Emerging Markets

Crude oil price volatility surged over the past week, and likely will remain elevated. Underlying prices continue to reflect heightened policy risk ranging from continuing Sino – U.S. trade-war tensions; new tariff threats against Mexico from the Trump administration; global growth concerns, which are fuelled by rising oil inventories in the U.S.; and the continued threat of war in the Persian Gulf (Chart of the Week). These factors are exacerbating recession fears in the U.S., where the yield curve is pricing in a greater than one-in-three chance of a recession one year forward (Chart 2). Given the above-trend performance of the American economy relative to other DM economies, this is disconcerting re global growth generally, and re EM GDP prospects in particular. EM GDP drives EM commodity demand. Given EM commodity demand is the principal driver of global commodity demand, it is especially important in our modeling. Chart of the WeekVolatility Surges on Policy-Risk Concerns Volatility Surges on Policy-Risk Concerns Volatility Surges on Policy-Risk Concerns   Reducing EM GDP growth from 4.2% and 4.5% this year and next to 3.8% and 4.1% shaves ~ $2/bbl off our 2019 Brent price expectation and $3/bbl off our 2020 expectation. Chart 2Bond Market Pricing High Odds of U.S. Recession Bond Market Pricing High Odds of U.S. Recession Bond Market Pricing High Odds of U.S. Recession To be conservative, our oil-demand assumptions for EM GDP have followed World Bank estimates, which means they’ve been below post-Global Financial Crisis (GFC) trend (Chart 3). Chart 3 Cutting right to the chase: Reducing EM GDP growth from 4.2% and 4.5% this year and next to 3.8% and 4.1% shaves ~ $2/bbl off our 2019 Brent price expectation and $3/bbl off our 2020 expectation. This brings our Brent forecast to $73/bbl and $77/bbl for this year and next.1 We continue to expect WTI to trade $7/bbl and $5/bbl below Brent this year and next. Highlights Energy: Overweight. We expect OPEC 2.0 – the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia – to extend its production cuts to year end when it meets later this month or next month. This will still allow OPEC 2.0 to raise production in 2H19 over 1H19 if needed, due to the group's current over-compliance with the agreed cuts. KSA's production is currently close to ~500k b/d below its output target. We believe Wednesday’s inventory report released by the U.S. EIA showing a 22.4mm-barrel increase in commercial crude oil and refined products inventories all but assures OPEC 2.0’s production cuts will be extended when the producer coalition meets. Base Metals: Neutral. Union members who voted to strike a Codelco copper mine over the weekend remain on the job, after Chilean government officials joined to mediate negotiations, according to Fastmarkets MB. Precious Metals: Neutral. Gold rallied above $1,340/oz – up 4% over the past week – as global trade tensions and other factors riling equity, bond and commodity markets intensified. Ags/Softs: Underweight. The USDA reported corn plantings were running at 67% this week, vs. an average of 96% percent over the 2014 – 18 period. The department surveyed 18 states, which account for 92% of all 2018 corn acreage. Feature Global oil demand concerns are manifesting themselves in the almost-relentless selling of futures seen in the past two weeks. This coincided with an increasing risk premium noted in our price decomposition, and with rising concerns over the health of the global economy generally.2 Markets are becoming increasingly concerned U.S. and Chinese trade and foreign policy will spill into the larger global economy and result in a full-blown global trade war. Already, Mexico and Canada have been drawn into this vortex once again – the former is being threatened with U.S. tariffs once more, after presumably having agreed to a revised NAFTA treaty, the latter via increased inspection of meat imports into China.3 On Wednesday, the World Bank lowered its global growth forecast, taking 0.3 percentage points off its 2019 growth estimate – lowering it to 2.6% in 2019 – and reducing its 2020 forecast to 2.7% from 2.8% earlier.4 The Bank noted, “Emerging and developing economy growth is constrained by sluggish investment, and risks are tilted to the downside. These risks include rising trade barriers, renewed financial stress, and sharper-than-expected slowdowns in several major economies.” Assessing Lower EM Growth Prospects We follow the World Bank’s GDP growth estimates closely, largely because the Bank’s forecasts tend to be lower than those of the IMF, which induces a measure of conservatism to our forecasts. We use the Bank’s EM GDP estimates (levels and growth rates) to estimate oil demand in our modelling. Prior to the Bank’s updated forecast released on June 4, we re-estimated EM oil consumption, by shaving 0.4 percentage points from our earlier EM GDP forecast. This means our simulation is 0.1 percentage point below the Bank’s most recent estimate for EM GDP this year, and 0.3 percentage points below the Bank’s 2020 estimate. Using the World Bank's revised forecasts as inputs to our fundamental model – and leaving all other assumptions unchanged – the lower EM GDP estimate for 2019 would take our average Brent expectation to $71/bbl. Averaging this with our existing expectation of $75/bbl leads us to change our 2019 forecast to $73/bbl. To hit this new estimate of $73/bbl would require 2H19 Brent prices to average ~ $79/bbl, which we believe is not unreasonable. For 2020, the slowdown in EM GDP we used gives an expectation of $73/bbl for Brent, versus our previous estimate of $80/bbl. We average these as well, and change our estimate for 2020 Brent to $77/bbl. OPEC 2.0 Remains Focused On Lower Inventories Our lower EM GDP estimates take growth rates to those roughly prevailing during the 2015 – 16 oil-price collapse. This episode was a true global shock, particularly for commodity exporters, which was not offset by higher growth in the GDPs of commodity importers (Chart 4). This go-round is different, however: The 2015 – 16 oil price collapse was a self-inflicted shock, occasioned by OPEC’s decision to launch an all-out market-share war in 2014. This had a devastating effect on EM commodity-exporting countries, particularly the oil exporting countries. We expect OPEC 2.0 to extend production cuts, even though we believe the market will need an additional 900k b/d of production from the producer coalition. This time, the global backdrop is considerably different. For one thing, the oil-price collapse laid the foundation for the formation of OPEC 2.0, which has shown remarkable production discipline since it was founded in November 2016, and took on the mission of reducing the massive unintended inventory accumulation brought on by the combination of the OPEC market-share war and surging U.S. shale production (Chart 5). The nominal target for this mission is OECD inventories. Chart 4EM Oil Demand vs. GDP EM Oil Demand vs. GDP EM Oil Demand vs. GDP Chart 5Commercial Oil Inventories Will Resume Drawing Commercial Oil Inventories Will Resume Drawing Commercial Oil Inventories Will Resume Drawing We continue to stress this founding principal of OPEC 2.0, because its leadership continues to make it a focal point when engaging with the press and guiding the market. It is for this reason we expect OPEC 2.0 to extend production cuts, even though we believe the market will need an additional 900k b/d of production from the producer coalition to keep prices below $85/bbl. KSA’s Energy Minister, Khalid al-Falih, this week said, “We will do what is needed to sustain market stability beyond June. To me, that means drawing down inventories from their currently elevated levels.”5 Fiscal, Monetary Policy Support EM Demand The other noteworthy aspect of the current market is central banks globally are more accommodative than they were during the 2015 – 16 oil-price collapse. In addition, fiscal stimulus is being deployed globally, and likely will be increased. Against this backdrop, it is difficult to see monetary or fiscal policy being the sort of headwind it has shown it can be post-GFC. As our colleague Peter Berezin noted in last week’s Global Investment Strategy, “politicians will pursue large-scale fiscal stimulus” to avoid a slide into deflation.6 U.S. – Iran Tensions High, But Ebbing Lastly, oil markets seem to have reduced their concern over U.S. – Iran tensions in the Persian Gulf. This may be due to the fact that U.S. Secretary of State Mike Pompeo said the U.S. was “prepared to engage in a conversation (with Iran) with no pre-conditions. We are ready to sit down.”7 All the same, the U.S. recently deployed an aircraft carrier strike group to the Persian Gulf, where it now is on station, and B52 bombers. From the oil market’s perspective, any thawing in the potential military standoff in the Gulf would require the U.S. to abandon its stated goal of reducing Iran’s oil exports to zero. In and of itself, a resumption of official Iranian oil exports would simply re-distribute production cuts and the make-up production OPEC 2.0 is providing markets in the wake of Venezuela’s collapse, where oil production has fallen to ~ 850k b/d from ~ 2mm b/d when OPEC 2.0 was formed. Bottom Line: Wednesday’s massive 22.4mm-barrel build in U.S. crude and refined product inventories shocked the global oil market, and pushed Brent prices toward $60/bbl as we went to press. Almost surely, this will harden KSA’s and OPEC 2.0’s resolve to maintain production cuts into 2H19 to drain oil inventories globally. The lower prices also will act as a headwind to U.S. shale producers, a topic we will take up in a two-part Special Report next week and the following week. We’ve established rig counts in the U.S. shales are closely tied to WTI price levels and curve shape: Lower prices and a flattening forward curve will restrain drilling in the shales, and the rate of growth in U.S. output. Lastly, fiscal and monetary policy globally will be supportive of commodity demand, and EM oil demand in particular, as this stimulus is deployed. We continue to expect prices to rally from here, but have lowered our forecasts slightly to $73 and $77/bbl for Brent this year and next. We continue to expect WTI to trade $7 and $5/bbl below these levels in 2019 and 2020.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com   Footnotes 1      Please note, we ran our simulations earlier this week, prior to the World Bank’s most recent forecast released June 4.  This means our simulation is 0.1 percentage point below the Bank’s most recent estimate for EM GDP this year, and 0.3 percentage points below the Bank’s 2020 estimate.  2      Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled “Policy Risk Sustains Oil’s Unstable Equilibrium,” dated May 23, 2019, available at ces.bcaresearch.com. 3      The amounts involved in the stepped up meat inspections in China are small. However, they can be read as an extension of the foreign-policy imbroglio involving the possible extradition of Huawei Technologies’ CFO from Canada to the U.S. to face trial on charges she and the company allegedly conspired to commit bank and wire fraud to avoid U.S. sanctions on Iran.  Chinese officials deny there is any connection.  Please see “Canada says China plans more meat import inspections, industry fears disaster,” published by reuters.com June 4, 2019. 4      Please see Global growth to Weaken to 2.6% in 2019, Substantial Risks Seen , published by the World Bank June 4, 2019. 5      This quote came from a reuters.com report that relayed what al-Falih told Arab News. Please see “Saudi’s Falih says OPEC+ consensus emerging on output deal in second half,” published June 3, 2019. 6      Please see Global Investment Strategy Weekly Report titled “MMT And Me,” dated May 31, 2019, which discusses the prospects for large-scale fiscal stimulus and accommodative monetary policy globally.  It is available at gis.bcaresearch.com.  Peter also expects a détente in the Sino – U.S. trade war, arguing both sides would benefit from reducing trade tensions and tariffs. 7      Please see U.S. prepared to talk to Iran with 'no preconditions', Iran sees 'word-play' published by reuters.com June 2, 2019.  This followed news that Iran’s President Hassan Rouhani said his country is willing to speak with the U.S. if it shows respect. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q1 Image Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades Image

Dear Client, Tomorrow we will publish a debate piece on China shedding more light on the ongoing discussions at BCA on this topic. This report will articulate the conceptual and analytical differences between my colleague, Peter Berezin, and I relating to our respective outlooks on China’s credit cycle. Peter believes that the credit boom in China is a natural outcome of a high household “savings” rate. I maintain that household “savings” have no bearing on credit growth, debt or bank deposit levels. Rather, China’s credit and money excesses are pernicious and will precipitate negative macro outcomes. I hope you will find this report valuable and interesting. Today we are publishing analysis and market strategy updates on Russia and Chile. Best regards, Arthur Budaghyan Chief Emerging Markets Strategist   Russia: A Fiscal And Monetary Fortress Underpins A Low-Beta Status Russian financial markets and the ruble have entered a low-beta paradigm. A combination of ultra-conservative fiscal and monetary policies over the past four years will help Russian equities, local bonds as well as sovereign and corporate credit to continue outperforming their respective EM benchmarks.   First, both the overall and primary fiscal surpluses now stand at over 3% of GDP (Chart I-1). The authorities have sufficient fiscal leeway to undertake substantial fiscal easing. They have announced a major fiscal spending program, which is planned to be in the order of $390 billion or 25% of GDP, over the next six years. Chart I-1Fiscal Balance Is In Large Surplus Fiscal Balance Is In Large Surplus Fiscal Balance Is In Large Surplus Importantly, government non-interest expenditures have dropped to 15.5% of GDP from 18% in 2016. Therefore, it makes perfect sense to ease fiscal policy materially to counteract the impact of lower commodities prices on the economy. What’s more, gross public debt is at 13% of GDP – out of which the foreign component is only 4% of GDP – and remains the lowest in the EM space. A fiscal fortress, as well as the potential for significant fiscal stimulus amid the current EM selloff, will help the Russian currency, local bonds and sovereign and corporate credit markets behave as a lower beta play within the EM universe. Second, there is scope for the Central Bank of Russia (CBR) to cut interest rates. Both nominal and real interest rates have remained high, particularly lending rates (Chart I-2). Furthermore, growth has been mediocre and inflation is likely to fall again (Chart I-3). Chart I-2Russian Real Interest Rates Are High Russian Real Interest Rates Are High Russian Real Interest Rates Are High Chart I-3Russia: Growth Has Been Weakening Prior To Oil Price Decline Russia: Growth Has Been Weakening Prior To Oil Price Decline Russia: Growth Has Been Weakening Prior To Oil Price Decline   Although overwhelming evidence warrants lower interest rates in Russia, it is not clear if the ultra-conservative Central Bank Governor Elvira Nabiullina will resort to rate reductions as oil prices and EM assets continue selling off – as we expect. Even if Governor Elvira Nabiullina delivers rate cuts, they will be delayed and small. Hence, real rates will remain high, helping the ruble outperform other EM currencies. Provided the central bank remains behind the curve, odds are that the yield curve will probably invert as long-term bond yields drop below the policy rate (Chart I-4). In short, a conservative central bank will provide a friendly environment for fixed-income and currency investors. Third, the Russian ruble will depreciate only modestly despite the ongoing carnage in oil prices due to high foreign exchange reserves and a positive balance of payments. The current account surplus stands at 7.5% of GDP, or $115 billion. Both the central bank and the Ministry of Finance (MoF) have been buying foreign currency. In particular, based on the fiscal rule, the MoF buys U.S. dollars when oil prices are above $40/barrel and sells U.S. dollars when the oil price is below that level. As such, policymakers have created a counter-cyclical ballast to counteract any negative shocks. A fiscal fortress, as well as the potential for significant fiscal stimulus amid the current EM selloff, will help the Russian currency, local bonds and sovereign and corporate credit markets behave as a lower beta play within the EM universe. Remarkably, the monetary authorities have siphoned out the additional liquidity that has been injected as part of their foreign currency purchases. In fact, the CRB’s net liquidity injections have been negative. This is in contrast to what has been happening in many other EMs. These prudent macro policies will limit the downside in the ruble versus the dollar and the euro. Chart I-4Russia: Yield Curve Will Probably Invert Russia: Yield Curve Will probably Invert Russia: Yield Curve Will probably Invert Chart I-5Cash Flow From Operations: Russia Versus EM Cash Flow From Operations: Russia Versus EM Cash Flow From Operations: Russia Versus EM Finally, rising profits in the non-financial corporate sector and balance sheet improvements justify Russian equity outperformance relative to EM. Specifically, Russian firms’ cash flows from operation have been diverging from EM, suggesting the former is in better financial health than its EM counterparts (Chart I-5). Bottom Line: Even though we expect oil prices to drop further,1 investors should continue to overweight Russian equities, sovereign and corporate credit and local currency bonds relative to their respective EM benchmarks (Chart I-6). Chart I-6Continue Overweighting Russian Stocks And Bonds Continue Overweighting Russian Stocks And Bonds Continue Overweighting Russian Stocks And Bonds To express our positive view on the ruble, we have been recommending a long RUB / short COP trade since May 31, 2018. This position has generated a 10.8% gain, and remains intact. Andrija Vesic, Research Analyst andrijav@bcaresearch.com   Chile: Heading Into A Recession? Our recommended strategy2 for Chile has been to (1) receive three-year swap rates, (2) favor local bonds versus stocks for domestic investors, (3) short the peso versus the U.S. dollar, and (4) overweight Chilean equities within an EM equity portfolio. Chart II-1Chile's Central Bank Is Behind The Curve Chile's Central Bank Is Behind The Curve Chile's Central Bank Is Behind The Curve The first three strategies have played out nicely as the economy has slowed, rate expectations have dropped and the peso has plunged (Chart II-1). Yet the Chilean bourse has recently substantially underperformed the EM benchmark, challenging our overweight equity stance. At the moment, we recommend staying with these recommendations, as the growth slowdown in Chile has much further to run and the central bank will cut rates substantially: Our proxy for marginal propensity to spend among both households and companies – which leads the business cycle by six months – has been falling (Chart II-2). The outcome is that growth conditions will worsen, and a recession is probable. There are already segments of the economy – retail sales volumes, car sales, non-mining exports and mining output, to name a few – that are contracting (Chart II-3). Chart II-2More Growth Retrenchment In The Next 6 Months More Growth Retrenchment In The Next 6 Months More Growth Retrenchment In The Next 6 Months Chart II-3Chilean Economy: Certain Segments Are Contracting Chilean Economy: Certain Segments Are Contracting Chilean Economy: Certain Segments Are Contracting   Shockwaves from the global slump in general and China’s slowdown in particular are taking a toll on this open economy. Copper prices are breaking down, and Chile’s industrial pulp and paper prices are falling in dollar terms (Chart II-4). Bank loan growth as well as employment growth have not yet decelerated. The latter are typically lagging indicators in Chile. Therefore, as weakening growth erodes business and consumer confidence, credit growth as well as hiring and wages will retrench. Finally, both core consumer prices and service inflation rates are at the lower end of the central bank’s inflation target band. It is a matter of time before the growth deterioration leads to even lower inflation. We argued in our last analysis on Chile3 that large net immigration has boosted labor supply and is hence disinflationary. This, along with forthcoming hiring cutbacks, will depress wages and lead to lower inflation. Overall, Chile’s central bank is well behind the curve. A major rate reduction cycle is in the cards, as both growth and inflation will undershoot the Chilean central bank’s targets. Chart II-4Chile: Industrial Paper And Pulp Prices Are Deflating Chile: Industrial Paper And Pulp Prices Are Deflating Chile: Industrial Paper And Pulp Prices Are Deflating Chart II-5The Chilean Peso Is Not Cheap The Chilean Peso Is Not Cheap The Chilean Peso Is Not Cheap Lower interest rates, shrinking exports and a large current account deficit will weigh on the exchange rate. In addition, Chilean companies have large amounts of foreign currency debt ($75 billion or 26% of GDP), and peso depreciation is forcing them to hedge their foreign currency liabilities. This will heighten selling pressure on the peso. Notably, the currency is not yet cheap and bear markets usually do not end until valuations become cheap (Chart II-5). That said, the main reasons to continue overweighting Chilean equities within an EM universe are potential monetary and fiscal easing in Chile that many other EM are not in a position to do amid their own ongoing currency depreciation. Besides, this bourse’s relative equity performance versus the EM benchmark is already very oversold and is likely to rebound as the EM stock index drops more than Chilean share prices. The main reasons to continue overweighting Chilean equities within an EM universe are potential monetary and fiscal easing in Chile that many other EM are not in a position to do. Our recommended strategy remains intact: Fixed-income investors should continue receiving three-year swap rates; Local investors should overweight domestic bonds versus stocks; Currency traders should maintain the short CLP / long U.S. dollar trade; Dedicated EM equity portfolio managers should maintain an overweight in this bourse versus the EM benchmark. One trade we are closing is our short copper / long CLP, which has returned a 1.6% gain since its initiation on September 6, 2017. The original motive for this trade was to express our negative view on copper. While we believe copper prices have more downside, the peso could undershoot, which tips the balances in favor of closing this trade. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Juan Egaña, Research Associate juane@bcaresearch.com Footnotes 1      The Emerging Markets Strategy team’s negative view on oil prices is different from the BCA house view which is bullish on oil. 2      Please see "Chile: Stay Overweight Equities, Receive Rates," dated May 31, 2018 and "Chile: Favor Bonds Over Stocks," dated February 7, 2019. 3      Please see "Chile: Favor Bonds Over Stocks," dated February 7, 2019. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The May official PMI shows that manufacturing in China will slow over the coming year unless the recent doubling of U.S. import tariffs can be reversed and the imposition of the remaining tariffs can be avoided. The divergence between H-shares and both A-shares and the domestic fixed-income market suggests that China’s domestic financial market participants are pricing in some probability of a major reflationary response by Chinese authorities. We agree that such a response will occur over the coming 6-12 months, and would recommend that investors stay overweight Chinese equities within a global equity portfolio over that time horizon. Feature Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, April’s activity data provided early evidence that the trajectory of the economy was beginning to turn prior to the breakdown in U.S./China trade talks, in response to a meaningful credit improvement in Q1. The May Caixin manufacturing PMI was stable, but the official PMI fell and the experience of last year clearly shows that manufacturing in China will slow over the coming year unless the recent doubling of U.S. import tariffs can be reversed and the imposition of the remaining tariffs can be avoided. Assuming that the Trump administration follows through with its threat, investors are likely to see a repeat of last year’s perversely positive effects of tariff frontrunning on the Chinese trade data over the next few months; this should be viewed as confirmation of an impending collapse in trade activity, rather than a sign that the underlying trade situation is improving. Table 1China Macro Data Summary China Macro And Market Review China Macro And Market Review Table 2China Financial Market Performance Summary China Macro And Market Review China Macro And Market Review Within financial markets, the most notable development is the contrast between the relative performance of investable Chinese stocks on the one hand, and domestic equities and the Chinese fixed-income market on the other. The recent performance of investable stocks confirms that they have been driven nearly exclusively by trade war developments for the better part of the past year, whereas the somewhat better relative performance of A-shares and the calm in the government bond, corporate bond, and sovereign CDS markets suggests that China’s domestic financial market participants are pricing in some probability of a major reflationary response by Chinese authorities. We agree that such a response will occur over the coming 6-12 months, and would recommend that investors stay overweight Chinese equities within a global equity portfolio over that time horizon. In reference to Tables 1 and 2, we provide below several detailed observations concerning developments in China’s macro and financial market data: Chart 1A Strong Response From Policymakers Will Likely Offset The Coming Tariff Shock A Strong Response From Policymakers Will Likely Offset The Coming Tariff Shock A Strong Response From Policymakers Will Likely Offset The Coming Tariff Shock Both Bloomberg’s and our alternative calculation of the Li Keqiang index (LKI) rose in April, albeit only fractionally in the case of the latter. Still, as we noted in last week’s report,1 the Q1 rebound in credit appears to have halted the decline in investment-relevant Chinese economic activity (Chart 1). This suggests that the trajectory of the economy was beginning to change in April prior to the breakdown in U.S./China trade talks, implying that an aggressively stimulative response from Chinese authorities to counter a full 25% tariff scenario has good odds of succeeding. This supports our cyclically overweight stance towards Chinese stocks. Our leading indicator for the LKI declined slightly in April, but remains in a very modest uptrend. The gap between accelerating credit growth and the sluggishness of our leading indicator is explained by the fact that growth in Chinese M2 and M3 has been slow to rise. A weaker-than-expected recovery in Chinese economic activity is much more likely if money growth remains weak, but we cannot reasonably envision an outcome where credit growth continues to trend higher and growth in the money supply does not meaningfully accelerate. The incoming Chinese housing data continues to provide conflicting signals. The annual change of the PBOC’s pledged supplementary lending injections declined further in April, which since 2015 has done an excellent job explaining weak housing demand. However, both floor space started and sold picked up in April (Chart 2), and house price growth remained steady despite a significant decline in the breadth of house price appreciation across 70 cities. Policymakers are likely to allow aggregate credit growth to accelerate significantly over the coming 6-12 months in order to counter the deflationary impact of a trade war with the U.S., but our sense is that policymakers will then refocus their financial stability efforts on the household sector (i.e. they will work to prevent another significant reacceleration in household debt growth). Given this, we continue to expect that housing demand will remain weak, although we will be closely watching floor space sold over the coming few months. The new export orders component of the official manufacturing PMI is signaling an external outlook that is as negative as the 2015/2016 episode. The May official manufacturing PMI fell back into contractionary territory, led by a very significant decline in the new export orders component (Chart 3). The Caixin manufacturing PMI was stable, but the outlook for manufacturing in China is clearly negative unless the recent doubling of U.S. import tariffs can be reversed and the imposition of the remaining tariffs can be avoided. Investors are likely to see a repeat of last year’s perversely positive effects of tariff frontrunning on the Chinese trade data over the next few months; this should be viewed as confirmation of an impending collapse in trade activity, rather than a sign that the underlying trade situation is improving. Chart 2Surprising Resilience In China's Housing Market (For Now) Surprising Resilience In China's Housing Market (For Now) Surprising Resilience In China's Housing Market (For Now) Chart 3A Clearly Negative Outlook For Manufacturing A Clearly Negative Outlook For Manufacturing A Clearly Negative Outlook For Manufacturing There has been a sharp contrast in the behavior of the Chinese investable and domestic equity markets over the past month, which in our view confirms that the former has been driven nearly exclusively by trade war developments for the better part of the past year. Chart 4 shows that the relative performance of investable stocks (versus global) has nearly fallen back to its late-October low, whereas A-shares technically remain in an uptrend despite having sold off. Some investors have attributed the relative support of A-shares to aggressive buying by the “national team”, state-related financial market participants that the government has relied on since 2015 to manage volatility in the domestic equity market. Chart 4Are A-Shares Acting More Rationally Than The Investable Market? Are A-Shares Acting More Rationally Than The Investable Market? Are A-Shares Acting More Rationally Than The Investable Market? However, it is also possible that the A-share market is acting more rationally than the investable market, by focusing on the possibility of a major reflationary response to the Trump tariffs. This contrast in behavior between the investable and domestic markets was also observed pre- and post-February 15th, when the January credit data was released. Prior to this point, the A-share market was (rightly) not confirming the relative uptrend in investable stocks; following February 15th, A-shares exploded higher in response to tangible evidence that a upcycle in credit had arrived. If it is true that the A-share market is better reflecting the prospect of a reflationary response from Chinese policymakers, the relative performance trend for domestic stocks supports our decision to remain cyclically overweight Chinese stocks versus the global benchmark.   Chinese utilities and consumer staples have outperformed in both the investable and domestic equity markets over the past month, which is not surprising given that these sectors typically outperform during risk-off phases. Within the investable market, the sharp underperformance of the BAT (Baidu, Alibaba, and Tencent) stocks has been the most interesting (Chart 5). To the extent that the selloff in BAT stocks reflects trade war retaliation risk (through, for example, delisting from U.S. exchanges), then the selloff is rational. But the fact that Tencent (which also trades in Hong Kong) has also declined so sharply suggests that investors are blanket selling Chinese technology-related stocks out of concern that the sector will be heavily implicated by punitive action from the Trump administration. The BAT stocks are domestically oriented, meaning that “Huawei risk” appears to be minimal. Chart 5A Potential (Future) Opportunity In The BAT Stocks A Potential (Future) Opportunity In The BAT Stocks A Potential (Future) Opportunity In The BAT Stocks Beyond the near-term risk from deteriorating sentiment, the selloff in BAT stocks may present a cyclical opportunity for investors. Unlike Huawei, whose export-oriented business model relied on the U.S. as part of its supply chain, Alibaba and Tencent are largely domestically-driven businesses whose earnings will depend mostly on the outlook for Chinese consumer spending. We agree that reflationary efforts by Chinese policymakers will attempt to avoid stoking a significant acceleration in residential mortgage credit, but it is difficult to envision a scenario in which China stimulates aggressively and consumer spending growth does not accelerate. As such, investors should closely watch the performance of BAT stocks in response to reflationary announcements and developments on the credit front; we would strongly consider an outright long stance favoring BAT stocks if a technical breakout occurs alongside the release of data that is consistent with a significant improvement in the macro outlook. There has been little movement in the Chinese government bond market over the past month, with the Chinese 10-year government bond yield having fallen merely 10 basis points since late-April. This is in contrast to what has occurred in the U.S., with yields on 10-year Treasurys having come in roughly three times as much over the past month (Chart 6). The relative calm in the Chinese government bond market is echoed by the relative 5-year CDS spread between China and Germany, a component of our BCA Market-Based China Growth Indicator. While the spread has certainly moved higher in response to the breakdown in trade talks and President Trump’s full imposition of tariffs on the second tranche of imports from China, it remains below its 2018 average and well below levels that prevailed in 2015 and 2016 (Chart 7). Similarly, Chinese onshore corporate bond spreads have not reacted negatively to the resumption in the trade war, with the spread on the aggregate ChinaBond Onshore Corporate Bond Index up one basis point over the past month. Taken together with the relative performance of A-shares as well as Charts 6 and 7 we see this as evidence that China’s financial market participants are pricing in some probability of a major reflationary response by Chinese authorities. Chart 6Relative Calm In China's Fixed-Income Market Relative Calm In China's Fixed-Income Market Relative Calm In China's Fixed-Income Market Chart 7China's Sovereign CDS Spread Is Rising, But The Level Remains Low China's Sovereign CDS Spread Is Rising, But The Level Remains Low China's Sovereign CDS Spread Is Rising, But The Level Remains Low A decline in the RMB is necessary to stabilize China’s economy (and is thus reflationary), but global investors will not act like it is until the economy visibly improves. Global financial market commentary on the RMB has been focused almost exclusively over the past month on the USD-CNY exchange rate, but Chart 8 shows that the decline in the currency has been broad-based. The RMB has fallen roughly 1.4% versus the euro over the past month, and over 2% versus an equally-weighted basket of Asian currencies. We highlighted in our May 15 Weekly Report that a 25% increase in tariffs affecting all U.S.-China trade would cause economic conditions in China to deteriorate to 2015/2016-like levels, and that currency depreciation was essential in order to generate a 2015/2016-magnitude policy response.2 However, to the extent that the decline in the RMB will contribute to a period of greater volatility in the global foreign exchange market, China-related assets are not likely to respond positively to this form of stimulus until “hard” activity data clearly shows a meaningful rise. Chart 8The RMB Has Declined Against Everything, Not Just The Dollar The RMB Has Declined Against Everything, Not Just The Dollar The RMB Has Declined Against Everything, Not Just The Dollar   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com   Footnotes   1 Please see China Investment Strategy Weekly Report, “Waiting For The Pain”, dated May 29, 2019, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, “Simple Arithmetic”, dated May 15, 2019, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

"Tariff Man" Is On Fire "Tariff Man" Is On Fire While the media has zeroed in on the newly announced tariffs on Mexico late last week, tariffs on Indian imports and the narrowly avoided Australia trade war front barely made the news. This heightened policy uncertainty has taken investors aback. Worrisomely, the recent May update of the “Baker, Bloom, and Davis” categorical trade policy uncertainty index surged, which bodes ill for the overall market (trade policy uncertainty shown inverted, top panel). Similarly, we updated the article count that mention “trade war” using Bloomberg data and the message is similar: the opening up of new trade war fronts will continue to weigh on the broad market (trade war article count shown inverted, bottom panel). Bottom Line: Refrain from trying to catch a falling knife, a tactically cautious equity market stance is still warranted.

Feature Markets have turned jittery in the past month. Global growth data have deteriorated further (Chart 1), with Korean exports, the German manufacturing PMI, and even U.S. industrial production weak. Moreover, trade negotiations between the U.S. and China appear to have broken down, with China threatening to retaliate against U.S. sanctions on Huawei by blocking sales of rare earths, and refusing to negotiate further unless the U.S. eases tariffs. BCA’s Geopolitical Strategists now give only a 40% probability of a trade deal by the time of the G20 summit at the end of June (Table 1). As a result, BCA alerted clients on 10 May to the risk of a further short-term 5% correction in global equities.1 Recommended Allocation Monthly Portfolio Update: China To The Rescue? Monthly Portfolio Update: China To The Rescue? Chart 1Worrying Signs? Worrying Signs? Worrying Signs? Table 1Chances Of A Trade Deal Fading Fast Monthly Portfolio Update: China To The Rescue? Monthly Portfolio Update: China To The Rescue? What is essentially behind the global slowdown, especially outside the U.S., is that both China and the U.S. last year were tightening monetary policy – China by slowing credit growth, the U.S. via Fed hikes. The U.S. economy was robust enough to withstand this, but economies in Europe, Asia, and Emerging Markets were not (Chart 2). The question now is whether the Chinese authorities and the Fed will come to the rescue and add stimulus that will cause a recovery in global growth. China has already triggered a rebound in credit growth since January (Chart 3). Chart 2U.S. Holding Up Better Than Elsewhere U.S. Holding Up Better Than Elsewhere U.S. Holding Up Better Than Elsewhere Chart 3China Stimulus Has Only Just Begun China Stimulus Has Only Just Begun China Stimulus Has Only Just Begun This has not come through clearly in Chinese – and other countries’ – activity data yet, partly because there is usually a lag of 3-12 months before this happens, and partly because Chinese authorities seemingly eased back somewhat on the gas pedal in April given rising expectations of a trade deal. But, judging by previous episodes such as 2009 and 2016, the Chinese will stimulate now based on the worst-case scenario. The risk is more that they overdo the stimulus than that they fail to do enough. Yes, China is worried about its excess debt situation. But this year they will prioritize growth – not least because of some sensitive anniversaries in the months ahead (for example, the 70th anniversary of the People’s Republic on October 1), and because the government is falling behind on its promise to double per capita real income between 2010 and 2020 (Chart 4). Chart 4Chinese Communist Party Needs To Prioritize Growth Chinese Communist Party Needs To Prioritize Growth Chinese Communist Party Needs To Prioritize Growth Chart 5U.S. Consumers Look In Fine State U.S. Consumers Look In Fine State U.S. Consumers Look In Fine State     In the U.S., consumption is likely to continue to buoy the economy. Wages are growing 3.2% a year and set to accelerate further, and consumer confidence is close to a 50-year high (Chart 5). It is easy to exaggerate the impact of even an all-out trade war. For China, exports to the U.S. are only 3.4% of GDP. A hit to this could easily be offset by stimulus leading to greater capital expenditure. For the U.S, most academic studies show that the impact of tariffs will largely be passed on to the consumer via higher prices.2 But even if the U.S. imposes 25% tariffs on all Chinese exports and all is passed on to the consumer with no substitutions for goods from other countries the impact, about $130 billion, would represent only 1% of total U.S. consumption. The question now is whether the Chinese authorities and the Fed will come to the rescue and add stimulus that will cause a recovery in global growth. But if China will bail out the global economy, we are not so convinced that the Fed will cut rates any time soon. The market has priced in two Fed rate cuts over the next 12 months (Chart 6). But we agree with comments from Fed officials that recent softness in inflation is transitory. For example, financial services inflation (mostly comprising financial advisor fees, linked to assets under management, and therefore very sensitive to the stock market) alone has deducted 0.4 percentage points from core PCE inflation over the past six months (Chart 7). The trimmed mean PCE (which cuts out other volatile items besides energy and food, which are excluded from the commonly used core PCE measure) is close to 2% and continues to drift up. Chart 6Will The Fed Really Cut Twice In 12 Months? Will The Fed Really Cut Twice In 12 Months? Will The Fed Really Cut Twice In 12 Months? Chart 7Soft Inflation Probably Is Transitory Soft Inflation Probably Is Transitory Soft Inflation Probably Is Transitory     Fed policy remains mildly accommodative: the current Fed Funds Rate is still two hikes below the neutral rate, as defined by the median terminal-rate dot in the FOMC’s Summary of Economic Projections (Chart 8). The market may be trying to push the Fed into cutting rates and could be disappointed if it does not. For now, we tend to agree with the Fed’s view that policy is about correct (Chart 9) but, if global growth does recover before the end of the year, one hike would be justified in early 2020 – before the upcoming Presidential election in November 2020 makes it less comfortable for the Fed to move. Chart 8Fed Policy Is Still Accommodative Fed Policy Is Still Accommodative Fed Policy Is Still Accommodative Chart 9Fed Doesn't Need To Move For Now Fed Doesn't Need To Move For Now Fed Doesn't Need To Move For Now     In this macro environment, we see global bond yields bottoming not far below their current (very depressed) levels, and equities eking out reasonable gains over the next 12 months. The risk of a global recession over the next year or so is not high, in our opinion. We, therefore, continue to recommend an overweight on global equities and underweight on bonds over the cyclical horizon.  We see global bond yields bottoming not far below their current (very depressed) levels, and equities eking out reasonable gains over the next 12 months. Fixed Income: Government bond yields have fallen sharply over the past eight months (by 110 basis points for the U.S. 10-year, for example) because of 1) falling inflation expectations, caused mostly by a weak oil price, 2) expectations of Fed rate cuts, 3) especially weak growth in Europe, which pulled German yields down to -20 basis points in May, and 4) global risk aversion which pushed asset allocators into government bonds, and lowered the term premium to near record low levels (Chart 10). If Brent crude rises to $80 a barrel this year as we forecast, the Fed does not cut rates, and European growth rebounds because of Chinese stimulus, we find it highly improbable that yields will fall much further. Ultimately, the global risk-free rate is driven by global growth (Chart 11). Investors are already positioned very aggressively for a further fall in yields (Chart 12). We would expect the U.S. 10-year yield to move back towards 3% over the next 12 months. We remain moderately positive on credit, which should also benefit from a growth rebound: U.S. high-yield spreads are still around 70 basis points for Ba-rated bonds, and 110 basis points for B-rated ones, above the levels at which they typically bottom in expansions; investment-grade bonds, though, have less room for spread contraction (Chart 13). Chart 10Term Premium Near Record Low Term Premium Near Record Low Term Premium Near Record Low Chart 11Global Rebound Would Push Up Yields Global Rebound Would Push Up Yields Global Rebound Would Push Up Yields   Chart 12Investors Very Long Duration Investors Very Long Duration Investors Very Long Duration Chart 13Credit Spreads Can Tighten Further Credit Spreads Can Tighten Further Credit Spreads Can Tighten Further     Equities:  We remain overweight U.S. equities, partly as a hedge against our overweight on the equity asset class, since the U.S. remains a relatively low beta market. Our call for the second half will be 1) when will Chinese stimulus start to boost growth disproportionately for commodity and capital-goods exporters, and 2) does that justify a shift out of the U.S. (which may be somewhat hurt short term by the Trade War) and into euro zone and Emerging Markets equities. Given the structural headwinds in both (the chronically weak banking system and political issues in Europe; high debt and lack of structural reforms in EM), we want clear evidence that the Chinese stimulus is working before making this call. We are likely to remain more cautious on Japan, even though it is a clear beneficiary of Chinese growth, because of the risk presented by the rise in the consumption tax in October: after previous such hikes, consumption not only slumped immediately afterwards but remained depressed (Chart 14). Chart 14Japan's Sales Tax Hike Is A Worry Japan's Sales Tax Hike Is A Worry Japan's Sales Tax Hike Is A Worry Chart 15Dollar Is A Counter-Cyclical Currency Dollar Is A Counter-Cyclical Currency Dollar Is A Counter-Cyclical Currency   Currencies:  Again, China is the key. The dollar is a counter-cyclical currency, and a pickup in global growth would weaken it (Chart 15). Any further easing by the ECB – for example, significantly easier terms on the next Targeted Longer-Term Refinancing Operations (TLTRO) – might actually be positive for the euro since it would augur stronger growth in the euro area. Moreover, long dollar is a clear consensus view, with very skewed market positioning (Chart 16). Also, on a fundamental basis, compared to Purchasing Power Parity, the dollar is around 15% overvalued versus the euro and 11% versus the yen. Chart 16 Chart 17Industrial Metals Driven By China Too Industrial Metals Driven By China Too Industrial Metals Driven By China Too Commodities: Industrial metals prices have generally been weak in recent months with copper, for example, falling by 10% since mid-April. It will require a sustained rebound in Chinese infrastructure spending to push prices back up (Chart 17). Oil continues to be driven by supply-side factors, not demand. With OPEC discipline holding, Iran sanctions about to be reimposed, political turmoil in Libya and Venezuela, BCA’s energy strategists continue to see inventories drawing down this year, and therefore forecast Brent crude to reach $80 during 2019 (Chart 18). Chart 18Oil Supply Remains Tight Oil Supply Remains Tight Oil Supply Remains Tight Garry Evans Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1       Please see Global Investment Strategy, Special Report, “Stay Cyclically Overweight Global Equities, But Hedge Near-Term Downside Risks From An Escalation Of A Trade War,” dated May 10, 2019, available at gis.bcaresearch.com 2      Please see, for example, Mary Amiti, Sebastian Heise, and Noah Kwicklis, “The Impact of Import Tariffs on U.S. Domestic Prices,” Federal Reserve Bank of New York Liberty Street Economics, dated 4 January 2019. Recommended Asset Allocation