Emerging Markets

Highlights A unified push among central banks to drop their currencies inevitably leads to lower interest rates, which eventually sows the seeds of a recovery. However, with prospects of a full-blown trade war in front view, fundamentals could be put to the wayside for longer, as markets keep the switch on risk aversion. The new round of tariffs could pin USD/CNY at about 7.3-7.4, given the impact from negative feedback loops. The breakdown in the AUD/JPY cross is precarious. Stay short USD/JPY, but focus on the crosses rather than on outright bets versus the dollar. The RBNZ’s dovish surprise was a positive catalyst for our AUD/NZD and SEK/NZD positions. Remain long. Feature Chart I-1Summer Blues Summer Blues Summer Blues Just as summer trading volumes are falling close to new lows, central banks appear to be weaponizing their exchange rates in a renewed currency war salvo. Both the Reserve Bank of India (RBI) and the Reserve Bank of New Zealand (RBNZ) surprised market participants this week by slashing rates by more than expected. In retrospect, the European Central Bank probably fired the first shot at its forum in Sintra, Portugal this June. ECB President Mario Draghi highlighted back then that if the inflation outlook failed to improve, the central bank had considerable headroom to launch a fresh expansion of its balance sheet. What has followed is a renewed wave of dovishness by global central banks, which should intensify, given the latest flare-up in the trade war. For currency strategy, this means fundamentals could be temporarily put to the wayside, as markets keep the switch on risk aversion (Chart I-1). This is because there is little visibility on either the political or the economic front. Our strategy remains three-fold: First, maintain tight stops on tactical positions. Second, we prefer trades at the crosses rather than versus the dollar, for now. Finally, maintain portfolio insurance by being short the USD/JPY. USD/CNY And The Economics Of Tariffs Chart I-2Sino-U.S. Trade Is Small Relative To Domestic Demand Sino-U.S. Trade Is Small Relative To Domestic Demand Sino-U.S. Trade Is Small Relative To Domestic Demand Standard theory suggests that exchange rates should move to equalize prices across any two countries. The question that naturally follows is by how much? The answer is that the exchange rate should move by exactly the same percentage point as the price change, everything else equal. If both countries produce homogeneous goods, then it is easy to see why, since there is perfect substitution. All demand will flow to one country, until its currency rises by enough to equalize prices across borders again. However, assume countries ‘A’ and ‘B’ produce heterogeneous goods (‘A’ being the U.S. in this case, and ‘B’ China). Then the loss of purchasing power in Country ‘A’ will lead to less demand for Country ‘B’’s goods. The former loses purchasing power because prices of imports have increased by the amount of the tariff. This means the latter’s currency will have to adjust downwards for the markets to clear. The decrease has to match the magnitude of the price increase, if there are no other outlets to liquidate Country ‘B’’s goods. This is obviously a very simplified version of the real world economy, but it highlights an important point that is central to the discussion: The currency move necessary to realign competitiveness will always be equal to, or less than, in percentage point terms, to the price increase. In the case where the entire production base is tradeable, it will be the former. But with a rise in the number of trading partners, a more complex export basket, import substitution, shipping costs, and many other factors that influence tradeable prices, the currency adjustment needed should be smaller. Since the onset of 2018, the U.S. has slapped various tariffs on China, the latest of which is 10% on $300 billion worth of Chinese goods. The U.S. currently imports $509 billion worth of goods from China, about 16% of its total imports. However, as a percentage of overall U.S. demand, this only represents 2.4% (Chart I-2). This suggests that at best, a 25% tariff on all Chinese imports will only lift import prices by 4% and consumer prices by much less. On the Chinese side of the equation, exports to the U.S. account for 18.4% of total exports, a ratio that has been falling since 2018. Therefore, a tariff of 25% should only lift export prices by 4.5%. The conclusion is that the yuan and the dollar only need to adjust by 4-5% to negate the impact of a 25% tariff. Part of the rise in the dollar and fall in the RMB has been due to tariffs, but it has mostly been due to the fact that global trade has been slowing. This brings us to an important point: Part of the rise in the dollar and fall in the RMB has been due to tariffs, but it has mostly been due to the fact that global trade has been slowing (Table I-1). The DXY index is up 10% since its 2018 trough, while the USD/CNY has risen by 12%. This is much more than economic theory would suggest. In quantity terms, the IMF estimated that a 20% import tariff from East Asia would lift the U.S. dollar’s REER by 5% over five years, while dropping output by 0.6% over the same timeframe.1 But if past is prologue, the new round of tariffs will pin USD/CNY at about 7.3-7.4, given the impact from negative feedback loops – mainly a slowing global economy and a slowing Chinese economy. Chart I- With no corresponding export subsidy for U.S. goods, however, the rise in the dollar makes exporters worse off. And with over 40% of S&P 500 sales coming from outside the U.S., this will make a meaningful dent in corporate profits. This is an important political impediment. Historically, trade wars are usually synonymous with recessions. As such, there are acute political constraints inching both sides towards an agreement. A Disorderly Breakdown Or Steady Depreciation? The RMB has been trading like a pro-cyclical currency, meaning it is becoming an important signaling mechanism for the evolution of the cycle. The USD/CNY has been moving tick-for-tick with emerging market equities, Asian currencies, and even some commodity prices (Chart I-3). It has also closely mirrored the broad trade-weighted dollar (Chart I-4). This has implications for developed market currencies, especially those tied to Chinese demand. Therefore, it will be important to see if the RMB has a disorderly breakdown towards 7.4 or if it stabilizes at higher levels. A few barometers will be key to watch: Chart I-3The Yuan Is Pro-cyclical The Yuan Is Pro-cyclical The Yuan Is Pro-cyclical Chart I-4Is The Dollar Headed Higher? Is The Dollar Headed Higher? Is The Dollar Headed Higher? In a world of rapidly falling yields, Chinese rates remain attractive. Historically, USD/CNY has moved in line with interest rate differentials between the U.S. and China. The current divergence is unsustainable (Chart I-5). Typically, offshore markets have had a good track record of anticipating depreciation in the yuan. Back in 2014, offshore markets started pricing in a rising USD/CNY rate, and maintained that view all the way through to 2018, when the yuan eventually bottomed. Right now, not much depreciation is being priced in (Chart I-6). The reason offshore markets in Hong Kong and elsewhere can be prescient is because more often than not, they are the destination for illicit flows out of China. Chart I-5The Chinese Bond Market Is Attractive The Chinese Bond Market Is Attractive The Chinese Bond Market Is Attractive Chart I-6Forward Markets Not Concerned As In 2015 Forward Markets Not Concerned As In 2015 Forward Markets Not Concerned As In 2015 Chinese money and credit growth, especially forward-looking liquidity indicators such as M2 relative to GDP, have bottomed. Historically, this led the cycle by a few months. The drop in Chinese bond yields is also reflationary, and should soon stimulate imports, especially if the improvement in exports continues (Chart I-7). Chinese government expenditures are likely to inflect higher, especially given acute weakness in the July manufacturing data. Again, this suggests stimulus this time around may be more fiscal than monetary (Chart I-8). In addition, the recent VAT cuts for manufacturing firms, a cut to social security contributions, and a pickup in infrastructure spending are all net positives. Chart I-7Trade War Extends Traditional Lags Trade War Extends Traditional Lags Trade War Extends Traditional Lags Chart I-8Government Spending Set To Increase Government Spending Set To Increase Government Spending Set To Increase The housing market remains healthy. A revival in the property market will support construction activity and investment. House prices have been rising to the tune of 10% year-on-year, and real estate stocks in China remain firm relative to the overall index. If house prices roll over, this will be a negative development (Chart I-9). The housing market remains healthy. A revival in the property market will support construction activity and investment. If house prices roll over, this will be a negative development. In terms of market dynamics, the AUD/JPY cross breached the important technical level of 72 cents, but has since recovered. This is important, since the cross failed to break below this level both during the euro area debt crisis in 2011-2012 and the China slowdown of 2015-2016. It will be especially important to see a clear breach to signal we are entering a deflationary bust (Chart I-10). Chart I-9China Housing Is Fine China Housing Is Fine China Housing Is Fine Chart I-10AUD/JPY Breakdown Is Precarious AUD/JPY Breakdown Is Precarious AUD/JPY Breakdown Is Precarious Bottom Line: We are watching a few key reflationary indicators to gauge whether it pays to be contrarian. The message is that it is not time yet, given the ramp-up in the trade war rhetoric.  Notes On The RBNZ Chart I-11AUD/NZD Is Cheap AUD/NZD Is Cheap AUD/NZD Is Cheap This week, the RBNZ surprised markets by cutting interest rates by 50 basis points to parity (expectations were for a 25-basis-point cut). From an external standpoint, this makes sense. Australia and China are New Zealand’s biggest trading partners, and have been easing policy much earlier. The RBNZ’s bet was that demand was probably going to recover by now. The latest salvo in the trade war probably dashed those hopes. Meanwhile, over the last 35 years, the AUD/NZD cross has spent more than 95% of the time over 1.06. With the AUD/NZD near record lows, the cross is cheap on a real effective exchange rate basis (meaning NZD is expensive) (Chart I-11).  This suggests that even though interest rates are aligning in both Australia and New Zealand, the Aussie should be 11% higher relative to the Kiwi because of the valuation starting point (Chart I-12). The market remains more dovish on Australia relative to New Zealand, in part due to a more accelerated downturn in house prices and a significant slowdown in China. The reality is that the downturn in Australia has allowed some cleansing of sorts, and brought it far along the adjustment path relative to New Zealand. Economic data in New Zealand are now converging to the downside relative to Australia (Chart I-13). Chart I-12Interest Rates Could Move In Favor Of AUD Interest Rates Could Move In Favor Of AUD Interest Rates Could Move In Favor Of AUD Chart I-13New Zealand Has More Economic Downside New Zealand Has More Economic Downside New Zealand Has More Economic Downside The RBNZ began a new mandate on April 1st to include full employment in addition to inflation targeting. But given that the RBNZ has been unable to fulfill its price stability mandate over the last several years, it is hard to argue it will find a dual mandate any easier. Business confidence is rapidly falling, and employment will soon follow suit (Chart I-14). Meanwhile, for an economy driven by agricultural exports, productivity gains will be hard to come by. Economic data in New Zealand are now converging to the downside relative to Australia. The final catalyst for the AUD/NZD cross will be a terms-of-trade shock which, at the moment, is turning in favor of the Aussie (Chart I-15). Iron ore prices may face further downside, given that supply from Brazil is back online, but China’s clear environmental push has lifted the share of liquefied natural gas in Australia’s export mix. Since eliminating pollution is a strategic goal in China, this will be a multi-year tailwind. As the market becomes more liberalized and long-term contracts are revised to reflect higher spot prices, the Aussie will get a boost. Chart I-14Employment Growth Could Collapse In New Zealand Employment Growth Could Collapse In New Zealand Employment Growth Could Collapse In New Zealand Chart I-15Terms Of Trade Favors##br## Aussie Terms Of Trade Favors Aussie Terms Of Trade Favors Aussie Bottom Line: Remain long AUD/NZD as a strategic position and SEK/NZD as a tactical position. Housekeeping The stop on our short XAU/JPY position was triggered at 158,000 with a loss of -3.27%. This was a mean-reversion trade between two safe-havens, likely to work even if volatility remains elevated. Put it back on. Finally, lift the limit sell on EUR/GBP to 0.95.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Maurice Obstfeld, “Tariffs Do More Harm Than Good At Home,” IMFBlog, September 8, 2016. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. have been mostly positive: Labor market remains tight: Unemployment rate was steady at 3.7%; Participation rate increased to 63%; Average hourly earnings increased by 3.2% year-on-year; Nonfarm payrolls increased by 164 thousand. Initial jobless claims fell to 209 thousand last week. Trade balance narrowed slightly to $55.2 billion in June. Michigan sentiment index was unchanged at 98.4 in July. Markit composite and services PMI both increased to 52.6 and 53 respectively in July, while ISM non-manufacturing PMI fell to 53.7 in July. DXY index fell by 1% this week, erasing the gains following the Fed’s hawkish surprise last week. Weakness in the dollar given a ramp-up in trade war rhetoric suggest that dollar tailwinds are facing diminishing marginal returns. A few of our favorite dollar indicators, including the bond-to-gold ratio, are sending a warning signal. Report Links: Focusing On the Trees But Missing The Forest - August 2, 2019 Global Growth And The Dollar - July 19, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have continued to deteriorate: Producer price inflation fell to 0.7% year-on-year in June. Retail sales increased by 2.6% year-on-year in June, surprising to the upside. Markit composite PMI was unchanged at 51.5 in July, while services PMI fell slightly to 53.2. Sentix investor confidence fell further to -13.7 in August, the lowest since 2014. EUR/USD increased by 1% this week. In the most recent Economic Bulletin, the ECB highlighted the risk of a weaker Q2 global services PMI which might lead to a more broad-based deterioration in global growth. With negative interest rates and diminishing marginal returns to monetary policy, the euro area will be ever dependent on fiscal stimulus. Report Links: Battle Of The Central Banks - June 21, 2019 EUR/USD And The Neutral Rate Of Interest - June 14, 2019 Take Out Some Insurance - May 3, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been mixed: Composite PMI was unchanged at 51.2 in July, while services PMI fell to 51.8. Household spending yearly growth fell to 2.7% in June. That said, previous growth of 4% was too high relative to Japan’s potential. Wages increased by 0.4% year-on-year in June. Leading economic index and coincident index both fell to 93.3 and 100.4 respectively in June. The trade balance increased to ¥759.3 billion in June. Current account balance narrowed to ¥1,211 billion in June. USD/JPY fell by 0.9% this week. In the Summary of Opinions released this week, the BoJ concluded that the Japanese economy has been moderately expanding, a trend that is likely to continue in the second half. However, this may be too ambitious. As we go to press, Q2 GDP growth is still pending, and a marked slowdown could be a harbinger for a much softer second half, especially given renewed trade tensions. That said, the path to easier monetary policy will be lined by a stronger yen. Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 Battle Of The Central Banks - June 21, 2019 Short USD/JPY: Heads I Win, Tails I Don’t Lose Too Much - May 31, 2019 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. have been mostly positive: Markit composite PMI increased to 50.7 in July. Services and construction components also increased to 51.4 and 45.3 respectively. Retail sales increased by 0.1% year-on-year in July. Halifax house prices contracted by 0.2% month-on-month in July. GBP/USD has been very volatile but returned flat this week. All eyes are on the new PM Boris Johnson and new Brexit developments. Our Geopolitical strategist is assigning 21% risk of a no-deal Brexit, and the probability would rise to 30% if negotiations with the EU fail. We believe that the pound could easily drop to 1.10-1.15 if there is no deal. That being said, we are looking to sell EUR/GBP at 0.94, given Europe will also absorb some collateral damage from a hard Brexit. Report Links: Battle Of The Central Banks - June 21, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 Take Out Some Insurance - May 3, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been mostly positive: Producer price inflation increased to 2% year-on-year in Q2. Retail sales grew by 0.4% month-on-month in June. Both composite and services PMI increased to 52.1 and 52.3 respectively in July. Australian Industry Group (AiG) construction index fell to 39.1 in July. Exports grew by 1% month-on-month in June, while imports contracted by 4% month-on-month. This nudged the trade surplus to A$8 billion in June, a record. AUD/USD fell by 1.8% initially, then rebounded, returning flat this week. The RBA held interest rates unchanged at 1% on Tuesday, after cutting by 25 bps both in June and July. Long-term government bond yields declined to record-lows. Currency markets are currently focused on interest rate differentials. Once the focus shifts to other fundamentals as global interest rates converge, the Aussie dollar will get a boost. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns- April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been positive: Consumer confidence decreased by 5.1% month-on-month in July. On the labor market front, the participation rate was steady at 70.4% in Q2; Unemployment rate fell to 3.9%; Wages increased by 2.2% year-on-year in Q2. NZD/USD fell by 0.8% this week. RBNZ shocked the market with the half-percentage point rate cut this Wednesday, stating that a larger initial move would be best to meet the inflation and employment objectives in New Zealand. The RBNZ also lowered 2-year inflation expectations from 2.01% to 1.86% in Q3. Relative terms-of-trade favors our long AUD/NZD position. Stay with it. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been mostly positive: Imports and exports both fell to C$50.2 billion and C$50.3 billion in June. The trade balance thus narrowed to C$0.14 billion. Bloomberg Nanos confidence index increased to 58.6 last week. Ivey PMI increased to 54.2 in July. New housing price index contracted by 0.2% year-on-year in June. USD/CAD increased by 0.2% this week. The sudden oil prices drop has dragged down the Canadian dollar. WTI crude oil prices plunged by more than 10% during the past week, and Western Canadian Select crude oil spot prices fell by 14.5%. Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been mostly negative: Headline and core consumer price inflation dropped to 0.3% and 0.4% year-on-year respectively in July. Manufacturing PMI fell to 44.7 in July. Consumer confidence fell to -8 in July. Real retail sales increased by 0.7% year-on-year in June. USD/CHF fell by 1.2% this week. The concerns over the global growth, an escalating trade war, a potential hard-Brexit, political tensions in the Middle East and East Asia continue to weigh on investors’ sentiment. VIX once again touched 24 following Trump’s tweet to threaten to impose 10% tariffs over $300 billion Chinese goods last Thursday. We continue to favor the safe-haven Swiss franc as a tactical portfolio hedge. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 There is little data from Norway this week: Manufacturing production yearly growth fell from 5% in May to 3% in June. USD/NOK has been flat this week.  Next week, the Norges Bank is likely to reverse its well-telegraphed forward guidance of rate hikes, following global developments. With oil prices down, and a new trade war, they will stand pat in line with market expectations, but an interest rate cut cannot be ruled out. Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been mixed: Industrial production contracted by 0.7% year-on-year in June. Services production yearly growth also fell to 1.3% in June. However, industrial orders increased by 7.5% year-on-year in June, the strongest since July 2018.  Budget balance widened to SEK 28.2 billion in July. USD/SEK fell by 0.9% this week. The upside surprise in industrial orders is mainly led by transport equipment. Mining and quarrying also rebounded to 9.3% compared with -7.8% in May. Our SEK/NZD position is now 0.4% in the money. The negative carry has been narrowed following RBNZ’s 50 bps rate cut. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights So What? Tariffs and currency depreciation will likely lead to military saber-rattling in Asia Pacific. Why? President Trump is not immune to the market’s reaction to his trade war escalation. Yet China’s currency depreciation is a major escalation and the near-term remains fraught with danger for investors. Military shows of force and provocations could crop up across Asia Pacific, further battering sentiment or delaying trade talks. Remain short CNY-USD, short the Hang Seng index, long JPY-USD, and long gold. Overweight the U.S. defense sector relative to global stocks. Feature The Osaka G20 tariff ceasefire has collapsed; U.S. President Donald Trump is threatening tariffs on all Chinese imports; the People’s Bank of China has allowed the renminbi to depreciate beneath the important 7.0 exchange rate to the dollar; and the United States has formally labeled China a “currency manipulator.” What a week! The spike in volatility is likely to be accompanied by a rise in credit risk, as measured by the TED spread (Chart 1). Safe havens like gold, treasuries, and the Japanese yen are rallying in a classic risk-off episode, while messengers of global growth like copper, the Australian dollar, and the CRB raw industrials index are stumbling (Chart 2). Only green shoots in Chinese trade and German manufacturing have kept the selloff in check this week by improving the cyclical outlook despite elevated near-term risks. Chart 1So Much For The Osaka G20 Tariff Ceasefire! So Much For The Osaka G20 Tariff Ceasefire! So Much For The Osaka G20 Tariff Ceasefire! Chart 2Key Risk-On/Risk-Off Indicators Breaking Down Key Risk-On/Risk-Off Indicators Breaking Down Key Risk-On/Risk-Off Indicators Breaking Down While we anticipated the re-escalation of U.S.-China tensions, now is the time to take stock and reassess. President Trump is a political animal. While he has demonstrated a voracious risk appetite throughout the year, he is ultimately focused on reelection in November 2020. The United States will survive without a trade deal by then, but Trump may not. Presumably, Trump’s reason for increasing pressure on China throughout 2019 is to secure a deal by the end of the year. This would be to see China’s concessions translate into trade perks for the U.S. markets and economy in 2020 by the time he hits the campaign trail. The experience of Q4 2018 suggests that Trump changed his negotiating tack after U.S. equities fell by only 4% from their peak – but we consider an equity correction a clear pain threshold (Chart 3). Trump is closely associated with the economic fortunes of the country, even more so than the average president. Bear markets tend to coincide with recessions. Trump – beset by controversy and scandal at home – must assume that a recession will be the coup de grâce. Chart 3Where Is President Trump's Pain Threshold? Where Is President Trump's Pain Threshold? Where Is President Trump's Pain Threshold? Chart 4Will Huawei Ban Hit The Tech Sectors? Will Huawei Ban Hit The Tech Sectors? Will Huawei Ban Hit The Tech Sectors? Investors will get some clarity next week when the Commerce Department decides whether to renew the general temporary license for American companies to trade with Chinese telecoms giant Huawei. A full denial of the license would signal that Trump is unconcerned with recession and reelection probabilities and focusing exclusively on the national security threat from China. It would send technology sectors and the broader equity market into a plunge on both sides of the Pacific (Chart 4) and could significantly increase the risk that the global economy begins a downturn. Positive signals are scarce as we go to press: New tariff is on track: The U.S. Trade Representative is preparing a final list of $300 billion in goods to fall under a new 10% tariff, despite reports that Trump overrode USTR Robert Lighthizer in announcing the new tariff. This does not guarantee that the tariff will go into effect on September 1 but it does make it more likely than not. Huawei is under pressure: Office of Management and Budget has disqualified Huawei from any U.S. government contracts as of August 13 – a ban to be extended to any third parties contracting Huawei as of the same date next year. This is not encouraging for Huawei but it is a separate and more limited determination from that of the Commerce Department. Still, we expect the Trump administration to take some moves to offset the ongoing trade escalation. While we are inclined to think the new tariff will take effect, Huawei will likely get a reprieve in the meantime. This will help to ensure that the September trade talks in Washington, DC go forward. The administration has an interest in keeping the trade negotiations alive. Furthermore, there is some evidence that President Trump is recognizing the need to calm other “trade wars” to mitigate the impact of the central China trade war. In September the administration will attempt ratification of the USMCA in Congress – we still think this is slightly favored to go through. We also expect a U.S.-Japan trade agreement to materialize rapidly – likely at the UN General Assembly from September 17-30. Another positive sign is that the European Union has agreed to expand beef imports from the United States. Real movement on agriculture, while China cancels U.S. ag imports, implies that President Trump is less likely to impose car tariffs on Europe for national security reasons on November 13-14.1 The problem is that the fallout from China’s currency depreciation and the new tariffs will hit the market before anything else, which means we remain tactically bearish. Heightened trade tensions are also likely to spill into the strategic sphere in the near term. Saber-rattling – military shows of force and provocations – will increase the geopolitical risk premium across the globe, especially in East Asia. A frightening U.S.-China clash may ultimately encourage real compromises in the trade negotiations, but the market would get the negative news first. If Washington does not make any reassuring moves but expands the current policy assault on China – including through a Huawei ban – then we will consider shifting to a defensive posture cyclically as well as tactically. Bottom Line: We recognize that President Trump may be forced by the risk of a recession to relax the trade pressure and accept some kind of China deal – we may upgrade this 40% chance if and when the U.S. veers toward an equity bear market. In the meantime we expect further negative fallout from the past week’s aggressive maneuvers by both sides. Currency War Assuming that an equity correction is inevitable at some point and that Trump goes crawling back to the Chinese for trade talks: How will they respond? Will Xi Jinping, the strongman general secretary of a resurgent Communist Party, return to talks and reassure global markets at Trump’s beck and call? Or will he refuse, let the market do what it will, and let Trump hang? By letting the currency drop … Beijing is expressing open defiance. The renminbi’s depreciation – through PBoC inaction on August 5, then through action on August 8 – is a warning that Trump is approaching the point of no return. His initial grievance has always been Chinese “currency manipulation” but until now he has refrained from formally leveling this accusation (only using it on Twitter). By letting the currency drop well beneath the level at which Trump was inaugurated (6.8 CNY-USD), and beyond the global psychological threshold, Beijing is expressing open defiance and threatening essentially to break off negotiations. Chart 5China Sends Warning Via Currency Depreciation China Sends Warning Via Currency Depreciation China Sends Warning Via Currency Depreciation The effect of continued depreciation would be to offset the effect of tariffs and ease financial conditions in China. This is fully in keeping with our view that China has opted for stimulus over reform this year. China is likely to follow up with further cuts to banks’ reserve requirement ratios and a cut to the benchmark policy interest rate (Chart 5). The July Politburo statement showed a greater willingness to stimulate the economy and it occurred prior to Trump’s new volley of tariffs. Currency appreciation is the surest way to rebalance China’s economy toward household consumption and obviate a strategic conflict with the United States. By contrast, yuan depreciation will exacerbate the U.S. trade deficit and give Trump’s Democratic rivals convenient evidence that the “Art of the Deal” is counterfeit. How far will the renminbi fall? Chart 6 updates our back-of-the-envelope calculation of the implication from different tariff scenarios assuming that the equilibrium bilateral exchange rate depreciation will equal the tariffs collected as a share of total exports to the United States. (10% tariff on $259 billion = $25.9 billion, which is 5% of $509 billion total.) The yuan is now approaching Scenario D, 25% tariffs on the first half of imports and 10% on the second half, which points toward 7.6 CNY-USD. There are reasons to believe that this simple framework won’t apply, at least in terms of the magnitude of the impact, but it gives an indication of considerable downward pressure. Chart 6The Yuan Will Fall, But Not Freely The Yuan Will Fall, But Not Freely The Yuan Will Fall, But Not Freely Chester Ntonifor of our Foreign Exchange Strategy sees the yuan falling to around 7.3-7.4 if the new tariffs are applied based on the fact that the 25% tariff on $250 billion worth of goods produced a roughly 10% decline in the bilateral exchange rate. Our Emerging Markets Strategy also expects about a 5% drop in the CNY-USD. Having tightened capital controls during the last bout of depreciation in 2015-16, China is probably capable of controlling the pace of depreciation, preventing capital outflows from becoming a torrent, by selling foreign exchange reserves, further tightening capital controls, or utilizing foreign currency forward swaps. But Asian currencies, global trade revenues in dollars, and EM currencies and risk assets will suffer – and they have more room to break down from current levels.2 Meanwhile even a modest drop in the renminbi – amid a return to dovish monetary policy in global central banks – has revived concerns about a global currency war. A rising dollar is anathema to President Trump, who aims to reduce the trade deficit, encourage the on-shoring of manufacturing, and maintain easy financial conditions for the U.S. economy. Table 1U.S. Demands On China In Trade Talks The Rattling Of Sabers The Rattling Of Sabers Chart 7U.S. Allies' Share Of Treasuries Rises U.S. Allies' Share Of Treasuries Rises U.S. Allies' Share Of Treasuries Rises Trump’s decision to slap a sweeping new tariff on China – reportedly at the objection of all of his trade advisers except the ultra-hawkish Peter Navarro (Table 1) – was at least partly driven by his desire to see the Fed cut rates beyond the 25 basis point cut on July 31 and weaken the dollar. Yet the escalation of the trade war weighs on global trade and growth, which will push the dollar up. This reinforces the above argument that Trump will probably seek to offset the recent trade war escalation with some mitigating moves. Beyond inducing the Fed to cut further, it is difficult for President Trump to drive the dollar down. The Treasury Department can intervene in foreign exchange markets, but direct intervention does not have a successful track record. Interventions usually have to be sterilized (expansion of the money supply externally must be addressed at home by mopping up the new liquidity), which in the context of free-moving global capital means that any depreciation will be short-lived. An unsterilized intervention would be extremely unorthodox and is unlikely short of a major crisis and breakdown in institutional independence. The U.S. could attempt to engineer an internationally coordinated currency intervention, as we have highlighted in the past. But it is highly unlikely to succeed this time around. The U.S. is less dominant of a military and economic power than it was when it orchestrated the Smithsonian Agreement of 1971 and the Plaza Accord of 1985. Neither the European nor the Japanese economies are in a position to tighten monetary policy or financial conditions through currency appreciation. While China weans itself off treasuries, U.S. allies and others fill the void. Indeed, after a long period in which American allies declined as a share total holders of treasuries – as China and emerging markets increased their forex reserves and treasury holdings momentously – allies are now taking a greater share (Chart 7). Chart 8China Diversifies While It Depreciates China Diversifies While It Depreciates China Diversifies While It Depreciates China is driving down the yuan not by buying more treasuries but by buying other things – diversifying away from the USD into alternative reserve currencies and hard assets, such as gold and resources tied to the Belt and Road Initiative (Chart 8). As trade, globalization, and global growth have slowed down, and as China’s growth model and the U.S.-China special relationship expire, global dollar liquidity is shrinking. Dollar liquidity is the lifeblood of the global financial system and the consequence is to tighten financial conditions, including via equity markets (Chart 9). The solution would be a trade deal in which China agrees to reforms to pacify the U.S., including an appreciation renminbi, while the U.S. abandons tariffs, enabling global trade, growth, commodity prices, and dollar liquidity to recover. Yet China was never likely to agree to a new Plaza Accord because it is delaying reform to its economy in order to maintain overall political stability – and the financial turmoil of 2015-16 only hardened this position. Chart 9Dollar Liquidity A Risk To Global Equities Dollar Liquidity A Risk To Global Equities Dollar Liquidity A Risk To Global Equities Moreover Japan in 1985 was already a subordinate ally and had a security guarantee from the United States that was not in question. By contrast, China today is asserting its “equality” as a nation with the U.S., and has no guarantee that Americans are not demanding economic reforms so as to debilitate China’s political stability and strategic capability. After tariffs and currency war comes saber-rattling. Comparing China to Japan in the decades leading up to the Plaza Accord shows how remote of a possibility this solution is: China’s currency has been moving in precisely the opposite direction (Chart 10). Chart 10So Much For Plaza Accord 2.0 So Much For Plaza Accord 2.0 So Much For Plaza Accord 2.0 The Plaza Accord is a useful analogy for another reason: it marked the peak in Japanese market share in the U.S. economy. In Japan’s case, currency appreciation was the primary mover, while Japan also relocated production to the United States. Chart 11The Real Analogy With The Plaza Accord The Real Analogy With The Plaza Accord The Real Analogy With The Plaza Accord In China’s case, if currency appreciation is ruled out and production is not relocated due to a failure to secure a trade agreement, then U.S. protectionism will remain the primary means of capping China’s share of the market (Chart 11). The dollar will remain strong and this will continue to weigh on global markets. Bottom Line: China’s recent currency depreciation is a warning signal to the U.S. that the trade negotiations could be broken off. There is further downside if the U.S. implements the new tariffs or hikes tariff rates further. The renminbi is unlikely to enter a freefall, however, because China maintains tight capital controls and is stimulating its economy. It is doubtful that the Trump administration can engineer a depreciation of the dollar through a multilateral agreement. It lacks the geopolitical heft of the 1970s-80s, and it does not have a strategic understanding with China that would enable Beijing to make the same degree of concessions that Tokyo made in 1985. Saber-Rattling After tariffs and currency depreciation, the next likeliest manifestation of strategic tensions lies in the military sphere. Chart 12 While the U.S. threatens to cut off Chinese tech companies like Huawei, Beijing has signaled that countermeasures would include an embargo on U.S. imports of rare earth elements and products.3 When China implemented a partial rare earth export ban on Japan (Chart 12), the context was a maritime-territorial dispute in the East China Sea in which military and strategic tensions were also escalating. The threat to industry only amplified these tensions. There are several locations in East Asia where conditions are ripe for clashes and incidents that could add to negative global sentiment. Indeed, saber-rattling has already begun in Hong Kong, Taiwan, the Koreas, and the East and South China Seas. The following areas are the most likely to darken the outlook for U.S.-China negotiations: Direct U.S.-China tensions: The U.S. and China have experienced several minor clashes since the beginning of the Trump administration. The near-collision of a Chinese warship with the USS Decatur occurred in October 2018, after the implementation of the first sweeping tariff on $200 billion worth of goods – a period of tensions very similar to that of today.4 October 1 marks the 70th anniversary of the People’s Republic of China, an event that will be marked by outpourings of nationalism and a flamboyant military parade displaying advanced new weapons. The government in Beijing will be extremely sensitive in the lead-up to this anniversary, leading to tight domestic controls of news and media, hawkish rhetoric, and the potential for provocations on the high seas. Hong Kong and Taiwan: Chinese officials, including the People’s Liberation Army garrison commander in Hong Kong, the director of the Office of Hong Kong and Macao Affairs, and the city’s embattled Chief Executive Carrie Lam have warned in various ways that if unrest spirals out of control, it could result in mainland China’s intervention. A large-scale police exercise in Shenzhen, Guangdong, just across the water, has highlighted Beijing’s willingness to take forceful action. The deployment of mainland troops would likely lead to casualties and could trigger sanctions from western countries that would have common cause on this issue. The Tiananmen Square incident shows that such an event could lead to a non-negligible hit to domestic demand and foreign exports under sanctions (Chart 13). Hong Kong is obviously a much smaller share of total exports to China these days, but when combined with Taiwan – where there could also be a hit to sentiment from Hong Kong unrest and possibly separate economic sanctions – the impact could be substantial (Chart 14). Chart 13Mainland Intervention In Hong Kong Could Prompt Sanctions Mainland Intervention In Hong Kong Could Prompt Sanctions Mainland Intervention In Hong Kong Could Prompt Sanctions Chart 14HK/Taiwan A Significant Share Of Greater China Trade HK/Taiwan A Significant Share Of Greater China Trade HK/Taiwan A Significant Share Of Greater China Trade Why would Taiwan get worse as a result of Hong Kong? Unrest in Hong Kong has already galvanized opposition to the mainland’s policies in Taiwan, where the presidential election polling has shifted in incumbent President Tsai Ing-wen’s favor (Chart 15). Beijing has imposed new travel restrictions and held a number of intimidating military exercises, while the U.S. has increased freedom of navigation operations in the Taiwan Strait. These trends could worsen over the next year. Japan and the East China Sea: Japan’s top military official – General Koji Yamazaki – recently warned that Chinese military intrusions are increasing around the disputed Senkaku (Diaoyu) islands in the East China Sea. He called particular attention to China’s change of the Coast Guard from civilian to military control, which he said posed new risks of escalation in disputed waters. Japan itself may have an interest in a more confrontational stance over the coming year. The Japanese government has seen a rise in public opposition to its plan to revise the constitution to enshrine the Self-Defense Forces and thus move toward a more “normal” Japanese military and security posture (Chart 16). Chart 15 Chart 16 A revival of trouble in the South China Sea: China has not reduced its assertive foreign policy in order to win regional allies amid its conflict with the United States. On the contrary, it has continued asserting itself to the point of alienating governments that have largely sought to warm up to the Xi administration, including both Vietnam and the Philippines. The Vietnamese have engaged in a month-long standoff over alleged Chinese encroachments in its Exclusive Economic Zone. And a clash near Sandy Cay in the Spratly Islands is forcing Philippine President Rodrigo Duterte, who has otherwise avoided confrontation with China, to address President Xi over the international court decision in 2016 that ruled out China’s claims of sovereignty over the disputed islands. The South China Sea is important because it is a vital supply line for all of the countries in the region. Even if the United States washed its hands of Beijing’s efforts to control the sea lanes, U.S. allies would still face a security threat that would drive tensions in these waters. This is a formidable group of Asian nations that China fears will seek to undermine it (Chart 17). And of course the Americans are not washing their hands of the region but actually reasserting their interest in maintaining a western Pacific defense perimeter. The Korean peninsula: North Korea has resumed testing short-range missiles, causing another hiccup in U.S. attempts at diplomacy (Chart 18). These tensions have the potential to flare as the U.S.-China trade talks deteriorate, since Beijing has offered cooperation on North Korea’s missile and nuclear program as a concession. Chart 17U.S. Asian Allies Formidable U.S. Asian Allies Formidable U.S. Asian Allies Formidable Chart 18North Korean Provocations Still Low-Level North Korean Provocations Still Low-Level North Korean Provocations Still Low-Level Ultimately North Korea needs to be part of the U.S.-China solution, so as long as tensions rise it sends a negative signal regarding the status of talks. And vice versa. South Korea is another case in which China is not reducing its foreign policy aggressiveness in order to win friends. On July 23, a combined Russo-Chinese bomber exercise over the disputed Dokdo (Takeshima) islands in the Sea of Japan led to interception by both Korean and Japanese fighter jets and the firing of hundreds of warning shots. The incident reveals that South Korean President Moon Jae-in is not seeing an improvement in relations with these countries despite his more pro-China orientation and his attempt to engage with North Korea. It also shows that while South Korea’s trade spat with Japan can persist for some time, it may take a back seat to these rising security challenges. As long as North Korean tensions rise it sends a negative signal regarding U.S.-China talks. Chart 19Russia May Need To Distract From Domestic Unrest Russia May Need To Distract From Domestic Unrest Russia May Need To Distract From Domestic Unrest Russia, like China, is feeling immense domestic political pressure, including large protests, that may result in greater foreign policy aggression (Chart 19). And as China and Russia tighten their informal alliance in the face of a more aggressive U.S., American allies face new operational pressures and the potential for geopolitical crises will rise. Bottom Line: The whole panoply of East Asian geopolitical risks is heating up as U.S.-China tensions escalate. While the U.S. and China may engage in direct provocations or miscalculations, their East Asian neighbors are implicated in the breakdown of the regional strategic order. A crisis in any of these hotspots could jeopardize the already unfavorable context for any U.S.-China trade deal over the next year, especially during rough patches like the very near term. Investment Implications Chart 20A Strategic Investment A Strategic Investment A Strategic Investment The potential for saber-rattling in the near term – on top of a series of critical U.S. decisions that could mitigate or exacerbate the increase in tensions surrounding the new tariff hike – argues strongly against altering our tactically defensive positioning at the moment. In this environment we advise clients to stick with our two strategic defense plays – long the BCA global defense basket in absolute terms, and long S&P500 Aerospace and Defense equities relative to global equities. The U.S. Congress’s newly agreed bipartisan budget deal provides a substantially improved fiscal backdrop for American defense stocks, which are already breaking out amid positive fundamentals. A host of non-negligible geopolitical risks speaks to the long-term nature of this trade (Chart 20). Our U.S. Equity Strategy recently reaffirmed its bullish position on this sector. We maintain that the U.S. and China have a 40% chance of concluding a trade agreement by November 2020. Note, however, that even a “no deal” scenario does not entail endless escalation. Presidents Trump and Xi could agree to another tariff ceasefire; negotiations could even lead to some tariff rollback in 2020. That would be, after all, Trump’s easiest way to “ease” trade policy amid recession risks. Nevertheless, our highest conviction call is not about whether there will be a deal, but that any trade truce that is reached will be shallow – an attempt to mitigate the trade war’s damage, save face, and bide time for the next round in U.S.-China conflict. We give only a 5% chance of a “Grand Compromise” by November 2020 that greatly expands the U.S.-China economic and corporate earnings outlook over the long haul. In this sense the ultimate trade deal will be a disappointment for markets.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 At the signing ceremony President Trump reminded his European interlocutors that the risk of car tariffs is not yet off the table. He concluded the celebration saying, “Congratulations. And we’re working on deal where the European Union will agree to pay a 25 percent tariff on all Mercedes-Benz’s, BMWs, coming into our nation. So, we appreciate that. I’m only kidding. (Laughter.) They started to get a little bit worried. They started — thank you. Congratulations. Best beef in the world. Thank you very much.” 2 See Emerging Markets Strategy Weekly Report, “EM: Into A Liquidation Phase?” August 8, 2019, ems.bcaresearch.com. 3 The national rare earth association holding a special working meeting and pledging to support any countermeasures China should take against U.S. tariffs. See Tom Daly, “China Rare Earths Group Supports Counter-Measures Against U.S. ‘Bullying,’” Reuters, August 7, 2019. 4 Military tensions are already heating up as Beijing criticizes the U.S. over the new Defense Secretary Mark Esper’s claim during his Senate confirmation hearings that new missile defense may be installed in the region in the coming years. This comes in the wake of the U.S. withdrawal from the 1987 Intermediate-Range Nuclear Forces Treaty, partly due to China’s not being a signatory of the agreement. Missile defense is a long-term issue but these developments feed into the current negative atmosphere.

Dear Client, In addition to this week’s Global Investment Strategy report, I am sending you a Special Report on Japan written by Amr Hanafy, Research Associate of BCA’s Global Asset Allocation service. Best regards, Peter Berezin, Chief Global Strategist Highlights The trade war is likely to get worse before it gets better, implying some near-term downside risks to global equities and corporate credit. Nevertheless, both sides have a strong incentive to keep the conflict from spiraling out of control.  Unlike in the earlier rounds, consumer goods represent the bulk of the imports subject to tariffs in the latest round. Many of these Chinese imports also do not have readily-available foreign or domestic alternatives. If U.S. retail prices start rising, voter attitudes – which are not that supportive of the trade war to begin with – will sour further, hurting President Trump’s re-election prospects. Investors should overweight global equities over a 12-month horizon. We intend to upgrade EM and European stocks. However, we are waiting for the trade war to simmer down and global growth to revive before we do so. Feature Tariffied Last week, we wrote that “Risk assets are likely to struggle over the next few weeks as investors grapple with both renewed trade war anxiety and the realization that the Fed’s “insurance cuts” may not be as generous as they had anticipated.”1 Stocks have been on a rollercoaster ride since then. S&P 500 futures were down almost 8% on Monday evening compared to last Thursday’s intraday highs before recovering much of their losses over the subsequent days (Chart 1). Chart 1 Needless to say, the brewing trade war between China and the U.S. remains foremost in investors’ minds. In what has become a familiar pattern of events, China moved quickly to retaliate against President Trump’s decision to raise tariffs on the remaining $300 billion of Chinese imports. The Chinese government announced that state-owned enterprises would suspend purchases of U.S. agricultural goods. The People’s Bank of China also allowed the USD/CNY exchange rate to move above 7, long regarded as a key psychological level. This prompted the U.S. Treasury to officially label China a “currency manipulator.” In and of itself, the decision to label China a currency manipulator means little. The designation was applied to China based on the loose criteria for manipulation used in the 1988 Omnibus Trade And Competitiveness Act, rather than under the more stringent criteria that the U.S. Treasury has employed since 2015 (the latest Treasury report issued in May, using this more stringent criteria, did not find China guilty of currency manipulation). The Treasury statement self-servingly said that Secretary Mnuchin “will engage with the International Monetary Fund to eliminate the unfair competitive advantage created by China’s latest actions.” Given that the IMF indicated as late as three weeks ago that China’s “current account is broadly in line with fundamentals,” we doubt that much will come of this.2 Nevertheless, the designation further sours the atmosphere surrounding the trade talks, suggesting that the conflict will probably get worse before it gets better. Tough Luck, I Am Hitting Send The Chinese were apparently blindsided by President Trump’s decision to raise tariffs. According to media reports, Trump brushed off suggestions from his advisors during a tense Oval Office meeting last Thursday to notify the Chinese, as a courtesy, of the pending tariff announcement, choosing instead to send his tweet while everyone was still present in the room. (With Trump’s permission, Robert Lighthizer did try to place a phone call to Liu He, China’s Vice Premier and lead trade negotiator. The call went unanswered).3  Trump has reportedly become incensed that the Chinese, in his view, are stalling, secretly hoping that they will have a more conciliatory counterparty to deal with following next year’s presidential elections. From Trump’s perspective, a key goal of the tariffs is to make a strategy of running out the clock less appealing. Having successfully used the threat of tariffs to prompt Mexico to take stronger steps to curtail the flow of migrants to the U.S., Trump now feels emboldened to use strong-arm tactics to extract concessions from China. It’s a risky gambit. The Chinese will resist locking in any structural reforms that could weaken Beijing’s authority. The protests in Hong Kong have only added urgency for China’s leaders to look and act tough in the presence of what they describe as “foreign meddling.” All this means that a deal to prevent the latest tranche of tariffs from taking effect on September 1st is unlikely to be hatched. Mutually Assured Destruction? How bad could things get? The good news is that both sides have a strong incentive to keep the conflict from spiraling out of control. For the Chinese, it is not just a matter of losing access to the vast U.S. market. It’s also about losing access to vital technologies that China needs to further its ambitions in everything from robotics, to AI, to genomics. Chart 2Voters Are Not That Supportive Of Protectionism Voters Are Not That Supportive Of Protectionism Voters Are Not That Supportive Of Protectionism From Trump’s perspective, a severe trade war could hurt his re-election chances. Unlike late last year, the stock market’s recent plunge can be squarely attributed to the intensification of the trade war. If stocks keep falling, many voters with sagging 401(k) accounts will blame Trump. The initial rounds of U.S. tariffs focused on capital goods. In contrast, consumer goods represent the bulk of the imports subject to the latest tranche of duties. If retail prices start rising, voter attitudes – which are not that supportive of the trade war to begin with (Chart 2) – may sour further. It is also worth noting that Chinese goods account for a large fraction of overall imports in many of the categories subject to the latest round of tariffs. This will limit the ability of U.S. companies to source imports from other countries, thus putting further upward pressure on U.S. consumer prices. A Headwind, Not A Game Changer Neither the U.S. nor China would gain from a prolonged trade war. This does not mean that a “World War I” scenario, where all parties end up severely worse off from their actions, can be completely excluded. However, it does mean that powerful forces will probably kick in before the trade war gets out of hand. While global equities may struggle over the coming weeks as investors try to navigate every twist and turn in the trade war saga, they will be higher 12 months from now. In such a “moderate” trade war scenario, where tariffs rise but the global supply chain continues to function, the asset market consequences are likely to be smaller than many observers believe. There are two reasons for this: First, there is the issue of magnitude. In value-added terms, U.S. exports of goods to China account for 0.5% of U.S. GDP, while Chinese exports to the U.S. represent 2.7% of Chinese GDP. These are not infinitesimal numbers, but even in the latter case, they are not particularly large either. Second, both the U.S. and China have some ability to offset the impact of a moderate trade war with stimulus. In the case of the U.S., the stimulus would come mainly in the form of more accommodative monetary policy. Indeed, since Jay Powell’s “hawkish” press conference last week, the 2-year yield has fallen by 24 basis points, while the 10-year yield has dipped by 29 basis points, largely because the market has priced in more rate cuts (Chart 3). In China’s case, the stimulus will continue to consist of credit-driven investment spending, with some tax cuts for consumers thrown in for good measure. Yes, China can stimulate its economy by further weakening its currency. However, such a strategy risks backfiring. As we saw in 2015-16, when China lost almost $1 trillion in reserves, even a small devaluation can foster expectations of a bigger one, leading to large-scale capital outflows (Chart 4). The fact that dollar-denominated debt has risen among China corporates further reduces the incentive to allow the yuan to weaken significantly. As such, we do not expect the Chinese to weaponize the yuan as a tool in the trade war. Chart 3U.S. Yields Are Lower As Markets Are Pricing In More Rate Cuts U.S. Yields Are Lower As Markets Are Pricing In More Rate Cuts U.S. Yields Are Lower As Markets Are Pricing In More Rate Cuts Chart 4China: A Devaluation Could Exacerbate Capital Outflows China: A Devaluation Could Exacerbate Capital Outflows China: A Devaluation Could Exacerbate Capital Outflows   Investment Conclusions As we discussed last week, the global manufacturing cycle tends to follow regular three-year periods – 18 months up, 18 months down (Chart 5). Given that the last downleg began in early 2018, we are due for another upturn in growth. The recent trade turbulence could delay the recovery for a bit, but ultimately, the manufacturing cycle will turn for the better. Central banks tend to be backward-looking. The weakness in both economic growth and inflation has prompted them to ease monetary policy. Just this week, central banks in Thailand, India, and New Zealand cut rates. The RBNZ shaved rates by 50 basis points, double what analysts were expecting. This brings to 16 the number of central banks which have lowered interest rates so far this year. Monetary policy affects the economy with a lag. Global growth is likely to start picking up just as the monetary stimulus is making its way through the system. Stocks will thrive in this environment. Thus, while global equities may struggle over the coming weeks as investors try to navigate every twist and turn in the trade war saga, they will be higher 12 months from now. As global growth recovers, bond yields will rise. Investors should favor stocks over bonds. We do not have a strong view on regional equity allocation for now, but intend to upgrade EM and European stocks once the trade war simmers down and leading indicators for global growth start to march higher. Chart 5The Global Manufacturing Cycle Has Likely Reached A Bottom The Global Manufacturing Cycle Has Likely Reached A Bottom The Global Manufacturing Cycle Has Likely Reached A Bottom   Peter Berezin, Chief Global Strategist Global Investment Strategy  peterb@bcaresearch.com Footnotes 1      Please see Global Investment Strategy Weekly Report, “A One-Two Punch,” dated August 2, 2019. 2      Please see Gita Gopinath, “Rebalancing the Global Economy: Some Progress but Challenges Ahead,” IMF Blogs, July 17, 2019; and “2019 External Sector Report: The Dynamics of External Adjustment,” IMF External Sector Reports, July 2019. 3      Vivian Salama and Josh Zumbrun, “Trump Ordered New Chinese Tariffs Over Objections of Advisers,” The Wall Street Journal, August 7, 2019.  Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 6   Tactical Trades Strategic Recommendations Closed Trades