Emerging Markets

Highlights The correction in global equities is not yet over, but we would turn more constructive if stocks retreated about 6% from current levels. Among the many things bothering investors, the fate of the Chinese economy remains high on the list. Chinese growth continues to slow, with the impact of the trade war yet to be fully felt. Investors are likely to end up being disappointed by both the size and the composition of Chinese stimulus. High debt levels and excess capacity limit the prospective benefits of traditional fiscal/credit easing. Stimulus measures aimed at boosting consumption, which is what the authorities are increasingly focusing on, would help the Chinese economy. However, they would generate only small gains for the rest of the world. A weaker yuan would be outright negative for other economies. Cyclically and structurally, we expect the bond bear market to continue, but slower Chinese growth and a stronger dollar could temporarily cap Treasury yields over the coming months. Feature Correction Slightly More Than Halfway Through We argued in our October 5th report that "prudent investors should consider scaling back risk if they are currently overweight risk assets" because the market was at an elevated risk of a "phase transition" from unbridled optimism to a more sober appreciation of the risks presently facing the global economy.1 The good news is that the ongoing correction will be just that, a correction. Both monetary and fiscal policy in the U.S. remain highly accommodative. The next recession will not occur until late-2020 at the earliest. U.S. equities, which account for over half of global stock market capitalization, rarely enter sustained bear markets outside of recessions (Chart 1). Chart 1Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap The bad news is that we have yet to reach a capitulation point. As we noted last week, corrections usually end when investors stop believing that they are witnessing a correction and start thinking that a bear market is afoot.2 Normally, stocks need to break through prior support levels several times before "buy the dip" investors throw in the towel. This week saw the S&P 500 fall below its October 11th lows. A few more iterations of this pattern may be necessary. To repeat what we wrote before, barring any major new developments, we would turn bullish on global equities again if the MSCI All-Country World Index were to fall by 12% 10% 8% 6% from current levels. With that in mind, we are putting in a limit order to buy the ACWI ETF at $64.3 Emerging Markets: Time To Pay The Piper Even if we were to turn more positive on global equities, we would maintain our preference for developed market stocks over emerging markets, despite the latter's higher beta nature. The wave of liquidity created by the Fed and other major central banks over the past decade ended up flowing into places where it was not needed. Emerging markets were a prime destination: Dollar-denominated debt in emerging markets now stands at levels reached just before the late-1990s Asian Crisis (Chart 2). Chart 2EM Dollar Debt At Late-1990s Levels EM Dollar Debt At Late-1990s Levels EM Dollar Debt At Late-1990s Levels While EM valuations have cheapened considerably, they are not yet at washed out levels. The latest BofA Merrill Lynch Global Fund Manager Survey showed that managers were slightly net overweight emerging market equities in October. This is a far cry from 2015, when a net 30% of managers were underweight EM stocks. Chinese Stimulus To The Rescue? China figures heavily into the equation. If the Chinese government were to deliver a massive dose of traditional fiscal/credit easing, this would boost fixed-asset investment and thus commodity prices, helping emerging markets in the process. Such a dollop of stimulus would also lift global growth. As a countercyclical currency, the U.S. dollar tends to weaken when global growth accelerates (Chart 3). The reflationary impulse from higher commodity prices and a softer dollar would be manna from heaven for emerging markets. Chart 3Decelerating Global Growth Tends To Be Bullish For The Dollar Decelerating Global Growth Tends To Be Bullish For The Dollar Decelerating Global Growth Tends To Be Bullish For The Dollar If we had strong confidence that such a burst of stimulus were forthcoming, we would be comfortable in calling the end of the global stock market correction now and going overweight EM assets. Unfortunately, the evidence so far suggests that while the Chinese authorities are stimulating the economy, they are not doing so by enough to reignite growth (Chart 4). Chart 4Chinese Growth Remains Soft Chinese Growth Remains Soft Chinese Growth Remains Soft Real GDP increased at a weaker-than-expected pace in the third quarter. Industrial production surprised on the downside in September, echoing declines in the manufacturing PMI. Home sales are running well below housing starts, suggesting downside risk for the latter in the months ahead. Goldman's China Current Activity Indicator has continued to grind lower, while the economic surprise index remains mired in negative territory. Our conversations with clients suggest that most are expecting the recently announced stimulus measures to arrest and then reverse the downward trend in growth. We are not so sure. As our geopolitical team has stressed, the Chinese government has expended a lot of political capital on its reform agenda.4 Abandoning it now would not only cause the government to lose credibility, but it would undermine the very reasons it was implemented in the first place. Waves of stimulus have caused total debt to soar from 140% of GDP in 2008 to 260% of GDP at present (Chart 5). Since most of the new credit has been used to finance fixed-asset investment, China has ended up with a severe overcapacity problem. The rate of return on assets in the state-owned corporate sector has fallen below borrowing costs (Chart 6). Our China team estimates that 15%-to-20% of apartments are sitting vacant.5 Chart 5China: Debt And Capital Accumulation Went Hand In Hand China: Debt And Capital Accumulation Went Hand In Hand China: Debt And Capital Accumulation Went Hand In Hand Chart 6Rate Of Return On Assets Below Borrowing Costs For Chinese SOEs Rate Of Return On Assets Below Borrowing Costs For Chinese SOEs Rate Of Return On Assets Below Borrowing Costs For Chinese SOEs Today, Chinese banks are being told that they must lend more money to support the economy, while ensuring that their loans do not sour. This has become an impossible feat. As such, we are skeptical that the recent acceleration in credit growth will have long legs (Chart 7). Anecdotal evidence suggests that some companies which are receiving credit are simply holding on to the cash, rather than running the risk of being accused of investing in money-losing projects. Monetary policy in China is increasingly pushing on a string. Chart 7China: Only A Modest Acceleration In Credit Growth China: Only A Modest Acceleration In Credit Growth China: Only A Modest Acceleration In Credit Growth Rebalancing: Be Careful What You Wish For This does not mean that China will not try to prop up its economy. It will. But the form of stimulus the government pursues may not be to foreign investors' liking. For example, consider the recently announced income tax reforms, which raise the threshold at which households need to start paying taxes while increasing deductions for education, health, housing, and eldercare. In and of themselves, these measures are admirable and long overdue. The Chinese income tax system is fairly regressive. Poor households face an effective income tax rate exceeding 40%. This is well above OECD norms (Chart 8).6 A more progressive tax system would boost consumption among poorer households. Chart 8High Tax Burden For Low-Income Households In China Chinese Stimulus: Not So Stimulating Chinese Stimulus: Not So Stimulating The snag is that raw materials and capital goods comprise 85% of Chinese imports. As Arthur Budaghyan, BCA's Chief EM strategist, has long noted, policies that boost Chinese consumption are simply less beneficial to the rest of the world than policies that boost investment.7 Pundits who talk about the virtue of "rebalancing" the Chinese economy away from fixed-asset investment and towards consumer spending should be careful what they wish for! The Trade War Will Heat Up One of the more notable aspects of China's recent slowdown is that it has been concentrated in domestic demand rather than in net exports. Remarkably, Chinese exports to the U.S. actually increased by 12% in dollar terms in the first nine months of the year, compared to the same period in 2017. However, judging from the steep drop in the export component of both the official and private-sector Chinese manufacturing PMI, the export sector is likely to come under increasing pressure over the next few quarters as the headwinds from higher tariffs fully manifest themselves (Chart 9). Chart 9China: An Ominous Sign For Exports China: An Ominous Sign For Exports China: An Ominous Sign For Exports Investors hoping that U.S. President Donald Trump and his Chinese counterpart Xi Jinping will reach a deal to end the trade war on the sidelines of the G20 leaders' summit in Buenos Aires on November 29 are likely to be disappointed. As we have stressed in the past, Trump's fiscal policy is completely inconsistent with his trade agenda. Fiscal stimulus in a full-employment economy will suck in imports. It will also force the Fed to raise rates more aggressively than it otherwise would, leading to a stronger dollar. The result will be a larger trade deficit. Trump will not be able to blame Canada or Mexico for a deteriorating trade position because he just signed a "big, beautiful" trade agreement with them (incidentally, the new USCAM USMCA agreement is remarkably similar to the "horrible" one that it replaced with the notable exception that it contains a clause barring Canada and Mexico from negotiating bilateral trade deals with China). This means Trump needs a patsy who will take the blame for America's burgeoning trade deficit. Reaching a deal with China would actually be a strategic mistake for Trump's political career. A Weaker RMB Ahead A weaker Chinese currency would blunt some of the pain inflicted on China's export sector from Trump's tariffs. There is obviously a limit to how far China can let its currency slide, but last week's decision by the U.S. Treasury to refrain from labeling China a currency manipulator will probably embolden the Chinese to allow the currency to depreciate some more from current levels.8 A weaker Chinese currency would be a cold shower for the rest of the world. Not only will it make other economies less competitive in global markets; it will also reduce Chinese imports. Concluding Thoughts Investors spend a lot of time debating the magnitude of China's stimulus plans and not enough time thinking about the composition of that stimulus. Credit/fiscal easing of the sort China has historically engaged in is good for other emerging markets because it sucks in raw materials and capital goods. In contrast, consumption-based stimulus is only modestly beneficial to the rest of the world, while a weaker Chinese currency is an outright negative for other economies. If China focuses more on the latter two types of stimulus and less on the former, global investors are likely to be disappointed. Emerging market assets have cheapened considerably over the past few months and will likely find a bottom in the first half of next year. For now, however, investors should overweight developed market stocks relative to their EM peers. Consistent with our July 5, 2016 call declaring "The End Of The 35-Year Bond Bull Market," both the cyclical and structural trend in bond yields is firmly to the upside. Tactically, however, bonds are deeply oversold (Chart 10). The combination of slower EM growth, disappointments over the magnitude and composition of Chinese stimulus, and a stronger dollar will put a lid on yields over the next few months. Chart 10Treasurys Are Oversold Treasurys Are Oversold Treasurys Are Oversold Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "The Next U.S. Recession: Waiting For Godot?" dated October 5, 2018. 2 Please see Global Investment Strategy Weekly Report, "Phase Transitions In Financial Markets: Lessons For Today," dated October 19, 2018. 3 Valid during extended trading hours. 4 Please see Geopolitical Strategy and China Investment Strategy Special Report, "How Stimulating Is The Stimulus? Part Two," dated August 15, 2018. 5 Please see Emerging Market Strategy Special Report, "China Real Estate: A Never-Bursting Bubble?" dated April 6, 2018. 6 Please see Global Investment Strategy Special Report, "Is China Heading For A Minsky Moment?" dated April 13, 2018. 7 Please see Emerging Markets Strategy Weekly Report, "The Dollar Rally And China's Imports," dated May 24, 2018. 8 Ironically, while China may not be manipulating its currency based on the Treasury's legal definition, economic logic suggests it is. True, China is no longer buying dollars in a bid to weaken the yuan. In fact, its reserves have actually declined significantly since 2015. However, the value of the yuan is determined not just by current dollar purchases; it is also determined by those that have taken place in the past. If a central bank buys dollars, this bids up the value of those dollars relative to its own currency. If it then stops buying dollars, its currency does not instantly fall back to its original level. All things equal, it just stays where it is. The best parallel is with quantitative easing. Both theory and evidence suggest that it is the stock of bonds that a central bank owns, rather than the flow of bonds in and out of its balance sheet, that determines the level of yields. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Five risks to our bullish dollar stance need to be monitored: further weakness in the S&P 500; rebounding gold prices; stabilizing EM exchange rates and bond prices; Spanish bank stocks at multi-decade lows; and large, long-exposure by speculators to the greenback. However, China's lackluster response to stimulus and the U.S.'s domestic strength still favor the dollar. In fact, the key force likely to cause U.S. growth to converge toward weaker global growth will be a stronger U.S. dollar. Feature BCA has a positive bias toward the dollar for the coming six to nine months. Admittedly, the dollar is expensive, but cyclical determinants still favor a rally. The Federal Reserve is hiking rates as the U.S. economy is at full capacity and goosed up by fiscal injections. Yet global growth is very wobbly. This combination is a potent cocktail for USD strength. Despite these key sources of support, we cannot be dogmatic, especially as financial markets are anticipatory mechanisms, and therefore the dollar could have already priced in some of these developments. As such, this week we explore the key risks to our dollar view. While serious threats for the dollar exist over the upcoming two to three quarters, the key macro and financial drivers remain dollar bullish. The Threats 1) The S&P Sells Off Further The MSCI EAFE index, expressed in USD terms, is down nearly 20% since its January 2018 highs. Meanwhile, the S&P 500 has fallen 9% since its recent all-time high, or 7% vis-Ã -vis where it stood in late January. The risk is that as the global economic slowdown deepens, investors end up selling their good assets along with their bad ones. This means the S&P 500 could fall more. In fact, our colleague Peter Berezin writes in BCA's Global Investment Strategy that U.S. equities could fall an additional 6% from current levels before finding a durable support.1 The problem for the dollar is not whether stock prices fall. It is about what it means for the Fed. Until earlier this week, equity weakness had no impact at all on bonds. However, now, weak stock prices are dragging down U.S. bond yields. Moreover, while the U.S. yield curve slope steepened between August 24 and October 5, it is flattening anew (Chart I-1). All these market moves suggest investors are beginning to price out anticipated interest rate hikes. If U.S. stocks were to fall further, these dynamics would most likely deepen. However, since there is little monetary tightening to price out of the European or Japanese interest rate curves, such a move would likely lead to a dollar-bearish narrowing of interest rate differentials. Chart I-1It Took A Stock Market Rout For Investors To Reconsider The Fed's Path It Took A Stock Market Rout For Investors To Reconsider The Fed's Path It Took A Stock Market Rout For Investors To Reconsider The Fed's Path 2) Gold Is Rebounding Keynes might have called gold a barbarous relic of a bygone era, but as an extremely long-duration asset with no cash flow, the yellow metal remains an important gauge of global monetary and liquidity conditions. As the stock of dollar foreign-currency debt is large, a strong dollar is synonymous with tightening global liquidity conditions. Unsurprisingly, since 2017, gold and the dollar have been tightly negatively correlated (Chart I-2). However, since October, this correlation has been breaking down. Both the dollar and gold are moving up. This suggests that the recent increase in U.S. interest rates and in the dollar might not be as deleterious for the world as markets are currently anticipating. Chart I-2Is Gold Not Hating A Strong Dollar Anymore? Is Gold Not Hating A Strong Dollar Anymore? Is Gold Not Hating A Strong Dollar Anymore? Moreover, gold prices often lead EM asset prices. Since gold prices are highly sensitive to global liquidity, this makes sense. When the yellow metal sniffs out whiffs of reflation, it is only a matter of time before EM assets do as well. Since a rally in EM assets would lead to an easing in EM financial conditions, this easing would improve the global growth outlook (Chart I-3). Hence, rising gold prices might be a sign that while investors are increasingly negative on global industrial activity, the light at the end of the tunnel could be around the corner. The dollar would suffer if the outlook for global growth were to improve. Chart I-3EM Financial Conditions Hold The Key To Global Growth EM Financial Conditions Hold The Key To Global Growth EM Financial Conditions Hold The Key To Global Growth 3) EM Currencies And EM High-Yield Bonds Stabilizing Something strange is happening. While EM equity prices are still falling, EM high-yield bonds and currencies are not. In fact, EM FX and EM debt prices bottomed at the beginning of September, despite rising U.S. interest rates. However, since then, EM stock prices denominated in USD terms have fallen nearly 10% (Chart I-4). EM exchange rates and yields are the most important determinants of EM financial conditions. This suggests that despite EM stock prices falling fast, EM financial conditions may not be deteriorating as quickly as assumed. Chart I-4Are EM Financial Conditions Easing? Are EM Financial Conditions Easing? Are EM Financial Conditions Easing? This market action is in fact consistent with the development we highlighted in the gold market. We must therefore maintain a watchful eye on EM bonds and EM FX. Further meaningful improvement in these assets, while not BCA's base-case, would dangerously challenge our view that global industrial activity slows further, undermining our dollar-bullish view. 4) Spanish Banks Near Post-2008 Lows As we highlighted in August, Spanish banks are the most exposed major banks in the world to EM woes (Chart I-5).2 The exposure of the Spanish banking sector to the weakest EM economies represents 170% of capital and reserves, which is driving the entire euro area's exposure to these markets to 32% of Eurozone banks' capital and reserves. Chart I-5Who Has More Exposure To EM? Risks To The Dollar View Risks To The Dollar View The weakening in EM expected growth and the fall in EM currencies is a risk for Spanish banks. However, Spanish banks also maintain a large chunk of their EM exposure in wholly or partly owned subsidiaries. This means that while an EM crisis will definitely have an important impact on Spanish bank earnings, the impact on the balance sheet of Spanish banks is likely to be more limited. However, Spanish banks now trade in line with the levels that prevailed in Q1 2009, Q3 2012 and Q1 2016 (Chart I-6). In other words, Spanish banks are already pricing in a crisis, especially after the Spanish Supreme Court ruled that banks - not customers - must pay mortgage duties. Chart I-6Spanish Banks Are Discounting Plenty Of Bad News Spanish Banks Are Discounting Plenty Of Bad News Spanish Banks Are Discounting Plenty Of Bad News While markets may not be the most efficient mechanism when it comes to pricing future shocks, markets are very efficient at lateral pricing - i.e. the pricing of an event in one market, even if wrong, will be equally reflected in other markets. If the impact of an EM crisis is fully priced into Spanish banks, the impact of such a crisis is likely to also be reflected in the expectations of what the European Central Bank will do over the coming quarters, and thus it is also priced into the euro. The pessimism already present in Spanish banks and euro area financial equities may explain why the euro has not cracked below its August 17 lows, while global stock prices have. The bad news could simply already be baked into the cake! If Spanish bank stocks rebound, the dollar is likely to suffer; if they break down, the dollar will likely rally more. 5) Speculators Are Already Long The Dollar For the dollar to rise further, someone needs to buy it. The problem is that speculators have already been buying the greenback, and they are now aggressively long the dollar (Chart I-7). This means that it may become more difficult to find new buyers for U.S. dollars, especially as investors may be in the process of unloading their U.S. equities. To be fair, while it is true that the net speculative positions are elevated, they also can remain so for extended periods. Chart I-7Investors Are Long The Dollar Investors Are Long The Dollar Investors Are Long The Dollar Bottom Line: There are important risks to our dollar-bullish view that we need to closely monitor. They are: the global stock selloff migrating to the U.S., which could prompt investors to price out Fed rate hikes; gold rebounding, which might indicate marginal improvement in global liquidity conditions; EM exchange rates and high-yield bonds not weakening anymore, which could result in an easing in financial conditions, ending the deterioration in global growth; Spanish banks potentially already pricing in a dire outcome in EM; and speculators being already long the dollar. Despite these Risks, Why Do We Still Like The Dollar? The first reason relates to global growth. Ultimately, the dollar is a counter-cyclical currency. When global growth weakens, the dollar strengthens. China continues to generate potent headwinds for the world economy. Beijing has been stimulating the Chinese economy, but this stimulus is having a muted impact. As Arthur Budaghyan writes in the week's Emerging Market Strategy report, China's monetary stimulus is falling flat.3 Not only are excess reserves in the banking sector rather meager, Chinese banks are not showing a deep propensity to lend. It is not just about the behavior of Chinese banks: Chinese firms are also not displaying a high propensity to spend and borrow, which is weighing on the velocity of money in China (Chart I-8). As a result, this means that liquidity injections are not generating much impact in terms of loan growth and economic activity. Chart I-8Chinese Stimulus Is Falling Flat Because Economic Agents Are Cautious bca.fes_wr_2018_10_26_s1_c8 bca.fes_wr_2018_10_26_s1_c8 This is evident when looking at two variables. China's Li-Keqiang Index, our preferred measure of Chinese industrial activity, has stopped rebounding. In fact, it is currently weakening anew, which suggests that Chinese growth, despite all the supposed easing in monetary conditions, is not responding (Chart I-9, top panel). Moreover, Chinese infrastructure spending is also contracting at its fastest pace in 14 years (Chart I-9, bottom panel). Further, the slowing in Chinese real estate sales suggests that construction will not come to the rescue, especially as vacancy rates in Chinese major cities currently stand at elevated levels. Chart I-9Chinese Growth Outlook Is Deteriorating Anew Chinese Growth Outlook Is Deteriorating Anew Chinese Growth Outlook Is Deteriorating Anew We continue to monitor our China Play index (Chart I-10) to see if China is showing any underlying improvement, but the rally evident from June to October is now dissipating. The impact of stimulus thus looks like it is leaving investors wanting for more. Yet, as Matt Gertken and Roukaya Ibrahim argue in this week's Geopolitical Strategy service, additional stimulus will be limited as Xi Jinping is not yet abandoning his three battles against indebtedness, pollution and poverty.4 Hence, we expect China to remain a significant drag on global growth over the coming two to three quarters. Chart I-10China-Related Plays Are Losing Momentum China-Related Plays Are Losing Momentum China-Related Plays Are Losing Momentum The second issue that supports our bullish-dollar stance is the mechanism required for U.S. and global growth to converge. As Ryan Swift argues in BCA's U.S. Bond Strategy service, U.S. growth will not be able to avoid the gravitational pull of a weaker global economy.5 The type of divergence currently on display between the global and U.S. Leading Economic Indicators (LEIs) is generally followed by a deteriorating U.S. growth outlook (Chart I-11). Chart I-11U.S. Growth Ultimately Converges With The Rest Of The World U.S. Growth Ultimately Converges With The Rest Of The World U.S. Growth Ultimately Converges With The Rest Of The World However, this weakening in U.S. growth won't happen out of nowhere. Either there will be domestic vulnerabilities that prompt the U.S. to become more sensitive to foreign shocks, or the dollar will force this adjustment. Today, unlike in 2015 and 2016, the sales-to-inventory ratio does not point to any imminent decline in U.S. industrial activity; to the contrary, it suggests further improvements in the coming months (Chart I-12). This leaves the dollar as the main culprit to put the brakes on U.S. growth. Chart I-12U.S. Domestic Fundamentals Are Fine U.S. Domestic Fundamentals Are Fine U.S. Domestic Fundamentals Are Fine Since 2009, the greenback has been very responsive to the relative growth outlook between the U.S. and the rest of the world. The accumulated gap between the U.S. and global LEIs shows the total impact of growth divergences. This indicator has done a good job at foretelling how the dollar will trade (Chart I-13). The dollar tends to respond to U.S. growth outperformance. Only once the dollar has rallied enough to meaningfully tighten U.S. financial conditions does the U.S. growth outlook deteriorate vis-Ã -vis the rest of the world. Currently, this chart suggests we are nowhere near having reached a chokepoint for U.S. growth. Chart I-13A Higher Dollar Needed For U.S. Growth To Resist The Gravitational Pull From The Rest Of The World A Higher Dollar Needed For U.S. Growth To Resist The Gravitational Pull From The Rest Of The World A Higher Dollar Needed For U.S. Growth To Resist The Gravitational Pull From The Rest Of The World Since the Fed remains quite unconcerned by the weakness in global growth and global stock prices, we expect that world financial markets will have to plunge deeper, the dollar to rally higher and U.S. financial conditions to tighten further before the FOMC shows enough concern to hurt the dollar. We are not there yet. Bottom Line: The absence of a meaningful response by the Chinese economy to stimulus suggests that China may have hit a debt wall. This implies that Chinese growth remains fragile and therefore a drag on global growth. Hence, international economic activity and trade will continue to provide an important tailwind for the U.S. dollar. Meanwhile, the U.S. economy is not displaying enough domestic vulnerabilities to be overly sensitive to the softness in global growth. Instead, more rounds of dollar strength will be required to force U.S. growth to converge lower toward global economic activity. As such, these two forces remain powerful enough to overweight currency exposure to the USD within global portfolios. That said, the five risks described in the previous section must be kept in mind. At the current juncture, they only warrant buying a few hedges, such as our long NZD/USD recommendation, but they do not warrant underweighting the greenback. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Chinese Stimulus: Not so Stimulating", dated October 26, 2018, available at gis.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report, "The Bear And The Two Travelers", dated August 17, 2018, available at fes.bcaresearch.com 3 Please see Emerging Markets Strategy Weekly Report, "China: Stimulus, Deleveraging And Growth", dated October 25, 2018, available at ems.bcaresearch.com 4 Please see Geopolitical Strategy Special Report, "China Sticks To The "Three Battles", dated October 24, 2018, available at gps.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Waiting For Peak Divergence", dated October 23, 2018, available at usbs.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. has been mixed: Markit Services PMI outperformed expectations, coming in at 54.7. This measure also increased from the previous month's reading of 53.5. However, durable good ex-defense month-on-month growth underperformed expectations, coming in at -0.6%. Finally, monthly new homes sales underperformed expectations, coming in at an annualized pace of 553 thousand. DXY has appreciated by 0.8% this week. We are bullish on the U.S. dollar on a cyclical basis. Furthermore, momentum, one of the strongest predictive factors for the dollar continues to be positive. Finally, global growth should continue to slowdown, as the monetary tightening by Chinese authorities starts to weigh on the global industrial cycle. Report Links: In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 The Dollar And Risk Assets Are Beholden To China's Stimulus - August 3, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area has been negative: Markit Manufacturing PMI surprised to the downside, coming in at 52.1. Moreover, Markit Services PMI also underperformed expectations, coming in at 53.3. Finally, private loan yearly growth surprised negatively, coming in at 3.1%. EUR/USD has fallen by 0.8% this week. We are bearish on the euro on a cyclical basis, as inflationary pressures continue to be too weak in the euro area for the ECB to start raising rates. Moreover, the fact that the euro area's economy is highly dependent on exports, makes it very sensitive to global growth and emerging markets. This means that the tightening by Chinese authorities should impact the euro area economy negatively, and consequently, put downward pressure on EUR/USD. Report Links: Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 Time To Pause And Breathe - July 6, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: The leading economic Index outperformed expectations, coming in at 104.5. However, the coincident index surprised to the downside, coming in at 116.7. USD/JPY has been flat this week. We are neutral on the yen on a tactical basis, given that the current risk-off environment should continue to help safe havens like the yen. However, we are bearish on the yen on a cyclical basis, as inflation expectations are not well anchored in Japan. This means that the BoJ will continue to conduct ultra-dovish monetary policy for the foreseeable future, putting a cap on how high the yen can rise. Report Links: Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 Rhetoric Is Not Always Policy - July 27, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 GBP/USD has decreased by 1.5% this week. Given the lack of a geopolitical risk premium embedded into the pound, we expect GBP volatility to remain elevated. This means that any hiccups in Brexit negotiations could bring about some downside for the pound. Furthermore, inflation should remain contained, even amid a tight labour market. This is mainly because inflation dynamics in the U.K. are much more driven by the external sector, as imports represent a very large portion of British final demand. Given that the pound has remained stable this year, inflation will remain subdued. We are currently short GBP/NZD in our portfolio, to take advantage of the dynamics mentioned above. Report Links: Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 AUD/USD has been flat this week. We are most bearish on this currency within the G10, given that the AUD is highly sensitive to the Chinese industrial cycle, which will continue to slow down, as Chinese authorities keep cleaning credit excesses in the economy. Moreover, policy tightening by the Fed will provide a further headwind to cyclical plays like the AUD. We are short AUD/CAD within our portfolio, as we believe that the oil currencies should fare better than other commodity currencies, given that OPEC supply cuts, as long as Iranian sanction in oil will keep upward pressure on oil prices. Report Links: Policy Divergences Are Still The Name Of The Game - August 14, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 NZD/USD has been flat this week. We are positive on the New Zealand dollar, particularly against the GBP, as there is very little room for kiwi rate expectations to fall. Moreover, this currency should also outperform the Australian dollar, given that New Zealand is less exposed to the Chinese industrial cycle than Australia. Nevertheless, we remain bearish on the NZD on a long-term basis, given that the new government proposals to reduce immigration and add an unemployment mandate to the RBNZ will lower the neutral rate in New Zealand, which will limit the central bank's ability to tighten monetary policy. Report Links: Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada has been negative: Core inflation underperformed expectations, coming in at 1.5%. This measure also decreased form 1.7% last month. Headline inflation also surprised to the downside, coming in at 2.2%. This measure decreased significantly, coming down from 2.8% the previous month. The Bank of Canada increased rates to tk% on Wednesday, and highlighted the potential for additional rate hikes over the coming 12 months. USD/CAD has been mostly flat this week. The upside in the CAD versus the USD is likely to be limited as the policy tightening by the BoC now seems well anticipated by market participants. To take advantage of this reality, we went short CAD/NOK in our portfolio. This cross also serves as a hedge to our long dollar view, given its positive correlation to the DXY. Despite some headwinds, the CAD should outperform the AUD, as we expect that oil will do better than base metals within the commodity complex. Report Links: Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 EUR/CHF has fallen by 0.5% this week, as investors have grown worried with the recent sell off in equities. We are bearish on the franc on a cyclical basis, given that inflation in Switzerland is still too weak for the SNB to move away from their ultra-dovish monetary policy. Moreover, Helvetic real estate prices should continue to fall, as the restrictions on immigration put forth by the Swiss government since 2014 should continue to weigh on housing demand. This will further hamper the ability of the SNB to tighten its extraodinarly accommodative monetary policy. That being said, EUR/CHF could continue to fall in the near term, as money flows into safe heaven assets amid the current sell off in equities. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 USD/NOK has risen by 0.9% this week. As expected, yesterday the Norges Bank left rates unchanged at 0.75%. In its report, the Norwegian central bank highlighted that although economic growth has been a little lower than anticipated, inflation has been somewhat higher than expectations. We are bullish on the krona against the Canadian dollar, given that rate hike expectation in Canada are much more fully priced in than in Norway even though the inflationary backdrop is very similar. Moreover, we are positive on the krone relatively to other commodity currencies like the AUD or the NZD, as we expect oil to outperform other commodities thanks to supply cuts by OPEC and sanctions against Iran. Report Links: Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 USD/SEK has rallied by 1% this week. We are positive on USD/SEK on a short-term basis, given that the SEK is the currency which is most negatively affected by the strength of the U.S. dollar. Furthermore, tightening by Chinese authorities should also weigh on the krona, given that the Swedish economy is very levered to the global industrial cycle, as many of its exports are intermediate goods that are then re-exported to emerging markets. That being said, we are bullish on the krona on a longer-term basis, as the Riksbank is on the verge of beginning a tightening cycle as imbalances in the Swedish economy are only growing more dangerous. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Mounting supply-side uncertainty will keep the risk premium in oil prices - and volatility - elevated after U.S. export sanctions against Iran kick in November 4 (Chart of the Week). Chart of the WeekOil-Price Risk Premium Will Continue To Increase Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity These sanctions likely will remove 1.0 - 1.5mm b/d of Iranian exports, and absorb the combined spare capacity of the Kingdom of Saudi Arabia (KSA) and Russia (Chart 2) in the process. Export capacity expansions on KSA's West coast - intended to keep oil flowing if the Strait of Hormuz is closed - put the supply-side risks sharply in focus. Chart 2Lost Iranian Exports Could Exceed KSA's and Russia's Spare Capacity Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity OPEC 2.0's production increases last month calmed markets.1 All the same, it is worth noting they occurred just before a widely expected U.S. Strategic Petroleum Reserve (SPR) release coinciding with refinery turnarounds, and one-off Asian demand shocks. On the back of these supply boosts, and an upward revision to U.S. shale output (see below), and a slight decrease in our expected demand growth next year, we lowered our 2019 Brent forecast to $92/bbl from $95/bbl. We now expect Brent prices to peak in April 2019. WTI will trade $6/bbl lower (Chart 3). Our forecasts are conditioned on Iranian export losses of 1.25mm b/d, and Venezuelan losses of just over 450k b/d. A loss of 1.7mm+ b/d of Iran exports, as Platts Analytics expects, or a Venezuela collapse, means an unplanned outage anywhere will take prices above $100/bbl. Chart 3OPEC 2.0 Production Hike Pushes Price Spike To 2Q19 OPEC 2.0 Production Hike Pushes Price Spike To 2Q19 OPEC 2.0 Production Hike Pushes Price Spike To 2Q19 Highlights Energy: Overweight. The IMF downgraded global GDP growth expectations from 3.9% to 3.7% p.a. this year and next. This reduced our base case demand growth for 2019 slightly, to 1.5mm b/d from 1.6mm b/d previously. Base Metals: Neutral. Global copper stocks stand at half their late April peak - the lowest level since late 2016, on the back of restrictions on Chinese scrap imports. Precious Metals: Neutral. Palladium traded to record levels above $1,140/oz this week, as persistent physical deficits into 2020 are priced into the market. Ags/Softs: Underweight. The USDA's Crop Progress Report showed soybean harvests accelerating: 53% of the crop was harvested as of last week, below the 2013 - 17 average of 69%, but well above the previous week's 38% level. Feature U.S. Treasury Secretary Steve Mnuchin is convinced global oil markets have fully priced in the loss of Iranian crude oil exports arising from the re-imposition of export sanctions by the U.S. November 4. Speaking with Reuters over the weekend, he said, "Oil prices have already gone up, so my expectation is that the oil market has anticipated what's going on in the reductions. I believe the information is already reflected in the price of oil."2 We are not so sure. The price-decomposition model shown in the Chart of the Week is a bottom-up fundamental model that assesses how changes in OPEC and non-OPEC supplies, global demand and inventories contribute to overall price changes, as new information becomes available regarding these variables. These variables are shown in Chart 4 and Table 1.3 Chart 4BCA Global Oil Supply-Demand Balances BCA Global Oil Supply-Demand Balances BCA Global Oil Supply-Demand Balances The "residual" term in the model covers everything not explained by these fundamental variables.4 We believe the unexplained effect on prices in the residuals reflects market participants' perception of riskiness - either to supply or demand - given the big fundamental drivers of price are accounted for in the other variables. Table 1BCA Global Oil Supply - Demand Balances (MMb/d) Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity Close inspection reveals the residual term has been increasing as we approach the deadline for the re-imposition of U.S. sanctions on Iran. And the fact is, estimates of the loss in Iranian exports are widely dispersed - from less than 1mm b/d to 1.7mm b/d by tanker trackers like Platts Analytics. As Chart 2 shows, export losses at the high end of this range would absorb almost all of the world's spare capacity - the 1.3mm b/d the U.S. EIA estimates for OPEC (most of it held by KSA, plus whatever other Gulf Arab producers can muster). Russia, which is producing at a record of ~ 11.4mm b/d, likely has ~ 250k b/d of spare capacity at its disposal. With the increase in global demand largely being covered by U.S. shales, which are constrained to ~ 1.3mm b/d of growth p.a. until 2H19, when we expect production to increase at a 1.44mm b/d annual rate, this leaves the global market perilously exposed to any and all unplanned production outages. Any deterioration in Venezuela's production, which we expect to fall to 865k b/d on average in 2019 (versus 1.3mm b/d on average this year), or an unplanned loss in exports from historically unstable states like Nigeria and Libya - where we raised our production estimates to 1.75mm b/d and 1.05mm b/d in line with OPEC survey data - almost surely will spike prices above $100/bbl.5 OPEC 2.0 Got Lucky OPEC 2.0 - the producer coalition led by KSA and Russia - picked a fortuitous moment to increase production this past month. OPEC, led by KSA, lifted crude and liquids production 140k b/d in September, while Russia's production rose 150k b/d. It is worth noting these output increases occurred just before a widely expected U.S. SPR release in October - November, which overlapped with refinery maintenance (turnaround) season in the U.S. Midwest refiners were expected to take 300k to 460k b/d of capacity offline in September and October, a relatively high level of maintenance, while Gulf Coast refiners were expected to take 430k to 535k b/d down.6 Both events raise the supply of crude relative to demand, and reduce inventory drawdowns. In addition, one-off Asian demand shocks - an earthquake and typhoon in Japan - dented demand. KSA lifted its production to 10.5mm b/d in September, bringing average 3Q18 production to 10.4mm b/d versus a bit more than 10mm b/d in 1H18. Russia's crude and liquids output rose to 11.45mm b/d in 3Q18 versus 11.2mm b/d in 1H18. The higher production calmed markets somewhat. OPEC 2.0 effectively got a two-month assist from the U.S. refinery turnarounds and a U.S. SPR release, just as markets were fretting prices would breach $90/bbl earlier this month.7 These production boosts will allow OECD inventories to rebuild somewhat going in to the Northern Hemisphere's winter (Chart 5). Nonetheless, OPEC 2.0 has begun tearing into spare capacity with these output increases. Chart 5OPEC 2.0 Production Boost Allows OECD Stocks To Rebuild OPEC 2.0 Production Boost Allows OECD Stocks To Rebuild OPEC 2.0 Production Boost Allows OECD Stocks To Rebuild KSA Talks Markets Lower... While the U.S. SPR release and inventory builds associated with U.S. turnarounds progressed, KSA's Energy Minister Khalid al-Falih was reassuring markets the Kingdom can ramp production to 11mm b/d, and even 12mm b/d if needs be. KSA has been increasing rig counts in 2H18 as Brent prices rise, but we remain highly dubious KSA can ramp production to 11mm b/d - let alone 12mm b/d - and sustain it for any meaningful length of time (Chart 6). Chart 6KSA Increasing Rig Counts, After Price-Induced Slowdown KSA Increasing Rig Counts, After Price-Induced Slowdown KSA Increasing Rig Counts, After Price-Induced Slowdown The likelihood KSA can significantly boost production before the end of 1H19 became even more doubtful, following reports the Kingdom and Kuwait were having difficulty agreeing on restarting Neutral Zone production. We've downgraded our assessment that 350k b/d of Neutral Zone production will be returned to the market beginning in 2Q19 to a 50% likelihood, following reports KSA and Kuwaiti officials are diverging on operational control of the production. Apparently, the two states also differ on geopolitical issues in the Gulf, as well - e.g., the Qatar blockade lead by KSA, and Iran policy.8 While core Gulf Arab producers are raising output, we expect the non-Gulf members of the Cartel continue to see output decline (Chart 7). Indeed, with the exception of the core OPEC Gulf Arab producers, U.S. shale operators and Russia, the rest of the world is barely keeping its output level (Chart 8). Chart 7Non-Gulf OPEC Output Continues to Decline Non-Gulf OPEC Output Continues to Decline Non-Gulf OPEC Output Continues to Decline Chart 8Global Production Growth Stalls Outside U.S. Onshore, GCC And Russia Global Production Growth Stalls Outside U.S. Onshore, GCC And Russia Global Production Growth Stalls Outside U.S. Onshore, GCC And Russia ...And Shores Up Export Capacity Export capacity expansions on KSA's West coast - intended to keep oil flowing if the Strait of Hormuz is closed - put global supply-side risks sharply in focus. KSA has added 3 mm b/d of oil export capacity to the Red Sea coast of the Kingdom, with an upgrade to its Yanbu crude oil terminal. Prior to the expansion, Yanbu terminal's export capacity was 1.3mm b/d; it was used mainly for refined products and petrochemicals shipments, due to its relative proximity to refineries in Yanbu, Rabigh, Yasref, Jeddah and Jazan. Shipping via the Red Sea port allows KSA to move crude to Asia through the Bab el-Mandeb Strait to the south, which at times is threatened by Yemen's Houthi militia, and the north to Western markets through the Suez Canal. In addition, KSA's national oil company, Aramco, says it intends to restore operations at al-Muajjiz crude oil terminal, which has been out of operation since Iraq's invasion of Kuwait in 1990. Aramco intends to integrate the Muajjiz terminal into the Yanbu facilities to expand Red Sea export capacity from ~ 8 mm b/d to some 11.5 mm b/d. KSA's total export capacity is scheduled to reach 15mm b/d by year-end. These expansions give KSA the option to reroute all of its ~ 7mm b/d exports through the Red Sea, in the event the Strait of Hormuz is closed by Iran. However, this option could be limited by pipeline infrastructure. The current capacity of the East - West crude pipeline is 5mm b/d, although Aramco signalled its intention to boost capacity to 7mm b/d by end-2018. No announcements indicating this was on schedule or completed could be found. Global Demand Holds Up The IMF downgraded its global GDP growth expectation from 3.9% p.a. to 3.7% this year and next. This reduced our base case demand growth for 2019 to 1.5mm b/d from 1.6mm b/d. Even so, we note that oil prices for EM consumers in local-currency terms are at or close to post-GFC highs (Charts 9A and9B). A number of EM governments relaxed or removed subsidies on fuel prices following the oil-price collapse of 2014 - 16, which means consumers in these states are feeling most or all of the effect of higher prices directly for the first time in the modern era (beginning in the 1960s, when OPEC became the dominant producer cartel in the market).9 Chart 9ALocal-Currency Cost Of Oil In Select EM Economies Local-Currency Cost Of Oil In Select EM Economies Local-Currency Cost Of Oil In Select EM Economies Chart 9BLocal-Currency Cost Of Oil In Select EM Economies Local-Currency Cost Of Oil In Select EM Economies Local-Currency Cost Of Oil In Select EM Economies As we've noted previously, high fuel costs (in local-currency terms) coupled with high absolute prices deliver a double-whammy to EM consumers, which are the driving force in global oil-demand growth. In fact, 1.1mm b/d of the 1.5mm b/d of demand growth we expect next year in our base case is accounted for by EM growth. In our scenarios analysis, we assume every $10/bbl jump in prices above $90/bbl destroys 100k b/d of EM demand. This lowers the unconstrained oil-price trajectory, and reduces our base case growth estimate of 1.5mm b/d next year to 1.3mm b/d (Chart 10). Chart 10An Oil-Supply Shock Would Lower Demand An Oil-Supply Shock Would Lower Demand An Oil-Supply Shock Would Lower Demand An oil-supply shock that seriously erodes EM demand would - in the course of months, we believe - translate into a disinflationary impulse into DM markets. This could force the Fed to change course and dial its rates-normalization policy back, as we recently noted.10 Bottom Line: Volatility will remain elevated following the re-imposition of sanctions against Iran's oil exports next month. OPEC 2.0's fortuitously timed production increases - coincident with a scheduled U.S. SPR release and refinery turnarounds - will be absorbed by markets once turnaround season ends in the U.S. Global spare capacity is insufficient to cover Iranian export losses at the high end of market expectations, if Venezuelan production falls more than expected or that state collapses. Any unplanned outage anywhere will quickly push prices through $100/bbl, necessitating further U.S. SPR releases. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 OPEC 2.0 is the name we coined for the OPEC/non-OPEC coalition led by KSA and Russia. This coalition likely will be formalized at the December 7 OPEC meeting in Vienna via treaty. This has been alluded to over the past year, most recently in an interview given to Tass, the Russian state-owned news agency. Please see "Saudi energy minister Al-Falih speaks to TASS on OPEC+, oil prices and Khashoggi," published by TASS, October 22, 2018. 2 Please see "Mnuchin says it will be harder for Iran oil importers to get waivers," published by uk.reuters.com October 21, 2018. 3 The Federal Reserve Bank of New York publishes a similar price-decomposition model weekly in its "Oil Price Dynamics Report," which is available online. 4 We can assume USD effects will be reflected in demand and supply at the margin - i.e., a stronger USD reduces demand by raising the local-currency costs of oil, and increases supply by lowering the local-currency costs of production, and vice versa. Uncertainty as to the USD's trajectory adds to overall uncertainty in the model. 5 This likely would trigger withdrawals from the U.S. SPR, or the EU's strategic petroleum reserves, but that will take time to implement. Both Libya and Nigeria likely will hold elections next year: Nigeria in February, Libya possibly on December 10, but more likely next year following passage of a UN resolution to extend the mandate of its political mission there to September 15, 2019. Civil unrest in Libya has been increasing, as ISIS fighters increase the tempo of operations on the ground. 6 Please see "Falling into refiner Turnaround Season & Maintenance outlook," published by Genscape August 23, 2018. 7 This occurs at a fortuitous time in the U.S. election cycle, as mid-terms will be held November 6, two days after Iran sanctions kick in. We expected an SPR draw ahead of midterms; please see "Trade, Dollars, Oil & Metals ... Assessing Downside Risk," published by BCA Research's Commodity & Energy Strategy August 23, 2018. It is available at: ces.bcaresearch.com. 8 Please see "Oil output from Saudi, Kuwait shared zone on hold as relations sour," published by uk.reuters.com October 18, 2018. 9 The U.S. Federal Reserve is in the process of a rates-normalization cycle, which likely will keep the USD appreciating against EM currencies into next year. Our House view calls for five additional hikes between December and the end of 2019. Please see "Trade, Dollars, Oil & Metals ... Assessing Downside Risk," published by BCA Research's Commodity & Energy Strategy August 23, 2018, for further discussion. ces.bcaresearch.com. 10 We discuss this at length in a Special Report published last week with BCA Research's entitled "Man Bites Dog: Could Sharply Rising Oil Prices Lead To Lower Global Bond Yields in 2019?" It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trade Recommendation Performance In 3Q18 Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity Trades Closed in 2018 Summary of Trades Closed in 2017 Summary Of Trades Closed In 2017 Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity

Highlights Policy easing is a necessary but not sufficient condition for a bottom in the business cycle. For monetary easing to become effective, there should be loan demand, banks should be willing to lend, and businesses and consumers should be keen to spend more. In China, risks to both the money multiplier and the velocity of money are to the downside. This will hinder the effectiveness of monetary policy easing in generating economic growth. Eroding business and consumer confidence in China will - for now - negate the budding improvement in its broad money impulse. Emerging markets risk assets and currencies are set to drop further. Stay put. Feature The selloff in EM and Chinese stocks has begun to weigh heavily on DM share prices. The global equity index has broken below its January lows, entailing further downside. Importantly, global cyclical equity sectors such as global industrials, materials and semiconductors are underperforming, and are breaking down in absolute terms. This confirms global trade is in a full downturn swing (Chart I-1). Chart I-1Global Trade Is Decelerating Global Trade Is Decelerating Global Trade Is Decelerating What is required to turn around this global trade slowdown? Our bias is that this growth slump has roots in China/EM and trade tensions are dampening business and investor sentiment on top of that. Consequently, a reversal in the equity selloff is largely contingent on an improvement in China's economy. It is in this context that we devote this week's report to an extensive discussion surrounding the issues of policy stimulus, deleveraging and growth in China. In this report, we answer the questions we think are most pertinent to investors at this moment. Question: Why are financial markets rioting, even though China has announced stimulus? Answer: The market's interpretation is that these stimuli are insufficient to turn around China's business cycle immediately. We agree with this assessment. Policy easing does not always immediately translate into higher share prices and improving growth. For example, amid China's 2015 stock market crash, the Chinese authorities began aggressively stimulating in the middle of 2015, yet Chinese and global markets continued to riot until February 2016 (Chart I-2). Chart I-2China In 2015: Money Growth Preceded Bottom In Markets By Seven Months China In 2015: Money Growth Preceded Bottom In Markets By Seven Months China In 2015: Money Growth Preceded Bottom In Markets By Seven Months Indeed, there was a period of seven months when EM and DM stocks plummeted, despite on-going and very aggressive policy easing in China. In short, these stimulus measures did not preclude a considerable drawdown in global and EM share prices. Outside China, there have been other examples where policy easing did not preclude a full-fledged bear market. For instance, in 2001-'02 and 2007-'08, the Federal Reserve was cutting interest rates aggressively, yet the bear market in U.S. equities did not reverse (Chart I-3). Chart I-3AFed's Easing Did Not Prevent Equity Bear Market Fed's Easing Did Not Prevent Equity Bear Market Fed's Easing Did Not Prevent Equity Bear Market Chart I-3BFed's Easing Did Not Prevent Equity Bear Market Fed's Easing Did Not Prevent Equity Bear Market Fed's Easing Did Not Prevent Equity Bear Market Similarly, the ECB was expanding its balance sheet from the onset of the euro area debt crisis in 2011, yet the region's share prices did not bottom until the middle of 2012, 12 months later (Chart I-4). Chart I-4ECB Balance Sheet Expansion Did Not Prevent Equity Bear Market ECB Balance Sheet Expansion Did Not Prevent Equity Bear Market ECB Balance Sheet Expansion Did Not Prevent Equity Bear Market Question: It is clear there could be a time lag between policymakers stimulating and financial markets and the business cycle turning the corner. What is causing these time lags, and how should one handicap them? Answer: Indeed, monetary and fiscal policies affect the economy with time lags. These lags vary from cycle to cycle. In China, the broad money impulse has improved of late (Chart I-5). Historically, this has led the mainland's business cycle by about nine months on average. Hence, it signifies a tentative bottom early next year. Chart I-5China: Money Impulse Has Bottomed China: Money Impulse Has Bottomed China: Money Impulse Has Bottomed The credit impulse, however, has not improved at all (Chart I-6). The current divergence between credit and money impulses is due to a plunge in shadow (non-bank) credit (Chart I-7). The distinction between broad money and credit is as follows: money is originated by commercial banks when they lend to or acquire an asset from non-banks. Meanwhile, total credit also includes lending and bond purchases by non-banks. Chart I-6China: Credit Impulse Has Not Yet Bottomed China: Credit Impulse Has Not Yet Bottomed China: Credit Impulse Has Not Yet Bottomed Chart I-7Bank And Non-Bank Credit Have Diverged Bank And Non-Bank Credit Has Diverged Bank And Non-Bank Credit Has Diverged Importantly, money/credit fluctuations are not the sole factors that generate swings in economic activity. Companies' and households' willingness to consume and invest matter too. We have written extensively in the past that changes in the velocity of money mirror fluctuations in the marginal propensity to consume and invest.1 Technically speaking, nominal GDP growth is a product of money growth and change in the velocity of money. Nominal GDP = Money Growth x Velocity Of Money When a decline in the velocity of money - stemming from eroding business and consumer confidence - overwhelms an acceleration in money growth, economic growth weakens, despite improvement in the money impulse. Notably, money and credit have led previous business cycles in China by varying time periods. In other words, the velocity of money has not been constant on the mainland. In particular, both the money and credit impulses were early - by about 12 months - in forecasting a growth slowdown in China and global trade at the beginning of 2017. The reason why a growth slowdown did not commence at that time was due to the surge in the velocity of money. The latter is akin to confidence among economic agents. In short, companies and households turned their money balances faster, which offset the impact of weak money/credit impulses on economic activity. Concerning fiscal policy, time lags differ because of implementation delays and varying fiscal multipliers. In China, aggregate fiscal spending, including central, local governments and managed funds, has not yet accelerated (Chart I-8). Chart I-8China: No Rebound In Broad Fiscal Spending China: No Rebound In Broad Fiscal Spending China: No Rebound In Broad Fiscal Spending While special bond issuance by local governments spiked in August and September, overall credit flows in the economy have not yet improved - please refer to Chart I-6. As an aside, there are reports that 42% of the amount raised via special bond issuance will be used to purchase land rather than for infrastructure spending.2 This will not benefit economic growth much. Question: Do you think the time lag between the bottom in China's money/credit impulses and the business cycle will be longer or shorter this time around? Answer: Our bias is that the time lag between the bottom in money/credit impulses and the resultant pickup in growth will be longer than before. Presently, there is some evidence that both business and consumer sentiment in China are beginning to whither at the hands of the trade wars, tanking domestic share prices and budding deflation in real estate prices. Eroding business and consumer confidence in China will - for now - negate the improvement in the broad money impulse. Chart I-9 depicts the velocity of money in China. After rising over the past two years, our bias is that it will drop again. It is critical to realize that forecasting the direction and magnitude of swings in the velocity of money - the marginal propensity to spend - is a dismal science. It reflects business and consumer sentiment, and any assessment on this is very subjective. This is why economic forecasting and investment calls are more of an art. Chart I-9China: The Velocity Of Money China: The Velocity Of Money China: The Velocity Of Money Among many variables we are monitoring to gauge the turn in the mainland's business cycle is the marginal propensity to invest among mainland industrial companies. This indicator is falling, suggesting that monetary policy easing is facing formidable hurdles in re-igniting investment appetite among Chinese companies (Chart I-10). Chart I-10Companies' Marginal Propensity To Spend Companies' Marginal Propensity To Spend Companies' Marginal Propensity To Spend The BCA Emerging Markets Strategy team's assessment is that China-related financial markets are in an air pocket. Investors should not try to catch falling knives. On the contrary, there is still meaningful downside. Question: But the People's Bank of China has been injecting a lot of liquidity into the system via various facilities. Would this liquidity not find its way into financial markets and the real economy? Answer: When a central bank injects liquidity into the banking system, it creates excess reserves. Excess reserves also rise when a central bank cuts the required reserve ratio (RRR). It is essential to differentiate money that households and business use to conduct transactions from reserves of commercial banks at the central bank. Required and excess reserves are not a part of narrow and broad monetary aggregates. Excess reserves are the banking system's liquidity held at the central bank. Importantly, banks do not lend reserves, and do not use reserves to pay for assets they purchase from non-banks. Banks use reserves to settle transactions/payments among themselves. Reserves are "manufactured" solely by central banks. Commercial banks cannot create reserves. They do, however, create the overwhelming majority of money when they lend to or purchase an asset from non-banks. Central banks create broad money - that circulates in the economy - only when they lend to or buy assets from non-banks. Given central banks typically do few transactions with non-banks, central banks originate a very small portion of the broad money supply. For example, as a part of quantitative easing efforts, new money is originated only when a central bank buys bonds from a non-bank (say, an insurance company). In contrast, no money is created when a central bank buys bonds from a bank. In brief, there is no automatic leakage of reserves into the real economy and financial markets. Banks need to be willing to lend to and purchase assets from non-banks for the money supply to expand. Question: But won't expanding excess reserves - banking system liquidity - eventually encourage banks to lend and purchase financial assets? Answer: It will at some point, but it is not imminent. The mainland banking system's excess reserves ratio is depicted in Chart I-11. A few observations are in order: Chart I-11China: Excess Reserves Not Are Growing China: Excess Reserves Not Are Growing China: Excess Reserves Not Are Growing First, the excess reserve ratio - excess reserves (ER) as a share of total deposits - is currently rather low (Chart I-11, top panel). The absolute level of ER is not elevated either (Chart I-11, middle panel). To adjust the absolute level of ER for seasonality, we show the annual change of this measure - it has dropped to zero in September (Chart I-11, bottom panel). This is in contrast to the prevailing market narrative that the PBoC is injecting a lot of liquidity into the system. While they have been injecting liquidity via RRR cuts, at the same time many lending facilities have been maturing without renewal. Does the low level of ER ratio mean the PBoC has been tightening? No, it has not been tightening. Shrinking excess reserves that lead to higher money market rates would qualify as tightening. Provided money market rates are low and are not rising in China, there has been no de-facto tightening, despite the low level of reserves (Chart I-12). Chart I-12China: Excess Reserves And Interest Rates China: Excess Reserves And Interest Rates China: Excess Reserves And Interest Rates Second, any central bank can simultaneously target either quantity of reserves or short-term interest rates, but not both. Before 2014, the PBoC was targeting the level of ER. As a result, short-term interest rates fluctuated a lot to equilibrate demand and supply for ER. Since early 2014, the PBoC has switched to targeting interest rates. Therefore, the level of ER is no longer a policy objective, but rather a tool to navigate interest rates. Chart I-13 illustrates what drives PBoC policy in terms of interest rates and liquidity management. The PBoC sets interest rates based on the strength in the economy - i.e., interest rates rise when loan demand is improving and fall when loan demand is weakening (Chart I-13, top panel). Chart I-13China: What Drives Interest Rates? China: What Drives Interest Rates? China: What Drives Interest Rates? Then, the central bank adjusts the amount of ER to achieve its desired level of short-term interest rates. Hence, the amount of ER is a function of demand for reserves by banks at the current level of interest rates. The current low level of ER is indicative of weak demand for ER by banks. As loan origination has diminished, economic activity has cooled off and the number of transactions by companies and consumers has dwindled, demand for reserves among banks has declined. Third, declining/expanding ER do not always cause a slowdown/acceleration in money/credit growth, as demonstrated on Chart I-14. There is another variable that stands between ER and money/credit: the money multiplier (MM). The latter is defined as how much broad money/credit banks create per one unit of ER. A rising money multiplier reflects banks' willingness and ability to expand their balance sheets aggressively. A falling multiplier signifies growing risk aversion among banks, or their inability to expand their balance sheets. Chart I-14China: Excess Reserves And Money/Credit Impulses China: Excess Reserves And Money/Credit Impulses China: Excess Reserves And Money/Credit Impulses Notably, the credit boom in China since 2009 has been driven not by rapidly expanding ER but primarily by a surging MM. The MM has skyrocketed from 40 in 2008 to 65 presently (Chart I-15). This was the manifestation of excessive risk taking by banks. Chart I-15China: Money Multiplier China: Money Multiplier China: Money Multiplier Why is it sensible to expect the MM in China to decline? With ongoing regulatory tightening, falling asset prices and rising defaults, the odds are non-trivial that mainland banks will be reluctant to expand their balance sheets aggressively. We are not implying they will not boost lending forever, but they may be slower to do so compared to previous downturns. Following the peak in their respective credit bubbles and experiencing deteriorating asset quality, banks in Japan, the U.S., the U.K. and euro area shrunk their balance sheets - even though their respective central banks provided enormous amount of excess reserves, and interest rates were at zero. We do not expect bank credit growth to contract in China like it did in those countries. In fact, bank assets and broad credit are still growing at an annual rate of 7% and 12%, respectively (Chart I-16 and Chart I-7 above). Our point is that deleveraging in China has barely begun, and it still remains a policy priority. Consequently, money and credit growth will languish longer in this downturn than in previous ones. Chart I-16China: Bank Asset Growth To Stay Tame China: Bank Asset Growth To Stay Tame China: Bank Asset Growth To Stay Tame Question: So, how would you summarize the key known unknowns to gauge whether and when monetary policy easing will translate into stronger economic growth? Answer: For monetary policy easing to translate effectively into economic growth, the MM and the velocity of money should rise. Both are driven by sentiment and marginal propensity to lend, borrow and spend. Hence, variations in the MM as well as the velocity of money are contingent on sentiment and behavior among bankers, companies and households. The regulatory clampdown on banks and non-bank financial institutions will hamper their willingness and ability to lend, despite sufficient liquidity and low interest rates. Hence, the MM could surprise on the downside. A combination of the ongoing crackdown on leverage, the starting point of high indebtedness, falling asset prices and trade confrontations, will likely weigh on corporate and consumer sentiment, curb their spending and, thereby, dampen the velocity of money. All in all, risks to both the MM and the velocity of money are to the downside rather than upside at the moment. This will hinder the transmission mechanism from policy easing to economic growth. Question: What is your take on financial markets? Are we close to the bottom in EMs and China-related plays? Answer: EMs and China-plays are in a genuine bear market as we have argued in past.3 BCA's Emerging Markets Strategy service reckons there is still meaningful downside in EM risk assets and currencies. The EM/China bear market will continue. The Fed is not about to come to markets' rescue, because U.S. growth is very robust and inflation is rising. A very important market to watch is the RMB exchange rate. If the RMB depreciates further - which is our baseline scenario - Asian and other EM financial markets will continue plunging. The RMB/USD exchange rate has been closely tracking the interest rate differential between China and the U.S. (Chart I-17). As the Fed continues to raise rates and China maintains rates at their current level or reduces them to stimulate, the RMB will depreciate. Chart I-17RMB/USD And Interest Rate Differentials RMB/USD And Interest Rate Differentials RMB/USD And Interest Rate Differentials Yuan depreciation will lead to a decline in other Asian currencies. In fact, the Korean won is at a critical technical juncture, and a major move is in the cards. Our bias is it will likely break down, consistent with our bearish view on EM risk assets and currencies. As the RMB depreciates, the amount of U.S. dollars that China emits to emerging economies via imports will decline. This will hurt EM exports to China, their currencies and commodities prices. Overall, the U.S. dollar has more upside. The growth disparity between the U.S. and the rest of world warrants a stronger greenback. The latter and a slowdown in EM/China herald a considerable drop in commodities prices. Question: One commodity that has defied the dollar rally and slowdown in China is oil. Will crude continue to float higher? Answer: Oil prices have risen much further and for far longer than we expected.That said, it appears that oil prices are finally beginning to crack, and we see considerable downside.4 China's imports of oil and petroleum products has decelerated substantially (Chart I-18, top panel). This is occurring at a time when Chinese oil strategic and commercial inventories are very elevated (Chart I-18, bottom panel). Chart I-18China's Oil Imports To Weaken Further China's Oil Imports To Weaken Further China's Oil Imports To Weaken Further Oil prices in local currency terms are at record highs in many developing countries. Given oil and fuel subsidies have been removed or reduced in recent years, high oil prices are curbing oil demand in many emerging economies. Global oil production has been outpacing global oil demand since May (Chart I-19, top panel). Typically, this heralds a rollover in oil prices (Chart I-19, bottom panel). Chart I-19A Risk To Oil Prices A Risk To Oil Prices A Risk To Oil Prices Finally, oil output has been surging in the U.S. and strong in Russia (Chart I-20); further, Saudi Arabia could boost its crude output as per its recent pledge. Chart I-20Global Oil Output Has Been Surging Global Oil Output Has Been Surging Global Oil Output Has Been Surging While geopolitics remains a supportive factor for crude prices, it seems a lot of good news is already priced in the oil market and investors are very long. In short, oil prices are probably heading south. This will contribute to the negative investment sentiment toward EM financial markets. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report, "Questions For Emerging Markets," dated November 29, 2017, available at ems.bcaresearch.com. 2https://www.bloomberg.com/news/articles/2018-10-21/china-s-195-billion-debt-splurge-has-less-bang-than-you-think 3 Please see Emerging Markets Strategy Weekly Report, "EMs Are In A Bear Market," dated October 18, 2018; the link is available on page 17. 4 This is BCA's Emerging Markets Strategy team's view and differs from the BCA house view on oil. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights We do not view October's equity downdraft as a signal to further trim risk assets to underweight. Nonetheless, stocks have not yet fallen enough to justify buying either. The economic divergence between the U.S. and the rest of the world is intensifying and showing up in relative EPS trends. We believe earnings growth is set to drop sharply in the Eurozone and Japan. The viciousness of the bond selloff in October is worrying. The good news is that the Treasury curve steepened and the selloff mostly reflected higher real yields, rather than inflation expectations. Both facts suggest that the Treasury rout was reflective of strong U.S. growth, rather than a signal that the Fed is overly restrictive. Our sense is that the fed funds rate has not yet reached the economic choke point, but it is critical to watch for signs of trouble. This month we focus on key monetary indicators. Our "R-Star" indicator is deteriorating, but is not yet in the danger zone for risk assets. It is possible that we will upgrade risk assets back to overweight if stocks in the developed markets cheapen further, as long as our monetary indicators are not flashing red and the U.S. earnings backdrop remains upbeat. However, the risks are formidable and show no signs of abating. Indeed, our global economic indicators continue to deteriorate and we might be headed for a brief manufacturing recession outside of the U.S. A Democratic win in the U.S. mid-terms might spark a knee-jerk equity selloff, but Congress is unlikely to unravel any of the fiscal stimulus currently in place through 2019. The Administration's foreign policy remains a larger risk for equities. Our high conviction view is that President Trump will continue to use a "maximum pressure" approach for Iran and China that will spark additional fireworks. Another growing risk is an oil price spike above US$100/bbl in early 2019, causing significant economic damage. Chinese policy stimulus is underwhelming and the credit impulse remains weak. In the absence of real policy action in China, the prospect of continuing Fed tightening means that it is too early to bottom-fish in emerging markets. The market is still underestimating the U.S. inflation outlook and the amount of Fed tightening over the next 12-18 months. We continue to recommend a neutral stance on global equities (with a preference for developed over emerging markets), a below-benchmark duration bias, and an overweight allocation in cash. Feature October's market action confirmed that we have entered a period of elevated volatility as investors digest the inevitability of rising U.S. interest rates. We do not view the downdraft in equity markets as a signal to further trim risk asset exposure to underweight. Nonetheless, stocks have not yet fallen enough to justify buying either. We took profits and downgraded risk assets to benchmark in June, placing the proceeds into cash. Our primary motivation was the advanced nature of the U.S. economic cycle, stretched valuations, heightened geopolitical tensions, the risk of a Chinese "hard landing" and upside potential for U.S. inflation and global bond yields. We did not foresee a recession either in the U.S. or the other major economies in the near future. Nonetheless, we concluded that the risk/reward balance did not favor staying overweight risk assets. A number of culprits could be blamed for October's pullback, but in reality the market has been primed for some profit-taking for a long while and so any little excuse could have been used by investors to sell. Fed Chair Powell's "long way to go" comment seemed to push the teetering equity market over the edge. He challenged the market's view that the fed funds rate is getting close to neutral, implying that the Fed is not close to pushing the pause button. The Treasury curve steepened as the market discounted a higher cyclical peak in the fed funds rate. Could it be that bond yields have reached a "choke point" where tightening financial conditions are derailing the economic expansion? The global economic deceleration is intensifying, but the U.S. economy still appears to be enjoying solid momentum outside of housing. We do not yet see any major dark clouds forming in the U.S. corporate earnings picture either, as discussed below. Moreover, the bond selloff in October mostly reflected rising real yields (rather than inflation expectations), and the curve steepened. Both facts suggest that the Treasury selloff was reflective of U.S. strong growth, rather than a signal that the Fed is now outright restrictive. Nonetheless, the issue is particularly tricky in this cycle because the equilibrium, or neutral, fed funds rate is undoubtedly somewhat lower than in past expansions. Given the uncertain level of the neutral rate, investors must be on the lookout for signs that interest rates are beginning to bite. Markets And The Fed Cycle BCA has long viewed financial markets through the lens of money and credit. This includes a framework that involves the Fed policy cycle. We begin by decomposing the fed funds rate cycle into four phases based on the interaction between the level of rates and their direction, as follows (Chart I-1 and Chart I-2): Phase I begins with the first rate hike of a new tightening cycle and ends when the fed funds rate crosses above our estimate of the equilibrium rate (shown as a dashed line in Charts I-1 and I-2). Phase II represents the latter stages of the tightening cycle, when the Fed hikes its target rate above equilibrium in a deliberate effort to cool an overheating economy. Phase III represents the early stage of the easing cycle. It begins with the first rate cut from the peak and lasts until the Fed cuts its target rate below equilibrium. Phase IV represents the late stage of the easing cycle. It encompasses both the period when the fed funds rate breaks below its equilibrium level until it bottoms. Chart I-1Stylized Fed Rate Cycle November 2018 November 2018 Chart I-2Fed Funds Rate And Equilibrium Fed Funds Rate And Equilibrium Fed Funds Rate And Equilibrium The tough part is estimating the neutral level of the fed funds rate. It is a theoretical concept - the level that is consistent with an economy at full employment with no upward or downward pressure on inflation or growth. The Fed lifts the fed funds rate above neutral when it wishes to dampen the economy and temper inflationary pressure. Economic theory ties the equilibrium interest rate to the pace of expansion of the supply side of the economy, or potential GDP growth. Our approach is to combine the CBO's estimate of potential GDP growth with a smoothed version of the actual fed funds rate, to account for the fact that the equilibrium rate periodically deviates from potential growth. The historical track record of this framework is compelling. The latest update of our analysis of equity returns during the four phases was published by BCA's U.S. Investment Strategy Service.1 The level of the fed funds rate relative to its equilibrium has mattered much more than the direction of rates for historical S&P 500 price returns (Table I-1 and I-2). Price returns during Phases I and IV (when the fed funds rate is below equilibrium) trounce returns during Phases II and III (when the funds rate is in restrictive territory). This is especially the case after adjusting returns for inflation. Table I-1Tight Policy Is Hazardous To Stocks' Health, ... November 2018 November 2018 Table I-2...Especially In Real Terms November 2018 November 2018 Further breaking down the historical returns into 12-month forward EPS estimates and 12-month forward multiples, it turns out that multiples usually contract when the Fed is tightening. However, during Phase I this is more than offset by the increase in forward earnings estimates, such that equity investors enjoy positive returns until rates move into restrictive territory in Phase II. Our sense is that we are still in Phase I, implying that it is too early to expect more than a correction in risk assets based solely on the U.S. monetary policy cycle. The fed funds rate has been rising, but so too has the equilibrium rate according on our measure. Powell's latest comments suggest that the Fed agrees. That said, it is a cliche to say that this cycle has been different in many ways. Nobody knows exactly where the neutral rate is today. This means that we must be on watch for signs that the fed funds rate has already crossed into restrictive territory. We looked at the behavior of a raft of monetary and credit indicators around the time that the fed funds rate broke above the estimated neutral rate in the past. None of them have been reliable across all business cycles since the 1970s, but the best ones are shown in Chart I-3: Growth in M1 generally begins to decelerate as the fed funds rate approaches neutral and falls into negative territory shortly thereafter. Bank liquidity is defined as short-term assets as a percent of total bank credit. It usually peaks just before rates become restrictive, and begins to fall quickly as the fed funds rate surpasses the equilibrium level. We interpret bank liquidity as a proxy for banks' willingness to provide funding liquidity that enables institutional investors to take positions. The peak level of bank liquidity differs across tightening cycles, but it is never a good sign when it begins to trend lower. Consumer credit growth has a somewhat spotty track record as an indicator of monetary restraint, but it has often peaked around the time that the Fed enters Phase II. The BCA Fed Monitor is an indicator designed to gauge the pressure on the Fed to adjust policy one way or the other. It generally peaks in "tight money required" territory just before, or coincident with, the shift from Phase I to Phase II. A shift of the Monitor into "easy money required" territory would suggest that policy has become outright restrictive, and that a peak in the fed funds rate is approaching. Chart I-3BCA R-Star Indicator And Its Components BCA R-Star Indicator And Its Components BCA R-Star Indicator And Its Components Combining the four into one indicator removes some of the noise of the individual series. The BCA "R-Star" Indicator is shown in the top panel of Chart I-3. A dip in this indicator below the zero line would warn that we have entered Phase II and that the equity bull market is out of time. Chart I-4 shows the BCA R-Star indicator again, along with the S&P 500, EPS growth and profit margins. It is shaded for periods when the R-Star indicator is below zero. The lead time has varied across the economic cycles and it is far from a perfect predictor. Nonetheless, when the indicator is negative it has generally been associated with falling stock prices, decelerating profit growth and eroding profit margins. The indicator has edged lower this year, but is not yet in the danger zone. Chart I-4BCA R-Star Indicator And The U.S. Profit Cycle BCA R-Star Indicator And The U.S. Profit Cycle BCA R-Star Indicator And The U.S. Profit Cycle Finally, we are of course watching the yield curve. Its recent steepening suggests that U.S. growth justifies higher bond yields and that policy has not yet become outright restrictive. Global Growth Divergence Continues... We do not see compelling evidence from the flow of U.S. economic data that higher rates are derailing the expansion, although there are a couple of worrying signs, suggesting that growth has peaked. The backdrop is quite supportive for consumer spending: tax cuts, robust employment gains, rising wages and elevated confidence. The fact that the household saving rate is relatively high means that consumers have the wherewithal to boost the pace of spending if they wish. Motor vehicle sales have moderated, but this is to be expected when the economic cycle is advanced. The replacement cycle for U.S. business investment still has further to run. The average age of the non-residential housing stock is the highest since 1963. Both capex intention surveys and the recent easing in lending standards for commercial and industrial loans suggest that U.S. capital expenditures will be well supported, although there has been some softness in the former recently (Chart I-5). Chart I-5U.S. Capex Outlook Is Bright U.S. Capex Outlook Is Bright U.S. Capex Outlook Is Bright That said, the soft U.S. housing data are a concern, especially because a peak in residential investment as a share of GDP has been a good (albeit quite early) leading indicator of recessions. It is difficult to fully explain why housing is losing altitude given all the tailwinds supporting demand, including solid household formation (see last month's Overview). Mortgage rates have increased but affordability is still favorable. It could be that the supply side, rather than demand, is the problem: tight lending standards, zoning restrictions and the high cost of building. Still, a continued housing downtrend relative to GDP would be a challenge to our view that there will be no recession in 2019. While the U.S. economy is enjoying strong momentum, the same cannot be said for the rest of the global economy. A raft of items has weighed on CEO confidence outside of the U.S., including trade wars, a strong dollar, rising oil prices, emerging market turbulence, the return of Italian debt woes and the continuing slowdown in the Chinese economy. The global PMI is beginning to erode from a high level (Chart I-6). The softening in world activity appears to be concentrated in capital spending. Growth in capital goods imports for an aggregate of 20 countries continues to decelerate, along with industrial production for capital goods and machinery & electrical equipment in the major advanced economies. Chart I-6Global Capex Is Softening Global Capex Is Softening Global Capex Is Softening Meanwhile, our favorite global leading indicators are flashing red (Chart I-7). BCA's Global LEI has broken below the boom/bust line and its diffusion index suggests further downside. The Global ZEW and the BCA Boom/Bust indicator are holding just below zero. The global credit impulse is also still pointing down. Chart I-7Global Leading Indicators Flashing Red Global Leading Indicators Flashing Red Global Leading Indicators Flashing Red Among the advanced economies, Europe and Japan are most vulnerable to the slowdown in global trade and capital spending. Industrial production growth has already stalled in both economies and their respective LEIs are heading south fast (Chart I-8). Chart I-8Global Divergence Global Divergence Global Divergence ...Affecting Relative Earnings Trends It is thus not surprising that corporate EPS growth has peaked in the Eurozone and Japan. The macro data that drive our top-down EPS growth models suggest that the profit situation is going to deteriorate quickly in the coming quarters. The peak in industrial production growth suggests that the corporate top line will lose more steam. Meanwhile, nominal GDP growth has decelerated sharply in both economies, in absolute terms and relative to the aggregate wage bill (Chart I-9). These trends suggest that profit margins are coming under significant downward pressure. Even when we build in a modest growth pickup and slight rebound in margins in 2019, EPS growth falls close to zero by year-end according to our model (Chart I-10). Chart I-9Diverging Macro Trends... Diverging Macro Trends... Diverging Macro Trends... Chart I-10...Implies Different EPS Outlook ...Implies Different EPS Outlook ...Implies Different EPS Outlook The earnings situation is completely different in the U.S. It is still early in Q3 earnings season, but company reports have been upbeat so far. The macro variables that feed into our top-down U.S. EPS model point to both continuing margin expansion and robust top line growth (Chart I-9). Nominal GDP growth has surged to more than 5% on a year-ago basis, while the expansion in the economy's wage bill has been steady at under 5%. It is also very impressive that industrial production growth continues to accelerate, bucking the global trend. We assume that U.S. GDP growth moderates from this year's hectic pace in 2019, but stays well above-trend because of the lingering fiscal tailwind. Impressively, the indicators we are following suggest that S&P 500 profit margins still have some upside potential, at least in the next quarter or two (Chart I-11). Nonetheless, we make the conservative assumption that margins will narrow somewhat in 2019. Plugging this macro scenario into our model, it suggests that EPS growth will decelerate to a still-solid 10% pace by the end of 2019. The impact on corporate profits from the rise in bond yields so far will be minimal. It is only now that the yield on the average corporate bond has reached the average coupon on outstanding debt. This means that it will require further increases in yields from here to have any meaningful impact on corporate interest expense. Chart I-11U.S. Margin Indicators Still Upbeat U.S. Margin Indicators Still Upbeat U.S. Margin Indicators Still Upbeat The U.S. economic and earnings backdrop is robust enough that we would be tempted to upgrade our risk asset allocation back to overweight if the S&P 500 moves even lower in the near term. Nonetheless, a number of key risks keep us at benchmark for now. (1) U.S. Foreign Policy The U.S. mid-term election is less than two weeks away as we go to press. Our geopolitical team places the odds of a Democratic House takeover at 65%, and the odds of a Senate takeover at 40%. Investors should expect a knee-jerk equity selloff if the Democrats manage to grab both parts of Congress. However, any damage to risk assets should be fleeting because the Democrats would not be able to unravel any of President Trump's main economic policies. Voters are not demanding budget discipline from either party, despite the surging federal deficit (Chart I-12). We highlighted in a recent Special Report that we foresee little political backlash against fiscal profligacy because of the shift-to-the-left by the median voter.2 The Trump tax cuts are here to stay. Chart I-12No Political Backlash To Big Deficits No Political Backlash To Big Deficits No Political Backlash To Big Deficits In fact, our geopolitical team argues that the odds would increase for an infrastructure plan and even of an immigration deal, if President Trump comes to the middle ground on some of his demands.3 The implication is that fiscal policy will remain highly stimulative in 2019, before the initial thrust begins to wear off in 2020. The Administration's foreign policy, however, remains a key risk for equities. Our high conviction view is that President Trump will continue pursuing unorthodox foreign and trade policies regardless of the midterm outcome. The just-announced 10% tariff on $200 billion of Chinese imports confirms our alarmist view on trade tensions. President Trump has threatened to lift the tariff to 25% by the end of the year in order to pile even more pressure on Beijing. This would represent a significant escalation in the trade war, one that we do not expect Chinese policymakers to simply roll over and accept. The risk is that the Chinese government not only hikes tariffs on U.S. exports, but also retaliates against U.S. firms with operations in China. Even more dangerously, a trade war with China could escalate into a military conflict in the South China Sea. Meanwhile, the U.S. embargo on Iranian oil exports will officially begin on November 4, just two days before the midterm election. We expect President Trump to turn the screws on Iranian exports in ways that President Obama did not. Once the election is out of the way, President Trump will refocus on his "maximum pressure" tactic, which he believes led to a breakthrough with North Korea. Unfortunately for the markets, we do not expect that this tactic will work as smoothly with Iran and China. (2) Rising Probability Of An Oil Shock The Administration's pressure on Iran adds to the already high risk of an oil price spike above US$100 per barrel in early 2019. While oil demand growth is slowing somewhat, exports from two of OPEC's largest producers - Iran and Venezuela - are falling precipitously. Global oil inventories are drawing down, while spare capacity is perilously low, leaving little in the way of readily available backup supply to deal with an unplanned production outage. The confluence of these factors is setting the global oil market up for a supply shock according to our energy experts (Chart I-13). Chart I-13Increasing Risk Of An Oil Spike Increasing Risk Of An Oil Spike Increasing Risk Of An Oil Spike It is important to differentiate between a steady demand-driven rise in the price of oil and a rapid supply-driven oil price spike. The former can be bond-bearish by forcing inflation expectations higher at a time when strong economic growth is also pushing up real bond yields. Nonetheless, equity prices could continue rising in this scenario as the robust economic backdrop outweighs the impact of higher yields. In contrast, an oil price spike that is driven by supply restrictions might initially be negative for bond prices, but ultimately would produce a deflationary impulse by depressing real economic activity. It could even be the catalyst for a recession. A supply-driven oil spike would be outright bearish for risk assets and may prove to be the trigger for a shift from benchmark to underweight for global stocks and corporate bonds. The risk facing corporates in the next economic downturn is one of the topics covered in this month's Special Report, beginning on page 21. The report looks at the structural changes to the economy and financial markets that have occurred because of the Great Recession and financial crisis. (3) EM Pain Is Not Over In the absence of policy stimulus in China, the prospect of continuing Fed tightening means that it is too early to bottom-fish in emerging markets. Emerging Asia is at the epicenter of the global trade and capital spending slowdown. The sharp deceleration in Taiwanese and Korean export growth rates suggests that growth in world industrial production and forward earnings estimates are not yet near a bottom (Chart I-14). Chart I-14Asian Exports Softening... Asian Exports Softening... Asian Exports Softening... Softening Chinese domestic demand is adding to the gloom. Chart I-15 shows that efforts by the Chinese authorities to curtail corporate debt have been bearing fruit. In response to the regulatory and administrative tightening, smaller financial institutions are not building up the working capital required to expand their loan book. As a result, the Chinese credit impulse remains weak and shows no sign of a bottom, despite the uptick in the latest reading on M3 growth. Chinese policy stimulus is underwhelming, confirming the view we expressed in the September BCA Overview. Xi Jinping has not yet abandoned his structural goals and shadow bank crackdown, which are weighing on overall credit expansion. Chart I-15...And No Growth Impulse From China Chinese Policy Tightening In Action ...And No Growth Impulse From China Chinese Policy Tightening In Action ...And No Growth Impulse From China Second, EM financial conditions continue to tighten (Chart I-15). Our currency strategists point out that many factors lie behind this deterioration in the EM financial conditions index, including the collapse in performance of carry trades, the dollar's ascent, and rising U.S. interest rates that are boosting the cost of servicing foreign currency EM debt. In turn, tighter EM financial conditions are contributing to the global manufacturing slowdown in a self-reinforcing negative feedback loop. EM Asia is particularly at risk to this loop, but Europe, Japan and commodity producers are also vulnerable. Some market commentators have argued that the Fed will soon have to back off its rate hike campaign in the face of global financial market stress. However, the FOMC's pain threshold is higher than at any time since the Great Recession because the domestic economy is showing signs of overheating. The correction in risk assets would have to get a lot worse before the Fed blinks. Meanwhile, the U.S. again passed on the chance to label China a currency manipulator. This opens the door to another downleg in the RMB, especially if the U.S./China trade war escalates. Additional RMB weakness would spell more trouble for EM assets. The implication is that any bounce in EM currencies or asset prices represents a selling opportunity for those investors not already short. Our EM strategists expect at least another 15% drop in share prices before the risk-reward profile of this asset class improves. (4) Italian Debt Crisis The main problem with the Italian economy is that the private sector saves too much and spends too little. A shrinking population has reduced the need for firms to invest in new capacity. Unlike Germany, Italy cannot export its savings to the rest of the world through a large trade surplus because it does not have a hypercompetitive economy. Nor can the Italian government risk running afoul of the bond vigilantes by emulating Japan's strategy of absorbing private-sector savings with large budget deficits. The implication is that Italy is stuck in a low-growth trap that is feeding political pressure to shed the EU's fiscal straight jacket. We believe that the populist government will be the first to blink, but it may require more bouts of financial stress to force capitulation. A 4% level on the 10 year BTP yield is a likely threshold for a compromise. Above that level, Italian banks become insolvent based on the market value of their holdings of Italian debt. In the meantime, rising global bond yields worsen Italy's tenuous financial situation, with possible contagion into global financial markets. Investment Conclusions: The U.S. bond market is waking up to the likelihood that U.S. short-term rates are going higher than previously expected, suggesting that recent investment themes will persist for a while longer. We continue to recommend a neutral stance on global equities (with a preference for developed over emerging markets), a below-benchmark duration bias, and an overweight allocation in cash. The bond market is only priced for the Fed to maintain its quarterly rate hike pace until June of next year (Chart I-16). Investors judge that some combination of tepid global economic momentum and tame U.S. core inflation temper the Fed's need or ability to take rates much higher. We disagree, based our own assessment of the U.S. economy and our out-of-consensus inflation view (see this month's Special Report). Rising volatility and/or a weaker global growth pulse are unlikely to prompt the Fed to bail out of its tightening campaign as quickly as it did in early 2016. Chart I-16Market Expectations For The Fed Still Too Complacent Market Expectations For The Fed Still Too Complacent Market Expectations For The Fed Still Too Complacent Meanwhile, our indicators suggest that the divergence between the red-hot U.S. economy and cooling global activity will continue, implying more upside potential for the U.S. dollar. We expect another 5-10% rise against most currencies, with the possible exception of the Canadian dollar. It is difficult to identify a "choke point" for bond yields in advance. A 10-year Treasury yield north of 3.7% might cause us to call the peak in yields and to become even more defensive on risk assets, but it will be critical to watch our monetary indicators. Indeed, we would be tempted to upgrade stocks back to overweight if the global selloff progresses much further, in the absence of negative reading from the monetary indicators or an inverted yield curve. The earnings backdrop will continue to be a tailwind for the U.S. equity market at least into early 2019. In contrast, profit growth in the Eurozone and Japan is set to disappoint market expectations. The U.S. equity market will therefore outperform, particularly in unhedged terms. Stay at benchmark on corporate bonds versus governments in the U.S. and Eurozone. Avoid emerging market assets and commodities. The main exception is oil, which is increasingly at risk of a spike above $100/bbl. Mark McClellan Senior Vice President The Bank Credit Analyst October 25, 2018 Next Report: November 29, 2018 1 Please see U.S. Investment Strategy Special Report "Revisiting The Fed Funds Rate Cycle," dated September 3, 2018, available at usis.bcaresearch.com 2 Please see The Bank Credit Analyst "U.S. Fiscal Policy: An Unprecedented Macro Experiment," dated July 2018, available at bca.bcaresearch.com 3 Please see BCA Geopolitical Strategy Weekly Report "A Story Told Through Charts: The U.S. Midterm Election," dated September 19, 2018, available at gps.bcaresearch.com II. The Long Shadow Of The Financial Crisis The Great Recession and financial crisis cast a long shadow that will affect economies, policymakers and investors for years to come. The roots of the crisis are already well known. The first of a two-part series looks forward by examining the areas where we believe structural change has occurred related to the economy or financial markets. First, the financial crisis transformed the corporate bond market in several ways that heighten the risk for quality spreads in the next downturn. Debt and market liquidity are two key concerns. Corporate leverage will not cause the next recession. Nonetheless, when one does occur, corporate spreads in the U.S. and (to a lesser extent) the Eurozone will widen by more for any given degree of recession. This reflects a low interest coverage ratio, poor market liquidity, the downward trend in credit quality and covenant erosion. Second, the shock of the Great Recession and its aftermath appears to have affected the relationship between economic slack and inflation. Firms have been extra reluctant to grant wage gains. However, we argue that the "shell shock" effect will wane. The fact that inflation has been depressed for so long may actually cultivate the risk that inflation will surprise on the upside in the coming years. Investors should hold inflation-protection in the inflation swaps market, or by overweighting inflation-linked bonds versus conventional issues. Third, the events of the last decade have left a lasting impression on monetary policymakers. They will err on the side of allowing the economy to overheat and inflation to modestly overshoot the target in the major economies, despite signs of financial froth. The Fed will respond only with a lag to the current fiscally-driven surge in U.S. growth, leading to a boom/bust economic scenario. Central bankers will have no trouble employing unorthodox policies again in the future, and will be willing to push the boundaries even further during the next recession. Expect aggressive manipulation of the long-end of the yield curve when the time arrives to ease policy. We may also observe more coordination between monetary and fiscal policies. Fourth, global bond yields fell to unprecedented levels, reflecting both structural and cyclical headwinds to demand growth. A dismal productivity performance is another culprit. Productivity growth is poised to recover to some extent, while some of the growth headwinds have reached an inflection point. We do not expect nominal bond yields to return to pre-Lehman norms, and yields could even fall back to previous lows in the case of a recession. Nonetheless, we expect a yield pattern of higher lows and higher highs over the coming business cycles. The 10-year anniversary of the Lehman shock this autumn sparked an avalanche of analysis on the events and underlying causes of the Great Recession and financial crisis. It is a woeful story of greed, a classic bubble, inadequate regulation, new-fangled financial instruments, and a globalized financial system that spread the shock around the world. The crisis cast a long shadow that will affect economies, policymakers and investors for many years to come. The roots of the crisis are well known, so we will not spend any time going over well-trodden ground. Rather, this Special Report looks forward by examining the areas where we believe structural change has occurred related to the economy or financial markets. In Part I, we cover the corporate bond market, the inflation outlook, central bank policymaking and equilibrium bond yields. Part II will look at the debt overhang, systemic risk in the financial sector, asset correlations, the cult of equity and the rise of populism. While not an exhaustive list, we believe these are the key areas of structural change. (1) Corporate Bond Market: Leverage And Downgrade Risk The financial crisis transformed the corporate bond market in several ways that heighten the risk for quality spreads in the next downturn. Debt and market liquidity are two key concerns. An extraordinarily long period of extremely low interest rates was too much for corporate CEOs to pass up. However, because the durability of the economic recovery was so uncertain, it seemed more attractive to hand over the borrowed cash to shareholders than to use it to aggressively expand productive capacity. The ongoing equity bull market rewarded CEOs for the financial engineering, serving to create a self-reinforcing feedback loop. And so far, corporate bondholders have not policed this activity. The result is that the U.S. corporate bond market has grown in leaps and bounds since 2009 (Chart II-1A and Chart II-1B). The average duration of the Bloomberg Barclays index has also risen as firms locked in attractive financing rates. The same is true, although to a lesser extent, in the Eurozone. Chart II-1AU.S. BBB-Rated Share Rising... U.S. BBB-Rated Share Rising... U.S. BBB-Rated Share Rising... Chart II-1B...Same In The Eurozone ...Same In The Eurozone ...Same In The Eurozone Balance sheet health is obviously not the key driver of corporate bond relative returns at the moment. Nonetheless, investors will begin to worry about the growth outlook if interest rates continue to rise. The U.S. national accounts data suggest that interest coverage remains relatively healthy, but this includes large companies such as some of the FAANGs that have little debt and a lot of cash. The national accounts data are unrepresentative of the companies that are included in the Bloomberg Barclays corporate bond index, which are heavy debt issuers. To gain a clearer picture, we calculated a bottom-up Corporate Health Monitor (CHM) for a sample of U.S. companies that provides a sector and credit-quality composition that roughly matches the Bloomberg Barclay's index. The CHM is the composite of six critical financial ratios. Chart II-2 highlights that the investment-grade (IG) CHM has improved over the past two years due to the profitability sub-components. However, the debt/equity ratio has been in a steep uptrend. Interest coverage does not appear alarming by historical standards at the moment, but one can argue that it should be much higher given the extremely low average coupon on corporate bonds, and given that profit margins are extraordinarily high in the U.S. The rapid accumulation of debt has overwhelmed these other factors. Evidence of rising leverage is broadly based across sectors and ratings. Chart II-2U.S. IG Corporate Health U.S. IG Corporate Health U.S. IG Corporate Health Unfortunately, the profit tailwind won't last forever. At some point, earnings growth will stall and this cycle's debt accumulation will start to bite in the context of rising interest rates. To gauge the risk, we estimate the change in the interest coverage ratio over the next three years for a 100 basis-point rise in interest rates across the corporate curve, taking into consideration the maturity distribution of the debt.1 For our universe of Investment-grade U.S. companies, the interest coverage ratio would drop from a little over 7 to under 6, which is close to the lows of the Great Recession (denoted as "x" in Chart II-3). Of course, the decline in interest coverage will be much worse if the Fed steps too far and monetary tightening sparks a recession. The "o" in Chart II-3 denotes the combination of a 100 basis-point interest rate shock and a mild recession in which the S&P 500 suffers a 25% peak-to-trough decline in EPS. The overall interest coverage ratio plunges close to all-time lows at 4½. Chart II-3Interest Coverage To Plunge... Interest Coverage To Plunge... Interest Coverage To Plunge... These simulations imply that, for any given size of recession, the next economic downturn will have a larger negative impact on corporate health than in the past. Rating agencies have undertaken some downgrading related to shareholder-friendly activity, but downgrades will proliferate when the agencies realize that the economy is turning and the profit boom is over (Chart II-4). Banks will belatedly tighten lending standards, adding to funding pressure for the corporate sector. Chart II-4...And Ratings To Be Slashed ...And Ratings To Be Slashed ...And Ratings To Be Slashed Fallen Angels The potential for a large wave of fallen angels means that downgrade activity will be particularly painful for corporate bond investors. The surge in lower-quality issuance has led to a downward trend in the average credit rating and has significantly raised the size of the BBB-rated bonds relative to the IG index and relative to the broader universe of corporate bonds including high yield (Chart II-5, and Chart II-1A).2 The downward trend in credit quality predates Lehman, but events since the Great Recession have likely reinforced the trend. Chart II-5Lower Ratings And Longer Duration Lower Ratings And Longer Duration Lower Ratings And Longer Duration Studies show that bonds that get downgraded into junk status can perform well for a period thereafter, suggesting that investors holding a fallen angel should not necessarily sell immediately. Nonetheless, the process of transitioning from investment-grade to high-yield involves return underperformance as the spread widens. Poor market liquidity and covenant erosion will intensify pressure for corporate spreads to widen when the bear market arrives. Market turnover has decreased substantially since the pre-Lehman years, especially for IG (Chart II-6). The poor liquidity backdrop appears to be structural, reflecting regulation that has curtailed banks' market-making activity and prop trading, among other factors. Chart II-6Poor Market Liquidity Poor Market Liquidity Poor Market Liquidity The Eurozone corporate bond market has also seen rapid growth and a deterioration in the average credit rating. Liquidity is an issue there as well. That said, the Eurozone corporate sector is less advanced in the leverage cycle than the U.S. Interest coverage ratios will fall during the next recession, but this will be concentrated among foreign issuers - domestic issuers are much less at risk to rising interest rates and/or an economic downturn.3 Bottom Line: Corporate leverage will not cause the next recession. Nonetheless, when one does occur, corporate spreads in the U.S. and (to a lesser extent) Eurozone will widen by more for any given degree of recession. Current spreads do not compensate for this risk. (2) Inflation Undershoot Breeds Overshoot Inflation in the U.S. and other developed economies has been sticky since the financial crisis. First, inflation did not fall as much in the recession and early years of the recovery as many had predicted, despite the worst economic contraction in the post-war period. Subsequently, central banks have had trouble raising inflation back to target. In the U.S., core PCE inflation has only recently returned to 2%. Several structural factors have been blamed, but continuing tepid wage growth in the face of a very tight labor market raises the possibility that the inflation-generating process has been fundamentally altered by the Great Recession. In other words, the relationship between slack in the labor market (or market for goods and services) and inflation has changed. In theory, inflation should rise when the economy's output is above its potential level or when the unemployment rate is below its full-employment level. Inflation should fall when the reverse is true. This means that the change (not the level) in inflation should be positively correlated with the level of the output gap or the labor market gap. Chart II-7 presents the change in U.S. core inflation with the output gap. Although inflation appears to have become less responsive to shifts in the output gap after 1990, it has been particularly insensitive in the post-Lehman period. Chart II-7The U.S. Phillips Curve: RIP? The U.S. Phillips Curve: RIP? The U.S. Phillips Curve: RIP? One reason may be that the business sector was shell-shocked by the Great Recession and financial crisis to such an extent that business leaders have been more reluctant to grant wage gains than in past cycles. Equally-unnerved workers felt lucky just to have a job, and have been less willing to demand raises. Dampened inflation expectations meant that low actual inflation became self-reinforcing. We have some sympathy with this view. Long-term inflation expectations have been sticky at levels that are inconsistent with the major central banks meeting their inflation targets over the long term. This suggests that people believe that central banks lack the tools necessary to overwhelm the deflationary forces. The lesson for investors and policymakers is that, while unorthodox monetary policies helped to limit the downside for inflation and inflation expectations during and just after the recession, these policies have had limited success in reversing even the modest decline that did occur. That said, readers should keep in mind a few important points: One should not expect inflation to rise much until economies break through their non-inflationary limits. The major advanced economies have only recently reached that point to varying degrees; Inflation lags the business cycle (Chart II-8). This is especially the case in long 'slow burn' economic expansions, as we have demonstrated in previous research; and The historical relationship between inflation and economic slack has been non-linear. As shown in Chart II-9, U.S. inflation has tended to accelerate quickly when unemployment drops below 4½%. Chart II-8U.S. Inflation Lags The Cycle November 2018 November 2018 Chart II-9A Kinked Phillips Curve November 2018 November 2018 Shell Shock Is Fading We believe that the "shell shock" effect of the Great Recession on inflation will wane over time. Indeed, my colleague Peter Berezin has made the case that the fact that inflation has been depressed for so long actually cultivates the risk that inflation will surprise on the upside in the coming years.4 Central bankers have been alarmed by the economic and financial events of the last decade. They also cast a wary eye on Japan's inability to generate inflation even in the face of massive and prolonged monetary stimulus. Policymakers at the FOMC are determined to boost inflation and inflation expectations before the next economic downturn strikes. They are also willing to not only tolerate, but actively encourage, an overshoot of the 2% inflation target in order to ensure that long-term inflation expectations return "sustainably" to a level consistent with meeting the 2% target over the long term. In other words, the Fed is going to err on the side of too much stimulus rather than too little. This is an important legacy of the last recession (see below). Meanwhile, other structural explanations for low inflation are less powerful than many believe. For example, globalization has leveled off and rising tariff and non-tariff barriers will hinder important global supply chains. Our research also suggests that the rising industrial use of robots and the e-commerce effect on retail prices have had only a small depressing effect on U.S. inflation. Bottom Line: The Phillips curve relationship has probably not changed in a permanent way since Lehman went down. It is quite flat when the labor market is not far away from full employment, but the relationship is probably non-linear. As the unemployment rate drops further, the business sector will have no choice but to lift wages as labor becomes increasingly scarce. The kinked nature of the Phillips curve augments the odds that the Fed will eventually find itself behind the curve, and inflation will rise more than the market is expecting. The same arguments apply to the Bank of England and possibly even the European Central Bank. Gold offers some protection against inflation risk, but the precious metal is still quite expensive in real terms. Investors would be better off simply buying inflation-protection in the inflation swaps market or overweighting inflation-linked bonds over conventional issues. (3) Monetary Policy: Destined To Fight The Last War There are several reasons to believe that the shocking events of the crisis and its aftermath have left a lasting impression on monetary policymakers. Several factors suggest that they will err on the side of allowing the economy to overheat and inflation to modestly overshoot the target: Inflation Persistence: As discussed above, there is a greater awareness that it is difficult to lift both actual inflation and inflation expectations once they have fallen. Some FOMC members believe that long-term inflation expectations are still too low to be consistent with the Fed meeting its 2% inflation target over the long term. A modest inflation overshoot in this cycle would be beneficial, according to this view, in the sense that it would boost inflation expectations and thereby raise the probability that the FOMC will indeed meet its goals over the long term. It might also encourage some discouraged workers to re-enter the labor market. Some policymakers also believe that the Fed is not taking much of a risk by pushing the economy hard, because the Phillips curve is so flat. Zero Bound: Low inflation expectations, among other factors, have combined to dramatically reduce the level of so-called r-star - the short-term rate of interest that is neither accommodative nor restrictive in terms of growth and inflation. R-star is thought to be rising now, at least for the U.S., but it is probably still low by historical standards across the major economies. This increases the risk that policy rates will again hit the lower bound during the next recession, making it difficult for central banks to engineer a real policy rate that is low enough to generate faster growth.5 Fighting the Last War: Memories of the crisis linger in the minds of policymakers. The global economy came dangerously close to a replay of the Great Depression, and policymakers want to ensure that it never happens again. Some monetary officials have argued that a risk-based approach means that it is better to take some inflation risks to limit the possibility of making a deflationary policy mistake down the road. Fears that the major economies are now more vulnerable to deflationary shocks seem destined to keep central banks too-easy-for-too-long. Central bankers will also be quicker and more aggressive in responding when negative shocks arrive in the future. This applies more to the U.S., the U.K. and Japan than the European Central Bank, but even for the latter there has been a clear change in the monetary committee's reaction function since Mario Draghi took over the reins. Financial Stability Concerns Policymakers are also more concerned about financial stability. Pre-crisis, the consensus among the monetary elite was that financial stability should play second fiddle to the inflation target. It was felt that central banks should focus on the latter, and pay attention to signs of financial froth only when they affect the inflation outlook. In practice, this meant paying only lip service to financial excess until it was too late. It was difficult to justify rate increases when inflation was not threatening. It was thought that macro-prudential regulation on its own was enough to contain financial excesses. Today, policymakers see financial stability as playing a key role in meeting the inflation target. It is abundantly clear that a burst bubble can be highly deflationary. Some policymakers still believe that aggressive macro-prudential policies can be effective in directly targeting financial excesses. However, others feel there is no substitute for higher interest rates; as ex-Governor Jeremy Stein stated, interest rates get "in all the cracks". Moreover, the Fed does not regulate the shadow banking sector. The Fed is thus balancing concerns over signs of financial froth against the zero-bound problem and fears of the next deflationary shock. We believe that the latter will dominate their policy choices, because it will still be difficult to justify rate hikes to the public when there is no obvious inflation problem. In the U.S., this implies that the economic risks are skewed toward a boom/bust scenario in which the FOMC is slow to respond to a fiscally-driven late cycle mini-boom. Inflation and inflation expectations react with a lag, but a subsequent acceleration in both forces the Fed to aggressively choke off growth. Policy Toolkit Central bankers will be quite willing to employ their new-found policy tools again in the next recession. The new toolbox includes asset purchases, aggressive forms of forward guidance, negative interest rates, and low-cost direct lending to banks and non-banks in some countries. Policymakers generally view these tools as being at least somewhat effective, although some have argued that the costs of using negative interest rates have outweighed the benefits in Europe and Japan. The debate on how to deal with the zero-bound problem in the U.S. has focused on lifting r-star, including raising the inflation target, adopting a price level target, policies to boost productivity, and traditional fiscal stimulus. Nonetheless, ex-Fed Chair Yellen's comments at the Jackson Hole conference in 2016 underscored that it will be more of the same in the event that the zero bound is again reached - quantitative easing and forward guidance.6 No doubt, the major central banks will rely heavily on both of these tools in order to manipulate yields far out the curve. Forward guidance may be threshold-based. For example, policymakers could promise to keep the policy rate frozen until unemployment or inflation reaches a given level. Now that central bankers have crossed the line into unorthodox monetary policy and inflation did not surge, future policymakers will be willing to stretch the boundaries even further in the event of a recession. For example, they may consider price-level targeting, which would institutionalize inflation overshoots to make up for past inflation undershoots. It is also possible that we will observe more coordination between monetary and fiscal policies in the next recession. The combination of fiscal stimulus and a cap on bond yields would be highly stimulative in theory, in part by driving the currency lower. Japan has gone half way in this direction by implementing a yield curve control (YCC) policy. However, it has failed so far to provide any meaningful fiscal stimulus since the yield cap has been in place. It also appears likely that central bank balance sheets will not return to levels as a percent of GDP that existed before the crisis. An abundance of bank deposits at the central bank will help to satisfy a structural increase in the demand for cash-like risk-free assets. Maintaining a bloated balance sheet will also allow central banks to provide substantial amounts of reverse repos (RRPs) into the market, which should improve the functioning of money markets that have been impaired to some degree by regulation. We do not expect that a structural increase in central bank balance sheets will have any material lasting impact on asset prices or inflation. We believe that inflation will surprise on the upside, but not because central banks will continue to hold significant amounts of government bonds on their balance sheets over the medium term. Bottom Line: The implication is that the monetary authorities will have a greater tolerance for an overshoot of the inflation target than in the past. The Fed will respond only with a lag to the fiscally-driven surge in U.S. growth, leading to a boom/bust economic scenario. During the next recession, policymakers will rely heavily on quantitative easing and forward guidance to manipulate the yield curve (after the policy rate reaches the lower bound). (4) Bond Prices: Structural Factors Turning Less Bullish Perhaps the most dramatic and lasting impact of the GFC has been evident in the global bond market. Government yields fell to levels never before observed across the developed countries and have remained extremely depressed, even as the expansion matured and economic slack was gradually absorbed. Real government bond yields are still negative even at the medium and long parts of the curve in the Eurozone and Japan (Chart II-10). It is tempting to conclude that there has been a permanent shift down in global bond yields. Chart II-10Real Yields Still Depressed Real Yields Still Depressed Real Yields Still Depressed Real Yields Still Depressed Real Yields Still Depressed Equilibrium bond yields are tied to the supply side of the economy. Potential GDP growth is the sum of trend productivity growth and the pace of expansion of the labor force. Equilibrium bond yields may fall below the potential growth rate for extended periods to the extent that aggregate demand faces persistent headwinds. The headwinds in place over the past decade include fiscal austerity, demographics, household deleveraging, increased regulation and lingering problems in the banking sector that limited the expansion of credit, among others. These headwinds either affect the desire to save or the desire to invest, the interplay of which affects equilibrium bond yields. Some of these economic headwinds predate 2007, but the financial crisis reinforced the desire to save more and invest less. Space limitations prevent a full review of the forces that depressed bond yields, but a summary is contained in Appendix 1 and we encourage interested readers to see our 2017 Special Report for full details.7 The Great Supply-Side Shortfall Falling potential output growth in the major advanced economies also helped to drag down equilibrium bond yields. The pace of expansion in the global labor force has plunged from 1¾% in 2005, to under 1% today (Chart II-11). The labor force has peaked in absolute terms in the G7, and is already shrinking in China. Chart II-11Slower Labor Force Expansion... Slower Labor Force Expansion... Slower Labor Force Expansion... Productivity growth took a dramatic turn for the worst after 2007 (Chart II-12). The dismal productivity performance is not fully understood, but likely reflected the peaking in globalization, increased regulation and the dramatic decline in capital spending relative to GDP. The latter was reflected in a collapse in the growth rate of the global capital stock (Chart II-13). In the U.S., for which we have a longer history of data, growth in the capital stocks has lead shifts in productivity growth with a 3-year lag. Firms have also been slower to adopt new technologies over the past decade. Chart II-12...And Lower Productivity November 2018 November 2018 Chart II-13Productivity And Investment Productivity And Investment Productivity And Investment The resulting impact on the level of GDP today has been nothing short of remarkable. The current IMF estimate for the level of potential GDP in 2018 is 10% lower than was projected by the IMF in 2008 (Chart II-14). There has been a similar downgrading of capacity in Europe, Japan and the U.K. Actual GDP has closed the gap with potential GDP to varying degrees in the major countries, but at a much lower level than was projected a decade ago. Paul Krugman has dubbed this the "Great Shortfall". Chart II-14A Permanent Loss Of Output A Permanent Loss Of Output A Permanent Loss Of Output The Great Shortfall was even greater with respect to capital spending. For 2017, the IMF estimates that global investment was more than 20% below the level implied by the pre-crisis trend (Chart II-15). Reduced credit intermediation, from a combination of supply and demand factors, was a significant factor behind the structural loss of economic capacity according to the IMF study.8 Chart II-15Permanent Scars On Capital Spending Permanent Scars On Capital Spending Permanent Scars On Capital Spending By curtailing the business investment relative to GDP for a prolonged period, major economic slumps can have a permanent effect on an economy's long-term prospects. The loss of output since the financial crisis will never be regained. That said, bond yields in theory are related to the growth rate of productivity, not its level. The IMF report noted that there may even be some long-lasting effects on the growth rate of productivity. The crisis left lingering scars on future growth due to both reduced global labor force migration and fertility rates. The latter rose in the decade before the crisis in several advanced economies, only to decline afterward. Households postponed births in the face of the economic and financial upheaval. The IMF argues that not all of the decline in fertility rates will be reversed. An Inflection Point In Global Bond Yields On a positive note, the pickup in business capital spending in the major countries in recent years implies an acceleration in the growth rate of the capital stock and, thus, productivity. In the U.S., this relationship suggests that productivity growth could rise by a percentage point over the coming few years (Chart II-13). This should correspond to a roughly equivalent rise in equilibrium bond yields. Moreover, some of the other structural factors behind ultra-low interest rates have waned, while others have reached an inflection point. For example, the age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool as people retire and begin to deplete their nest eggs. Household savings rates will trend sharply lower in the coming years. Again, we encourage readers to read the 2017 Special Report for a full account of the structural factors that are shifting in a less bond-bullish direction. QE Reversal To Weigh On Bond Prices And let's not forget the unwinding of central bank balance sheets. The idea that central bank asset purchases on their own had a significant depressing effect on global bond yields is controversial. Some argue that the impact on yields occurred more via forward guidance; quantitative easing was a signal to markets that the central bank would stay on hold for an extended period, which pulled down yields far out the curve. This publication believes that QE had a meaningful impact on global bond yields on its own (Chart II-16). Nonetheless, either way, the Fed is now shrinking its balance sheet and the European Central Bank will soon end asset purchases. This means that the private sector this year is being forced to absorb a net increase in government bonds available to the private sector for the first time since 2014 (Chart II-17). Investors may demand juicier yields in order to boost their allocation to fixed-income assets. Chart II-16Reverse QE To Weigh On Bonds Reverse QE To Weigh On Bonds Reverse QE To Weigh On Bonds Chart II-17Private Investors Will Have To Buy More November 2018 November 2018 We are not making the case that real global bond yields are going to quickly revert to pre-Lehman averages. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations suggest that investors still have an overly benign view on the outlook for yields. For example, implied real short-term rates remain negative until 2027 in the Eurozone, while they stay negative out to 2030 in the U.K. (Chart II-18). The implied path of real rates in the U.S. looks more reasonable, but there is still upside potential. Moreover, there is room for the inflation expectations component of nominal yields to shift up, as discussed above. Chart II-18Real Yields Still Too Low Real Yields Still Too Low Real Yields Still Too Low Another way of making this point is shown in Chart II-19. The market expects the 10-year Treasury yield in ten years to be only slightly above today's spot yield, which itself is still very low by historical standards. Market expectations are equally depressed for the 5-year/5-year forward rate for the U.S. and the other major economies. Chart II-19Market Expectations Still Low Market Expectations Still Low Market Expectations Still Low Bottom Line: Global bond yields fell to unprecedented levels due to a combination of cyclical and structural factors. The bond-bullish structural factors were reinforced by shifts in desired savings and business investment as a result of the Great Recession and financial crisis. Some of these structural factors will linger in the coming years, but others are shifting in a less bond-bullish direction. We do not expect nominal bond yields to return to pre-Lehman norms, and yields could even return close to previous lows in the case of a recession. Nonetheless, we expect a yield pattern of higher lows and higher highs over the coming business cycles. Mark McClellan Senior Vice President The Bank Credit Analyst Appendix 1: Key Factors Behind The Decline In Equilibrium Global Bond Yields The so-called Global Savings Glut has been a bullish structural force for bonds for the past couple of decades. A key factor is population aging in the advanced economies. Ex-ante desired savings rose as baby boomers entered their high-income years. China became a major source of global savings after it joined the WTO, and its large trade surplus was recycled into the global pool of savings. A slower pace of labor force growth in the developed countries resulted in a permanently lower level of capital spending relative to GDP. Slower consumer spending growth, as a result of a more moderate expansion in the working-age population, meant a reduced appetite for new factories, malls, and apartment buildings. The integration of the Chinese and Eastern European workforces into the global labor pool during the 1990s and 2000s resulted in an effective doubling of global labor supply in a short period of time. The sudden abundance of cheap labor depressed real wages from what they otherwise would have been, thus incentivizing firms to use more labor and less capital at the margin. The combination of slower working-age population growth in the advanced economies and a surge in the global labor force resulted in a decline in desired global capital spending. The increase in ex-ante savings and reduction in ex-ante capital spending resulted in a substantial drop in equilibrium global interest rates. The wave of cheap labor also aggravated the trend toward greater inequality in the advanced economies and the downward trend in labor's share of the income pie. A positive labor supply shock should benefit global living standards in the long run, but the adjustment costs related to China's integration into the global economy imposed on the advanced economies were huge and long-lasting. The lingering adjustment phase contributed to greater inequality in the major countries. Management was able to use the threat of outsourcing to gain the upper hand in wage negotiations. Moreover, technology appears to be resulting in faster, wider and deeper degrees of hollowing-out than in previous periods of massive technological change. The result has been a rise in the share of income going to high-income earners in the Advanced Economies, at the expense of low- and middle-income earners. This represents a headwind to growth that requires lower interest rates all along the curve. In other words, firms in the developed world either replaced workers with machinery in areas where technology permitted, or outsourced jobs to lower-wage countries in areas that remained labor-intensive. Both trends undermined labor's bargaining power, depressed labor's share of income, and contributed to inequality. 1 We make the simplifying assumptions that companies do not issue any more debt over the three years, and that EBIT is unchanged, in order to isolate the impact of higher interest rates. 2 The average credit rating for the U.S. is unavailable before 2000 in the Bloomberg Barclays index. However, other data sources confirm the long-term downward trend. 3 Please see The Bank Credit Analyst Special Report "Leverage And Sensitivity To Rising Rates: The Eurozone Corporate Sector," dated May 31, 2018, available at bca.bcaresearch.com 4 Please see Global Investment Strategy Special Reports "1970s-Style Inflation: Could It Happen Again? (Part 1)," dated August 10, 2018 and "1970s-Style Inflation: Could It Happen Again? (Part 2)," dated August 24, 2018, available at gis.bcaresearch.com 5 The lower bound is zero in the U.S., but is in negative territory for those central banks willing to impose negative rates on the banking sector. 6 For more background on the zero bound debate, the usefulness of a large central bank balance sheet and ways to lift r-star, please see The Bank Credit Analyst Special Report "Herding Cats At the Fed," dated October 2016, available at bca.bcaresearch.com 7 Please see The Bank Credit Analyst Special Report "Beware Inflection Points In The Secular Drivers Of Global Bonds," dated April 27, 2017, available at bca.bcaresearch.com 8 The Global Economic Recovery 10 Years After the 2008 Financial Meltdown. IMF World Economic Outlook, October 2018. III. Indicators And Reference Charts Our proprietary equity indicators remained bearish in October and valuation is still stretched, suggesting that it is too early to buy stocks. Our Willingness-to-Pay (WTP) indicators for the U.S. and Japan are both heading down. The Eurozone WTP has flattened-off recently, but is certainly not bullish. The WTP indicators track flows, and this provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Our Revealed Preference Indicator (RPI) for stocks continues to issue a sell signal. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Momentum remains out of sync with valuation and policy, underlining the idea that caution is warranted. Our Monetary Indicator continues to hover in negative territory for stocks, but interestingly it is not deteriorating even as the Fed tightening campaign endures and bond yields have risen. Our Technical Equity Indicator appears poised to break down, but as of the end of October it was not giving a sell signal. The Speculation Indicator is still elevated, but the Composite Sentiment Indicator is in the middle of the range. It does not appear that the latest equity selloff was driven mainly by an unwinding of frothy market sentiment. Nonetheless, value has not improved enough to justify bottom-feeding on its own. On balance, our indicators continue to suggest that the underlying supports of the U.S. equity bull market are eroding. The U.S. earnings backdrop is still providing support overall, although there was a tick down in October in the U.S. net earnings revisions ratio and in positive-minus-negative earnings surprises. The backdrop for Treasurys has not changed, despite October's painful selloff. Valuation (still slightly cheap) and technicals (oversold by almost 2 standard deviations) imply that the countertrend pullback near month-end will continue into November. Beyond a near-term correction, though, complacency about inflation and the Fed's ability to hike rates to at least the level of the FOMC voters' median projection points to looming capital losses. The dollar is quite expensive on a purchasing power parity basis, and its long-term outlook is not constructive, but policy and growth divergences with other major economies will likely keep the wind at its back in the near term. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys And Valuations U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights So What? Ongoing reforms will drag on China's policy easing measures. Why? Xi Jinping is not abandoning his "Three Tough Battles" against leverage, pollution, and poverty. China is striving to contain leverage, despite the shift of rhetoric away from deleveraging. China's anti-pollution targets have eased, but in a pragmatic way. Barring a sharp economic deceleration, China's stimulus measures will be about stability rather than reacceleration. Feature China's leader Xi Jinping has clearly focused on two systemic risks: leverage and pollution (Table 1). Xi redoubled his efforts to address these risks in 2017 when he launched the "Three Tough Battles" against financial systemic risk, pollution, and poverty that will last through 2020. In this Special Report we provide a "status update" on the three battles, particularly the anti-pollution campaign. Investors should not mistake China's policy easing for a wholesale reversal of reform in order to stimulate growth. Today's policy environment and response is different from what investors are familiar with, which is large-scale fiscal and credit injections that pump up infrastructure and property construction and materially reaccelerate global and Chinese demand. Table 1Central Government Spending Preferences (Under Leader's Immediate Control) China Sticks To The "Three Battles" China Sticks To The "Three Battles" The First Battle: Financial Systemic Risk First, a word about financial systemic risk, which is of the utmost importance to China's economic trajectory, the global investment outlook, and Xi Jinping's other two policy battles. We have now had two months of full data - August and September - since China's top leaders announced in late July that they would ease economic policy. The data show that there has not been a major acceleration in total private credit growth. This is based on the adjusted total social financing measure used by BCA's China Investment Strategy, which now includes the special purpose bonds that local governments have been issuing rapidly in response to central government demands to ease policy (Chart 1). Chart 1No Credit Spike ... Yet No Credit Spike ... Yet No Credit Spike ... Yet We also closely watch China's money supply. Monetary impulses are bottoming and the M2 impulse is now positive (Chart 2). This is a marginal positive for both the Chinese and global economic outlook in 2019, though it is at odds with China's credit impulse. Chart 2Money And Credit Impulses At Odds Money And Credit Impulses At Odds Money And Credit Impulses At Odds While bank loan growth remains steady, informal lending growth is starting to pick up (Chart 3). This could herald a relaxation of controls on shadow banking, although that is by no means clear yet. Chart 3Shadow Banking Crackdown Is Easing Shadow Banking Crackdown Is Easing Shadow Banking Crackdown Is Easing Fiscal spending is also becoming more proactive, as is apparent from the spike in local government bond issuance (Chart 4). However, these new bonds hardly make a dent in the total credit picture, as shown in Chart 1 above. Chart 4Fiscal Policy Becomes More Proactive China Sticks To The "Three Battles" China Sticks To The "Three Battles" We expect China to stimulate more if internal or external conditions worsen. That looks likely, as we also have a structurally bearish view of the U.S.-China relationship. The trade war could prompt the U.S. to extend tariffs to all Chinese imports at the 25% rate that will apply to $200 billion worth of imports as of January 1, 2019. To be prudent, investors need to be prepared for even a 45% tariff rate on all Chinese imports, as President Trump first threatened on the campaign trail. People's Bank of China Governor Yi Gang has recently implied that benchmark interest rates could be cut if necessary, in addition to further cuts to the required reserve ratio. These measures would have the additional effect of weakening CNY/USD, which could also be stimulative for China, but may first disrupt emerging markets and worsen the trade war. The foregoing data reveal that, while the government has clearly toned down its rhetoric about deleveraging, it continues to try to contain the rise in leverage. China's administration - in contrast to many bullish investors - views leverage as a form of systemic risk. The top leaders perceive that excess leverage is bad for productivity. It delays China's adjustment to a more sustainable, consumer-driven economic model. And it exacerbates quality-of-life problems that could lead to socio-political instability, such as land appropriation and environmental degradation. China's economy can only reaccelerate sharply if Xi Jinping and his deputies - namely his top economic adviser Liu He and also Guo Shuqing, the party secretary of the PBOC - throw in the towel and allow total credit to skyrocket. President Xi is pragmatic and ultimately may have to do this - if conditions get bad enough. But for now, the pace of deceleration is not so quick that throwing in the towel is warranted. Furthermore, the trade war provides Xi with ample domestic political "coverage" to blame the U.S. for any economic pain incurred while pursuing badly needed domestic restructuring. Bottom Line: The Chinese administration wants to contain leverage, and this policy imperative will not easily waver. Data shows that the policy shifts announced in July were indeed evidence of "fine-tuning" rather than wholesale stimulus. The U.S. trade war provides the Xi administration with a scapegoat to absorb public anger when the pain of long-needed economic adjustments sets in. We remain data-dependent and will alter our global asset allocation recommendation - long DM / short EM - if evidence of a wholesale policy shift occurs. The Second Battle: Pollution What about Xi's second battle, the anti-pollution campaign? Is China already throwing out its new environmental regulations in order to stimulate growth? No, but it is compromising them for the sake of stability. Chart 5China Is Resource Intensive China Is Resource Intensive China Is Resource Intensive China's rapid rise from an agrarian society to an industrial power came at a devastating environmental cost. The heavy resource intensity of its economy (Chart 5) translates to extremely high pollution levels (Chart 6). Chart 6A Highly Polluting Economy A Highly Polluting Economy A Highly Polluting Economy To some extent, this is a natural phase of development. The "environmental Kuznets curve" hypothesizes that as economies industrialize they become increasingly polluting - and yet at a certain level of income the relationship reverses and economic growth becomes associated with environmental improvement (Diagram 1).1 Diagram 1The 'Environmental Kuznets Curve' Applies To Air Pollution China Sticks To The "Three Battles" China Sticks To The "Three Battles" Chart 7China Following In The Footsteps Of Less Resource-Intensive Neighbors China Sticks To The "Three Battles" China Sticks To The "Three Battles" As China transitions to a services-led economy, its appetite for commodities will slow. This is what happened in the advanced economies - and China is already on this path (Chart 7). The transition points away from export-manufacturing, which means that the share of electricity consumed by the industrial sector - currently disproportionately large - will ease (Chart 8). Chart 8Manufacturing Intensity Will Moderate China Sticks To The "Three Battles" China Sticks To The "Three Battles" Chart 9Reliance On Coal Power Will Fall China Sticks To The "Three Battles" China Sticks To The "Three Battles" China's consumption of coal, on which it depends very heavily (Chart 9), will continue to fall as a share of total energy consumption. And coal is significantly more polluting than other forms of energy (Table 2). Table 2Natural Gas Emits Less Carbon China Sticks To The "Three Battles" China Sticks To The "Three Battles" Already, growth in the service sector - the so-called tertiary industries - now outpaces manufacturing growth and accounts for more than half of Chinese GDP (Chart 10). Chart 10Rising Service Sector Means Less Pollution Rising Service Sector Means Less Pollution Rising Service Sector Means Less Pollution However, the pace of change is too slow for the Chinese public, which has been suffering from the health-related costs of rapid industrialization. The World Health Organization reports that in 2016, over a million deaths in China were attributed to ambient air pollution.2 Chart 11There Is A Reason Xi Jinping Cracked Down On Corruption And Pollution China Sticks To The "Three Battles" China Sticks To The "Three Battles" The Pew Research Center finds that 76% of survey respondents would classify air pollution as a "big problem," and nearly half of which a "very big problem" (Chart 11). On top of that, a 2016 survey shows that the Chinese public favors clean air over industry if forced to make a tradeoff (Chart 12). Chart 12The Public Understands The Tradeoff China Sticks To The "Three Battles" China Sticks To The "Three Battles" To prevent public discontent from boiling over, China launched a sweeping effort to restrain pollution when Xi Jinping took power in 2012-13 - particularly after the appallingly smoggy winter of 2013, known as "airpocalypse." Chart 13Air Pollution Is Trending Downwards Air Pollution Is Trending Downwards Air Pollution Is Trending Downwards These measures have broadly been effective. Readings of China's preferred measure of air pollution - PM2.5 concentration3 - have fallen steadily (Chart 13). The goals were achieved by means of overcapacity cuts in the coal and steel sectors - including shutting down low-quality steel plants - and replacing coal with cleaner forms of energy, particularly natural gas (Chart 14). Chart 14Coal Reliance Is Declining Coal Reliance Is Declining Coal Reliance Is Declining However, pollution is a structural challenge, not one that can be solved in a single five-year plan. Though PM2.5 emissions have fallen by 35% in 2017 compared to 2012, the current concentration of 47.3 µm/m3 remains well above China's national standard for maximum annual average exposure of 35 µm/m3. China's standards are also lax relative to international peers. The World Health Organization recommends a much lower annual mean for the concentration level at 10 µm/m3. Furthermore, air pollution is not equally concentrated throughout the country. The industrialized north is significantly more polluted than the rest of the country (Map 1). The provinces of Shanxi and Shaanxi saw PM2.5 levels rise from 2015-17, reaching the highest alert levels. Map 1China's Air Pollution By Province China Sticks To The "Three Battles" China Sticks To The "Three Battles" As a result, the Xi administration has doubled down on its anti-pollution goals. The 13th Five Year Plan, covering 2016-20, was the first national economic blueprint to include air pollution targets. It got off to a rocky start because China had to stimulate the economy aggressively in 2015-16 to fend off a destabilizing slowdown. Pumping credit and fiscal spending into the industrial economy led to a rebound in high-polluting activity (Chart 15). Yet, as mentioned, when Xi consolidated power in 2017, he elevated the war on pollution to the "second battle" of the three battles. Chart 15Excess Credit Means Excess Pollution Excess Credit Means Excess Pollution Excess Credit Means Excess Pollution Pursuant to this 2018-20 framework, the latest action plan for air pollution reinforces the targets of the Five Year Plan and its 2020 deadline: The plan applies to all cities of prefectural or higher level, and thus expands the government's actions beyond the major cities in the Beijing-Tianjin-Hebei, Yangtze River Delta, and Pearl River Delta areas. Furthermore, the Pearl River Delta is no longer one of the key regions, having made substantive progress. It has been replaced by the Fen-Wei Plains, which include Xi'an and parts of Shaanxi, Henan, and Shanxi provinces. These provinces rely on coal for energy and contain polluting industries. PM2.5 levels must fall by at least 18% from 2015 baseline levels in cities of prefectural or higher level and anywhere else where standards have not been met. Targets for reducing volatile organic compounds (VOC) and nitrogen oxide emissions are set to 10% and 15%, respectively, by the end of the period. The number of good-air days should reach 80 percent annually and the percentage of heavily polluted days should decrease by more than 25 percent from 2015 levels. The new air pollution goals are not as aggressive as those of the 2012-17 plan. For instance, the 18% cut in PM2.5 levels is less than the maximum 25% cut in the previous plan. However, the new goals are more precise and targeted. Rather than impose further declines in regions where air pollution has been successfully reduced, the plan aims to prevent heavy industries from migrating to other parts of China to evade environmental restrictions. After all, many of China's coal producers are located in the Fen-Wei Plains, which will no longer escape the regulator's eye (Chart 16). Chart 16The Fen-Wei Plain Now Under Scrutiny China Sticks To The "Three Battles" China Sticks To The "Three Battles" What is the market implication of the above? In our view, some market participants have misread the new anti-pollution targets as a form of economic stimulus because they are less aggressive than those of the previous five years. While it is true that China faces a tradeoff between clean air and economic growth (Chart 17), the regulatory easing looks like an attempt to make the anti-pollution goals more realistic and achievable rather than abandoning the overarching anti-pollution push (see Box 1). In net terms, China is still tightening regulation. Chart 17Heavy Industrial Model Drives Pollution Heavy Industrial Model Drives Pollution Heavy Industrial Model Drives Pollution Box 1 Easing Up On winter Curbs? China has recently relied on heavy industry production curbs to limit pollution during the especially smog-prone winter months. The 2017-18 season saw the first of these wintertime cuts. Production in highly polluting industries such as coal, aluminum, and steel was slashed by up to 50% in 28 northern cities between mid-November 2017 and mid-March 2018. As a result, fine particle emissions fell. The year-on-year change in emissions peaked with the start of the cuts and troughed with their end, falling by an average 18% y/y over the period (Chart 18). Chart 18Last Winter's Anti-Pollution Crackdown China Sticks To The "Three Battles" China Sticks To The "Three Battles" Cuts will continue this winter, in theory limiting steel and aluminum production as well as coal consumption. However, the impact looks to be less dramatic this time around: While the August draft plan reportedly set PM2.5 reduction targets at 5% y/y for the 2018-19 winter, the final plan, released by the newly formed Ministry of Ecology and Environment, set a less ambitious objective of a 3% reduction in emissions. Blanket production cuts are being replaced by more flexible measures that will be overseen by local governments. Central government inspection teams will be dispatched less frequently. The new changes reflect the fact that Chinese policymakers are fine-tuning their policies to minimize the negative impact on industry as well as households that use coal-fired heating: The revision of emissions cuts from 5% in the August draft to 3% in the final plan reflects a more realistic cut than the 15% cut last year. But it is still a cut. The scrapping of blanket measures, in favor of more flexible cuts determined by regional emissions levels, will avoid penalizing producers who have already abided by the targets. It will also reward producers who have upgraded their facilities to be more eco-friendly. While year-on-year changes in emissions fell in northern China last winter, they spiked in the rest of the country, as economic agents shifted to areas not covered by the new rules. The same pattern emerged in the steel industry: steel production cuts in northern China were offset by a ramp-up in steel production from other regions (Chart 19). The newest plan expands the coverage of the regulations even as its demands are less draconian. Chart 19Polluters Know How To Evade Controls Polluters Know How To Evade Controls Polluters Know How To Evade Controls Last winter, local governments frantically shut down coal usage in order to meet strict 2017 deadlines for the plan to convert 20 million rural households from coal-heating to gas-heating by 2020. However, natural gas supplies could not pick up the slack - storage capacity, LNG import capacity, internal distribution, Central Asian imports, and bureaucratic coordination all fell short.4 Millions of households lost heating during the winter months, the authorities were forced to backtrack and allow coal imports, and a massive public backlash ensued. It is not surprising, then, that the government is compromising its coal-to-gas requirements for the coming winter.5 While the gas crunch is not expected to be as bad this winter, the underlying problems with natural gas storage, import, or distribution problems remain unresolved. So it makes sense for Beijing to give local governments more flexibility. A total conversion to natural gas heating is still supposed to be accomplished by 2020 in the Beijing-Tianjin-Hebei region as well as in Shanxi and Shaanxi.6 The goal post may be moved but policies will still push in this direction. Ultimately, pollution is a cross-regional phenomenon - and it has proven to generate significant political opposition movements over time. Many developed nations have gone through a period of political upheaval sparked by popular backlash against the excesses of industrialization - including pollution.7 China does not have voters who can vote on environmental demands, but it greatly fears the political ramifications of widespread protests due to unbearable living and health conditions. As with the anti-corruption and anti-leverage campaigns, the Xi administration is trying to catch up to the magnitude of the problem and mitigate it before something snaps and triggers a general uproar. Bottom Line: China has pared back its emissions cuts for 2018-20 and softened its pollution curbs for the winter. These actions are less negative for economic growth than earlier curbs and proposals would have been. However, they still amount to a net increase in China's environmental regulation, which is in keeping with Xi Jinping's overarching policy priorities. The Third Battle: Poverty Poverty rates have collapsed in China since its opening up and reform in 1979. Xi's third battle is to eliminate rural poverty by 2020. This is the only battle of the three that is growth-enhancing rather than growth-constraining. It lifts China's growth by transferring government funds to the poorest citizens, who have the highest propensity to consume. At the average rate of rural poverty reduction over the past several years, there will still be around 11-12 million rural poor by the end of 2020 (Chart 20). Thus China will have to spend more to meet the target, creating a net increase in fiscal spending. Chart 20Anti-Poverty Campaign Requires Spending Anti-Poverty Campaign Requires Spending Anti-Poverty Campaign Requires Spending The war on poverty underscores a constraint on the previous two battles: growth and stability. Financial and environmental regulation cannot be imposed so aggressively as to lead to a sharp drop in growth or employment. This is China's "Socialist Put" - and it remains in place despite the fact that the government has a higher threshold for economic pain since 2017. While Xi has signaled that China will do away with annual GDP growth targets, he has not discarded them immediately. The leadership is still bound by the economic targets due in 2020 - the doubling of GDP from 2010 levels and the doubling of rural and urban incomes (Chart 21). Chart 21Stimulus Necessary If 2020-21 Goals In Jeopardy Stimulus Necessary If 2020-21 Goals In Jeopardy Stimulus Necessary If 2020-21 Goals In Jeopardy These targets are especially important because they more or less coincide with the "centenary goal" of making China a "moderately prosperous society" by 2021. The latter year will mark the 100th anniversary of the Communist Party; the administration will want to make sure that the economy is in good shape. The Chinese leadership takes its two centenary goals (2021 and 2049) seriously.8 As long as headline GDP growth does not fall too far below the average of 6.5% per year in 2018-20, the first centenary goals will be met. New tax cuts worth an estimated 1% of GDP, and other targeted measures, will help reach the goal for urban income, which is the one most at risk. If these goals look to be met, China can save its biggest stimulus measures for later. In recent years, China's economic "mini-cycles" have lasted about 1.4-to-2 years, from the trough of the total credit impulse to the peak of nominal GDP (Chart 22). 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. Chart 22Economy Peaks Two Years Post-Stimulus Economy Peaks Two Years Post-Stimulus Economy Peaks Two Years Post-Stimulus Bottom Line: We would need to see a much bigger shock to the economy than is currently in the offing for Xi to abandon his reform agenda for a traditional fiscal-and-credit splurge that exacerbates the credit bubble, fires up overbuilt industries, and annihilates all the hard work of his recent financial and environmental regulations. Investment Conclusions The above findings suggest that coal prices can rise in the near term.Demand will be supported by more flexibility on pollution curbs, while supply will be constrained by the ongoing supply-side cuts in coal production. Steel prices may fall, as production will rise amid less stringent environmental rules. More broadly, however, investors should understand what the recent tactical "easing" measures suggest about China's policy settings overall. China's political system is a system of single-party rule, in which the Communist Party explicitly rejects the legitimacy of "checks and balances" or political liberalism. However, the government cannot do whatever it wants. Its authoritarian model still requires it to address public pressure and maintain general popular approval - otherwise it would lose legitimacy and ultimately power. For the past four decades, the Communist Party has maintained legitimacy by providing economic growth and rising incomes - and these are still essential. But as the economy matures and growth rates naturally fall, it becomes more important to re-establish the party's legitimacy on improving quality of life. Xi Jinping made this point official in his address to the nineteenth National Party Congress last October, but it has driven his administration since 2012.9 The Communist Party is flush with tax revenues and maintains absolute control over government branches, banks, key corporations, security forces, and most forms of civil association. With these tools it can, for the most part, maintain its rule against regional or topical challenges. What it fears are systemic risks - challenges to its authority that span ideological, ethnic, class, or regional divides. Here the government is behind the curve, as quality of life has been entirely neglected during the country's high-growth phase of economic development. Thus Xi has tried to make up for lost time and tackle the most flagrant quality-of-life concerns. His anti-corruption campaign, for instance, sought to address the chief source of public discontent from the moment he came into office - as well as to recentralize power into his own hands so that he could tackle the other major grievances with zero resistance from the party or state bureaucracy. Now his top priorities are leverage and pollution, both of which pose systemic risks and hence the forthcoming improvement in fiscal and credit indicators will not proceed unchecked. Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist roukayai@bcaresearch.com 1 There is a large body of literature on the Environmental Kuznets Curve; the important point for this study is that it holds up well to empirical scrutiny when it comes to modeling air pollution concentrations. Please see David I. Stern, "The Environmental Kuznets Curve After 25 Years," Australian National University, CCEP Working Paper 1514 (December 2015), available at ageconsearch.umn.edu. 2 The death rate attributable to ambient air pollution is 81 per 100,000 people, which places China among the most dangerously polluted countries, alongside North Korea, Russia, and several developing eastern European countries. Please see the WHO's Global Health Observatory data repository, available at www.who.int/gho/en. 3 PM2.5 is a general term for particles and liquid droplets in the atmosphere with aerodynamic diameters less than or equal to 2.5 microns (µm). Short- or long-term exposure to these particles has been found to lead to adverse cardiovascular effects such as heart attacks and strokes. 4 Please see David Sandalow, Akos Losz, and Sheng Yan, "A Natural Gas Giant Awakens: China's Quest for Blue Skies Shapes Global Markets," Columbia Center on Global Energy Policy, July 27, 2018. 5 Please see Yujing Liu, "China scrambles to avoid a repeat of last winter's botched coal-to-gas conversion programme in highly polluting northern rural areas," SCMP, September 24, 2018, available at www.scmp.com. 6 Please see "China coal city vows 'no-coal zones' in bid to curb pollution," Reuters, October 11, 2018, available at reuters.com. 7 The Great London Smog of 1952 is a classic example, but for a detailed study please see Russell J. Dalton and Manfred Kuechler, Challenging the Political Order: New Social and Political Movements in Western Democracies (Cambridge: Polity, 1990). 8 The first goal is to create a "moderately prosperous society in all respects," namely by doubling real GDP and rural and urban per capita income from 2010 levels by 2020. The second goal is to make China into a "modern socialist country that is prosperous, strong, democratic, culturally advanced, and harmonious," with the GDP per capita of a moderately developed country at around $55,000 in 2014 dollars. Please see "CPC Q&A: What are China's two centennial goals and why do they matter?" Xinhua, October 17, 2017, available at www.xinhuanet.com. 9 Xi, in his work report at the party congress in 2017, said, "what we now face is the contradiction between unbalanced and inadequate development and the people's ever-growing needs for a better life." This is a new formulation of the "principal contradiction" facing Chinese society, by contrast with the earlier formulation, which emphasized "the ever-growing material and cultural needs of the people and the low level of social production," according to former President Hu Jintao in 2007.