artificially depressing the value of its exchange rate by pegging it to the euro since November 2013. Despite the fact that the CNB abandoned its peg in April of this year, the CNB continues to artificially suppress the exchange rate by printing money and accumulating foreign exchange reserves. Chart II-1Pay Czech / Receive Polish ##br##10-year Swap Rates Pay Czech / Receive Polish 10-year Swap Rates Pay Czech / Receive Polish 10-year Swap Rates Chart II-2Czech Economy Will Overheat ##br##Faster Than Poland's Czech Economy Will Overheat Faster Than Poland's Czech Economy Will Overheat Faster Than Poland's Chart II-3Inflation Dynamics Warrant ##br##Smaller Swap Spread Inflation Dynamics Warrant Smaller Swap Spread Inflation Dynamics Warrant Smaller Swap Spread Foreign exchange reserves, measured in euros, in the Czech Republic are growing at an astronomical 60% annually while growth and inflation are already in full upswing (Chart II-4, top panel). Due to the ongoing foreign currency accumulation - accompanied by insufficient sterilization - the CNB has generated an overflow of liquidity and money/credit in the Czech economy (Chart II-4, middle panels). Chart II-4Monetary Conditions Are Easier In ##br##Czech Republic Relative To Poland Monetary Conditions Are Easier In Czech Republic Relative To Poland Monetary Conditions Are Easier In Czech Republic Relative To Poland In turn, this liquidity overflow has led a real estate boom and has super-charged overall growth (Chart II-4, bottom panel). On the contrary, the NBP has been much less aggressive in easing monetary conditions. The policy rate in Poland is at 1.5% while it is 0.05% in Czech Republic. Therefore, any potential upside in inflation and bond yields will be more limited in Poland than in the Czech Republic. Even though both Czech and Polish economic growth are robust, the Czech economy is showing more imminent signs of overheating and inflationary outbreak than Poland. The CNB is further behind the curve than the NBP. When a central bank is behind the curve, its yield curve should be steeper than a central bank that is not. However, the 10/1-year swap curve is as steep in Poland as it is in the Czech Republic. With the policy rate at a mere 0.05%, the Czech economy is sitting on the verge of an inflationary precipice. The longer the CNB maintains such a low policy rate, the higher long-term bond yields will rise. The basis being that the longer policymakers wait, the more they will have to tighten to slow growth and bring down inflation. Finally, this relative trade offers a hefty 143 basis points carry and is thus very attractive. Investment Conclusions In the fixed income and currency space in central Europe, we have been and continue recommending the following relative positions: A new fixed income trade: pay Czech / receive Polish 10-year swap rates Continue betting on yield curve steepening in Hungary: Receive 1-year / paying 10-year Hungarian swap rates Long Polish and Hungarian 5-year local currency bonds / short South African and Turkish domestic bonds. Long PLN and CZK versus EM currencies and/or the euro - we are long the following crosses: PLN/HUF, PLN/IDR, CZK/EUR For dedicated EM equity investors, we continue to recommend overweighting central Europe within an EM equity portfolio. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Reports titled, "Misconceptions About China's Credit Excesses", dated October 26, 2016; "China's Money Creation Redux And The RMB", dated November 23, 2016; "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017; links available on page 20. 2 Please refer to the Emerging Markets Strategy Special Report titled, "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017; link available on page 20. 3 Werner, R. (2014b), "How Do Banks Create Money, and Why Can Other Firms Not Do the Same?", International Review of Financial Analysis, 36, 71-77. 4 Please see, "Local Officials Now Liable for Bad Debt-Management Decisions for Life", July 17th 2017, Caixin Global, available at http://www.caixinglobal.com/2017-07-17/101117307.html Please see, "Local Governments Find New Ways to Play Debt Game", July 14th 2017, Caixin Global, available at http://www.caixinglobal.com/2017-07-14/101116048.html Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights To change our EM strategy, we would need to change our view on China and accept that China's credit bubble - especially in combination with the ongoing policy tightening - does not constitute a material risk to mainland growth in the foreseeable future. We are simply not ready to make this call. It is a matter of time until mainland's growth relapses and China-related plays (including commodities and EM) enter a bear market. Even though the headline growth numbers out of China have so far remained solid, their second derivatives - change in growth rate - have turned negative. Asian export growth has already rolled over, and a slowdown will become pronounced in the months ahead. This will likely halt and reverse the EM rally. Having taken into consideration various factors, we believe it would be wrong to change our strategy at the moment. Feature The U.S. dollar has tumbled and EM risk asset prices have spiked following last week's testimony by Federal Reserve Chair Janet Yellen to Congress. This week we review what has gone wrong with respect to our view, as well as weigh the pros and cons of altering strategy at this point. Our bearish view on EM has been contingent on two pillars: Our downbeat view on EM over the past year has rested on higher U.S. bond yields pushing up the U.S. dollar. This view played out in the second half of last year but has been wrong since early this year. We have continuously argued that EM risk assets are vulnerable due to China's growth relapse amid ongoing liquidity tightening and the lingering credit bubble. Even though the headline growth numbers out of China have so far remained solid, their second derivatives - change in growth rate - have turned negative (more details are provided in the section below). We maintain that our theme of slower mainland growth still has high odds of playing out later this year. We expect meaningfully weak data (on a first-, not second-derivative basis) out of China before year end. If equity markets are forward-looking, they should start pricing in such a scenario now. What has surprised us is the fact that EM investors have utterly and altogether ignored political woes in a number of EM countries, lower commodities prices and lingering structural and cyclical problems in many developing economies, as well as China's tightening amid the credit excesses. Instead, EM investors have singularly focused on downward surprises in U.S. inflation - even ignoring strong employment data in America. Remarkably, EM share prices historically plunged when U.S. inflation and inflation expectations dropped (Chart I-1). Hence, the year-to-date negative correlation between EM stocks and U.S. inflation is out of sync with the historical relationship. We review some other inconsistencies and contradictions below. Chart I-1U.S. Inflation And EM Stocks Were Historically Positively Correlated, But Not This Year U.S. Inflation And EM Stocks Were Historically Positively Correlated, But Not This Year U.S. Inflation And EM Stocks Were Historically Positively Correlated, But Not This Year Inconsistencies In Prevalent Narrative The purpose of this section is not to justify our investment strategy, which has been wrong-footed, but to elaborate on financial markets' nuances that have been much less clear-cut than popular financial market narratives imply. The reality is much more complicated than the following prevalent among investors narrative: low U.S. inflation entails little tightening by the Fed, resulting in a weak U.S. dollar and an EM rally. There are some contradictions in this story: If U.S. household consumption growth in nominal terms is as weak as portrayed by the latest retail sales and inflation readings (Chart I-2), how can U.S. corporate earnings continue to grow at a double-digit rate, as most investors currently expect? The only way this can happen is if productivity growth is really strong and profit margins continue to expand. Productivity is a black box that no one can measure accurately in real time. If underlying productivity growth is indeed robust, the bull market will persist and bears will be humiliated. The snag is that productivity assessment is a judgement call, and only time will reveal true productivity dynamics. Not having more insight, we have so far assumed that the official statistics on productivity in the U.S. and EM are generally right. If U.S. productivity data are close to reality, unit labor costs - calculated as wages divided by productivity - are rising faster than underlying inflation (Chart I-3, top panel). This entails that U.S. corporate profit margins should be contracting. The middle and bottom panels of Chart I-3 portray our macro proxy for U.S. corporate profit margins based on core PCE inflation and unit labor costs. Chart I-2The U.S.: Very Low Nominal Growth The U.S.: Very Low Nominal Growth The U.S.: Very Low Nominal Growth Chart I-3A Macro Proxy For U.S. Corporate Profit Margins Entails Shrinking Margins A Macro Proxy For U.S. Corporate Profit Margins Entails Shrinking Margins A Macro Proxy For U.S. Corporate Profit Margins Entails Shrinking Margins Overall, if low inflation and weak U.S. nominal retail sales data are a true representation of current U.S. economic conditions, the corporate profit outlook cannot be benign, and American stock prices should be lower - not higher. If lower inflation and nominal growth of recent months in the U.S. were an aberration, U.S. interest rate expectations will have to be revised higher and the U.S. dollar will rally. We are even more puzzled by the nature of the drop in U.S. bond yields, and EM financial markets' reaction to it. Typically, EM risk assets negatively correlate with real (TIPS) yields (Chart I-4), and positively correlate with the inflation component of U.S. bond yields (Chart I-1 on page 1). The decline in U.S. bond yields since the beginning of the year has been almost entirely driven by the inflation component, with U.S. real yields actually not dropping at all. Yet, EM risk assets have rallied sharply. This goes against the predominant correlation of the past several years and is very puzzling. In short, the historical correlations between EM stocks and currencies on one hand and U.S. real yields and inflation expectations on the other, have in the past six months reversed for no reason. If the weaker U.S. dollar and lower U.S. bond yields/rate expectations represent an unwinding of the "Trump trade", why has the S&P 500 - which has surged amid "Trump trade" - not yet corrected? Broadly speaking, if U.S. bond yields drop further and the greenback continues deprecating, it would signal a major relapse in U.S. growth and U.S. share prices will dive. On the contrary, if U.S. growth is solid, the dollar selloff is overdone and the greenback is close to a major bottom. In addition, EM risk assets have decoupled from commodities prices, as we have detailed many times since early this year. Also, as a side note, the broad trade-weighted U.S. dollar decoupled from precious metals prices this whole year up until last week. These are non-trivial divergences that are by and large puzzling. Finally, EM net earnings-per-share revisions have rolled over, yet share prices have continued to move higher (Chart I-5). Such decoupling has simply never happened before. Chart I-4Another Breakdown In Correlations: ##br##EM Currencies And U.S. TIPS Yields Another Breakdown In Correlations: EM Currencies And U.S. TIPS Yields Another Breakdown In Correlations: EM Currencies And U.S. TIPS Yields Chart I-5EM EPS Net Revisions ##br##Have Failed To Turn Positive EM EPS Net Revisions Have Failed To Turn Positive EM EPS Net Revisions Have Failed To Turn Positive Besides, EM EPS net revisions have not turned positive throughout this 18-month rally. In short, analysts in aggregate have not upgraded their EPS estimates for EM companies at all. Bottom Line: There are a number of contradictions and inconsistencies that cannot be explained by the prevailing financial market narrative. What About Global Growth? One way to square the above inconsistencies is to argue that the drop in the U.S. dollar and the EM rally have little to do with U.S. dynamics and much to do with strength in the rest of the world, especially outside the U.S. This is coherent reasoning. We review global growth dynamics in this section and elaborate on China in the following one. Without disputing the fact that there has been a notable recovery in global growth and trade in the past year, we would like to emphasize that on a rate-of-change (second derivative) basis, global trade, and particularly Asian export growth, has already rolled over, and a slowdown will become pronounced in the months ahead. Consistently, the U.S. dollar should rise or EM risk assets should reverse their gains in the near future, if and as global trade/EM growth falters: The pace of export growth in key Asian manufacturing hubs such as Korea, Taiwan and Singapore has already rolled over (Chart I-6). Both Taiwanese exports of electronic parts and the country's overall exports to China have rolled over - the latter two lead global export volumes and Chinese exports, respectively, by a few months, as shown in Chart I-7. Chart I-6Asian Export Growth Has Rolled Over Asian Export Growth Has Rolled Over Asian Export Growth Has Rolled Over Chart I-7Global Export Growth Has Peaked Global Export Growth Has Peaked Global Export Growth Has Peaked The reason why Taiwanese exports of electronic parts lead global trade cycles is because these parts are used in the assembly of final products, and producers order and receive these parts before final products are made and shipped. Similarly, a lot of Taiwanese exports to China serve as inputs into final products assembled in China and are shipped worldwide. This is why Taiwanese shipments to China lead mainland aggregate exports. Provided U.S. consumer spending has recently weakened, as depicted by core retail sales, U.S. imports are bound to slump sooner than later (Chart I-8). Consequently, Asian and European shipments to America are likely to roll over soon. Imports are more volatile than domestic demand, reflecting inventory re-stocking and de-stocking cycles. The decoupling between the not-so-strong U.S. final demand and robust imports suggests an inventory re-stocking cycle in the U.S. has recently been taking place. As such, this will be followed by a period of destocking, i.e., weaker imports, weighing on the rest of the world's shipments to the U.S.. A genuine area of global growth acceleration has been continental Europe. Undoubtedly, growth is extremely robust in these economies, and there is no reason for European economies to plunge into recession. That said, U.S. growth dynamics following the 2008 crisis have generally been "two steps forward, one step back." This has typically held true for post-crisis economic recoveries in all major economies. There is no reason why Europe's economic recovery will be any different. As such, having experienced "two steps forward" in the past year, European growth is more than likely to take a "one step back" - i.e., slow down a bit. In brief, if growth dynamics in Europe were to resemble that of the U.S. post-crisis era, mean reversion in European growth is overdue. Finally, global auto sales growth has rolled over decisively (Chart I-9, top panel). The deceleration is very broad-based including the U.S., Europe (Chart I-9, bottom panel) and China (please refer to Chart I-12 on page 10). Chart I-8Weak U.S. Retail Sales Entail ##br##U.S. Import Deceleration Weak U.S. Retail Sales Entail U.S. Import Deceleration Weak U.S. Retail Sales Entail U.S. Import Deceleration Chart I-9Global Vehicle Sales ##br##Growth Heading South Global Vehicle Sales Growth Heading South Global Vehicle Sales Growth Heading South Bottom Line: If the global growth recovery has been behind the U.S. dollar selloff and the EM rally, the forthcoming reversal in global trade will at minimum halt and reverse the EM rally. China is critical to our theme of slowdown in global trade. China's Growth: Looking Beyond Headlines China's headline growth numbers for GDP and industrial production have been on the strong side, but forward-looking variables such as money growth and various liquidity measures entail a major deceleration by the end of this year: Narrow and broad money growth - which have historically led the business cycle in China - have relapsed (Chart I-10). Although credit growth has not yet decelerated, money often leads or coincides with credit growth, suggesting a credit slowdown is forthcoming. Furthermore, commercial banks' excess reserves at the central bank are key to their lending capacity. The top panel of Chart I-11 demonstrates that China's money multiplier - the ratio of broad money-to-excess reserves, or banks' assets-to-excess reserves - have surged, implying that banks are over-extended. Chart I-10China: Money Leads Business Cycle China: Money Leads Business Cycle China: Money Leads Business Cycle Chart I-11China: Bank Loan Growth To Slow China: Bank Loan Growth To Slow China: Bank Loan Growth To Slow In addition, banks' shrinking excess reserves point to a rollover in bank loan growth in the months ahead (Chart I-11, bottom panel). The pace of growth in China's many economic indicators has already rolled over - i.e., their second derivative has turned negative. These include total and ex-oil imports, electricity output and auto production (Chart I-12). Finally, the central bank will continue to tighten liquidity. The recent softness in interest rates may have been temporary, as June is a month in which liquidity demand spikes, and the People's Bank of China probably did not want a replay of the June 2013 SHIBOR crisis. Notably, both core consumer prices and consumer services inflation measures in China are grinding higher (Chart I-13). This, along with "a mandate of preventing bubble formations," will all but ensure that the PBoC tightens further. Chart I-12China: The Pace Of Growth Has Already Rolled Over China: The Pace Of Growth Has Already Rolled Over China: The Pace Of Growth Has Already Rolled Over Chart I-13China: Inflation Is Rising China: Inflation Is Rising China: Inflation Is Rising Tighter liquidity/higher interest rates along with regulatory tightening on banks and shadow banking will cause credit growth to slow down considerably, weighing on the real economy. Bottom Line: In China, liquidity is tightening and interest rates are rising amid a credit bubble. Meanwhile, investors remain complacent, and the overwhelming majority of the global investment community believes that China will be able to deflate its financial bubbles and deleverage its corporate sector without a meaningful impact on the real economy. The reality is there has been no historical precedent of this occurring in any country. Strategy Considerations: The Dollar And China Hold The Key The greenback holds the key to EM strategy - not only because it mechanically drives the performance of EM financial markets, but also because it reflects many global financial and economic trends. Having taken into consideration various factors, we believe it would be wrong to change our strategy at a time when: There has already been capitulation by U.S. dollar bulls, the greenback is technically oversold and the Fed will soon commence reduction of its balance sheet. All of this makes us reluctant to change our view on the U.S. dollar and EM at the moment. Notably, the U.S. dollar is at a critical technical level against numerous currencies (Chart I-14A and I-14B). Chart I-14AThe U.S. Dollar Is At A Critical Technical Level (II) The U.S. Dollar Is At A Critical Technical Level (I) The U.S. Dollar Is At A Critical Technical Level (I) Chart I-14BThe U.S. Dollar Is At A Critical Technical Level (I) The U.S. Dollar Is At A Critical Technical Level (II) The U.S. Dollar Is At A Critical Technical Level (II) In short, it is too late to abandon a positive view on the dollar. We have been and remain much more certain about the U.S. dollar strength versus EM, commodities, and Asian currencies than against the euro. Meanwhile, EM financial markets are overbought, and implied volatility across most global financial markets in general and EM in particular is at record-low levels (Chart I-15). Chart I-15Implied Volatilities Are Depressed ##br##Across Most Asset Markets Implied Volatilities Are Depressed Across Most Asset Markets Implied Volatilities Are Depressed Across Most Asset Markets The Fed will shrink its balance sheet, and high-power U.S. dollar liquidity will diminish. Besides, the PBoC will continue to tighten liquidity and guide interest rates higher amid lingering credit excesses. These developments are at the margin bullish for the greenback, and invariably bearish for EM/China-related plays. China's industrial cycle has peaked and Asian exports have rolled over, as we have illustrated above. China's narrow money (M1) growth is slowing, and broad money (M2) growth is at an all-time low. Money leads business cycles in China. Our biggest concerns have been and remain continued strong flows to EM and how well risk assets have been trading. Past flows are no guarantee of future flows. However, both DM and EM risk assets have been trading really well. It is hard to know and forecast when this will change. That said, we maintain that the next 20% move in EM share prices and commensurate moves in other EM risk assets will be down - not up. Weighing the pros and cons, we are reluctant to alter our view and recommended strategy at the moment. To change our EM strategy, we would need to change our view on China and accept that China's credit bubble - especially in combination with the ongoing policy tightening - does not constitute a material risk to mainland growth in the foreseeable future. We are simply not ready to make this call. It is a matter of time until mainland growth relapses and China-related plays (including commodities and EM) enter a new bear market. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The strong tailwinds behind China's recovery since early 2016 are likely to wane in the coming months. Diminishing reflationary forces will not immediately lead to a growth relapse, as the domestic economy has developed some self-feeding momentum. China's PPI inflation will continue to drift lower. Disinflation in PPI is less positive for the economy, but is not outright negative, unless PPI deflates. Odds are low that PPI will deflate anytime soon. Without a major growth relapse and PPI deflation, the upturn in the Chinese profit cycle should have further to run, which bodes well for asset prices - particularly for investable Chinese shares and corporate bonds. Feature China's GDP figures to be released next week will likely show that the economy continued to accelerate in the second quarter, as indicated by recent high-frequency macro indicators (Chart 1). Looking forward, the near-term outlook remains promising, but the strong tailwinds behind China's recovery since early 2016 are likely to wane in the coming months, which could lead to softer growth down the road. However, the Chinese economy has regained some self-sustaining momentum, which will allow it to glide at cruising speed without major growth difficulties. For investors, H-shares and onshore corporate bonds should continue to advance, aided by the profit cycle upturn and a largely accommodative policy setting over the next six to nine months. Chart 1Chinese GDP Likely Accelerated In Q2 Chinese GDP Likely Accelerated In Q2 Chinese GDP Likely Accelerated In Q2 Chart 2Exports And Monetary Conditions ##br##Drive Chinese Industrial Activity Exports And Monetary Conditions Drive Chinese Industrial Activity Exports And Monetary Conditions Drive Chinese Industrial Activity Tailwinds Are Waning... China's seemingly static GDP growth figures disguise much greater volatility in the underlying economy, especially in the industrial sector. The famed Keqiang index, named after China's incumbent premier which incorporates electricity consumption, railway transportation and bank lending, has shown dramatic swings in the past two decades (Chart 2). The index has roared back from rock bottom in late 2015 to currently a one sigma overshoot above its long-term trend, underscoring a sharp recovery in industrial activity. Some have attributed this to a massive dose of fiscal and monetary stimuli - we disagree. In our view, the swings in China's industrial sector performance can be fully explained by the performance of exporters and the country's Monetary Conditions Index (MCI). Our "Reflation Indicator," a combination of export growth and MCI, shows a very tight correlation with the Keqiang Index in the past several cycles. In other words, the rapid recovery in industrial activity since early 2016 was boosted by tailwinds from both accelerating export growth and easing monetary conditions. Currently, the tailwinds are likely passing maximum strength and will wane on both fronts going forward: Global demand appears to be in a synchronized upturn, which bodes well for Chinese exports. The manufacturing PMI new export orders component has been in expansionary territory for eight consecutive months and made a new recovery high in June, pointing to upside surprises in export growth in the near term. Looking further out, our model predicts export growth will likely peak out before the end of the year (Chart 3). After all, it is unrealistic to expect Chinese exports to always grow at double-digit rates - particularly with global trade having downshifted structurally post-global financial crisis. On monetary conditions, the depreciation of the trade-weighted RMB, a major reflationary force for the Chinese economy since late 2015, has stalled in recent weeks. Broad dollar weakness of late has failed to further push down the trade-weighted RMB - either because of the People's Bank of China's intervention, or because bearish bets on the RMB by investors are now off the table (Chart 4). Regardless, a stable RMB exchange rate decreases investors' anxiety on China's macro situation, but also reduces a reflationary source for the overall economy. Overall, recent changes in China's macro environment suggest growth tailwinds are diminishing, but have not yet become headwinds. This on margin is bad news for the economy, but should not lead to a significant growth slowdown. Chart 3Exports: Upside Is Limited Exports: Upside Is Limited Exports: Upside Is Limited Chart 4The RMB Is No Longer Falling The RMB Is No Longer Falling The RMB Is No Longer Falling ...But Growth Drivers Remain Largely In Place We expect Chinese business activity to remain reasonably buoyant going into the second half of the year. It is not realistic to expect growth figures, measured by year-over-year growth rates, to accelerate in perpetuity, but downside risks to the economy will stay low. Some major growth drivers in the economy remain largely in place. Looking at the consumer sector, the growth recovery and labor market improvement have significantly lifted consumer confidence, which historically is positive for retail sales (Chart 5). Chinese households are under-levered and over-saved, and improving confidence should on margin reduce savings and further boost consumption. Retail sales have already bottomed out and will likely accelerate. The corporate sector's inventory restocking cycle is likely still at an early stage, as the inventory component of the manufacturing Purchasing Managers' Index (PMI) surveys has never moved above 50 since 2012, underscoring increasingly lean stock of finished goods. Industrial firms' inventory levels relative to sales are still standing at close to record low levels (Chart 6). Going forward, inventory re-stocking may supercharge production, should new orders remain elevated. At a minimum, very lean inventory levels limit the downside in industrial production - even if the improvement in new orders stalls. Chart 5Consumer Spending Should Remain Strong Consumer Spending Should Remain Strong Consumer Spending Should Remain Strong Chart 6Inventory Restocking Has Further To Go Inventory Restocking Has Further To Go Inventory Restocking Has Further To Go Furthermore, China's capital spending cycle has likely bottomed out, especially among private enterprises and in the resource sectors. The corporate profit cycle recovery has continued to unfold, and business confidence has improved sharply - both of which are conducive for private sector expansion (Chart 7). There has been dramatic improvement in resource sector profits, which at a minimum will put a floor under the relentless contraction in capex these industries have experienced in recent years. Overall, it is premature to expect a major boom, but the case for a modest upturn in private capital spending continues to strengthen. Finally, the risk of a significant housing growth slowdown due to the government's tightening measures, a major concern among investors earlier this year, has abated. Home sales have cooled off due to local government restrictive policies, but developers' inventories have declined substantially following booming sales in previous years. Therefore, housing starts have continued to improve, which should lift real estate investment going forward (Chart 8). Anecdotal evidence suggests land purchases by developers have been buoyant. Meanwhile, developers' stocks have been outperforming the benchmark, which historically has led housing transactions. All of this means a sharp reduction in real estate investment is highly unlikely, at least from a cyclical point of view. Chart 7Private Sector Capex ##br##Will Likely Accelerate Private Sector Capex Will Likely Accelerate Private Sector Capex Will Likely Accelerate Chart 8Real Estate: Near Term Outlook Improving ##br##The Chain Reactions In Housing Real Estate: Near Term Outlook Improving The Chain Reactions In Housing Real Estate: Near Term Outlook Improving The Chain Reactions In Housing In short, we see limited downside risks in the Chinese economy in the near term. Diminishing reflationary forces will not immediately lead to a growth relapse, as the domestic economy has developed some self-feeding momentum. Will PPI Deflate Again? Chinese producer prices have quickly rolled over in the past several months, falling from a peak of 7.8% in February to 5.5% in June. Rising PPI last year was regarded as a key signpost of China's reflationary trend; in this vein, the latest deterioration in PPI indeed raises a red flag. Our model predicts that PPI inflation will likely drift even lower, reaching 3% before year end (Chart 9). We rely on our models to understand the trend rather than to make number forecasts. It now appears a sure bet that Chinese PPI will continue to surprise to the downside in the coming months. How investors will react to likely increasingly disappointing PPI numbers remains to be seen. Our sense is that disinflation in PPI is less positive, but is not outright negative, unless PPI deflates. For now, we see low odds that PPI will deflate anytime soon. Chart 9PPI Will Continue To Moderate PPI Will Continue To Moderate PPI Will Continue To Moderate Chart 10Industrial Goods Prices Are Fairly Robust Industrial Goods Prices Are Fairly Robust Industrial Goods Prices Are Fairly Robust A key reason for the rapid decline in PPI inflation is an increasingly unfavorable "base effect," where the year-over-year growth rate naturally tapers off after a period of rapid acceleration. In terms of levels, overall PPI should remain largely stable, according to our model. The recent softness in Chinese PPI largely reflects weakness in crude oil prices, while prices of most basic industrials prices have been fairly robust, including some products that are widely perceived as suffering chronic overcapacity (Chart 10). This suggests the weakness in PPI is fairly concentrated, and likely reflects the unique supply demand dynamics of the oil market, rather than a demand slowdown in the broader economy. More importantly, China's PPI deflation that lasted between February and June was to a large extent due to policy tightening by the Chinese authorities, which, together with weak global demand amplified strong deflationary pressures in the Chinese economy. This time around, the PBoC is highly unlikely to repeat the policy mistakes of draconian credit and monetary tightening. Even if the central bank intends to tighten policy, it will be a lot more cautious and data-dependent. We will follow up on this issue in the coming weeks. The bottom line is that falling PPI inflation should be closely monitored. For now, we expect continued disinflation rather than outright PPI deflation. Profits And Markets Without a major growth relapse and PPI deflation, the upturn in the Chinese profit cycle should have further to run, which bodes well for asset prices - particularly for investable Chinese shares and corporate bonds. For stocks, net earnings revisions of Chinese companies have been rising, confirming the profit cycle upturn (Chart 11). Even if profit growth rolls over along with other macro numbers, a profit contraction is unlikely. Meanwhile, Chinese stocks are among the cheapest of the major bourses (Chart 12), particularly H shares. Overall, Chinese stocks should continue to do well from a cyclical perspective, and will outperform global and EM peers. For bonds, we went long onshore corporate bonds after the sharp selloff earlier this year - namely because the selloff was entirely triggered by the authorities' liquidity tightening rather than corporate fundamentals. The upturn in the profit cycle should also improve the corporate sector's balance sheet, which should be good news for corporate bonds. This trade has been profitable so far, but we expect further narrowing in corporate bond spreads, as they are still elevated both compared with their global counterparts and their historical norms (Chart 13). Investors should hold. Chart 11Earnings Outlook ##br##Will Continue To Improve Earnings Outlook Will Continue To Improve Earnings Outlook Will Continue To Improve Chart 12Chinese Stocks Multiples ##br##Are Among The Lowest Globally Chinese Stocks Multiples Are Among The Lowest Globally Chinese Stocks Multiples Are Among The Lowest Globally Chart 13Chinese Corporate Bond Spreads Set ##br##To Narrow Further Chinese Corporate Bond Spreads Set To Narrow Further Chinese Corporate Bond Spreads Set To Narrow Further Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights EM growth is set to falter due to budding weakness in Asia's trade, a decline in commodities prices, and the frailty of EM banking systems. U.S./DM bond yields are heading higher for now and China's money/credit growth is set to decelerate. Together, these will trigger a selloff in EM risk assets. The EM equity outperformance versus DM has been extremely narrow and, hence, it is unsustainable. The EM tech sector is unlikely to support the equity rally much further because these stocks are overbought, and the Asian semiconductor cycle is entering a soft patch. Take profits on the yield curve flattening trade in Mexico. Stay long MXN on crosses versus BRL and ZAR and continue overweighting Mexican bonds. Feature Higher bond yields within the advanced economies and policy tightening in China remain the key threats to EM risk assets in the near term (the next three months). In the medium-term (the next three to 12 months or so), the principle risk is weaker growth in EM/China, and hence contracting corporate profits in EM. While this rally has lasted longer and has gone further than we had anticipated, we find the risk-reward for EM risk assets extremely unattractive. In fact, the huge amount of money that has flown into EM equity and debt markets in the past year amid poor fundamentals suggests to us that the next move will not be a simple correction but rather a major bear market. EM Recovery To Falter Although on the surface global growth appears to be on solid footing, there are early signs of a slowdown in Asian exports. Both Taiwanese exports of electronic parts and the country's overall exports to China have rolled over - the latter two lead global export volumes by a few months, as shown in Chart I-1. The reason why Taiwanese exports of electronic parts lead global trade cycles is because these parts are used in the assembly of final products, and producers order and receive these parts before final products are made and shipped. Similarly, a lot of Taiwanese exports to China serve as inputs into final products assembled in China and shipped worldwide. This is why Taiwan's overall shipments to China lead global trade cycles. On top of this, Korea's overall manufacturing and semiconductor shipments-to-inventory ratios have relapsed. Historically, these ratios have correlated with the KOSPI (Chart I-2). Chart I-1Signs Of Slowdown ##br##In Asian Trade Signs Of Slowdown In Asian Trade Signs Of Slowdown In Asian Trade Chart I-2Korea's Manufacturing ##br##Growth Has Peaked Korea's Manufacturing Growth Has Peaked Korea's Manufacturing Growth Has Peaked Outside the manufacturing-based Asian economies, most other EMs are basically commodities plays, except for India and Turkey. The latter two countries are not only relatively small, but Indian stocks are also expensive and overbought while Turkey is sufferings from its own malaise. In short, if the Asian tech cycle rolls over, China slows down and commodities prices relapse, EM growth will falter. That is why the focus of our analysis has been and remains on China's growth, commodities prices and the Asian trade cycle. Meanwhile, many banking systems in the developing world remain frail following the credit excesses of the preceding years. BCA's Emerging Markets Strategy service remains bearish on commodities, and believes the breakdown in the correlation between commodities prices and EM risk assets since the beginning of this year is temporary and unsustainable. As for the increased importance of the technology sector in the EM equity benchmark, we offer further analysis on page 10. Our negative view on EM growth is not contingent on a relapse in U.S. and euro area growth. In fact, our current baseline scenario is that DM growth will remain solid, and government bond yields in these markets will rise further. Although growth in both the U.S. and euro area is robust, their importance for EM has become small. For example, exports to the U.S. and EU altogether account for 35% of total exports in China, 22% in Korea and 20% in Taiwan. All in all, if commodities prices continue to downshift and Asian trade slows, as we expect, EM growth will decelerate. Bottom Line: EM growth is set to falter notably, despite solid demand growth in DM. Liquidity Backdrop To Deteriorate Investors and market commentators often use the term "liquidity" loosely, and denote numerous things by it. We use the term 'liquidity' to signify the level and/or direction of interest rates as well as the level and/or direction of money/credit growth. Below we review some different perspectives of liquidity: EM narrow money (M1) growth points to both lower share prices and a relapse in EPS growth in the months ahead (Chart I-3). Chart I-3EM: Narrow Money (M1) Points To EPS Downturn And Lower Stock Prices EM: Narrow Money (M1) Points To EPS Downturn And Lower Stock Prices EM: Narrow Money (M1) Points To EPS Downturn And Lower Stock Prices This is an equity market cap-weighted aggregate of narrow money growth. M1 growth in China - the largest market cap in the EM equity benchmark - has been essential in driving aggregate EM M1 cycles in recent years. More importantly, China has been tightening liquidity, yet the majority of investors remain complacent about its impact on growth. In this regard, investors should remind themselves that monetary policy works with time lags, and the considerable rise in China's interbank rates and corporate bond yields will produce a growth slowdown in the real economy later this year. Chart I-4 demonstrates that China's broad money growth (M2) - which has in effect dropped to an all-time low - leads bank and non-bank credit origination. This suggests the odds of a slowdown in bank and non-bank credit flows are considerable. There has been no stable correlation between the size of DM central banks' balance sheets and EM stock prices, bond yields and currencies since 2011. Therefore, the Fed's move to reduce its balance sheet by itself should not matter for EM risk assets from a fundamental perspective. Nevertheless, EM risk assets have been negatively correlated with U.S. TIPS yields (Chart I-5), and the potential further rise in U.S./DM real and nominal yields will hurt EM sentiment, with flows to EM drying up. Chart I-4China: M2 Heralds ##br##Slowdown In Credit Growth China: M2 Heralds Slowdown In Credit Growth China: M2 Heralds Slowdown In Credit Growth Chart I-5EM Currencies To Depreciate ##br##As U.S. Real Yields Drift Higher EM Currencies To Depreciate As U.S. Real Yields Drift Higher EM Currencies To Depreciate As U.S. Real Yields Drift Higher Importantly, traders' bets on U.S. yield curve flattening have risen, as evidenced by large short positions in 2-year U.S. notes and considerable long positions in 10- and 30-year bonds. The unwinding of these positions will drive bond yields higher. Chart I-6Precious Metals Signal ##br##Higher Real Yields Ahead Precious Metals Signal Higher Real Yields Ahead Precious Metals Signal Higher Real Yields Ahead Notably, precious metal prices have failed to break out amid a weak U.S. dollar and have lately relapsed (Chart I-6). Precious metals prices could be sensing a further rise in U.S. real yields and/or an upleg in the U.S. dollar. Both the rise in U.S. yields and a stronger dollar will be negative for EM. Bottom Line: We maintain that U.S./DM bond yields are heading higher in the months ahead and China's money/credit growth is set to decelerate. Altogether these will trigger a selloff in EM risk assets. Underwhelming EM Technicals It is a well-known fact that flows into EM debt funds have been enormous, making EM fixed-income markets vulnerable to a reversal of these flows at the hands of tightening liquidity and EM growth disappointments, as argued above. This section focuses on a number of bearish technical signals for EM share prices. In particular: The EM equity implied volatility curve - 12-month VOL minus 1-month VOL - is at a record steep level, based on available history (Chart I-7). Periods of VOL curve flattening have historically coincided with a selloff in EM share prices, as evidenced by Chart I-7. Given that the VOL curve is record steep, the odds of flattening are substantial. Consistently, the probability of an EM selloff is considerable. Chart I-7A Sign Of Top In EM Share Prices? A Sign Of Top In EM Share Prices? A Sign Of Top In EM Share Prices? In absolute terms, EM equity implied 1-month VOL is at an all-time low and reflects enormous complacency about EM. EM equity breadth has also been poor. The MSCI EM equally weighted stock index (where each stock commands an equal weight) has considerably underperformed the EM market cap-weighted index since May 2016 (Chart I-8). This suggests the EM rally has been very narrowly driven. The same measure for DM stocks has done relatively better (Chart I-8). Remarkably, EM has underperformed DM based on equal-weighted equity indexes since July 2016 (Chart I-9). This confirms that EM outperformance against DM since early this year has been largely driven by a few stocks, namely the five companies accounting for the bulk of the EM tech index. Furthermore, EM ex-tech stocks have also failed to establish a bull market, in that the index remains below its prior low (Chart I-10). Chart I-8EM Equity Breadth ##br##Has Been Poor EM Equity Breadth Has Been Poor EM Equity Breadth Has Been Poor Chart I-9EM Versus DM: Relative ##br##Equity Performance EM Versus DM: Relative Equity Performance EM Versus DM: Relative Equity Performance Chart I-10EM Ex-Technology Stocks: ##br##Rebound But No Bull Market EM Ex-Technology Stocks: Rebound But No Bull Market EM Ex-Technology Stocks: Rebound But No Bull Market Finally, the magnitude of the EM rally this year is somewhat misleading. Only three out of 11 sectors - technology, real estate and consumer discretionary (mainly, autos) - have outperformed the EM benchmark this year. Table I-1 illustrates that these three sectors have been responsible for about 50% of the EM rally year-to-date while their market cap is only 36% of total. Table I-1EM Rally In 2017: Return Decomposition The Case For A Major Top In EM The Case For A Major Top In EM Bottom Line: The EM equity outperformance versus DM has been extremely narrow: it has been due to five tech companies that are currently very overbought (see Chart I-8 on page 7). Valuations EM equity valuations are not cheap, as most of the rally since the early 2016 bottom has been driven by a multiple expansion rather than a rise in corporate earnings (Chart I-11). We are not suggesting EM stocks are expensive, but they do not offer good value either. In fact, good companies/countries/sectors are expensive, while those, that appear "cheap", command low multiples for a reason. As for currencies, they are not cheap either. The real effective exchange rate of EM ex-China is rather elevated after the rally of the past year or so (Chart I-12). Finally, not only are EM sovereign and corporate spreads close to record lows, but also local government bond yield spreads over U.S. Treasurys are at multi-year lows (Chart I-13). Chart I-11Decomposing EM Equity ##br##Return Into P/E And EPS Decomposing EM Equity Return Into P/E And EPS Decomposing EM Equity Return Into P/E And EPS Chart I-12EM Ex-China Currencies ##br##Are Not Cheap And Vulnerable EM Ex-China Currencies Are Not Cheap And Vulnerable EM Ex-China Currencies Are Not Cheap And Vulnerable Chart I-13EM Local Bond Yields Spreads ##br##Over U.S. Treasurys Is Low EM Local Bond Yields Spreads Over U.S. Treasurys Is Low EM Local Bond Yields Spreads Over U.S. Treasurys Is Low Bottom Line: Adjusted for fundamentals, EM equity, currency and credit market valuations are rather expensive. The odds are that the reality will underwhelm expectations, and that EM risk assets will sell off. A Word On EM Tech: Is This Time Different? During our recent trip to Europe, many clients argued that the increased weight of technology in the EM equity benchmark will cause EM share prices to decouple from the traditional variables they have historically been correlated with, like commodities prices, commodities stocks and others. In brief, the argument is that EM has entered a new paradigm, and past correlations will not work. The last time we at BCA heard similar arguments was back in early 2000 at the peak of the global tech bubble. At the time, the argument was that this time was truly different - that tech stocks could drive the market higher regardless of the old indicators and the performance of other sectors. Chart I-14 portrays that in 2000 the EM equity index, for several months, decoupled from global mining and energy stocks when tech and telecom stocks went ballistic. Chart I-14EM And Commodities Stocks: Can The Recent Decoupling Persist? EM And Commodities Stocks: Can The Recent Decoupling Persist? EM And Commodities Stocks: Can The Recent Decoupling Persist? Back in 2000, the bubble was in tech and telecom stocks. These two sectors together comprised 33% of the EM benchmark as of January 2000 (Chart I-15). This compares with a 27% weighting of technology stocks alone in the EM benchmark now. The combined weight of energy and materials is currently 14% versus 19% in January 2000, as can been seen in Chart I-15. Chart I-15EM Equities Sector Composition Now And In Late 1990s The Case For A Major Top In EM The Case For A Major Top In EM To be sure, we are not suggesting that tech stocks are in a bubble as they were in 2000, and that a bust in share prices is imminent. However, several observations are noteworthy: Chart I-16EM Equities Sector ##br##Composition Now And In Late 1990s EM Equities Sector Composition Now And In Late 1990s EM Equities Sector Composition Now And In Late 1990s Just because EM tech stocks have skyrocketed in the past six months does not mean they will continue to do so. In fact, EM tech is already extremely overbought and likely over-owned (Chart I-16). As global bond yields rise, high-multiples stocks, especially social media/internet companies, could selloff. We, like all macro strategists, can add little value on how to value internet/social media companies and assess their business models. However, we can shed some light on the business cycle in the semiconductor sector that influences performance of heavyweight companies like TSMC and Samsung. As Chart I-1 and I-2 on pages 1 and 3 demonstrate, there are signs that the semi/electronics cycle in Asia has peaked. We do not mean that this sector is headed toward recession. But this is a very cyclical sector, and some slowdown is to be expected following the growth outburst of the past 18 months. This will be enough to cause a correction in semi stocks from extremely overbought levels. The tight correlation between EM share prices and energy and mining stocks has persisted for the past 20 years (Chart I-14 on page 10), and we believe it will re-establish as technology stocks' shine diminishes. Finally, we have been recommending an overweight position in Taiwanese, Korean, and Chinese stocks primarily because of their large tech exposure. For now we maintain this strategy. Bottom Line: While the technology sector could make a difference for EM economies and equity markets in the long run, it is unlikely to support the current rally and outperformance much further. Indeed, tech stocks are heavily overbought, and the Asian semiconductor cycle is entering a soft patch. In brief, the overall EM equity benchmark is at a major risk of relapse and underperformance versus the DM bourses. Stay underweight. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Mexico: Take Profits On Yield Curve Flattener And Stay Long MXN On Crosses Mexico's 10/1-year swap curve has inverted for the first time in history and we are taking a 160 basis points profit on our yield curve flattening trade recommended on June 8, 2016 (Chart II-1). Will the central bank begin cutting interest rates soon? Is it time to get bullish on stocks? We do not think so: Inflation is well above the central bank's target and is broad based (Chart II-2). Notably, wage growth is elevated (Chart II-3). Chart II-1Mexico's Yield Cruve Has Inverted: Take Profits Mexico's Yield Cruve Has Inverted: Take Profits Mexico's Yield Cruve Has Inverted: Take Profits Chart II-2Mexico: Inflation Is Above The Target Mexico: Inflation is Above The Target Mexico: Inflation is Above The Target Chart II-3Mexico: Wage Inflation Is High Mexico: Wage Inflation Is High Mexico: Wage Inflation Is High Provided productivity growth is meager in Mexico, unit labor costs - which are calculated as wage per hour divided by productivity (output per hour) - are rising. This will depress companies' profit margins and make them eager to hike selling prices. This will in turn prevent inflation from falling and, consequently, hamper Banxico's ability to cut rates for now. Meanwhile, the impact of higher interest rates will continue filtering through the economy. High interest rates entail further slowdown in money and credit growth and, hence, in domestic demand. Both consumer spending and capital expenditure by companies are set to weaken a lot (Chart II-4). This will weigh on corporate profits and share prices. Fiscal policy is not going to support growth either because policymakers will opt to consolidate the recent improvement in the fiscal deficit. This is especially true given the latest selloff in oil prices. Notably, oil accounts for about 20% of government revenues. Even though non-oil exports and manufacturing output are accelerating (Chart II-5), non-oil exports - that make about 30% of GDP - are not large enough to offset the deceleration in domestic demand from monetary tightening. Chart II-4Mexico: Domestic Demand To Buckle Mexico: Domestic Demand To Buckle Mexico: Domestic Demand to Buckle Mexico: Domestic Demand To Buckle Mexico: Domestic Demand to Buckle Chart II-5Mexico: Exports Are Robust Contracting Non-Oil Exports Signal Headwinds For Manufacturing Mexico: Exports are Robust Contracting Non-Oil Exports Signal Headwinds For Manufacturing Mexico: Exports are Robust Investment Conclusions The outlook for Mexican stocks in absolute terms is poor as domestic demand will slump, further hampering corporate profits. Meanwhile, inflation is still elevated to justify rate cuts by the central bank. Within an EM equity portfolio, we recommend neutral allocation to this bourse mainly due to our expectations of the peso outperforming other EM currencies. The Mexican peso is still cheap (Chart II-6). Therefore, we continue to recommend long positions in MXN versus ZAR and BRL. If EM currencies depreciate and oil prices drop further as we expect, it will be hard for the peso to appreciate versus the U.S. dollar. However, the peso will outperform many other EM currencies. Mexican local currency bonds and sovereign credit offer good value relative to their EM counterparts. (Chart II-7). Fixed income investors should continue to overweight Mexican local currency and sovereign credit within their respective EM benchmarks. Chart II-6Mexico: Peso Is Cheap Mexico: Peso is Cheap Mexico: Peso is Cheap Chart II-7Continue Overweighting Mexican Bonds Continue Overweighting Mexican Bonds Continue Overweighting Mexican Bonds Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Duration: Investor optimism about U.S. growth and inflation will return in the coming months. Remain at below-benchmark duration and enter a short position in the July fed funds futures contract. Close short positions in the January contract for a small gain. Credit Spreads: Spreads are at risk of widening as Fed rate hike expectations ramp up in the second half of the year, though we would be inclined to view a Fed-driven back-up in spreads as a buying opportunity. Bank Bonds: Banks continue to shore up their balance sheets and are likely to see rising profits in the coming months. Bank bonds also offer a spread advantage compared to other similarly risky sectors. Feature Chart 1Synchronized Global Selloff Synchronized Global Selloff Synchronized Global Selloff The bond selloff is now two weeks old. What began as a reaction to perceived hawkish policy shifts from central banks outside of the U.S. - the European Central Bank in particular - is now morphing into a selloff built on optimism about U.S. growth. Needless to say, we think the recent bearish price action has further to run. Global participation makes it more likely that the weakness in U.S. Treasuries will persist because it prevents the dollar from strengthening as yields move higher (Chart 1). In recent years, most U.S. bond selloffs have been met with an appreciating exchange rate. The stronger dollar then caused investors to lower their U.S. growth expectations, and capped the upside in yields. We view the dollar's current stability as a bearish signal for U.S. bonds. But it has not just been non-U.S. factors driving the uptrend in yields. Last week's positive ISM and employment figures are ushering in renewed optimism about U.S. growth. We also think that U.S. growth is poised to bounce back in the second half of the year, and the Fed is inclined to agree. The Fed's median projection calls for one more 25 basis point rate hike before the end of the year, and we also expect the committee to announce the run-off of the balance sheet in September. With the market still only priced for 15 bps of hikes between now and year-end, there remains scope for further upside surprises. Of course, this forecast for balance sheet run-off in September and another rate hike in December hinges on a second-half snapback in growth, continued strength in labor markets and a rebound in core inflation. Growth Is On The Way Although GDP growth averaged just 1.75% during past two quarters, all signs suggest that the next two quarters will be much stronger. As was mentioned above, both the manufacturing and non-manufacturing ISM surveys delivered strong readings in June. The manufacturing ISM came in at 57.8 and the non-manufacturing survey came in at 57.4, both signal stronger GDP growth in the coming months (Chart 2). The crucial new orders-to-inventories figure calculated from the manufacturing survey is also displaying remarkable strength (Chart 2, bottom panel). We can also infer the current trend in growth from the employment and productivity data. In fact, aggregate hours worked - a combination of total employment and average weekly hours - plus labor productivity growth is more or less equivalent to GDP (Chart 3). After last week's payrolls report, aggregate hours worked are now growing at 1.99% year-over-year. If we combine that growth rate with quarterly productivity growth of 0.7%, the average since 2012, we get a tracking estimate of just below 2.7% for GDP growth. The Atlanta Fed's GDPNow model also currently expects that second quarter growth will be 2.7%. Chart 2PMIs Point To Stronger Growth... PMIs Point To Stronger Growth... PMIs Point To Stronger Growth... Chart 3...As Does The Labor Market ...As Does The Labor Market ...As Does The Labor Market Labor Markets: Watching The Participation Rate Last week's jobs report showed that the economy added 222k jobs in June, and that the prior two months were also revised higher. This pushed the 3-month moving average up to +180k jobs per month, right in line with the +187k jobs per month averaged in 2016. However, despite robust payroll gains, the unemployment rate actually ticked higher in June. This is because many previously sidelined workers re-entered the labor force, pushing the labor force participation rate up to 62.8%. Going forward, for the Fed to have confidence that wage growth and inflation will continue to rise, the unemployment rate will have to remain under downward pressure (Chart 4). As long as the labor force participation rate remains flat (or declines) this should be relatively easy to achieve. We calculate that the economy needs to add just above 117k jobs per month for the unemployment rate to continue falling. However, if we assume a higher labor force participation rate of 63.2%, we would need to add 195k jobs per month, a much higher hurdle.1 We detailed the main drivers of the labor force participation rate in a recent report,2 and while we do not see much potential for a significant increase in the participation rate, its trend is critical for the monetary policy outlook and should be monitored closely going forward. Inflation: Is The Fed Too Sanguine? The most important question for policymakers is whether inflation will rebound in the second half of the year. While the Fed will probably start winding down its balance sheet in September no matter what, another rate hike in December is likely contingent on core inflation showing some signs of strength in the next few months. We have previously written3 that if the Fed were to proceed with a December rate hike in the face of low and falling inflation, the market would start to price in a "policy mistake" scenario. The yield curve would flatten, credit spreads would widen, TIPS breakevens would narrow and long-dated Treasury yields could even decline. However, we do expect that core inflation will trend higher in the coming months, mostly driven by strength in the core services (excluding shelter and medical care) component. That component is historically the most sensitive to tight labor markets and rising wage growth (Chart 5). Chart 4Falling Unemployment Rate = ##br##Rising Inflation Falling Unemployment Rate = Rising Inflation Falling Unemployment Rate = Rising Inflation Chart 5A Boost From Import##br## Prices Is Coming A Boost From Import Prices Is Coming A Boost From Import Prices Is Coming Although it is unlikely to be a long-run driver of inflation, the core goods component also has some upside in the coming months in response to recent dollar weakness and rising non-oil import prices (Chart 5, bottom 2 panels). Investment Strategy Chart 6Too Few Hikes In The Price Too Few Hikes In The Price Too Few Hikes In The Price We think U.S. growth and inflation are poised to snap back during the second half of the year, probably by enough for the Fed to deliver another hike before year-end. We therefore continue to recommend that investors maintain below-benchmark portfolio duration. We have also been advising clients to hold short positions in the January 2018 fed funds futures contract since March 21.4 That contract is now priced for the fed funds rate to increase 15 bps between now and the end of the year. Given that even an optimistic economic scenario would likely only result in a 25 bps increase in the funds rate, there is not much potential for further gains in this trade. We close this position, booking a small profit of +1 bp. Looking further out, we now see an attractive opportunity to short the July 2018 fed funds futures contract. That contract is currently priced for 32 bps of rate hikes between now and next June (Chart 6), and would therefore turn a profit in the event of two or more rate hikes during that timeframe. Bottom Line: Investor optimism about U.S. growth and inflation will return in the coming months. Remain at below-benchmark duration and enter a short position in the July fed funds futures contract. Close short positions in the January contract for a small gain. Credit Spreads: When Good News Is Bad News Chart 7High Risk Of A Near-Term Selloff High Risk Of A Near-Term Selloff High Risk Of A Near-Term Selloff Renewed optimism on U.S. growth and inflation could ironically pose a problem for credit spreads, at least in the very short term. As we have often discussed in the context of our Fed Policy Loop,5 hawkish shifts in Fed policy tend to result in wider credit spreads and tighter financial conditions more broadly. Fortunately, these periods are usually short lived. Once financial conditions tighten, the Fed backs away from its hawkish stance, allowing financial conditions to ease once again. An extreme example of this dynamic is the 2014/15 selloff in credit markets. Of course, the plunge in oil prices and related stress in the energy sector was the chief catalyst, but what is often overlooked is that Fed rate hike expectations were also quite elevated during that period (Chart 7). It is the combination of stress in the energy sector and unsupportive Fed policy that resulted in the prolonged rise in spreads. A more benign example is the price action from this past March. Junk spreads widened from 344 bps on March 2 to 406 bps on March 22, as rate hike expectations ramped up heading into the March FOMC meeting. Ultimately, this period of spread widening represented a buying opportunity in credit markets. It is a March 2017 style selloff that we see as quite likely in the coming months as growth recovers by just enough to give the Fed cover for another rate increase. Bottom Line: Credit spreads are at risk of widening as Fed rate hike expectations ramp up in the second half of the year. But with inflation and inflation expectations still well below target, the Fed will ultimately be forced to remain supportive. We would therefore view any period of Fed-driven weakness in credit markets as a buying opportunity. Bank Bonds: Still A Strong Buy The Federal Reserve released the results of its annual bank stress tests last month and for once it did not object to the capital plans of any of the 34 participating bank holding companies, a recognition of the fact that banks have dramatically boosted their capital ratios since the first round of stress tests in 2009 (Chart 8). For the most part bank profit growth has also outpaced debt growth during this period, with the exception of last year when profit growth turned negative and debt growth surged (Chart 8, panel 2). A large portion of last year's increase in debt growth was likely a response to the new Total Loss Absorbing Capital (TLAC) regulations which require banks to issue a specified minimum amount of securities that can be easily written off in case of bankruptcy. This includes capital and long-term unsecured debt. Regardless, bank debt growth has already fallen back close to zero and we see upside for bank profits in the next 6-12 months. Meanwhile, non-financial corporate profits have had a much more difficult time outpacing debt growth in recent years (Chart 8, bottom panel). Bank Profits On The Rise A number of forward looking loan growth indicators suggest that credit and capital formation are on an upward trajectory (Chart 9). Our U.S. Equity Strategy service's proprietary Capex Indicator,6 consumer and business confidence, manufacturing new orders and our own C&I loan growth model all point to accelerating loan growth in the coming months. Net interest margins also have scope to widen. A recent blog post from the Federal Reserve Bank of New York7 showed that net interest margins are sensitive to both the level of interest rates and the slope of the yield curve (Chart 10). Lower rates and a flatter curve have both compressed margins in recent years. In addition, net interest margins tend to narrow when banks take less risk on the asset side of their balance sheets, we proxy this by showing banks' risk-weighted assets as a percent of total assets (Chart 10, bottom panel). Chart 8Bank Health Still Improving Bank Health Still Improving Bank Health Still Improving Chart 9Loan Growth Will Accelerate Loan Growth Will Accelerate Loan Growth Will Accelerate Chart 10A Higher, Steeper Curve Will Help NIMs A Higher, Steeper Curve Will Help NIMs A Higher, Steeper Curve Will Help NIMs Going forward, higher rates and a steeper yield curve8 will apply widening pressure to net interest margins. Similarly, risk-weighted assets have already risen considerably as a fraction of total assets and will increase further as the Fed starts to drain reserves from the banking system. Bank Bonds Are Still Cheap The truly remarkable thing is that even though banks have been raising capital while the non-financial sector has been taking on leverage, bank spreads still look attractive compared to most non-financial sectors after adjusting for credit rating and duration (Chart 11). This is true for both senior and subordinated bank debt. As can be seen in Chart 11, senior bank debt has a low duration-times-spread (DTS) compared to the overall index. This means that it acts as a "low-beta" sector, underperforming the investment grade benchmark during rallies and outperforming during selloffs. Conversely, subordinate bank bonds are a high-DTS sector. They tend to outperform during rallies and underperform during selloffs (Chart 12). Chart 11Corporate Sector Risk Vs. Reward* Summer Snapback Summer Snapback LegendCorporate Sector Abbreviations Summer Snapback Summer Snapback Chart 12Add "Beta" With Subordinate Bank Debt Add "Beta" With Subordinate Bank Debt Add "Beta" With Subordinate Bank Debt While we strongly recommend grabbing the extra spread available in both senior and subordinate bank debt relative to other similarly risky alternatives, subordinate bank bonds look particularly attractive in the current environment. This is because they both add some pro-cyclical risk ("beta") to a corporate bond portfolio and offer a spread advantage compared to other similarly risky bonds. Bottom Line: Banks continue to shore up their balance sheets and are also likely to see rising profits in the coming months. Meanwhile, bank bonds still offer a spread advantage compared to other similarly risky sectors. Remain overweight both senior and subordinate bank debt. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 These calculations assume population growth of 0.08% per month, or 1% per year. 2 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Equity Strategy Weekly Report, "Unfazed", dated June 12, 2017, available at uses.bcaresearch.com 7 http://libertystreeteconomics.newyorkfed.org/2017/06/low-interest-rates-and-bank-profits.html 8 For further details on the case for a bear-steepening yield curve please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The long-term interests of both Chinese policymakers and foreign investors are aligned regarding the Chinese onshore bonds. There is a strong case for higher demand for Chinese bonds going forward. The Bond Connect program may not immediately lead to a massive influx of foreign capital into the Chinese onshore bond market, but it holds the promise of improving the efficiency of China's financial system over the long run, making the economy less dependent on the banking sector for financial intermediation. Chinese domestic bonds will become increasingly more "investable" to foreigners, and investors' interest in Chinese bonds will only grow. This week we review some basics of this asset class. Feature The Bond Connect program, which launched early this week, has established another channel for foreign investors to tap into China's massive onshore bond markets. Like Chinese A shares' inclusion in the MSCI indices announced last month, the Bond Connect scheme offers little near term impact but marks yet another milestone in China's financial market liberalization. Together with some existing channels, the new program opens up China's vast fixed-income assets to world financial markets, which have yet to be explored by global investors. There is a clear case for rising interest among global investors in Chinese onshore bonds going forward. This also holds the promise of improving the efficiency of China's financial system over the long run. It Takes Two To Tango For Chinese regulators, the benefits of opening up the bond market to foreigners are straightforward. First, it helps develop a deep and more efficient bond market, which is instrumental in allowing market forces to set interest rates for the overall economy.1 Although already one of the largest in the world, the Chinese bond market is primarily for the government and government-related entities. Corporate issuers also tend to be state-owned enterprises, which overwhelmingly carry investment-grade ratings from local rating agencies - i.e. little differentiation in credit quality (Chart 1). The primitive state of the corporate bond market (and financial markets in general) is a key reason why China's financial resources are predominantly channeled by the banking sector. A key target of China's financial sector reforms is to improve the efficiency of financial markets and reduce the reliance on the banking sector. Along with the Bond Connect initiative, Chinese regulators also granted access to overseas rating agencies to its domestic bond market, which should also help Chinese investors properly price credit risks. Chart 1Outstanding Corporate Bonds##br## By Credit Ratings Embracing Chinese Bonds Embracing Chinese Bonds Second, it also facilitates further internalization of the RMB, as it offers a vast asset class for foreign investors to park their RMB exposure. A major consideration for the Chinese authorities to internationalize the RMB has been to reduce exchange rate risk for domestic entities both for trade and financing. Governments and companies in the developed world mostly issue bonds in their respective local currencies, while developing countries typically issue bonds in foreign "hard currencies" such as the dollar and the euro, which makes them vulnerable to exchange rate volatility. By joining the IMF Special Drawing Right (SDR) basket, the Chinese authorities aim to foster the RMB to be an international "hard currency." This, together with a sufficiently deep and efficient RMB bond market, allows Chinese corporate borrowers to issue local currency bonds that are immune to exchange rate fluctuations. Finally, there is clearly a short-term intention to support the RMB exchange rate. The newly established Connect program only allows for "northbound" flows, meaning foreigners are only able to purchase onshore bonds through Hong Kong. This is designed to offset domestic capital outflows and mitigate any downward pressure on the RMB exchange rate. A reciprocal "southbound" channel that allows domestic investors to purchase foreign bonds will inevitably be established. However, the timing will be contingent on conditions of cross-border capital flows and exchange rate performance. For foreign investors, the Connect program and onshore RMB bonds will also prove attractive. Unlike existing programs facilitating foreign bond purchases such as Qualified Foreign Institutional Investors (QFII), RMB QFII (RQFII) and foreign eligible institutions' direct participation in the onshore interbank bond market, the Bond Connect program bypasses China's often lengthy and complicated regulatory procedures, making it easier and more flexible for foreign investors to directly hold Chinese onshore bonds. Holding RMB fixed income assets offers diversification benefits. Foreigners' exposure to Chinese bonds is practically nonexistent, which will inevitably increase. It is worth noting that foreign holdings in most emerging countries' bonds have been rising over time, despite exchange rate fluctuations (Chart 2). The volatility of the RMB exchange rate against the dollar is the smallest among SDR currencies, and Chinese onshore bonds offer the highest yields - both of which will prove attractive for foreign bond investors over the long run (Chart 3). China's structurally higher economic growth should also deliver higher returns for investors over the long run. Chart 4 shows that total returns of Chinese stocks and bonds have been almost identical since 2004 (when Chinese bond data became available) - both of which significantly outperformed global benchmarks. However, the volatility of Chinese stocks has been much greater than bonds. In other words, Chinese bonds offer an attractive risk-return trade off for investors to capitalize on China's growth outlook. Chart 2Foreign Holdings Of Chinese Bonds ##br##Are Set To Grow Foreign Holdings Of Chinese Bonds Are Set To Grow Foreign Holdings Of Chinese Bonds Are Set To Grow Chart 3China's Yield Advantage China's Yield Advantage China's Yield Advantage Chart 4Chinese Bonds: A Long Term Play ##br##To Capitalize On Chinese Growth Chinese Bonds: A Long Term Play To Capitalize On Chinese Growth Chinese Bonds: A Long Term Play To Capitalize On Chinese Growth All in all, the Bond Connect program may not immediately lead to a massive influx of foreign capital into the Chinese onshore bond market. However, it is clear that the long-term interests of both Chinese policymakers and foreign investors are aligned, which builds a strong case for higher demand for Chinese bonds going forward. A Synopsis Of The Chinese Onshore Bond Market Regardless of any near-term considerations, Chinese domestic bonds, and onshore assets in general, will become increasingly more "investable" to foreigners, and investors' interest in Chinese bonds will only grow. It is useful to review some basics of this asset class. At the onset, China's total outstanding bonds currently stand at RMB 69 trillion, or US$10.2 trillion, the majority of which are issued by government and related entities (Table 1). Treasurys and bonds issued by policy banks are backed by the central government. Municipal bonds issued by local governments are not explicitly backed by Beijing, but in reality the odds of a local government defaulting on its bonds are very low. Bonds issued by the corporate sector account for about 20% of the market, but corporate issuers also tend to be state-owned enterprises. Bonds and Certificates of Deposits (CDs) issued by banks are also state-owned. The Bond Connect program allows foreigners to tap into Chinese onshore bonds traded in the interbank market (CIBM), where the majority of Chinese bond transactions take place. CIBM hosts about 70% of total Chinese onshore bonds, while the rest are listed on securities exchanges and over-the-counter (OTC) markets (Chart 5). Chinese bonds are primarily held by commercial banks (and credit co-ops), accounting for about 65% of total outstanding bonds. In recent years, investment funds have become increasingly active, currently holding 15% of the market, compared with 10% three years ago. This, together with increasing foreign participation, will over time help improve the efficiency of the onshore bond market. Table 1Chinese Bond Market Breakdown Embracing Chinese Bonds Embracing Chinese Bonds Chart 5Where Are The Bonds Traded? Embracing Chinese Bonds Embracing Chinese Bonds Bond issuance increased sharply in previous years, mostly boosted by municipal bonds and more recently by banks' CDs (Chart 6). The Chinese authorities' regulatory tightening to rein in financial excesses has led to a notable slowdown in overall bond issuance, which is likely to be temporary.2 Overall, the country's financial reforms will continue to encourage bond issuance and reduce the economy's overreliance on the banking sector for financial intermediation. Chart 6The Growing Importance Of Bond Market Embracing Chinese Bonds Embracing Chinese Bonds The importance of bond issuance for the corporate sector to raise capital has been increasing in recent years, but is still marginal. Currently, corporate bond issuance accounts for over 10% of total social financing (TSF), up from practically zero in the early 2000s (Chart 7). As stated earlier, corporate bonds are primarily issued by state-owned enterprises or listed firms, while small and private enterprises' access to bond issuance is still very restrictive. Maturities of the majority of Chinese corporate bonds are less than five years, while long-dated corporate bonds are rare. Corporate bonds with over 10-year maturities account for about 1% of total outstanding bonds (Chart 8). Chart 7The Growing Importance Of Corporate Bonds The Growing Importance Of Corporate Bonds The Growing Importance Of Corporate Bonds Chart 8Maturity Profile Embracing Chinese Bonds Embracing Chinese Bonds China's bond market liberalization measures have allowed some ETFs to be established to track the onshore bond market - a trend that is set to accelerate going forward with the latest Bond Connect scheme (Table 2). Onshore bonds will likely follow A shares to progressively enter major international bond indexes over time, which will further stoke global investors' interest. Table 2ETFs For Chinese Onshore Bonds Embracing Chinese Bonds Embracing Chinese Bonds An Update On The Chinese Economy Chart 9The Economy Will Remain Resilient The Economy Will Remain Resilient The Economy Will Remain Resilient Recent growth numbers from China confirm that the economy has remained resilient amid the regulatory crackdown by Chinese regulators. Both official and privately sourced manufacturing PMI numbers have improved, and both have moved above the 50 threshold. The regained momentum is also reflected in the rebound in raw materials prices in the global market (Chart 9, top panel). The regained strength in the Chinese economy, in our view, is probably due to easing in monetary conditions, primarily through the exchange rate. Although the RMB has stopped depreciating against the dollar of late, it has relapsed in trade-weighted terms, thanks to weakness in the greenback. This has led to a period of easing in monetary conditions, which in turn has helped the economy reflate (Chart 9, bottom panel). Looking forward, we maintain the view that China's business activity will remain reasonably buoyant. It is not realistic to expect growth figures, measured by year-over-year growth rates, to accelerate in perpetuity, but downside risks in the economy will remain low. China's growth improvement since early last year was primarily due to easing in monetary conditions rather than a massive dose of fiscal and monetary stimuli,3 and it is highly unlikely that the authorities will tighten their overall policy stance significantly, causing major growth problems. As such, we remain positive on both the economy and Chinese H shares. Overall, China's growth performance has been largely in line with our expectations outlined in our 2017 outlook report published in January.4 We will offer a mid-year revisit on the cyclical trends of the economy and financial markets next week. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Chinese Financial Tightening: Passing The Phase Of Maximum Strength," dated June 22, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Chinese Financial Tightening: Passing The Phase Of Maximum Strength," dated June 22, 2017 available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, “A Chinese Slowdown: How Much Downside?” dated June 08, 2017 available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report, "China: The 2017 Outlook, And The Trump Wildcard," dated January 12, 2017 available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights The euro area's structural growth prospects (adjusted for demographics) are no different to any other developed economy such as the U.K., U.S. or Japan. Liberated from the headwinds of its own policy errors, the euro area's relative growth is now transitioning from a down-cycle to a multi-year up-cycle, and this brings three multi-year investment implications: Underweight German bunds and French OATs, both in a European bond portfolio and in a global bond portfolio. Overweight the euro, specifically euro/dollar and euro/yuan. Overweight euro area retailers versus U.S. retailers. Feature Over the past 20 years or so, every major European country has at one time or another been given the dubious title 'the sick man of Europe'. Chart of the Week AAfter 2008, Everybody Recapitalised Their Banks... After 2008, Everybody Recapitalised Their Banks... After 2008, Everybody Recapitalised Their Banks... Chart of the Week B...Except Italy ...Except Italy ...Except Italy Remarkable as it sounds today, in the early 2000s the sick man was Germany - whose economy suffered recurring stalls; in 2007 it was Portugal; then in the aftermath of the Great Recession the sick man title went at different points in 2009 to the U.K. and to Spain, as both economies struggled to bounce back from the downturn. Thereafter, the title has variously gone to Ireland, Finland, France, and Italy. In most cases, the sick man title mistakes a cyclical problem for a structural problem. So when the cyclical weakness ends, the country shakes off the dubious title. Another common mistake is rushing to judgement on the wrong analysis. The best example of this is Japan. You may be familiar with Japan's so-called 'lost decades' or the term 'Japanification' used as a pejorative. The trouble is that the perception of such lost decades is outright wrong! The truth is that over the past two decades Japan's growth in real GDP per head, at 34%, is the best among major developed economies, easily outperforming Germany, the U.K. and the U.S. (Chart I-2). Chart I-2What Lost Decades? Japan Has Outperformed Everybody Else What Lost Decades? Japan Has Outperformed Everybody Else What Lost Decades? Japan Has Outperformed Everybody Else The point is that to level the playing field for countries' different demographic profiles, it is important to compare growth on a per head basis. Real growth per head is what determines improvement in wellbeing and living standards and the best resolution of indebtedness for society as a whole. High nominal growth via inflation may sound appealing to a highly indebted society, but it is over-simplistic. One person's debt is another person's asset, so inflation reduces the burden on half of society - the debtors - by robbing the other half - the creditors. Which isn't necessarily good for society as a whole. Can Italy Recover? This brings us to Europe's current 'sick man', Italy. Some people claim that Italy has underperformed through the full 18 years of the euro. Not true. Based on the all-important real GDP per head metric, Italy was performing more or less in line with the other major developed economies until the Great Recession (Chart I-3). Still, an underperformance that started at the Great Recession means it has lasted almost nine years. So can Italy really be a cyclical 'sick man' - or in this case, is something structural at work? In The Euro's 18th Birthday: Why Isn't Italy Partying?1 we suggested that the root cause of Italy's nine year problem is its still undercapitalised and dysfunctional banking system. This has paralysed an economy heavily dependent on small and medium sized enterprises (SMEs), and their access to bank financing. We can say this with conviction for two reasons. Can it really be just coincidence that Italy is the only major economy that has not recapitalised its banks after the 2008 crisis, and that its underperformance began at exactly the same moment (Chart of the Week)? And can it really be just coincidence that as soon as Spain substantially recapitalised its banks in 2013, the Spanish economy made a remarkable transformation from sick man to strapping health2 (Chart I-4)? To us, these are not coincidences. They pinpoint the root of Italy's problem and solution. Chart I-3Italy Did Not Underperform ##br##Until The Great Recession Italy Did Not Underperform Until The Great Recession Italy Did Not Underperform Until The Great Recession Chart I-4Spain Recovered Strongly As##br## Soon As Its Banks Were Recapitalised Spain Recovered Strongly As Soon As Its Banks Were Recapitalised Spain Recovered Strongly As Soon As Its Banks Were Recapitalised The good news is that Italy is progressing to a solution, albeit slowly. Last week's relatively trouble-free winding down of the failing Banca Popolare di Vicenza and Veneto Bank showed that the ECB, Brussels and the Italian government are on the same page. A pragmatic solution let institutional investors suffer losses while protecting 'widows and orphans' retail investors with public money. In Italy, with many retail investors owning banks' senior bonds, this is the politically acceptable way to go. And at the current rate of resolution, we estimate that the further €50-75 billion of recapitalisation required can be finished within a year. If Italy can get through its next general election without a shock, it will be on the road to a long-term recovery. Euro Area: Don't Mistake A Cyclical Problem For A Structural Problem To reiterate, one of the biggest mistakes in economics and investment is to mistake a cyclical problem for a structural problem. This is especially true when two cyclical downturns come in quick succession. The resulting extended period of poor performance inevitably feels like something structural rather than something cyclical. Many commentators regard the poor performance of the euro area economy since 2008 as evidence of a structural malaise. But the bigger picture does not support this thesis. Through the 18 year lifetime of the monetary union, the euro area and the U.S. have generated identical growth in real GDP per head (Chart I-5). Chart I-5Since The Euro's Birth, The Euro Area And##br## U.S. Have Produced Identical Growth Since The Euro"s Birth, The Euro Area And U.S. Have Produced Identical Growth Since The Euro"s Birth, The Euro Area And U.S. Have Produced Identical Growth Within this bigger picture, the euro area has underperformed through multi-year periods encompassing around half of the 18 years. And it has outperformed through the multi-year periods encompassing the other half. Seen in this light, the post-2008 phase of poor performance is really the impact of back to back recessions separated by an unusually short gap - with the second of the two recessions the direct result of policy errors specific to the euro area. First, the ECB resisted taking on its critical role as lender of last resort to solvent but illiquid sovereign borrowers, thereby enflaming a containable liquidity crisis into an almost uncontainable and catastrophic solvency crisis. Then, when the ECB ultimately relented, a protracted stress test of European banks forced lenders to shrink their assets, effectively paralysing an economy heavily dependent on bank finance. Still, the euro area does not have a monopoly when it comes to damaging policy errors and misanalysis. We tend to have short memories, but let's not forget former U.K. Finance Minister and Prime Minister Gordon Brown's claim that the boom-bust cycle had been abolished, justifying a much lighter touch regulation of the financial system through the early 2000s. Or Ben Bernanke's now infamous misanalysis of the U.S. housing market in 2005: "Well, I guess I don't buy the premise that U.S. house prices will come down substantially. It's a pretty unlikely possibility..." These observations are not meant to criticise, but just to illustrate that policymakers are not omniscient. They understand the economy and financial markets little more than we do. Furthermore, political constraints often limit their room for manoeuvre, forcing the policy errors. Policy Error Now More Likely Outside The Euro Area Looking ahead to the next few years, our sense is that the risk of policy error is now greater outside the euro area than inside. Specifically, the still uncertain trajectories of Brexit and of the Trump administration are likely to have their greatest disruptive impacts in the U.K. and U.S. respectively. Our broad thesis is that the euro area's structural growth prospects (adjusted for demographics) are no different to any other developed economy such as the U.K., U.S. or Japan. And liberated from the headwinds of its own policy errors, the euro area's relative growth is now transitioning from a down-cycle to a multi-year up-cycle. Which brings three multi-year investment implications: Underweight euro area government bonds, specifically German bunds and French OATs, both in a European bond portfolio and in a global bond portfolio (Chart I-6 and Chart I-7). Overweight the euro, specifically euro/dollar and euro/yuan. For equities, the translation to the headline euro area index, the Eurostoxx50 is somewhat complicated by its dominant sector skew (overweight banks, underweight technology) which tends to drive relative performance. Instead, we find that in recent years the relative performance of the more domestic-focussed retailers has closely tracked relative economic performance (Chart I-8). Hence, overweight euro area retailers versus U.S. retailers. Chart I-6Relative Bond ##br##Yields... Relative Bond Yields... Relative Bond Yields... Chart I-7...Must Follow Relative##br## Economic Performance ...Must Follow Relative Economic Performance ...Must Follow Relative Economic Performance Chart I-8Retailers Relative Performance Tracks##br## Relative Economic Performance Retailers Relative Performance Tracks Relative Economic Performance Retailers Relative Performance Tracks Relative Economic Performance Please note there will be no report next week. Our next report will come out on July 20. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Published on June 1, 2017 and available at eis.bcaresearch.com 2 Spain's real GDP per head has grown by over 12% since its trough in 2013. Fractal Trading Model* Long nickel / short palladium has achieved its 10% profit target, and is now closed, leaving four open positions. There are no new trades this week. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 Long Nickel / Short Palladium Long Nickel / Short Palladium * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Global Growth: Global bond yields have fallen in a coordinated fashion among the major economies, even with only a modest cooling of growth momentum and realized inflation outcomes. With little sign of an imminent downturn in growth on the horizon, government bonds now look a bit expensive. Global Inflation: Inflation expectations in the major economies have fallen too far relative to underlying non-energy inflation pressures. With oil prices likely to begin rising again as the demand-supply balance in global energy markets tightens up, both realized inflation and expectations should move higher in the latter half of the year, especially in the U.S. Bond Market Strategy: Markets are pricing in too few rate hikes in the U.S., leaving U.S. Treasuries exposed to higher yields in the next 3-6 months. Yields should also rise in core Europe, although not by as much as in the U.S. with the ECB not yet ready to turn less dovish. Stay underweight U.S., neutral core Europe and overweight Japan in global government bond portfolios. Feature Have bond investors now become too pessimistic on global growth and inflation prospects? This is a question worth asking after the sharp decline in longer-dated government bond yields witnessed since the peak in mid-March. The benchmark 10-year yield has fallen during that period by -43bps in the U.S., -21bps in Germany, -24bps in the U.K., -45bps in Canada and -54bps in Australia. Granted, there has been a bit of softer news on both growth and, more importantly, inflation readings in several economies in the past couple of months. Those pullbacks, however, have been relatively modest compared to the severe bull-flattening bond rally seen in most developed economies (Chart of the Week). Chart of the WeekAn Overreaction From Bond Investors An Overreaction From Bond Investors An Overreaction From Bond Investors Global leading economic indicators are still pointing to faster growth over the latter half of the year, led by easing financial conditions given booming equity and credit markets. With most major economies either at full employment (U.S., U.K., Japan, Australia) or approaching full employment (Euro Area, Canada), accelerating growth will ensure that the recent downtick in global inflation will not persist for long - especially if oil prices begin to move higher again as our commodity strategists expect. This week brings several major central bank meetings with an opportunity to change the bullish tone in the bond markets. The Federal Reserve, the Bank of England (BoE) and the Bank of Japan (BoJ) all meet, although only the Fed is expected to deliver another rate hike that is now heavily discounted in the markets. The BoE's hands are now effectively tied, even with high U.K. inflation, after last week's election outcome where the ruling Conservatives lost their majority government, thus ensuring even more uncertainty over the contours of the Brexit process. The BoJ is also stuck in a bind, with surprisingly strong Japanese economic growth but shockingly weak inflation. This is also the situation that the European Central Bank (ECB), Bank of Canada and Reserve Bank of Australia are facing, to a lesser extent: solid domestic growth but without enough inflation to force any immediate tightening of monetary policy. These sorts of mixed messages and conflicting signals also exist in the bond markets in the developed world, as we discuss in this Weekly Report. Our conclusion is that yields have now priced in too much pessimism and the balance of risks points to yields rising again in the months ahead, led by U.S. Treasuries. A Big Move In Yields For Such A Small Change In Growth... Looking at the change in government bond yields within the major developed markets since the peak on March 13th (Table 1) shows a few important facts: Table 1A Bull Flattening Of Global Yield Curves Since March Alternative Facts In The Bond Market Alternative Facts In The Bond Market The largest yield declines were in the U.S., Canada & Australia; The smallest declines were in the U.K., the Euro Area and Japan - unsurprisingly, the countries where central banks are engaged in large bond purchase programs; Lower market-based inflation expectations have played a role in the bond rally, coinciding with softer energy prices and declines in realized inflation outcomes; Real yields (i.e. nominal yields minus inflation expectations) have fallen sharply in the U.S., Canada & Australia; Yield curves have bull-flattened everywhere; Breaking the curve moves into real yield and inflation expectations components shows that both contributed to the flatter yield curves. The U.S. Treasury action stands out compared to the others. There has also been a 103bp flattening in the 2-year/10-year TIPS real yield curve, while the TIPS breakeven curve has steepened by 64bps. This is the result of the -89bp drop in 2yr breakevens, which now sit at 1.38% - well below the current U.S. headline CPI inflation rate of 2.2%. Even allowing for any potential liquidity issues that can distort the precise interpretation of shorter-dated TIPS breakevens, the market appears to be expecting a bigger drop in inflation in the next couple of years than both the Fed and the Bloomberg consensus of economic forecasters (Table 2).1 This U.S. move stands out relative to the other countries, where there has been very little change in 2-year inflation expectations (using CPI swaps instead of breakeven rates from inflation-linked bonds). With the headline U.S. unemployment rate now at a cyclical low of 4.3%, and with the broader U-6 measure, now down to a decade low of 8.4%, we anticipate a recovery in realized inflation, and TIPS breakevens, in the next few months. The source for the broader downturn in global inflation expectations is a bit of a mystery. While some cyclical global growth indicators like manufacturing PMIs have fallen a bit in some countries, most notably the U.S. and China, they are still at strong levels above 50 that point to faster economic growth (Chart 2). Leading economic indicators (LEIs) are also still pointing to some acceleration in the latter half of 2017 although, admittedly, the list of countries with rising LEIs has been diminishing in recent months. We see that as a potential sign of slower growth next year, but not for the rest of 2017. Table 2Consensus Growth & Inflation Forecasts Alternative Facts In The Bond Market Alternative Facts In The Bond Market Chart 2Global Economic Upturn Still Intact bca.gfis_wr_2017_06_14_c2 bca.gfis_wr_2017_06_14_c2 Bottom Line: Global bond yields have fallen in a coordinated fashion among the major economies, even with only a modest cooling of growth momentum and realized inflation outcomes. With little sign of an imminent downturn in growth on the horizon, government bonds now look a bit expensive. ...And Inflation Of course, some of the decline in inflation expectations can be attributed to softer readings on realized inflation over the past few months. Yet the markets seem to have overreacted a bit to that move, as well. The run of stronger-than-expected inflation outcomes has taken a breather in both the developed and emerging world, as evidenced by the rolling over of the Citigroup inflation surprise indices (Chart 3). Yet those indices remain at high levels and are not pointing to a meaningful, extended pullback in realized inflation. Chart 3Global Inflation Data Has Cooled A Bit Global Inflation Data Has Cooled A Bit Global Inflation Data Has Cooled A Bit The pullback in global energy prices since March has played a role in softer headline inflation in most countries. That decline has been part of a broader move lower in commodity prices that is likely related to less reflationary monetary and fiscal policies out of the world's biggest commodity consumer, China. However, our colleagues at BCA Commodity & Energy Strategy have noted that export and import volumes in the emerging economies accelerated sharply in the first quarter of 2017. Given that there is a strong correlation between trade volumes and oil demand in the emerging markets, this bodes well for a rebound in global oil demand. Combined with the "OPEC 2.0" production cuts, the demand-supply balance in world oil markets is likely to turn positive in the months ahead, which will allow oil prices to return to a range close to $60/bbl by year-end.2 A move in oil prices back to that level would help arrest the downturn in overall commodity price indices, and help stabilize goods CPI inflation in the developed economies in the latter half of 2017 (Chart 4). This should help boost global inflation expectations, and eventually bond yields, as the downturn in energy prices has shown very little pass-through into non-energy inflation in the developed world (Chart 5). Chart 4Disinflationary Impulse##BR##From Energy Will Soon Fade... Disinflationary Impulse From Energy Will Soon Fade... Disinflationary Impulse From Energy Will Soon Fade... Chart 5...Although The Impact On##BR##Inflation Has Been Modest ...Although The Impact On Inflation Has Been Modest ...Although The Impact On Inflation Has Been Modest Yet that stability of non-energy inflation visible in the charts masks many of the cross-currents seen across countries and within countries. Services CPI inflation remains strong in the U.S. at 3%, and has accelerated to 2% in both the U.K. and the Euro Area (Chart 6). Yet at the same time, both services and core inflation are falling rapidly towards 0% in Japan, despite a solid economic upturn and tight labor market. The situation is even more confusing in Canada, where wage inflation has fallen to below 1% but services inflation has picked up to 3%. Australia is in a similar boat, with services inflation above 3% but wages growing at only 2%. The divergence between the inflation outcomes across the countries can also be seen in our headline CPI diffusion indices, which measure the number of CPI sectors that are witnessing accelerating rates of inflation. The diffusion indices in the U.S., Japan and Canada are all at low levels, with the majority of CPI components seeing slowing rates of inflation, yet overall inflation seems to be holding up well despite the breadth of the "downturn", at least based on past correlations (Chart 7). The opposite is true in the Euro Area and Australia, where a majority of inflation components are growing faster, yet overall inflation is only moving slowly higher. Only in the U.K. is there a clear robust rise in the breadth of inflation (90% of CPI components accelerating) and overall inflation (headline CPI expanding at around 3%). Chart 6Underlying Inflation Has Not##BR##Slowed Much (Except In Japan) Underlying Inflation Has Not Slowed Much (Except In Japan) Underlying Inflation Has Not Slowed Much (Except In Japan) Chart 7Mixed Signals From The##BR##Global CPI Diffusion Indices Mixed Signals From The Global CPI Diffusion Indices Mixed Signals From The Global CPI Diffusion Indices Given all these diverging signals within the national inflation data, we are surprised that there has been such a uniform decline in inflation expectations across the major bond markets. That leads us to look to the oil price decline as the main cause of the lower expectations, rather than a more pernicious drop caused by expectations of slowing economic growth and cooling domestic inflation pressures. Given the BCA view that oil prices have likely reached bottom and will begin to move higher, the decline in global inflation expectations is likely to also end soon. Bottom Line: Inflation expectations in the major economies have fallen too far relative to underlying non-energy inflation pressures. With oil prices likely to begin rising again as the demand-supply balance in global energy markets tightens up, both realized inflation and expectations should move higher in the latter half of the year, especially in the U.S. Bond Market Strategy For The Second Half Of 2017 The outlook for government bond yields in the remaining months of the year will be driven by decent global growth and rising inflation expectations. Our Central Bank Monitors continue to point to the need for tighter monetary policy in every major developed market excluding Japan (Chart 8), leaving bond yield exposed to any unexpected moves from central bankers. This is especially problematic in the U.S., where fed funds futures now discount only a 25-30% probability of a Fed rate hike in September and December after the expected hike at this week's FOMC meeting (Chart 9). With the U.S. OIS curve pricing in only 48bps of hikes over the next 12 months, the Treasury market is exposed to a Fed moving more aggressively in meetings later in 2017. Chart 8Our Central Bank Monitors Still##BR##Calling For Tighter Policy (Ex Japan) Our Central Bank Monitors Still Calling For Tighter Policy (Ex Japan) Our Central Bank Monitors Still Calling For Tighter Policy (Ex Japan) Chart 9Markets Will Be Surprised##BR##By The Fed Later This Year Markets Will Be Surprised By The Fed Later This Year Markets Will Be Surprised By The Fed Later This Year In Europe, the ECB talked up a more positive economic growth story at last week's policy meeting, eliminating the language suggesting that rate cuts would be necessary because the growth recovery was still fragile. No signal was given about slowing the pace of ECB asset purchases, which was not a surprise given the still-low readings on core inflation in the Euro Area. The ECB did slightly downgrade its inflation projections for the next two years, with core inflation now expected to rise to 1.8% by 2019. Our Months-to-Hike measure for the Euro Area now out to 29 months, indicating that the first ECB rate hike is now expected in November of 2019 (Chart 10). Our view remains that the ECB will look to taper asset purchases before contemplating any rate hikes, and will likely signal a move to slow the pace of bond buying at the September policy meeting. While we agree that a rate hike is unlikely until 2019, the current market pricing does leave European bond markets exposed to any upside surprises in inflation over the next year. For now, we continue to recommend a neutral allocation to core European government bonds, with a curve steepening bias, while focusing Peripheral exposure on Spain relative to Italy. We envision moving to underweight Europe over the summer if the growth and inflation data continue to point to an eventual ECB taper, especially given the strong comparisons between Europe now and the pre-Taper Tantrum period in the U.S. in 2012-13 (Chart 11). Chart 10No ECB Hikes##BR##Expected Until 2019 No ECB Hikes Expected Until 2019 No ECB Hikes Expected Until 2019 Chart 11Bunds Still Following The U.S.##BR##Post-QE Experience Bunds Still Following The U.S. Post-QE Experience Bunds Still Following The U.S. Post-QE Experience In Japan, we expect the BoJ to continue to target a 0% 10yr JGB yield for some time, in order to ensure that there is enough currency weakness to keep headline inflation from decelerating (Chart 12). This will especially be true if our call for higher U.S. interest rates comes to fruition and USD/JPY begins moving higher again. We continue to recommend an overweight position on Japan with government bond portfolios, given the low yield beta of JGBs to the other bond markets (Chart 13). Chart 12The BoJ Will Do "Whatever It Takes"##BR##To Keep The Yen Soft The BoJ Will Do "Whatever It Takes" To Keep The Yen Soft The BoJ Will Do "Whatever It Takes" To Keep The Yen Soft Chart 13Stay Overweight##BR##Low-Beta JGBs Stay Overweight Low-Beta JGBs Stay Overweight Low-Beta JGBs Finally, we continue to recommend long CPI swaps positions in both the Euro Zone and Japan, and an overweight in U.S. TIPS versus nominal Treasuries, as a way to play for the rebound in global inflation expectations that we are expecting over the balance of 2017. However, given the disturbing downturn in core inflation readings in Japan, we are implementing a tight stop-loss level at 0.4% on our long 10yr Japan CPI swaps position (Chart 14). Chart 14Stay Long CPI Swaps##BR##In Europe & Japan (With A Stop) Stay Long CPI Swaps In Europe & Japan (With A Stop) Stay Long CPI Swaps In Europe & Japan (With A Stop) Bottom Line: Markets are pricing in too few rate hikes in the U.S., leaving U.S. Treasuries exposed to higher yields in the next 3-6 months. Yields should also rise in core Europe, although not by as much as in the U.S. with the ECB not yet ready to turn less dovish. Stay underweight U.S., neutral core Europe and overweight Japan in global government bond portfolios. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The FOMC projections for growth in the headline Personal Consumption Expenditure (PCE) deflator from the latest set of forecasts released in March called for inflation of 1.9% in 2017 and 2.0% in 2018. The gap between the headline measures of CPI inflation and PCE deflator inflation has averaged about 50bps in recent years, so that implies that the Fed is expecting CPI inflation to be much higher than the 1.38% 2-year TIPS breakeven. 2 Please see BCA Commodity & Energy Strategy Weekly Report, "Strong EM Trade Volumes Will Support Oil", dated June 8 2017, available at ces.bcaresearch.com. Recommendations Alternative Facts In The Bond Market Alternative Facts In The Bond Market Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns