Emerging Markets

Feature Chart I-1Recent Defaults Have Focused Attention ##br##On Corporate Health Recent Defaults Have Focused Attention On Corporate Health Recent Defaults Have Focused Attention On Corporate Health The recent spike in defaults on bonds and loans in China, including missed debt repayments by local government financing vehicles (LGFV) and some listed companies, has unsettled investors over the past few weeks.1 The yield spread between 5-year government bonds and 5-year corporate bonds AA minus in China's domestic bond market, has recently hit their widest level in nearly two years (Chart I-1). As a result, some investors are concerned about the possibility of widespread defaults as the Chinese government's deleveraging campaign continues to roll out, and sweeping new rules on shadow banking take effect. Given the report focus on corporate health, this week we are updating our China Industry Watch thematic chartpack to present a visual presentation of the changing situation in China's corporate sector, and its relevance to the broader stock market performance. Overall, the Chinese corporate sector has continued to deleverage and its financial situation has improved modestly. Our Corporate Health Monitor (CHM),2 which is an equally weighted average of net income margin, return on capital, EBIT-to-debt ratio, debt-to-asset ratio and interest coverage ratio, shows that the health of most sectors are improving. Specifically, for steel, construction materials, automobile, food& beverage and tech, our CHMs are in healthy territory. For oil & gas, coal, non-ferrous metals and machinery, CHMs are still below zero but are recovering. In terms of profit growth, it has remained robust for most of the sectors shown in the report. In particular, profit growth has accelerated substantially in the coal and steel sectors, as higher selling prices helped offset the impact of production constraints on revenue and aggressive cost cutting increased gross margins. Firms in the energy sector have also enjoyed higher profit growth as oil prices rebounded. In terms of the leverage picture, the liabilities-to-assets ratio has continued to decline broadly across sectors (Chart I-2). However, in regards of debt sustainability, the interest-to-sales ratio has increased substantially in coal, steel, and non-ferrous sectors, due to dramatic decline in sales resulting from production constraints. The interest coverage ratio in these sector is less problematic because of improving gross margins. For the tech sector, however, there has been a spike in the interest-to-sales ratio and a sharp decline in interest coverage. Looking beyond the fairly broad-based improvement in our overall non-financial CHM, we doubt that a broad-based default wave will occur in response to the crackdown on shadow banking. First, by our estimation, the recent defaults cited above account for only 0.09% of outstanding corporate bonds. Second, the latest PBOC monetary report changed the tone from emphasizing "deleveraging" to "stabilizing leverage and restructuring", which shows that regulators are as concerned about the stability of the economy as they are about reducing excessive debts. One problem that is worth monitoring is the negative trend in overall industrial enterprises sales, which had a negative growth rate in Q1 relative to the same quarter last year. Part of this negative growth rate is likely due to base effects, given that Q1 2017 itself was abnormally strong. Nevertheless, comparing first three month of the sales this year to that of previous years, it is clear that 2018's value did not reflect an uptrend in the data (Chart I-3). This weak top line performance is somewhat worrisome and we will continue to watch for signs of a further slowdown. Chart I-2A Continued Decline In Debt-To-Assets A Continued Decline In Debt-To-Assets A Continued Decline In Debt-To-Assets Chart I-3Tepid Topline Growth Is Worrisome Tepid Topline Growth Is Worrisome Tepid Topline Growth Is Worrisome Lin Xiang, Research Analyst linx@bcaresearch.com Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com BCA China Industry Watch includes four categories of financial ratios to monitor a sector's leverage, profitability, growth and efficiency, respectively. Some of these ratios, as shown in Table 1, are slightly tweaked from conventional definitions due to data availability. The financial data in our exercise are from the official statistics on overall industrial firms, of which the listed companies are a subset, but most financial ratios based on the two sets of data are very similar, especially for the heavy industries that dominate the Chinese stock markets - both onshore and offshore. The financial ratios on leverage, growth and profitability are almost identical for some sectors, while some other sectors that are not well represented in the stock market, such as technology, healthcare and consumer sectors, show notable divergences. As the Chinese equity universe continues to expand, we expect that the two sets of data will increasingly converge. Table 1The China Industry Watch Messages From BCA's China Industry Watch Messages From BCA's China Industry Watch 1 More than 10 companies, several of them listed, from a variety of industries have defaulted on 17 bonds worth more than 16.5 billion yuan (US$2.6 billion), according to figures from Choice. 2 Please see China Investment Strategy Special Report, “Introducing The BCA China Industry Watch,” dated February 10, 2016, available at cis.bcaresearch.com. Appendix: China Industry Watch All Firms Chart II-1Non-Financial Firms: Stock Price & Valuation Indicators Non-Financial Firms: Stock Price & Valuation Indicators Non-Financial Firms: Stock Price & Valuation Indicators Chart II-2Non-Financial Firms: Relative Performance Of Valuation Indicators Non-Financial Firms: Relative Performance Of Valuation Indicators Non-Financial Firms: Relative Performance Of Valuation Indicators Chart II-3Non-Financial Firms: Leverage Indicators Non-Financial Firms: Leverage Indicators Non-Financial Firms: Leverage Indicators Chart II-4Non-Financial Firms: Growth Indicators Non-Financial Firms: Growth Indicators Non-Financial Firms: Growth Indicators Chart II-5Non-Financial Firms: Profitability Indicators Non-Financial Firms: Profitability Indicators Non-Financial Firms: Profitability Indicators Chart II-6Non-Financial Firms: Efficiency Indicators Non-Financial Firms: Efficiency Indicators Non-Financial Firms: Efficiency Indicators Oil & Gas Sector Chart II-7Oil&Gas Sector: Stock Price & Valuation Indicators Oil&Gas Sector: Stock Price & Valuation Indicators Oil&Gas Sector: Stock Price & Valuation Indicators Chart II-8Oil&Gas Sector: Relative Performance Of Valuation Indicators Oil&Gas Sector: Relative Performance Of Valuation Indicators Oil&Gas Sector: Relative Performance Of Valuation Indicators Chart II-9Oil&Gas Sector: Leverage Indicators Oil&Gas Sector: Leverage Indicators Oil&Gas Sector: Leverage Indicators Chart II-10Oil&Gas Sector: Growth Indicators Oil&Gas Sector: Growth Indicators Oil&Gas Sector: Growth Indicators Chart II-11Oil&Gas Sector: Profitability Indicators Oil&Gas Sector: Profitability Indicators Oil&Gas Sector: Profitability Indicators Chart II-12Oil&Gas Sector: Efficiency Indicators Oil&Gas Sector: Efficiency Indicators Oil&Gas Sector: Efficiency Indicators Coal Sector Chart II-13Coal Sector: Stock Price & Valuation Indicators Coal Sector: Stock Price & Valuation Indicators Coal Sector: Stock Price & Valuation Indicators Chart II-14Coal Sector: Relative Performance Of Valuation Indicators Coal Sector: Relative Performance Of Valuation Indicators Coal Sector: Relative Performance Of Valuation Indicators Chart II-15Coal Sector: Leverage Indicators Coal Sector: Leverage Indicators Coal Sector: Leverage Indicators Chart II-16Coal Sector: Growth Indicators Coal Sector: Growth Indicators Coal Sector: Growth Indicators Chart II-17Coal Sector: Profitability Indicators Coal Sector: Profitability Indicators Coal Sector: Profitability Indicators Chart II-18Coal Sector: Efficiency Indicators Coal Sector: Efficiency Indicators Coal Sector: Efficiency Indicators Steel Sector Chart II-19Steel Sector: Stock Price & Valuation Indicators Steel Sector: Stock Price & Valuation Indicators Steel Sector: Stock Price & Valuation Indicators Chart II-20Steel Sector: Relative Performance Of Valuation Indicators Steel Sector: Relative Performance Of Valuation Indicators Steel Sector: Relative Performance Of Valuation Indicators Chart II-21Steel Sector: Leverage Indicators Steel Sector: Leverage Indicators Steel Sector: Leverage Indicators Chart II-22Steel Sector: Growth Indicators Steel Sector: Growth Indicators Steel Sector: Growth Indicators Chart II-23Steel Sector: Profitability Indicators Steel Sector: Profitability Indicators Steel Sector: Profitability Indicators Chart II-24Steel Sector: Efficiency Indicators Steel Sector: Efficiency Indicators Steel Sector: Efficiency Indicators Non Ferrous Metals Sector Chart II-25Non Ferrous Metals Sector: Stock Price & Valuation Indicators Non Ferrous Metals Sector: Stock Price & Valuation Indicators Non Ferrous Metals Sector: Stock Price & Valuation Indicators Chart II-26Non Ferrous Metals Sector: Relative Performance Of Valuation Indicators Non Ferrous Metals Sector: Relative Performance Of Valuation Indicators Non Ferrous Metals Sector: Relative Performance Of Valuation Indicators Chart II-27Non Ferrous Metals Sector: Leverage Indicators Non Ferrous Metals Sector: Leverage Indicators Non Ferrous Metals Sector: Leverage Indicators Chart II-28Non Ferrous Metals Sector: Growth Indicators Non Ferrous Metals Sector: Growth Indicators Non Ferrous Metals Sector: Growth Indicators Chart II-29Non Ferrous Metals Sector: Profitability Indicators Non Ferrous Metals Sector: Profitability Indicators Non Ferrous Metals Sector: Profitability Indicators Chart II-30Non Ferrous Metals Sector: Efficiency Indicators Non Ferrous Metals Sector: Efficiency Indicators Non Ferrous Metals Sector: Efficiency Indicators Construction Material Sector Chart II-31Construction Material Sector: Stock Price & Valuation Indicators Construction Material Sector: Stock Price & Valuation Indicators Construction Material Sector: Stock Price & Valuation Indicators Chart II-32Construction Material Sector: Relative Performance Of Valuation Indicators Construction Material Sector: Relative Performance Of Valuation Indicators Construction Material Sector: Relative Performance Of Valuation Indicators Chart II-33Construction Material Sector: Leverage Indicators Construction Material Sector: Leverage Indicators Construction Material Sector: Leverage Indicators Chart II-34Construction Material Sector: Growth Indicators Construction Material Sector: Growth Indicators Construction Material Sector: Growth Indicators Chart II-35Construction Material Sector: Profitability Indicators Construction Material Sector: Profitability Indicators Construction Material Sector: Profitability Indicators Chart II-36Construction Material Sector: Efficiency Indicators Construction Material Sector: Efficiency Indicators Construction Material Sector: Efficiency Indicators Machinery Sector Chart III-37Machinery Sector: Stock Price & Valuation Indicators Machinery Sector: Stock Price & Valuation Indicators Machinery Sector: Stock Price & Valuation Indicators Chart III-38Machinery Sector: Relative Performance Of Valuation Indicators Machinery Sector: Relative Performance Of Valuation Indicators Machinery Sector: Relative Performance Of Valuation Indicators Chart III-39Machinery Sector: Leverage Indicators Machinery Sector: Leverage Indicators Machinery Sector: Leverage Indicators Chart III-40Machinery Sector: Growth Indicators Machinery Sector: Growth Indicators Machinery Sector: Growth Indicators Chart III-41Machinery Sector: Profitability Indicators Machinery Sector: Profitability Indicators Machinery Sector: Profitability Indicators Chart III-42Machinery Sector: Efficiency Indicators Machinery Sector: Efficiency Indicators Machinery Sector: Efficiency Indicators Automobile Sector Chart III-43Automobile Sector: Stock Price & Valuation Indicators Automobile Sector: Stock Price & Valuation Indicators Automobile Sector: Stock Price & Valuation Indicators Chart III-44Automobile Sector: Relative Performance Of Valuation Indicators Automobile Sector: Relative Performance Of Valuation Indicators Automobile Sector: Relative Performance Of Valuation Indicators Chart III-45Automobile Sector: Leverage Indicators Automobile Sector: Leverage Indicators Automobile Sector: Leverage Indicators Chart III-46Automobile Sector: Growth Indicators Automobile Sector: Growth Indicators Automobile Sector: Growth Indicators Chart III-47Automobile Sector: Profitability Indicators Automobile Sector: Profitability Indicators Automobile Sector: Profitability Indicators Chart III-48Automobile Sector: Efficiency Indicators Automobile Sector: Efficiency Indicators Automobile Sector: Efficiency Indicators Food & Beverage Sector Chart III-49Food&Beverage Sector: Stock Price & Valuation Indicators Food&Beverage Sector: Stock Price & Valuation Indicators Food&Beverage Sector: Stock Price & Valuation Indicators Chart III-50Food&Beverage Sector: Relative Performance Of Valuation Indicators Food&Beverage Sector: Relative Performance Of Valuation Indicators Food&Beverage Sector: Relative Performance Of Valuation Indicators Chart III-51Food&Beverage Sector: Leverage Indicators Food&Beverage Sector: Leverage Indicators Food&Beverage Sector: Leverage Indicators Chart III-52Food&Beverage Sector: Growth Indicators Food&Beverage Sector: Growth Indicators Food&Beverage Sector: Growth Indicators Chart III-53Food&Beverage Sector: Profitability Indicators Food&Beverage Sector: Profitability Indicators Food&Beverage Sector: Profitability Indicators Chart III-54Food&Beverage Sector: Efficiency Indicators Food&Beverage Sector: Efficiency Indicators Food&Beverage Sector: Efficiency Indicators Information Technology Sector Chart III-55Information Technology Sector: Stock Price & Valuation Indicators Information Technology Sector: Stock Price & Valuation Indicators Information Technology Sector: Stock Price & Valuation Indicators Chart III-56Information Technology Sector: Relative Performance Of Valuation Indicators Information Technology Sector: Relative Performance Of Valuation Indicators Information Technology Sector: Relative Performance Of Valuation Indicators Chart III-57Information Technology Sector: Leverage Indicators Information Technology Sector: Leverage Indicators Information Technology Sector: Leverage Indicators Chart III-58Information Technology Sector: Growth Indicators Information Technology Sector: Growth Indicators Information Technology Sector: Growth Indicators Chart III-59Information Technology Sector: Profitability Indicators Information Technology Sector: Profitability Indicators Information Technology Sector: Profitability Indicators Chart III-60Information Technology Sector: Efficiency Indicators Information Technology Sector: Efficiency Indicators Information Technology Sector: Efficiency Indicators Utilities Sector Chart III-61Utilities Sector: Stock Price & Valuation Indicators Utilities Sector: Stock Price & Valuation Indicators Utilities Sector: Stock Price & Valuation Indicators Chart III-62Utilities Sector: Relative Performance Of Valuation Indicators Utilities Sector: Relative Performance Of Valuation Indicators Utilities Sector: Relative Performance Of Valuation Indicators Chart III-63Utilities Sector: Leverage Indicators Utilities Sector: Leverage Indicators Utilities Sector: Leverage Indicators Chart III-64Utilities Sector: Growth Indicators Utilities Sector: Growth Indicators Utilities Sector: Growth Indicators Chart III-65Utilities Sector: Profitability Indicators Utilities Sector: Profitability Indicators Utilities Sector: Profitability Indicators Chart III-66Utilities Sector: Efficiency Indicators Utilities Sector: Efficiency Indicators Utilities Sector: Efficiency Indicators Cyclical Investment Stance Equity Sector Recommendations

Highlights China-U.S. trade détente goes against our alarmist forecast, prompting us to reassess the view; We do not expect the truce to last long, as China has not given the U.S. what we believe the Trump administration wants; Instead, we see the truce lasting until at least the completion of the North Korea - U.S. summit, at most early 2019; Market is correct to fret about Italy, as the populist agenda will be constrained by the bond market in due course; Stay long DXY, but close our recommendations to short China-exposed S&P 500 companies. Feature Our alarmist view on trade wars appears to be in retreat, or at least "on hold," following the conclusion of the latest trade talks between U.S. and Chinese officials. Global markets breathed a sigh of relief on Monday, after a weekend of extremely positive comments from President Trump's advisers and cabinet members. Particularly bullish were the comments from Trump's top economic adviser, Larry Kudlow, who claimed that China had agreed to reduce its massive trade surplus with the U.S. by $200 billion (Chart 1). Chart 1China, Not NAFTA, Is The Problem China, Not NAFTA, Is The Problem China, Not NAFTA, Is The Problem The official bilateral statement, subsequently published by the White House, was vague. It claimed that "there was a consensus" regarding a substantive - but unquantifiable - reduction in the U.S. trade deficit.1 The only sectors that were mentioned specifically were "United States agriculture and energy exports." China agreed to "meaningfully" increase the imports of those products, which are low value- added commodity goods. With regard to value-added exports, China merely agreed that it would encourage "expanding trade in manufactured goods and services." The two sides also agreed to "attach paramount importance to intellectual property protections," with China specifically agreeing to "advance relevant amendments to its laws and regulations in this area." Subsequent to the declaratory statement, China lowered tariffs on auto imports from 25% to 15%. It will also cut tariffs on imported car parts, to around 6%, from the current average of about 10%. Is that it? Was the consensus view - that China would merely write a check for some Boeings, beef, and crude oil - essentially right? The key bellwether for trade tensions has been the proposed tariffs on $50-$150 billion worth of goods, set to come in effect as early as May 21. According to Treasury Secretary Steven Mnuchin, this tariff action is now "on hold." Mnuchin was also supposed to announce investment restrictions by this date, another bellwether that is apparently on hold. This is objective evidence that trade tensions have probably peaked for this year.2 On the other hand, there are several reasons to remain cautious: Section 301 Investigation: Robert Lighthizer, the cantankerous U.S. Trade Representative who spearheaded the Section 301 investigation into China's trade practices that justified the abovementioned tariffs and investment restrictions, immediately issued a statement on Sunday dampening enthusiasm: "Real work still needs to be done to achieve changes in a Chinese system that facilitates forced technology transfers in order to do business in China." In the same statement, Lighthizer added that China facilitates "the theft of our companies' intellectual property and business know-how." In other words, Lighthizer does not appear to be excited by the prospect of trading IP and tech protection for additional exports of beef and crude oil. Political Reaction: The reaction from conservative circles was less than enthusiastic, with both congressional officials and various Trump supporters announcing their exasperation with the supposed deal over the weekend.3 The Wall Street Journal claimed that China refused to put a number - such as the aforementioned $200 billion - in the final statement.4 The implication is that Beijing won this round of negotiations. But President Trump will not want to appear weak. If a narrative emerges that he "lost," we would expect President Trump to pivot back to tariffs and confrontation. Support for free trade has recently rebounded among Republican voters but remains dramatically lower among them than among Democrats (Chart 2). As such, it is a salient issue for the president politically. Chart 2Support For Free Trade Recovering, ##br##But Republicans Still Trail Democrats Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) Chart 3China Already ##br##Imports U.S. Commodities... Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) Investment Restrictions: Senator Cornyn's (Texas, Republican) bill to strengthen the Committee on Foreign Investment in the United States (CFIUS) process continues to move through the Senate.5 The Foreign Investment Risk Review Modernization Act Of 2017 (FIRRMA) is currently being considered by the Senate Committee on Banking, Housing, and Urban Affairs and should be submitted to a vote ahead of the November election. Congress is also looking to pass a bipartisan bill that would prevent President Trump from taking it easy on Chinese telecommunication manufacturer ZTE. Chart 4U.S. Commodity Export Growth Is Solid Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) Chart 5... But Impedes Market Access For Higher Value-Added Goods Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) Beef And Oil Is Not Enough: The U.S. already has a growing market share in China's imports of commodities and crude materials, although it could significantly increase its exports in several categories (Chart 3). As the Chinese people develop middle-class consumption habits, the country was always going to import more agricultural products. And as their tastes matured, the U.S. was always going to benefit, given the higher quality and price point of its agricultural exports. In fact, China's imports of U.S. primary commodity exports have been increasing faster than imports of U.S. manufacturing goods (Chart 4). As such, the statement suggests that the U.S. and China have opted for the easiest compromises (commodities) to grant U.S. greater market access; the U.S. may have fallen short on market access for value-added manufacturing (Chart 5). In addition, there was little acknowledgment of the American demands that China cease forced tech transfers, cut subsidies for SOEs, reduce domestic content requirements under the "Made in China 2025" plan, and liberalize trade for U.S. software and high-tech exporters (Chart 6). Given these outstanding and unresolved issues, there are three ways to interpret the about-face in U.S. trade demands: Geopolitical Strategy is wrong: One scenario is that we are wrong, that the Trump administration is not focused on forced tech transfers and IP theft in any serious way.6 On the other hand, if that is true, the U.S. is also not serious about significantly reducing its trade deficit with China, since structurally, IP theft and non-tariff barriers to trade of high-value exports are a major reason why China has a massive surplus. Instead, the U.S. may only be focused on reducing the trade deficit through assurances of greater market access - a key demand as well, but one that could prove temporary or un-strategic, especially if access is only granted for commodities.7 If this is true, it suggests that President Trump's demands on China are transactional, not geopolitical, as we asserted in March.8 Midterms matter: Another scenario is that President Trump does not want to do anything that would hurt the momentum behind the GOP's polling ahead of the November midterms (Chart 7). The administration can always pick up the pressure on China following the election, given that 2019 is not an election year. Trump's political team may believe that Beijing concessions on agriculture, autos, and energy will be sufficient to satisfy the base until then. By mid-2019, the White House can also use twelve months of trade data to assess whether Beijing has actually made any attempt to deliver on its promises of increased imports from the U.S. Chart 6China's High-Tech Protectionism Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) Chart 7Republicans Are Gaining... Republicans Are Gaining... Republicans Are Gaining... North Korea matters: Along the same vein as the midterms, there is wisdom in delaying trade action against China given the upcoming June 12 summit between President Trump and North Korean Supreme Leader Kim Jong-un in Singapore. President Trump's approval ratings began their second surge this year following the announced talks (Chart 8), and it is clear that the administration has a lot of political capital invested in the summit's success. Recent North Korean statements, suggesting that they are willing to break off dialogue, may have been the result of the surprise May 8 meeting between Chinese President Xi Jinping and Kim, the second in two months. As such, President Trump may have had to back off on the imposition of tariffs against China in order to ensure that his summit with Kim goes smoothly. At this point, it is difficult to gauge whether the decision to ease the pressure against China was due to strategic or tactical reasons. We expect that the market will price in both, easing geopolitical risk on equity markets. However, if the delay is tactical - and therefore temporary - then the risk premium would remain appropriate. We do not think that we are wrong when it comes to U.S. demands on China. These include greater market access for U.S. value-added exports and services (not just commodities), as well as a radical change in how China awards such access (i.e., ending the demand that technology transfers accompany FDI and market access). In addition, China still massively underpays for U.S. intellectual property (IP) rights and has been promising to do more on that front for decades (Chart 9). Given that China has launched some anti-piracy campaigns, and given its recent success in other top-down campaigns like shuttering excess industrial capacity, it is hard to believe that Beijing could not crack down on IP theft even more significantly. Chart 8...Thanks To Tax Cuts And Kim Jong-un ...Thanks To Tax Cuts And Kim Jong-un ...Thanks To Tax Cuts And Kim Jong-un Chart 9What Happened To ~$100 Billion IP Theft? Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) Furthermore, U.S. demands on China are not merely about market access and IP. There is also the issue of aggressive geopolitical footprint in East Asia, particularly the South China Sea. The U.S. defense and intelligence establishment is growing uneasy over China's pace of economic and technological development, given its growing military aggressiveness. In fact, over the past two weeks, China has: Landed the Xian H-6K strategic bombers capable of carrying nuclear weapons on disputed "islands" in the South China Sea; Installed anti-ship cruise missiles, as well as surface-to-air missiles, on three of its outposts in disputed areas. Of course, if we are off the mark on our view of Sino-American tensions, it would mean that the Trump administration is willing to make transactional economic concessions for geopolitical maneuvering room. In other words, more crude oil and LNG exports in exchange for better Chinese positioning in vital sea and air routes in East Asia. We highly doubt that the Trump administration is making such a grand bargain, even if the rhetoric from the White House often suggests that the "America First" agenda would allow for such a strategic shift. Rather, we think the Trump administration, like the Obama administration, put the South China Sea low on the priority list, but will focus greater attention on it when is deemed necessary at some future date. Bottom Line: Trade tensions between China and the U.S. have almost assuredly peaked in a tactical, three-to-six month timeframe. While still not official, it appears that the implementation of tariffs on $50-$150 billion worth of imports from China, set for any time after May 21, is now on hold. As such, a trade war is on hold. We are closing our short China-exposed S&P 500 companies versus U.S. financials and telecoms, a trade that has returned 3.94% and long European / short U.S. industrials, which is down 2% since inception. This greatly reduces investment-relevant geopolitical risk this summer and makes us far less confident that investors should "sell in May and go away." Our tactical bearishness is therefore reduced, although several other geopolitical risks - such as Iran-U.S. tensions, Italian politics, and the U.S. midterm election- remain relevant.9 We do not think that Sino-American tensions have peaked cyclically or structurally (six months and beyond). The Trump Administration continues to lack constraints when it comes to acting tough on China. As such, investors should expect tensions to renew either right after the summit between Trump and Kim in early June or, more likely, following the November midterm elections. Italy: The Divine Comedy Continues Since 2016, we have noted that Italy remains the premier risk to European markets and politics.10 There are two reasons for the view. First, Italy has retained a higher baseline level of Euroskepticism relative to the rest of Europe (Chart 10). While support for the common currency has risen in other member states since 2013, it has remained between 55%-60% in Italy. This is unsurprising given the clearly disappointing economic performance in Italy relative to that of its Mediterranean peers (Chart 11). Chart 10Italy Remains A Relative Euroskeptic Italy Remains A Relative Euroskeptic Italy Remains A Relative Euroskeptic Chart 11Lagging Economy Explains Cyclical Euroskepticism Lagging Economy Explains Cyclical Euroskepticism Lagging Economy Explains Cyclical Euroskepticism Italy's Euroskepticism, however, is not merely a product of economic malaise. Chart 12 shows that a strong majority of Europeans are outright pessimistic about the future of their country outside of the EU. But when Italians are polled in that same survey, the population is increasingly growing optimistic about the option of exit (Chart 13). The only other EU member state whose citizens are as optimistic about a life outside the bloc is the U.K., where population obviously voted for Brexit. Chart 12Europeans Are Pessimists About EU Exit... Europeans Are Pessimists About EU Exit... Europeans Are Pessimists About EU Exit... Chart 13...But Italians Are More Like Brits ...But Italians Are More Like Brits ...But Italians Are More Like Brits Furthermore, Italian respondents have begun to self-identify as Italian only, not as "European" also, which breaks with another long-term trend in the rest of the continent (Chart 14) and is also reminiscent of the U.K. The second reason to worry about Italy is its economic performance. Real GDP is still 5.6% below its 2008 peak, while domestic demand continues to linger at 7.9% below its pre-GFC levels (Chart 15). As we posited at the end of 2017, the siren song of FX devaluation would become a powerful political elixir in the 2018 election, as populist policymakers blame Italy's Euro Area membership for the economic performance from Chart 15.11 Chart 14Italians Feel More Italian Italians Feel More Italian Italians Feel More Italian Chart 15Italian Demand Never Fully Recovered Italian Demand Never Fully Recovered Italian Demand Never Fully Recovered Is the Euro Area to blame for Italy's ills? No. The blame lies squarely at the feet of Italian policymakers, who flubbed efforts to boost collapsing productivity throughout the 1990s and 2000s (Chart 16). There was simply no pressure on politicians to enact reforms amidst the post-Maastricht Treaty convergence in borrowing costs. Italy punted reforms to its educational system, tax collection, and corporate governance. Twenty years of complacency have led to a massive loss in global market share (Chart 17). Chart 16Italy Has A Productivity Problem Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) Chart 17Export Performance Is A Disaster Export Performance Is A Disaster Export Performance Is A Disaster While it is difficult to prove a counterfactual, we are not sure that even outright currency devaluation would have saved Italy from the onslaught of Asian manufacturing in the late 1990s. Euro Area imports from EM Asia have surged from less than 2% of total imports to nearly 10% in the last twenty years. Italy began losing market share to Asia well before the euro was introduced on January 1, 1999, as Chart 18 illustrates. The incoming populist government is unfortunately coming to power with growing global growth headwinds (Chart 19), with negative implications for Italy (Chart 20). These are likely to act as a constraint on plans by the Five Star Movement (M5S) and Lega coalition to blow out the budget deficit in pursuit of massive tax cuts, reversals of pension reforms, minimum wage hikes, and a proposal to increase spending on welfare. Our back-of-the-envelope calculation sees Italy's budget deficit growing to over 7% in 2019 if all the proposed reforms were enacted, well above the 3% limit imposed by the EU on its member states. Chart 18Italy Lost Market Share Amid Globalization Italy Lost Market Share Amid Globalization Italy Lost Market Share Amid Globalization Chart 19Tepid Global Growth... Tepid Global Growth... Tepid Global Growth... Chart 20...Is Bad News For Italy ...Is Bad News For Italy ...Is Bad News For Italy How would the EU Commission react to these proposals, given that Italy would break the rules of the EU Stability and Growth Pact (SGP)? We think the question is irrelevant. The process by which the EU Commission enforces the rules of the SGP is the Excessive Deficit Procedure (EDP), which would take over a year to put into place.12 First, the Commission would have to review the 2019 budget proposed by the new Italian government in September 2018. It would likely tell Rome that its plans would throw it into non-compliance with SGP rules, at which point the EU Commission would recommend the opening of a Significant Deviation Procedure (SDP). If Italy failed to follow the recommendations of the SDP, the Commission would then likely throw Italy into EDP at some point in the first quarter of 2019, or later that year.13 And what happens if Italy does not conform to the rules of the EDP? Italy would be sanctioned by the EU Commission by forcing Rome to make a non-interest-bearing deposit of 0.2% GDP.14 (Because it makes perfect sense to force a country with a large budget deficit to go into an even greater budget deficit.) Even if Rome complied with the sanctions, the punishment would only be feasible at the end of 2019, most likely at the end of Q1 2020. The point is that the above two paragraphs are academic. The Italian bond market would likely react much faster to Rome's budget proposals. The EU Commission operates on an annual and bi-annual timeline, whereas the bond market is on a minute-by-minute timeline. Given the bond market reaction thus far, it is difficult to see how Rome could be given the benefit of the doubt from investors (Chart 21). Investors have been demanding an ever-greater premium on Italian bonds, relative to their credit rating, ever since the election (Chart 22). Chart 21Uh Oh Spaghettio! Uh Oh Spaghettio! Uh Oh Spaghettio! Chart 22Bond Vigilantes Are Coming Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) As such, the real question for investors is not whether the EU Commission can constrain Rome. It cannot. Rather, it is whether the bond market will. Rising borrowing costs would obviously impact the economy via several transmission channels, including overall business sentiment. But the real risk is Italy's banking sector. Domestic financial institutions hold 45% of Italian treasury bonds (BTPs) (Chart 23), which makes up 9.3% of all their assets, an amount equivalent to 77.8% of their capital and reserves (Chart 24). Foreign investors own 32%, less than they did before the Euro Area crisis, but still a significant amount. Chart 23Foreign Investors Still Hold A Third Of All Italian Debt Some Good News (Trade), Some Bad News (Italy) Some Good News (Trade), Some Bad News (Italy) Chart 24Italian Banks Also Hold Too Many BTPs Italian Banks Also Hold Too Many BTPs Italian Banks Also Hold Too Many BTPs In 2011, when the Euro Area crisis was raging, Italian 10-year yields hit 7%, or a spread of more than 500 basis points over German bunds. This was equivalent to an implied probability of a euro area breakup of 20% over the subsequent five years (Chart 25).15 What would happen if the populists in Rome followed through with their fiscal plans by September 2018 by including them in the 2019 budget? The bond market would likely begin re-pricing a similar probability of a Euro Area breakup, if not higher. In the process, Italian bonds could lose 20%-to-30% of their value - assuming that German bunds would rally on risk-aversion flows - which would result in a potential 15%-to-25% hit to Italian banks' capital and reserves. With the still large overhang of NPLs, Italian banks would be, for all intents and purposes, insolvent (Chart 26). Chart 25In 2011, Italian Spreads Signal Euro Break-Up In 2011, Italian Spreads Signal Euro Break-Up In 2011, Italian Spreads Signal Euro Break-Up Chart 26Italian Banks Still Carry Loads Of Bad Loans Italian Banks Still Carry Loads Of Bad Loans Italian Banks Still Carry Loads Of Bad Loans The populist government in Rome may not understand this dynamic today, but they will soon enough. This is perhaps why the leadership of both parties has decided to appoint a relatively unknown law professor, Guiseppe Conte, as prime minister. Conte is, according to the Italian press, a moderate and is not a Euroskeptic. It will fall to Conte to try to sell Europe first on as much of the M5S-Lega fiscal stimulus as he can, followed by the Italian public on why the coalition fell far short of its official promises. If the coalition pushes ahead with its promises, and ignores warnings from the bond market, we can see a re-run of the 2015 Greek crisis playing out in Italy. In that unlikely scenario, the ECB would announce publicly that it would no longer support Italian assets if Rome were determined to egregiously depart from the SGP. The populist government in Rome would try to play chicken with the ECB and its Euro Area peers, but the ATM's in the country would stop working, destroying its credibility with voters. In the end, the crisis will cause the populists to mutate into fiscally responsible Europhiles, just as the Euro Area crisis did to Greece's SYRIZA. For investors, this narrative is not a reassuring one. While our conviction level that Italy stays in the Euro Area is high, the scenario we are describing here would still lead to a significant financial crisis centered on the world's seventh-largest bond market. Bottom Line: Over the next several months, we would expect bond market jitters concerning Italy to continue, supporting our bearish view on EUR/USD, which we are currently articulating by being long the DXY (the EUR/USD cross makes up 57.6% of the DXY index). Given global growth headwinds, which are already apparent in the European economic data, and growing Italian risks, the ECB may also turn marginally more dovish for the rest of the year, which would be negative for the euro. Our baseline expectation calls for the new coalition government in Rome to back off from its most populist proposals. We expect that Italy will eventually flirt with overt Euroskepticism, but this would happen after the next recession and quite possibly only after the next election. If we are wrong, and the current populist government does not back off, then we could see a global risk-off due to Italy either later this summer, or in 2019. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see "Joint Statement of the United States and China Regarding Trade Consultations," dated May 19, 2018, available at whitehouse.gov. 2 President Trump later tweeted that the announced deal was substantive and "one of the best things to happen to our farmers in many years!" 3 The most illustrative comment may have come from Dan DiMicco, former steel industry CEO and staunch supporter of President Trump on tariffs, who tweeted "Did president just blink? China and friends appear to be carrying the day." 4 Please see Bob Davis and Lingling Wei, "China Rejects U.S. Target For Narrowing Trade Gap," The Wall Street Journal, dated May 19, 2018, available at wsj.com. 5 Please see "S. 2098 - 115th Congress: Foreign Investment Risk Review Modernization Act Of 2017," dated May 21, 2018, available at www.govtrack.us. 6 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War," dated March 6, 2018, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Weekly Report, "Are You Ready For 'Maximum Pressure?'" dated May 16, 2018; and "Expect Volatility... Of Volatility," dated April 11, 2018, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 12 Please see, The Treaty on the Functioning of the European Union, "Excessive deficit procedure (EDP)," available at eur-lex.europa.eu. 13 Have you been missing the European alphabet soup over the past three years? 14 The EU Commission can also suspend financing from the European Structural and Investment Funds (ESIF), but Italy has never participated in a bailout and thus could not be sanctioned that way. 15 Please see BCA European Investment Strategy Weekly Report, "Threats And Opportunities In The Bond Market," dated April 7, 2016, available at eis.bcaresearch.com.

Highlights The Swan Diagram depicts four different "zones of economic unhappiness," each one corresponding to a case where unemployment and inflation is either too high or too low, and the current account position is either too large or too small. The global economy has made significant progress in moving towards both internal and external balance over the past few years, but shortfalls remain. A number of large economies, including Japan, China, and Italy, continue to need stimulative fiscal policy to prop up domestic demand. In Italy's case, investor unease about the country's fiscal outlook is likely to raise borrowing costs for the government, curb capital inflows into the euro area, and push the ECB in a more dovish direction. All this will weigh on the euro. The U.S. should be tightening fiscal policy at this stage in the cycle. Instead, President Trump has pushed through significant fiscal easing. This is the main reason the 10-year Treasury yield hit a seven-year high this week. An overheated U.S. economy will pave the way for further Fed hikes, which will likely result in a stronger dollar. Rising U.S. rates and a strengthening dollar will hurt emerging markets. Turkey, South Africa, Brazil, and Indonesia are among the most vulnerable. Feature The Dismal Science, Illustrated Last week's report discussed the market consequences of the tug-of-war that policymakers often face in trying to achieve a variety of economic objectives with a limited set of policy instruments.1 In passing, we mentioned that some of these trade-offs can be depicted using the so-called Swan Diagram, named after Australian economist Trevor Swan. This week's report delves further into this topic by estimating where various economies find themselves inside the Swan Diagram, and what this may mean for their currency, equity, and bond markets. True to the reputation of economics as the dismal science, the Swan Diagram depicts four "zones of economic unhappiness" (Chart 1). Each zone represents a different way in which an economy can deviate from "internal balance" (low and stable unemployment) and "external balance" (an optimal current account position). This amounts to saying that an economy can suffer from one of the following: 1) high unemployment and an excessively large current account deficit; 2) high inflation and an excessively large current account surplus; 3) high unemployment and an excessively large current account surplus; and 4) high inflation and an excessively large current account deficit. Box 1 describes the logic behind the diagram. Chart 1Four Zones Of Unhappiness Swan Songs Swan Songs BOX 1 The Logic Behind The Swan Diagram As noted in the main text, the Swan Diagram depicts four different "zones of economic unhappiness," each one corresponding to a case where unemployment and inflation are either too high or too low, and the current account balance is either too large or too small. A rightward movement along the horizontal axis can be construed as an easing of fiscal policy, whereas an upward movement along the vertical axis can be thought of as an easing in monetary policy. All things equal, easier monetary policy is assumed to result in a weaker currency. The internal balance schedule, which corresponds to the ideal state where the economy is at full employment and inflation is stable, is downward sloping because an easing in fiscal policy must be offset by a tightening in monetary policy in order to keep the economy from overheating. The external balance schedule is upward sloping because easier fiscal policy raises aggregate demand, which results in higher imports, and hence a deterioration in the trade balance. A depreciation of the currency via an easing in monetary policy is necessary to bring imports back down. Any point to the right of the internal balance schedule represents too much inflation; any point to the left represents too much unemployment. Likewise, any point to the right of the external balance schedule represents a larger-than-acceptable current account deficit, whereas any point to the left represents an excessively large current account surplus. Note that according to the Swan Diagram, an economy that suffers from high unemployment may still need a weaker currency even if it already has a current account surplus. Intuitively, this is because a depressed economy suppresses imports, leading to a "stronger" current account balance than would otherwise be the case. We use two variables to estimate the degree to which an economy has diverged from internal balance: core inflation and the output gap (Chart 2). If the output gap is negative, the economy is producing less output than it is capable of. If the output gap is positive, the economy is operating beyond full capacity. All things equal, high core inflation and a large and positive output gap is symptomatic of an economy that is showing signs of overheating. Chart 2The Two Dimensions Of Internal Balance Swan Songs Swan Songs When it comes to estimating the extent to which an economy is deviating from external balance, we include both the current account position and the net international investment position (NIIP) in our calculations (Chart 3). The NIIP is the difference between an economy's external assets and its liabilities. If one were to sum all current account balances into the distant past and adjust for valuation effects, one would end up with the net international investment position. If a country has a positive NIIP, it can run a current account deficit over time by running down its accumulated foreign wealth.2 Chart 3The Two Dimensions Of External Balance Swan Songs Swan Songs Policy And Market Outcomes Within The Swan Diagram Chart 4 shows our estimates of where the main developed and emerging markets fall into the Swan Diagram. The top right quadrant depicts economies that need to tighten both monetary and fiscal policy. The bottom left quadrant depicts economies that need to ease both monetary and fiscal policy. The other two quadrants denote cases where either tighter fiscal/looser monetary policy or looser fiscal/tighter monetary policy are appropriate. In order to gauge progress over time, we attach an arrow to each data point. The base of the arrow shows where the economy was five years ago and the tip shows where it is today. Chart 4Policy Prescription Arising From The Swan Diagram Swan Songs Swan Songs From a market perspective, an economy's currency is likely to weaken if it finds itself in one of the two quadrants requiring easier monetary policy. Among developed economies, the best combination for equities in local-currency terms is usually an easier monetary policy and a looser fiscal policy. That is also the configuration that results in the sharpest steepening of the yield curve. Conversely, the worst outcome for developed market stocks in local-currency terms is tighter monetary policy coupled with fiscal austerity. That is also the policy package that is most likely to result in a flatter yield curve. In dollar terms, a stronger local currency will typically boost returns. This is particularly the case in emerging markets, where stock markets are likely to suffer in situations where the home currency is under pressure. A few observations come to mind: The global economy has made significant progress in restoring internal balance over the past five years. That said, negative output gaps remain in nearly half of the countries in our sample. And even in several cases where output gaps have disappeared, a shortfall in inflation suggests the presence of latent slack that official estimates of excess capacity may be missing. External imbalances have also declined over time. Since earth does not trade with Mars, the global current account balance and net international investment position must always be equal to zero. Nevertheless, the absolute value of current account balances, expressed as a share of global GDP, has fallen by half since 2006 (Chart 5). Chart 5Shrinking Global Imbalances Swan Songs Swan Songs The decline in China's current account balance has played a key role in facilitating the rebalancing of demand across the global economy. The current account showed a deficit in Q1 for the first time in 17 years. While several technical factors exacerbated the decline, the current account will probably register a surplus of only 1% of GDP this year, down from a peak of nearly 10% of GDP in 2007. The Chinese economy also appears to be close to internal balance. However, maintaining full employment has come at the cost of rapid credit growth and a massive quasi-public sector deficit, which the IMF estimates currently stands at over 12% of GDP (Chart 6). Thus, one could argue that a somewhat weaker currency and less credit expansion would be in China's best interest. Similar to China, Japan has been able to reach internal balance only through lax fiscal policy (Chart 7). The lesson here is that economies such as China and Japan which have a surfeit of savings - partly reflecting a very low neutral real rate of interest - would probably be better off with cheaper currencies rather than having to rely on artificial means of propping up demand. Chart 6China's 'Secret' Budget Deficit Swan Songs Swan Songs Chart 7The Cost Of Propping Up Demand Swan Songs Swan Songs Germany has overtaken China as the biggest contributor to current account surpluses in the world. Germany's current account surplus now stands at over 8% of GDP, up from a small deficit in 1999, when the euro came into inception. In contrast to China and Japan, Germany is running a fiscal surplus. Solely from its perspective, Germany would benefit from more fiscal stimulus and a stronger euro. The problem, of course, is that a stronger euro would not be in the best interest of most other euro area economies. While external imbalances within the euro area have decreased markedly over the past decade, they have not gone away (Chart 8). Investors also remain wary of fiscal easing in Southern Europe. This week's spike in Italian bond yields - fueled by speculation that a Five-Star/League government will abandon plans for fiscal consolidation - is a timely reminder that the bond vigilantes are far from dead (Chart 9). The Italian government's borrowing costs are likely to rise over the coming months, which will curb capital inflows into the euro area and push the ECB in a more dovish direction. All this will weigh on the common currency. Chart 8The Euro Club: Imbalances Have Been Decreasing The Euro Club: Imbalances Have Been Decreasing The Euro Club: Imbalances Have Been Decreasing Chart 9Uh Oh Spaghettio! Uh Oh Spaghettio! Uh Oh Spaghettio! The U.S. is the opposite of Germany. Unlike Germany, it has a large fiscal deficit and a current account deficit. The Swan Diagram says that the U.S. would benefit from tighter fiscal policy and a weaker dollar. President Trump and the Republicans in Congress have other plans, however. They have pushed through large tax cuts and significant spending increases (Chart 10). This will likely prompt the Fed to raise rates more aggressively than the market is currently discounting, leading to a stronger dollar. Chart 10The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline Rising U.S. rates and a strengthening dollar will hurt emerging markets, particularly those with current account deficits and negative net international investment positions. High levels of external debt could exacerbate any problems (Chart 11). On that basis, Turkey, South Africa, Brazil, and Indonesia are among the most vulnerable. Chart 11External Debt And Debt Servicing Across EM Swan Songs Swan Songs Investment Conclusions Chart 12The U.S. Economy Is Doing ##br##Better Than Its Peers The U.S. Economy Is Doing Better Than Its Peers The U.S. Economy Is Doing Better Than Its Peers The global economy is approaching internal balance, but this may produce some unpleasant side effects. Productivity growth is anaemic and the retirement of baby boomers from the workforce will reduce the pace of labor force growth. In such a setting, potential GDP growth in many countries is likely to remain subpar. If demand growth continues to outstrip supply growth, inflation will rise. Heightened stock market volatility this year has partly been driven by the realization among investors that the Goldilocks environment of above-trend growth and low inflation may not last as long as they had hoped. The U.S. economy has now moved beyond full employment, and bountiful fiscal stimulus could lead to further overheating. This is the main reason the 10-year Treasury yield reached a seven-year high this week. Continued above-trend growth is likely to prompt the Fed to raise rates more than the market expects, which should result in a stronger dollar. The fact that the U.S. economy is outperforming the rest of the world based on economic surprise indices and our leading economic indicators could give the dollar a further lift (Chart 12). A resurgent dollar will help boost competitiveness in developed economies such as Japan and Europe. Emerging markets will also benefit in the long run from cheaper currencies, but if the adjustment happens rapidly, as is often the case, this could exact a short-term toll. For the time being, investors should overweight developed over emerging markets in equity portfolios. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Tinbergen's Ghost," dated May 11, 2018. 2 To keep things simple, we assume that a country's Net International Investment Position (NIIP) shrinks to zero over 50 years. Thus, if a country has a positive NIIP of 50% of GDP, we assume that it should target a current account deficit of 1% of GDP; whereas if it has a negative NIIP of 50% of GDP, it should target a current account surplus of 1% of GDP. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights So long as EM corporate and sovereign bond yields continue to rise, EM share prices will remain in a downtrend. EM corporate earnings growth has peaked while EM corporate profitability remains structurally weak. We recommend re-establishing a short Brazilian bank stocks position, and to continue shorting the BRL versus the U.S. dollar. Put Malaysian stocks on an upgrade watch list as the elections outcome is a long-term positive. However, its financial markets will likely face meaningful headwinds in the months ahead. Stay short MYR versus the U.S. dollar. Feature Monitoring Market Signals Rising U.S. bond yields are wreaking havoc on EM risk assets. Not only are EM currencies plunging, but sovereign and corporate bond yields are also spiking. In fact, EM share prices always decline when EM corporate and sovereign bond yields rise (Chart I-1). There is less correlation between EM equity and U.S. bond yields. Chart I-1EM Share Prices Always Decline When EM Corporate Bond Yields Rise EM Share Prices Always Decline When EM Corporate Bond Yields Rise EM Share Prices Always Decline When EM Corporate Bond Yields Rise The basis: So long as the rise in U.S. bond yields is offset by compressing EM credit spreads, EM corporate bond yields decline and EM share prices rally. But when EM corporate (or sovereign) yields rise, irrespective of whether this is due to rising U.S. Treasury yields or widening EM credit spreads, EM equity prices come under considerable selling pressure. Lately, both EM credit spreads have been widening and U.S. bond yields have been mounting. That said, EM sovereign and corporate credit spreads still remain tight by historical standards, suggesting this asset class is still pricing in little risk. Hence, as EM currencies continue to sell off, EM credit spreads will widen further (Chart I-2). Meanwhile, U.S. government bond yields in our view have more upside: U.S. growth is robust (nominal GDP growth is 5%) and inflationary pressures are heightening. Long-term Treasury yields have risen much less than 2- and 5-year bond yields. Therefore, it is not surprising that a bit of catch-up is now underway. Rising U.S. bond yields will inevitably inflict more damage on EM risk assets. EM share prices are sitting on their 200-day moving average (Chart I-3, top panel). Relative to DM, EM share prices have decisively broken below their 200-day moving average (Chart I-3, bottom panel). Chart I-2Weaker EM Currencies = Wider Credit Spreads Weaker EM Currencies = Wider Credit Spreads Weaker EM Currencies = Wider Credit Spreads Chart I-3A Breakdown In The Making? A Breakdown In The Making? A Breakdown In The Making? In addition to widening EM corporate and sovereign bond yields, there are some other market-based indicators that investors should monitor: The ratio of total return (including carry) of commodities currencies relative to safe-haven currencies1 is hovering around 200-day moving average (Chart I-4). A breakdown in this ratio will herald that the rally in EM risk assets is over and a bear market is underway. Chinese offshore and onshore corporate spreads are widening (Chart I-5). This could be the canary in the proverbial coal mine predicting a nascent downturn in Chinese share prices and China-related plays globally. Chart I-4Watch This Market Indicator bca.ems_wr_2018_05_17_s1_c4 bca.ems_wr_2018_05_17_s1_c4 Chart I-5China' On- And Off-Shore Credit Spreads China' On- And Off-Shore Credit Spreads China' On- And Off-Shore Credit Spreads Finally, investor sentiment on EM equities remains bullish. For example, net long positions of asset managers and leveraged funds in EM stock index futures was still extremely elevated as of May 11th (Chart I-6). Bottom Line: We continue to recommend a bearish stance on EM risk assets in absolute terms and underweighting EM stocks, currencies and credit markets versus their DM counterparts. The list of our recommended fixed-income and currency positions is available on page 19. EM Corporate Profits And Profitability It appears that EM profit growth has topped out, regardless of whether we consider net profits (Chart I-7, top panel), EBITDA or cash earnings2 (Chart I-7, bottom panel). These data are for EM non-financial companies included in the MSCI EM overall equity index. The blue lines are from Datastream's World Scope database, and the dotted lines are from MSCI. Chart I-6Investors Remain Positive On EM Equities Investors Remain Positive On EM Equities Investors Remain Positive On EM Equities Chart I-7EM Corporate Earnings Have Topped Out EM Corporate Earnings Have Topped Out EM Corporate Earnings Have Topped Out The last data points for World Scope's net income and EBITDA are as of the end of March 2018, before EM currencies began to plunge. It seems that net income and EBITDA data from World Scope slightly leads the comparable series from MSCI at turning points. This is due to statistical data compilation processes these sources employ. We examine non-financials' corporate profits because EM financials/banks' earnings are often distorted by provisions and other adjustments.3 As a result, they are a poor timing tool for profit cycle turning points. Our negative viewpoint on EM equities is contingent on a significant slowdown, and probably an outright contraction in EM corporate profits in the next 12 months. We have several observations on the EM profit cycle: China's credit plus fiscal spending as well as broad money impulses nicely lead EM corporate profit cycles, and they presently point to an impending cyclical downturn (Chart I-8). As a top-line slowdown transpires, consistent with our expectations, EM profit margins will shrink. If this indeed occurs, EM non-financial profit margins will roll over at levels on par with previous bottoms (Chart I-9). This holds when using both net income and EBITDA. Chart I-8China's Credit Cycle And ##br##EM Non-Financial Profits bca.ems_wr_2018_05_17_s1_c8 bca.ems_wr_2018_05_17_s1_c8 Chart I-9EM Non-Financials: ##br##Profit Margins Are Still Low EM Non-Financials: Profit Margins Are Still Low EM Non-Financials: Profit Margins Are Still Low The same point is pertinent for return on assets (RoA) of listed EM non-financial companies. Chart I-10 portends two versions of RoA measures using net income and EBITDA. If RoA were to peak now in this cycle - which is our baseline scenario - it would roll over at levels on par with previous bottoms reached in 2002 and 2008. Chart I-10EM Non-Financials: Return On Assets EM Non-Financials: Return On Assets EM Non-Financials: Return On Assets Bottom Line: If our outlook for a considerable slowdown in EM revenue growth this year materializes, EM non-financials' profit margins and RoA will relapse at very low levels - the levels that prevailed at previous cycle lows. Hence, EM corporate profitability remains structurally weak, consistent with our view that there has been little corporate restructuring in recent years. Among EM bourses, we are overweighting Taiwan, Korea, Thailand, India, central Europe, Mexico and Chile. Our underweights are Brazil, Turkey, South Africa, Peru, Malaysia and Indonesia. Brazil: Reinstate Short Bank Stocks Position Brazilian markets have sold off sharply of late. The currency has been the main culprit of the selloff. As we have repeatedly argued in the past, the exchange rate holds the key in Brazil. The country's stocks and local bonds as well as sovereign and corporate credit do well when the currency is strong or stable, and sell off during periods of real depreciation. We expect more downside in the currency, which will lead to escalating selling pressure in equity, credit and probably fixed-income markets. We are therefore reiterating our negative stance on Brazilian financial markets: The pace of real economic activity might be rolling over (Chart I-11A). This is occurring at a time when levels of economic activity are still severely depressed, well below their 2012 peak (Chart I-11B). Chart I-11ABrazil: Signs Of Growth Rollover... Brazil: Signs Of Growth Rollover... Brazil: Signs Of Growth Rollover... Chart I-11B...At Low Levels ...At Low Levels ...At Low Levels Business confidence also remains weak amid uncertainty ahead of this fall's presidential elections, which will continue to inhibit hiring and investment. In the meantime, the export sector, which has led growth since 2015, is facing headwinds. Exports in terms of volumes as well as value (U.S. dollars) have decelerated considerably (Chart I-12). As China's growth slows and commodities prices dwindle in the second half of this year, Brazil exports will contract. Nominal GDP growth has relapsed to its 2015 lows - a period when the country's financial markets were rioting (Chart I-13, top panel). Even though economic activity in real terms has rebounded, inflation has plunged resulting in extremely weak nominal income growth. Chart I-12Brazil: Exports Are Slowing Brazil: Exports Are Slowing Brazil: Exports Are Slowing Chart I-13Brazil Suffers From Low Inflation Brazil Suffers From Low Inflation Brazil Suffers From Low Inflation The GDP deflator and core consumer price inflation have plummeted to 20-year lows (Chart I-13, bottom panel). As a result, interest rates deflated by inflation - i.e., real interest rates - remain extremely high. Fiscal policy is restrained by a rule that limits current year spending growth to last year's inflation rate. This year's fiscal expenditure growth is going to be 3% in nominal terms. Given that inflation is still very depressed, this means that fiscal spending growth will be extremely low next year too. Furthermore, the central bank is unlikely to cut interest rates amid the turmoil in the currency market. The central bank also typically shrinks the banking system's reserves - tightens liquidity - during periods of exchange rate depreciation, as illustrated in Chart I-14. Therefore, the combination of weak nominal growth and high real interest rates will slip Brazil into a debt deflation dynamic - where indebtedness rises as nominal income/revenue growth remains below borrowing costs (Chart I-15). Chart I-14Falling BRL = Tighter Liquidity Falling BRL = Tighter Liquidity Falling BRL = Tighter Liquidity Chart I-15Brazil: An Unsustainable Gap Brazil: An Unsustainable Gap Brazil: An Unsustainable Gap This is especially true for government debt in Brazil. We maintain that the nation's public debt dynamics will remain on an unsustainable trajectory as long as government revenue growth does not exceed the level of nominal interest rates. In turn what Brazil needs are much lower real interest rates and a weaker currency to boost nominal GDP/income growth. This would ultimately stabilize public and private debt dynamics and improve debtors' ability to service debt. However, a sizable exchange rate depreciation, which is all but required to boost nominal growth, will in the interim be bad for financial markets, especially foreign investors. Chart I-16Brazil: Markets Have Hit Critical Levels Brazil: Markets Have Hit Critical Levels Brazil: Markets Have Hit Critical Levels Finally, there are a number of technical patterns that suggest a major top has been reached in Brazilian financial markets, and that downside from current levels will likely be significant. In particular, Brazil share prices in U.S. dollar terms have failed to break above their multi-year moving average, which has served as both a support and resistance in the past (Chart I-16, top panel). Likewise the real's total return including carry versus the dollar has been unable to break above its previous high. This, combined with the head-and-shoulder pattern of BRL (Chart I-16, bottom panel), suggests the real might be entering a bear market. Bank stocks are a large part of the equity index, and they have lately been under severe selling pressure. We are reinstating our short position in Brazilian banks. We closed this position last week when we removed our short Brazilian banks / long Argentine banks equity recommendation due to the selloff in Argentine banks.4 The currency depreciation is forcing local interest rates to rise, which is causing liquidity to tighten in Brazil. High borrowing costs in real terms are inhibiting credit demand. In particular, banks' aggregate loans to companies and households in both nominal and real terms are still shrinking. Although consumer loans are rising, the contraction in corporate lending has more than offset the recovery in household credit. Further, Chart I-17 demonstrates that the relapse in nominal GDP growth (shown inverted in the chart) heralds a rise in the rate of change of non-performing loans (NPL) as well as their provisions. As provisions begin to rise, banks' earnings will take a hit. Chart I-18 illustrates that banks have been reducing NPL provisions to boost profits and a rate of change in provisions has been a decisive factor driving bank equity prices in recent years. Chart I-17Slower Nominal Growth = Higher Provisions & NPLs Slower Nominal Growth = Higher Provisions & NPLs Slower Nominal Growth = Higher Provisions & NPLs Chart I-18NPL Provisions And Bank Stocks NPL Provisions And Bank Stocks NPL Provisions And Bank Stocks Bottom Line: Re-establish a short bank stocks position, and continue to short the BRL versus the U.S. dollar and MXN. Remain underweight Brazilian stocks as well as sovereign and corporate credit within respective EM portfolios. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Analyst andrijav@bcaresearch.com Malaysia: Short-Term Challenges, Long-Term Opportunities Chart II-1Malaysia: Banks Have Been ##br##'Cooking Their Books' Malaysia: Banks Have Been 'Cooking Their Books' Malaysia: Banks Have Been 'Cooking Their Books' The election victory by the Malaysian opposition coalition, Pakatan Harapan, offers a major opportunity to reverse the significant deterioration in Malaysia's governance and, hence, poor productivity growth that has occurred under the former Prime Minister Najib Razak. The political change is therefore a bullish development for Malaysia in the long-run. As such, we are placing the Malaysian bourse on an upgrade watch list. Yet the performance of Malaysia's financial markets in the coming months will remain challenged by vulnerabilities emanating from the country's weak banking system and potential negative forces that will subdue its external sector. These factors will slow growth in the months ahead, hurt the ringgit and exert downward pressures on Malaysian share prices: The health of Malaysian commercial banks is questionable. Since the economic downturn started in 2014, banks have grossly underreported their non-performing loans (NPLs) (Chart II-1). Additionally, they have been lowering NPL provisions to artificially boost their earnings in the past year or so (Chart II-1, bottom panel). Hence, banks' reported earnings are inflated. The former government tolerated these actions to ensure "economic and financial stability". Yet this sense of false "stability" will reverse under the new government. The latter headed by incoming Prime Minister Mahathir Mohamad will likely attempt to change leadership of state institutions and SOEs and also clean the financial system in order to improve its transparency and soundness. We suspect as a part of this restructuring, the authorities and the central bank will begin exerting pressure on commercial banks to recognize and provision for NPLs. It is always new leadership within financial regulatory institutions or banks that opt to open the books and recognize NPLs. Higher provisioning will cause bank earnings to slump considerably, jeopardizing their share prices (Chart II-2). Malaysian banks account for 34% of the MSCI Malaysia index and 40% of its total earnings. Finally, bank stocks are not cheap with a price-to-book value ratio of 1.6 and a trailing P/E ratio at 15. On the external front, rising U.S. bond yields will cause the U.S. dollar to strengthen versus the ringgit, which will not bode well for Malaysian financial assets. Chart II-3 shows that spreads of Malaysian local government bond yields over U.S. Treasurys have reached new cyclical lows. As such, local yields offer little caution for foreign bond investors. Given that around 29% of domestic currency bonds are owned by foreigners, the ringgit depreciation will likely generate selling pressure in the local bond market. Chart II-2Malaysia: Bank Stocks Are At Risk Malaysia: Bank Stocks Are At Risk Malaysia: Bank Stocks Are At Risk Chart II-3Malaysia: Local Bond Yields ##br##Spreads Over U.S. Treasurys Malaysia: Local Bond Yields Spreads Over U.S. Treasurys Malaysia: Local Bond Yields Spreads Over U.S. Treasurys Further, the outlook for Malaysia's trade balance is negative due to potential cracks in the semiconductors industry and in commodities. Semiconductors account for 15% of Malaysia's exports while commodities account for around a quarter of its exports; with energy making up 14% exports and palm oil accounting for 8%. Malaysian exports of semiconductors are likely peaking. Chart II-4 shows that the average of Taiwan's and Korea's semiconductors shipment-to-inventory ratios is pointing to a deceleration in Malaysia's semiconductor exports. Taiwan and Korea are major semiconductor manufacturing hubs that ship some of their chips to Malaysia for testing and assembly. On this note, Chart II-5 shows that Taiwanese semiconductor exports to Malaysia are decelerating. This is confirming a forthcoming slump in Malaysia's semiconductor exports. And finally, various semiconductor prices are beginning to decline. Chart II-4Malaysia's Semiconductor Industry At Risk Malaysia's Semiconductor Industry At Risk Malaysia's Semiconductor Industry At Risk Chart II-5Malaysia's Semi Exports To Slow Malaysia's Semi Exports To Slow Malaysia's Semi Exports To Slow As for commodities, palm oil prices have been weak (Chart II-6). The industry is facing significant headwinds due to import restrictions from India and the EU. Besides, Malaysia is probably bound to lose palm oil market share to Indonesia. China and Indonesia signed an agreement last week with the former agreeing to purchase more of this commodity from Indonesia. Chart II-6Unusual Divergence Between ##br##Oil And Palm Oil Prices Unusual Divergence Between Oil And Palm Oil Prices Unusual Divergence Between Oil And Palm Oil Prices Meanwhile, as our colleagues from the Geopolitical Strategy service argued this week, the incoming Prime Minister Mahathir Mohamad plans to review some Chinese investments in Malaysia that were undertaken by his predecessor.5 Doing so could induce China to retaliate by limiting Malaysian palm oil imports and reducing imports of other Malaysian products as well. Around 13% of Malaysian exports are shipped to China. A final word on oil is warranted. The surge in oil prices is unambiguously bullish for this economy. However, it is important to realize that this price surge is driven by escalating geopolitical risks and mushrooming traders' net long positions in crude rather than global demand. The former might persist for some time as U.S.-Iran hostilities linger. Continued strength in the dollar, however, could trigger a considerable decline in oil prices as traders head for the exits. On the whole, Malaysia's current account balance will deteriorate which will weigh on the Malaysian currency and hurt U.S. dollar returns of Malaysian financial assets. Faced with currency depreciation, the Malaysian central bank is unlikely to defend the currency by hiking interest rates or selling its foreign exchange reserves (doing so would also tighten banking system liquidity). The Malaysian economy cannot bear much higher interest rates as private-sector debt-to-GDP stands at a whopping 134%. In the meantime, currency depreciation will inflict pain on debtors with foreign currency liabilities. Malaysian companies are amongst the largest foreign currency borrowers in the developing economies univers. In short, the ringgit will come under material selling pressure like many other EM currencies and this will hurt the economy. This will also weigh on the equity index - which is dominated by banks. Bottom Line: While we recommend investors to maintain an underweight position in Malaysian equities for now, we are placing this bourse on upgrade watch list given the positive election results. We are waiting for the following to occur before upgrading Malaysia's stock market: (1) Commodities prices to fall and the semiconductor cycle to slow and (2) Malaysian commercial banks to recognize more NPLs and increase provisioning for bad loans. Meanwhile, currency traders should stay short MYR versus the U.S. dollar and equity investors should remain short banks. Finally, for fixed-income traders we continue to recommend long Thai / short Malaysia local bonds. Credit portfolios should underweight this sovereign credit for now. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 This index is constructed using an equal-weighted index of six total return commodities currencies such as BRL, CLP, ZAR, AUD, NZD and CAD divided by the total returns of the safe-haven currencies: JPY and CHF. 2 Cash earnings are defined and calculated by MSCI as earnings per share including depreciation and amortization as reported by the company - i.e. depreciation and amortization expenses are added to earnings in order to calculate cash earnings. 3 For example, please refer to discussion on Brazilian and Malaysian banks on pages 7 and 13, respectively. 4 Please refer to Emerging Markets Strategy Weekly Report "EM: A Correction Or Bear Market?" dated May 10, 2018, link is available on page 20. 5 Pleas see Geopolitical Strategy Weekly Report "Are You Ready For "Maximum Pressure?" dated May 16, 2018, available on gps.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Stay tactically long the SEK. Our preferred expression is long SEK/GBP. Stay tactically short the NOK. Our preferred expression is long AUD/NOK. Take profits in the underweight to Poland... ...and open a tactical countertrend position: long Poland's Warsaw General Index, short Italy's MIB. A coalition of populists governing Italy might ruffle some feathers in Brussels, but the main risk appears to be contained. Both The League and 5 Star Movement have dropped calls for a referendum on Italy's membership of the monetary union. Feature Italy And The U.K. Compete For Political Risk The European political lens is once again focussed on Italy as the two anti-establishment parties - The League and 5 Star Movement - negotiate to form a government. A coalition of populists governing Italy might ruffle some feathers in Brussels, but the main risk appears to be contained. Both parties have dropped calls for a referendum on Italy's membership of the monetary union, and have instead turned their fire on the EU's fiscal rules, specifically the 3 per cent limit on budget deficits. Chart of the WeekThe SEK Is Due A Tactical Rebound The SEK Is Due A Tactical Rebound The SEK Is Due A Tactical Rebound The populist demand for some fiscal relaxation is actually smart economics. When the private sector is paying down debt - as it is in Italy - private sector demand shrinks. To prevent a recession, the government must step in to borrow and spend the paid-down debt. And what seems to be fiscal largesse does not lead to crowding out, inflation, or surging interest rates. This means that as long as Italian populists correctly push back on the EU's draconian fiscal rules rather than the monetary union per se, the market is right to regard Italian politics as a drama, rather than an existential risk to the euro (Chart I-2). Chart I-2The Market Remains Unconcerned ##br##About Euro Break-Up Risk The Market Remains Unconcerned About Euro Break-Up Risk The Market Remains Unconcerned About Euro Break-Up Risk Maybe the European political lens should be focussed instead on Britain. The Conservative party remains as bitterly divided as ever on its vision for the U.K.'s future trading and customs relationships with the EU and the rest of the world. Paralysed and frightened by this division, Theresa May is delaying the legislative passage of three crucial bills - the EU Withdrawal Bill, the Trade Bill, and the Customs Bill. When these bills eventually reach a vote in the House of Commons later this year, any one of them could result in a humiliating defeat for May - and, quite likely, resignations from the government. Meanwhile, as the government kicks the issue into the long grass, firms are holding fire on long-term spending commitments in the U.K. and rechannelling the investment to elsewhere in Europe. Buy SEKs, Avoid NOKs For all the recent swings in the euro versus the dollar and pound, the trade-weighted euro has remained a paragon of relative stability (Chart I-3). This is because the moves versus the dollar and pound have largely cancelled out (Chart I-4). Earlier this year, euro weakness versus the pound coincided with strength versus the dollar; more recently, euro weakness versus the dollar has coincided with strength versus the pound. Chart I-3The Trade-Weighted Euro Has ##br##Remained Relatively Stable... The Trade-Weighted Euro Has Remained Relatively Stable... The Trade-Weighted Euro Has Remained Relatively Stable... Chart I-4...Because Moves Versus The Dollar And The ##br##Pound Have Largely Cancelled Out ...Because Moves Versus The Dollar And The Pound Have Largely Cancelled Out ...Because Moves Versus The Dollar And The Pound Have Largely Cancelled Out Interestingly, the driver of the trade-weighted euro remains the same as it has been for the past fifteen years - it is simply the euro area's long bond yield shortfall versus the U.K. and U.S. (Chart I-5). With the ECB already at the realistic limit of ultra-loose policy, the path for policy rate expectations cannot go meaningfully lower. This means that the trade-weighted euro has some long-term support given that the BoE and/or the Fed have tightening expectations that could be priced out, while the ECB effectively doesn't. Chart I-5The Trade Weighted Euro Is A Function Of The Euro Area's ##br##Long Bond Yield Shortfall Versus The U.K. And U.S. The Trade Weighted Euro Is A Function Of The Euro Area's Long Bond Yield Shortfall Versus The U.K. And U.S. The Trade Weighted Euro Is A Function Of The Euro Area's Long Bond Yield Shortfall Versus The U.K. And U.S. Put another way, for the trade-weighted euro to drift significantly lower, relative surprises in the economic, financial and political news have to be significantly worse in the euro area than in both the U.K. and the U.S. We think this configuration is unlikely. Nevertheless, the more interesting tactical opportunities lie elsewhere: the Swedish krona and the Norwegian krone. Recent tweaks to monetary policy frameworks in Sweden and Norway are responsible, at least partly, for technically exaggerated moves in their currencies which are likely to reverse. In the case of Sweden, the inflation target is unchanged at 2 per cent but the Riksbank introduced a variation band of 1-3 per cent, because "monetary policy is not able to steer inflation in detail." Given that Sweden's inflation rate is now close to 2 per cent, the market interpreted this tweak as very dovish - because it permits the continuation of ultra-accommodative policy. The upshot was that the SEK sold off. But our tried and tested indicator of excessive groupthink suggests that the currency may have overreacted (Chart of the Week). Hence, the tactical opportunity is to stay long the SEK, and our preferred expression is long SEK/GBP. In the case of Norway, a Royal Decree on Monetary Policy lowered the Norges Bank inflation target from 2.5 to 2.0 per cent. This followed years of failure to achieve the higher target. The market interpreted this change as hawkish, as it created the scope for tighter - or at least, less loose - policy than was previously expected. The upshot was that the NOK rallied. But again, the market reaction shows evidence of a technical overreaction (Chart I-6). Hence, the tactical opportunity is to stay short the NOK, and our preferred expression is long AUD/NOK. Chart I-6Our Preferred Expression Of Short NOK Is Versus The AUD Our Preferred Expression Of Short NOK Is Versus The AUD Our Preferred Expression Of Short NOK Is Versus The AUD Financial Markets Are Not Complicated, But They Are Complex The words 'complicated' and 'complex' appear to be interchangeable, but their meanings are quite distinct. The distinction is important because financial markets are not complicated, but they are complex. Something that is complicated is the sum of a large number of separate parts or processes. For example, making a car is complicated. But predicting the performance of financial markets over the medium term - say, a year or longer - is uncomplicated. The philosophy of Investment Reductionism teaches us that investment strategy is not made up of many separate parts or processes. It reduces to just three things: Predicting the evolution of the global economy. Predicting central bank reaction functions. Predicting tail-events: political, economic and financial. For example, this week's lesson in Investment Reductionism is to illustrate that the medium term decision to allocate between emerging market equities and the Eurostoxx600 largely reduces to the prospects for global metal prices (Chart I-7). Chart I-7EM Versus Eurostoxx600 = Metal Prices EM Versus Eurostoxx600 = Metal Prices EM Versus Eurostoxx600 = Metal Prices By contrast, something that is complex is not the sum of its parts, because the parts interact in unpredictable ways. Complexity characterizes the behaviour of financial markets over the short term - say, up to around six months. Therefore, the best way to model the behaviour of any investment over the very short term is to think of it as a complex adaptive system. A complex adaptive system is a system with a large number of mutually interacting agents, which can learn from their interactions and thereby adapt their subsequent behaviour. Examples include traffic flows, crowds in stadiums, and of course financial markets. A crucial property of all such systems is they possess an endogenous tipping point of instability, at which the behaviour undergoes a 'phase-shift'. This is the essence of how we identify likely short-term trend reversals in any investment such as the SEK and the NOK. This week's final trade recommendation uses this idea once again. Poland's equity market has underperformed recently in line with the general underperformance of the emerging market basket - and our underweight in the Warsaw General Index versus the Eurostoxx600 is handsomely in profit. However, looking at the market as a complex adaptive system, the extent of Poland's underperformance is overdone (Chart I-8). Chart I-8The Extent Of Poland's Underperformance Is Overdone The Extent Of Poland's Underperformance Is Overdone The Extent Of Poland's Underperformance Is Overdone Hence we are taking profit on our underweight in Poland and putting on a short-term countertrend position: long Poland's Warsaw General Index, short Italy's MIB. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* As discussed in the main body of the report, this week's new trade recommendation is a pair-trade: long Poland's Warsaw General Index, short Italy's MIB. The profit target is 5% with a symmetrical stop loss. Our preferred expression of long SEK is versus the GBP which is already in profit since initiation. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 Long SEK Long SEK The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Copper has been stuck in the $2.90-$3.30/lb trading range since late August, 2017. Offsetting supply- and demand-side effects are keeping us neutral: Concerns over restrictions on China's scrap imports and possible industrial action in Chile, along with continued worries over a slow-down in China will keep prices range-bound until we see a fundamental catalyst on one side of the market. Our updated balances model shows a physical surplus in 2018, followed by a deficit in 2019. Energy: Overweight. Rising crude oil prices and steepening backwardation in Brent and WTI, to a lesser extent, will be supportive of our energy-heavy S&P GSCI recommendation, as we expected. The position is up 17.1% since it was initiated on December 7, 2017. Base Metals: Neutral. Our updated balances model points to a physical surplus in the copper market by year end (see below). Precious Metals: Neutral. A stronger USD and higher real rates are pressuring precious metals lower. Our long gold and silver positions are down 1.8% and 0.8%, respectively, over the past week. Ags/Softs: Underweight. The USDA expects Brazil to surpass the U.S. as the world's largest soybean producer in the upcoming crop year, for the first time in history. Nevertheless - and despite U.S.-Sino trade tensions - the report also predicts record U.S. exports of the bean in the 2018/19 crop year. Feature Chart of the WeekStuck In A Trading Range Stuck In A Trading Range Stuck In A Trading Range Copper on the COMEX averaged $3.12/lb since the beginning of the year - slightly higher than our $3.10/lb expectation published in January (Chart of the Week).1 Fears of a slowdown in China -suggested by weaker readings of the Li Keqiang Index - as well as a stronger dollar have been headwinds to further upside. On the flip side, upcoming contract renegotiations at Escondida, China's ongoing environmental efforts, and global PMI readings above the 50 boom-bust line have kept bulls interested in the red metal. Our estimate of the refined copper balance is for a physical surplus this year (Chart 2). Strong demand from Asia, and to a lesser extent North America, will support a moderate pickup in consumption this year. This will be met by greater refined output - a ramp in primary refined output will more than offset the expected decline in secondary production (i.e. refined copper produced from the scrap metal). Upside risk to this outlook comes from supply-side disruptions at the ore mines - particularly in Chile - and at refined levels. The biggest downside risk remains China's growth trajectory: If policymakers are unable to manage the transition to sustainable, consumer- and services-led growth in the market that accounts for 50% of global demand, prices will fall. Longer term, our models point to a physical refined-copper deficit on the back of stronger consumption growth vis-à-vis output growth. The key to a breakout - up or down -lies in the evolution of financial and fundamental factors. On the financial side, the USD has been edging higher since mid-April. Absent an upward copper price catalyst, a continuation in the USD's path will prevent the metal from booking strong gains. On the fundamental side, we expect copper markets to be in surplus this year. However, downside risks from a greater-than-expected slowdown in China could easily tilt the balance. Ongoing Chinese tightening of scrap copper imports will resist sharp moves to the downside. Chart 2Updated Balances: Expect A Refined Copper Surplus This Year Copper: A Break Out, Or A Break Down? Copper: A Break Out, Or A Break Down? Any of these factors may emerge as a catalyst for a breakout or a breakdown in the copper market this year. Yet for now our model is pointing to a physical surplus and we are comfortable with our neutral outlook. We expect near term prices to trade in the $2.90 to $3.15/lb range. Nevertheless, the evolution of these known unknowns may tilt our balances to either side. A break lower would be reason to sell, while a break above the upper bound would support an outlook for higher prices. Geopolitical Risks On The Horizon Political tensions are spilling into the copper market, threatening supplies, and bringing with them the prospect of higher prices. This is not without reason: Supply-side shocks to mined output have historically been a source of upside risk to prices. Foremost among the potential shocks is labor action at the Escondida mine in Chile, the world's largest. June 4 is the deadline for contract renegotiations to begin. These talks will follow last year's contract renewal efforts, which led to a 44-day strike, a 63% y/y decline in the mine's copper output in 1Q17, and eventually, an 18-month contract extension. As the world's largest mine, Escondida accounts for 1.27mm MT out of the 22mm MT of world capacity, and contributes ~5% of global supply. Efforts to lock in an advance deal ended late last month to no avail.2 Nevertheless, Escondida's production in 1Q18 has been exceptional - more than triple the same period last year. Furthermore, copper was among the metals that caught a bid last month amid fears of further rounds of U.S. sanctions on Russian companies. Russian oligarch Vladimir Potanin has a 33% stake in Norilsk, one of the world's largest copper mines - accounting for 388k MT of output last year. While sanctions against Potanin have not been announced, he was named in the U.S. Section 241 Foreign Asset Control filing, suggesting that he may be targeted in future sanctions, putting Norilsk's future at risk, à la Rusal. While fears of U.S. sanctions on Russia appear to have eased, the risk of such action on global copper supply was a tailwind to the copper market last month. In addition to the upside from these potential supply-side shocks, ongoing environmental reform efforts in China remain a theme in metals markets globally. In the case of the red metal, restrictions on Chinese access to "foreign waste" will curtail scrap shipments going forward. World secondary refined production from scrap accounts for almost 20% of global refined copper. China produces more than half of the world's secondary refined copper. This means that China's secondary output makes up 10% of all world refined copper production (Chart 3). Chart 3China's Secondary Output Important To Refined Copper Supply... Copper: A Break Out, Or A Break Down? Copper: A Break Out, Or A Break Down? As such, scrap copper imports play an important role in China - they act as a buffer against high prices, rising when prices lift, and dwindling in times of low prices. Among the measures implemented to gain more control over scrap markets in China are the following: 1. For the period between May 4 and June 4, the Chinese customs inspection firm - China Certification and Inspection Group North America - announced it would suspend the issuance of export certificates for scrap material shipments, including scrap copper.3 The aim of the suspension is to inspect the waste material and ensure it complies with China's new environmental regulations. In general China imports 15% of its copper scrap from the U.S. - purchasing more than 500k MT of scrap copper from the U.S. last year (Chart 4). Since the U.S. is China's top supplier of scrap copper, this specific initiative and China's ongoing efforts for environmental reform could be consequential to secondary refined output. 2. This move comes in addition to ongoing restrictions on imported solid waste. Starting in 2019, Category 7 scrap copper imports - i.e., solid waste, which account for ~20% of all scrap - will be banned.4 Since the beginning of the year, import licenses were granted only to scrap end-users and, since March 1, hazardous impurity levels in scrap copper imports were limited to 1% by weight. A Metal Bulletin report late last month estimated import quotas for scrap copper were 84% lower so far this year.5 As such, Jiangxi Copper - the largest copper refinery in the world - estimates that these restrictions will culminate in a 500k MT decline in scrap copper imports this year. In fact, scrap copper imports have already been falling significantly, with Chinese purchases down 40% y/y in 1Q18. The near-term implication of these restrictions on China's scrap copper imports would be to raise imports of refined copper, or of ores and concentrates. Scrap copper displaced from these restrictions will likely be diverted to other countries where they will be refined and shipped to China for final consumption. While an eventual move by Chinese companies to Southeast Asian countries in a bid to set up processing facilities there would eliminate the long term price impact, there may be some upside to prices during the transition phase. As such, China's imports of copper ores and concentrates, and of the refined metal, have been strong. During the first four months of the year, imports of ores and concentrates were up almost 10% y/y, while inflows of the refined metal are 15% above last year's levels (Chart 5). Chart 4...But Scrap Imports Are Restrained ...But Scrap Imports Are Restrained ...But Scrap Imports Are Restrained Chart 5China's Copper Imports Still Going Strong China's Copper Imports Still Going Strong China's Copper Imports Still Going Strong As these policy measures have been known to the public for quite some time, we suspect they are already priced into markets, and do not foresee further upside risk arising from this source. Nevertheless, their impact will remain significant, given that limited ability to produce scrap copper, which will restrict supply, will keep the market resistant to significant downward price pressure. Moderate Consumption Growth This Year Our updated balances model does not include any significant changes to our demand outlook from our January estimate. This is consistent with our consumption estimates for other industrial commodities that share strong co-movement properties with copper demand. We expect lower global consumption and growth than what's being projected by the International Copper Study Group (ICSG) and the Australian Department of Industry, Innovation and Science in its Resources & Energy Quarterly report. While China will remain the world's major copper consumer, a slowdown in its economy remains the foremost demand-side concern for us this year. DM economies appear to be comfortably perched at an above trend level. Fiscal stimulus in the U.S. and solid growth figures from the rest of the world will help keep demand in DM economies supported (Table 1). Table 1Strong Global Growth Will Support##BR##Copper Consumption Copper: A Break Out, Or A Break Down? Copper: A Break Out, Or A Break Down? However, Chinese demand growth remains vulnerable to a slowdown. As we outlined in our March 29 Weekly Report, while there are fundamental reasons to be concerned about Chinese growth going forward, there are no signs of alarm just yet.6 Manufacturing PMIs have come down in recent months, but they remain above the 50 boom-bust mark. That said, it is worth pointing out that the most significant indicator of the Chinese economy we track - the Li Keqiang index -has also been slowing as of late. We continue to expect the government to be able to pull off the managed slowdown it has embarked on. However, we are alert for any sign the Chinese economy is sharply decelerating, as it would lead us to revise our consumption forecast. A Surplus...At Least This Year Our demand and supply expectations lead us to call for a surplus of refined copper this year. Further out, we expect consumption growth to outpace production next year. The upward adjustment in our balance to a surplus since January is a result of upside revisions to supply amid a stable consumption growth path (Chart 6). Copper inventories remain elevated (Chart 7). While current levels of inventories are not a predictor of future price movements, they do indicate there is sufficient cushion in the market to withstand near-term supply disruptions. Chart 6Solid Production Path Amid Stable Consumption;##BR##Surplus Will Emerge Solid Production Path Amid Stable Consumption; Surplus Will Emerge Solid Production Path Amid Stable Consumption; Surplus Will Emerge Chart 7Inventories Will Cushion##BR##Against Supply Shocks Inventories Will Cushion Against Supply Shocks Inventories Will Cushion Against Supply Shocks Of course, along with other commodity markets, copper prices remain vulnerable to USD movements. In fact, the red metal's performance over the past month is especially impressive given the relative strength in the USD as of late. BCA expects the USD will appreciate in the coming months. Absent fundamental changes - i.e. supply- or demand-side shocks - copper markets will likely be restrained from staging a break-out rally by a stronger USD going forward. Bottom Line: Fundamental and financial risks to the copper market are slightly skewed to the downside this year. We expect a physical surplus to emerge by year-end, given slightly higher output and slower demand growth as China slows. On the downside, prices are vulnerable to a stronger USD and muted demand growth in China. On the upside, they are supported by supply-side concerns, chiefly at the Escondida mine and due to restrictions on China's imports of scrap copper. Stay neutral the red metal. Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see p.11 of BCA Research's Commodity & Energy Strategy Weekly Report titled "Stronger USD, Slower China Growth Threaten Copper," dated January 25, 2018, available at ces.bcaresearch.com. 2 Please see "Union at BHP's Escondida copper mine in Chile says no advance deal likely," dated April 24, 2018, available at reuters.com. 3 Please see "China to suspend checks on U.S. scrap metal shipments, halting imports," dated May 4, 2018, available at reuters.com. 4 Please see "China scrap metal firms face pressure from import curbs: official", dated April 26, 2018, available at reuters.com and BCA Research's Commodity & Energy Strategy Weekly Report titled "Copper Getting Out Ahead Of Fundamentals, Correction Likely," dated August 24, 2017, available at ces.bcaresearch.com. 5 Please see "FOCUS: China's copper scrap import quotas down 84% so far this year," dated April 23, 2018, available at metalbulletin.com. 6 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "China's Managed Slowdown Will Dampen Base Metals Demand," dated March 29, 2018, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Insert table images here Trades Closed in Summary of Trades Closed in

Highlights Divergence between U.S. and global economic outcomes is bullish for the U.S. dollar and bad for EM assets; Maximum Pressure worked with North Korea, but it may not with Iran, putting upside pressure on oil; An election is the only way to resolve split over Brexit and the new anti-establishment coalition in Italy is not market positive; Historic election outcome in Malaysia and the prospect of a weakened Erdogan favors Malaysian over Turkish assets; Reinitiate long Russian vs EM equities in light of higher oil price and reopen French versus German industrials as reforms continue unimpeded in France. Feature "Speak softly and carry a big stick; you will go far." - Theodore Roosevelt, in a letter to Henry L. Sprague, January 26, 1900. May started with a geopolitical bang. On May 4, a high-profile U.S. trade delegation to Beijing returned home after two days of failed negotiations. Instead of bridging the gap between the two superpowers, the delegation doubled it.1 On May 8, President Trump put his Maximum Pressure doctrine - honed against Pyongyang - into action against Iran, announcing that the U.S. would withdraw from the Obama administration's Iran nuclear deal - also referred to as the Joint Comprehensive Plan of Action (JCPOA). These geopolitical headlines were good for the U.S. dollar, bad for Treasuries, and generally miserable for emerging market (EM) assets (Chart 1).2 We have expected these very market moves since the beginning of the year, recommending that clients go long the DXY on January 31 and go short EM equities vs. DM on March 6.3 Chart 1EM Breakdown? EM Breakdown? EM Breakdown? Chart 2U.S. Dollar Rallies When Global Trade Slows U.S. Dollar Rallies When Global Trade Slows U.S. Dollar Rallies When Global Trade Slows Geopolitical risks, however, are merely the accelerant of an ongoing process of global growth redistribution. A key theme for BCA's Geopolitical Strategy this year has been the divergent ramifications of populist stimulus in the U.S. and structural reforms in China. This political divergence in economic outcomes has reduced growth in the latter and accelerated it in the former, a bullish environment for the U.S. dollar (Chart 2).4 Data is starting to support this narrative: Chart 3Global Growth On A Knife Edge Global Growth On A Knife Edge Global Growth On A Knife Edge Chart 4German Data... German Data... German Data... The BCA OECD LEI has stalled, but the diffusion index shows a clear deterioration (Chart 3); German trade is showing signs of weakness, as is industrial production and IFO business confidence (Chart 4); Another bellwether of global trade, South Korea, is showing a rapid deterioration in exports (Chart 5); Global economic surprise index is now in negative territory (Chart 6). Chart 5...And South Korean, Foreshadows Risks ...And South Korean, Foreshadows Risks ...And South Korean, Foreshadows Risks Chart 6Unexpected Slowdown In Global Growth Unexpected Slowdown In Global Growth Unexpected Slowdown In Global Growth Meanwhile, on the U.S. side of the ledger, wage pressures are rising as the number of unemployed workers and job openings converge (Chart 7). Given the additional tailwinds of fiscal stimulus, which we see no real chance of being reversed either before or after the midterm election, the U.S. economy is likely to continue to surprise to the upside relative to the rest of the world, a bullish outcome for the U.S. dollar (Chart 8). In this environment of U.S. outperformance and global growth underperformance, EM assets are likely to suffer. Chart 7U.S. Labor Market Is Tightening U.S. Labor Market Is Tightening U.S. Labor Market Is Tightening Chart 8U.S. Outperformance Should Be Bullish USD U.S. Outperformance Should Be Bullish USD U.S. Outperformance Should Be Bullish USD Additionally, it does not help that geopolitical risks will weigh on confidence and will buoy demand for safe haven assets, such as the U.S. dollar. First, U.S.-China trade relations will continue to dominate the news flow this summer. President Trump's positive tweets on the smartphone giant ZTE aside, the U.S. and China have not reached a substantive agreement and upcoming deadlines on trade-related matters remain a risk (Table 1). Table 1Protectionism: Upcoming Dates To Watch Are You Ready For "Maximum Pressure?" Are You Ready For "Maximum Pressure?" Second, President Trump's application of Maximum Pressure on Iran will cause further volatility and upside pressure on the oil markets. The media was caught by surprise by the president's announcement that he is withdrawing the U.S. from the JCPOA, which is puzzling given that the May 12 expiration of the sanctions waiver was well-telegraphed (Chart 9). It is also surprising given that President Trump signaled his pivot towards an aggressive foreign policy by appointing John Bolton and Mike Pompeo - two adherents of a hawkish foreign policy - to replace more middle-of-the-road policymakers. It was these personnel changes, combined with the U.S. president's lack of constraints on foreign policy, that inspired us to include Iran as the premier geopolitical risk for 2018.5 Chart 9Iran: Nobody Was Paying Attention! Iran: Nobody Was Paying Attention! Iran: Nobody Was Paying Attention! Iran-U.S. Tensions: Maximum Pressure Is Real Last year, BCA's Geopolitical Strategy correctly forecast that President Trump's Maximum Pressure doctrine would work against North Korea. First, we noted that President Trump reestablished America's "credible threat," a crucial factor in any negotiation.6 Without credible threats, it is impossible to cajole one's rival into shifting away from the status quo. The trick with North Korea, for each administration that preceded President Trump, was that it was difficult to establish such a credible threat given Pyongyang's ability to retaliate through conventional artillery against South Korean population centers. President Trump swept this concern aside by appearing unconcerned with what were to befall South Korean civilians or the Korean-U.S. alliance. Second, we noted in a detailed military analysis that North Korean retaliation - apart from the aforementioned conventional capacity - was paltry.7 President Trump called Kim Jong-un's bluff about targeting Guam with ballistic missiles and kept up Maximum Pressure throughout a summer full of rhetorical bluster. As tensions rose, China blinked first, enforcing President Trump's demand for tighter sanctions. China did not want the U.S. to attack North Korea or to use the North Korean threat as a reason to build up its military assets in the region. The collapse of North Korean exports to China ultimately starved the regime of hard cash and, in conjunction with U.S. military and rhetorical pressure, forced Kim Jong-un to back off (Chart 10). In essence, President Trump's doctrine is a modification of President Theodore Roosevelt's maxim. Instead of "talking softly," President Trump recommends "tweeting aggressively".8 It is important to recount the North Korean experience for several reasons: Maximum Pressure worked with North Korea: It is an objective fact that President Trump was correct in using Maximum Pressure on North Korea. Our analysis last year carefully detailed why it would be a success. However, we also specifically outlined why it would work with North Korea. Particularly relevant was Pyongyang's inability to counter American economic pressure and rhetoric with material leverage. Kim Jong-un's only objective capability is to launch a massive artillery attack against civilians in Seoul. Given his preference not to engage in a full-out war against South Korea and the U.S., he balked and folded. Trump is tripling-down on what works: President Trump, as all presidents before him, is learning on the job. The North Korean experience has convinced him that his Maximum Pressure tactic works. In particular, it works because it forces third parties to enforce economic sanctions on the target nation. If China were to abandon its traditional ally North Korea and enforced painful sanctions, the logic goes, then Europeans would ditch Iran much faster. Iran is not North Korea: The danger with applying a Maximum Pressure tactic against Iran is that Tehran has multiple levers around the Middle East that it could deploy to counter U.S. pressure. President Obama did not sign the JCPOA merely because he was a dove.9 He did so because the deal resolved several regional security challenges and allowed the U.S. to pivot to Asia (Chart 11). Chart 10Maximum Pressure Worked On Pyongyang Maximum Pressure Worked On Pyongyang Maximum Pressure Worked On Pyongyang Chart 11Iran Nuclear Deal Had A Strategic Imperative Iran Nuclear Deal Had A Strategic Imperative Iran Nuclear Deal Had A Strategic Imperative To understand why Iran is not North Korea, and how the application of Maximum Pressure could induce greater uncertainty in this case, investors first have to comprehend why the U.S.-Iran nuclear deal was concluded in the first place. Maximum Pressure Applied To Iran The 2015 U.S.-Iran deal resolved a crucial security dilemma in the Middle East: what to do about Iran's growing power in the region. Ever since the U.S. toppling of Saddam Hussein's regime in 2003, the fulcrum of the region's disequilibrium has been the status of Iraq. Iraq is a natural geographic buffer between Iran and Saudi Arabia, the two regional rivals. Hussein, a Sunni, ruled Iraq - 65% of which is Shia - either as an overt client of the U.S. and Saudi Arabia (1980-1988), or as a free agent largely opposed to everyone in the region (from 1990s onwards). Both options were largely acceptable to Saudi Arabia, although the former was preferable. Iran quickly seized the initiative in Iraq following the U.S. overthrow of Hussein, which created a vast vacuum of power in the country. Elite members of the country's Revolutionary Guards (IRGC), the so-called Quds Force, infiltrated Iraq and supplied various Shia militias with weapons and training that fueled the anti-U.S. insurgency. An overt Iranian ally, Nouri al-Maliki, assumed power in 2006. Soon the anti-U.S. insurgency evolved into sectarian violence as the Sunni population revolted and various Sunni militias, supported by Saudi Arabia, rose up against Shia-dominated Baghdad. The U.S. troops stationed in Iraq quickly became either incapable of controlling the sectarian violence or direct targets of the violence themselves. This rebellion eventually mutated into the Islamic State, which spread from Iraq to Syria in 2012 and then back to Iraq two years later. The Obama administration quickly realized that a U.S. military presence in Iraq would have to be permanent if Iranian influence in the country was to be curbed in the long term. This position was untenable, however, given U.S. military casualties in Iraq, American public opinion about the war, and lack of clarity on U.S. long-term interests in Iraq in the first place. President Obama therefore simultaneously withdrew American troops from Iraq in 2011 and began pressuring Iran on its nuclear program between 2011 and 2015.10 In addition, the U.S. demanded that Iran curb its influence in Iraq, that its anti-American/Israel rhetoric cease, and that it help defend Iraq against the attacks by the Islamic State in 2014. Tehran obliged on all three fronts, joining forces with the U.S. Air Force and Special Forces in the defense of Baghdad in the fall 2014.11 In 2014, Iran acquiesced in seeing its ally al-Maliki replaced by the far less sectarian Haider al-Abadi. These moves helped ease tensions between the U.S. and Iran and led to the signing of the JCPOA in 2015. From Tehran's perspective, it has abided by all the demands made by Washington during the 2012-2015 negotiations, both those covered by the JCPOA overtly and those never explicitly put down on paper. Yes, Iran's influence in the Middle East has expanded well beyond Iraq and into Syria, where Iranian troops are overtly supporting President Bashar al-Assad. But from Iran's perspective, the U.S. abandoned Syria in 2012 - when President Obama failed to enforce his "red line" on chemical weapons use. In fact, without Iranian and Russian intervention, it is likely that the Islamic State would have gained a greater foothold in Syria. The point that its critics miss is that the 2015 nuclear deal always envisioned giving Iran a sphere of influence in the Middle East. Otherwise, Tehran would not have agreed to curb its nuclear program! To force Iran to negotiate, President Obama did threaten Tehran with military force. As we have detailed in the past, President Obama established a credible threat by outsourcing it to Israel in 2011. It was this threat of a unilateral Israeli attack, which Obama did little to limit or prevent, that ultimately forced Europeans to accept the hawkish American position and impose crippling economic sanctions against Iran in early 2012. As such, it is highly unlikely that a rerun of the same strategy by the U.S., this time with Trump in charge and with potentially less global cooperation on sanctions, will produce a different, or better, deal. The recent history is important to recount because the Trump administration is convinced that it can get a better deal from Iran than the Obama administration did. This may be true, but it will require considerable amounts of pressure on Iran to achieve it. At some point, we expect that this pressure will look very much like a preparation for war against Iran, either by U.S. allies Israel and Saudi Arabia, or by the U.S. itself. First, President Trump will have to create a credible threat of force, as President Obama and Israeli Prime Minister Benjamin Netanyahu did in 2011-2012. Second, President Trump will have to be willing to sanction companies in Europe and Asia for doing business with Iran in order to curb Iran's oil exports. According to National Security Advisor John Bolton, European companies will have by the end of 2018 to curb their activities with Iran or face sanctions. The one difference this time around is Iraqi politics. Elections held on May 13 appear to have resulted in a surge of support for anti-Iranian Shia candidates, starting with the ardently anti-American and anti-Iranian Shia Ayatollah Muqtada al-Sadr. Sadr is a Shia, but also an Iraqi nationalist who campaigned on an anti-Tehran, anti-poverty, anti-corruption line. If the election signals a clear shift in Baghdad against Iran, then Iran may have one less important lever to play against the U.S. and its allies. However, we are only cautiously optimistic about Iraq. Pro-Iranian Shia forces, while in a clear minority, still maintain the support of roughly half of Iraqi Shias. And al-Sadr may not be able to govern effectively, given that his track record thus far mainly consists of waging insurgent warfare (against Americans) and whipping up populist fervor (against Iran). Any move in Baghdad, with U.S. and Saudi backing, to limit Iranian-allied Shia groups from government could lead to renewed sectarian conflict. Therein lies the key difference between North Korea and Iran. Iran has military, intelligence, and operational capabilities that North Korea does not. This is precisely why the U.S. concluded the 2015 deal in the first place, so that Iran would curb those capabilities regionally and limit its operations to the Iranian "sphere of influence." In addition, Iran is constrained against reopening negotiations with the U.S. domestically by the ongoing political contest between the moderates - such as President Hassan Rouhani - and the hawks - represented by the military and intelligence nexus. Supreme Leader Khamenei sits somewhere in the middle, but will side with the hawks if it looks like Rouhani's promise of economic benefits from the détente with the West will fall short of reality. The combination of domestic pressure and capabilities therefore makes it likely that Iran retaliates against American pressure at some point. While such retaliation could be largely investment-irrelevant - say by supporting Hezbollah rocket attacks into Israel or ramping up military operations in Syria - it could also affect oil prices if it includes activities in and around the Persian Gulf. Bottom Line: We caution clients not to believe the narrative that "Trump is all talk." As the example in North Korea suggests, Trump's rhetoric drove China to enforce sanctions in order to avert war on the Korean Peninsula. We therefore expect the U.S. administration to continue to threaten European and Asian partners and allies with sanctions, causing an eventual drop in Iranian oil exports. In addition, we expect Iran to play hardball, using its various proxies in the region to remind the Trump administration why Obama signed the 2015 deal in the first place. Could Trump ultimately be right on Iran as he was on North Korea? Absolutely. It is simply naïve to assume that Iran will negotiate without Maximum Pressure, which by definition will be market-relevant. Impact On Energy Markets BCA Energy Sector Strategy believes that the re-imposition of sanctions could result in a loss of 300,000-500,000 b/d of production by early 2019.12 This would take 2019 production back down to 3.3-3.5 MMB/d instead of growing to nearly 4.0 MMb/d as our commodity strategists have modeled in their supply-demand forecasts. In total, Iranian sanctions could tighten up the outlook for 2019 oil markets by 400,000-600,000 b/d, reversing the production that Iran has brought online since 2016 (Chart 12). Is the global energy market able to withstand this type of loss of production? First, Chart 13 shows that the enormous oversupply of crude oil and oil products held in inventories has already been cut from 450 million barrels at its peak to less than 100 million barrels today. Surplus inventories are destined to shrink to nothing by the end of the year even without geopolitical risks. In short, there is no excess inventory cushion. Chart 12Current And Future Iran Production Is At Risk Current And Future Iran Production Is At Risk Current And Future Iran Production Is At Risk Chart 13Excess Petroleum Inventories Are All But Gone Excess Petroleum Inventories Are All But Gone Excess Petroleum Inventories Are All But Gone Second, spare capacity within the OPEC 2.0 alliance - Saudi Arabia and Russia - is controversial. Many clients believe that OPEC 2.0 could easily restore the 1.8 MMb/d of production that they agreed to hold off the market since early 2017. However, our commodity team has always considered the full number to be an illusion that consists of 1.2 MMb/d of voluntary cuts and around 500,000 b/d of natural production declines that were counted as "cuts" so that the cartel could project an image of greater collaboration than it actually has achieved (Chart 14). In fact, some of the lesser "contributors" to the OPEC cut pledged to lower 2017 production by ~400,000 b/d, but are facing 2018 production levels that are projected to be ~700,000 b/d below their 2016 reference levels, and 2019 production levels are estimated to decline by another 200,000 b/d (Chart 15). Chart 14Primary OPEC 2.0 Members Are ##br##Producing 1.0 MMb/d Below Pre-Cut Levels Primary OPEC 2.0 Members Are Producing 1.0 MMb/d Below Pre-Cut Levels Primary OPEC 2.0 Members Are Producing 1.0 MMb/d Below Pre-Cut Levels Chart 15Secondary OPEC 2.0 "Contributors"##br## Can't Even Reach Their Quotas Secondary OPEC 2.0 "Contributors" Can't Even Reach Their Quotas Secondary OPEC 2.0 "Contributors" Can't Even Reach Their Quotas Third, renewed Iran-U.S. tensions may only be the second-most investment-relevant geopolitical risk for oil markets. Our commodity team expects Venezuelan production to fall to 1.23 MMb/d by the end of 2018 and to 1 MMb/d by the end of 2019, but these production levels could turn out to be optimistic (Chart 16). Venezuelan production declined by 450,000 b/d over the course of 21 months (December 2015 to September 2017), followed by another 450,000 b/d plunge over the past six months (September 2017 to March 2018), as the country's failing economy goes through the death spiral of its 20-year socialist experiment. The oil production supply chain is now suffering from shortages of everything, including capital. It is difficult to predict what broken link in the supply chain is most likely to impact production next, when it will happen, and what the size of the production impact will be. The combination of President Trump's Maximum Pressure doctrine applied to Iran, continued deterioration in Venezuelan production, and the inability of OPEC 2.0 to surge production as fast as the market thinks is unambiguously bullish for oil prices. Oil markets are currently pricing in a just under 35% probability that oil prices will exceed $80/bbl by year-end (Chart 17).13 We believe these odds are too low and will take the other side of that bet. Indeed, we think that the odds of Brent prices ending above $90/bbl this year are much higher than the 16% chance being priced in the markets presently, even though this is up from just under 4% at the beginning of the year. Chart 16Venezuela Is A Bigger Risk Venezuela Is A Bigger Risk Venezuela Is A Bigger Risk Chart 17Market Continues To Underestimate High Oil Prices Are You Ready For "Maximum Pressure?" Are You Ready For "Maximum Pressure?" Bottom Line: Our colleague Bob Ryan, Chief Commodity & Energy Strategist, also expects higher volatility, as news flows become noisier. The recommendation by BCA's Commodity & Energy Strategy is to go long Feb/19 $80/bbl Brent calls expiring in Dec/18 vs. short Feb/19 $85/bbl calls, given our assessment that the odds of ending the year above $90/bbl are higher than the market's expectations. A key variable to watch in the ongoing saga will be President Trump's willingness to impose secondary sanctions against European and Asian companies doing business with Iran. We do not think that the White House is bluffing. The mounting probability of sanctions will create "stroke of pen" risk and raise compliance costs to doing business with Iran, leading to lower Iranian exports by the end of the year. Europe Update: Political Risks Returning Risks in Europe are rising on multiple fronts. First, we continue to believe that the domestic political situation in the U.K. regarding Brexit is untenable. Second, the coalition of populists in Italy - combining the anti-establishment Five Star Movement (M5S) and the Euroskeptic Lega - appears poised to become a reality. Brexit: Start Pricing In Prime Minister Corbyn Since our Brexit update in February, the pound has taken a wild ride, but our view has remained the same.14 PM May has an untenable negotiating position. The soft-Brexit majority in Westminster is growing confident while the hard-Brexit majority in her own Tory party is growing louder. We do not know who will win, but odds of an unclear outcome are growing. The first problem is the status of Northern Ireland. The 1998 Good Friday agreement, which ended decades of paramilitary conflict on the island, established an invisible border between the Republic of Ireland and Northern Ireland. Membership in the EU by both made the removal of a physical border a simple affair. But if the U.K. exits the bloc, and takes Northern Ireland with it, presumably a physical barrier would have to be reestablished, either in Ireland or between Northern Ireland and the rest of the U.K. The former would jeopardize the Good Friday agreement, the latter would jeopardize the U.K.'s integrity as a state. The EU, led on by Dublin's interests, has proposed that Northern Ireland maintain some elements of the EU acquis communautaire - the accumulated body of EU's laws and obligations - in order to facilitate the effectiveness of the 1998 Good Friday agreement. For many Tories in the U.K., particularly those who consider themselves "Unionists," the arrangement smacks of a Trojan Horse by the EU to slowly but surely untie the strings that bind the U.K. together. If Northern Ireland gets an exception, then pro-EU Scotland is sure to ask for one too. The second problem is that the Tories are divided on whether to remain part of the EU customs union. PM May is in favor of a "customs partnership" with the EU, which would see unified tariffs and duties on goods and services across the EU bloc and the U.K. However, her own cabinet voted against her on the issue, mainly because a customs union with the EU would eliminate the main supposed benefit of Brexit: negotiating free trade deals independent of the EU. It is unclear how PM May intends to resolve the multiple disagreements on these issues within her party. Thus far, her strategy was to simply put the eventual deal with the EU up for a vote in Westminster. She agreed to hold such a vote, but with the caveat that a vote against the deal would break off negotiations with the EU and lead to a total Brexit. The threat of such a hard Brexit would force soft Brexiters among the Tories to accept whatever compromise she got from Brussels. Unfortunately for May's tactic, the House of Lords voted on April 30 to amend the flagship EU Withdrawal Bill to empower Westminster to send the government back to the negotiating table in case of a rejection of the final deal with the EU. The amendment will be accepted if the House of Commons agrees to it, which it may, given that a number of soft Brexit Tories are receptive. A defeat of the final negotiated settlement could prolong negotiations with the EU. Brussels is on record stating that it would prolong the transition period and give the U.K. a different Brexit date, moving the current date of March 2019. However, it is unclear why May would continue negotiating at that point, given that her own parliament would send her back to Brussels, hat in hand. The fundamental problem for May is the same that has plagued the last three Tory Prime Ministers: the U.K. Conservative Party is intractably split with itself on Brexit. The only way to resolve the split may be for PM May to call an election and give herself a mandate to negotiate with the EU once she is politically recapitalized. This realization, that the probability of a new election is non-negligible, will likely weigh on the pound going forward. Investors would likely balk at the possibility that Jeremy Corbyn will become the prime minister, although polling data suggests that his surge in popularity is over (Chart 18). Local elections in early May also ended inconclusively for Labour's chances, with no big outpouring for left-leaning candidates. Even if Labour is forced to form a coalition with the Scottish National Party (SNP), it is unlikely that the left-leaning SNP would be much of a check on Corbyn's Labour. Chart 18Corbyn's Popularity Is In Decline Corbyn's Popularity Is In Decline Corbyn's Popularity Is In Decline Bottom Line: Theresa May will either have to call a new election between now and March of next year or she will use the threat of a new election to get hard-Brexit Tories in line. Either way, markets will have to reprice the probability of a Labour-led government between now and a resolution to the Brexit crisis. Italy: Start Pricing In A Populist Government Leaders of Italy's populist parties - M5S and Lega - have come to an agreement on a coalition that will put the two anti-establishment parties in charge of the EU's third-largest economy. Markets are taking the news in stride because M5S has taken a 180-degree turn on Euroskepticism. Although Lega remains overtly Euroskeptic, its leader Matteo Salvini has said that he does not want a chaotic exit from the currency bloc. Is the market right to ignore the risks? On one hand, it is a positive development that the anti-establishment forces take over the reins in Italy. Establishment parties have failed to reform the country, while time spent in government will de-radicalize both anti-establishment parties. Furthermore, the one item on the political agenda that both parties agree on is to radically curb illegal migration into Italy, a process that is already underway (Chart 19). On the other hand, the economic pact signed by both parties is completely and utterly incompatible with reality. It combines a flat tax and a guaranteed basic income with a lowering of the retirement age. This would blow a hole in Italy's budget, barring a miraculous positive impact on GDP growth. The market is likely ignoring the coalition's economic policies as it assumes they cannot be put into action. This is not because Rome is afraid to flout Brussels' rules, but because the bond market is not going to finance Italian expenditures. Long-dated Italian bonds are already cheap relative to the country's credit rating (Chart 20), evidence that the market is asking for a premium to finance Italian expenditures. This is despite the ongoing ECB bond buying efforts. Once the ECB ends the program later this year, or in early 2019, the pressure on Rome from the bond market will grow. Chart 19European Migration Crisis Is Over European Migration Crisis Is Over European Migration Crisis Is Over Chart 20Italian Bonds Still Require A Risk Premium Are You Ready For "Maximum Pressure?" Are You Ready For "Maximum Pressure?" We suspect that both M5S and Lega are aware of their constraints. After all, neither M5S leader Luigi Di Maio nor Lega's Salvini are going to take the prime minister spot. This is extraordinary! We cannot remember the last time a leader of the winning party refused to take the top political spot following an election. Both Di Maio and Salvini are trying to pass the buck for the failure of the coalition. In one way, this is market-positive, as it suggests that the anti-establishment coalition will do nothing of note during its mandate. But it also suggests that markets will have to deal with a new Italian election relatively quickly. As such, we would warn investors to steer clear of Italian assets. Their performance in 2017, and early 2018, suggests that the market has already priced in the most market-positive outcome. Yes, Italy will not leave the Euro Area. But no, there is no "Macron of Italy" to resolve its long-term growth problems. Bottom Line: The Italian government formation is not market-positive. Italian bonds are cheap for a reason. While it is unlikely that the populist coalition will have the room to maneuver its profligate coalition deal into action, the bond market may have to discipline Italian policymakers from time to time. In the long term, none of the structural problems that Italy faces - many of which we have identified in a number of reports - will be tackled by the incoming coalition.15 This will expose Italy to an eventual resurgence in Euroskepticism at the first sight of the next recession. Emerging Markets: Elections In Malaysia And Turkey Offer Divergent Outcomes As we pointed out at the beginning of this report, an environment of rising U.S. yields, a surging dollar, and moderating global growth is negative for emerging markets. In this context, politics is unlikely to make much of a difference. The recently announced early election in Turkey is a case in point. Markets briefly cheered the announced election (Chart 21), before investors realized that there is unlikely to be a consolidation of power behind President Erdogan (Chart 22). Even if Erdogan were to somehow massively outperform expectations and consolidate political capital, it is not clear why investors would cheer such an outcome given his track record, particularly on the economy, over the past decade. Chart 21Investors Briefly Cheered Ankara's Snap Election Investors Briefly Cheered Ankara's Snap Election Investors Briefly Cheered Ankara's Snap Election Chart 22Is Erdogan In Trouble? Is Erdogan In Trouble? Is Erdogan In Trouble? Malaysia, on the other hand, could be the one EM economy that defies the negative macro context due to political events. Our most bullish long-term scenario for Malaysia - a historic victory for the opposition Pakatan Harapan coalition - came to pass with the election on May 9 (Chart 23).16 Significantly, outgoing Prime Minister Najib Razak accepted the election results as the will of the people. He did not incite violence or refuse to cede power. Rather, he congratulated incoming Prime Minister Mahathir Mohamad and promised to help ensure a smooth transition. This marks the first transfer of power since Malaysian independence in 1957. It was democratic and peaceful, which establishes a hugely consequential and market-friendly precedent. How did the opposition pull off this historic upset? Ethnic-majority Malays swung to the opposition; Mahathir's "charismatic authority" had an outsized effect; Barisan Nasional "safety deposits" in Sabah and Sarawak failed; Voters rejected fundamentalist Islamism. What are the implications? Better Governance - Governance has been deteriorating, especially under Najib's rule, but now voters have demanded improvements that could include term-limits for prime ministers and legislative protections for officials investigating wrongdoing by top leaders (Chart 24). Economic Stimulus - Pakatan Harapan campaigned against some of the painful pro-market structural reforms that Najib put in place. They have promised to repeal the new Goods and Services Tax (GST) and reinstate fuel subsidies. They have also proposed raising the minimum wage and harmonizing it across the country. While these pledges will be watered down,17 they are positive for nominal growth in the short term but negative for fiscal sustainability in the long term. Chart 23Comfortable Majority For Pakatan Harapan Coalition Are You Ready For "Maximum Pressure?" Are You Ready For "Maximum Pressure?" Chart 24Voters Want Governance Improvements Are You Ready For "Maximum Pressure?" Are You Ready For "Maximum Pressure?" The one understated risk comes from China. Najib's weakness had led him to court China and rely increasingly on Chinese investment as an economic strategy. Mahathir and Pakatan Harapan will seek to revise all Chinese investment (including under the Belt and Road Initiative). This review is not necessarily to cancel projects but to haggle about prices and ensure that domestic labor is employed. Mahathir will also try to assert Malaysian rights in the South China Sea. None of this means that a crisis is impending, but China has increasingly used economic sanctions to punish and reward its neighbors according to whether their electoral outcomes are favorable to China,18 and we expect tensions to increase. Investment Conclusion On the one hand, in the short run, the picture for Malaysia is mixed. Pakatan Harapan will likely pursue some stimulative economic policies, but these come amidst fundamental macro weaknesses that we have highlighted in the past - and may even exacerbate them. On the other hand, a key external factor is working in the new government's favor: oil. With oil prices likely to move higher, the Malaysian ringgit is likely to benefit (Chart 25), helping Malaysian companies make payments on their large pile of dollar-denominated debt and improving household purchasing power, a key election grievance. Higher oil prices are also correlated with higher equity prices. Over the long run, we have a high-conviction view that this election is bullish for Malaysia. It sends a historic signal that the populace wants better governance. BCA's Emerging Markets Strategy has found that improvements in governance are crucial for long-term productivity, growth, and asset performance.19 Hence, BCA's Geopolitical Strategy recommends clients go long Malaysian equities relative to EM. Now is a good entry point despite short-term volatility (Chart 26). We also think that going long MYR/TRY will articulate both our bullish oil story as well as our divergent views on political risks in Malaysia and Turkey (Chart 27). Chart 25Oil Outlook Favors Malaysian Assets Oil Outlook Favors Malaysian Assets Oil Outlook Favors Malaysian Assets Chart 26Long Malaysian Equities Versus EM Long Malaysian Equities Versus EM Long Malaysian Equities Versus EM Chart 27Higher Oil Prices Favor MYR Than TRY Higher Oil Prices Favor MYR Than TRY Higher Oil Prices Favor MYR Than TRY We are re-initiating two trades this week. First, the recently stopped out long Russian / short EM equities recommendation. We still believe that the view is on strong fundamentals, at least in the tactical and cyclical sense.20 Russian President Vladimir Putin has won another mandate and appears to be focusing on domestic economy and the constraints to Russian geopolitical adventurism have grown. The Trump administration has apparently also grown wary of further sanctions against Russia. However, our initial timing was massively off, as tensions between Russia and West did not peak in early March as we thought. We are giving this high-risk, high-reward trade another go, particularly in light of our oil price outlook. Second, we booked 10.26% gains on our recommendation to go long French industrials versus their German counterparts. We are reopening this view again as structural reforms continue in France unimpeded. Meanwhile, risk of global trade wars and a global growth slowdown should impact the high-beta German industrials more than the French. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Senior Analyst jesse.kuri@bcaresearch.com 1 Washington's demand that China cut its annual trade surplus has grown from $100 billion, announced previously by President Trump, to at least $200 billion. 2 Please see BCA Emerging Markets Strategy Weekly Report, "EM: A Correction Or Bear Market?" dated May 10, 2018, available at ems.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "'America Is Roaring Back!' (But Why Is King Dollar Whispering?),"dated January 31, 2018, and Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War," dated March 6, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Politics Are Stimulative, Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Client Note, "Trump Re-Establishes America's 'Credible Threat,'" dated April 7, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Weekly Report, "Insights From The Road - The Rest Of The World," dated September 6, 2017, and "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 8 Instead of a "big stick," President Trump would likely also recommend a "big nuclear button." 9 This is an important though obvious point. We find that many liberally-oriented clients are unwilling to give President Trump credit for correctly handling the North Korean negotiations. Similarly, conservative-oriented clients refuse to accept that President Obama's dealings with Iran had a strategic logic, even though they clearly did. President Obama would not have been able to conclude the JCPOA without the full support of U.S. intelligence and military establishment. 10 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 11 While there was no confirmed collaboration between Iranian ground forces in Iraq and the U.S. Air Force, we assume that it happened in 2014 in the defense of Baghdad. The U.S. A-10 Warthog was extensively used against Islamic State ground forces in that battle. The plane is most effective when it has communication from ground forces engaging enemy units. Given that Iranian troops and Iranian backed Shia militias did the majority of the fighting in the defense of Baghdad, we assume that there was tactical communication between U.S. and the Iranian military in 2014, a whole year before the U.S.-Iran nuclear détente was concluded. 12 Please see BCA Energy Sector Strategy Weekly Report, "Geopolitical Certainty: OPEC Production Risks Are Playing To Shale Producers' Advantage," dated May 9, 2018, available at nrg.bcaresearch.com. 13 Please see BCA Commodity & Energy Strategy Weekly Report, "Feedback Loop: Spec Positioning & Oil Price Volatility," dated May 10, 2018, available at ces.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Weekly Report, "Bear Hunting And A Brexit Update," dated February 14, 2018, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, and "Europe's Divine Comedy Party II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "How To Play Malaysia's Elections (And Thailand's Lack Thereof)," dated March 21, 2018, available at gps.bcaresearch.com. 17 For instance, the proposed Sales and Services Tax (SST) is more like a rebranding of the GST than a true abolition. And while fuel subsidies will be reinstated - weighing on the fiscal deficit - they will have a quota and only certain vehicles will be eligible. It will not be a return to the old pricing regime where subsidies were unlimited and were for everyone. 18 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Does It Pay To Pivot To China?" dated July 5, 2017, available at gps.bcaresearch.com. 19 Please see BCA Emerging Markets Strategy Special Report, "Ranking EM Countries Based on Structural Variables," dated August 2, 2017, available at ems.bcaresearch.com. 20 Please see BCA Geopolitical Strategy Special Report, "Vladimir Putin, Act IV," dated March 7, 2018, available at gps.bcaresearch.com.

Highlights An examination of the three pillars of China's economy provides an unambiguous signal that a slowdown is underway. This would normally warrant, at most, a neutral allocation to Chinese stocks, but several factors argue against cutting exposure for now. Stay overweight, but with a short leash. Recent changes in the BCA China Investable Sector Alpha Portfolio's recommended allocation have validated two of our recent investment recommendations. In addition, the model is providing a curiously bullish signal about the relative performance of Chinese vs global stocks that heightens our reluctance to reduce Chinese equity exposure. Our China Reform Monitor signals that investors do not view the current pace of structural reforms as being overly burdensome for the economy. In addition, while Chinese policymakers have made some significant gains in improving China's air quality over the past 18 months, these changes have mostly occurred from a near-hazardous starting point (suggesting that more progress will be needed). As such, we recommend that investors stick with our long ESG leaders / short investable benchmark trade over the coming year. Feature Global investor sentiment improved modestly on Monday, in response to statements from President Trump indicating a possible détente between the U.S. and China on the issue of trade. In particular, Mr. Trump signaled a willingness to assist ZTE, a Chinese telecommunications equipment maker, whose operations would have been enormously impacted by the U.S. Commerce Department's decision last month to ban American companies from selling to the firm. In the view of our Geopolitical Strategy Service, announcements like these should be viewed as marginally positive developments within the context of a serious downtrend in U.S./China relations. Investors appear to be eager to respond to positive news about waning U.S. protectionism, but the reality is that several important decisions related to the U.S.' section 301 probe have yet to be announced.1 As we noted in last week's Special Report,2 this underscores that the near-term risks to China from the external sector are clearly to the downside. Abstracting from the day-to-day assessment of the trade picture, we have emphasized that other core elements of the China outlook have deteriorated. As we present below, an aggregate view of the three pillars of China's economy continues to argue for a (contained) slowdown, with protectionism acting as a downside risk to an already sober economic outlook. Extremely cheap valuation and the high-beta nature of Chinese ex-tech stocks continue to justify an overweight stance versus global equities, but we recommend that investors keep Chinese stocks on downgrade watch for the remainder of Q2 as the risks to the Chinese economy warrant an ongoing assessment of what is currently a finely balanced equity allocation decision. Assessing The Three Pillars Chart 1 presents our stylized framework for analyzing China's economy. It highlights that China's business cycle is largely driven by three "pillars": industrial activity, the housing market, and trade. While the services sector, the Chinese consumer, and/or the technology sector are of interesting secular relevance, generally-speaking China's business cycle continues to be subject to its "old" growth model centered on investment and exports. Chart 1The Three Pillars Of China's Business Cycle The Three Pillars Of China's Economy The Three Pillars Of China's Economy Industrial Activity: We took an empirical approach to predicting China's industrial sector activity in our November 30 Special Report,3 and tested the ability of 40 different macro data series to lead the Li Keqiang index (LKI). While the LKI is closely followed and somewhat cliché, we have focused on it because of its strong correlation with ex-tech earnings and import growth. The results of our November report pointed to the success of monetary condition indexes, money supply, and credit measures to reliably predict the LKI since China's real GDP growth peaked in 2010. We constructed our BCA Li Keqiang Leading Indicator based on these measures, and we have frequently highlighted over the past few months that the indicator is pointing to a continued deceleration in China's industrial activity (Chart 2). Housing: We noted in our November report that housing market data also correlates with the LKI, albeit less well than the components of our Leading Indicator. One important observation about China's housing market that we highlighted in our February 8 Weekly Report is that residential floor space sold appears to have reliably led floor space started (a proxy for real residential investment) since 2010 (Chart 3). Over the past 6-8 months, however, floor space started appears to have diverged from the trend in floor space sold, which may have been caused by a non-trivial reduction in housing inventories over the past few years.4 Nonetheless, we also noted that the level of inventories remains quite elevated, suggesting that the uptrend in floor space started is unlikely to continue without a renewed uptrend in sales volume. In our view, this conclusion implies that the housing outlook over the coming 6-12 months is neutral, at best. Chart 2China's Industrial Sector ##br##Will Continue To Slow China's Industrial Sector Will Continue To Slow China's Industrial Sector Will Continue To Slow Chart 3Resi Sales Volume Does Not Point To ##br##A Sustained Pickup In Construction Resi Sales Volume Does Not Point To A Sustained Pickup In Construction Resi Sales Volume Does Not Point To A Sustained Pickup In Construction Trade: The third pillar of China's economy is the external sector, which remains important even though net exports have fallen quite significantly in terms of contribution to China's growth. We noted in our April 18 Weekly Report that there is a strongly positive relationship between the annual change in contribution to growth from China's net exports and subsequent gross capital formation, highlighting that external demand provides an important multiplier effect for Chinese activity. For now, nominal export growth (in CNY terms) remains at the high end of its 5-year range, reflecting the strength of the global economy. But three significant risks remain to the export outlook: 1) the clear and present danger of U.S. import tariffs, 2) the possibility that Chinese policymakers may accelerate their reform efforts to take advantage of the "window of opportunity" provided by robust global demand,4 and 3) the very substantial rise in the export-weighted RMB (Chart 4), which is fast approaching its 2015 high. As a final point on trade, Chart 5 highlights that the recent divergence between the LKI and nominal import growth is resolved when examining the latter in CNY terms. The chart suggests that while export growth has been buoyed by a strong global economy, China's contribution to the global growth impulse is diminishing. The very tight link demonstrated in Chart 5 also suggests that industrial activity is the most important pillar to watch among the three noted above, which means that Chart 2 argues for a negative export outlook for China's major trading partners. Chart 4A Non-Trivial Deterioration ##br##In Competitiveness A Non-Trivial Deterioration In Competitiveness A Non-Trivial Deterioration In Competitiveness Chart 5The Rise In CNYUSD Is Flattering ##br##Imports Measured In Dollars The Rise In CNYUSD Is Flattering Imports Measured In Dollars The Rise In CNYUSD Is Flattering Imports Measured In Dollars Our assessment of the three pillars of China's economy points to a conclusion that we have highlighted frequently in our recent reports: China's industrial sector is slowing, and there are downside risks to the export outlook. The character of the slowdown does not suggest that a major shock to the global economy is likely to emanate from China over the coming 6-12 months, but the outlook is more consistent with a reduction than an expansion in China's contribution to global growth. Under normal circumstances, at best this would warrant a neutral asset allocation outlook to China-related financial assets. Chart 6The Uptrend In Relative Chinese ##br##Ex-Tech Performance Is Intact The Uptrend In Relative Chinese Ex-Tech Performance Is Intact The Uptrend In Relative Chinese Ex-Tech Performance Is Intact However, we have also argued that the relatively attractive valuation and the technical profile of Chinese equities suggests that investors should have a high threshold for reducing their exposure to China within a global equity portfolio. Chart 6 highlights that Chinese ex-tech share prices continue to demonstrate resilient performance versus their global peers, despite the ongoing slowdown in China's economy. In addition, as we will note below, our BCA China Investable Sector Alpha Portfolio is providing a curiously bullish signal about the relative performance of Chinese stocks, which heightens our reluctance to cut exposure. Bottom Line: An examination of the three pillars of China's economy provides an unambiguous signal that a slowdown is underway. This would normally warrant, at most, a neutral allocation to Chinese stocks, but several factors argue against cutting exposure for now. Stay overweight, but with a short leash. Reading The Tea Leaves From Our Sector Alpha Portfolio We introduced our BCA China Investable Sector Alpha Portfolio in a January Special Report, in part to demonstrate that the concept of alpha persistence (i.e. alpha that is persistently positive or negative) has material implications for portfolio returns. In particular, we noted that the portfolio's strategy of allocating to China's investable equity sectors based on the significance of alpha has resulted in over 200bps of long-term outperformance versus the investable benchmark, without taking on any additional risk (Table 1). Table 1An Alpha-Based Sector Model Has Historically Outperformed China's Investable Stock Market The Three Pillars Of China's Economy The Three Pillars Of China's Economy Table 2 presents the portfolio's current allocation, relative to the current benchmark weights for each sector as well as the portfolio's sectoral allocation when we published our January report. Two observations are noteworthy: The model recommends an overweight allocation to resources; consumer staples; health care; utilities; and real estate, at the expense of industrials; consumer discretionary; financials; technology; and telecom services. These positions are largely in-line with the model's recommendations in January, except for a non-trivial increase in exposure to energy and financials, and a significant reduction in technology and consumer discretionary. The portfolio's reduced exposure to technology and consumer discretionary stocks validate two recent investment recommendations from BCA's China Investment Strategy team: we recommended a long consumer staples / short consumer discretionary trade on November 16,5 and we recommend that investors retain cyclical exposure to investable Chinese stocks while neutralizing exposure to the tech sector on February 15.6 Table 2Our Sector Alpha Portfolio Has Validated Two Of Our Recent Recommendations The Three Pillars Of China's Economy The Three Pillars Of China's Economy Chart 7 highlights another interesting insight from the model, by presenting the beta of the portfolio relative to the investable benchmark alongside the benchmark's performance versus global stocks. First, the chart underscores the limited systemic risk of the portfolio, as the portfolio's beta rarely deviates materially from 1. But more importantly, it appears that the portfolio's beta versus the investable benchmark is somewhat correlated with (and leads) China's performance versus global stocks: Chart 7A Curiously Bullish Signal From ##br##Our Sector Alpha Portfolio A Curiously Bullish Signal From Our Sector Alpha Portfolio A Curiously Bullish Signal From Our Sector Alpha Portfolio Prior to the global financial crisis, the portfolio's beta was above 1 and rising, until early-2007 (preceding the peak in relative performance by about a year). Following the crisis, the portfolio beta steadily declined until late-2014/early-2015, interrupted only by a brief rise back above 1 from 2009-2010. Chinese stock prices steadily underperformed global equities during this period. The portfolio beta rose back to 1 in mid-2015, and stayed flat until early last year. Chinese stocks technically underperformed global stocks during this period, but by a much more modest amount than what occurred on average from 2009 to 2014. In this case, the rise in the portfolio beta in 2015 appeared to correctly signal that a sharply underweight stance towards Chinese stocks was no longer warranted. Finally, the portfolio beta surged rapidly higher last year, in line with a material rise in the relative performance of Chinese stocks. It has fallen modestly since January, but remains at one of the highest levels seen over the past 15 years. Drawing pro-cyclical inferences from the beta characteristics of risk-adjusted performers is a novel approach for BCA's China Investment Strategy service, and for now we regard the results of Chart 7 as a curious signal that warrants further examination. Still, this bullish sign is consistent with the general resilience of Chinese stocks that we have observed over the past several months, which continues to argue in favor of a high threshold to cut exposure to China within a global equity portfolio. Bottom Line: Recent changes in the BCA China Investable Sector Alpha Portfolio's recommended allocation have validated two of our recent investment recommendations. In addition, the model is providing a curiously bullish signal about the relative performance of Chinese vs global stocks that heightens our reluctance to reduce Chinese equity exposure. An Update On The "Reform Trade" We noted in the aftermath of last November's Communist Party Congress that China was likely to step up its reform efforts in 2018, and make meaningful efforts to: Pare back heavy-polluting industry Hasten the transition of China's economy to "consumer-led" growth7 Halt leveraging in the corporate/financial sector Eliminate corruption and graft As a result of this outlook, we highlighted that the pace of renewed structural reforms would be a key theme to watch this year, in order to ensure that the pursuit of these policies would not unintentionally cause a repeat of the significant slowdown in the economy that occurred in 2014/2015. We presented our framework for monitoring this risk in our November 16 Weekly Report, which was to track an index that we called the BCA China Reform Monitor. The monitor is calculated as an equally-weighted average of four "winner" sectors that outperformed the investable benchmark in the month following the Party Congress relative to an equally-weighted average of the remaining seven sectors. We argued that significant underperformance of "loser" sectors could be a sign that reform intensity has become too burdensome for the economy (and thus a material headwind ex-tech equity performance), and highlighted that we would be watching for signs that our monitor was rising largely due to outright declines in the denominator. Using this framework, Chart 8 suggests that structural reform efforts are ongoing but that investors do not view the current pace of these reforms as overly burdensome for the economy. In particular, panel 2 highlights that recent movements in our Reform Monitor have been driven by fairly steady outperformance of the "winner" sectors, with "loser" sectors simply trending sideways. While it is possible that Chinese policymakers will intensify their efforts to reform the economy over the coming 6-12 months,4 for now our China Reform Monitor continues to support an overweight stance towards Chinese ex-tech stocks vs their global peers. However, given the message of our Reform Monitor, it is somewhat surprising that another of our reform-themed trades has fared so poorly over the past three months. Chart 9 presents the performance of our long investable environmental, social and governance (ESG) leaders / short investable benchmark trade, which was up approximately 4% since inception in late-January but is now down 1.4%. The basis of this trade was to overweight stocks that are best positioned to deliver "sustainable" growth, which we argued would fare well in a reform environment. Does the underperformance of this trade suggest that the reform theme is unlikely to be investment-relevant over the coming year? Chart 8Structural Reforms Not Viewed As ##br##Economically Restrictive By Investors Structural Reforms Not Viewed As Economically Restrictive By Investors Structural Reforms Not Viewed As Economically Restrictive By Investors Chart 9ESG Leaders Should Fare Quite ##br##Well In A Reform Environment ESG Leaders Should Fare Quite Well In A Reform Environment ESG Leaders Should Fare Quite Well In A Reform Environment In our view, the answer is no. First, while the MSCI ESG leaders index maintains roughly similar sector weights as the investable benchmark (which limits the beta risk of the trade), Table 3 highlights that differences do exist. These modest differences in sector allocation do appear to be impacting performance (Chart 10), in particular the underweight allocation to energy stocks (which are outperforming) and the overweight allocation to technology (which has sold off since mid-March). Table 3Sector Allocation Has Impacted The Recent Performance Of China's ESG Leaders The Three Pillars Of China's Economy The Three Pillars Of China's Economy Chart 10Sector Allocation Impacting Recent ##br##Performance Of ESG Leaders Sector Allocation Impacting Recent Performance Of ESG Leaders Sector Allocation Impacting Recent Performance Of ESG Leaders Second, while China made significant gains last year in improving air quality in several major population centers (such as Beijing and Shanghai), these improvements have mostly occurred from a near-hazardous starting point and have simply rendered China's air to be less unhealthy. Even in Beijing, Chart 11 highlights that PM2.5 readings have started to increase again, from a level that only briefly reached "good" quality. In addition, Chart 12 highlights that some of the improvement in air quality last year occurred, at least in part, because China shifted polluting activity from one province to another. This implies that Chinese policymakers will continue to wrestle with improving the country's air quality for some time to come, which in our view continues to favor ESG leaders over the coming year and beyond. Chart 11Some Significant Recent Gains In Air ##br##Quality, But Part Of An Ongoing Battle Some Significant Recent Gains In Air Quality, But Part Of An Ongoing Battle Some Significant Recent Gains In Air Quality, But Part Of An Ongoing Battle Chart 12Air Quality Gains In Some Provinces, At The Expense Of Others The Three Pillars Of China's Economy The Three Pillars Of China's Economy Bottom Line: Our China Reform Monitor signals that investors do not view the current pace of structural reforms as being overly burdensome for the economy. In addition, while Chinese policymakers have made some significant gains in improving China's air quality over the past 18 months, these changes have mostly occurred from a near-hazardous starting point (suggesting that more progress will be needed). As such, we recommend that investors stick with our long ESG leaders / short investable benchmark trade over the coming year. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see Geopolitical Strategy Weekly Report "Inside The Beltway," dated May 2, 2018, available on gps.bcaresearch.com 2 Please see Geopolitical Strategy and China Investment Strategy Special Report "China's "Red Line" In The Trade Talks," dated May 9, 2018, available on cis.bcaresearch.com 3 Please see China Investment Strategy Special Report "The Data Lab: Testing The Predictability Of China's Business Cycle," dated November 30, 2017, available on cis.bcaresearch.com 4 Please see China Investment Strategy Weekly Report "China: A Low-Conviction Overweight," dated May 2, 2018, available on cis.bcaresearch.com 5 Please see China Investment Strategy Weekly Report "Messages From The Market, Post-Party Congress," dated November 16, 2017, available on cis.bcaresearch.com 6 Please see China Investment Strategy Weekly Report "After The Selloff: A View From China," dated February 15, 2018, available on cis.bcaresearch.com 7 Investors should note that BCA's China Investment Strategy service has long been skeptical of calls to shift China's economy to a consumption-driven growth model, because it significantly raises the odds that the country will not be able to escape the middle income trap. For example, please see Please see China Investment Strategy Special Report, "On A Higher Note", dated October 5, 2017, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Tinbergen's rule says that the successful implementation of economic policy requires there to be at least as many "instruments" as "objectives." Policymakers today are increasingly discovering that they have too many of the latter but not enough of the former. By turning fiscal policy into a political tool rather than one for macroeconomic stabilization, the U.S. has found itself in a position where it can either meet President Trump's goal of having a smaller trade deficit or the Fed's goal of keeping the economy from overheating, but not both. In the near term, we expect the Fed's priorities to prevail. This will keep the dollar rally intact, which could spell bad news for some emerging markets. Longer term, the Fed, like most other central banks, must confront the vexing problem that the interest rate necessary to prevent asset bubbles from frequently forming may be higher than the rate necessary to keep the economy near full employment. Getting inflation up a bit may be one way to mitigate this problem, as it would allow nominal interest rates to rise without pushing real rates into punitive territory. This suggests that the structural path for bond yields is up, consistent with our thesis that the 35-year bond bull market is over. Feature Constraints And Preferences The late Jan Tinbergen was one of the great economists of the twentieth century. Often referred to as the father of econometrics, Tinbergen and Ragnar Frisch were the first people to be awarded the Nobel Prize in Economics in 1969. One of Tinbergen's most enduring contributions was his demonstration that the successful implementation of economic policy requires there to be at least as many "instruments" (i.e., policy tools) as "objectives" (i.e., policy goals). Just like any system of equations can be "overdetermined" or "underdetermined," any set of "policy functions" may have a unique solution, many solutions, or no solution at all. The first outcome corresponds to a situation where there are as many instruments as objectives, the second where there are more instruments than objectives, and the third where there are fewer instruments than objectives. In essence, the Tinbergen rule is a mathematical formulation of the idea that it is hard to hit two birds with one stone. The Tinbergen rule often comes up in macroeconomics. Consider a country that wants to have a low and stable unemployment rate (what economists call "internal balance") and a current account position that is neither too big nor too small ("external balance"). This amounts to two objectives, which can be realized with the right mix of two instruments: Monetary and fiscal policy. As discussed in greater detail in Appendix A, the classic Swan Diagram, named after Australian economist Trevor Swan, shows how this is done. Chart 1Spain: The Cost Of The Crisis Spain: The Cost Of The Crisis Spain: The Cost Of The Crisis If the country wants to add a third objective to its list of policy goals, it has to either give up one of its existing objectives or find an additional policy instrument. Suppose, for example, that a country wants to move to a pegged exchange rate. It can either forego monetary independence, or introduce capital controls in order to allow domestic interest rates to deviate from the interest rates of the economy to which it is pegging its currency. This is the logic behind Robert Mundell's "Impossible Trinity," which states that an economy cannot simultaneously have all three of the following: A fixed exchange rate, free capital mobility, and an independent central bank. It can only choose two items from the list. Peripheral Europe learned this lesson the hard way in 2011. Not only did euro membership deny Greece, Italy, Spain, Portugal, and Ireland access to an independent monetary policy and a flexible currency, but the ECB's failure under the bumbling leadership of Jean-Claude Trichet to backstop sovereign debt markets necessitated fiscal austerity at a time when these economies needed stimulus. These countries were left with no effective macro policy instruments whatsoever, thus putting them at the complete mercy of the bond vigilantes, German politicians, and the multilateral lending agencies. The only thing they could do was incur a brutal internal devaluation to make themselves more competitive. Even for "success stories" such as Spain, the cost in terms of lost output was over one-third of GDP (Chart 1) - and probably much more if one includes the deleterious effect on potential GDP growth from the crisis. Trump Versus Tinbergen One might think that the U.S. is largely immune from Tinbergen's rule. It is not. President Trump and the Republicans in Congress have rammed through massive tax cuts and spending increases (Chart 2). By doing so, they have turned fiscal policy into a political tool rather than one for macroeconomic stabilization. In and of itself, that is not an insuperable constraint since monetary policy can still be used to achieve internal balance. The problem is that Trump has also declared that he wants external balance, meaning a much smaller trade deficit. Now we have two policy objectives (full employment and more net exports) and only one available instrument: Monetary policy. Chart 2The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline This puts the Fed in a bind. If the Fed hikes rates aggressively, this will keep the economy from overheating, thus achieving internal balance. But higher rates are likely to bid up the value of the dollar, leading to a larger trade deficit. On the flipside, if the Fed drags its feet in raising rates, the dollar could weaken, resulting in a smaller trade deficit and moving the economy closer to external balance. However, the combination of low real interest rates, a weaker dollar, and dollops of fiscal stimulus will cause the unemployment rate to fall further, leading to higher inflation. Investor uncertainty about which path the Fed will choose may be partly responsible for the gyrations in the dollar of late. At least for the next year or so, our guess is that the Fed's independence will keep it on course to raise rates more than the market is currently pricing in, which will result in a stronger dollar. Beyond then, the picture is less clear. This is partly because the increasing politicization of society may begin to affect the Fed's behavior. History suggests that inflation tends to be higher in countries with less independent central banks (Chart 3). But it is also because Tinbergen's ghost is likely to make another appearance, this time in a wholly different way. Chart 3Inflation Tends To Be Higher In Countries Lacking Independent Central Banks Tinbergen's Ghost Tinbergen's Ghost The Fed's "Other" Mandate Officially, the Fed has two mandates: ensuring maximum employment and stable prices. In practice, this "dual mandate" can be boiled down to a single policy objective: Keeping the unemployment rate near NAIRU, the so-called Non-Accelerating Inflation Rate of Unemployment. The Fed has sought to meet this objective through the use of countercyclical monetary policy: Easing monetary policy when output falls below potential and tightening it when the economy is at risk of overheating. So far, so good. The problem is that the Fed, like most other central banks, is being asked to take on another policy objective: ensuring financial stability. Here's the rub though: The interest rate necessary to prevent asset bubbles from frequently forming may be higher than the rate necessary to keep the economy near full employment. Excessively low rates are a threat to financial stability. A decline in interest rates pushes up the present value of expected cash flows; the lower the discount rate, the more of an asset's value will depend on cash flows that may not be realized for many years. This tends to increase asset market volatility. In addition, borrowers need to devote a smaller share of their incomes towards servicing their debt obligations when interest rates are low. This tends to increase debt levels. From The Great Moderation To The Great Intemperance Starting in the 1990s, far from entering an era which policymakers once naively referred to as the "Great Moderation," it is possible that the world entered a precarious period where the only way to generate enough spending was to push down interest rates so much that asset bubbles became commonplace. In a world where central bankers have to choose between insufficient demand and recurrent asset bubbles, the idea of a "neutral rate" loses much of its meaning. By definition, the neutral rate is a steady-state concept. However, if the interest rate that produces full employment and stable inflation is so low that it also generates financial instability, how can one possibly describe this interest rate as "neutral"? Faced with the increasingly irreconcilable twin objectives of keeping the unemployment rate near NAIRU and putting the financial system on the straight and narrow, central bankers have reached out for a second policy instrument: macroprudential regulations. So far, however, the jury is still out on whether this tool is sufficiently powerful to prevent future financial crises. Politics has a bad habit of getting in the way of effective regulation. President Trump and the Republicans have been looking for ways to water down the Dodd-Frank Act. The Democrats are complaining that banks and other financial institutions are not doing enough to channel credit to various allegedly "underserved" groups. Faced with such political pressure, it is not clear that regulators can do their jobs. If You Can't Raise r-Star, Raise i-Star What is the Fed to do? One possibility may be to aim for somewhat more inflation. A higher inflation target would allow the Fed to raise nominal policy rates while still keeping real rates low enough to maintain full employment. Higher nominal rates would impose more discipline on borrowers and discourage excessive debt accumulation. Higher inflation would also reduce the likelihood of reaching the zero bound again, while also limiting the economic fallout of asset busts. The Case-Shiller 20-City Composite Index declined by 34% in nominal terms and 41% in real terms between April 2006 and March 2012. Had inflation averaged 4% over this period rather than 2.2%, a 41% decline in real home prices would have corresponded to a less severe 26% decrease in nominal prices, resulting in fewer underwater mortgages. Finally, higher inflation would allow countries to increase nominal income growth. In fact, higher inflation may be the only viable way to reduce debt-to-GDP ratios in a high-debt, low-productivity growth world. Investment Conclusions We advised clients on July 5, 2016 that we had reached "The End Of The 35-Year Bond Bull Market." As fate would have it, this was the exact same day that the 10-year yield reached an all-time closing low of 1.37%. Bond positioning is very short now (Chart 4), so a partial retracement in yields is probable. Cyclically and structurally, however, the path for yields is up. Much like what transpired between the mid-1960s and the early 1980s, investors should expect global bond yields to reach a series of "higher highs" and "higher lows" with each passing business cycle (Chart 5). Chart 4Traders Are Short Treasurys Traders Are Short Treasurys Traders Are Short Treasurys Chart 5A Template For The Next Decade? A Template For The Next Decade? A Template For The Next Decade? Just as was the case back then, the Fed is now behind the curve in raising rates. The three-month and six-month annualized change in core PCE has reached 2.6% and 2.3%, respectively. Yesterday's CPI report was softer than expected, but the miss was almost entirely due to a deceleration in used car prices and airfares, both of which are likely to be temporary. Meanwhile, the labor market remains strong. The unemployment rate is down to 3.9%, just slightly above the 2000 low of 3.8%. According to the latest JOLTS survey released earlier this week, there are now more job openings than unemployed workers, the first time this has happened in the 17-year history of the survey (Chart 6). Faced with this reality, the Fed will keep begrudgingly raising rates until the economy slows. Right now, the real economy is not showing much strain from higher rates. The cyclical component of our MacroQuant model, which draws on a variety of forward-looking economic indicators, moved back into positive territory this week. Both the housing market and capital spending are in reasonably good shape (Chart 7). Chart 6There Are Now More Vacancies Than Jobseekers There Are Now More Vacancies Than Jobseekers There Are Now More Vacancies Than Jobseekers Chart 7Higher Rates Have Not (Yet) Slowed The Economy Higher Rates Have Not (Yet) Slowed The Economy Higher Rates Have Not (Yet) Slowed The Economy The U.S. financial sector should also be able to weather further monetary tightening. Corporate debt has risen, but overall U.S. private-sector debt as a percent of GDP is still 18 percentage points lower than in 2008 (Chart 8). Lenders are also more circumspect than they were before the Great Recession. For example, banks have been tightening lending standards on credit and automobile loans, which should reverse the increase in delinquency rates seen in those categories (Chart 9). Chart 8U.S. Private Debt Still Below Pre-Recession Levels U.S. Private Debt Still Below Pre-Recession Levels U.S. Private Debt Still Below Pre-Recession Levels Chart 9Lenders Are More Circumspect These Days Lenders Are More Circumspect These Days Lenders Are More Circumspect These Days Resilience to Fed tightening may not extend to the rest of the world, however. Following the script of the late 1990s, it is likely that the combination of higher U.S. rates and a stronger dollar will cause some emerging markets to fall out of bed before U.S. financial conditions have tightened by enough to slow U.S. growth (Chart 10). This week's turbulence in Turkey and Argentina may be a sign of things to come. For now, investors should underweight EM assets relative to their developed market peers. Chart 10Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com APPENDIX A The Swan Diagram The Swan Diagram depicts four "zones of economic unhappiness," each one representing the different ways in which an economy can deviate from "internal balance" (low and stable unemployment) and "external balance" (an optimal current account position). A rightward movement along the horizontal axis represents an easing of fiscal policy, whereas an upward movement along the vertical axis represents an easing in monetary policy. All things equal, easier monetary policy is assumed to result in a weaker currency. The internal balance schedule is downward sloping because an easing in fiscal policy must be offset by a tightening in monetary policy in order keep the unemployment rate stable. The external balance schedule is upward sloping because easier fiscal policy raises aggregate demand, which results in higher imports, and hence a deterioration in the trade balance. To bring imports back down, the currency must weaken. Any point to right of the internal balance schedule represents overheating; any point to the left represents rising unemployment. Likewise, any point to the right of the external balance schedule represents a larger-than-acceptable current account deficit, whereas any point to the left represents an excessively large current account surplus. Appendix Chart 1Four Zones Of Unhappiness Tinbergen's Ghost Tinbergen's Ghost Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The U.S. dollar still has meaningful upside versus the majority of currencies. We continue to recommend shorting a basket of the following EM currencies versus the U.S. dollar: TRY, ZAR, BRL, IDR, MYR and KRW. Fixed-income investors should continue to adopt a defensive allocation with respect EM local bonds. Asset allocators should underweight EM sovereign and corporate credit within a global credit portfolio. Argentine financial markets are rioting. We elaborate on our investment strategy below. Downgrade Indonesian stocks from neutral to underweight within an EM equity portfolio. Feature The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought. Rüdiger Dornbusch Emerging markets (EM) currencies have come under substantial selling pressure. Various indexes of EM currencies versus the U.S. dollar have broken below their 200-day moving averages (Chart I-1). EM sovereign spreads are widening, and local bonds yields are moving higher from very low levels. Chart I-1EM Currencies: A Breakdown? EM Currencies: A Breakdown? EM Currencies: A Breakdown? Our view is that we are witnessing the beginning of a major down leg in EM currencies and a major up leg in the U.S. dollar. This constitutes a negative environment for all EM risk assets. As the above quote from professor Rüdiger Dornbusch eloquently states, a meltdown in financial markets could take much longer to develop, but once it commences it is likely to play out much faster than investors expect. This does not mean we are certain that a full-blown EM crisis is bound to happen. Neither can we predict the speed of financial market moves. Nevertheless, based on our macro themes, we maintain that this down leg in EM currencies and EM risk assets will likely be large enough to qualify as a bear market rather than a correction. Consistently, we continue to recommend that investors adopt defensive strategies or play EM risk assets on the short side. This bear market in EM could be comparable to the EM selloff episodes of 2013 (Taper Tantrum) or 2015 (China's slowdown). In this report, we first discuss the outlook for the broad U.S. dollar, then examine the factors that typically drive EM currencies, and those that do not. The Dollar: A Major Bottom In Place The U.S. dollar has recently rebounded sharply, and we believe this marks the beginning of a major rally. The following factors will support the greenback in the months ahead: The U.S. dollar does well in periods of a slowdown in global trade (Chart I-2). The average manufacturing PMI index of export-oriented Asia economies such as Korea, Taiwan and Singapore points to a peak in global export volumes (Chart I-3). Further, China's Container Freight index signifies an impending deceleration in Asian export shipments (Chart I-4, top panel). Chart I-2U.S. Dollar Rallies When Global Trade Slows U.S. Dollar Rallies When Global Trade Slows U.S. Dollar Rallies When Global Trade Slows Chart I-3A Peak In Global Export Growth A Peak In Global Export Growth A Peak In Global Export Growth Chart I-4A Leading Indicator For Asian Exports ##br##And Asian Currencies A Leading Indicator For Asian Exports And Asian Currencies A Leading Indicator For Asian Exports And Asian Currencies Notably, this freight index - the price to ship containers - also correlates with emerging Asia currencies, and suggests that the latter stands to depreciate (Chart I-4, bottom panel). Chart I-5U.S. Dollar Liquidity And Exchange Rate U.S. Dollar Liquidity And Exchange Rate U.S. Dollar Liquidity And Exchange Rate The dollar should do particularly well if the epicenter of the global growth slowdown is centred in China - and if U.S. domestic demand remains robust due to fiscal stimulus, as we expect. Within advanced economies, the U.S. is the least vulnerable to a China and EM slowdown. Delta of relative growth will be shifting in favor of the U.S. versus the rest of the world. This will propel the dollar higher. Amid weakness in the world trade, growth will be priced at a premium. This will favor financial markets with stronger growth. The greenback will be the winner in the coming months. The U.S. twin deficits - the current account and budget deficits - would have acted as a drag on the dollar if global growth was robust/recovering. However, amid weakening global growth, the U.S. twin deficits are not a malignant phenomenon for the dollar; they will in fact support it as they instigate and reflect strong U.S. growth. As the Federal Reserve continues to reduce its balance sheet, the banking system's excess reserves will decline. Our U.S. dollar liquidity measure has petered out, which has historically been consistent with a bottom in the dollar; the latter is shown inverted on Chart I-5. As we have argued for some time, and to the contrary of widespread investor consensus, the U.S. dollar is not expensive. According to the real effective exchange rate based on unit labor costs, the greenback is fairly valued, as is the euro (Chart I-6). The yen is cheap but the Korean won is expensive (Chart I-6, bottom two panels). In our opinion, a real effective exchange rate based on unit labor costs is the most pertinent measure of exchange rate valuation. The basis is that it takes into account both wages and productivity. Labor costs are the largest cost component in many companies and unit labor costs are critical to competitiveness. Chart I-7 demonstrates that commodities-related currencies including those of Australia, New Zealand and Norway are on the expensive side, while the Canadian dollar is fairly valued. Chart I-6The U.S. Dollar Is Not Expensive The U.S. Dollar Is Not Expensive The U.S. Dollar Is Not Expensive Chart I-7Commodities Currencies Are Not Cheap Commodities Currencies Are Not Cheap Commodities Currencies Are Not Cheap There are no measures of real effective exchange rate based on unit labor costs for many EM currencies. If DM commodities currencies are not cheap, then it is fair to assume that EM commodities currencies are not cheap either. We are not suggesting that exchange rates of commodity producing EM nations are expensive, but we do believe their valuations are probably closer to neutral. When valuations are neutral, they are not a constraint for the underlying asset price. The latter can go either up or down. In short, the dollar is not expensive, and valuations will not deter its appreciation in the coming months. Finally, from the perspective of market technicals, the dollar's exchange rates versus many currencies appear to have encountered resistance at their long-term moving averages, as illustrated in Chart I-8A and Chart I-8B. Usually, when a market finds support (or resistance) at its long-term moving average, it often makes new highs (or lows). Chart I-8ATechnicals Are Positive For Dollar, ##br##Negative For EM Currencies Technicals Are Positive For Dollar, Negative For EM Currencies Technicals Are Positive For Dollar, Negative For EM Currencies Chart I-8BTechnicals Are Positive For Dollar, ##br##Negative For EM Currencies Technicals Are Positive For Dollar, Negative For EM Currencies Technicals Are Positive For Dollar, Negative For EM Currencies We are not certain if the broad trade-weighted U.S. dollar will make a new high. However, some EM currencies will drop close to or retest their early 2016 lows. Such potential downside is substantial enough to short the most vulnerable EM currencies. Bottom Line: The U.S. dollar has meaningful upside versus the majority of currencies. We continue to recommend shorting a basket of the following EM currencies versus the U.S. dollar: TRY, ZAR, BRL, IDR, MYR and KRW. What Really Drives EM Currencies A common narrative is that EM balance of payments and fiscal balances have already improved, making many EMs less vulnerable than they were during the 2013 Taper Tantrum. What's more, the interest rate differential between EM and the U.S. is still positive, heralding upward pressure on EM currencies. We do not subscribe to this analysis. First, current account balances do not always drive EM exchange rates. Chart I-9A and Chart I-9B illustrates that there is no meaningful positive correlation between EM currencies and both the level and changes in their current account balances. The same holds for the correlation between fiscal balances and exchange rates. Chart I-9ACurrent Account Balances ##br##And Currencies: No Correlation Current Account Balances And Currencies: No Correlation Current Account Balances And Currencies: No Correlation Chart I-9BCurrent Account Balances ##br##And Currencies: No Correlation Current Account Balances And Currencies: No Correlation Current Account Balances And Currencies: No Correlation Second, neither nominal nor real interest rate differentials over U.S. rates explain the trend in EM currencies, as shown in Chart I-10. Further, neither the level nor changes in interest rate differentials explain trends in EM exchange rates. On the contrary, it is the trend in EM currencies that drives local interest rates in EM. That is why getting the currencies right is of paramount importance to investors in various EM asset classes. So which factors do drive EM exchange rates? The key variables that define trends in EM currencies are U.S. bond yields, global trade cycles and commodities prices. The changes in U.S. bond yields and TIPS (inflation-adjusted) yields - not their difference with EM yields - have explained EM currency moves in recent years (Chart I-11). Chart I-10Interest Rate Differential Does Not ##br##Explain EM Exchange Rates Moves Interest Rate Differential Does Not Explain EM Exchange Rates Moves Interest Rate Differential Does Not Explain EM Exchange Rates Moves Chart I-11EM Currencies And U.S. Bond Yields EM Currencies And U.S. Bond Yields EM Currencies And U.S. Bond Yields Chart I-4 on page 3 demonstrates that China's Container Freight index leads regional exports and strongly correlates with emerging Asian currencies. Non-Asian EM currencies are mostly leveraged to commodities prices, as these countries (all nations in Latin America, Russia and South Africa) produce commodities. Not surprisingly, the EM exchange rate composed primarily of EM non-Asian currencies correlates well with commodities prices (Chart I-12). Finally, EM currencies are substantially more exposed to China than to DM economies. Chart I-13 shows that when Chinese imports are underperforming DM imports, EM currencies tend to depreciate. Chart I-12EM Currencies And Commodities Prices EM Currencies And Commodities Prices EM Currencies And Commodities Prices Chart I-13EM Currencies Are Exposed To China Not DM EM Currencies Are Exposed To China Not DM EM Currencies Are Exposed To China Not DM As such, what has caused EM currencies to riot in recent weeks? In short, it is the combination of the rise in U.S. bond yields and budding signs of slowdown in global trade. Chart I-14EM Currencies' Vol Is Still Low EM Currencies' Vol Is Still Low EM Currencies' Vol Is Still Low Commodities prices have so far been firm with oil prices skyrocketing. We expect the combination of China's slowdown and a stronger U.S. dollar to eventually suppress commodities prices in the months ahead. That will produce another down leg in EM currencies. Finally, the volatility measure for EM currencies is still very low, albeit rising (Chart I-14). This suggests that investors remain somewhat complacent on EM exchange rates. Bottom Line: Our negative view on EM currencies has been anchored on two pillars: the U.S. dollar rally driven by higher U.S. interest rate expectations and weaker Chinese growth/lower commodities prices. We are now witnessing the first down leg in EM currency bear market propelled by the first pillar. It is not over yet. The second down leg will come when China's growth slows and commodities prices relapse in the coming months. All in all, there is still material downside in EM exchange rates. EM Local Bond And Credit Markets EM local bond yields typically rise when EM currencies drop meaningfully (Chart I-15). Foreign investors hold a large share of EM local currency bonds (Table I-1). Chart I-15EM Local Bond Yields And EM Currencies EM Local Bond Yields And EM Currencies EM Local Bond Yields And EM Currencies Table I-1Foreign Ownership Of EM Local Bonds EM: A Correction Or Bear Market? EM: A Correction Or Bear Market? As EM currency depreciation erodes foreign investors' returns on EM local currency bonds, there could be a rush to exit their positions. Chart I-16 portrays that the total return on J.P. Morgan GBI EM local currency bonds in U.S. dollar terms has broken below its 200-day moving average. Fluctuations in total return on local bonds is primary driven by currency moves. If our negative EM currency view is correct, there will be more downside in this EM domestic bonds total return index. EM sovereign and corporate credit spreads often widen when EM currencies depreciate (Chart I-17). As EM currencies lose value, U.S. dollar debt becomes more expensive to service, and credit spreads should widen to reflect higher credit risks. Chart I-16EM Local Bonds Total ##br##Return Index In U.S. Dollars EM Local Bonds Total Return Index In U.S. Dollars EM Local Bonds Total Return Index In U.S. Dollars Chart I-17EM Credit Spreads And EM Currencies EM Credit Spreads And EM Currencies EM Credit Spreads And EM Currencies Finally, the ratios of U.S. dollar debt-to-exports and U.S. dollar debt-to-international reserves for EM ex-China are very elevated (Chart I-18). If these nations' exports stumble in the months ahead, the inflows of foreign currency will diminish, and credit spreads could widen to price this in. Chart I-18EM Ex-China: U.S. Dollar Debt ##br##Burden In Perspective EM Ex-China: U.S. Dollar Debt Burden In Perspective EM Ex-China: U.S. Dollar Debt Burden In Perspective To be sure, this does not mean there will be widespread defaults. Simply, credit spreads are too low and investor sentiment is too upbeat. As EM growth deteriorates, asset prices will have to re-price. Bottom Line: Asset allocators should continue to adopt a defensive allocation with respect EM local bonds. Asset allocators should underweight EM sovereign and corporate credit within a global credit portfolio. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Argentina Is Under Fire 10 May 2018 Argentine financial markets have been rioting, with the currency plunging by 11% versus the U.S. dollar since the beginning of April. What is the underlying cause of turbulence, and what should investors do? Argentina's macro vulnerability stems from the following factors: First, the country has very large twin deficits, and has relied on foreign portfolio flows to finance them (Chart II-1). Second, private credit growth has lately surged as households and companies have borrowed to buy imported consumer goods and capital goods (Chart II-2). This has created demand for U.S. dollars at a time when the greenback has begun to rebound and foreign investors' appetite for EM assets has diminished. Finally, progress on disinflation has been slow. Core inflation is still above 20% as sticky regulated prices have kept inflation high (Chart II-3). Chart II-1Argentina's Achilles Heal: Twin Deficits Argentina's Achilles Heal: Twin Deficits Argentina's Achilles Heal: Twin Deficits Chart II-2Argentina: Credit Growth Has To Be Reined In Argentina: Credit Growth Has To Be Reined In Argentina: Credit Growth Has To Be Reined In Chart II-3Argentina: Inflation Is Still A Problem Argentina: Inflation Is Still A Problem Argentina: Inflation Is Still A Problem Faced with a market riot, the Argentine central bank hiked its policy rate from 27.25% to 40% in the span of 8 days. Furthermore the government has requested a $30 billion IMF credit line. The aggressive rate hikes prove that the Argentine authorities, unlike many of their EM counterparts, have been adhering to orthodox macro policies. This makes Argentina stand out versus others in general, and Turkey in particular. Such orthodox macro policy responses leads us to maintain our long position in Argentine local bonds. The central bank has hiked interest rates well above both the inflation rate and nominal GDP growth (Chart II-4). Real interest rates are now at their highest level in the past 13 years (Chart II-5). We reckon that this policy tightening will likely be sufficient to stabilize macro dynamics, albeit at the cost of a growth downturn. Chart II-4Argentina: Are Interest ##br##Rates High Enough? Argentina: Are Interest Rates High Enough? Argentina: Are Interest Rates High Enough? Chart II-5Argentina: Highest Real Interest ##br##Rates In Over 13 Years! Argentina: Highest Real Interest Rates In Over 13 Years! Argentina: Highest Real Interest Rates In Over 13 Years! The drastic monetary tightening will crash credit growth and hence depress domestic demand and imports (Chart II-6). This will help narrow the trade deficit. The monetary squeeze with some fiscal tightening, shrinking real wages (deflated by headline consumer inflation) and a minimum wage nominal growth ceiling of 12.5% for 2018, will bring down inflation, albeit with a time lag (Chart II-7). The fixed-income market could look through the near-term spike in inflation due to the currency plunge. Chart II-6Argentina: High Borrowing Costs ##br##Will Crash Domestic Demand Argentina: High Borrowing Costs Will Crash Domestic Demand Argentina: High Borrowing Costs Will Crash Domestic Demand Chart II-7Argentina: Real Wage Growth Is Moderate Argentina: Real Wage Growth Is Moderate Argentina: Real Wage Growth Is Moderate Finally, the authorities have been gradually implementing their structural reform agenda. Crucially, recent tax and pension reforms were major wins for President Mauricio Macri's Cambiemos coalition, and should help ameliorate the country's fiscal balance. This stands in stark contrast to Brazil, which has so far failed to enact social security reforms despite a mushrooming public debt burden. High interest rates and a domestic demand squeeze are negative for corporate profits, including banks' earnings. However, they are positive for local bonds and ultimately for the currency. The diminishing current account deficit - due to contracting imports - and IMF financing will ultimately put a floor under the Argentine exchange rate. In turn, a cyclical growth downturn, moderating inflation, orthodox macro policies and high yields will entice investors into local currency bonds. Investment Recommendations Wait for the currency to depreciate another 5-10% versus the dollar in the next several weeks, and use that as an opportunity to double down on local currency bonds. While the peso could still depreciate by another 10% in the following 12 months, the extremely high coupon and potential for capital gains as yields ultimately decline will more than offset losses on the exchange rate. This makes the risk-reward of local bonds attractive. Maintain long Argentine sovereign credit and short Venezuelan and Brazilian sovereign credit positions. Orthodox macro policies, a continuation of structural reforms and an IMF credit line will likely cap upside in sovereign credit spreads versus Venezuela and Brazil, where public debt dynamics are worse. The difference between Argentine local currency bonds and U.S. dollar bonds is as follows: Local currency bond yields at 18% offer better value than sovereign credit spreads trading at 300 basis points over U.S. Treasurys. This is the reason why we are taking the risk of an unhedged position in domestic bonds, but remain reluctant to bet on the nation's sovereign U.S. dollar bonds in absolute terms. In addition, correlation among EM nations' sovereign spreads is much higher than correlation between their local bonds. We expect more turmoil in EM financial markets, but there is a chance that Argentine local bonds could decouple from the EM aggregates in the coming weeks or months. We are closing our long ARS/short BRL and long Argentine banks/short Brazilian banks trades. We had been expecting a riot in EM financial markets, but had not anticipated that Argentina would be affected more than Brazil. Finally, structurally we remain optimistic on Argentina's equity outperformance versus the frontier equity benchmark. Tactically (say the next 3 months), however, Argentine equities could underperform. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Indonesia: Facing Major Headwinds 10 May 2018 Indonesian stocks appear to be in freefall in absolute terms and relative to the EM benchmark (Chart III-1). Meanwhile, the currency has been selling off and local currency as well as sovereign (U.S. dollar) bonds spreads are widening versus U.S. Treasurys from low levels (Chart III-2). Chart III-1Indonesian Equities: Absolute ##br##And Relative Performance Indonesian Equities: Absolute And Relative Performance Indonesian Equities: Absolute And Relative Performance Chart III-2Indonesian Local Bonds ##br##And Sovereign Spreads Indonesian Local Bonds And Sovereign Spreads Indonesian Local Bonds And Sovereign Spreads These developments have been occurring due to vulnerabilities relating to Indonesia's balance of payments (BoP) dynamics. We believe Indonesia's BoP dynamics will deteriorate further and as such there is more downside for both the rupiah and its financial markets from here: Stronger U.S. growth and higher inflation prints will likely lead to higher interest rate expectations in the U.S. and lift the U.S. dollar further. This will likely lead to Indonesia's underperformance. Chart III-3 shows that Indonesia's relative equity performance versus the EM benchmark has been extremely sensitive to moves in U.S. Treasury yields. Hence, the cost of funding has been a critical variable for Indonesia. Indonesia is also a large commodities exporting nation and the latter account for around 30% of its exports. Specifically, coal, palm oil and copper make up about 9%, 8% and 2% of its exports, respectively. Coal exports are facing major headwinds. The Chinese government has moved to restrict coal imports in several Chinese ports in order to protect its domestic coal producers as we argued in our Special Report titled Revisiting China's De-Capacity Reforms.1 This development will be devastating for Indonesia's coal industry. Chart III-4 shows that the Adaro Energy's stock price - a large Indonesian coal mining company - is falling sharply. This stock price has already fallen by 40% in U.S. dollar terms since its peak on January 30. Chart III-3Indonesia Is Very Sensitive ##br##To U.S. Bond Yields Indonesia Is Very Sensitive To U.S. Bond Yields Indonesia Is Very Sensitive To U.S. Bond Yields Chart III-4Trouble In Indonesia's Coal Sector Trouble In Indonesia's Coal Sector Trouble In Indonesia's Coal Sector Further, palm oil prices have been weak while copper prices might be on edge of breaking down. Meanwhile, there are others negatives related to shipments of these commodities. Palm oil exports are at risk because India has imposed import duties on palm oil, while the European Parliament voted in favor of a ban on the use of palm oil in bio fuel by 2021. Offsetting these, however, China has just agreed to purchase more palm oil from Indonesia. In regard to copper, the ongoing dispute on environmental regulation between Freeport-McMoRan - a U.S. mining company that operates a large copper mine in Indonesia - and the Indonesian government, risks disrupting Freeport's copper production in Indonesia, hurting the country's export revenues. On the whole, export revenues are at risk of plummeting at a time when Indonesian imports are already too strong. This will worsen BoP dynamics further. Chart III-5 shows that a deteriorating trade balance in Indonesia is usually bearish for its equity market. It seems that the current account deficit will be widening when foreign funding is drying up. This requires either a major depreciation in the currency or much higher interest rates. As such, Bank Indonesia (BI) - Indonesia's central bank - might be forced to raise interest rates to cool down domestic demand and attract foreign funding to stabilize the rupiah. Even if the BI does not raise rates, it might opt to defend the rupiah by selling its international reserves. This would still bid up local interbank rates as defending the currency entails drawing down banking system liquidity, i.e., banks' reserves at the central bank. Chart III-6 shows that Indonesian interbank rates are starting to rise in response to falling international reserves. Chart III-5Indonesia: Swings In Trade ##br##Balance And Share Prices Indonesia: Swings In Trade Balance And Share Prices Indonesia: Swings In Trade Balance And Share Prices Chart III-6Indonesia: Currency Defense By Selling ##br##FX Reserves Leads To Higher Interbank Rates Indonesia: Currency Defense By Selling FX Reserves Leads To Higher Interbank Rates Indonesia: Currency Defense By Selling FX Reserves Leads To Higher Interbank Rates Higher rates will weaken domestic demand and are bearish for share prices. Importantly, foreign ownership of local bonds is still high at 39% and a weaker rupiah could cause selling by foreign investors, pushing yields even higher. Chart III-7Indonesia: Banks Profits Are At Risk As Banks' NPL Provisions Rise, Bank Stocks Could Fall Indonesia: Banks Profits Are At Risk As Banks' NPL Provisions Rise, Bank Stocks Could Fall Indonesia: Banks Profits Are At Risk Finally, a word on Indonesian banks is warranted. Financials account for 42% of Indonesia's MSCI market cap and 47% of its total earnings. Thus their performance is also very crucial for the outlook of the overall stock market. In our March 1st Weekly Report,2 we argued that Indonesian banks have been lowering their provisions to artificially boost earnings. This is not sustainable as these provisions are insufficient and will have to rise. As they ultimately rise, bank profits and share prices will hurt (Chart III-7). Bottom Line: We recommend investors to downgrade Indonesia's stocks from neutral to underweight within an EM equity portfolio. We also reiterate our short IDR / long USD trade and the short position in local bonds. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report "Revisiting China's De-Capacity Reforms," dated April 26, 2018, the link available on page 23. 2 Please see Emerging Markets Strategy Weekly Report "EM Equity Valuations (Part II)," dated March 1, 2018, the link available on page 23. Equity Recommendations Fixed-Income, Credit And Currency Recommendations