Emerging Markets

Highlights The Eurostoxx600’s short bursts of outperformance require either global technology to underperform or the euro to underperform. EM’s short bursts of outperformance usually coincide with the global healthcare sector’s short bursts of underperformance. Remain tactically overweight to Europe and EM, but expect to reverse position later in the year. The ECB is justified in setting an accommodative monetary policy, but it is not justified in setting an ultra-accommodative monetary policy. Soft inflation prints will cap the extent to which bond yields can rise in the near term. Italian BTPs are an attractive long-term proposition, especially relative to other euro area bonds. Feature Chart of the WeekEuro Area Inflation Appears To Be Underperforming... Euro Area Inflation Appears To Be Underperforming... ...But Adjusted For Its 'Negative Space' It Is Not Euro Area Inflation Appears To Be Underperforming... ...But Adjusted For Its 'Negative Space' It Is Not ...But Adjusted For Its 'Negative Space' It Is Not Euro Area Inflation Appears To Be Underperforming... ...But Adjusted For Its 'Negative Space' It Is Not Euro Area Inflation Appears To Be Underperforming... ...But Adjusted For Its 'Negative Space' It Is Not     “The music is not in the notes, but in the silence between”  – Wolfgang Amadeus Mozart As Mozart pointed out, true awareness lies not in appreciating what is there, but in appreciating what is not there. This is the concept of ‘negative space’: to understand an object, you have to understand the empty space that defines it. This week’s report extends the concept of negative space into the fields of investment and economics to make more sense of Europe’s recent past and its future. The Negative Space In Stock Markets Picking stock markets is a relative game. This means that what a stock market does not contain – its negative space – is often more important than what it does contain (Table I-1). This is not an abstract proposition, it is a mathematical truth. When a major global sector is strongly outperforming, a stock market’s zero or near-zero exposure to that sector will create a strong headwind to relative performance. And when the major sector is underperforming, its absence in the stock market will necessarily create a strong tailwind to relative performance. Chart I- For the European stock market, the negative space is technology, a sector in which European equities have a near-zero exposure. But there is another factor to consider: the currency. The technology sector’s global profits are mostly translated into shares quoted in dollars, while European equities’ global profits are mostly translated into shares quoted in euros. It follows that the Eurostoxx600’s short bursts of outperformance require at least one of the following two conditions (Chart I-2): Chart I-2The Eurostoxx600 Usually Outperforms When Technology Underperforms The Eurostoxx600 Outperforms When Technology Underperforms The Eurostoxx600 Outperforms When Technology Underperforms Technology to underperform. Or: The euro to underperform. For emerging market (EM) equities, the negative space is healthcare, a sector in which EM has a near-zero exposure. Therefore unsurprisingly, EM’s short bursts of outperformance usually coincide with the healthcare sector’s short bursts of underperformance (Chart I-3). Sceptics will raise an obvious question: what is the cause and what is the effect? The answer is that sometimes EM is the driver of healthcare relative performance, and at other times vice-versa. Chart I-3EM Usually Outperforms When Healthcare Underperforms EM Outperforms When Healthcare Underperforms EM Outperforms When Healthcare Underperforms A sharp slowdown emanating from emerging economies would undoubtedly drag down global equities. In the ensuing bear market, the more defensive healthcare sector would almost certainly outperform the financials. Under these circumstances the direction of causality would clearly be from EM to healthcare’s relative performance. On the other hand, absent a major bear market, in a common or garden reassessment of sector relative valuations versus their growth prospects, the causality would run in the other direction: sector rotation would drive the relative performance of equity markets: healthcare’s underperformance would help EM to outperform; and technology’s underperformance would help European equities to outperform. As we have explained in recent reports, the major sectors – and therefore the major stock markets – are now in this latter configuration in a brief countertrend burst before reverting to their structural trends later this year (Chart I-4 and Chart I-5). So for the time being, remain tactically overweight to Europe and to EM.1 Chart I-4The Eurostoxx600 Outperformance Is A Countertrend Burst The Eurostoxx600 Outperformance Is A Countertrend Burst The Eurostoxx600 Outperformance Is A Countertrend Burst Chart I-5The EM Outperformance Is A Countertrend Burst The EM Outperformance Is A Countertrend Burst The EM Outperformance Is A Countertrend Burst The Negative Space In European Inflation And Unemployment On the face of it, inflation is structurally underperforming in the euro area versus the U.S. But on closer examination this is only because of what the euro area harmonised index of consumer prices (HICP) does not contain: owner occupied housing costs – which tend to rise faster than other items in the price basket. Adjusting for this negative space in the HICP, the euro area and the U.S. have both achieved the exact same modest structural inflation, which their central banks define as ‘price stability’ (Chart of the Week).   In a similar vein, the unemployment rate disregards changes in the labour participation rate. When people join the labour force – as they are in their tens of millions in Europe (Chart I-6) – the joining cohort tends to have a slightly higher unemployment rate given its inexperience in the formal labour market. So the joiners tend to lift the overall unemployment rate too. The paradox is that the percentage of the working age (15-74) population in employment also rises at the same time. Looking at this alternative measure of labour market health, the euro area employment market is in a structural uptrend and much healthier than it was at the peak of the last cycle in 2008 (Chart I-7). Chart I-6Europeans Are Joining The Labour Force In Their Tens Of Millions Europeans Are Joining The Labour Force In Their Tens Of Millions Europeans Are Joining The Labour Force In Their Tens Of Millions   Chart I-7The European Employment To Population Ratio Is In A Structural Uptrend The European Employment To Population Ratio Is In A Structural Uptrend The European Employment To Population Ratio Is In A Structural Uptrend Hence, once we adjust for what is missing in euro area inflation and the euro area unemployment rate, neither inflation nor employment market performance appear to be too cold or too hot. This means that the ECB is justified in setting an accommodative monetary policy, but it is not justified in setting an ultra-accommodative monetary policy. The Negative Space In Monetary Policy The negative space in monetary policy is literally the negative space, by which we mean that interest rates cannot go deeply into negative territory. With the deposit rate already at -0.4 percent, the ECB’s room for manoeuvre in the dovish direction is limited. On the other hand, neither can monetary policy get meaningfully hawkish in the near term. The simple reason is that the ECB, like other central banks, is now even more wedded to ‘data-dependency’. The problem with this is that the data on which the central banks depend is always backward-looking. So policy will reflect what was happening one or two months ago, rather than what is happening now. Specifically, the plunge in the price of crude oil will depress both headline and core inflation rates (Chart I-8). And the recent wobble in risk-asset prices has weighed down some sentiment surveys (Chart I-9). Having promised to be data-dependent, the central banks have effectively created ‘an algorithm’ for their policy setting, an algorithm which everyone can see and read. It follows that the data, especially soft inflation prints, will cap the extent to which bond yields can rise in the near term. Chart I-8The Plunge In The Price Of Crude Will Subdue Inflation The Plunge In The Price Of Crude Will Subdue Inflation The Plunge In The Price Of Crude Will Subdue Inflation Chart I-9The Stock Market Sell-Off Hurt Sentiment The Stock Market Sell-Off Hurt Sentiment The Stock Market Sell-Off Hurt Sentiment However, core euro area bonds are an unattractive long-term proposition. When yields are so close to their lower bound, there is little scope for a capital gain, even in a crisis. Whereas the scope for a capital loss is considerably greater. By contrast, Italian BTPs are an attractive long-term proposition, especially relative to other euro area bonds. Almost all of the 2.75 percent yield on 10-year BTPs is a premium for euro break-up risk. Yet the populists in Italy do not want to break up the euro. And despite their rhetoric, neither do the populists in the core countries. To understand why, we must explain the negative space of ECB QE. When the ECB bought BTPs from Italian investors, what the Italian investors did not do was deposit the cash in Italian banks. Instead, they deposited it in German banks – something that we can see very clearly in the euro area’s mirror-image Target2 imbalances (Chart I-10). Chart I-10ECB QE Has Exacerbated The Target2 Imbalances ECB QE Has Exacerbated The Target2 Imbalances ECB QE Has Exacerbated The Target2 Imbalances In effect, the core countries, through their equity in the Eurosystem, are holding a huge quantity of Italy’s €2.7 trillion of BTPs. Meaning that if the euro broke up, the core countries would be the ones picking up the tab. For the euro area’s future, this is the most important negative space of all. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System* There are no new trades this week. But all four of our open trades – long PKR/INR, industrials versus utilities, litecoin and ethereum, and MIB versus Eurostoxx – are in profit. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Footnotes 1 Please see the European Investment Strategy Weekly Report, “Why 2019 Is The Mirror-Image Of 2018”, dated January 10, 2019, available at eis.bcaresearch.com. Fractal Trading Model Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights So What? It is too soon to adopt a cyclical overweight position on Chinese equities. Remain overweight only tactically. Why? China is still maintaining a disciplined approach to economic stimulus. The US-China trade talks are making tentative progress, but there is still a 30% chance of tariff rate hikes this year. The House Democrats show that the US’s tougher approach to China is a bipartisan policy consensus. Feature China released preliminary 2018 GDP data on January 21. The annual real growth rate was recorded at 6.6%, a fall from the 6.9% of 2017, although the latter has now been revised down to 6.8% (Chart 1). The big picture in 2018 is the slowest credit growth on record, the slowest retail sales growth since 2003, the weakest manufacturing output since 2014, and a negative export shock due to trade war (Chart 2). Chart 1China’s Slowdown In Perspective China's Slowdown In Perspective China's Slowdown In Perspective Chart 2A Rocky Road For Beijing A Rocky Road For Beijing A Rocky Road For Beijing The immediate question for investors in 2019 is whether the downside risk has become so pressing that President Xi will shift the policy gear from growth stabilization to total reflation. So far the evidence suggests that the policy stance has not changed from last July. Official rhetoric continues to eschew opening the stimulus floodgates. This disciplined approach is clear when examining the most recent reflationary actions: Fiscal Easing: Local governments are allowed to start issuing 1.39 trillion RMB in new bonds from the beginning of the year, rather than waiting until April or May like usual (Chart 3). This will create a substantial new fiscal boost in the first half of the year that could help stabilize the economy in the second half.1 This 1.39 trillion RMB is not the full-year quota (last year’s was 2.18 trillion RMB). If the government had wanted to create a “big bang” effect, it would have announced a very large new quota for the full year all at once – something approaching 3.4 trillion RMB. This is what the year’s total would be if new issuance grew at the average 55% growth rate since 2015 (Chart 4). But so far the government is focusing on “frontloading” rather than “expanding” the amount of new bonds allowed to be issued. The full-year quota is important to watch in March. Anything above 2.9 trillion RMB would mean a looser fiscal stance from last year. Chart 3 Chart 4 Otherwise, fiscal easing is focusing on tax cuts for households, small businesses, and consumers rather than new loans to SOEs as in the past. The new tax cuts in 2019, for small and medium-sized enterprises (SMEs), amount to about 200 billion RMB, according to government statements. This comes on top of a 1.3 trillion RMB tax cut that took effect at the end of last year. Therefore the minimum tax relief in 2019 is 1.5 trillion RMB or 2% of GDP. The impact is positive for consumer demand but unlikely to produce a rapid V-shaped turnaround in the growth rate, as was once the case with huge bursts of new loans to the corporate sector. Finally, depending on monetary policy, increases to fiscal spending will mostly serve to offset weak credit growth and the resulting drag on economic activity. Monetary Easing: The People’s Bank of China is, on balance, injecting liquidity into the system (net negative sterilization). Injections via the medium-term lending facility are also growing (Chart 5). However, the interbank rate had increased recently, so that recent central bank injections are mostly maintaining the easy conditions of H2 2018 (Chart 6). The extraordinary liquidity injections of January are preemptive attempts to ensure ample liquidity ahead of the Lunar New Year, when funds are tight. Chart 5PBoC Remains Supportive PBoC Remains Supportive PBoC Remains Supportive Chart 6Interbank Rates Pushed Back Down Interbank Rates Pushed Back Down Interbank Rates Pushed Back Down   Cuts in banks’ required reserve ratios (RRRs) have not yet triggered a clear revival in credit growth. The twelve-month credit impulse has not yet bottomed, even though broad money impulses are positive or moving into positive territory (Chart 7). Shadow financing remains weak. Regulatory tightening is suppressing non-bank lenders while private business sentiment remains troubled (Chart 8). Chart 7No Clear Bottom In Credit Impulse Yet bca.gps_sr_2019_01_23_c7 bca.gps_sr_2019_01_23_c7 Chart 8Shadow Financing Still Under Pressure Shadow Financing Still Under Pressure Shadow Financing Still Under Pressure ​​​​​​​ Once the credit impulse bottoms and turns upward, there will likely be a 6-9 month lag before it lifts overall economic activity. In March at the National People’s Congress session, Premier Li Keqiang is expected to set the official GDP growth target at a range of 6%-6.5% for 2019, lower than 2018’s “around 6.5%.” Several of China’s provinces are downgrading their growth targets for this year (Chart 9). The various stimulus measures are apparently seen as limiting downside risks rather than creating a new upside risk. Chart 9 ​​​​​​​ As a result of the policy easing that is taking place, our Global Investment Strategy expects Chinese growth to stabilize and global growth to recover after H1.2 Bottom Line: The clear implication is that the Xi administration remains disciplined in its use of macroeconomic tools to ease fiscal and monetary conditions. We have not yet seen a “whatever it takes” moment. Nevertheless, the accumulation of easing measures suggests that the economy could stabilize by mid-year. A Sign Of Progress In The Trade Talks The most likely basis for a “whatever it takes” moment is either a sudden and sharp deterioration in the economy despite the various easing measures, or a renewed escalation of the trade war. For the moment we will assume that the economy will respond to stimulus measures, albeit with a lag, which would be conducive to a bottoming in mid-2019. In this case, what is the likelihood that the trade war will escalate again, with President Trump increasing the Section 301 tariffs from their current level of 10% on $200 billion worth of imports? We maintain that the odds of the two sides agreeing to a framework trade deal by the March 1 negotiation deadline are about 45%. We upgraded the odds of a deal in December given the tariff ceasefire reached on December 1. Since then the news flow has generally suggested that the two sides are making progress in the 90-day talks: a US delegation in Beijing went into an extra day of talks, and was attended by Vice Premier Liu He, the top economics adviser of President Xi Jinping. However, given the difficulty of the negotiations – the thorny issues like forced tech transfer – we also give 25% odds to an extension of negotiations, prolonging the tariff ceasefire beyond March 1. This adds up to a 70% chance that tariffs will not increase this year. The remaining 30% is the chance that the trade war escalates again (Table 1). Table 1Updated Trade War Probabilities Is China Already Isolated? Is China Already Isolated? ​​​​​​​ The key question going forward: How pragmatic are Donald Trump and Xi Jinping? We have evidence that President Trump is pragmatic. He rapidly shifted his approach to Iran, by issuing the waivers on oil sanctions in November, and to China, by agreeing to the tariff ceasefire. He softened his stance to avoid an oil price shock and equity bear market in Q4 last year. Equity bear markets tend to coincide with recessions (Chart 10). And a recession would dramatically reduce Trump’s chances of reelection in November 2020 (Chart 11). Hence Trump is pushing for a short-term trade deal. He is now reportedly even considering a rollback of some tariffs in return for Chinese concessions.3 Chart 10   Chart 11… And Presidents Lose Reelection Amid Recession ...And Presidents Lose Reelection Amid Recession ...And Presidents Lose Reelection Amid Recession What about Xi? We have argued that Xi is somewhat pragmatic – at least, more so than the consensus holds. It is undeniable that Xi is a hardliner who has reasserted his personal control, and Communist Party dominance, to a degree not seen in recent memory. He is also aggressive on foreign policy, unlike his predecessors. These trends are deeply concerning both for China’s governance and for relations with the West. They help to support our view that US-China relations are worsening on a secular basis. Nevertheless, as things currently stand, the weak domestic economy and negative sentiment seem to be encouraging Xi to play for time – which is, after all, the traditional Chinese play in trade tensions with the United States. His administration has offered a handful of concessions – on soybeans, auto tariffs, and goods imports – in order to push the negotiations along. The most important potential concession, however, is the new draft law on foreign investment. This is the one concession so far that addresses the US’s structural demands on technology transfer and intellectual property (the grievances that motivate the tariffs). China has one of the most restrictive environments for foreign investment in the world (Chart 12) and this is one of the US’s chief complaints: both because of the inherent denial of market access and because FDI restrictions are used as leverage to extract technology. Chart 12 The National People’s Congress released a new draft law on December 26, 2018, updating a draft law issued by the Ministry of Commerce in 2015 that was never passed.4 An extraordinary meeting of the Standing Committee occurred in January to speed this draft along. The law would ostensibly: Protect intellectual property rights of foreign firms; Prohibit forced technology transfers – including by replacing earlier laws that required companies to operate as “joint ventures,” often exposing them to forced tech transfer. Grant equal treatment to foreign-invested enterprises within China, compared to state-owned and state-controlled enterprises; Implement a negative investment list so that foreign investors could assume that they are free to invest in areas not explicitly proscribed; Allow foreign firms to raise funds, including through initial public offerings on China’s domestic equity market. This law confirms our view that the 90-day negotiation period is tied to the Trump administration’s emphasis on the implementation of any agreements: in early March, China’s National People’s Congress can enact new laws that will ostensibly address US concerns and thus put its concessions in ink. On paper this law would go some way in assuaging US and other foreign investor concerns. However, without a strong central government commitment to enforce the law, it is doubtful that it would reduce the trade and investment practices in China that offend the United States. After all, China’s methods of tech transfer and IP theft are mostly executive rather than legislative in nature – they stem from positive actions by central and local governments, and state-controlled companies, rather than from gaps or loopholes in the legal framework. Even taking the law at face value, its implementation – which is slated for a period of no fewer than five years – could be a mixed blessing for foreign investors.5 For instance, companies with a small foreign ownership stake will now be qualified as foreign-invested companies, which could bring difficulties if the new law is not implemented fairly or in good faith. Many foreign-invested enterprises would have to restructure their ownership and operations in order to fit into the new foreign investment framework (e.g. variable interest enterprises). While foreign enterprises are supposed to receive equal treatment even in government procurement, it is not clear whether they will in the quasi-government sector. Expropriation of foreign assets may still be justified very broadly. The law could also be used as a substitute for lifting the caps on foreign equity ownership in enterprises and for resolving problems with intellectual property licensing and payment of royalties. Moreover, the law is likely to enshrine a tougher regime for national security risk reviews. The US has tightened scrutiny of Chinese investments through the Foreign Investment Risk Review Modernization Act (FIRRMA) over the past year, and China may wish to toughen its own stance. Ultimately China does not need a law to strike down foreign investments that it believes jeopardize national security, but the law could provide justification for retaliation when the US strikes down Chinese investment on similar grounds. Nevertheless, in general, this law is an example of the kind of concession that is necessary for Trump to save face if he is determined to agree to a short-term framework trade deal to help prevent a bear market. Will the US accept this new law as a substantial concession, worthy of rolling back tariffs? So far the feedback is not encouraging. The chief US negotiator, Trade Representative Robert Lighthizer, has reportedly told Senator Chuck Grassley that China has not made any “structural” concessions yet – which suggests that Lighthizer is not impressed by the mere rubber-stamping of a new law.6 Much will depend on the next round of negotiations, dated January 30-31, when Vice Premier Liu He will come to DC for the first time since his humiliation in May last year. At that time he negotiated a deal and the US and China released a joint statement, only to have Trump renege on it three days later. He would not be going back to the US if there were not a substantial commitment on both sides to seek progress. Ultimately Trump, not Lighthizer, will determine whether to pause or roll back the tariff rates. Trump may decide he needs a deal and therefore accept the new law as a sufficient concession. He would still have the possibility of disputing its implementation (or lack thereof) at a later date – for instance, just before the 2020 election. The durability of any framework deal will be measured in the irreversibility of China’s concessions and the extent to which Trump moderates the tariffs. At least some rollback would seem necessary to reciprocate China’s concessions if a framework deal is to be done. The tariffs were imposed in separate tranches with adjustable rates, so Trump can reduce the tariffs in various ways. Bottom Line: There is room for a short-term, tactical trade deal that allows for some tariff rollback, given that China is tentatively making concessions on core US demands. Talks could also be extended, with tariff rates remaining at their current levels. These two possibilities mean that a hike in tariff rates is not the likeliest scenario for most of 2019. However, the new law on foreign investment only tentatively answers what the US is really demanding. We continue to believe that US-China relations are getting worse on a secular basis and that improvements will be tactical (or at best cyclical) in nature. Democrats Are Not Pro-China One of the main reasons for thinking that Xi may offer short-term concessions to get a deal with Trump is also one of the main reasons for thinking that long-term concessions are out of reach: there is an across-the-board policy consensus taking shape in Washington demanding tougher policy on China. We have emphasized that this policy consensus is apparent not only from Trump’s election – as an avowed protectionist and China-basher within the Republican Party – but also from the hardening position of the US defense establishment, and the disillusionment of the corporate lobby, over the past decade (Chart 13). Chart 13 ​​​​​​​ It is also a bipartisan consensus in Congress. For instance, last year, the House draft of the aforementioned FIRRMA Act, tightening foreign investment scrutiny on China, passed by a 398-vote margin in June. The final version passed by a large margin in the House (359-54) and Senate (87-10) in the form of the John S. McCain Defense Authorization Act. The Taiwan Travel Act and the Asia Reassurance Initiative Act, which offended Beijing, both passed with unanimous consent in the Senate (and voice vote in the House). Now the new Democrat majority in the House is confirming that tougher rules on China are something that everyone can agree on. For example, the new Chairman of the House Ways and Means Committee, Representative Richard Neal (D, MA), has struck a hawkish tone on the 90-day trade talks. He has warned that the US Trade Representative has “an obligation to look beyond the political pressures of the moment and the easy, one-off transactions, and secure real and lasting change to China’s anti-competitive behavior.”7 Furthermore, Senator Chris Van Hollen (D, MD) and Representative Ruben Gallego (D, AZ) have joined with Republicans Tom Cotton (R, AR) and Mike Gallagher (R, WI) to propose legislation that would give “the death penalty” to Chinese tech companies such as Huawei and ZTE if they violate US sanctions laws or export controls.8 This is an extremely aggressive piece of legislation that President Trump will have to contain if he is to keep a deal with President Xi. This bipartisan effort should come as no surprise. The Democrats were the more skeptical party about both global free trade and China in recent decades. This is because they positioned themselves as the defenders of workers, wages, and manufacturing, notably in the Midwestern Rustbelt States. Democrats have also always criticized China’s human rights record, with President Bill Clinton famously calling China’s leaders “the Butchers of Beijing” during the 1992 presidential campaign (Chart 14). Chart 14 In the post-Cold War context, this protectionist strain was subdued as the free market consensus prevailed across the political spectrum. It was President Clinton who negotiated for China to enter the World Trade Organization – despite the opposition of many within his party, including current House Speaker Nancy Pelosi – in order to smooth the process of globalization underway. This context began to change after the Great Recession, as the US debt supercycle ended, China emerged as a major competitor, and the Barack Obama administration attempted to develop a Democrat response to new challenges. President Obama supported “Buy America” provisions in the crisis-era stimulus package and engaged in tit-for-tat tariffs with China. The Trans-Pacific Partnership (TPP) multilateral trade deal deliberately excluded China, particularly if it could not embrace the liberal reforms, and trade and cyber-security standards, included in the TPP’s provisions. Finally, President Obama and Secretary of State Hillary Clinton initiated the “Pivot to Asia,” an attempt to reduce US military commitments in the Middle East and reposition for a long-term strategic competition with China in the Asia Pacific. The Trump administration has continued the pivot to Asia in all but the TPP. Trump reportedly even considered naming Jim Webb, a Democratic former navy secretary and China hawk, as his new Secretary of Defense, to replace Secretary James Mattis. But the new policy consensus is best encapsulated by Mattis’s interim replacement, Pat Shanahan, who began his job as acting Defense Secretary this month by telling his staff to focus on “China, China, China.”9 Trump is now considering keeping Shanahan for a “long time.” Now, with Democrats coming back into power in the House, it is becoming even clearer that China faces hawkish trade policies from the Left as well as the Right. This has important implications. In the short term, this process suggests that President Xi may be incentivized to offer some concessions to President Trump, who wants to protect the business cycle and position himself as a successful dealmaker before 2020, rather than stonewalling and fueling the rise of the new anti-China consensus. In the long term, however, this process also suggests that Xi is unlikely to offer deep structural concessions, given that either Trump or a new Democratic administration could ultimately reject the terms of the deal. After all, if the stock market avoids a bear market and the economy strengthens, Trump could turn his back on the deal. In particular, the fired-up US economy is likely to widen the deficit, forcing Trump to give an explanation on the campaign trail (Chart 15).10 But if the economy goes into recession, Trump may have no other policy option to rally voters other than aggressive foreign policy – which could mean aggressive trade policy against China. Chart 15Trump Will Have To Explain This In 2020 Trump Will Have To Explain This In 2020 Trump Will Have To Explain This In 2020 ​​​​​​​ Subsequent to 2020, Trump will either have a renewed election mandate to pursue trade war – in which he is less vulnerable to recession timing – or a new Democratic administration will pick up where President Obama left off, with the Pivot to Asia … including the TPP and other multilateral initiatives. It is also entirely likely that the US and China could adhere to a framework trade deal and yet heighten their strategic standoff in other areas. First, the US is making progress in forming a coalition of nations against Huawei’s participation in 5G networks – China’s relations with Canada are deteriorating rapidly and now Germany, a critical swing player, is even considering a ban on Huawei.11 Second, Taiwan and the South China Sea could see more saber-rattling or incidents even as trade tensions stagnate. (North Korean diplomacy, by contrast, is continuing to progress as long as the US-China trade talks are progressing – Trump and Kim Jong Un are set to hold a second summit in late February.) Bottom Line: The “anti-China” turn in US policy is not limited to Trump. Rather, Trump was the catalyst for a new policy consensus that was already emerging in the Obama years. Democrats will likely take a tough stance on China trade, including pressuring Trump if he strikes a deal with Xi Jinping, in order to woo voters in the Midwest. Any future Democratic White House should be expected to continue pressing China on issues ranging from national security to cyber-security to human rights, while likely pursuing a more multilateral diplomatic approach than the current White House. Investment Implications BCA’s Geopolitical Strategy is tactically overweight Chinese equities ex-tech relative to emerging markets. We are closing our short China-exposed US companies relative to the S&P 500 for a gain of 1.7%. Meanwhile China Investment Strategy is tactically overweight Chinese equities relative to the MSCI World index. Tariffs remaining at their current level now appears to be the most likely scenario for this year. Holding all else constant, this scenario is positive for Chinese growth and China-related assets. But beyond a near-term pop for financial markets, we still need to see hard evidence that the accumulation of China’s easing measures will indeed stabilize its domestic economy. This suggests that it is too soon to give the “all clear” sign from a cyclical perspective. On the other hand, a verified failure of the current, substantive US-China attempt to negotiate a truce would have a deeper negative impact on sentiment and trade than the original outbreak of trade war in 2018, as there will no longer be a basis for optimism. The market will have to price an ultimate 25% tariff on $500 billion worth of goods. This will likely cause the CNY-USD exchange rate to plummet (Chart 16). This would, at least at first, send a deflationary impact across emerging markets and the world, causing another negative hit to global trade and hence a flight to quality. Chart 16A Trade War Escalation Will Send The Yuan Reeling A Trade War Escalation Will Send The Yuan Reeling A Trade War Escalation Will Send The Yuan Reeling ​​​​​​​ The PBoC would most likely have to stage a defense of the currency while the State Council, judging by its actions in July 2018, would likely launch a large stimulus package of the sort that it has thus far avoided for fear of credit excesses. This would come at the cost of a still larger debt burden and misallocation of capital – undoing overnight the work that President Xi has put into mitigating these structural imbalances – but it would prevent a precipitous slowdown for the time being. A trade war-induced stimulus would ostensibly help reaccelerate the Chinese economy and global growth, but in our view financial markets would not respond all that happily to such a huge dose of volatility, trade uncertainty, and policy uncertainty at a time when the cycle will be very late anyway. The risk premium would go up sharply, at least for a time, raising the odds of a very sizeable earnings contraction before the economy begins to recover.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Please see BCA Emerging Markets Strategy Weekly Report, “Dissecting China’s Stimulus,” January 17, 2019, available at www.bcaresearch.com. 2 Please see BCA Global Investment Strategy Weekly Report, “Patient Jay,” January 18, 2019, and “Low Odds Of An FCI Doom Loop,” January 4, 2019, available at www.bcaresearch.com. 3 Please see Steve Holland, Tom Brown, and Leslie Adler, “Trump says deal ‘could very well happen’ with China,” Reuters, January 19, 2019, available at af.reuters.com. 4 Please see “Foreign Investment Law of the People’s Republic of China (Draft) for comments,” National People’s Congress of the People’s Republic of China, December 26, 2018, available at www.npc.gov.cn. See also “Public Comments Sought on the Foreign Investment Law of the People’s Republic of China,” Ministry of Commerce, January 19, 2015, available at www.troutman.com. 5 Please see Lester Ross, Kenneth Zhou, and Tingting Liu, “China Rolls Out New Draft Foreign Investment Law,” January 10, 2019, available at www.wilmerhale.com. See also Manuel Torres and Diego D’Alma, “China Publishes New Draft Of Foreign Investment Law,” Garrigues, Commentary: Corporate China, January 17, 2019, available at www.garrigues.com. 6 Please see Humeyra Pamuk, “U.S. trade chief saw no progress on key issues in China talks: Senator,” Reuters, January 15, 2019, available at www.reuters.com. 7 Please see James Politi, “Washington’s China hawks fear Trump will yield in trade war,” Financial Times, January 12, 2019, available at www.ft.com. 8 Please see Diane Bartz and Christian Shepherd, “U.S. legislation steps up pressure on Huawei and ZTE, China calls it ‘hysteria,’” Reuters, January 16, 2019, available at ca.reuters.com. Note that Democrats have also joined proposals “to condemn gross human rights violations of ethnic Turkic Muslims in Xinjiang” and to restore Taiwan’s observer status in the World Health Organization in the first month of the congressional session. 9 Please see Robert Burns, “New Pentagon leader Shanahan says he is focusing on China,” Associated Press, January 2, 2019, available at www.pbs.org. 10 Please see BCA Global Investment Strategy Weekly Report, “The Next U.S. Recession: Waiting For Godot?” dated October 5, 2018, available at www.bcaresearch.com. 11 Please see Elizabeth Schulze, “Huawei could be banned from 5G in Germany,” CNBC, January 18, 2019, available at www.cnbc.com.  

Highlights The U.S. economy is slowing in a completely predictable manner. With inflationary pressures largely dormant, the Fed can afford to stay on hold for the next few FOMC meetings. Growth in the U.S. and the rest of the world should stabilize by mid-year. This will enable the Fed to resume raising rates in June. A bearish stance towards U.S. Treasurys is warranted over a 12-month horizon. As long as the Fed is hiking rates in response to above-trend GDP growth rather than accelerating inflation, risk assets will fare well. Investors should overweight global equities and spread product for now, but monitor inflation trends closely for signs of when to get out. Brexit fears are overdone. Stay long the pound versus the euro. We were stopped out of our short AUD/JPY trade for a gain of 10%. Feature A Predictable Slowdown Investors are misunderstanding the nature of the current slowdown in the United States and much of the world. Completely predictable slowdowns, such as this one, rarely morph into recessions. Real U.S. GDP rose at a blistering 3.8% average annualized pace in Q2 and Q3 of 2018. There is no way that sort of growth rate could have been sustained. Financial conditions also tightened sharply in Q4, which has inevitably weighed on growth. Given the stock market rout, it is actually surprising that the economy has not weakened more than it has. The New York Fed GDP Nowcast points to growth of 2.5% in Q4 of 2018 and 2.1% in Q1 of 2019. This is still above the Fed’s long-term estimate of potential GDP growth of 1.9%. Most of the slowdown has been concentrated in the manufacturing sector, but even there, the bloodletting may be ending. The latest Philadelphia Fed survey — arguably the most important of the regional Fed manufacturing reports — showed an uptick in activity, with the new orders component hitting the highest level since last July. Despite the tightening in financial conditions, bank lending to the business sector has accelerated over the past three months (Chart 1). The Conference Board’s Leading Credit Index remains in expansionary territory (Chart 2). While business capex intention surveys have come off their highs, they still point to robust spending plans over the next few quarters (Chart 3). Chart 1Credit Is Still Flowing To U.S. Businesses Credit Is Still Flowing To U.S. Businesses Credit Is Still Flowing To U.S. Businesses Chart 2Little Sign Of A Looming Credit Crunch Little Sign Of A Looming Credit Crunch Little Sign Of A Looming Credit Crunch Chart 3Capex Plans Still Solid Capex Plans Still Solid Capex Plans Still Solid The labor market remains healthy, as evidenced by ongoing strong payroll growth and low initial unemployment claims. Faster wage growth is boosting consumer spending. Holiday sales rose by 5.1% from a year earlier according to the Mastercard SpendingPulse report, the fastest growth in six years. The Redbook same-store index tells a similar story (Chart 4). Chart 4Same-Store Sales Are Robust Same-Store Sales Are Robust Same-Store Sales Are Robust The housing market struggled for much of 2018, but the recent stabilization in mortgage rates should help matters (Chart 5). Notably, mortgage applications for purchase have surged to their highest levels since 2010 (Chart 6). Homebuilder confidence improved in January, mirroring the rally in homebuilder shares (Chart 7). We are long homebuilders versus the S&P 500, a trade that is up 5.3% since we recommended it on November 1, 2018. Chart 5aThe U.S. Housing Sector Will Stabilize (I) The U.S. Housing Sector Will Stabilize (I) The U.S. Housing Sector Will Stabilize (I) Chart 5BThe U.S. Housing Sector Will Stabilize (II) The U.S. Housing Sector Will Stabilize (II) The U.S. Housing Sector Will Stabilize (II) Chart 6A Positive Signal For U.S. Housing A Positive Signal For U.S. Housing A Positive Signal For U.S. Housing Chart 7U.S. Homebuilder Stocks Have Been Outperforming Recently U.S. Homebuilder Stocks Have Been Outperforming Recently U.S. Homebuilder Stocks Have Been Outperforming Recently U.S. Government Shutdown: A Near-Term Hit To Growth The government shutdown poses a near-term risk to the U.S. economy. If it lasts until the end of March, it will shave about 1.7% off Q1 GDP based on White House estimates. While this represents a potentially significant hit to the economy, the effect is likely to be completely reversed once the shutdown ends. Moreover, the drag to growth from the shutdown pales in comparison to the overall stance of fiscal policy. According to the IMF, the cyclically-adjusted budget deficit is set to reach 5.7% of GDP this year, up from 3.2% of GDP in 2015. There is also a reasonable chance that any deal to end the shutdown will involve a commitment to increase spending beyond currently budgeted levels. This would increase the overall amount of fiscal stimulus the economy is receiving. Taking The Pulse Of Global Growth The slowdown in growth has been deeper and more protracted outside the United States. Nevertheless, rays of sunshine are emerging. Our global Leading Economic Indicator diffusion index, which measures the proportion of countries with rising LEIs compared to those with falling LEIs, has bottomed. The diffusion index leads the global LEI by a few months (Chart 8). Chart 8The Uptick In The LEI Diffusion Index Suggests Global Growth Could Stabilize The Uptick In The LEI Diffusion Index Suggests Global Growth Could Stabilize The Uptick In The LEI Diffusion Index Suggests Global Growth Could Stabilize As is increasingly the case, the fate of the Chinese economy will be critical in determining when global growth begins to reaccelerate. The latest Chinese activity data has been disappointing, with this week’s downright awful export figures being the latest example. That said, credit growth may be starting to stabilize, as evidenced by stronger-than-expected loan growth for December. With credit growth now running only slightly above nominal GDP growth, the need for the authorities to maintain their deleveraging campaign has diminished. In an encouraging sign, the Market-Based China Growth Indicator developed by our China Investment Strategy service has been moving higher (Chart 9). Chart 9Encouraging Sign For The Chinese Economy Encouraging Sign For The Chinese Economy Encouraging Sign For The Chinese Economy A revival in Chinese growth would aid trade-sensitive economies such as Japan and Germany. The former saw a decline in economic momentum in the second half of 2018, exacerbated by typhoons and an earthquake in Hokkaido. With the consumption tax set to increase from 8% to 10% in October, the Bank of Japan will need to maintain its yield curve control regime at least until 2020. This could weigh on the yen. With that in mind, we tightened the stop on our short AUD/JPY trade two weeks ago and subsequently exited the position with a gain of 10%. The German economy has taken it on the chin recently. Real GDP contracted in the third quarter and barely grew in the fourth quarter. The economy should rebound in 2019 as external demand improves. The drag on growth from the decline in automobile assemblies following the introduction of new emission standards should also turn into a modest tailwind as production resumes. In addition, fiscal policy is set to turn more stimulative, while robust wage growth, lower oil prices, and rising home prices should support consumption. Elsewhere in Europe, the Italian economy should recover as bond yields come down from their highs and confidence improves following the resolution of the impasse with the EU over budget targets. The modest easing in Italy’s fiscal policy of about 0.5% of GDP in 2019 should also benefit growth. It is too early to quantify the effect on the French economy from the “yellow vest” protests. France is no stranger to protests of this sort, so our guess is that the impact on the economy will be minimal. President Macron’s pledge to loosen fiscal policy in hopes of placating the protestors should also support demand. Brexit: A “No Deal” Outcome Looks Less Likely The Brexit saga could end in one of three ways: 1) A “no deal” where the U.K. leaves the EU with no alternative in place; 2) A “soft Brexit” involving an agreement to form a permanent customs union or some sort of “Norway plus” arrangement; 3) A decision to reverse the results of the original referendum and stay in the EU. In thinking about which of these three outcomes is most likely, one should keep the following in mind: Any course of action that the U.K. takes must have the support of the British parliament. A no deal outcome does not have parliament’s support. Not even close. Thus, it will not happen. This leaves options 2 and 3. This publication has argued since the day after the Brexit vote that the European establishment, following the example of the Irish and Danish referendums over various EU treaties, will keep insisting on do-overs until it gets the result it wants. If one referendum is good, two is even better – it’s twice as much democracy! The betting markets seem to be coming around to our view. As we go to press, PredictIt shows a one-in-three chance that a new referendum will be called by March 31 (Chart 10). Polling trends suggest that if another referendum were held, the remain side would probably prevail (Chart 11). Chart 10 Chart 10 Chart 11U.K.: A Change Of Heart? U.K.: A Change Of Heart? U.K.: A Change Of Heart? In some sense though, it does not matter for investors whether the original referendum is reversed or a soft-Brexit deal is reached. Either outcome would be welcomed by markets. We continue to advocate buying GBP/EUR. My colleague Dhaval Joshi, BCA’s Chief European strategist, also recommends that equity investors purchase the FTSE 250 index, which comprises from the 101st to the 350th largest companies listed on the London Stock Exchange. Unlike its large-cap counterpart, the FTSE 100, the FTSE 250 index is more geared to what happens in the U.K. than in the rest of the world. Investment Conclusions Global inflation remains subdued, which gives central banks the luxury of taking a wait-and-see approach to tightening monetary policy. Growth in the U.S. and the rest of the world should stabilize by mid-year. This will enable the Fed to resume raising rates in June. Given that the market is no longer pricing in any Fed hikes, a bearish stance towards U.S. Treasurys is warranted over a 12-month horizon (Chart 12). Outside of Japan, bond yields will also rise in the major developed economies. Chart 12Treasurys Will Underperform If The Fed Hikes Rates By More Than Expected Treasurys Will Underperform If The Fed Hikes Rates By More Than Expected Treasurys Will Underperform If The Fed Hikes Rates By More Than Expected We downgraded global equities in June as our leading indicators began to point to slower growth ahead, but upgraded them back to overweight after stocks plunged following the December FOMC meeting. The rally over the past three weeks has reversed deeply oversold conditions and our tactical MacroQuant model is once again flagging some near-term risk to stocks. Nevertheless, if the global economy avoids a recession this year, as we expect, equities should fare well over a 12-month horizon. The MSCI All-Country World index is trading at a modest 13.6-times forward earnings (Chart 13). Profit estimates have been revised down meaningfully, suggesting that the bar for upward earnings surprises is now quite low. Chart 13A Lot Of Bad News Already Discounted? A Lot Of Bad News Already Discounted? A Lot Of Bad News Already Discounted? Risk assets can tolerate higher rates as long as tighter monetary policy is the result of stronger growth. What risk assets cannot withstand is a stagflationary environment where growth is slowing but the Fed is hiking rates in order to bring down inflation. That is not the situation today, but could be the situation next year. Bottom line: Investors should overweight global equities and spread product for now, but monitor inflation trends closely for signs of when to get out. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 14 Tactical Trades Strategic Recommendations Closed Trades

Highlights Please note that country sections on Mexico and Colombia published below. The policy stimulus in China could produce a growth revival in the second half of 2019, but there are no signs of an imminent bottom in China’s growth over the next several months. The lack of policy support for real estate is the key difference between the current stimulus program and previous ones. Crucially, the property market holds the key to consumer and business sentiment and hence, their willingness to spend. Continue to overweight Mexico within EM currency, fixed-income and equity portfolios. Colombia warrants a neutral weighting. A new trade: bet on yield curve flattening. Feature China has been undertaking both fiscal and monetary stimulus since last summer. A key question among investors is: At what point will the cumulative effects of these efforts become sufficient to revive the mainland’s business cycle and produce a rally in China-related plays akin to 2016-’17? This report helps investors dissect China’s stimulus, and reviews the indicators that will likely help identify the turning point in the mainland’s business cycle, as well as in China-exposed financial markets. Chart I-1 conveys the main message: Our credit and fiscal spending impulse is still falling, indicating that the slump in the Chinese industrial sector will persist for now with negative ramifications for EM corporate profits and other segments of the global economy that are leveraged to China. Chart I-1 Looking forward, odds are reasonably high that the credit and fiscal spending impulse will bottom sometime in the first half of 2019. Yet, a bottom in China-plays in global financial markets is likely be several months away from now and potential downside could still be substantial. Monetary Stimulus On the monetary policy front, there has been multifaceted easing: Several cuts to banks’ reserve requirement ratios (RRRs) have been implemented; Lower interest rates for SME borrowers and a reduction in funding costs for the banks that originate these loans; The use of preferential liquidity provisions to encourage banks to purchase bonds issued by private companies. Monetary easing in of itself is not a sufficient condition to produce an economic revival. There are two variables standing between easing liquidity/lower borrowing costs, on the one hand, and the performance of the economy on the other: The first one is the money multiplier, which is calculated as a ratio of broad money supply (or banks assets) to excess reserves. It measures the willingness of banks to expand their balance sheets at a given level of excess reserves, assuming there is loan demand. Chart I-2 shows that China’s money multiplier has risen substantially since 2008 but has recently rolled over. A further drop in the money multiplier could offset the positive effect of monetary easing. Chart I-2China: Money Multiplier Is Falling China: Money Multiplier Is Falling China: Money Multiplier Is Falling In other words, the central bank is injecting more liquidity into the banking system and interbank rates are falling, but commercial banks may be unwilling or unable to originate more loans due to financial regulations, lack of loan demand or for other reasons. Notably, the growth rate of bank assets (including policy banks) remains lackluster, while non-bank (shadow) credit is decelerating (Chart I-3). Chart I-3China: Bank Credit And Non-Bank Credit China: Bank Credit And Non-Bank Credit China: Bank Credit And Non-Bank Credit The second variable is the willingness of companies and households to spend. This is captured by our proxies for marginal propensity to spend by companies and consumers. Chart I-4 denotes that both propensity measures are dropping, signifying a diminishing willingness to spend among these two sectors. Chart I-4China: Diminishing Propensity To Spend By Consumers And Companies China: Diminishing Propensity To Spend By Consumers And Companies China: Diminishing Propensity To Spend By Consumers And Companies If economic sentiment among businesses and households remains downbeat – which has been the case in China over the past six to nine months – their reduced expenditures could offset any positive impulse from increased credit origination. Economists think of nominal GDP (aggregate spending) as money supply times the velocity of money (Nominal GDP = Money Supply x Velocity of Money). New lending activity among banks increases money supply, while economic agents’ spending raises the velocity of money. If the velocity of money drops more than the rise in money supply, aggregate expenditure (nominal GDP growth) will decline. Chart I-5 illustrates that the velocity of money rose in 2017, supporting robust growth during this period, despite very lackluster money growth. The opposite phenomenon – a decline in the velocity of money offsetting faster money expansion – could be a risk to the positive view on Chinese growth in 2019. Chart I-5Velocity Of Money: Will It Resume Its Decline? Velocity Of Money: Will It Resume Its Decline? Velocity Of Money: Will It Resume Its Decline? Bottom Line: There is so far no clear evidence that the credit cycle has bottomed. Besides, a bottom in the credit impulse is not in and of itself sufficient to herald an economic recovery. Fiscal Stimulus Unlike in previous easing episodes, policymakers this time around have prioritized fiscal over monetary stimulus because of the already high leverage. In the past six months or so, the government has announced the following fiscal measures: A reduction in the personal income tax rate; Subtraction of certain household expenses from taxable personal income; A reduction in taxes and fees paid by small businesses; A potential VAT cut. These measures will certainly have a positive impact on small businesses and consumer spending. This is why we do not foresee a deepening slump in consumer spending. Nevertheless, the tax reductions and other policies benefiting small businesses and households are unlikely to boost industrial output and construction in China. The latter two are crucial for global investors because many countries are leveraged to China’s industrial and construction activity. For the industrial part of the economy, the most pertinent stimulus measure announced so far has been the issuance of local government special bonds. These bonds are used for infrastructure/public welfare projects. Chart I-6A shows the growth rates of aggregate fiscal spending and its components, which are expenditures by central and local governments as well as by government managed funds (GMFs). GMF spending – a form of quasi-government (off-balance sheet) spending – has surged in recent years and now accounts for 8.5% of GDP, which is more than twice larger than central government spending (Chart I-6B). Chart I-6AChina: Fiscal Spending Annual Growth... China: Fiscal Spending Annual Growth... China: Fiscal Spending Annual Growth... Chart I-6B…And As % Of Nominal GDP chart 6b ...And As % Of Nominal GDP ...And As % Of Nominal GDP Although the 2019 budget has not yet been released – it will be announced in March during the National People's Congress – there have been some announcements that we can use to gauge the potential fiscal spending impulse in 2019. On the positive side, Beijing has recently authorized local governments to begin issuing bonds in early 2019 before the overall budget is released in March. Local governments are sanctioned to issue RMB 810 trillion of special bonds, which is 60% of their 2018 quotas. This contrasts with the previous years' practice, when local governments only started to issue bonds in April after obtaining directives from Beijing. The earlier-than-usual quota authorization will allow local governments to issue bonds from the beginning of the year. There is no timeline as to when these bonds will be issued, but it is safe to assume that their issuance will occur in the first half of 2019. This, in turn, should boost infrastructure investments throughout 2019. On the negative side, government managed funds (GMFs) derive 85% of their revenues from land sales. Land sales are tumbling due to previous credit tightening and scarce access to financing among property developers. Chart I-7 demonstrates that land sales lag the credit cycle by nine months. As developers are no longer acquiring land, GMF revenues and spending are set to shrink over the next 12 months. This will, to a certain degree, offset the augmented special bonds issuance. Chart I-7China: Credit Leads Land Sales And Quasi-Fiscal Spending China: Credit Leads Land Sales And Quasi-Fiscal Spending China: Credit Leads Land Sales And Quasi-Fiscal Spending We performed a simulation on what would be the aggregate fiscal impulse in 2019 using the following assumptions: Central and local government spending growth rates are held constant at 2018 levels. Local government special bond issuance is RMB 1.62 trillion. This is twice the recently authorized quota. Hence, our simulation assumes a 20% increase in local government special bond issuance in 2019 over 2018, respectively. GMF land revenues drop by 25% – a comparable drop in land sales occurred in 2015. Table I-1 reveals that using these assumptions, the fiscal spending impulse in 2019 will be 0.1% of GDP down from 4% in 2018 (Chart I-8, bottom panel). Chart I-   Chart I-8China: Credit And Fiscal Spending Impulse China: Credit And Fiscal Spending Impulse China: Credit And Fiscal Spending Impulse The next step is to combine this with our credit impulse forecast. We assume the 2019 year-end growth rate of credit to companies and households will be 9% in our pessimistic scenario, 10% in our baseline scenario and 11% in our optimistic scenario, compared with the December 2018 recorded rate of 10%. This entails no deleveraging at all. Under these assumptions, our forecasts for aggregate credit and fiscal impulses are 0.2% of GDP (pessimistic), 2.3% (baseline) and 4.4% (optimistic) (Table I-1). Presently, the credit and fiscal impulse is close to zero (Chart I-8). Bottom Line: China’s credit and fiscal spending impulse will bottom in the first half of 2019 (Chart I-8). However, this does not mean that EM/China plays have already bottomed and investors should chase the latest rebound in China-plays worldwide. We discuss the historical correlation between the credit and fiscal impulse and China-related financial markets below. What Is Different From Previous Stimulus Programs? The lack of stimulus targeting the real estate sector is the key difference between the current stimulus programs and those implemented in the past 10 years. The central government has so far abstained from stimulating the property market due to already existing speculative excesses there. This is very different from the policy easing that took place in 2008-‘09, 2012 and 2015-’16, when the authorities boosted property markets along with other sectors of the economy. Chart I-9 reveals that the 2015-‘17 residential property market revival and following boom was facilitated by the Pledged Supplementary Lending (PSL) program conducted by the People’s Bank of China (PBoC) – which was de-facto the outright monetarization of real estate by the central bank.1 The authorities have so far been reluctant to use this PSL program again, and the odds are that housing sales and new construction will continue to decline (Chart I-10). Chart I-9Residential Property Market Is Deteriorating Residential Property Market Is Deteriorating Residential Property Market Is Deteriorating Chart I-10China: Construction Volumes Are Shrinking China: Construction Volumes Are Shrinking China: Construction Volumes Are Shrinking Importantly, the property market holds the key to consumer and business sentiment and, hence, their willingness to spend. The latter is crucial to the growth outlook. Overall, a deepening slump in real estate demand and prices could dent consumer and small business confidence as well as their spending. Meanwhile, shrinking construction volumes will dampen industrial sectors (Chart I-10). Investment Implications: A Replay Of 2016-‘17? How does the credit and fiscal impulse relate to financial markets globally that are leveraged to the Chinese economy? The top two panels of Chart I-11 show our money impulse as well as credit and fiscal spending impulse (CFI), while the bottom two panels contain EM share prices and industrial metals prices. There are a few observations to be made: Chart I-11China: Money And Credit/Fiscal Impulses, EM Stocks And Metals Prices China: Money And Credit/Fiscal Impulses, EM Stocks And Metals Prices China: Money And Credit/Fiscal Impulses, EM Stocks And Metals Prices First, the CFI has not yet bottomed – i.e., it has not confirmed the upturn in the money impulse. Second, as illustrated in this Chart, the bottoms in the money impulse as well as the CFI in July 2015 preceded the bottom in EM and commodities by six months, and their peaks led the top in financial markets - in January 2018 - by about 15 months. Besides, in 2012-‘13, the rise in both the money impulse and CFI did not do much to help EM stocks or industrial commodities prices. Third, the credit and fiscal impulse leads the global manufacturing PMI by several months as illustrated in Chart I-1 on page 1, as well as mainland’s capital goods imports (Chart I-12). Chart I-12China's Impact On Industrial Goods And Commodities China's Impact On Industrial Goods And Commodities China's Impact On Industrial Goods And Commodities On the whole, investors should consider buying China-related plays only after both the money impulse and the CFI bottom together which has not yet occurred. Besides, even if these indicators rise in tandem, the bottom in China-related financial market plays could be a few months later because these impulses have historically led markets. This is why we believe a final down leg in EM and China-related plays still lies ahead. Typically, the last/capitulation phase in bear markets is considerable and being early can be very painful. Bottom Line: We continue to recommend underweighting/playing EM and China-related risk assets on the short side. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com Mexico: Reiterating Our Overweight Stance Mexican financial markets have rebounded, outperforming their EM counterparts since mid-December. This outperformance has further upside because the AMLO administration is proving to be less populist and more pragmatic, especially relative to investors’ expectations. We are reiterating our recommendations to overweight Mexican markets, especially the currency, local fixed-income and sovereign credit, within respective EM portfolios due to the following considerations: The 2019 budget is a prime example of sensible rather than populist policies by the AMLO administration. The budget targets a primary surplus of 1% of GDP versus 0.8% of GDP in 2018 (Chart II-1). Notably, the 2019 budget envisages an absolute decline in nominal expenditures in 29 out of 56 categories. Chart II-1Fiscal Tightening In 2019 Fiscal Tightening In 2019 Fiscal Tightening In 2019 Such a restrained budget follows the conservative fiscal policy of the previous administration. In brief, the nation’s fiscal policy and public debt profile remain sound. Public spending will be increased mostly in the areas that are critical to boosting productivity. These include infrastructure spending, vocational training, promoting “financial deepening” and competition, eliminating graft and improving security. These efforts are critical to boosting business confidence, investment and ultimately productivity. On the revenue side, the budget has become much less reliant on oil revenues than before. The share of oil revenues in total government revenues historically hovered around 30%, but in 2018 it declined to 18%. The 2019 budget assumes an average oil price of $55 per barrel, a conservative projection. Investors have also been somewhat alarmed by the 16% hike in minimum wages, but this should be put into historical context. Chart II-2 illustrates that the minimum wage in real terms (deflated by consumer price inflation) dropped by 70% since its peak in 1976, before rising in the recent years. Chart II-2Historical Perspective On Minimum Wage Historical Perspective On Minimum Wage Historical Perspective On Minimum Wage Importantly, Mexico’s competitiveness problem does not stem from high wages but from a lack of productivity gains. Productivity has been stagnant, and wages in real terms have not risen in many years. Hence, the true test for the nation is to raise productivity, not curb wages. Remarkably, the Mexican peso is very cheap, as measured by the real effective exchange rate based on unit labor costs (Chart II-3). Hence, the minimum wage hike can be viewed as payback after decades of dramatic declines in the minimum wage in real terms. Chart II-3The Mexican Peso Is Cheap The Mexican Peso Is Cheap The Mexican Peso Is Cheap The central bank has overdone it with hiking interest rates: interest rates are currently among the highest of the mainstream EM economies, both in nominal and real terms (Chart II-4). Hence, local rates offer great value relative to other EMs (Chart II-4, bottom panel). Chart II-4High Real And Nominal Interest Rates High Real And Nominal Interest Rates High Real And Nominal Interest Rates Tight fiscal and monetary policies will curb domestic demand and promote disinflation. Money and credit growth remain very sluggish (Chart II-5). This is negative for consumer and business spending, but positive for investors in local currency bonds. Chart II-5Monetary Growth Is Weak Monetary Growth Is Weak Monetary Growth Is Weak The basis is that a retrenchment in domestic demand and thereby imports will help stabilize the trade balance amid low oil prices. Hence, this is on the margin a positive for the peso as well as for local currency bonds relative to their EM counterparts. Finally, Mexico will benefit from its ties to the U.S. economy, unlike many other EMs that are more exposed to China. Investment Recommendation We continue to recommend overweighting the peso and local currency bonds within an EM fixed-income portfolio. Currency traders should maintain our long MXN / short ZAR trade (Chart II-6, top two panels). Chart II-6Remain Overweight Mexican Currency And Fixed-Income Remain Overweight Mexican Currency And Fixed-Income Remain Overweight Mexican Currency And Fixed-Income Credit market investors should continue to overweight Mexican sovereign credit within an EM credit portfolio (Chart II-6, bottom panel). Finally, we are also reiterating our long Mexico position within an EM equity portfolio. While domestic demand growth and corporate profits will continue to disappoint, the declining risk premium on Mexican assets due to a re-assessment among investors of AMLO’s policies warrants a mild overweight in large caps and a sizable overweight in small caps relative to their EM peers. Colombia: Headed Into Another Downtrend The Colombian economy is set to undergo another phase of growth retrenchment: The government is planning to reduce the overall fiscal deficit from 4.5% to 2.4% of GDP by the end of 2019 (Chart III-1). Oil-related revenues make up under 10% of total government revenues, and they are shrinking as both oil production and prices have plunged. Chart III-1Fiscal Policy Will Tighten In 2019 Fiscal Policy Will Tighten In 2019 Fiscal Policy Will Tighten In 2019 As a result, the government should undertake major fiscal cutbacks and hike taxes to achieve the overall budget deficit target of 2.4%. Such substantial fiscal tightening will hurt domestic demand. Regarding the exchange rate, the central bank is pursuing a “hands-off” approach, which is likely to continue. Therefore, the currency is set to depreciate due to the large current account deficit and lack of sufficient foreign funding. Notably, the current account deficit excluding oil is -7% of GDP (Chart III-2, top panel), and the plunge in oil prices and weak domestic demand will cause FDI inflows to drop meaningfully (Chart III-2, bottom panel). Together, this points to further currency depreciation. Chart III-2BoP Dynamics Are Deteriorating BoP Dynamics Are Deteriorating BoP Dynamics Are Deteriorating Meanwhile, the central bank is not in a position to ease policy to offset the impact of fiscal tightening, as a weaker exchange rate historically leads to higher inflation (Chart III-3, top panel). In fact, given core inflation is at the upper end of the central bank’s target range (Chart III-3, bottom panel), a considerable currency depreciation could lead to rate hikes. Raising rates amid weakening growth is a recipe for considerable yield curve flattening. Chart III-3Weaker Currency = Higher Inflation Weaker Currency = Higher Inflation Weaker Currency = Higher Inflation Lending rates remain well above nominal GDP growth, and the banking system is still restructuring following years of a credit boom. Credit growth will remain weak, reinforcing weakness in domestic demand stemming from substantial fiscal tightening. Finally, consumer and business confidence seem to be faltering due to the negative attention surrounding Colombian President Iván Duque Márquez’s policies. The negative terms-of-trade shocks and the imminent fiscal tightening will reinforce worsening sentiment among economic agents. Profound cyclical headwinds to growth indicate that the economy is set to return to a growth recession – a very low but slightly positive growth rate. With respect to investment strategy, we recommend the following: First, we are downgrading this bourse from overweight to neutral within an EM equity portfolio. While overweighting Latin American stocks as a whole within an EM equity portfolio, we believe that Brazilian, Chilean and Mexican share prices offer a better risk-reward profile than Colombian ones (Chart III-4). Chart III-4Colombia Is Unlikely To Outperform LATAM Colombia Is Unlikely To Outperform LATAM Colombia Is Unlikely To Outperform LATAM Second, as to sovereign credit investors, we are reiterating an overweight stance because fiscal tightening and monetary policy orthodoxy as well as low government debt levels will help Colombian sovereign credit to outperform. Third, two opposing cross-currents will shape the domestic bond market. On the one hand, weak growth is positive for bonds. On the other hand, currency depreciation is negative. Net-net, investors in local currency government bonds should be slightly overweight or neutral this market within an EM local bond portfolio. For fixed-income investors, we recommend a new trade: position for yield curve flattening (Chart III-5). This is a bet on a considerable growth slowdown amid looming fiscal austerity. Chart III-5Colombia: Bet On Yield Curve Flattening Colombia: Bet On Yield Curve Flattening Colombia: Bet On Yield Curve Flattening Andrija Vesic, Research Analyst andrijav@bcaresearch.com Footnotes 1      Please see Emerging Markets Strategy Special Report "China Real Estate: A Never-Bursting Bubble?" dated April 6, 2018, available on ems.bcaresearch.com   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

The Fed’s near-term capitulation on its rates-normalization policy highlighted by our fixed-income desks will provide a tailwind for EM oil demand this year by weakening the USD. This will reduce refined-products’ costs in local-currency terms ex-U.S., as it buoys EM growth prospects.1 If, as we expect, Chinese policymakers also deploy modest stimulus, global oil demand still will remain on track to grow 1.4mm b/d this year, per our forecast. We are mindful of potential upside surprises on the demand side, particularly, if, as we noted in our last balances update, the 100th anniversary of the Chinese Communist Party in 2021 provokes policymakers to deploy large-scale stimulus in 2H19 or 2020.2 The odds of this occurring before 2H19 are low, and we are not yet raising our demand estimates. A partial defusing of the Sino – U.S. trade war is possible, as the 90-day negotiating window agreed at the December G20 meeting starts to close next month. This could trigger a short-term rally in commodities, but, absent durable agreements on the technology front, this potential thawing will be transitory. Highlights Energy: Overweight. China’s crude oil imports surged 30% y/y in December 2018, which helped lift total 2018 imports by 10% vs. 2017 levels. This partly was the result of independent refiners scrambling to use up 2018 import quotas at year-end, so that they could retain those levels this year, according to S&P Global’s Platts.3 Base Metals: Neutral. China’s copper ore and concentrate imports were down 11.5% y/y in December – the largest y/y decline since May 2017 – in line with slowing growth there. Precious Metals: Neutral. We expect gold to continue to rally over the next 3 – 6 months on the back of a weaker USD in 1H19, as the Fed likely pauses on its rate-hiking schedule. Ags/Softs: Underweight. Grains likely will get a short-term price lift as the Fed dials back its rates-normalization policy. Feature For the moment, the Fed’s apparent capitulation on its rates-normalization policy reduces the risk the U.S. central bank will err on the side of being overly aggressive, which would have thrown a spanner into EM growth prospects this year. An easier Fed monetary policy will buoy EM GDP and weaken the USD over the short term, which will, support oil prices via stronger demand (Chart of the Week). Chart of the WeekEM GDP Growth On Track, Keeping Oil Demand Growth On Track EM GDP Growth On Track, Keeping Oil Demand Growth On Track EM GDP Growth On Track, Keeping Oil Demand Growth On Track On the supply side, we remain convinced OPEC 2.0 is resolved to drain the global inventory overhang as quickly as possible. This unintended inventory accumulation resulted from OPEC 2.0’s production surge and the granting of waivers on U.S. export sanctions against Iran by the Trump administration in November (Chart 2). This conviction was strengthened earlier this week, following the announcement of a proposed earlier-than-expected meeting of the coalition’s market monitoring committee in Baku, Azerbaijan, in mid-March to assess global supply and demand conditions. This could be followed by a full OPEC 2.0 meeting in Vienna in mid-April, following up on their December meeting in Vienna, according to S&P Global Platts.4 Chart 2OPEC 2.0 Is Resolved To Drain Inventory Overhang OPEC 2.0 Is Resolved To Drain Inventory Overhang OPEC 2.0 Is Resolved To Drain Inventory Overhang Pieces Of The Price Puzzle Falling Into Place The Fed is signaling it has put its rates normalization policy on hold, given indications global economic growth is slowing in a manner similar to what occurred in 2014 – 15. Then, the U.S. central bank was attempting to escape the zero lower bound of its monetary policy, following the end of its QE program. In the event, the Fed only raised rates once in December 2015, as the slowdown in growth stayed its hand. Our colleagues at BCA’s Global Fixed Income Strategy note, “the downturn in cyclical growth indicators like manufacturing purchasing managers indices (PMI) and the global leading economic indicator (LEI) … reached levels last seen after that 2014/15 episode” as 2019 unfolded (Chart 3).5 The slowdown in global growth could stabilize, as the LEI diffusion index suggests, but the Fed, at least for now, appears to be comfortable waiting for clear evidence this is the case. Chart 3Global Growth Slowdown Provokes Fed Restraint Global Growth Slowdown Provokes Fed Restraint Global Growth Slowdown Provokes Fed Restraint In and of itself, the Fed’s near-term capitulation to the market will not be sufficient to reverse the “darkening prospects” foreseen by the World Bank in its most recent forecast, but it will be supportive of oil prices.6 On the back of our expectation the Fed will take a break from its rate-normalization, we are expecting a weaker USD over the short term, which will support oil demand and EM GDP growth. All else equal, this will create a tailwind for oil prices, given EM is the main driver of demand growth (Chart 4). Chart 4USD Near-Term Trajectory Will Support Oil Prices USD Near-Term Trajectory Will Support Oil Prices USD Near-Term Trajectory Will Support Oil Prices The Chart of the Week introduces a new model we developed to understand the effect of EM GDP growth on oil prices. The level of EM demand is mean reverting to a linear trend, and anchors other variables – oil prices and FX rates, for example – that oscillate randomly with the arrival of new information to the market. Our modeling indicates Brent and WTI prices can be expected to increase (decrease) 94bp and 73bp for every 1 percent increase (decrease) in EM GDP, assuming the broad trade-weighted index (TWIB) for the USD remains unchanged. A 1 percent decrease (increase) in the USD TWIB (holding EM GDP constant) translates into an increase (decrease) in Brent and WTI prices of ~ 4.0% and 3.6%, respectively. We have found EM GDP levels to be as useful an explanatory variable for Brent and WTI prices as non-OECD oil consumption, our proxy for EM demand. Indeed, it is perhaps even cleaner, since using it directly in our models does not require us to estimate an income elasticity of demand for EM economies, in order to forecast prices.7 We are not raising our expectation for demand growth on the back of the Fed’s apparent moderation in its rates policy. We are keeping our 2019 demand growth estimate at 1.4mm b/d, with 1.0mm b/d of that coming from EM and the remainder from DM. Should the Fed signal a further pause in its rates-normalization policy – extending perhaps deep into 2H19 – we would be inclined to raise our demand-growth estimates. Additional Stimulus Coming From China? China is not the be-all and end-all of EM growth. All the same, next to the U.S., it is the second-largest consumer in the world, accounting for ~ 14% of the 103.75mm b/d of global demand we expect this year. Next in line is India, which accounts for ~ 5% of global demand. The news coming out of China at the moment is confusing. While the Xi administration prosecutes its “Three Tough Battles” – i.e., deleveraging, pollution and poverty – it also is pulling policy levers to counter the economic damage inflicted by its trade war with the U.S.8 Government policymakers are signaling fiscal and monetary stimulus will be forthcoming via tax cuts and bond issuance this year, to counter these headwinds.9 However, we do not expect a massive deployment of stimulus. More than likely, the big stimulative measures arrive in 2H19 or next year. The key target dates for policymakers are further in the future, and are focused on the upcoming 100th Anniversary of the Communist Party in 2021. By 2020, the Xi administration is targeting a doubling of real GDP vs. 2010 levels, and a doubling of rural and urban incomes (Chart 5). Chart 5China Keeping Powder Dry For 2021 "Centenary Goal" China Keeping Powder Dry For 2021 "Centenary Goal" China Keeping Powder Dry For 2021 "Centenary Goal" So the real stimulus out of China likely comes later this year or next year. As our Geopolitical Strategy service notes: “If China launches a large-scale stimulus now, peak output will occur in 2020 and the economy will be decelerating into 2021. This would be bad timing for the centenary. It would make more sense for China to save some dry powder for 2019 or 2020 to ensure a positive economic backdrop in 2021.” There is, as we noted in our last balances update, a low-probability chance stimulus could surprise to the upside if growth – particularly employment – falls precipitously. For now, we are comfortable with our House view that the more extensive fiscal and monetary stimulus will be saved for later this year or next in the run-up to the Communist Party’s anniversary.10 Bottom Line: The Fed appears to have capitulated to markets in the short term, and likely will hold off on another rate hike in 1H19. All else equal, this will weaken the USD and buoy EM GDP over the short term. Together, these effects will keep oil demand on track to growth 1.4mm b/d, per our forecast. Markets are reacting to news of fiscal and monetary stimulus coming out of China. We have been expecting modest stimulus to be deployed this year, most likely in 2H19. We continue to expect a larger package of fiscal and monetary stimulus later in the year and next year in the run-up to the Communist Party’s 100th anniversary.   Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1      Please see “Enough With the Gloom: Upgrade Global Corporates On A Tactical Basis,” published January 15, 2019, by BCA Research’s Global Fixed Income Strategy. It is available at gfis.bcaresearch.com. See also “Buy Corporate Credit,” published by BCA’s U.S. Bond Strategy January 15, 2019. It is available at usbs.bcaresearch.com. 2      Please see “Oil Volatility Will Persist; 2019 Brent Forecast Lowered to $80/bbl,” published January 3, 2019, by BCA Research’s Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 3      Please see “China’s 2018 crude oil imports rise 10% to 9.28 mil b/d,” published by S&P Global Platts January 14, 2019, online. 4      OPEC 2.0 ministerial meetings usually are held in May/June and again November/December. Please see “OPEC eyes mid-March monitoring committee meeting, mid-April full ministerial,” published by S&P Platts Global January 14, 2019. The cartel also will meet in early February to put the finishing touches on a charter formalizing the coalition. We will be delving deeper into the supply side next week, when we update our balances. 5      Please see footnote 1 above. 6      The World Bank’s most recent forecast can be found in its Global Economic Prospects, published January 8, 2019. The lead article is entitled “Darkening Skies.” 7      We use forecasts of EM GDP and GDP growth published by the World Bank and IMF in our modeling. This is useful for us for a number of reasons, particularly since it is calculated externally by well-regarded global institutions tasked with this function. Like other estimates and projections – e.g., the EIA’s, IEA’s and OPEC’s supply/demand estimates – we can take a view on these data relative to our House view or our own Commodity & Energy Strategy view. NB: Because these are cointegrated systems, regressions in levels is appropriate. 8      This campaign is discussed in depth in “China Sticks To The ‘Three Battles’,” published by BCA Research’s Geopolitical Strategy October 24, 2018. It is available at gps.bcaresearch.com. 9      Please see “China signals more stimulus as economic slowdown deepens,” published by uk.reuters.com January 15, 2019. 10     Please see footnote 2 above. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 4Q18 Image Commodity Prices and Plays Reference Table   Trades Closed in 2019 Summary of Trades Closed in 2018 Image