Emerging Markets

Highlights The current U.S.-China trade skirmish is essentially the beginning of a new cold war. The U.S. and China are engaged in a struggle for supremacy, so trade conflicts will persist. The conflict could evolve into a "game of chicken" - the most dangerous type of game. The U.S. needs Europe's help against China - but an adventure in Iran could cost it that help. Geopolitical risks will cap the rise in bond yields over the next six months, push up oil, and give a tailwind to global defense stocks. Feature The opening salvo of the U.S.-China trade war has caught the investment community by surprise as the market is quickly repricing the odds of a global trade war.1 Nervousness over the breakdown of globalization comes at the same time as our key China view - that Beijing's structural reforms will constrain growth - are beginning to have an impact on global growth (Chart 1).2 Chart 1China Reforms Dragging On Global Growth China Reforms Dragging On Global Growth China Reforms Dragging On Global Growth Fortuitously, we found ourselves in Asia at the onset of "hostilities" and were thus able to see regional investors' reactions in real time. Our clients focused their questions on the economic impact of the announced tariffs (yet to be determined, in our view), constraints facing President Trump (minimal as well), and potential Chinese retaliation (understated). The focus, however, should be on the big picture. The March 23 U.S. announcement of tariffs on around $50 billion worth of Chinese imports is not just the opening salvo of a trade war. Rather the emerging trade war is the opening salvo of a new cold war, a global superpower competition between the U.S. and China that will define the twenty-first century. Put simply, the U.S. and China are now enemies. Not rivals, competitors, or sparing partners. Enemies. It will take the market some time for investors to internalize this idea and price it properly. Meanwhile, in the short term, fears of a full-born global trade war are overblown. The trade tensions are really only about two countries, with uncertain global implications. Investors are right to be cautious, but risks to global earnings are overstated at this time. How Did We Get Here? The ongoing trade tensions are not merely a product of a nationalist Trump administration that decided to call out China for decades of unfair trade practices. They are also the product of the geopolitical context, which we have defined through three "big picture" themes. These three themes allowed us to correctly forecast that the defining feature of the twenty-first century would be a Sino-American conflict. We would be thrilled to see this culminate merely in a trade war. The themes are: Multipolarity (Chart 2)3 Apex of globalization (Chart 3)4 The breakdown of laissez-faire economics (Chart 4)5 Chart 2Multipolarity Is Messy And Volatile Multipolarity Is Messy And Volatile Multipolarity Is Messy And Volatile Chart 3When Hegemony Declines, Globalization Declines When Hegemony Declines, Globalization Declines When Hegemony Declines, Globalization Declines Chart 2 elucidates a key lesson of history: the collapse of British hegemony at the end of the nineteenth century ushered in two world wars. Political science, game theory, and history teach us that periods of multipolarity are rarely peaceful.6 Today's world is not exactly multipolar, as the U.S. remains the preeminent global power. However, regional powers - such as China, the EU, Russia, India, Japan, Iran, and perhaps Turkey and Brazil - have a lot more room to maneuver within their spheres of influence. This means that global rules written by the U.S. at the conclusion of the Second World War are being rewritten for regional contexts. Normatively there is nothing wrong with this process. But practically, multipolarity means that "challenger powers" - such as China today or the German empire in the late nineteenth century - seek to undermine rules and norms of behavior that they had little or no say in setting up. And such rules are necessary to underpin geopolitical stability and grease the wheels of globalization. As Chart 3 shows, trade globalization peaked in the past when the hegemon could no longer enforce global rules. We have therefore emphasized to clients since 2014 that, if we are right that the world is multipolar, then we are essentially at the apex of globalization. A parallel process has seen the breakdown of the laissez-faire consensus, which underpinned the expansion of trade in goods, labor, and capital across sovereign borders. Economic globalization has lifted many boats around the world, but outsourcing - combined with technological innovation - has seen the lower middle class in developed nations face diminishing returns (Chart 4). Chart 4Globalization: No Friend To Developed-Market Middle Class We Are All Geopolitical Strategists Now We Are All Geopolitical Strategists Now That said, a revolt against globalization and "globalists" is thus far mainly an Anglo-Saxon phenomenon, and particularly an American one. Why? Because the particularities of the U.S. laissez-faire economic model, with its scant social protections, laid its middle class bare to the vagaries of globalization and technological change (Chart 5). However, there is no guarantee that other DM countries will not succumb to the same pressures down the line. Chart 5The 'Great Gatsby' Curve: Or, How Anglo-Saxons Turned Against Laissez Faire We Are All Geopolitical Strategists Now We Are All Geopolitical Strategists Now This background is important for investors because merely blaming a nationalist Trump administration or a mercantilist Beijing for today's tensions ignores the underlying context. President Trump can change his mind on a dime, but the geopolitical context can only evolve slowly.7 Mercantilism is here to stay; it is a feature, not a bug, of a multipolar world. Contrast today's tensions with those of the 1970s and 1980s between the U.S. and its major trade partners. The 1971 Smithsonian Agreement and the 1985 Plaza Accord ended overt trade protectionism by the U.S. (in 1971), and threats thereof (in 1985), by securing the compliance of these trade partners with Washington's currency and trade demands. Japan further conceded to U.S. demands in 1989 after a two-year trade war. Today, the U.S. and China are not geopolitical allies huddled under the same nuclear umbrella for protection against an ideologically fueled rival. They are ideological rivals. The reason it took a decade for the conflict to erupt is two-fold. First, the U.S. became entangled in the global war on terror after 9/11, which took its focus off of its emerging competitor in Asia. Second, the consensus view - that China would asymptotically approach a Western democracy as it embraced capitalism - has proven to be folly.8 Bottom Line: The China-U.S. trade conflict is a product of today's particular geopolitical context. At heart, it is a conflict for geopolitical primacy in the twenty-first century and thus unlikely to end quickly. Sino-American Conflict Is Intractable The current U.S.-China trade tensions are more of a skirmish than a war. We think that there is considerable room for a step-down in tensions over the next 12 months. First, the Trump administration has not launched an economic war against China. Not only has the U.S. restricted its list of Chinese goods under tariff consideration to just $50 billion of imports - roughly 12% of total Chinese exports to the U.S. - but it has decided to bring a case against China to the World Trade Organization (WTO). The latter is hardly a move by a mercantilist administration dead-set on across-the-board economic nationalism. Second, China has responded almost immediately by offering several concessions, including renewing pledges to open its economy to inward investment and to protect intellectual property (IP) rights. While these may seem like boilerplate concessions that Beijing has floated before, the current context of trade tensions and domestic structural reforms makes it more likely that Chinese policymakers will follow through on their promises. As such, we can see the current round of tensions tapering off, especially after the U.S. midterm elections. However, we doubt that the structural trajectory of Sino-American relations will be significantly altered even if current tensions subside. First, from China's perspective, its extraordinary economic ascent (Chart 6) is merely the return of the millennium's status quo (Chart 7). The last 180 years - roughly from the beginning of the First Opium War in 1839 to today - were the aberration. During this short period of Chinese weakness, the West - with Britain and then the U.S. at the helm - conspired to restructure global rules and norms of geopolitical and economic behavior without input from the Middle Kingdom. Chart 6China's Economic Rise Has Been Extraordinarily Fast... We Are All Geopolitical Strategists Now We Are All Geopolitical Strategists Now Chart 7China Sees Its Success As A Return To The Status Quo We Are All Geopolitical Strategists Now We Are All Geopolitical Strategists Now As such, China's influence in key post-WWII economic institutions like the WTO and the IMF is limited while its military has second-class status even in its own "Caribbean Sea," the South China and East China Seas. From the U.S. perspective, China's growth over the past two decades was made possible by U.S. hegemony. The U.S. secured the global rules and norms that enabled China to integrate seamlessly into the global marketplace and then compete its way to the top. Not only did the U.S. allow China to access its credit-fueled markets, but the U.S. Navy protected China's maritime trade, including vital energy supplies transiting from the Middle East. As a thank you for these efforts, China reneged on its WTO commitments, periodically suppressed its currency, stole American intellectual property, and withheld market access from U.S. corporations via tariff and non-tariff barriers to trade. Washington policymakers, and not only Trump's hawkish advisors, are turning against China. There is an emerging consensus among the U.S. foreign policy, defense, intelligence, and economic policy elites that: Sino-American economic symbiosis is over (Chart 8); Chart 8U.S.-China ##br##Symbiosis Is Dead U.S.-China Symbiosis Is Dead U.S.-China Symbiosis Is Dead Chart 9The U.S. Is Least##br## Exposed To Trade The U.S. Is Least Exposed To Trade The U.S. Is Least Exposed To Trade Chart 10China's Share Of Global##br## Exports Has Skyrocketed China's Share Of Global Exports Has Skyrocketed China's Share Of Global Exports Has Skyrocketed The U.S. can afford to confront China over trade because it is the least exposed major economy to global trade (Chart 9); The Chinese have acquired a massive share of global exports without a commensurate opening of their domestic market (Chart 10); Arresting Chinese technology transfer and intellectual property theft is a national security issue (Chart 11); The U.S. can confront China because it has emerged victorious from every global conflagration in the past (Chart 12). Chart 11China Imports Conspicuously Little U.S. IP We Are All Geopolitical Strategists Now We Are All Geopolitical Strategists Now Chart 12America Is Chaos-Proof America Is Chaos-Proof America Is Chaos-Proof Fundamentally, American policymakers want to see China's rapid economic growth slow, they want to see China's capital markets and companies constrained by openness to global competition, and they want to put a leash on China's catch-up in the technological and manufacturing value chain (Chart 13). This is not their stated objective as it would imply that the U.S. wants to see China weakened, and the Chinese leadership miss its decade and century economic development goals. But this is precisely what the U.S. establishment wants. As such, the political and economic visions of American and Chinese policymakers are directly at odds with one another. What does this mean for investors? Over the past several years we have developed a reputation of being sanguine about geopolitics. While many of our peers in the political analysis industry overstate the probability of geopolitical risk, we have (successfully) bet against the worst-case scenario in several prominent crises.9 We like to think that this is because we combine game theory with an understanding of the underlying power dynamics. By emphasizing constraints, we have successfully identified how power dynamics constrain the worst-case outcome.10 When it comes to Sino-American tensions, however, we have always been alarmists. This is because we believe the constraints to conflict are overstated, not understated. Furthermore, the potential market impact of a new cold war is unclear and potentially very large. Both the U.S. and China fundamentally think they can win a trade war. This means that they are engaged in a "regular game of chicken," named after the 1950s practice of racing hot rods head-on in order to prove one's manhood.11 Game theory teaches us that a game of chicken is the most unpredictable game because it can create an equilibrium in which all rational actors have an incentive to keep driving head on - to stick to their guns - despite the risks. In Diagram 1, we can see that continuing to drive carries the greatest risk, but also the greatest reward, provided that your opponent swerves. Chart 13China's Steady Climb Up##br## The Value Ladder Continues We Are All Geopolitical Strategists Now We Are All Geopolitical Strategists Now Diagram 1A Regular ##br##Game Of Chicken We Are All Geopolitical Strategists Now We Are All Geopolitical Strategists Now Since all actors in a game of chicken assume the rationality of their opponents, they also expect them to eventually swerve. In the current context, this means that the U.S. assumes that China is driven by economic rationality and will not dare face off against the U.S., which has far less to lose given its modest exposure to global trade. Chinese policymakers, however, also think they can win. They look over the Pacific and see a country riven by political polarization (Chart 14) where half of the country thinks the other is "a threat to the nation's well-being" (Chart 15).12 China, meanwhile, has just consolidated its political leadership and feels confident enough in its domestic stability to dabble with growth-constraining economic reforms. Beijing can use any trade tensions with the U.S. to further justify painful reforms. Chart 14Inequality Fuels Political Polarization Inequality Fuels Political Polarization Inequality Fuels Political Polarization Chart 15Live And Let Die We Are All Geopolitical Strategists Now We Are All Geopolitical Strategists Now Who is right? We do not know. And that scares us as it means that the most sub-optimal equilibrium - the bottom-right quadrant of Diagram 1 - is more probable than people think. An important difference maker, one that would alter Beijing's risk calculus considerably, is Europe. Despite being highly leveraged to China's growth, the EU still exports nearly double the value of goods to the U.S. than China (Chart 16). In addition, Europe's trade surplus with the U.S. mostly pays for its deficit with China (Chart 17). Chart 16The EU Exports More To U.S. Than China The EU Exports More To U.S. Than China The EU Exports More To U.S. Than China Chart 17EU Surplus With U.S. Pays For Deficit With China EU Surplus With U.S. Pays For Deficit With China EU Surplus With U.S. Pays For Deficit With China Over the next several months, investors will be able to gauge whether the Trump administration is filled with ideological nationalists who believe in Fortress America or wily realists who know how to get things done. The key question is whether Trump will embrace America's traditional transatlantic alliance with Europe and harness it for the trade war with China. If he embraces it, we will predict that the combined forces of U.S. and Europe will successfully force China to concede to the pressure. If Trump fails, however, we could have a prolonged U.S.-China trade war. Early indications are optimistic. The U.S. gave the EU an exemption from tariffs on steel and aluminum imports on March 22, a delay that will end on May 1. This followed a March 21 meeting between EU Commissioner for Trade Cecilia Malmström and U.S. Secretary of Commerce Wilbur Ross. We suspect, but have no evidence, that the U.S. asked the EU to join in its effort to force China to change its trade practices at the WTO. As an exporting bloc, the EU has a lot more to lose from attacking China than the U.S. But it also has much to lose from unabated Chinese mercantilism and technological theft, and much to gain if China opens its doors wider. As such, we posit that Europe will, in the end, join the U.S. and Japan in a concerted effort to pressure China. This will increase the probability that Beijing ultimately gives in to trade pressure. In the long term, it will also ensure that President Trump does not break the critical transatlantic alliance with Europe, which would be paradigm shifting. But, on the other hand, it will set China and the West on a collision course. China's and the West's suspicions of each other will ossify. Bottom Line: In the short term, trade tensions are likely overstated as U.S. actions against China are largely muted and restrained. In the long term, the U.S.-China trade war could potentially devolve into a "game of chicken," the most dangerous type of conflict. The key variable will be whether the U.S. administration is savvy enough to arrange European collaboration against China. If the U.S. treats the EU harshly and ignores its transatlantic ally on other issues - such as conflict with Iran, discussed below - we could be in for a wild ride in the coming months and years. Either way, Europe stands to gain from a conflict between China and the U.S. Both sides are likely going to try to enlist the EU on their side. As such, we are opening a long Europe industrials / short U.S. industrials trade. Meanwhile, growing trade tensions, policy-induced slowdown in China, and repricing of geopolitical risks in East Asia and the Middle East should cap global bond yields over the next six months. We take 50.4bps and 54.4bps profits on our short U.S. 10-year government bond vs. German bund and short Fed Funds December 2018 futures trades. Iran: The Next Target Of Trump's "Maximum Pressure" Policy President Trump's North Korea policy worked brilliantly in 2017. The policy of "maximum pressure" combined military maneuvers, economic sanctions, and extremely bellicose rhetoric to convince Pyongyang and regional powers that the U.S. has lowered its threshold for full-scale war on the Korean peninsula. China reacted swiftly, starving North Korea of hard currency through economic sanctions (Chart 18). The result was a declaration by Pyongyang in late November that it had finally completed its quest to obtain a nuclear deterrent (an exaggeration at best), an olive branch for the Olympics, and an offer by Supreme Leader Kim Jong Un to meet with President Trump. Chart 18China Gives Kim To Trump China Gives Kim To Trump China Gives Kim To Trump The policy of "maximum pressure" yielded such extraordinary results with North Korea that President Trump is now eager to trademark the process and apply it to Iran and potentially other global issues. Ahead of the all-important May 12 deadline - when the White House will decide whether to end the current waiver of economic sanctions against Iran - President Trump has replaced two establishment advisors with hawks. Secretary of State Rex Tillerson has been replaced with CIA Director and noted Iran-hawk Mike Pompeo. Meanwhile, National Security Advisor H.R. McMaster has been replaced by conservative pundit (and former U.S. Ambassador to the UN) John Bolton. Bolton is on record arguing that the U.S. should bomb Iran. The role of the national security advisor varies with the president. Some presidents rely on the position more than others. However, given this administration's inexperience with foreign policy, the role is critical in shaping the White House worldview. The national security advisor manages the staff of the National Security Council (NSC), whose role is to coordinate with the vast network of U.S. intelligence agencies and filter information to the president. Given how large America's foreign, defense, and intelligence establishment is, and given the nature of human and signals intelligence, U.S. presidents often have to act upon diametrically opposing pieces of intelligence. As such, the national security advisor and the NSC can play a critical role in deciding what intelligence makes it to the president's desk and in what context. Staffers in the National Security Council (NSC) are often apolitical. We have been told that several current experts are leftovers from the Obama administration. It is likely that an ideological pundit like John Bolton, who served briefly in the George W. Bush administration, will set out to quickly eliminate non-partisan staffers on the NSC and tilt the information flow away from the empirical to the conspiratorial. With Bolton and Pompeo effectively in charge of U.S. foreign policy it is possible that the U.S. will misapply "maximum pressure" policy to Iran and bungle the complicated coordination with geopolitical allies on China. In particular, the U.S. has to endear itself to the EU if it wants a global economic alliance against China. But the EU also does not want to renegotiate Iran sanctions. Abrogating the 2015 nuclear deal - the Joint Comprehensive Plan of Action (JCPA) - would throw the tentative Middle East equilibrium into chaos. While Iran has played a role in preserving the regime of Bashar al-Assad in Syria, it has largely kept its vast network of Shia militias and allies in check, particularly in Lebanon and Iraq. Ironically, it was the Obama administration's "flawed" JCPA that has allowed Trump to focus on China in the first place. As we argued when the deal was signed, the conservative critics of the deal itself were correct. The JCPA did not degrade Iran's nuclear capability but merely arrested it.13 The point of the deal was implicitly to give Iran a sphere of influence in the Middle East so that the U.S. could extricate itself and focus on China. The Obama administration assessed, in our view non-ideologically, that the U.S. cannot fight two wars at the same time. If the Trump administration decides not to waive sanctions on May 12, it will be in abrogation of the deal. Unlike North Korea, however, Iran has multiple levers it can deploy against the U.S. and its allies' interests in the region. As such, the policy of "maximum pressure" will create much greater risks when applied to Iran. At the very end, it could be as successful as when applied to North Korea, but our conviction view is much lower (and to remind clients, we were optimists about the strategy when applied to North Korea!).14 Furthermore, and again unlike North Korea, Iran is beset with domestic risks. This actually makes it less likely that Tehran will cooperate with the U.S. North Korea is a simple domestic political system where Kim Jong Un can alter policy on a whim without much domestic pushback. In Iran, the dovish and moderate President Hassan Rouhani has to contend for power with hawks who have been critical of the JCPA. Meanwhile, the restive youth population could rise up at the first sign of elite division or weakness. This complicated domestic dynamic is why we cautioned clients back in January that Iran would likely add geopolitical risk premium to the oil markets.15 Bottom Line: It appears that President Trump, motivated by the success of his "maximum pressure" strategy against North Korea, now thinks he can apply it as successfully to Iran. This raises the prospect that Trump will discontinue the waiver of economic sanctions on May 12, effectively re-imposing a slew of economic sanctions against Iran and foreign companies looking to conduct business with it. Geopolitical risks are likely to rise in the Middle East as a result of U.S.-Iran tensions. As we go to publication, Saudi authorities have intercepted another Houthi missile heading towards Riyadh just days after Saudi Crown Prince Mohammad Bin Salman visited Washington, D.C. The White House appears to relish the opportunity to fight a war on two fronts, a trade war with China and a geopolitical war with Iran. Expect volatility and an elevated geopolitical risk premium in oil markets. Stay overweight global defense companies across markets. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War," dated March 6, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Politics Are Stimulative, Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2013," dated January 16, 2013, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, and "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 6 Please see John Mearsheimer, The Tragedy Of Great Power Politics (New York: Norton, 2001). 7 Would President Hillary Clinton have avoided a trade war with China? We do not think so. Secretary Clinton was considered a "China Hawk" while at the State Department and pushed for the "Pivot to Asia." Jennifer Harris, the lead architect of Clinton's economic statecraft agenda in the U.S. State Department, recently penned a book that called for greater use of economic tools for geopolitical ends. The book, War By Other Means, introduces the term geoeconomics and calls for the U.S. to use economic instruments to promote and defend national interests. Please see BCA Geopolitical Strategy Blog, "We Read (And Liked)... War By Other Means," dated July 13, 2016, available at gps.bcaresearch.com. 8 In 2000, while campaigning on behalf of China's WTO entry, President Bill Clinton remarked, "economically, this agreement (China's WTO entry) is the equivalent of a one-way street. It requires China to open its markets ... to both our products and services in unprecedented new ways. All we do is to agree to maintain the present access which China enjoys ..." Please see "Full Text of Clinton's Speech On China Trade Bill," dated March 9, 2009, available at nytimes.com. 9 To name just a few: the risk of an Israeli attack against Iran, the risk of a full-scale Russian invasion of Ukraine, the risk of Euro Area collapse, the risk of Saudi-Iranian war, the risk of Russian-Turkish war, etc. 10 For the best example of how game theory is combined with our constraint-based paradigm, please see BCA Geopolitical Strategy Special Report, "After Greece," dated July 8, 2015, available at gps.bcaresearch.com. 11 See James Dean in Rebel Without A Cause. 12 Please see BCA Geopolitical Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 13 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. 14 Please see BCA Geopolitical Strategy Client Note, "Trump Re-Establishes America's 'Credible Threat,'" dated April 7, 2017, "North Korea: Beyond Satire," dated April 19, 2017, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, and "Insights From The Road - The Rest Of The World," dated September 6, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com.

Highlights The China-specific tariffs proposed by the Trump administration last week represent a great escalation in U.S. protectionism, but the actual measures may be smaller than what was initially announced. The proposed tariffs, if applied as stated, would likely shave 2% off of China's export growth over the coming 6-12 months. This would prevent an acceleration that we would have otherwise expected given the strength of the global economy. A 2% deceleration in export growth is not in and of itself a significantly negative event for China's economy, but the shift in U.S. protectionism from rhetoric to action and the continued decline in our leading indicators makes a tenuous case for a continued overweight stance towards Chinese stocks. We recommend that investors put Chinese ex-tech stocks on downgrade watch over the course of Q2. The recent weakness in the Hong Kong dollar is not a sign of any major economic weakness or financial market instability that should concern investors. However, the prospect of tighter monetary policy is a potential threat to the highly leveraged Hong Kong economy that needs to be monitored. Feature The Trump administration doubled down on its protectionist agenda last week, by announcing its intention to levy US$50 billion in tariffs against a variety of imports from China. This follows the administration's decision earlier in the month to impose a tariff on all steel and aluminum imports, which we discussed at length in our March 7 Weekly Report.1 While the China-specific tariffs represent a great escalation in protectionism relative to those on steel and aluminum imports, there are several important factors for investors to take into consideration: Chart 1President Trump Can Ill-Afford ##br##Any Major Economic Turmoil Chinese Stocks: Trade Frictions Make For A Tenuous Overweight Chinese Stocks: Trade Frictions Make For A Tenuous Overweight The decision on Chinese import tariffs is not yet final, as the White House will propose a list of Chinese goods potentially subject to tariffs for public comment and consultations. This opens the door for an enormous lobbying effort from U.S. retailers and negotiations with Chinese officials, signaling that the end result is not set in stone. China's very muted retaliation (so far) increases the odds of a benign, negotiated outcome. Following the initial announcement of the steel and aluminum tariffs, the Trump administration significantly watered down the measures by granting Canada and Mexico an exemption and allowing exemption applications from other countries. This could suggest that the final tariffs to be applied against Chinese imports will be considerably smaller than what the administration signaled last week. Finally, given that the U.S. midterm election will be occurring later this year and that the administration can ill-afford to lose control of the legislative process, President Trump's actions on trade may be designed to maximize the perception of serious trade reform without threatening to substantially impact U.S. or global ex-U.S. economic momentum (Chart 1). This perspective would further support the notion that the bark of China-specific tariffs will be worse than the ultimate bite. The Impact Of Proposed Tariffs On Growth Still, investors cannot assume that the tariffs will be significantly watered down, meaning that it is important to have a forecast for the impact of the proposed tariffs on Chinese growth. We take a simple approach to judging the economic impact on nominal export growth, by calculating an aggregate tariff rate as if the amount of proposed tariffs applied equally across all Chinese exports to the U.S. We then multiply that rate by an estimate of U.S. import price elasticity, and again by the weight of U.S. exports as a share of total Chinese exports. Table 1 presents a list of import elasticity estimates for the G7 countries, both over the short- and long-term. Given that the short-run is our primary concern when modeling the likely cyclical impact on Chinese exports, we use the 0.6 elasticity estimate for the U.S. as a starting point for our analysis. We shock this estimate upwards to 0.8, for two reasons: To generate a relatively conservative estimate of the impact on Chinese export growth It is not clear whether the demand for goods from China is more or less price elastic than goods from other countries. However, given that the majority of Chinese exports to the U.S. are consumer-oriented (and thus less differentiated than highly specialized industrial goods), it is plausible that the price elasticity of Chinese imports is higher than it is on average. Table 1U.S. Short-Run Import Price Elasticity Is Not Trivial Chinese Stocks: Trade Frictions Make For A Tenuous Overweight Chinese Stocks: Trade Frictions Make For A Tenuous Overweight Given that US$50 billion is roughly 10% of annual U.S. imports from China, our simple approach suggests that the proposed tariffs would cause China's total export growth to decelerate about 1.6% (10% effective tariff rate times -0.8 import price elasticity times 20% export weight). Including the effect of Chinese re-exports to the U.S. via other major trading partners would slightly increase this estimate, meaning that 1.5 - 2.0% is a conservative range of estimates for the tariff impact. When applied to the current growth rate of Chinese exports, the impact of this estimate would be minimal. Chart 2 shows that Chinese nominal export growth recently accelerated to 22% even when shown as a 3-month moving average, suggesting that a U.S. import tariff would be coming at a time of considerably strong export momentum. In fact, China's February export data was so positive that it raised the Citigroup economic surprise index for China to a 9-year high (Chart 3). Chart 2At First Blush, Chinese Export Growth ##br##Has Accelerated Significantly At First Blush, Chinese Export Growth Has Accelerated Significantly At First Blush, Chinese Export Growth Has Accelerated Significantly Chart 3The Pop In Export Growth Has##br## Turbocharged The Surprise Index The Pop In Export Growth Has Turbocharged The Surprise Index The Pop In Export Growth Has Turbocharged The Surprise Index However, our view is that the growth rates of China's nominal imports and exports do not currently reflect the underlying pace of trade, with both series likely overstating the recent pace of growth. On the import side, we have highlighted in previous reports that import demand has recently outpaced what the Li Keqiang index would suggest. On the export side, a model of global US$ imports from China regressed against extrapolated global industrial production growth has an extremely strong fit over the past several years, and implies that the underlying pace of Chinese export growth is closer to 10%. Chart 4 illustrates this estimate of underlying export growth (based on global imports from China) along with the impact of the proposed tariffs, and highlights that a 2% export growth shock would simply prevent the 2% acceleration in underlying growth that we would normally expect over the coming months given the recent pickup in our global LEI. Chart 4If Enacted, The Proposed Tariffs Will ##br##Prevent An Acceleration In Export Growth Chinese Stocks: Trade Frictions Make For A Tenuous Overweight Chinese Stocks: Trade Frictions Make For A Tenuous Overweight Bottom Line: The import tariffs proposed by the Trump administration, if applied as stated, would likely shave about 2% off of China's export growth over the coming 6-12 months. This would prevent an acceleration that we would have otherwise expected given the strength of the global economy. The Implications For Chinese Stock Prices A 2% deceleration in export growth is not a significantly negative event for China's economy, especially if underlying export growth was set to trend higher due to strong global activity. But it does have the strong potential to mute a source of positive economic momentum, at a time when the industrial sector is clearly slowing. We presented our decision tree for Chinese stocks (Chart 5) in our first report of the year,2 and referenced it again in our March 7th report. The decision tree lays out four key questions for investors to answer over the coming 6-12 months in order to decide on the ideal allocation to Chinese equities within a global portfolio: Is The Global Economy Slowing Significantly? Is Significant Further Monetary Policy Tightening Likely? Is The Pace Of Renewed Structural Reforms Likely To Be Too Aggressive? Is The Existing Slowdown In China's Growth Momentum Metastasizing? Chart 5The Chinese Equity 'Decision Tree' Chinese Stocks: Trade Frictions Make For A Tenuous Overweight Chinese Stocks: Trade Frictions Make For A Tenuous Overweight While the answer to questions 2 and 3 remains "no", Trump's shift towards protectionism certainly raises the risk of an eventual "yes" to the first question, especially given that our analysis has assumed no retaliation or counter-retaliation. Regarding the issue of China's industrial sector slowdown, the Li Keqiang index is not falling sharply, but it remains in a downtrend and is set to decline further according to our BCA Li Keqiang Leading Indicator (Chart 6). At best, the answer to question 4 is a lukewarm "no". We have previously noted that the uptrend in Chinese ex-tech stock prices vs their global peers over the past two years suggests that investors should have a high threshold for reducing exposure to China. We continue to agree with that assessment, but we must also acknowledge that the shift in U.S. protectionism from rhetoric to action and the continued decline in our leading indicators makes a tenuous case for a continued overweight stance towards Chinese stocks. We are not yet changing our investment recommendations, but we are putting Chinese ex-tech stocks on downgrade watch for Q2. An outright recommendation to cut exposure to neutral will likely occur in response to a technical breakdown which, for now, does not appear to be imminent (Chart 7). Chart 6China's Industrial Sector Is Set To Slow Further China's Industrial Sector Is Set To Slow Further China's Industrial Sector Is Set To Slow Further Chart 7Still In An Uptrend, For Now Still In An Uptrend, For Now Still In An Uptrend, For Now Bottom Line: A 2% deceleration in export growth is not in and of itself a significantly negative event for China's economy, but the shift in U.S. protectionism from rhetoric to action and the continued decline in our leading indicators makes a tenuous case for a continued overweight stance towards Chinese stocks. We recommend that investors put Chinese ex-tech stocks on downgrade watch over the course of Q2. An Update On The Hong Kong Dollar The Hong Kong dollar (HKD) has been weakening for the better part of a year, but recently it has fallen quite sharply relative to its history and now trades very close to the weak side of the peg (7.85 Hong Kong dollars to 1 U.S. dollar). The pace of recent weakness has caught the attention of investors and market participants, in part because it would be the first time in 12 years since the HKD threatened to decline below the lower end of the peg. In our view, both the HKD's weakness over the past year and the recent slide have been caused largely by technical factors, and are not in and of themselves signs of any major economic weakness or financial market instability that should concern investors. As highlighted in Chart 8, the significant rise in USD/HKD (a depreciation in the Hong Kong dollar) can be explained by a sizeable rise in the 3-month U.S. LIBOR / Hong Kong HIBOR spread. Panel 2 shows that the first portion of the rise in LIBOR vs HIBOR can be explained on the Hong Kong side. 3-month HIBOR itself has fallen quite substantially relative to the base rate, which has risen in lockstep with the Fed funds rate. This decline in 3-month HIBOR suggests that there is a supply-demand imbalance in the Hong Kong interbank market (in favor of excess supply), and that the Hong Kong Monetary Authority (HKMA) is likely to reduce the aggregate balance maintained by commercial banks in the days and weeks ahead (after having reduced it by HKD 80 billion in the second half of 2017; Chart 9) in order to defend the peg. Chart 8HKD Weakness Caused By Factors##br## On Both Sides Of The Pacific HKD Weakness Caused By Factors On Both Sides Of The Pacific HKD Weakness Caused By Factors On Both Sides Of The Pacific Chart 9To Raise 3-Month HIBOR, ##br##The HKMA Has To Tighten Interbank Liquidity To Raise 3-Month HIBOR, The HKMA Has To Tighten Interbank Liquidity To Raise 3-Month HIBOR, The HKMA Has To Tighten Interbank Liquidity Panel 3 of Chart 8 highlights that the second portion of the LIBOR/HIBOR spike is due to events completely unconnected with Hong Kong's monetary policy or its banking system. As discussed in detail in last week's U.S. Bond Strategy,3 the sharp rise in 3-month LIBOR relative to the Fed funds rate (the opposite of what is occurring in Hong Kong) appears to be driven by the U.S. Treasury rebuilding its cash balance following the recent extension of the debt ceiling, the money market effect of U.S. corporations repatriating U.S. dollars, and the Fed's ongoing balance sheet contraction. The combination of these two factors has created incentives for investors to sell the Hong Kong dollar and buy the U.S. dollar, which explains the weakness of the former. While these factors are technical in nature and are likely to dissipate over time, they are both significantly rooted in the fact that the U.S. is tightening its monetary policy. This will be discussed in more depth in next week's report, as the combination of tighter monetary conditions, the ongoing slowdown in China's industrial sector, and the extremely high levels of leverage in Hong Kong's private sector legitimately raises the odds of a smashup over the coming 1-2 years. We will gauge how bearish investors should be on Hong Kong and will present a new indicator that investors can use to monitor whether tighter monetary policy is likely to tip the economy into a debt-driven downturn. Stay tuned. Bottom Line: The recent weakness in the Hong Kong dollar is not a sign of any major economic weakness or financial market instability that should concern investors. However, the prospect of tighter monetary policy is a potential threat to the Hong Kong economy that needs to be monitored. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China And The Risk Of Escalation," dated March 7, 2018, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "The "Decision Tree" For Chinese Stocks," dated January 4, 2018, available at cis.bcaresearch.com. 3 Please see U.S. Bond Strategy Weekly Report, "Profiting From A Higher LIBOR," dated March 20, 2018, available at usbs.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights China and Brazil are two extremes in regard to investment and savings - the former saves and invests a lot, the latter very little. The key difference between Brazil and China is neither the existing amount of deposits nor their propensity to save. Rather, it is their real economies' capacity to produce goods and services. Regardless of how capital expenditures are financed, when inputs for capital spending are procured domestically it is recorded as national "savings," but when they are imported there is no change in the level of national "savings." In China, policymakers are currently being forced to walk a very thin line between inflation and deflation. Brazilian consumers do not need to save more for companies to get financing for their investments. Instead, businesses - along with facilitation from the government - should build the supply side. Banks can finance the latter by originating loans "out of thin air." However, the natural consequence of this adjustment in Brazil will be considerable currency deprecation. Feature The Fallacy This is the fifth report in our series on money, credit, savings and investment. Its objective is to show that financing of investments is not constrained by national and foreign savings. This report argues against a postulate in mainstream economic literature which holds that in order to invest, nations with low savings rates need to either reduce consumption and boost national savings or to borrow foreign savings. Some examples of this economic thesis can be seen here: As Lindner neatly summarizes: "Many economists hold the position that "saving finances investment." They argue that saving - a reduction of consumption relative to income - is necessary for the provision of loans and the financing of investment." (Lindner 2015).1 Linder also provides other examples suggesting that this thesis is well entrenched in the economic theory and analysis. For example, he cites Gregory Mankiw's influential introductory macroeconomics textbook that upholds: "Saving is the supply of loans - individuals lend their saving to investors, or they deposit their saving in a bank that makes the loan for them. [. . . ] At the equilibrium interest rate, saving equals investment, and the supply of loans equals the demand." (1997, p. 63) (Lindner 2015).2 This mainstream economic thesis - that financing is constrained by savings - is intuitive, and not surprisingly many investors take it for granted. Yet this is a false proposition. This thesis is correct for barter economies but is not pertinent to modern economies with their own banking systems and national currencies. Further, Lindner (2015)3 argues: "The fallacies loanable funds theory commits might be explainable by the mis-application of some ideas and concepts of neoclassical growth models - especially the Ramsey (1928), Solow (1956) and Diamond (1965) models - to the sphere of money and finance... The Ramsey and Solow models are models of real investment only. Financial markets, financial assets and financial saving do not play any role in those models. There is only one good which, for simplicity, will be called "corn". Corn has three functions: it can be consumed, invested and used as a means of payment since wages and interest payments are made with it..." Clearly, modern economies with their fiat money systems are much more complicated than a barter economies with no banks and money. The Veracity: Financing Is Different From "Savings" This and previous reports4 clarify and elaborate on the following aspects of banking, money creation and financing as well as savings and investments: 1. Attributing the lack of investment in many emerging market (EM) economies to their low savings is a major fallacy. Borio (2015)5 argues: "Crucially, the provision of financing does not require someone to abstain from consuming. It is purely a financial transaction and hence distinct from saving... The equality of saving and investment is an accounting identity that always holds ex post and reveals nothing about financing patterns. In ex post terms, being simply the outcome of expenditures, saving does not represent a constraint on how much agents are able to spend ex ante. If we step back from comparative statics and consider the underlying dynamics, it is only once expenditures take place that income and investment, and hence saving, are generated." 2. Banks do not need deposits or "savings" to lend. They create money/deposits when they originate loans or buy assets from non-banks. To settle payments with their peers as well as the central bank, they require reserves at the central bank. Reserves at the central bank - not client deposits - constitute true liquidity for banks. For a more detailed discussion on loan origination and money creation in absence of new deposits entering into the banking system, please refer to Appendix 1 and 2 on pages 14 and 18. Certainly, there are several factors such as regulations and shareholder preferences that can curtail banks' ability to expand their balance sheets. However, households' or nations' "savings" do not constrain banks' ability to originate new loans/create deposits. 3. In an economy where banks exist, "savings" and financing are very different things. Many investors use the term "savings" to refer to bank deposits. Yet, in macroeconomics, national and household "savings" are not related to deposits or money in the banking system at all. Chart I-1 demonstrates that there is no relationship between the savings and changes in the amount of money in the banking system. Chart I-1Savings And New Money ##br##Creation Do Not Correlate Savings And New Money Creation Do Not Correlate Savings And New Money Creation Do Not Correlate The confusion between national "savings" and financing creation is dealt with nicely again by Fabian Lindner. Having modelled it, Lindner argues: "... the aggregate economy's saving is equal to the newly produced tangible assets and inventories. That total saving is equal to just the increase in tangible assets ... (because) all changes in net financial assets in the economy add up to zero... Thus, for every economic agent increasing her net financial assets, there is a corresponding decrease in net financial assets of all other economic agents in the economy (Lindner 2015).6 Put in more general terms: An economic agent can only save financially if other agents dis-save financially by the same amount... That is why in the entire economy (that is the world economy or a closed economy) only the increase in tangible assets, thus investment, is saving...." In another paper, Lindner asserts: "Investment is the production of any non-financial asset in an economy and thus is always directly and unambiguously savings: it increases the economy's net worth... The economy as a whole cannot change its net financial wealth since it always equals zero. The aggregate economy can only save in the form of non-financial assets...The only way an economy can save is by increasing its non-financial wealth, i.e., its physical capital stock" (Lindner 2012).7 On the whole, deposits are a monetary concept; they represent money savings. Deposits are created by banks "out of thin air," as illustrated in Appendix 1 on page 14. Meanwhile, "savings" are a net addition to capital stock. Not surprisingly, there is no relationship between "real savings" and money savings, as illustrated in Chart I-1. In a nutshell, "savings" is an addition to the capital stock of a nation, which is the same as investment. Hence, the Savings = Investment identity for a closed economy is nothing other than a tautology as it de-facto means Investment = Investment. That is why in this report we use "savings" in quotations whenever we refer to it in the traditional sense of economic theory. 4. Households' (or businesses') propensity to save alters the velocity of money, not the amount of deposits/money in the banking system. A decision by a household to spend more rather than save does not change the amount of deposits in the banking system and does not affect the banking system's ability to provide more financing. When households or companies decide to spend their deposits, the velocity of money rises. Conversely, when households and companies decide to save (retain) their deposits, the velocity of money drops. The amount of deposits in the banking system stays constant. In turn, the amount of deposits and hence broad money supply in any banking system equals the cumulative net money creation by banks and the central bank over the course of their history. This has nothing to do with household and national "savings," which form the country's capital stock. 5. In a country with its own national currency, the true macro constraint on commercial banks' ability to expand financing infinitely are inflation and currency depreciation - not "savings." This is of course apart from demand for loans, regulations and shareholder preferences that can limit commercial banks' capacity to expand their balance sheets. Bottom Line: In an economy with banks, one does not need to save in the form of a deposit in a bank for the latter to lend money to another entity. Tales Of Brazil And China Chart I-2Two Extremes Of Investment ##br##And Savings: China And Brazil Two Extremes Of Investment And Savings: China And Brazil Two Extremes Of Investment And Savings: China And Brazil We use China and Brazil solely for illustrative purposes. One can use any country with a low savings rate instead of Brazil or a high savings rate economy such as Korea, Taiwan or Singapore in place of China. China has enjoyed a very high national savings rate and has been investing substantially (Chart I-2). In contrast, both the national savings rate and the investment-to-GDP ratio in Brazil have been depressed. It is very tempting to argue that Brazil has been experiencing very low investment because it saves so little. The narrative goes like this: Brazil's national savings rate is low because households save so little and the public sector dis-saves a lot - i.e., the government runs enormous fiscal deficits. This constrains the pool of available "savings" to finance private capital expenditures. This typical analysis concludes that Brazil needs to boost its "savings" - i.e., reduce its spending. This will allegedly enlarge the pool of available "savings" for investment and allow the country to invest, and consequently boost productivity and its potential growth rate. This narrative is misplaced in our view, because as we have shown in the past and in this report, banks do not need households, businesses or the government to save in order to provide financing. Banks can provide financing by simply expanding the money multiplier, among other things (see a more detailed discussion about the money multiplier below). So what is the true difference between Brazil and China? How has the latter achieved such high savings and investment rates, while the former has failed to finance its capital spending? Why have Brazilian banks not expanded their balance sheets more rapidly to finance investment (Chart I-3)? Chart I-3Snapshot Of Bank Assets-To-GDP Ratios Snapshot Of Bank Assets-To-GDP Ratios Snapshot Of Bank Assets-To-GDP Ratios Let's consider a hypothetical example. For simplicity and illustrative purposes, we assume there are two economies of equal size and have the same level of investment: savings and net exports. In short, they have identical starting points. We refer to these economies as Brazil and China. Now, commercial banks in both countries provide new financing of $50 - or equal to 5% of their respective GDP - to businesses for infrastructure building. This is new purchasing power created by commercial banks "out of thin air" in both economies. We assume that the only difference between these two countries is that in China, 100% of inputs for infrastructure (materials, machinery/equipment and so on) are produced/purchased domestically. In contrast, in Brazil, 100% of the inputs for infrastructure construction are imported, because this economy lacks production capacity. Table I-1 illustrates this hypothetical numerical example. As this infrastructure project is implemented, Brazil's imports will surge, and its net exports will deteriorate. Chart I-4 shows that this indeed is the case in Brazil - when capital spending expands, its current accounts deficit widens, entailing that Brazil imports a considerable portion of inputs for its investments. Table I-1A Hypothetical Example Of Investment - Saving Dynamics Is Investment Constrained By Savings? Tales Of China And Brazil Is Investment Constrained By Savings? Tales Of China And Brazil Chart I-4Foreign Content Of Brazil's ##br##Capital Spending Is High Foreign Content Of Brazil's Capital Spending Is High Foreign Content Of Brazil's Capital Spending Is High If there is no matching rise in foreign investor demand for Brazilian assets, the nation's currency will depreciate. Consequently, to support the plunging currency, Brazilian interest rates would have to rise. As a result, higher borrowing costs short-circuit the credit cycle. In China, because inputs for infrastructure are sourced and procured locally, there is no impact on its exchange rate or interest rates. If there is excess capacity in China to produce these inputs for infrastructure building, this new purchasing power will not lift inflation. A caveat is in order: Similar dynamics in trade balance deterioration, currency depreciation and inflation will prevail if there is a rise in consumer spending instead of capital expenditures. Importantly, the outcome will be the same in both economies if investment spending is done using existing money savings (deposits), not new credit. This example illustrates that a similar amount of capital expenditures financing via money creation "out of thin air" in both economies has increased national savings in China from $250 to $300, yet Brazilian savings stayed at $250 (Table I-1). In terms of savings rate, China will record a rise in its national savings rate from 25% to 28.6% of GDP (Table I-1). In Brazil, however, the national savings rate will remain at 25% of GDP, even though its banks, like Chinese ones, originated money "out of thin air" to finance infrastructure spending. The starting-point difference between China and Brazil is neither their banking systems' ability to expand their balance sheets nor the existing amount of deposits and assets. Rather, it is their real economies' capacity to produce goods and services. Therefore, we conclude: Regardless of how capital expenditures are financed - via new borrowing from banks or non-banks or using the investing company's own financial resources - when inputs for capital spending are procured domestically it is recorded as an increase in national "savings" level, but when they are imported there is no change in the level of national "savings." Over the decades, China, Korea, Taiwan, Singapore and Japan have all aggressively expanded their capacity to produce goods and services. They funded this capacity build-up via both money creation "out of thin air" and by attracting foreign capital. In the meantime, their large exports shielded their currencies from abrupt depreciation - as and when local bank financing was used to acquire foreign inputs. In the past decade, in China, loans - which banks have originated to build infrastructure - were largely spent on domestic inputs: cement, steel, chemicals, machinery and equipment all produced in the mainland. Even though some of that money/loans was used to purchase foreign inputs (commodities and equipment), China had large U.S. dollar revenues from exports that acted as an offset in its balance of payments. In short, Brazil and other low "savings" rate nations do not need to raise interest rates to curtail consumption and boost savings in order to release funds for financing capital expenditures. Chart I-5 demonstrates that there has been no positive relationship between real interest rates and the national savings rate in Brazil. Remarkably, real interest rates in this nation were often very high but that still did not lead to high "savings." Chart I-5Real Interest Rates And Savings Are Not Positively Correlated As They Are Supposed To Be Real Interest Rates And Savings Are Not Correlated Real Interest Rates And Savings Are Not Correlated What Brazil and other low "savings" rate economies need is to build efficient and competitive productive capacity - i.e., they need changes in the supply side of their economies. Only then can their banks expand their balance sheets and provide financing similar to how banks in high "savings" countries do. However, to shield the exchange rate from depreciation, these nations need to boost their exports first. This can be done by depreciating the currency and developing their global competitiveness. This is in effect what China has done in the past 25-30 years. Bottom Line: The key difference between Brazil and China is not their propensity to consume versus save, but their ability to produce goods and services domestically. So long as a nation builds and maintains excess productive capacity, its banks can originate loans "out of thin air" and finance capital and consumer expenditures. Money Multiplier Versus "Savings" Redundancy of the mainstream economic view that a pool of "savings" represents a constraint on financing investments becomes apparent when one applies the money multiplier concept, which is in fact accepted by mainstream economic theory. The money multiplier is the ratio of broad money relative to excess reserves. A rise in the money multiplier will lead to more money creation and financing in an economy per one unit of excess reserves (liquidity provided by the central bank), everything else held constant. In brief, money supply/the amount of deposits in the banking system will change regardless of the level of national or household "savings." Let's assume two countries with the same level of income per capita and GDP have identical national savings and investment rates as well as money supply and excess reserves. In short, they have indistinguishable macro parameters. Now suppose their banking systems in the past year had different money multipliers. The monetary authorities in both countries maintain the banking system's excess reserves at 10 units. If the money multiplier were to remain constant, say at 15, the money supply/deposits in both banking systems would remain at 150 units (10x15). Let's assume the money multiplier increased to 20 in Country A while held constant at 15 in Country B. In such a case, broad money supply would have risen to 200 units (10x20) in Country A and would stay at 150 (10x15) units in Country B. This entails that banks in Country A increased their funding yet those in Country B did not. That is despite the fact that the savings rates (and amount of savings) were identical before the change in the money multipliers occurred. This is one way to prove that a nation does not need to cut consumption for its banks to provide financing. The reason why the money multipliers could vary in these two countries with otherwise similar macro-economic parameters is due to animal spirits: In Country A, banks may have felt increasingly confident to lend more per one unit of their excess reserves, and there was demand for credit from borrowers. In the meantime, the money multiplier remained the same in Country B. In China, the money multiplier - the ratio of broad money to excess reserves - has risen dramatically since 2013 (Chart I-6). Interestingly, the amount of excess reserves at the People's Bank of China has been broadly the same over the past five years, yet broad money has grown by an enormous 75% (Chart I-6, middle and bottom panel). The exponential money/credit creation in China since 2009 has to a large extent been due to the rising money multiplier - wild animal spirits among bankers and borrowers - rather than high national "savings." Bottom Line: In any country, banks can provide more financing simply by expanding the money multiplier. This can happen regardless of the country's savings rate. Investment Relevance Why is this analysis pertinent to investors? First, this issue is critical to assess whether China's excessive credit expansion is an outcome of the nation's high savings - like many economists and investors claim - or due to the enormous amount of money/deposits and credit originated by the mainland's banks "out of thin air." If it is the former, investors have no need to worry about China's money and credit dynamics. If it is the latter, we are facing a typical banking and money/credit bubble. This report corroborates that it is the latter. Chart I-7 shows that China's broad money has grown 4-fold since January 2009 and has reached RMB 200 trillion, or the equivalent of $30 trillion. Chart I-6China: Money Multiplier Has Risen A Lot China: Money Multiplier Has Risen A Lot China: Money Multiplier Has Risen A Lot Chart I-7A Money Bubble In China? A Money Bubble In China? A Money Bubble In China? Does this enormous quantity of RMBs pose an inflation and/or currency depreciation risk? Or will the ongoing policy tightening cause another deflationary slump in China? It is clear that Chinese policymakers are currently being forced to walk a very thin line: On the one hand, the immense amount of money created "out of thin air" could stoke inflation or currency depreciation. It may not take much of a rise in the velocity of money for inflation to become a problem. On the other, tightening policy amid high leverage in an economy that is addicted to money and credit could push it into a growth slump and deflation. There is always a chance that policymakers will get it right and manage it perfectly so that neither inflation/currency depreciation nor a growth slump transpire. We would assign a 25-30% probability to this benign outcome. Hence, in our opinion there are 70-75% odds of either inflation or deflation in China in the next 12-24 months. Given these odds, we have been and remain reluctant to chase the rally in EM and China-related plays. In particular, the Chinese authorities have been tightening liquidity and banking/shadow banking regulation as well as projecting the ongoing anti-corruption campaign into the financial industry. This poses a meaningful risk given the existing macro imbalances. Second, this analysis re-shapes how investors should think about economic development and understand how nations with low savings can grow without relying on foreign funding. This provides us with a framework to assess the developmental path and the sustainability of growth in various developing economies. These include but are not limited to nations with low national savings rates such as Brazil, South Africa, Turkey, Russia, Colombia and many others. Finally, this analysis leads us to argue that Brazil does not need to maintain high real interest rates as a way to force consumers to cut spending and boost savings. In fact, this is the wrong prescription for Brazil. The most optimal macro adjustment path for Brazil is to reduce interest rates much further and encourage banks to finance private investment. Brazil needs to build an efficient supply side, and banks can provide funding by originating loans "out of thin air." Brazilian consumers do not need to save more for companies to get financing for their projects and invest. The natural causality of this adjustment will be considerable currency deprecation. However, Brazil is currently suffering from low inflation and high real interest rates (Chart I-8). Hence, reflationary policies are the right policy prescription. Chart I-8Brazil Needs To Reduce ##br##Interest Rates Much Further Brazil Needs To Reduce Interest Rates Much Further Brazil Needs To Reduce Interest Rates Much Further Foreign investors are therefore at risk due to potential currency depreciation. The new leaders to be elected in the October presidential elections may well adopt such a macro policy mix. Markets will front run this by pushing the real down and this will be negative for foreign investors. However, there will be a buying opportunity after the currency finds a floor. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Analyst andrijav@bcaresearch.com Appendix 1: Loan Origination, Deposits/Money Creation And Settlement The amount of deposits is not a constraint on a banking system's ability to make loans and buy assets from non-banks. Figure I-1 and I-2 present stylized cases of how commercial banks can originate new loans without requiring a new deposit or extra excess reserves entering the banking system. Specifically Figure I-1 illustrates how commercial banks can originate loans with the subsequent net settlements among themselves taking place via inter-bank borrowing/lending. In this stylized example, the banking system is comprised of three commercial banks. These commercial banks hold all deposits in the system. Cash does not exist and all payments are done via wire transfers. Figure I-1Money Creation By Banks With Net Settlement Among Banks Via Inter-Bank Lending/Borrowing Is Investment Constrained By Savings? Tales Of China And Brazil Is Investment Constrained By Savings? Tales Of China And Brazil Figure I-2Money Creation By Banks With Net Settlement Between Banks & Central Bank Is Investment Constrained By Savings? Tales Of China And Brazil Is Investment Constrained By Savings? Tales Of China And Brazil 1. Loan Origination/Money Creation In the morning, Bank 1 originates a new loan worth $100 for Client 1. This transaction creates a new asset and, for the balance sheet to balance, Bank 1 should also increase the liabilities side of its balance sheet. Therefore, it simultaneously credits Client 1's chequing account by $100. Bank 1 does not transfer other depositors' money to Client 1's chequing account; it creates a new $100 deposit. The rest of the bank's depositors still have their full deposits, which they can draw on. In a nutshell, both assets and liabilities of Bank 1 rose by $100 - this was done "out of thin air" by just pressing the enter button on the computer. That also means that a $100 of new money was created by Bank 1 which increases the overall money stock in the banking system. Meanwhile, Bank 2 lends $200 to Client 2 and Bank 3 lends $300 to Client 3. Let's assume these were the only lending transactions during that day. In aggregate, the three banks originated $600 of new loans, and consequent new deposits/money "out of thin air." 2. Money Transfer / Payments Debtors do not borrow money and leave it sitting idle. They borrow money to pay their suppliers and others they owe. Even though Clients 1, 2 and 3 wire their payments to their respective suppliers on the same day, the total amount of deposits in the banking system does not change: Deposits simply move from one bank to another or from one bank client to another. In Figure I-1, Client 1 wires its $100 from Bank 1 to Supplier B that has an account at Bank 2; Client 2 pays its $200 invoice to Supplier C which in turn has an account at Bank 3; and finally Client 3 transfers $300 to Supplier A, who holds an account at Bank 1. The amount of money/deposits in the overall banking system has not changed as a result of these wire transfers. 3. Multilateral Net Settlement At the end of the day, banks should settle with other banks. Many countries employ a multilateral net settlement system typically operated by the central bank. In a multilateral net settlement system, at the end of the day, each bank pays (receives from) the system only the net amount they are due to pay to (receive from) other banks combined. Importantly, banks settle their payments with other banks using their excess reserves (herein called reserves) at the central bank, not the deposits of their clients. This entails that banks do not need deposits to pay their dues to other banks or the central bank. Figure I-1 illustrates the impacts on the banks' reserves under the multilateral net settlement system: Bank 1's reserves at the central bank change as follows: -$100 (Client 1's wire transfer out) + $300 (this is the amount that Supplier A with an account in Bank 1 gets from Client 3) = $200. The impact on Bank 2's reserves is as follows: -$200 (Client 2's wire transfer out) + $100 (this is the amount that Supplier B with an account in Bank 2 gets from Client 1) = -$100. The net change in Bank 3's reserves is: -$300 (Client 3's wire transfer out) + $200 (this is the amount that Supplier C with an account in Bank 3 gets from Client 2) = -$100. If we assume that all banks had no excess reserves before this day, then how do they settle their accounts? There are various alternatives, but we highlight two: Figure I-1 demonstrates the case of interbank lending. As a result of the settlements, Bank 1 has $200 in extra reserves, while Bank 2 and Bank 3 each have a $100 deficit in reserves. As such, Bank 1 lends $100 to each of Bank 2 and Bank 3. Why does it lend to other banks rather than keeping these reserves at the central bank? Because interbank rates are typically slightly above the central bank's rate - the rate Bank 1 would get if it were to lend the $200 to the central bank. Figure I-2 portends the same transactions with the sole difference being the reserves flow. Unlike Figure I-1, here banks do not lend to/borrow from each other. Banks lend excess reserves to the central bank as well as borrow deficient reserves from the central bank. This is done to settle their payments with other banks. Bank 1 lends its free reserves of $200 to the central bank. Bank 2 and Bank 3 each borrow $100 reserves from the central bank to settle with the system at the end of the day. As a result, the aggregate amount of reserves at the central bank does not change. On the whole, banks created $600 of new deposits/money/loans during the day without requiring savings from households, companies, the government or foreigners. Thereby, the money supply was expanded and new financing in the amount of $600 was provided "out of thin air." Appendix 2: Deposits Versus Liquidity Below are additional questions that we seek to answer to provide further elaboration on the issues of banks creating money and the difference between deposits and liquidity: 1. Why would central banks provide reserves to banks? When a central bank targets interest rates, which is nowadays the most common policy framework in both advanced and developing countries, it must provide liquidity to banks: the latter is required to preclude interbank rates from deviating from the policy rate. Under an interest rate targeting regime, the central bank does not have complete control over banks' reserves nor broad money supply. A central bank can control either the quantity of money or the price of money (interest rates), but not both simultaneously. The following two quotes from the New York Federal Reserve Chairman William Dudley and the European Central Bank confirm that central banks nowadays provide banks with reserves on demand - i.e., the amount of reserves is determined by demand from banks. "The Federal Reserve has committed itself to supply sufficient reserves to keep the fed funds rate at its target. If banks want to expand credit and that drives up the demand for reserves, the Fed automatically meets that demand in its conduct of monetary policy. In terms of the ability to expand credit rapidly, it makes no difference whether the banks have lots of excess reserves or not." (Dudley, 2009) European Central Bank (2012), May 2012 Monthly Bulletin: "The Eurosystem ... always provides the banking system with the liquidity required to meet the aggregate reserve requirement. In fact, the ECB's reserve requirements are backward-looking, i.e. they depend on the stock of deposits (and other liabilities of credit institutions) subject to reserve requirements as it stood in the previous period, and thus after banks have extended the credit demanded by their customers." 2. Why do banks compete for deposits if they create deposits themselves? The true reason banks compete for deposits is not that they require more deposits, but because they require more reserves. When a bank attracts a deposit from another bank, the latter must transmit to the former reserves equal to the amount of the deposit transferred. When a bank is experiencing a liquidity shortage, more deposits are of no help. Banks can always create more deposits themselves, but they cannot create reserves at the central bank. The true liquidity for banks is their reserves at the central bank - not deposits. Reserves are solely created by central banks "out of thin air." A central bank may decide not to provide funding to certain banks in some cases when the authorities deem these banks insolvent and/or in breach of regulations. Otherwise, if the central bank wants to keep policy rates stable, it must provide all liquidity (reserves) banks require. 3. Why do banks attract deposits if the central bank provides liquidity on demand? The primary reason why banks seek to attract deposits instead of borrowing from the central bank is due to the cost of funding and duration of liabilities as well as regulatory requirements. Deposits may be cheaper and have longer duration than short-term funding from the central bank. 1 Lindner, F. (2015), "Does Savings Increase the Supply of Credit? A Critique of Loanable Funds Theory", Macroeconomic Policy Institute, World Economic Review 4, 2015. 2 Lindner, F. (2015), "Did Scarce Global Savings Finance the US Real Estate Bubble? The Global Saving Glut thesis from a stock flow Consistent Perspective", Macroeconomic Policy Institute, Working Paper 155, July 2015. 3 Lindner, F. (2015), "Does Savings Increase the Supply of Credit? A Critique of Loanable Funds Theory", Macroeconomic Policy Institute, World Economic Review 4, 2015. 4 Please refer to the Emerging Markets Strategy Special Reports from October 26, 2016, November 23, 2016, January 18, 2017 and December 20, 2017; available on ems.bcaresearch.com 5 Borio, C. and Disyatat, P. (2015), "Capital flows and the current account: Taking financing (more) seriously", BIS Working Papers, No. 525, October 2015. 6 Lindner, F. (2015), "Did Scarce Global Savings Finance the US Real Estate Bubble? The Global Saving Glut thesis from a stock flow Consistent Perspective", Macroeconomic Policy Institute, Working Paper 155, July 2015. 7 Lindner, F. (2012), "Savings does not finance Investment: Accounting as an indispensable guide to economic theory", Macroeconomic Policy Institute, Working Paper 100, October 2012. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Malaysian elections are likely in April or May and we expect will return the ruling BN coalition to power; Malaysia's banking system is vulnerable and economy is highly exposed to a relapse in Chinese growth and/or commodity prices; Thailand's military junta has delayed elections until February 2019 and may delay again, but that is not cause for a selloff; Transitions from military to civilian rule are historically positive for Thai assets relative to emerging markets; Favor Thai currency, equities, and bonds within the EM space; go long Thai local bonds versus Malaysian, currency unhedged. Feature The word is out that Malaysian Prime Minister Najib Razak will call elections ahead of Ramadan in late April or early May. The timing makes sense, as Malaysia's economy has recovered from the turmoil of 2015 and Najib has survived the political scandals that threatened to topple him (Chart 1). We expect the long-ruling Barisan Nasional coalition to emerge victorious from the vote.1 Chart 1Call Elections While Growth Is Strong Call Elections While Growth Is Strong Call Elections While Growth Is Strong Meanwhile, to the north, Thailand's military junta has delayed elections for the third time, pushing them from November 2018 to February 2019. Having revised the constitution and guided the country through the royal succession,2 the military is running out of excuses to cling to power. It is likely to hand the reins partially back to civilian politicians within the next 24 months, if not next February. The first election since the 2014 coup is likely (though not guaranteed) to favor military-backed parties. In both countries, the political status quo is familiar, and likely to persist for some time. What does this mean for investors? First, it means a degree of certainty. Second, it means mixed prospects for pro-market policies. Both BCA's Geopolitical Strategy and Emerging Markets Strategy favor Thai assets over Malaysian within the EM universe. Malaysia: Election Is Tactically Bullish At Best On the political front, there is a 45% subjective probability that the election impact will be genuinely market-positive and a 55% probability that it will be neutral or status quo. To understand this, investors need to understand how unlucky Malaysia's political opposition is. The twenty-first century was supposed to be the opposition's moment in the sun, when it would defeat the ruling Barisan Nasional (BN) coalition for the first time since the country's independence in 1957. A large and ambitious middle class was emerging on the back of export-led industrialization and a commodity bull market (Chart 2). The time seemed ripe for an unlikely coalition of middle-class progressive Malays, ethnic Chinese entrepreneurs, and rural Islamists to take power in the name of change. Unfortunately for the opposition, the 2008 election came before the global financial crisis struck and the 2013 election came before the oil price plunge of 2014 (Chart 3). The opposition made a valiant showing nonetheless. In the first case it deprived the BN of a supermajority for the first time since 1969; in the second case, it won the popular vote. But in neither case was the opposition able to win a majority of seats in parliament, as its victories were confined to a few small regions (Chart 4). Chart 2Middle Class Angst In Malaysia How To Play Malaysia's Elections (And Thailand's Lack Thereof) How To Play Malaysia's Elections (And Thailand's Lack Thereof) Chart 3Opposition Timing Unlucky... Opposition Timing Unlucky... Opposition Timing Unlucky... Chart 4... Can It Keep Gaining Seats? How To Play Malaysia's Elections (And Thailand's Lack Thereof) How To Play Malaysia's Elections (And Thailand's Lack Thereof) Today the opposition's bad luck continues. The Pakatan Harapan coalition, as it is now called, is headed into the yet-to-be-scheduled 2018 elections at a time when Malaysia's economy and exports have recovered along with global demand and commodity prices (Chart 5). Consumer sentiment and employment have improved, albeit from a low point. Chart 5Economy Recovers Ahead Of Vote Economy Recovers Ahead Of Vote Economy Recovers Ahead Of Vote Moreover, Prime Minister Najib, who became embroiled in scandals almost immediately after winning the 2013 election, has been cleared of wrongdoing by various authorities. What little opinion polling exists suggests that the majority of the populace still disapproves of him, but apathy is widespread.3 Needless to say it is Najib's advantage as prime minister that he gets to decide the timing of the elections. The opposition has also lost a critical partner, the Malaysian Islamic Party (PAS). Najib has lured PAS into joining BN, giving it a larger majority and putting the remaining opposition forces even farther from the 112 seats needed for a majority in the lower house (the Dewan Rakyat) (Chart 6). At the same time, Pakatan Harapan has no platform other than opposition to Najib's government. Malaysia's chief opposition leader and advocate of structural reform, Anwar Ibrahim, has entered into an unholy alliance with his former boss and arch-enemy, the long-ruling strongman Mahathir Mohamad, who will soon turn 93 years old. This alliance is manifestly self-interested and unstable. There is a scenario in which the opposition could take power - but it is the least probable. In Chart 7 we present three scenarios: the first is the best case for the opposition, the second is the best case for BN, and the third is the status quo. To these scenarios we assign subjective probabilities: Scenario 1: Opposition Takes Power (20% probability): For the opposition to win, it needs to retain all of its current 71 seats and stage a historic upset by winning all the seats in Kedah and Johor. It then needs to convince PAS to return to its fold through coalition-building. Winning every seat in Kedah and Johor is a stretch. And PAS has learned how to wield power without the opposition, so why would it rejoin? BN has granted it concessions on its Islamist agenda that the more secular opposition parties would be loath to adopt. Scenario 2: BN Wins Supermajority (25% probability): The real question is whether the BN coalition will retake the supermajority that it lost in 2008. This would require BN to win an additional 19 seats on top of retaining its current 129 seats. If BN retains its current seats and the alliance with PAS, and wins half or more of the 37 seats in Malay-dominant, or mixed-Malay, constituencies currently held by the opposition, then it will achieve this supermajority. In Chart 7 above we illustrate this scenario as an even bigger sweep in which the BN also picks up some seats that it lost in ethnic Chinese and other constituencies. Scenario 3: BN Preserves Status Quo (55% probability): In this scenario, both BN and PAS retain their seats and remain allied, but make zero gains. Najib and his government are relatively unpopular and tainted by scandal, Malaysian governance has worsened, and winning back non-Malay and mixed-Malay seats could be very difficult in practice. What would be the likely market responses to these outcomes? In Scenario 1, an opposition victory would be the most market-friendly outcome in light of Malaysia's poor governance, flagging productivity, and lackluster economy in recent years. It would demonstrate to the world that although Malaysia's demographic trajectory strongly favors the majority Malay population (Chart 8), that trajectory need not condemn the country to a future of ethnic nationalism and communal tensions. Chart 6Defection Helps Ruling Coalition How To Play Malaysia's Elections (And Thailand's Lack Thereof) How To Play Malaysia's Elections (And Thailand's Lack Thereof) Chart 7Malaysia 2018 Election Scenarios How To Play Malaysia's Elections (And Thailand's Lack Thereof) How To Play Malaysia's Elections (And Thailand's Lack Thereof) Chart 8Demographics Favor Malay Majority How To Play Malaysia's Elections (And Thailand's Lack Thereof) How To Play Malaysia's Elections (And Thailand's Lack Thereof) True, the untested Pakatan Harapan coalition would bring a great deal of uncertainty. But the authority of Mahathir, the reformist bent of Anwar, the fact that the Islamist members of the coalition are progressive, and the increased political inclusion of the ethnic Chinese, would all be seen as positives. Moreover a vote against the long-ruling BN, and the BN's expected acceptance of the vote, would show that the country is flexible enough to handle real political change, unlike many EMs. Nevertheless, this is a low probability outcome. In Scenario 2, a BN supermajority would be cheered by markets (less enthusiastically than Scenario 1) for providing a clear sense of direction. It would reaffirm the United Malay National Organization's (UMNO's) status as the institutional ruling party (the core of the BN) after a decade of apparent decay. And it would remove the uncertainty of recent government scandals and mistakes. It would also give Najib enough political capital to press forward with structural reforms (Chart 9), which he has pursued under less ideal conditions. However, the downside of Scenario 2 is that, over the long run, Malaysia's governance would likely deteriorate (Chart 10). BN would regain the ability to pass constitutional amendments on its own and would use this power to reinforce Malay nationalism and authoritarianism, which would exacerbate tensions with the pro-business Chinese community. Chart 9Najib Has Done Some Reforms Najib Has Done Some Reforms Najib Has Done Some Reforms Chart 10Governance Could Fall Further How To Play Malaysia's Elections (And Thailand's Lack Thereof) How To Play Malaysia's Elections (And Thailand's Lack Thereof) The third scenario - a status quo BN simple majority - is the most likely yet least market-friendly outcome. This electoral result would leave Najib only able to do piecemeal reforms and more dependent on his Islamist coalition partner, PAS. The risk is not that radical Islamism would spiral out of control - Malaysia is a moderate Muslim country - but rather that in this scenario both governance and economic orthodoxy could continue to suffer.4 Economic conditions would be better than just after the 2014 commodity bust, but would remain lackluster. The crux of the matter is whether the election enables the government to take a more proactive stance in grappling with Malaysia's latent financial risks and external vulnerabilities. The latter are significant. Indeed, BCA's Emerging Markets Strategy is underweight Malaysian assets versus their EM peers, and argues that Malaysia needs to see the following developments for investors to upgrade this bourse: Progress in recognition of non-performing loans (NPLs) and increased bank provisions. NPLs are too low given the credit boom over the past nine years, and provisions are also extremely inadequate (Chart 11, panels 1 and 2). Further, Malaysian commercial banks have artificially boosted their earnings because they have lowered their provisions for bad loans. Given that global growth and Malaysian exports are likely at or near their peak, Malaysian commercial banks will soon face rising NPLs and will be forced to increase their provisions for bad loans, putting their profit growth at risk. In a scenario where banks raise provisions by 35%, banks' operating profits would fall from 11% to zero. This presents a major risk to bank share prices (Chart 12). Chart 11Bad Loans Are Under-Recognized Bad Loans Are Under-Recognized Bad Loans Are Under-Recognized Chart 12If Provisions Go Up, Profits Will Fall If Provisions Go Up, Profits Will Fall If Provisions Go Up, Profits Will Fall Crucially, commercial bank share prices are extremely important for Malaysia's stock market, as they account for 35% of the country's total MSCI market cap and 38% of the index's total earnings. Commercial banks also have been largely responsible for the recent rally in Malaysian stocks. An outlook of stable demand growth in China and stable-to-higher commodities prices, so that Malaysia's economy would be able to grow without too much reliance on credit and fiscal stimulus. Currently, exports to China comprise 9% of GDP and commodities exports make up 30% of exports and 20% of GDP. An outlook for stable-to-strong currency that would lower the external debt burden and lower debt-servicing costs, which are among the highest in the EM world. In turn, the exchange rate outlook is contingent on commodities prices and the EM carry trade. Importantly, these adjustments may only take place once Chinese growth has slowed and Malaysia's external vulnerabilities have become painfully apparent to investors and discounted in financial markets. Only an opposition victory or a BN supermajority would increase the probability that Malaysia will start trying to reduce these vulnerabilities preemptively, allowing investors to look beyond the valley and price in a better structural outlook. Given that the combined subjective probability of the two scenarios is 45%, we are neutral on Malaysian politics in the near term. Our conviction level on pro-market policies is low, given that the status quo outcome offers only piecemeal reforms, while a transition to opposition rule for the first time or a return to a traditional BN supermajority would be fraught with uncertainty. Bottom Line: The current rally in Malaysian assets can continue as long as the global bull market persists and China's slowdown remains benign. However, there is no guarantee that China will remain benign, and Malaysia is poorly positioned among EMs to deal with external shocks. Thus while there is space for a tactical play on the election, the prudent long-term position is to be underweight Malaysian stocks, local bonds, and currency relative to their EM counterparts. Thailand: Stay Bullish At Least Until Elections While Malaysia prepares to hold elections, Thailand's military junta has delayed them for at least the third time. They are expected by February 2019. While we would not be surprised to see another delay, this period of military rule is getting long in the tooth, by Thai standards, and we would expect the transition to civilian rule to occur within the next year or two.5 The election delay is mildly positive for Thai risk assets, as investors have broadly approved of the junta or at least grown accustomed to it. During previous periods of military rule, such as 1991-92 and 2006-07, Thai stocks have typically underperformed the EM benchmark, both in USD and local currency terms (Chart 13). But the 2014 coup proved to be different. The government of General Prayuth Chan-Ocha has provided three fundamentally stabilizing factors: Banishing the Shinawatras: The junta forced a conclusion (for the time being at least) to the domestic political struggle that has raged in the country since 2001. It did so by ousting Prime Minister Yingluck Shinawatra and sending her to join her brother, former Prime Minister Thaksin Shinawatra, in exile, and by suppressing their rural, populist political coalition. Shepherding the royal succession: The junta's decision to throw a coup in 2014 was heavily influenced by the desire to ensure that a stable royal succession would occur upon the death of the widely revered King Bhumibol Adulyadej. Bhumibol had played a calming role in Thai politics since 1946 and was a major source of authority for the political elite. When the king's death actually occurred in October 2016, the junta was exercising strict control over the country and the succession did not occasion any significant instability. Managing the post-GFC economy: The junta brought relatively competent and stable economic management during the turbulent period in which emerging markets climbed down from the massive DM and EM stimulus policies enacted during the Great Recession. Thailand's uneventful politics differed markedly from those of Malaysia, South Korea, Turkey, Brazil and others that have seen severe considerable political upheaval since 2013. As a result, Thailand has enjoyed greater policy "certainty" over the past four years than would otherwise have been the case. Credit default swaps, for example, have collapsed from the levels witnessed during the Thai political unrest and natural disasters in 2006-13. No surprise, then, that over the past three years, financial markets have cheered any sign that the junta will stay in power for longer (Chart 14). Chart 13Thai Equities Underperform EM Peers And Long-Term Average During Military Rule Thai Equities Underperform EM Peers And Long-Term Average During Military Rule Thai Equities Underperform EM Peers And Long-Term Average During Military Rule Chart 14Market Content With Postponed Elections Market Content With Postponed Elections Market Content With Postponed Elections To be sure, the Thai economy faces immediate, cyclical challenges. Thailand's frequent military coups have always had a deflationary impact due to austere policies and dampened animal spirits (Chart 15). The latest coup specifically initiated a period of macroeconomic deleveraging (Chart 16), and all indications suggest that the deleveraging has farther to go. Banks are repairing their balance sheets and less ready to extend credit. Capital formation is weak and construction is subdued (Chart 17). Chart 15Thai Coups Are Deflationary Thai Coups Are Deflationary Thai Coups Are Deflationary Chart 16Junta Imposed Deleveraging... Junta Imposed Deleveraging... Junta Imposed Deleveraging... This is not even to mention more structural challenges: A shrinking labor force (Chart 18, top panel; High household debt levels (Chart 18, bottom panel); Chart 17...So Economy Is Subdued ...So Economy Is Subdued ...So Economy Is Subdued Chart 18Structural Headwinds Structural Headwinds Structural Headwinds A stark deterioration in governance due to frequent coups and mass protests that are violently suppressed (see Chart 10 above). Furthermore, the impending transition to civilian rule will initiate a new round of political instability. Whenever "free and fair" elections are held in Thailand (i.e. elections not stage-managed by the military), the populace almost always returns the provincial, "democratic" parties to power (the so-called "Red Shirts"), as opposed to urban, royalist parties (the "Yellow Shirts"). This was the case in 2001, 2005, 2006, 2011, and 2014. The military has adjusted the constitution and electoral system to prevent this outcome, and it may succeed in arranging the first post-coup civilian government to come to power in 2019 or 2020. But these periodic constitutional and electoral rewrites have repeatedly failed to prevent the majority of the population from winning elections and forming governments. Even if the military succeeds in rigging the first post-junta election, the return to the democratic process itself will empower the rural populists and trigger a new cycle of conflict with the royalist establishment. After all, the military junta has not resolved the fundamental grievances of the Thai population, particularly in the restive north and northeast regions, where about 51% of the population lives. While poverty has declined rapidly, a hallmark of economic development, this trend has supported the ambitions of the countryside. Meanwhile the share of the population making over $20 per day has only slightly risen (Chart 19). The mean-to-median household wealth ratio is rising sharply, as wealthy households are lifting the national average while the median family's wealth has been virtually flat in absolute terms (Chart 20). Chart 19Lower Middle Class Is Large... How To Play Malaysia's Elections (And Thailand's Lack Thereof) How To Play Malaysia's Elections (And Thailand's Lack Thereof) Chart 20...And Inequality Is Rising ...And Inequality Is Rising ...And Inequality Is Rising The stark disparity between Bangkok, the home of the civil bureaucracy, and the rest of the country is apparent in the fact that public sector wages are almost twice as high as private sector wages. And since the coup, the wages of bureaucrats and soldiers have risen faster than the wages of farmers (Chart 21). It is the latter who in great part fuel the rural opposition movement. All of this suggests that a new cycle of instability will begin in Thailand once civilian government resumes. The good news for investors is that this instability will creep in only gradually. The military will try to orchestrate the initial elections and civilian government (February 2019 at earliest), which means that policy will remain continuous at first. Chart 22 shows what happens to the THB/USD exchange rate, and Thai equity returns (both in absolute and relative to EM), in the months following three key phases in the Thai political cycle: (1) coups and military rule (2) military-arranged governments and initial post-coup elections (3) free and fair elections. Chart 21Stark Economic Disparities Stark Economic Disparities Stark Economic Disparities Chart 22Return To Civilian Rule Good For Stocks How To Play Malaysia's Elections (And Thailand's Lack Thereof) How To Play Malaysia's Elections (And Thailand's Lack Thereof) The first and third phases bring mixed results: coups are bad for the baht and good for equities in the short term, while free elections are good for the baht and mixed for equities. The second phase - the transition to civilian government - is the only one that produces all positive returns. Of course, the external environment will be an overwhelming factor. The THB/USD and equity performances after the 2007 post-coup election and the 2008 military-arranged government were all distorted by the global financial crisis and the V-shaped recovery in 2009. We cannot predict the external environment after Thailand's upcoming transition to civilian rule other than to say that it will likely be worse than today's (as globally synchronized growth is very strong today). What we can say is that Thai equities outperformed EM equities in all three cases of pseudo-civilian government that we observed (1992, 2007, 2008). While history may not repeat itself, the key point is that Thailand's junta has overseen relatively orthodox economic management that makes Thailand relatively well positioned to deal with external volatility and shocks - quite unlike Malaysia. The country runs a massive current account surplus of 10% of GDP. Public debt and external debt are low, as is the share of bonds owned by foreigners who could sell in a fit of volatility. The junta has also capitalized on the strong external backdrop to rebuild Thailand's foreign exchange reserves (Chart 23). And the deflationary and deleveraging tendencies of the junta period mean that Thailand does not face a significant inflation constraint, allowing the Bank of Thailand to cut interest rates if it should need to (Chart 24). Chart 23Junta Knows How To Hoard Junta Knows How To Hoard Junta Knows How To Hoard Chart 24Room To Cut Rates Room To Cut Rates Room To Cut Rates Thus when China's slowdown hits emerging markets, Thailand is relatively well positioned to outperform. Certainly it is better fortified against any trade or commodity shock than its neighbor to the south, Malaysia. Bottom Line: The Thai junta is getting closer to relinquishing power to a civilian government. This will initiate a new cycle of political instability in Thailand, as low- and middle-class angst and regional disparities remain. Nevertheless the junta will be in power for another 12-24 months, and the initial transition is likely to maintain policy continuity at least at the beginning. Investors can benefit from Thailand's relative stability in this regard. Investment Conclusions BCA's Geopolitical Strategy and Emerging Markets Strategy have different tactical approaches to Malaysia, with the political analysts more constructive in the short term due to the fact that the upcoming election will at least enable Najib to continue with piecemeal reforms. However, both strategy services agree that Malaysia remains highly vulnerable to the ongoing slowdown in China and any relapse in commodity prices. On Thailand, by contrast, both teams are clearly positive on this bourse, currency, and local bonds relative to their respective EM benchmarks. The macro context is stable if uninspiring. Politically, Thai politics are a liability in the long run, but not particularly so in the next 24 months. There will be a new bout of instability in two-to-five years, when the rural, populist movement elects a government that is at odds with the military and the Thai political establishment in Bangkok. Until that time, however, the junta's tight grip provides a continuation of the status quo, which has been positive for investors. Thailand stands on much more solid ground than Malaysia and many other EMs when it comes to external debt and foreign funding. It will be able to withstand considerable global/EM turmoil. Therefore Emerging Markets Strategy and Geopolitical Strategy recommend that investors go long Thai / short Malaysian local currency bonds currency unhedged: The Malaysian ringgit will depreciate versus the Thai baht in the next 12 months. The current account surplus is 10% of GDP in Thailand and 2.9% in Malaysia and will move in favor of Thailand as commodity prices slump. The outlook for foreign capital flows favors Thailand over Malaysia. Foreigners own 26% of domestic bonds in Malaysia but only 16% in Thailand. The ringgit depreciation will lead to some selling pressure in local bond markets. Thai local bonds are more immune to this risk. Thailand's public debt position is also smaller than in Malaysia especially when off-balance sheet liabilities are taken into account. That puts Malaysia's true public debt closer to 69% of GDP versus only 33% in Thailand. The Malaysian fiscal deficit is also wide (2.7% of GDP) and the government will face difficulties cutting spending and raising taxes at a time when global growth is slowing. One final word on geopolitics. In an increasingly multipolar world, certain states will be able to parlay their strategic relevance to get advantageous commercial, financial, and military deals from great powers. Both Malaysia and Thailand are well positioned to extract benefits from the U.S. and China in their great power competition. However, Thailand is unlikely to suffer from concentrated U.S. or Chinese antagonism anytime soon, whereas Malaysia faces a more complicated relationship with China due to its geographically strategic location, maritime sovereignty disputes in the South China Sea, tensions between the ethnic Malay and Chinese communities, and lack of mutual defense treaty with the United States.6 Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 2 Please see BCA Emerging Markets Strategy Weekly Report, "The EM Rally: Running Out Of Steam?" dated October 19, 2016, available at ems.bcaresearch.com. 3 Please see Hafiz Noor Shams, "Malaysia Power Shift Unlikely Despite Mahathir Factor," Financial Times, January 29, 2018, available at www.ft.com. 4 Please see footnote 1 above. 5 Thailand's current Prime Minister Prayuth Chan-Ocha has been in power since he launched the coup of May 2014. If elections are held in February 2019, this five-year period will be the third longest period of military rule since 1932. Prayuth himself is already ranked fourth out of thirteen military prime ministers in terms of his time in office. If he steps down in 2019-20 then his term would rival that of Prem Tinsulanonda in the 1980s and Plaek Phibunsongkhram in the 1950s. If he is elected and stays on as prime minister, he could rival Thanom Kittikachorn who ruled for ten years. 6 Please see BCA Geopolitical Strategy Special Report, "Does It Pay To Pivot To China?" dated July 5, 2017, "The South China Sea: Smooth Sailing?" dated March 28, 2017, and Weekly Report "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com.

Dear Clients, This week we are re-publishing an excellent Special Report written by our geopolitical team that appeared in the January 2018 Bank Credit Analyst. The recent removal of term limits on the Chinese presidency, a move that was foreshadowed in the report, has refocused global investor attention on the country's secular outlook. The report explains why the long-run outlook for China hinges on Xi Jinping's willingness to use his immense personal authority and concentration of power for the purposes of good governance and market-oriented economic reform. Without concrete progress, investors will have to decide whether they want to invest in a China that is becoming less economically vibrant as well as more authoritarian. I trust you will find this report insightful. Best regards, Jonathan LaBerge, CFA, Vice President Special Report Highlights 2018 is a pivotal year for China, as it will set the trajectory for President Xi Jinping's second term ... and he may not step down in 2022. Poverty, inequality, and middle-class angst are structural and persistent threats to China's political stability. The new wave of the anti-corruption campaign is part of Xi's attempt to improve governance and mitigate political risks. Yet without institutional checks and balances, Xi's governance agenda will fail. Without pro-market reforms, investors will face a China that is both more authoritarian and less productive. Feature Hearts rectified, persons were cultivated; persons cultivated, families were regulated; families regulated, states were rightly governed; states rightly governed, the whole world was made tranquil and happy. - Confucius, The Great Learning Comparisons of modern Chinese politics with Confucian notions of political order have become cliché. Nevertheless, there is a distinctly Confucian element to Chinese President Xi Jinping's strategy. Xi's sweeping anti-corruption campaign, which will enter "phase two" in 2018, is essentially an attempt to rectify the hearts and regulate the families of Communist Party officials and civil servants. The same could be said for his use of censorship and strict ideological controls to ensure that the general public remains in line with the regime. Yet Xi is also using positive measures - like pollution curbs, social welfare, and other reforms - to win over hearts and minds. His purpose is ultimately the preservation of the Chinese state - namely, the prevention of a Soviet-style collapse. Only if the regime is stable at home can Xi hope to enhance the state's international security and erode American hegemony in East Asia. This would, from Beijing's vantage, make the whole world more tranquil and happy. Chart 1The New Normal The New Normal The New Normal Thus, for investors seeking a better understanding of China in the long run, it is necessary to look at what is happening to its governance as well as to its macroeconomic fundamentals and foreign relations.1 China's greatest vulnerability over the long run is its political system. Because Xi Jinping's willingness to relinquish power is now uncertain, his governance and reform agenda in his second term will have an outsized impact on China's long-run investment outlook. The Danger From Within From 1978-2008, the Communist Party's legitimacy rested on its ability to deliver rising incomes. Since the Great Recession, however, China has entered a "New Normal" of declining potential GDP growth as the society ages and productivity growth converges toward the emerging market average (Chart 1). In this context, Chinese policymakers are deathly afraid of getting caught in the "middle income trap," a loose concept used to explain why some middle-income economies get bogged down in slower growth rates that prevent them from reaching high-income status (Chart 2).2 Such a negative economic outcome would likely prompt a wave of popular discontent, which, in turn, could eventually jeopardize Communist Party rule. The quid pro quo between the Chinese government and its population is that the former delivers rising incomes in exchange for the latter's compliance with authoritarian rule. The party is not blind to the fate of other authoritarian states whose growth trajectory stalled. Chart 2Will China Get Caught In The Middle-Income Trap? A Long View Of China A Long View Of China The threat of popular unrest in China may seem remote today. The Communist Party is rallying around its leader, Xi Jinping; the economy rebounded from the turmoil of 2015 and its cyclical slowdown in recent months is so far benign; consumer sentiment is extremely buoyant; and the global economic backdrop is bright (Chart 3). Yet these positive political and economic developments are cyclical, whereas the underlying political risks are structural and persistent. China has made massive gains in lifting its population out of poverty, but it is still home to 559 million people, around 40% of the population, living on less than $6 per day, the living standard of Uzbekistan. It will be harder to continue improving these workers' quality of life as trend growth slows and the prospects for export-oriented manufacturing dry up. This is why the Xi administration has recently renewed its attention to poverty alleviation. The government is on target in lifting rural incomes, but behind target in lifting urban incomes, and urban-dwellers are now the majority of the nation (Chart 4). The plight of China's 200-250 million urban migrants, in particular, poses the risk of social discontent. Moreover, while China knows how to alleviate poverty, it has less experiencing coping with the greatest threat to the regime: the rapid growth of the middle class, with its high expectations, demands for meritocracy and social mobility, and potential for unrest if those expectations are spoiled (Chart 5). Chart 3China's Slowdown So Far Benign China's Slowdown So Far Benign China's Slowdown So Far Benign Chart 4Urban Income Targets At Risk Urban Income Targets At Risk Urban Income Targets At Risk Chart 5The Communist Party's Greatest Challenge The Communist Party's Greatest Challenge The Communist Party's Greatest Challenge Democracy is not necessarily a condition for reaching high-income status, but all of Asia's high-income countries are democracies. A higher level of wealth encourages household autonomy vis-à-vis the state. Today, China has reached the $8,000 GDP per capita range that often accompanies the overthrow of authoritarian regimes.3 The Chinese are above the level of income at which the Taiwanese replaced their military dictatorship in 1987; China's poorest provinces are now above South Korea's level in that same year, when it too cast off the yoke of authoritarianism (Chart 6). Chart 6China's Development Beyond Point At Which##br## Taiwan And Korea Overthrew Dictatorship A Long View Of China A Long View Of China This is not an argument for democracy in China. We are agnostic about whether China will become democratic in our lifetime. We are making a far more humble point: that political risk will mount as wealth is accumulated by the country's growing middle class. Several emerging markets - including Thailand, Malaysia, Turkey and Brazil - have witnessed substantial political tumult after their middle class reached half of the population and stalled (Chart 7). China is approaching this point and will eventually face similar challenges. Chart 7Middle Class Growth Troubles Other EMs Middle Class Growth Troubles Other EMs Middle Class Growth Troubles Other EMs The comparison reveals that an inflection point exists for a society where the country's political establishment faces difficulties in negotiating the growing demands of a wealthier population. As political scientists have shown empirically, the very norms of society evolve as wealth erodes the pull of Malthusian and traditional cultural variables.4 Political transformation can follow this process, often quite unexpectedly and radically.5 Clearly the Chinese public shows no sign of large-scale, revolutionary sentiment at the moment. And political opposition does not necessarily result in regime change. Nevertheless, it is empirically false that the Chinese people are naturally opposed to democracy or representative government. After all, Sun Yat Sen founded a Republic of China in 1912, well before many western democratic transformations! And more to the point, the best survey evidence shows that the Chinese are culturally most similar to their East Asian neighbors (as well as, surprisingly, the Baltic and eastern European states): this is not a neighborhood that inherently eschews democracy. Remarkably, recent surveys suggest that China's millennial generation, while not wildly enthusiastic about democracy, is nevertheless more enthusiastic than its peers in the western world's liberal democracies (Chart 8)! Chart 8Chinese People Not Less Fond Of Democracy Than Others A Long View Of China A Long View Of China China is also home to one of the most reliable predictors of political change: inequality. China's economic boom is coincident with the rise of extreme inequalities in income, wealth, region, and social status. True, judging by average household wealth, everyone appears to be a winner; but the average is misleading because it is pulled upward by very high net worth individuals - and China has created 528 billionaires in the past decade alone. Chart 9Inequality: A Severe Problem In China Inequality: A Severe Problem In China Inequality: A Severe Problem In China A better measure is the mean-to-median wealth ratio, as it demonstrates the gap that opens up between the average and the typical household. As Chart 9 demonstrates, China is witnessing a sharp increase in inequality relative to its neighbors and peers. More standard measures of inequality, such as the Gini coefficient, also show very high readings in China. And this trend has combined with social immobility: China has a very high degree of generational earnings elasticity, which is a measure of the responsiveness of one's income to one's parent's income. If elasticity is high, then social outcomes are largely predetermined by family and social mobility is low. On this measure, China is an extreme outlier - comparable to the U.S. and the U.K., which, while very different economies, have suffered recent political shocks as a result of this very predicament (Chart 10). "China does not have voters" unlike the U.S. and U.K., is the instant reply. Yet that statement entails that China has no pressure valve for releasing pent-up frustrations. Any political shock may be more, not less, destabilizing. In the U.S. and the U.K., voters could release their frustrations by electing an anti-establishment president or abrogating a trade relationship with Europe. In China, the only option may be to demand an "exit" from the political system altogether. Chart 10China An Outlier In Inequality And Social Immobility A Long View Of China A Long View Of China Note that there is already substantial evidence of social unrest in China over the past decade. From 2003 to 2007, China faced a worrisome increase in "mass incidents," at which point the National Bureau of Statistics stopped keeping track. The longer data on "public incidents" suggests that the level of unrest remains elevated, despite improvements under the Xi administration (Chart 11). Broader measures tell a similar story of a country facing severe tensions under the surface. For instance, China's public security spending outstrips its national defense spending (Chart 12). Chart 11Chinese Social Unrest Is Real Chinese Social Unrest Is Real Chinese Social Unrest Is Real Chart 12China Spends More On ##br##Domestic Security Than Defense A Long View Of China A Long View Of China In essence, Chinese political risk is understated. This conclusion may seem counterintuitive, given Xi's remarkable consolidation of power. But is ultimately structural factors, not individual leaders, that will carry the day. The Communist Party is in a good position now, but its leaders are all-too-aware of the volcanic frustrations that could be unleashed should they fail to deliver the "China Dream." This is why so much depends upon Xi's policy agenda in the second half of his term. To that question we will now turn. Bottom Line: The Communist Party is at a cyclical high point of above-trend economic growth and political consolidation under a strongman leader. However, political risk is understated: poverty, inequality, and middle-class angst are structural and persistent and the long-term potential growth rate is slowing. If we assume that China is not unique in its historical trajectory, then we can conclude that it is approaching one of the most politically volatile periods in its development. The Governance And Reform Agenda Since coming to office in 2012-13, President Xi has spearheaded an extraordinary anti-corruption campaign and purge of the Communist Party (Chart 13). The campaign has understandably drawn comparisons to Chairman Mao Zedong's Cultural Revolution (1966-76). Yet these are not entirely fair, as Xi has tried to improve governance as well as eradicate his enemies. As Xi prepares for his "re-election" in March 2018, he has declared that he will expand the anti-corruption campaign further in his second term in office: details are scant, but the gist is that the campaign will branch out from the ruling party to the entire state bureaucracy, on a permanent basis, in the form of a new National Supervision Commission.6 There are three ways in which this agenda could prove positive for China's long-term outlook. First, the regime clearly hopes to convince the public that it is addressing the most burning social grievances. Corruption persistently ranks at the top of the list, insofar as public opinion can be known (Chart 14). Public opinion is hard to measure, but it is clear that consumer sentiment is soaring in the wake of the October party congress (see Chart 3 above). It is also worth noting that the Chinese public's optimism perked up in Xi's first year in office, when the policy agenda on offer was substantially the same and the economy had just experienced a sharp drop in growth rates (Chart 15). Reassuring the public over corruption will improve trust in the regime. Chart 13Xi's Anti-Corruption Campaign Xi's Anti-Corruption Campaign Xi's Anti-Corruption Campaign Chart 14Chinese Public Grievances A Long View Of China A Long View Of China Second, the anti-corruption campaign feeds into Xi's broader economic reform agenda. Productivity growth is harder to generate as a country's industrialization process matures. With the bulk of the big increases in labor, capital, and land supply now complete in China, the need to improve total factor productivity becomes more pressing (Chart 16). Unlike the early stages of growth, this requires reaching the hard-to-get economic conditions, such as property rights, human capital, financial deepening, entrepreneurship, innovation, education, technology, and social welfare. Chart 15Anti-Corruption Is Popular A Long View Of China A Long View Of China Chart 16Productivity Requires Institutional Change Productivity Requires Institutional Change Productivity Requires Institutional Change On this count, the Xi administration's anti-corruption campaign has been a net positive. The most widely accepted corruption indicators suggest that it has made a notable improvement to the country's governance. Yet the country remains far below its competitors in the absolute rankings, notably its most similar neighbor Taiwan (Chart 17 A&B). The institutionalization of the campaign could thus further improve the institutional framework and business environment. Chart 17AAnti-Corruption Campaign Is A Plus ... A Long View Of China A Long View Of China Chart 17B... But There's A Long Way To Go A Long View Of China A Long View Of China Third, the anti-corruption campaign can serve as a central government tool in enforcing other economic reforms. Pro-productivity reforms are harder to execute in the context of slowing growth because political resistance increases among established actors fighting to preserve their existing advantages. If the ruling party is to break through these vested interests, it needs a powerful set of tools. Recently, the central government in Beijing has been able to implement policy more effectively on the local level by paving the way through corruption probes that remove personnel and sharpen compliance. Case in point: the use of anti-corruption officials this year gave teeth to environmental inspection teams tasked with trimming overcapacity in the industrial sector (Chart 18). And there are already clear signs that this method will be replicated as financial regulators tackle the shadow banking sector.7 Chart 18Reforms Cut Steel Capacity, ##br##Reduced Need For Scrap Reforms Cut Steel Capacity, Reduced Need For Scrap Reforms Cut Steel Capacity, Reduced Need For Scrap These last examples - financial and environmental regulatory tightening - are policy priorities in 2018. The coercive aspect of the corruption probes should ensure that they are more effective than they would otherwise be. And reining in asset bubbles and reducing pollution are clear long-term positives for the regime. Ideally, then, Xi's anti-corruption campaign will deliver three substantial improvements to China's long-term outlook: greater public trust in the government, higher total factor productivity, and reduced systemic risks. The administration hopes that it can mitigate its governance deficit while improving economic sustainability. In this way it can buy both public support and precious time to continue adjusting to the new normal. The danger is that these policies will combine to increase downside risks to growth in the short term.8 Bottom Line: Xi's anti-corruption campaign is being expanded and institutionalized to cover the entire Chinese administrative state. This is a consequential campaign that will take up a large part of Xi's second term. It is the administration's major attempt to mitigate the socio-political challenges that await China as it rises up the income ladder. Absolute Power Corrupts Absolutely? The problem, however, is that Xi may merely use the anti-corruption campaign to accrue more power into his hands. As is clear from the above, Xi's governance agenda is far from impartial and professional. The anti-corruption campaign is being used not only to punish corrupt officials but also to achieve various other goals. Xi has even publicly linked the campaign to the downfall of his political rivals.9 In essence, the campaign highlights the core contradiction of the Xi administration: can Xi genuinely improve China's governance by means of the centralization and personalization of power? Over the long haul, the fundamental problem is the absence of checks and balances, i.e. accountability, from Xi's agenda. For instance, the National Supervision Commission will be granted immense powers to investigate and punish malefactors within the state - but who will inspect the inspectors? Xi's other governance reforms suffer the same problem. His attempt to create "rule of law" is lacking the critical ingredients of judicial independence and oversight. The courts are not likely to be able to bring cases against the party, central government, or powerful state-owned firms, and they will not be able to repeal government decisions. Thus, as many commentators have noted, Xi's notion of rule of law is more accurately described as "rule by law": the reformed legal system will in all probability remain an instrument in the hands of the Communist Party. Chart 19China's Governance Still Falls Far Behind A Long View Of China A Long View Of China Likewise, Xi's attempt to grant the People's Bank of China greater powers of oversight in order to combat systemic financial risk suffers from the fact that the central bank is not independent, and will remain subordinate to the State Council, and hence to the Politburo Standing Committee. This is not even to mention the lamentable fact that Xi's campaign for better governance has so far coincided with extensive repression of civil society, which does not mesh well with the desire to improve human capital and innovation.10 Thus it is of immense importance whether Xi sets up relatively durable anti-corruption, legal, and financial institutions that will maintain their legitimate functions beyond his term and political purposes. Otherwise, his actions will simply illustrate why China's governance indicators lag so far behind its peers in absolute terms. Corruption perceptions may improve further, but there will be virtually no progress in areas like "voice and accountability," "political stability and absence of violence," "rule of law," and "regulatory quality," each of which touches on the Communist Party's weak spots in various ways (Chart 19). Analysis of the Communist Party's shifting leadership characteristics reinforces a pessimistic view of the long run if Xi misses his current opportunity.11 The party's top leadership increasingly consists of career politicians from the poor, heavily populated interior provinces - i.e. the home base of the party. Their educational backgrounds are less scientific, i.e. more susceptible to party ideology. (Indeed, Xi Jinping's top young protégé, Chen Miner, is a propaganda chief.) And their work experience largely consists of ruling China's provinces, where they earned their spurs by crushing rebellions and redistributing funds to placate various interest groups (Chart 20). While one should be careful in drawing conclusions from such general statistics, the contrast with the leadership that oversaw China's boldest reforms in the 1990s is plain. Bottom Line: Xi's reform agenda is contradictory in its attempt to create better governance through centralizing and personalizing power. Unless he creates checks and balances in his reform of China's institutions, he is likely to fall short of long-lasting improvements. The character profiles of China's political elite do not suggest that the party will become more likely to pursue pro-market reforms in Xi's wake. Chart 20China's Leaders Becoming More 'Communist' Over Time A Long View Of China A Long View Of China Xi Jinping's Choice Xi is the pivotal player because of his rare consolidation of power, and 2018 is the pivotal year. It is pivotal because it will establish the policy trajectory of Xi's second term - which may or may not extend into additional terms after 2022. So far, the world has gained a few key takeaways from Xi's policy blueprint, which he delivered at the nineteenth National Party Congress on October 18: Xi has consolidated power: He and his faction reign supreme both within the Communist Party and the broader Chinese state; Xi's policy agenda is broadly continuous: Xi's speech built on his administration's stated aims in the first five years as well as the inherited long-term aims of previous administrations; China is coming out of its shell: In the international realm, Xi sees China "moving closer to center stage and making greater contributions to mankind"; The 2022 succession is in doubt: Xi refrained from promoting a successor to the Politburo Standing Committee, the unwritten norm since 1992. Chart 21Market Not Too Worried About##br## Party Congress Outcomes Market Not Too Worried About Party Congress Outcomes Market Not Too Worried About Party Congress Outcomes Markets have not reacted overly negatively to these developments (Chart 21), as the latter do not pose an immediate threat to the global rally in risk assets. The reasons are several: Maoism is overrated: While the Communist Party constitution now treats Xi Jinping as the sole peer of the disastrous ruler Mao Zedong, the market does not buy the Maoist rhetoric. Instead, it sees policy continuity, yet with more effective central leadership, which is a plus. Reforms are making gradual progress: Xi is treading carefully, but is still publicly committed to a reform agenda of rebalancing China's economic model toward consumption and services, improving governance and productivity, and maintaining trade openness. Whatever the shortcomings of the first five years, this agenda is at least reformist in intention. China's tactic of "seeking progress while maintaining stability" is certainly more reassuring than "progress at any cost" or "no progress at all"! Trump and Xi are getting along so far: Xi's promises to move China toward center stage threaten to increase geopolitical tensions with the United States in the long run, yet markets are not overly alarmed. China is imposing sanctions on North Korea to help resolve the nuclear missile standoff, negotiating a "Code of Conduct" in the South China Sea, and promoting the Belt and Road Initiative (BRI), which will marginally add to global development and growth. Trump is hurling threatening words rather than concrete tariffs. 2022 is a long way away: Markets are unconcerned with Xi's decision not to put a clear successor on the Politburo Standing Committee, even though it implies that Xi will not step down at the end of his term in five years. Investors are implicitly approving Xi's strongman behavior while blissfully ignoring the implication that the peaceful transition of power in China could become less secure. Are investors right to be so sanguine? Cyclically, BCA's China Investment Strategy is overweight Chinese investible equities relative to EM and global stocks.12 Geopolitical Strategy also recommends that clients follow this view and overweight China relative to EM. Beyond this 6-12 month period, it depends on how Xi uses his political capital. If Xi is serious about governance and economic reform, then long-term investors should tolerate the other political risks, and the volatility of reforms, and overweight China within their EM portfolio. After all, China's two greatest pro-market reformers, Deng Xiaoping and Jiang Zemin, were also heavy-handed authoritarians who crushed domestic dissent, clashed with the United States from time to time, and hesitated to relinquish control to their successors. However, if Xi is not serious, then investors with a long time horizon should downgrade China/EM assets - as not only China but the world will have a serious problem on its hands. For Deng Xiaoping and Jiang Zemin always reaffirmed China's pro-market orientation and desire to integrate into the global economic order. If Xi turns his back on this orientation, while imprisoning his rivals for corruption, concentrating power exclusively in his own person, and contesting U.S. leadership in the Asia Pacific, then the long-run outlook for China and the region should darken rather quickly. Domestic institutions will decay and trade and foreign investment will suffer. How and when will investors know the difference? As mentioned, we think 2018 is critical. Xi is flush with political capital and has a positive global economic backdrop. If he does not frontload serious efforts this year then it will become harder to gain traction as time goes by.13 If he demurs, the Chinese political system will not afford another opportunity like this for years to come. The country will approach the 2020s with additional layers of bureaucracy loyal to Xi, but no significant macro adjustments to its governance or productivity. It is not clear how long China's growth rate is sustainable without pro-productivity reforms. It is also not clear that the world will wait five years before responding to a China that, without a new reform push, will appear unabashedly mercantilist, neo-communist, and revisionist. Bottom Line: The long-run investment outlook for China hinges on Xi Jinping's willingness to use his immense personal authority and concentration of power for the purposes of good governance and market-oriented economic reform. Without concrete progress, investors will have to decide whether they want to invest in a China that is becoming less economically vibrant as well as more authoritarian. We think this would be a bad bet. Matt Gertken Associate Vice President Geopolitical Strategy Marko Papic Senior Vice President Chief Geopolitical Strategist Geopolitical Strategy 1 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms", dated May 13, 2015, available at gps.bcaresearch.com. 2 Chinese policymakers are expressly concerned about the middle-income trap. Please see the World Bank and China's Development Research Center of the State Council, "China 2030: Building A Modern, Harmonious, And Creative Society," 2013, available at www.worldbank.org. Liu He, who is perhaps Xi Jinping's top economic adviser, had a hand in drafting this report and is now a member of the Politburo and shortlisted to take charge of the newly established Financial Stability and Development Commission at the People's Bank of China. 3 Please see Indermit S. Gill and Homi Kharas, "The Middle-Income Trap Turns Ten," World Bank, Policy Research Working Paper 7403 (August, 2015), available at www.worldbank.org 4 Please see Ronald Inglehart and Christian Welzel, Modernization, Cultural Change and Democracy: the Human Development Sequence (Cambridge: CUP, 2005). 5 For example, the collaps of the Soviet Union and the Arab Spring, as well as the downfall of communist regimes writ large, were completely unanticipated. 6 Specifically, Xi is creating a National Supervision Commission that will group a range of existing anti-graft watchdogs under its roof at the local, provincial, and central levels of administration, while coordinating with the Communist Party's top anti-graft watchdog. More details are likely to be revealed at the March legislative session, but what matters is that the initiative is a significant attempt to institutionalize the anti-corruption campaign. Please see BCA Geopolitical Strategy Special Report, "China's Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 7 China has recently drafted top anti-graft officials, such as Zhou Liang, from the powerful Central Discipline and Inspection Commission and placed them in the China Banking Regulatory Commission, which is in charge of overseeing banks. Authorities have already imposed fines in nearly 3,000 cases in 2017 affecting various kinds of banks, including state-owned banks. On the broader use of anti-corruption teams for economic policy, please see Barry Naughton, "The General Secretary's Extended Reach: Xi Jinping Combines Economics And Politics," China Leadership Monitor 54 (Fall 2017), available at www.hoover.org. 8 Please see BCA Geopolitical Strategy Special Report, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 9 Please see Gao Shan et al, "China's President Xi Jinping Hits Out at 'Political Conspiracies' in Keynote Speech," Radio Free Asia, January 3, 2017, available at www.rfa.org 10 Xi has cranked up the state's propaganda organs, censorship of the media, public surveillance, and broader ideological and security controls (including an aggressive push for "cyber-sovereignty") to warn the public that there is no alternative to Communist Party rule. This tendency has raised alarms among civil rights defenders, lawyers, NGOs, and the western world to the effect that China's governance is actually regressing despite nominal improvement in standard indicators. This is the opposite of Confucius's bottom-up notion of order. 11 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress", dated July 19, 2017, available at gps.bcaresearch.com. 12 Investors should note that, since the publication of this report, BCA's China Investment Strategy service has closed its long MSCI China / short MSCI EM trade. We are now primarily expressing our cyclically positive stance towards Chinese stocks by being long MSCI China ex-technology versus MSCI All Country World (ACW) ex-tech. For more information please see China Investment Strategy Weekly Report "After The Selloff: A View From China", dated February 15, 2018, available at cis.bcaresearch.com. 13 Xi faces politically sensitive deadlines in the 2020-22 period: the economic targets in the thirteenth Five Year Plan; the hundredth anniversary of the Communist Party in 2021; and Xi's possible retirement at the twentieth National Party Congress in 2022. At that point he will need to focus on demonstrating the Communist Party's all-around excellence and make careful preparations either to step down or cling to power. Cyclical Investment Stance Equity Sector Recommendations

Highlights Portfolio Strategy Synchronized global growth, a soft U.S. dollar, our resurgent Boom/Bust Indicator and avoidance of a Chinese economic hard landing, are all signaling that it still pays to overweight cyclicals at the expense of defensives. Economically hyper-sensitive transports also benefit from synchronous global growth and capex. We expect a rerating phase in the coming months. Within transports, we reiterate our overweight stance in the key railroads sub-index as enticing macro tailwinds along with firming operating metrics underscore that profits will exit deflation in calendar 2018. Recent Changes There are no portfolio changes this week. Table 1 Staying Focused On The Dominant Macro Themes Staying Focused On The Dominant Macro Themes Feature The S&P 500 continued to consolidate last week, still digesting the early February tremor. Policy uncertainty is slowly returning and sustained Administration reshufflings are becoming slightly unnerving (bottom panel, Chart 1). Nevertheless, the dual themes of synchronized global growth and budding evidence of coordinated tightening in global monetary policy, i.e. rising interest rate backdrop, continue to dominate and remain intact. Importantly in the U.S., the latest non-farm payrolls (NFP) report was a goldilocks one. Month-over-month NFPs surpassed the 300K hurdle for the first time since late-2014, on an as-reported-basis, while wage inflation settled back down. The middle panel of Chart 2 shows that both in the 1980s and 1990s expansions, NFPs were growing briskly, easily clearing the 300K mark. The 2000s was the "jobless recovery" expansion and likely the exception to the rule. In all three business cycle expansions wage growth touched the 4%/annum rate before the recession hit. The yield curve slope also supports this empirical evidence, forecasting that wage inflation will likely attain 4%/annum before this cycle ends (wages shown inverted, Chart 3). Chart 1Watch Policy Uncertainty Watch Policy Uncertainty Watch Policy Uncertainty Chart 2Goldilocks NFP Report... Goldilocks NFP Report... Goldilocks NFP Report... Chart 3...But Wage Growth Pickup Looms ...But Wage Growth Pickup Looms ...But Wage Growth Pickup Looms One key element in the current cycle is that the government is easing fiscal policy to the point where both NFPs and wages will likely surge in the coming months as the fiscal thrust gains steam, likely extending the business cycle. This is an inherently inflationary environment, especially when the economy is at full employment and the Fed in slow and steady tightening mode. Last autumn, we showed that the SPX performs well in times of easy fiscal and tight money iterations, rising on average 16.7% with these episodes, lasting on average 16 months (Table 2).1 The latest flagship BCA monthly publication forecasts that the current fiscal impulse will last at least until year-end 2019, contributing positively to real GDP growth. Thus, if history at least rhymes, SPX returns will be positive and likely significant for the next couple of years (Chart 4). With regard to the composition of the equity market's return, we reiterate our view - backed by empirical evidence - that EPS will do the heavy lifting whereas the forward P/E multiple will continue to drift sideways to lower.2 Not only will rising fiscal deficits cause the Fed to remain vigilant and continue to raise interest rates and weigh on the equity market multiple (Chart 5), but also heightened volatility will likely suppress the forward P/E multiple. Table 2SPX Returns During Periods Of Loose##br## Fiscal And Tight Monetary Policy Staying Focused On The Dominant Macro Themes Staying Focused On The Dominant Macro Themes Chart 4Stimulative Fiscal Policy##br## Extends The Business Cycle... Stimulative Fiscal Policy Extends The Business Cycle... Stimulative Fiscal Policy Extends The Business Cycle... Chart 5...But Weighs On ##br##The Multiple ...But Weighs On The Multiple ...But Weighs On The Multiple This week we revisit our cyclical versus defensive portfolio bent and update the key transportation overweight view. Cyclicals Thrive When Global Growth Is Alive And Well... While retaliatory tariff wars are dominating the media headlines, global growth is still resilient. Our view remains that the odds of a generalized trade war engulfing the globe are low, and in that light we reiterate our cyclical over defensive portfolio positioning, in place since early October.3 Global growth is firing on all cylinders. Our Global Trade Indicator is probing levels last hit in 2008, underscoring that cyclicals will continue to have the upper hand versus defensives (Chart 6). Synonymous with global growth is the softness in the U.S. dollar. In fact, the two are in a self-feeding loop where synchronized global growth pushes the greenback lower, which in turn fuels further global output growth. Tack on the rising likelihood that the trade-weighted dollar has crested from a structural perspective, according to the 16-year peak-to-peak cycle4 (Chart 7) and the news is great for cyclicals versus defensives (Chart 8). Chart 6Global Trade Is Alright Global Trade Is Alright Global Trade Is Alright Chart 7Dollar The Great Reflator... Dollar The Great Reflator... Dollar The Great Reflator... Chart 8...Is A Boon For Cyclicals Vs. Defensives ...Is A Boon For Cyclicals Vs. Defensives ...Is A Boon For Cyclicals Vs. Defensives Related to the greenback's likely secular peak is the booming commodity complex, as the two are nearly perfectly inversely correlated. Commodity exposure is running very high in the deep cyclical sectors and thus any sustained commodity price inflation gains will continue to underpin the cyclicals/defensives share price ratio. BCA's Boom/Bust Indicator (BBI) corroborates this upbeat message for cyclicals versus defensives. The BBI is on the verge of hitting an all-time high and, while this could serve as a contrary signal, there are high odds of a breakout in the coming months if synchronized global growth stays intact as BCA expects, rekindling cyclicals/defensives share prices (Chart 9). Finally, if China avoids a hard landing, and barring an EM accident, the cyclicals/defensives ratio will remain upbeat. Chart 10 shows that China's LEI is recovering smartly from the late-2015/early-2016 manufacturing recession trough, and the roaring Chinese stock market - the ultimate leading indicator - confirms that the path of least resistance for the U.S. cyclicals/defensive share price ratio is higher still. Chart 9Boom/Bust indicator Is Flashing Green Boom/Bust indicator Is Flashing Green Boom/Bust indicator Is Flashing Green Chart 10China Is Also Stealthily Firming China Is Also Stealthily Firming China Is Also Stealthily Firming Bottom Line: Stick with a cyclical over defensive portfolio bent. ...As Do Transports, Thus... Transportation stocks have taken a breather recently on the back of escalating global trade war fears. But, we are looking through this soft-patch and reiterate our barbell portfolio approach: overweight the global growth-levered railroads and air freight & logistics stocks at the expense of airlines that are bogged down by rising capacity and deflating airfare prices (Chart 11). Leading indicators of transportation activity are all flashing green. Transportation relative share prices and manufacturing export expectations are joined at the hip, and the current message is to expect a reacceleration in the former (top panel, Chart 12). Similarly, capital expenditures, one of the key themes we are exploring this year, are as good as they can be according to the regional Fed surveys, and signal that transportation profits will rev up in the coming months (middle panel, Chart 12). The possibility of an infrastructure bill becoming law later this year or in 2019 would also represent a tailwind for transportation EPS. Not only is U.S. trade activity humming, but also global trade remains on a solid footing. The global manufacturing PMI is resilient and sustaining recent gains, suggesting that global export volumes will resume their ascent. This global manufacturing euphoria is welcome news for extremely economically sensitive transportation profits (Chart 13). All of this heralds an enticing transportation services end-demand outlook. In fact, industry pricing power is gaining steam of late and confirms that relative EPS will continue to expand (Chart 12). Under such a backdrop, a rerating phase looms in still depressed relative valuations (bottom panel, Chart 13). Chart 11Stick With Transports Exposure Stick With Transports Exposure Stick With Transports Exposure Chart 12Domestic... Domestic... Domestic... Chart 13...And Global Growth/Capex Beneficiary ...And Global Growth/Capex Beneficiary ...And Global Growth/Capex Beneficiary ...Stay On Board The Rails Railroad stocks have worked off the overbought conditions prevalent all of last year, and momentum is now back at zero. In addition, forward EPS have spiked, eliminating the valuation premium and now the rails are trading on par with the SPX on a forward P/E basis (Chart 14). The track is now clear and more gains are in store for relative share prices in the coming quarters. Despite trade war jitters, we are looking through the recent turbulence. If the synchronized global growth phase endures, as we expect, then rail profits will remain on track. In fact, BCA's measure of global industrial production (hard economic data) is confirming the euphoric message from the global manufacturing PMI (soft economic data) and suggests that rails profits will overwhelm (Chart 15). Our S&P rails profit model also corroborates this positive global trade message and forecasts that rail profit deflation will end in 2018 (bottom panel, Chart 15). Beyond these macro tailwinds, operating industry metrics also point to a profit resurgence this year. Importantly, our rails profit margin proxy (pricing power versus employment additions) has recently reaccelerated both because selling prices are expanding at a healthy clip and due to labor restraint (second panel, Chart 15). Demand for rail hauling remains upbeat and our rail diffusion indicator has surged to a level last seen in 2009, signaling that there is a broad based firming in rail carload shipments (second panel, Chart 16). Chart 14Unwound Both Overbought Conditions And Overvaluation Unwound Both Overbought Conditions And Overvaluation Unwound Both Overbought Conditions And Overvaluation Chart 15EPS On Track To Outperform EPS On Track To Outperform EPS On Track To Outperform Chart 16Intermodal Resilience Intermodal Resilience Intermodal Resilience The significant intermodal segment that comprises roughly half of all shipments is on the cusp of a breakout. The retail sales-to-inventories ratio is probing multi-year highs on the back of the increase in the consumer confidence impulse and both are harbingers of a reacceleration in intermodal shipments (Chart 16). Coal is another significant category that takes up just under a fifth of rail carload volumes and bears close attention. While natural gas prices have fallen near the lower part of the trading range in place since mid-2016 and momentum is back at neutral, any spike in nat gas prices will boost the allure of coal as a competing fuel for energy generation (middle panel, Chart 17). Keep in mind that coal usage is highly correlated with electricity demand and the industrial business cycle, and the current ISM manufacturing survey message is upbeat for coal demand. Tack on the whittling down in coal inventories at utilities and there is scope for a tick up in coal demand (third panel, Chart 18). Finally, the export relief valve has reopened for coal with the aid of the depreciating U.S. dollar, and momentum in net exports has soared to all-time highs, even surpassing the mid-1982 peak (bottom panel, Chart 18). Chart 17Key Coal Shipments Underpin Selling Prices Key Coal Shipments Underpin Selling Prices Key Coal Shipments Underpin Selling Prices Chart 18Upbeat Leading Indicators Of Coal Demand Upbeat Leading Indicators Of Coal Demand Upbeat Leading Indicators Of Coal Demand All of this suggests that coal shipments will make a comeback later in 2018, and continue to underpin industry pricing power, which in turn boost rail profit prospects (bottom panel, Chart 17). Bottom Line: Continue to overweight the broad S&P transportation index, and especially the heavyweight S&P railroads sub-index. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Can Easy Fiscal Offset Tighter Monetary Policy?" dated October 9, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "EPS And 'Nothing Else Matters'," dated December 18, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Special Report, "Top 5 Reasons To Favor Cyclicals Over Defensives," dated October 16, 2017, available at uses.bcaresearch.com. 4 Please see BCA Foreign Exchange Strategy Weekly Report, "The Euro's Tricky Spot," dated February 2, 2018, available at fes.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).

Highlights Financial market volatility in general and FX market volatility in particular is set to increase because of the following three factors: Rising U.S. inflation will make the Federal Reserve increasingly hawkish, and the European Central Bank is moving away from maximum accommodation; The Chinese economy is not accelerating; And geopolitical tensions are growing. While EM and commodity currencies will suffer, safe havens like the yen and Swiss franc will benefit. The euro may correct at first, but it remains on an upward trajectory. Feature Chart I-1Low And High Growth Sentiment##br## Are Linked Low And High Growth Sentiment Are Linked Low And High Growth Sentiment Are Linked A defining feature of global financial markets over the past two years has been the outright collapse of volatility. However, in late January the VIX rebounded, recording readings not seen since 2015. Currency volatility also hit three-year lows before the same wake-up call, causing a sharp but temporary increase in FX volatility. It is important to understand whether this recent rebound in volatility was just a blip or a symptom of something more profound - a sign that volatility is back on an uptrend and will continue to rise as it did from 1996 to 2002, or again from 2007 to 2009. This matters because volatility is an important determinant of FX returns. High-yielding carry currencies perform well when volatility is low. While low-yielding funding currencies like the Swiss franc or the yen suffer in periods of calm, their returns improve once volatility rises. Moreover, low-volatility environments are often associated with buoyant expectations about global growth among international investors (Chart I-1). Thus, a return of volatility could fray the edges of global growth sentiment, which is currently ebullient. This would hurt EM and commodity currencies. Our view is that volatility is making a comeback as global monetary policy is becoming less accommodative, China's path is becoming rockier and global geopolitical risks are rising. These dynamics will hurt EM and commodity currencies, while at the margin, help safe-haven currencies like the yen and Swiss franc. Monetary Policy In DM Economies Monetary policy in the advanced economies is not yet tight, but is moving away from the large accommodation implemented in the wake of the Great Financial Crisis. Historically, a removal of accommodative policy tends to be associated with rising volatility, especially in the FX space. The link is not that clear-cut though. Policy tightening tends to lead to higher volatility. However, it only does so once we enter the latter innings of the business cycle. Only when inflation begins to gain enough momentum to force the Fed to increase rates fast enough to raise the specter that policy will soon begin to hurt growth, does volatility start rising durably. We are getting closer to this moment in the U.S. The U.S. is increasingly showing signs of late-stage business expansion. For one, the yield curve has flattened to 53 basis points. This level of slope has historically been associated with full employment and rising wage pressures. Surveys corroborate this picture. The NFIB survey of U.S. small businesses shows that the gap between the difficulties of finding qualified labor versus demand problems is close to record highs. This normally marks rising wage pressures, the hallmark of full employment (Chart I-2). Moreover, the ISM manufacturing survey shows that companies are paying more for the price of their inputs and experiencing delays with suppliers. Normally, this also describes a late-cycle environment marked with rising inflationary pressures (Chart I-3). Chart I-2Late Cycle Dynamics##br## In The U.S. Late Cycle Dynamics In The U.S. Late Cycle Dynamics In The U.S. Chart I-3Firms Are Facing Budding##br## Inflationary Pressures Firms Are Facing Budding Inflationary Pressures Firms Are Facing Budding Inflationary Pressures Other variables are generally pointing toward an acceleration of U.S. inflation. Because aggregate U.S. capacity utilization - which incorporates both labor market conditions and the Fed's own capacity utilization measure - highlights a notable absence of slack, and because the change in the velocity of money in the U.S. is accelerating, our models forecast a sustained uptick in U.S. core inflation to 2% and above (Chart I-4). U.S. CPI excluding food and energy data for February is also pointing toward budding inflationary pressures. While the annual core inflation rate was flat compared to January, the annualized three-month rate of change has surged to 3%. The muted year-on-year comparison is being depressed by some base effect. In 2017, inflation started to weaken significantly in March. Therefore, beginning in March 2018, consumer price inflation in the U.S. will likely accelerate more noticeably than it has until now. Shelter inflation too is moving from a headwind to a tailwind. Shelter inflation represents 42% of the core CPI basket, and it has been on a decelerating trend for 14 months. However, the model developed by our U.S. Bond Strategy colleagues shows that U.S. shelter inflation is now set to start bottoming (Chart I-5, top panel). Chart I-4Core Inflation Will Rise Core Inflation Will Rise Core Inflation Will Rise Chart I-5Other Inflationary Pressures Other Inflationary Pressures Other Inflationary Pressures Core goods prices are also regaining some vigor. This is not much of a surprise. The strength of the global economy along with the weakness of the U.S. dollar have filtered through to higher import prices. Historically, import prices tend to lead core goods prices in the U.S. (Chart I-5, bottom panel). We could see rising inflationary pressures on the services front as well. The employment cost index - the cost component used to compute unit labor costs - is still displaying a tight positive correlation with the employment-to-population ratio for prime-age workers (Chart I-6). BCA estimates that employment gains above 123,000 new jobs a month will push this ratio up, and consequently labor costs. But as Chart I-7 illustrates, the strength in the Conference Board Leading Credit Index highlights that employment growth in the U.S. is likely to remain robust. This suggests the key driver of service inflation - wages - will continue to improve. Chart I-6Wages Will Keep Rising... The Return Of Macro Volatility The Return Of Macro Volatility Chart I-7...As Employment Growth Will Stay Strong ...As Employment Growth Will Stay Strong ...As Employment Growth Will Stay Strong Thus, it seems the stars are already aligning to foment a rise in U.S. core CPI. The Trump administration throwing in some large-scale fiscal stimulus into the mix is only akin to throwing fuel on a fire. Accordingly, we expect the Fed to upgrade its interest rate forecasts for 2019. Markets are not yet ready for this scenario, anticipating only five rate hikes between now and the end of 2019. Thus, the most important central bank for setting the global cost of capital will likely surprise in a hawkish fashion over the coming 21 months. But what about the other big DM central bank, the ECB? The ECB too has begun to remove monetary accommodation, as it has started to taper its purchases of securities. It aims to be done this in September. Moreover, the narrowing gap between the unemployment rate and NAIRU in the euro area points to budding inflationary pressures (Chart I-8). This would argue that the ECB will begin lifting interest rates toward the summer of 2019. In fact, the shadow policy rate for the euro area has already begun to turn higher (Chart I-9), suggesting European policy is already starting to move away from its accommodative extremes. This combination is very important for volatility. As Chart I-10 illustrates, the average shadow policy rate for the U.S., the euro area, the U.K., and Japan leads financial markets and FX volatility. While Japanese rates may remain at low levels, the path for Europe and the U.S. is clearly up, suggesting volatility will rise. Chart I-8Growing Wage Pressures In Europe Growing Wage Pressures In Europe Growing Wage Pressures In Europe Chart I-9ECB Policy Is Already Less Accommod ECB Policy Is Already Less Accommod ECB Policy Is Already Less Accommod Chart I-10Tighter Global Policy Leads To Higher Volatility Tighter Global Policy Leads To Higher Volatility Tighter Global Policy Leads To Higher Volatility Bottom Line: The U.S. is increasingly displaying symptoms that its business cycle expansion is at an advanced stage. With inflationary pressures growing more intense, the Fed will need to ratchet up its tightening path. The ECB too has begun removing accommodation. This means that two of the three most important price setters for the cost of money are either fully tightening policy or beginning to remove accommodation. This has historically marked the point when global financial market volatility begins to rise. China Uncertainty China is another factor pointing toward a rise in global financial volatility. China has exerted a benign influence on global growth from the second half of 2016 and through most of 2017. In response to a large easing in monetary conditions and a hefty dose of fiscal stimulus, Chinese growth had until recently regained vigor, with the Li Keqiang index - our preferred measure of Chinese industrial activity - swinging from -2.6 sigma to 0.5 sigma in 15 months. A key gauge of Chinese activity - the average of the new orders and backlog of order subcomponents of the PMIs surveys - captured these dynamics very well. This indicator also explains the gyrations in various measures of asset markets volatility well (Chart I-11). Currently, it points to a rise in global financial market volatility. Going forward, the key question for investors is whether or not Chinese orders continue to deteriorate, flagging a further rise in volatility. We are inclined to say yes. Chinese monetary conditions have continued to deteriorate, and administrative measures to slow down the growth of total social financing are starting to bite. Chart I-12 shows that the issuance of bonds by small financial intermediaries has slowed significantly. Based on this message, the early slowdown in total debt growth should continue over the coming months. Optimists about China often highlight that this should have a limited impact on economic activity. After all, 62% of fixed asset investments in China are financed by internally generated funds. However, the biggest problem for China is the misallocation of capital. As Chart I-13 shows, construction as a percentage of total capex has been linked to population growth. However, after 2008, these two series decoupled: population growth has been stagnating while construction activity has been skyrocketing, despite a slowdown in the rate of migration from rural to urban areas. This suggests that post-2008, China has been building too many structures. Chart I-11China To Affect ##br##Volatility China To Affect Volatility China To Affect Volatility Chart I-12Administrative Tightening Will ##br##Weigh On Chinese Credit Administrative Tightening Will Weigh On Chinese Credit Administrative Tightening Will Weigh On Chinese Credit Chart I-13After The GFC, Chinese ##br##Construction Took Off After The GFC, Chinese Construction Took Off After The GFC, Chinese Construction Took Off When capital is misallocated, even if the share of debt financing is low, tight monetary conditions and administrative measures to limit excesses in the economy can bite sharply. This raises the risk that Chinese growth will not pick up much going forward, and that in fact, capex and industrial activity will struggle. Jonathan LaBerge, who writes BCA's Chinese Investment Strategy, has built a list of some of the key indicators he follows to track the evolution of the Chinese economy. Table I-1 shows that all but the Caixin/Markit manufacturing PMI index are in a downtrend, and that 11 out of the 14 variables have been deteriorating in recent months.1 Moreover, as Chart I-14 illustrates, the strength in the Caixin PMI is likely to be an aberration. When the spread between the Caixin and the official measure is as wide as it currently is, the following quarters tend to be followed by a fall in the average of the two series. Table I-1No Convincing Signs Of An Impending##br## Upturn In China's Economy The Return Of Macro Volatility The Return Of Macro Volatility Chart I-14The Caixin PMI Is Probably##br## The Noise, Not The Signal The Caixin PMI Is Probably The Noise, Not The Signal The Caixin PMI Is Probably The Noise, Not The Signal We would therefore expect Chinese economic momentum to slow further. Since Chinese policymakers still want to engineer some deleveraging, the Chinese industrial sector will decelerate. This will contribute to the rise in financial market volatility for the remainder of the business cycle, especially as global monetary policy in the G-10 is becoming less accommodative. Bottom Line: The Chinese economy contributed to low levels of volatility in financial markets from 2016 to late 2017. However, China still suffers from a large misallocation of capital, which is making its economy vulnerable to both monetary and administrative tightening. With most key gauges of Chinese economic activity still pointing south, industrial activity could deteriorate further. This will contribute to a rise in global financial market volatility, especially as DM central banks are removing monetary accommodation. Rising Geopolitical Tensions The last factor pointing toward rising financial market volatility are growing global geopolitical tensions. As Marko Papic has highlighted in BCA's Geopolitical Strategy service, the world's unipolar moment under the umbrella of U.S. dominance is over. The world is increasingly becoming a multi-polar environment, where multiple powers vie for local dominance. As the early 20th century and the 1930s showed, when the world becomes multi-polar, geopolitical risks rise (Chart I-15). Chart I-15Geopolitical Risk Is The Outcome Of Global Multipolarity Geopolitical Risk Is The Outcome Of Global Multipolarity Geopolitical Risk Is The Outcome Of Global Multipolarity Today's increasingly multi-polar world may not be headed for an imminent global war, but tensions are likely to increase. This means policies could become more erratic. Additionally, domestic politics are under stain as well. Rising inequality and social stagnation in the U.S. are fomenting public discontent (Chart I-16). Moreover, U.S. citizens are not champions of free trade; in fact, they view unfettered trade with a rather suspicious eye, as do the citizens of Italy, Japan or France (Chart I-17). Chart I-16The U.S. Is Unequal And Ossified The Return Of Macro Volatility The Return Of Macro Volatility Chart I-17America Belongs To The Anti-Globalization Bloc The Return Of Macro Volatility The Return Of Macro Volatility Practically, this means tensions such as those experienced two weeks ago around the imposition of tariffs on steel and aluminum imports into the U.S. are likely to continue. The White House is already discussing the possibility of imposing a 15% tariff on Chinese imports to the U.S. totaling US$60 billion. As we highlighted last week, alleged intellectual property theft by China will likely remain a hot-button topic that could result in painful sanctions, prompting swift retaliation by Beijing. Additionally, NAFTA negotiations are not over, pointing to continued headline risk in the space. Moreover, relations with Russia are tense, and the Iran deal looks increasingly fraught with uncertainty. These two spots could easily morph into yet another source of risk. Bottom Line: The global geopolitical environment has become a multi-polar system - an environment historically prone to serious tensions. The rise of populism in the U.S. only makes this risk more salient, especially with respect to global trade. As a result, the threat of a trade war, especially between the U.S. and China, is increasing. This means shocks to global trade and global growth could become more frequent. This will likely create another source of financial market volatility, compounding the impact of economic fundamentals like global monetary policy and China's economic risks. Investment Implications Carry trades should fare especially poorly in this environment, as they abhor rising volatility.2 Hence, the performance of EM high-yielders like the BRL, TRY, and ZAR could progressively deteriorate. Moreover, because rising volatility often hurts economic sentiment, this increase in volatility could weigh on growth-sensitive currencies like the KRW in the EM space or the AUD and the NZD in the DM space. The SEK would normally suffer when global growth sentiment deteriorates. Yet this time may play out differently. Swedish short rates are -0.5%, making the SEK a funding currency. If carry trades do suffer, the need to buy back funding currencies could put a bid under the SEK. In this context, the JPY and the CHF could be the great winners. Both currencies have been used as funding vehicles. Moreover, both Switzerland and Japan sport outsized net international investment positions equal to 126% and 65% of their respective GDPs. If volatility does rise, some Swiss and Japanese investors will likely repatriate funds from abroad, generating purchases of yen and Swiss francs in the process. Moreover, from an empirical perspective, both these currencies continue to react well when global volatility spikes. Chart I-18The Euro Is Vulnerable To Higher Vol The Euro Is Vulnerable To Higher Vol The Euro Is Vulnerable To Higher Vol However, both Japan and Switzerland are still experiencing weak inflation. The BoJ and the SNB will therefore try to lean against currency strength caused by exogenous volatility shocks. The JPY and the CHF could be caught between these forces. The currency depreciation these central banks try to engineer will be occasionally interrupted by sharp rallies when financial market volatility spikes. This means that monetary policy in these two countries will have to stay extremely accommodative. For now, it is still too early to bet against the yen's current strength. Finally, the impact of rising volatility on the euro's outlook is more nebulous. The euro is neither a carry currency nor a funding currency, but it generally appreciates when global growth sentiment improves. Thus, since long positioning in the euro is very stretched, a renewed spike in volatility would likely hurt the euro, especially as European economic surprises are plummeting relative to the U.S. (Chart I-18). Nonetheless, this pain will be a temporary phenomenon. The euro is still cheap, and one of the factors driving global volatility higher is the ECB abandoning its accommodative monetary policy stance. Moreover, as terminal interest rate expectations in Europe are still well below their historical average relative to the U.S., there is still ample room for investors to upgrade their assessment of where the European policy rate will end up vis-à-vis the U.S. at the end of the cycle. Bottom Line: Any negative impact of rising global financial markets volatility will be felt most acutely by carry and growth-sensitive currencies like the BRL, TRY, ZAR, AUD, and KRW. Contrastingly, funding currencies underpinned with large positive net international investment positions such as the JPY and the CHF will be beneficiaries. The impact on the euro may be negative at first, as speculators are massively long the euro despite a collapse in euro area economic surprises. However, the long-term impact should prove to be more muted as the euro's fundamentals are still improving. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China And The Risk Of Escalation", dated March 7,2018, available at cis.bcaresearch.com. 2 Please see Foreign Exchange Strategy Special Report, titled "Carry Trades: More than Pennies And Steamrollers", dated May 6, 2016, available at fes.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 U.S. data was generally positive for the dollar: Headline and core CPI came in line with expectations, growing at 2.2% and 1.8% annually, respectively; NFIB Business Optimism Index was hit 107.6, beating expectations of 107.1; Continuing jobless claims came in at 1.879 million, beating the expected 1.9 million; Initial jobless claims came in line with expectations at 226,000; However, retail sales came in weaker than expected, contracting by 0.1% monthly. Despite this generally positive tone to the data, the dollar was still soft this week. However, downward momentum has slowed, paving the way for a short-term counter trend rally. This is consistent with a global growth slowdown. Report Links: Are Tariffs Good Or Bad For The Dollar? - March 9, 2018 The Dollar Deserves Some Real Appreciation - March 2, 2018 Who Hikes Again? - February 9, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 European data was disappointing: Industrial production contracted in monthly terms by 1% and also grew at only 2.7% yearly, less than the expected 4.7% pace; German CPI grew at a 1.4% yearly pace, with the harmonized index growing by 1.2%, both in line with expectations. In a speech on Wednesday, President Draghi clarified that "monetary policy will remain patient, persistent and prudent" as there is still a need for "further evidence that inflation dynamics are moving in the right direction". As global growth is downshifting, the euro could experience a significant correction before resuming its bull market. Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: Machinery orders yearly growth came in at 2.9%, outperforming expectations. However, domestic corporate goods inflation surprised to the downside, coming in at 2.5%. Moreover, the tertiary industry Index month-on-month growth also underperformed expectations, coming in at -0.6%. Finally, labor cash earnings yearly growth came in line with expectations at 0.7%. Last Friday, the BoJ decided to leave its interest rate benchmark unchanged at 0.1%. In its minutes, the board members shared the view that CPI will reach their 2% in fiscal 2019. Overall, we expect that rising global interest rates will cause a rise in currency volatility. This will result in a positive environment for the yen for now, but one that could prevent Japanese inflation from hitting that 2% objective in 2019. Report Links: The Yen's Mighty Rise Continues... For Now - February 16, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Industrial production yearly growth underperformed expectations, coming in at 1.6%. Manufacturing production also underperformed expectations, coming in at 2.7%. However, the trade balance outperformed expectations, coming in at -3.074 billion pounds. The pound has been relatively flat this week against the U.S. dollar. Overall, we believe that the upside to the British pound against the dollar is limited, as there are already 40 basis points of interest rate hikes priced for the BoE this year. Given that inflation is set to ease following last year's rally in the pound, it is unlikely that the pound will raise rates more than what is currently priced. Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Australian data was mixed: Home loans fell by 1.1%; Investment lending for homes increased by 1.1%; The NAB Confidence survey declined to 9 from 11 but was in line with expectations; The NAB Conditions survey increased to 21, outperforming expectations; The Westpac Consumer Confidence increased from -2.3% to 0.2%. Elevated Household debt and the absence of wage growth are still at the forefront of Australian policymaker's minds. The RBA is reluctant to raise rates in order to avoid a deflationary spiral which would set the economy back severely. The AUD will most likely suffer this year because of this. Report Links: Who Hikes Again? - February 9, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been negative: The current account surprised to the downside, coming in at -2.7% of GDP. Moreover, GDP yearly growth also underperformed expectations, coming in at 2.9%. However, it did improve from last quarter growth of 2.7%. Finally, Food Price Index monthly growth decline from last month, coming in at -0.5%. The New Zealand dollar has been flat this week against the U.S. dollar. We believe that NZD/USD and NZD/JPY are likely to suffer moving forward, as financial markets volatility is set to rise in the coming months due to the rise in global interest rates and the possibility of a slowdown in China. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Canadian employment figures remain strong, with the ADP employment change coming in at 39,700, above the 10,700 experienced last month. Canada's export growth should improve further as the White House is adding large amounts of fiscal stimulus in the U.S. economy, Canada's largest trading partner. This will help the BoC stick to its hiking path. However, risks are high. While Canada has so far been able to avoid the U.S. steel and aluminum tariffs, NAFTA negotiations still remain a danger for the Canadian economy. Furthermore, the housing market still remains overheated and the debt load is at risk of spiraling when mortgages begin to be refinanced at higher rates. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 The SNB left its reference rate unchanged at -0.75%. The Swiss central bank reiterated that the negative rates as well as foreign exchange intervention "remain essential". Moreover, the SNB decreased its inflation forecast for this year form 0.7% to 0.6%. The SNB also changed its forecast for 2019 from 1.1% to 0.9%. Overall, the SNB is likely to maintain a very dovish stance, given the headwinds to Swiss inflation. This will continue to put upward pressure on EUR/CHF. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been positive: Headline inflation surprised to the upside, coming in at 2.2%. It also increased from 1.6% the previous month. Meanwhile, core inflation also outperformed expectations, coming in at 1.4%. It also increased from 1.1% the previous month. USD/NOK has depreciated by roughly 1.4% this week. On Thursday, the Norges Bank left its policy rate unchanged at 0.5%. In its monetary policy report the central bank highlighted that the outlook for the Norwegian economy suggests that "it will soon be appropriate to raise rates". Overall, we believe that the krone is likely to outperform other commodity currencies, given that there are only 18 basis points priced for the next 12 months, which is less than is warranted given the strength of the economy and BCA's outlook for oil prices in 2018. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 While Swedish inflation came in line with expectations, with consumer prices growing at a 0.7% monthly pace and a 1.6% yearly pace, Sweden's unemployment came in at a much lower level than anticipated. The krona is finally strengthening after EUR/SEK traded above the critical 10.00 level. This trend should continue as the euro weakens from overbought levels. Furthermore, the eventual resurgence of inflation in Sweden will propel the SEK to stronger levels as markets reprice the Riksbank's likely policy path. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Several economic and financial market indicators point to a budding downtrend in Chinese capital spending and its industrial sector. The recent underperformance of global mining, chemicals and machinery/industrials corroborate that capital spending in China is starting to slump. Shipments-to-inventory ratios for Korea and Taiwan also point to a relapse in Asian manufacturing. This is occurring as our global growth sentiment proxy sits on par with previous peaks, and investor positioning in EM and commodities is overextended. Stay put on EM. Markets with currency pegs to the U.S. dollar, such as the Gulf states and Hong Kong, will face tightening local liquidity. Share prices in these markets have probably topped out. Feature On the surface, EM equities, currencies and local bond and credit markets are still trading well. However, there are several economic indicators and financial variables that herald negative surprises for global and Chinese growth. In particular: China's NBS manufacturing PMI new orders and backlogs of orders have relapsed in the past several months. Chart I-1 illustrates the annual change in new orders and backlogs of orders to adjust for seasonality. The measure leads industrial profits, and presently foreshadows a slowdown going forward. Furthermore, the average of NBS manufacturing PMI, new orders, and backlog orders also points to a potential relapse in industrial metals prices in general as well as mainland steel and iron ore prices (Chart I-2). The message from Charts I-1 and I-2 is that the recent weakness in iron ore and steel prices could mark the beginning of a downtrend in Chinese capital spending. While supply cuts could limit downside in steel prices, it would be surprising if demand weakness does not affect steel prices at all.1 Chart I-1China: Slowdown Has Further To Run China: Slowdown Has Further To Run China: Slowdown Has Further To Run Chart I-2Industrial Metals Prices Have Topped Out Industrial Metals Prices Have Topped Out Industrial Metals Prices Have Topped Out Although China's money and credit have been flagging potential economic weakness for a while, the recent manufacturing PMI data from the National Bureau of Statistics finally confirmed an impending deceleration in industrial activity and ensuing corporate profit disappointment. Our credit and fiscal spending impulses continue to point to negative growth surprises in capital spending. The latter is corroborated by the weakening Komatsu's Komtrax index, which measures the average hours of machine work per unit in China (Chart I-3). In both Korea and Taiwan, the overall manufacturing shipments-to-inventory ratios have dropped, heralding material weakness in both countries' export volumes (Chart I-4). Chart I-3Signs Of Weakness In Chinese Construction Signs Of Weakness In Chinese Construction Signs Of Weakness In Chinese Construction Chart I-4Asia Exports Are Slowing Asia Exports Are Slowing Asia Exports Are Slowing Notably, global cyclical equity sectors that are leveraged to China's capital spending such as materials, industrials and energy have all recently underperformed the global benchmark (Chart I-5). Some of their sub-sectors such as machinery, mining and chemicals have also begun to underperform (Chart I-6). Chart I-5Global Cyclicals Have ##br##Begun Underperforming... Global Cyclicals Have Begun Underperforming... Global Cyclicals Have Begun Underperforming... Chart I-6...Including Machinery ##br##And Chemical Stocks ...Including Machinery And Chemical Stocks ...Including Machinery And Chemical Stocks Among both global and U.S. traditional cyclicals, only the technology sector is outperforming the benchmark. However, we do not think tech should be treated as a cyclical sector, at least for now. In brief, the underperformance of global cyclical equity sectors and sub-sectors following last month's equity market correction corroborate that China's capital spending is beginning to slump. Notably, this is occurring as our global growth sentiment proxy rests on par with its previous apexes (Chart I-7). Previous tops in this proxy for global growth sentiment have historically coincided with tops in EM EPS net revisions, as shown in this chart. Chart I-7Global Growth Sentiment: As Good As It Gets Global Growth Sentiment: As Good As It Gets Global Growth Sentiment: As Good As It Gets All told, we may be finally entering a meaningful slowdown in China that will dampen commodities prices and EM corporate earnings. The latter are still very strong but EPS net revisions have rolled over and turned negative again (Chart I-8). Chart I-8EM EPS Net Revisions Have Plummeted EM EPS Net Revisions Have Plummeted EM EPS Net Revisions Have Plummeted EM share prices typically lead EPS by about nine months. In 2016, EM stocks bottomed in January-February, yet EPS did not begin to post gains until December 2016. Even if EM corporate profits are to contract in the fourth quarter of this year, EM share prices, being forward looking, will likely begin to wobble soon. Poor EM Equity Breadth There is also evidence of poor breadth in the EM equity universe, especially compared to the U.S. equity market. First, the rally in the EM equally-weighted index - where all individual stocks have equal weights - has substantially lagged the market cap-weighted index since mid 2017. This suggests that only a few large-cap companies have contributed a non-trivial share of capital gains. Second, the EM equal-weighted stock index's and EM small-caps' relative share prices versus their respective U.S. counterparts have fallen rather decisively in the past six weeks (Chart I-9, top and middle panels). While the relative performance of market cap-weighted indexes has not declined that much, it has still rolled over (Chart I-9, bottom panel). We compare EM equity performance with that of the U.S. because DM ex-U.S. share prices themselves have been rather sluggish. In fact, DM ex-U.S. share prices have barely rebounded since the February correction. Third, EM technology stocks have begun underperforming their global peers (Chart I-10). This is a departure from the dynamics that prevailed last year, when a substantial share of EM outperformance versus DM equities was attributed to EM tech outperformance versus their DM counterparts and tech's large weight in the EM benchmark. Chart I-9EM Versus U.S. Equities: Relative ##br##Performance Is Reversing EM Versus U.S. Equities: Relative Performance Is Reversing EM Versus U.S. Equities: Relative Performance Is Reversing Chart I-10EM Tech Has Started ##br##Underperforming DM Tech EM Tech Has Started Underperforming DM Tech EM Tech Has Started Underperforming DM Tech Finally, the relative advance-decline line between EM versus U.S. bourses has been deteriorating (Chart I-11). This reveals that EM equity breadth - the advance-decline line - is substantially worse relative to the U.S. Chart I-11EM Versus U.S.: Relative Equity Breadth Is Very Poor EM Versus U.S.: Relative Equity Breadth Is Very Poor EM Versus U.S.: Relative Equity Breadth Is Very Poor Bottom Line: Breadth of EM equity performance versus DM/U.S. has worsened considerably. This bodes ill for the sustainability of EM outperformance versus DM/U.S. We continue to recommend an underweight EM versus DM position within global equity portfolios. Three Pillars Of EM Stocks EM equity performance is by and large driven by three sectors: technology, banks (financials) and commodities. Table I-1 illustrates that technology, financials and commodities (energy and materials) account for 66% of the EM MSCI market cap and 75% of MSCI EM total (non-diluted) corporate earnings. Therefore, getting the outlook of these sectors right is crucial to the EM equity call. Table I-1EM Equity Sectors: Earnings & Market Cap Weights EM: Disguised Risks EM: Disguised Risks Technology Four companies - Alibaba, Tencent, Samsung and TSMC - account for 17% of EM and 58% of EM technology market cap, respectively. This sector can be segregated into hardware tech (Samsung and TSMC) and "new concept" stocks (Alibaba and Tencent). We do not doubt that new technologies will transform many industries, and there will be successful companies that profit enormously from this process. Nevertheless, from a top-down perspective, we can offer little insight on whether EM's "new concept" stocks such as Alibaba and Tencent are cheap or expensive, nor whether their business models are proficient. Further, these and other global internet/social media companies' revenues are not driven by business cycle dynamics, making top-down analysis less imperative in forecasting their performance. We can offer some insight for technology hardware companies such as Samsung and TSMC. Chart I-12 demonstrates that semiconductor shipment-to-inventory ratios have rolled over decisively in both Korea and Taiwan. In addition, semiconductor prices have softened of late (Chart I-13) Together, this raises a red flag for technology hardware stocks in Asia. Chart I-12Asia's Semiconductor Industry Asia's Semiconductor Industry Asia's Semiconductor Industry Chart I-13Semiconductor Prices: A Soft Spot? Semiconductor Prices: A Soft Spot? Semiconductor Prices: A Soft Spot? Finally, Chart I-14 compares the current run-up in U.S. FANG stocks (Facebook, Amazon, Netflix and Google) with the Nasdaq mania in the 1990s. An equal-weighted average stock price index of FANG has risen by 10-fold in the past four and a half years. Chart I-14U.S. FANG Stocks Now ##br##And 1990s Nasdaq Mania U.S. FANG Stocks Now And 1990s Nasdaq Mania U.S. FANG Stocks Now And 1990s Nasdaq Mania A similar 10-fold increase was also registered by the Nasdaq top 100 stocks in the 1990s over eight years (Chart I-14). While this is certainly not a scientific approach, the comparison helps put the rally in "hot" technology stocks into proper historical perspective. The main take away here is that even by bubble standards, the recent acceleration in "new concept" stocks has been too fast. That said, it is impossible to forecast how long any mania will persist. This has been and remains a major risk to our investment strategy of being negative on EM stocks. In sum, there is little visibility in EM "new concept" tech stocks. Yet Asia's manufacturing cycle is rolling over, entailing downside risks to tech hardware businesses. Putting all this together, we conclude that it is unlikely that EM tech stocks will be able to drive the EM rally and outperformance in 2018 as they did in 2017. Banks We discussed the outlook for EM bank stocks in our February 14 report,2 and will not delve into additional details here. In brief, several countries' banks have boosted their 2017 profits by reducing their NPL provisions. This has artificially boosted profits and spurred investors to bid up bank equity prices. We believe banks in a number of EM countries are meaningfully under-provisioned and will have to augment their NPL provisions. The latter will hurt their profits and constitutes a major risk for EM bank share prices. Energy And Materials The outlook for absolute performance of these sectors is contingent on commodities prices. Industrial metals prices are at risk of slower capex in China. The mainland accounts for 50% of global demand for all industrial metals. Oil prices are at risk from traders' record-high net long positions in oil futures, according to CFTC data (Chart I-15, top panel). Traders' net long positions in copper are also elevated, according to the data from the same source (Chart I-15, bottom panel). Hence, it may require only some U.S. dollar strength and negative news out of China for these commodities prices to relapse. Chart I-15Traders' Net Long Positions In ##br##Oil And Copper Are Very Elevated Traders' Net Long Positions In Oil And Copper Are Very Elevated Traders' Net Long Positions In Oil And Copper Are Very Elevated How do we incorporate the improved balance sheets of materials and energy companies into our analysis? If and as commodities prices slide, share prices of commodities producers will deflate in absolute terms. However, this does not necessarily mean they will underperform the overall equity benchmark. Relative performance dynamics also depend on the performance of other sectors. Commodities companies could outperform the overall equity benchmark amid deflating commodities prices if other equity sectors drop more. In brief, the improved balance sheets of commodities producers may be reflected in terms of their relative resilience amid falling commodities prices but will still not preclude their share prices from declining in absolute terms. Bottom Line: If EM bank stocks and commodities prices relapse as we expect, the overall EM equity index will likely experience a meaningful selloff and underperform the DM/U.S. benchmarks. Exchange Rate Pegs Versus U.S. Dollar With the U.S. dollar depreciating in the past 12 months, pressure on exchange rate regimes that peg their currencies to the dollar has subsided. These include but are not limited to Hong Kong, Saudi Arabia and the United Arab Emirates (UAE). As a result, these countries' interest rate differentials versus the U.S. have plunged (Chart I-16). In short, domestic interest rates in these markets have risen much less than U.S. short rates. This has kept domestic liquidity conditions easier than they otherwise would have been. However, maneuvering room for these central banks is narrowing. In Hong Kong, the exchange rate is approaching the lower bound of its narrow band (Chart I-17). As it touches 7.85, the Hong Kong Monetary Authority (HKMA) will have no choice but to tighten liquidity and push up interest rates. Chart I-16Markets With U.S. Dollar Peg: ##br##Policymakers' Maneuvering Window Is Closing Markets With U.S. Dollar Peg: Policymakers' Maneuvering Window Is Closing Markets With U.S. Dollar Peg: Policymakers' Maneuvering Window Is Closing Chart I-17Hong Kong: Interest ##br##Rates Are Heading Higher Hong Kong: Interest Rates Are Heading Higher Hong Kong: Interest Rates Are Heading Higher In Saudi Arabia and the UAE, the monetary authorities have used the calm in their foreign exchange markets over the past year to not match the rise in U.S. short rates (Chart I-18A and Chart I-18B). However, with their interest rate differentials over U.S. now at zero, these central banks will have no choice but to follow U.S. rates to preserve their currency pegs.3 Chart I-18ASaudi Arabian Interest Rates Will Rise The UAE Interest Rates Will Rise The UAE Interest Rates Will Rise Chart I-18BThe UAE Interest Rates Will Rise Saudi Arabian Interest Rates Will Rise Saudi Arabian Interest Rates Will Rise If U.S. interest rates were to move above local rates in Saudi Arabia and the UAE, those countries' currencies will come under considerable depreciation pressure because capital will move from local currencies into U.S. dollars. Hence, if U.S. short rates move higher, which is very likely, local rates in these and other Gulf countries will have to rise if their exchange rate pegs are to be preserved. Neither the Hong Kong dollar nor Gulf currencies are at risk of devaluation. The monetary authorities there have enough foreign currency reserves to defend their respective pegs. Nevertheless, the outcome will be domestic liquidity tightening in the Gulf's and Hong Kong's banking system. In addition, potentially lower oil prices will weigh on Gulf bourses and China's slowdown will hurt growth and equity sentiment in Hong Kong. All in all, equity markets in Gulf countries and Hong Kong have probably seen their best in terms of absolute performance. Potential negative external shocks and higher interest rates due to Fed tightening have darkened the outlook for these bourses. Bottom Line: Local liquidity in Gulf markets and Hong Kong is set to tighten. Share prices in these markets have probably topped out. However, given these equity markets have massively underperformed the EM equity benchmark, they are unlikely to underperform when the overall EM index falls. Hence, we do not recommend underweighting these bourses within an EM equity portfolio. For asset allocators, a neutral or overweight allocation to these bourses is warranted. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report "China's "De-Capacity" Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017; the link is available on page 16. 2 Please see Emerging Markets Strategy Special Report "EM Bank Stocks Hold The Key," dated February 14, 2018; the link is available on page 16. 3 Please see BCA's Frontier Markets Strategy Special Report "United Arab Emirates: Domestic Tailwinds, External Headwinds," dated March 12, 2018. The link is available on fms.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Escalating trade tensions - most notably between the U.S. and China, and the U.S. and its NAFTA partners - threaten the outperformance ags posted in 1Q18, which was driven by unfavorable weather and transportation disruptions in major producing regions, along with a weak dollar. Energy: Overweight. The IPO of Saudi Aramco apparently will be delayed into 2019, according to various press reports. New York, London and Hong Kong remain in contention for the foreign listing of KSA's national oil company. Base Metals: Neutral. China's iron ore and copper imports in January - February 2018 were up 5.4% and 9.8% y/y, respectively. China's year-to-date (ytd) steel product exports are down 27.1% y/y, while ytd aluminum exports are up 25.8% y/y. The aluminum data are consistent with our assessment that the global aluminum deficit will likely ease this year.1 Precious Metals: Neutral. A global trade war would boost gold's appeal, and we continue to recommend it as a strategic portfolio hedge. Ags/Softs: Underweight. Weather and transport disruptions boosted global ag markets in 1Q18. However, this outperformance is under threat as global trade tensions build (see below). Feature Chart of the WeekAgs Are Off To A Good Start Ags Are Off To A Good Start Ags Are Off To A Good Start Weather concerns in highly productive regions of South America as well as the U.S. have supported ag prices since the beginning of the year (Chart of the Week). Corn and wheat bottomed in mid-December, and have since gained 14.8% and 25.4%, respectively, while soybeans bottomed mid-January and have since gained 10.6%. This pushed the Grains and Oilseed CCI up 12.6% since the beginning of the year. Drought ... And Flooding In The U.S. Erratic weather in the U.S. could affect yields. The chief areas of concern are the U.S. mid-South and lower Midwest, which have recently experienced flooding, and are raising fears of lower yields of winter wheat. At the same time, the area from Southwestern Kansas to Northern Texas experienced unusually dry weather, causing winter grains to suffer. On top of that, high water levels in the Ohio River also led to shipping disruptions. Although the U.S. Department of Agriculture (USDA) did not lower its 2017/18 estimates of U.S. wheat yields in its latest World Agricultural Supply and Demand Estimates (WASDE), yield estimates stand significantly lower than those of the last crop year (Chart 2). In addition, American wheat farmers are expected to harvest the smallest area recorded in the history of the series, which dates back to the 1960/61 crop year. U.S. wheat production is expected to be the lowest since 2002/03 - a 25% year-on-year (y/y) drop in output. As a result, the U.S. supply surplus will likely be the smallest since 2002, weighing on U.S. exports. The U.S. generally accounts for only ~8% of global wheat production, and increases elsewhere, primarily in Russia and India, are expected to more than offset the fall in U.S. output. Despite the poor conditions in the U.S., global supply is expected to continue growing this year with the wheat market in surplus and inventories swelling to record levels (Chart 3). Chart 2Depressed Yield, Record Low Acreage In U.S. Depressed Yield, Record Low Acreage In U.S. Depressed Yield, Record Low Acreage In U.S. Chart 3World Remains Well Supplied World Remains Well Supplied World Remains Well Supplied Drought In Argentina Supporting Soybean, And To A Lesser Extent Corn Prices In addition to the unfavorable North American weather, warm and dry weather in Argentina have resulted in a fall in estimated yields of Argentine corn and soybeans.2 Argentina accounts for 14% and 3% of global soybean and corn production, respectively. The USDA cut back its estimate of Argentine soybean production by 13% in the latest WASDE, causing a downward revision of ~4 mm MT in global inventories (Chart 4). Although Argentina's estimated corn output was also reduced, the resulting decline in its exports is expected to be picked up by U.S. exports. American farmers thus are benefitting from the unfavorable weather in Argentina. As is the case with soybeans, the net effect on corn is a 4 mm MT downwards revision to global inventories. In addition, grain exports from Argentina's main agro-export hub of Rosario were stalled last month due to a truckers' strike. While the strike has now eased, it led to transportation bottlenecks and contributed to limited global supply earlier this year. Back in the U.S., the Trump administration's lack of clarity regarding where it stands on the Renewable Fuel Standard (RFS), which mandates refiners blend biofuels like corn-based ethanol into the nation's fuels, is worrying farmers. While the energy industry is unsatisfied with the current policy, claiming that the RFS is unfair and costly, it gives a lifeline to corn farmers with excess stock. Bottom Line: Unfavorable weather and transportation disruptions, primarily in the U.S. and Argentina, have been bullish for ags since the beginning of the year. Lower production is expected to push both soybeans and corn to deficits in 2017/18 (Chart 5). The longevity of the impact of these forces hinges on whether the weather will improve between now and harvest, causing yields to come in better-than-expected. Chart 4Weather Weighs On Soybean And Corn Yields Weather Weighs On Soybean And Corn Yields Weather Weighs On Soybean And Corn Yields Chart 5Corn And Soybeans In Deficit This Year Corn And Soybeans In Deficit This Year Corn And Soybeans In Deficit This Year "We Can Also Do Stupid"3 In addition to the impact of his domestic immigration policy on the availability of farm workers, President Trump's controversial trade policies are threatening to spill into ags.4 In direct response to the 25% and 10% tariff Trump slapped on steel and aluminum imports, several of America's key ag trading partners have already reacted by communicating the possibility of imposing similar tariffs on their imports of American goods - chiefly agricultural goods. Among the commodities rumored to be at risk are Chinese soybean, sorghum and cotton imports, and EU agriculture imports including corn and rice imports. While President Trump's stated aim is to make America great again by reviving industries hurt by cheap imports and unfair trade, his strategy is proving risky as many of the trade partners he is threatening to rock ties with are in fact major consumers of U.S. agricultural products (Chart 6). In fact, the top three importers of U.S. ag products - collectively accounting for 42%, or $58.7 billion worth of U.S. ag exports in 2017 - are Canada, China, and Mexico (Charts 7A and 7B). Chart 6Risky Strategy, Mr. President Ags Could Get Caught In U.S. Tariff Imbroglio Ags Could Get Caught In U.S. Tariff Imbroglio Chart 7ASoybeans Appear To Be At Risk... Ags Could Get Caught In U.S. Tariff Imbroglio Ags Could Get Caught In U.S. Tariff Imbroglio Chart 7B... As Is Cotton Ags Could Get Caught In U.S. Tariff Imbroglio Ags Could Get Caught In U.S. Tariff Imbroglio However, when it comes to the bulk commodities we cover, China is by far the U.S. ag industry's biggest customer - importing more than 30% of all U.S. exports, equivalent to $14.9 billion. Thus, China appears to have significant leverage in the case of a trade war, and U.S. farmers are worried of the impact from trade disputes. China has already indicated that it is investigating import restrictions on sorghum. Chinese trade restrictions - if implemented - will have a significant impact on U.S. sorghum farmers. In value terms, sorghum exports contributed less than 1% to U.S. agricultural product exports last year, but exports to China made up more than 80% of all U.S. sorghum exports. Sino-American Trade Dispute Would Hurt U.S. Ags...But Not As Much As Is Feared Chart 8Relatively Low Soybean Inventories Relatively Low Soybean Inventories Relatively Low Soybean Inventories The biggest fear among U.S. farmers is not the loss of sorghum exports, but that China will impose restrictions on its imports of U.S. soybeans. Soybeans are the U.S.'s largest ag export - contributing 16% to the value of all agricultural product exports. Nearly 60% of U.S. soybean exports, and more than a third of U.S. soybeans, end up in China. Thus it may appear that China has some leverage there. In fact, Brazil, which is already China's top soybean supplier, has already communicated that it would be willing to supply China with more soybeans. However, China's ability to find alternative suppliers is questionable. While China imported ~32 mm MT of soybeans from the U.S. last year, Brazil's total soybean inventories stand at ~22 mm MT. Brazil simply does not have enough excess supply to cover all of China's needs. In fact, global soybean inventories are ~95 mm MT - only three times the amount of China's annual imports from the U.S. On top of that, although China generally tries to shield itself from supply shocks by building large inventories, its soybean inventories - measured as stocks-to-use - are significantly lower than that of other ags (Chart 8). In fact, Beijing has already tightened its scrutiny on U.S. soybeans, announcing at the beginning of the year that it would no longer accept shipments with more than 1% of foreign material. Half of last year's shipments reportedly would have failed this criterion, and the net effect of this new policy is higher costs for U.S. farmers. Cotton is another agricultural commodity that China has indicated may be caught up in a trade dispute. 16% of U.S. cotton exports went to China last year, but although the U.S. is the dominant global cotton exporter, its value accounts for less than 5% of total U.S. agricultural products exports. Given that China's inventories are extremely high - enough to cover a year's worth of consumption - and that Chinese imports from the U.S. are equivalent to ~3% of global inventories, there is significant opportunity for China to diversify its imports and find an alternative supplier to the U.S. Bottom Line: Although China would be better able to implement restrictions on cotton imports from the U.S. compared to soybeans, the impact on U.S. farmers would be less painful given that they are not as dependent on China as U.S. soybean farmers are. U.S. Ags Dominate Exports, But Substitutes Abound The U.S. is the world's top exporter of corn and cotton, and the second largest exporter of wheat and soybeans. While it remains a dominant player in global export markets, its share of global agriculture exports has been declining sharply over time (Chart 9). While in levels, the general trend for U.S. agriculture exports - with the exception of wheat - appears to be upward, the share of U.S. exports as a percentage of global exports has actually been falling. Compared to the year 2000, the global share of U.S. corn and wheat exports has almost halved, going from 64% to 36%, and 29% to 14%, respectively. In the soybean market, U.S. soybean exports now account for 37% of exports, down from half of global trade. Lastly, U.S. rice exports now account for 7% of global exports, a fall from 11% in 2000. Unlike most other ag commodities, U.S. cotton has captured a larger share of the global market - currently at almost 50%, from 26% in 2000. Russian, Canadian, and European wheat farmers have been tough competitors. This crop year, Russia is expected to surpass the U.S. as the top wheat exporter for the first time (Chart 10). In addition, while the U.S. was the dominant wheat exporter just 10 years ago, more recently, Canada and the EU have on some occasions exported more wheat than the U.S. Chart 9U.S. Exports Relatively Less Attractive U.S. Exports Relatively Less Attractive U.S. Exports Relatively Less Attractive Chart 10U.S. Exports Face Growing Competition Ags Could Get Caught In U.S. Tariff Imbroglio Ags Could Get Caught In U.S. Tariff Imbroglio In the case of soybeans, Brazilian exports have grown significantly since 2010, consistently exporting more than the U.S. since 2012. Brazilian corn exports are also catching up to the U.S., as are Argentine corn exports which have been growing steadily. If these trade disputes prove to be an ongoing trend, we see two potential scenarios panning out: U.S. farmers could move away from farming crops most impacted by trade restrictions, and instead increase the farmland allocated to crops that are consumed domestically, and thus insulated from the Trump administration's trade policy decisions. In this scenario, the longer term impact would be an increase in the supply of locally consumed ags and a decrease in the U.S. supply of exportable ags. Global ag trade flows could shift, such that U.S. allies begin importing more of their ag products from the U.S., while countries that are in trade disputes with the U.S. switch to other ag suppliers. NAFTA Is Still At Risk The ongoing re-negotiation of NAFTA ultimately could lead to an abrogation of the treaty. Should this evolve with no superseding bilateral trade agreements, it would mark a significant blow to the U.S. agricultural industry. Mexico is the second-largest destination for U.S. agricultural exports after China, accounting for 13% of all U.S. exports of agricultural bulks, while Canada makes up a much smaller 2% share. Nearly 30% of U.S. corn exports and 23% of U.S. rice exports end up in Mexico. As a result, these two bulks are especially vulnerable in the event of a treaty abrogation. Wheat, cotton and soybeans - Mexico accounts for 14%, 7%, and 7% of these exports, respectively - would also be impacted by a trade dispute. In the interest of diversifying its sources of ag imports, Mexico has already started exploring other suppliers from South America. Its corn imports from Brazil are reported to have increased 10-fold last year. Furthermore, government officials and grain buyers have been visiting Brazil and Argentina to investigate other ag suppliers for Mexico. BCA Research's Geopolitical Strategy service assign a 50/50 probability to a breakdown in the NAFTA negotiations. In the event of a NAFTA abrogation, they assign a 25% chance of a failure to strike bilateral agreements - resulting in a conditional probability of only 12.5%. Bottom Line: The shrinking role of the U.S. as a global ag supplier at a time when global storage facilities are well-stocked will - in most cases - allow its global consumers to diversify away from U.S. exports. In the case of soybeans, however, this is less certain. A Weaker USD Also Helped Buoy Ag Prices In 1Q18 Chart 11A Stronger Dollar Would Weigh On Ags A Stronger Dollar Would Weigh On Ags A Stronger Dollar Would Weigh On Ags A weaker dollar has been supportive of commodities prices so far this year (Chart 11). The recent bout of U.S. import restrictions has investors expecting the USD to further weaken on the back of a trade war. However, our FX Strategists believe the current set of tariffs will have a muted effect on the dollar.5 In fact, given that the U.S. economy is currently at full employment, and their expectation that the Fed will be proactive, tariffs will likely generate inflationary pressures, causing the tighter monetary policy, which does not support further weakening of the USD. Bottom Line: A pick-up in the dollar along with an escalation in trade disputes or the scrapping of NAFTA would be bearish for ags. For now, bullish weather forecasts prevail, and are keeping prices well supported. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "Global Aluminum Deficit Set To Ease," dated March 1, 2018, available at ces.bcaresearch.com. 2 Soybean and corn plantings are reported to be half their typical height. Please see "Argentina Drought Bakes Crops Sparks Grain Price Rally," available at reuters.com. 3 As expressed by EU Commission President Jean-Claude Juncker's about the potential tit-for-tat retaliatory measures in response to steel and aluminum import tariffs. 4 According to Chuck Conner, president of the National Council of Farm Cooperatives, and former deputy agriculture secretary during the George W. Bush administration, roughly 1.4 million undocumented immigrants work on U.S. farms each year, or roughly about 60% of the agriculture labor force. 5 Please see BCA Research's Foreign Exchange Strategy Weekly Report titled "Are Tariffs Good Or Bad For the Dollar?," dated March 9, 2018, available at fes.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Ags Could Get Caught In U.S. Tariff Imbroglio Ags Could Get Caught In U.S. Tariff Imbroglio Trades Closed in 2018 Summary of Trades Closed in 2017 Ags Could Get Caught In U.S. Tariff Imbroglio Ags Could Get Caught In U.S. Tariff Imbroglio

Highlights The protectionist option in U.S. policy is here to stay; President Trump is likely to impose punitive measures on China before the U.S. midterm elections; The U.S. Section 301 investigation into China's intellectual property theft is about national security more than trade; China's NPC session suggests the Communist Party is downshifting growth rates; The North Korean diplomatic breakthrough is real ... stay focused on U.S.-China tensions. Feature "I won't rule out direct talks with Kim Jong Un. I just won't ... As far as the risk of dealing with a madman is concerned, that's his problem, not mine." - U.S. President Donald J. Trump, March 4, 2018 Two of our key 2018 views came to the fore over the past two weeks. First, U.S. President Donald Trump took protectionist action that rattled the markets.1 Second, North Korean diplomacy surprised to the upside, with Trump accepting an invitation to meet with Kim Jong Un by this May.2 The nuclear program is allegedly up for discussion. Markets recovered quickly from Trump's steel and aluminum tariffs, with the VIX falling and American and global equities continuing to rally (Chart 1). Trump's formal tariff proclamation was not as disruptive as some had feared. He provided exemptions for entire countries - rather than merely companies - based on an appeals process that will include economic as well as geopolitical criteria. But while he struck an optimistic note on NAFTA (on which Canada's and Mexico's exemptions will depend), he struck a pessimistic note on trade talks with China. Chart 1Markets Shrugged Off Protectionism Markets Shrugged Off Protectionism Markets Shrugged Off Protectionism China is quickly becoming the foremost political and geopolitical risk of the year, as we discuss in this report. First, diplomacy with North Korea will not remove the risk of serious U.S. protectionism toward China.3 Second, China's domestic reforms are proceeding, posing downside risks to Chinese imports and hence global growth. We conclude with a brief word on why investors should take the North Korean diplomacy as a hugely positive development. There may be some volatile episodes during the upcoming negotiations, but U.S.-China relations are the real risk and North Korea remains largely a derivative of the emerging "Warm War" between the two global behemoths. "Death By China" In the past few weeks, the Trump administration has moved swiftly to begin implementing its protectionist platform.4 Trump's formal announcement of global tariffs on steel and wrought and unwrought aluminum products marked the shift, although investors got a foreshadowing with the January announcement of washing machine and solar panel tariffs. The latest tariffs are insignificant in macroeconomic terms. They will affect less than 0.3% of global exports and less than 2% of U.S. imports.5 The market has thus far cheered the limited scope of the tariffs and the numerous exemptions that will surely follow. But the danger is that investors are underestimating the political shifts that underpin Trump's move. In fact, there is little reason to think that protectionism will fade when Trump leaves office: Americans are susceptible to it, according to opinion polling (Chart 2). Now that the seal has been broken - and that by a president who hails from the "pro-free trade" Republican Party - the danger is what happens when the next recession occurs. Politicians of all stripes will be more likely to propose protectionist solutions. The long trend of decline in U.S. tariffs since the 1930s may gradually begin to reverse (Chart 3), confirming our key decade theme that globalization has reached its apex. Chart 2Americans Not Immune To Protectionism Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Chart 3U.S. Tariffs: Nowhere To Go But Up! U.S. Tariffs: Nowhere To Go But Up! U.S. Tariffs: Nowhere To Go But Up! How far will the protectionist threat go in the short term? Investors should focus on two bellwethers. First, the outcome of NAFTA re-negotiations.6 Second, a decision by the Trump administration on how to respond to the U.S. Trade Representative Section 301 of the Trade Act of 1974 investigation into China's practices on technology transfer, intellectual property, and innovation, discussed below. China is an industrial powerhouse that is becoming more technologically adept, which threatens the core advantage of the United States in what could soon become a "Warm War" between the two global hegemons. Trump was elected on a pledge to get aggressive on China and is relatively unconstrained on trade policy (Table 1). U.S.-China economic interdependency has declined, reducing the two countries' ability to manage tensions.7 Table 1Trump Lacks Legal Constraints On Trade Issues Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Moreover, Trump is relatively unpopular - which jeopardizes the GOP Congress in November - and he will need to take actions to remain relevant ahead of the November 6 midterm elections (Chart 4). The U.S. and China are currently bickering about the size of the trade imbalance (Chart 5), not to mention the causes and solutions. What will the U.S. demand? This was the question of Xi Jinping's top economic adviser, Politburo member Liu He, when he visited Washington D.C. on March 1-3 for emergency meetings with the U.S. administration. He was rebuffed with the announcement on tariffs. Washington has been arguing that high-level dialogues with China - that investors cheered after the Mar-a-Lago Summit - have failed and that punitive measures will go forward unless China makes quick and concrete improvements to the trade balance, starting with $100 billion worth of new imports.8 Chart 4Trump's Low Approval Jeopardizes Control Of Congress In November Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Chart 5U.S.-China: Disagreeing Even On The Facts U.S.-China: Disagreeing Even On The Facts U.S.-China: Disagreeing Even On The Facts In response, Liu has promised that China will redouble its economic "reform and opening up" process and has asked the United States for an official list of demands. Our sense is that there are broadly two types of demands: Cyclical demands: Beijing often does one-off purchases of big-ticket items to ally Washington's ire over trade. This time, it would have the added benefit for Trump of coming right ahead of the midterm election. Trump's request on March 8 for an immediate $100 billion reduction in the trade deficit could fall in this category. Structural demands: If Trump seeks to be a game changer in the U.S.-China relationship, then he will demand accelerated structural reforms: for instance, a lasting decrease in the deficit due to a permanent opening of market access. He could also begin pushing a "mirror tax" on trade (reciprocal tariffs) so as to reduce the gap between the U.S. and China, which is less justifiable now that China is an economic juggernaut (Chart 6). Trump could also demand action on several long-standing U.S. requests: Chart 6Not All That Much Daylight On U.S.-China Tariff Rates Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Opening foreign investment access to a broad range of sectors (beyond finance), such as transportation, logistics, information technology, or even telecommunications; The right to operate wholly U.S.-owned companies in China; An open capital account and truly free-floating currency; Subsidy cuts for state-owned enterprises (SOEs); Full digital access for U.S. tech companies; An improved arbitration system for legal disputes. Since rapidly implementing many of these demands could threaten China's stability or even undermine the Communist Party, Trump may have to use the threat of sweeping tariffs to try to force them through. The current news flow suggests that Trump is favoring cyclical solutions. At the same time, we expect China to make at least some significant structural compromises: China does not want a trade war. China is more exposed to the U.S. than the U.S. is to China (Chart 7). Moreover, China's political system is rigid and opposed to mass unemployment. The last time China allowed mass layoffs was in 1999, and even then the state controlled the process. A trade war, by contrast, would threaten 223 million manufacturing employees with uncontrolled job losses. The central government is focused on stability; while it will insist on "saving face" internationally through tit-for-tat measures, it will go to great lengths to avoid a negative spiral. This will require compromises. China wants structural reform. Xi Jinping is rebooting a reform agenda that requires transitioning away from old industries. These reforms are long overdue and Xi can parlay many of them to pacify Trump. For instance, China has improved the market-orientation of the renminbi, causing Trump to cease his complaints about currency manipulation (Chart 8). China currently claims it is about to increase imports and open its financial sector further to foreign investment. Chart 7China More Exposed To U.S., But Not By Much Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Chart 8China: Structural Reform As Trade Concession China: Structural Reform As Trade Concession China: Structural Reform As Trade Concession The jury is still out on the deepest structural issues. We expect Xi's latest reform push to surprise to the upside, but it is not clear how far he will go. For instance, while Beijing might begin to ease capital controls imposed in 2016, it would be a shock if it agreed to rapidly liberalize the capital account. The same goes for granting extensive access to strategic sectors, downgrading state support for SOEs, or moderating cyber controls that punish U.S. companies. Any promises of gradual progress on these issues will likely be seen by the U.S. as no different from past promises to past presidents. Hence everything depends on whether Trump will be satisfied by token Beijing actions that look good ahead of the midterms. It is ominous that China has already drastically cut steel and aluminum overcapacity, and yet Trump imposed tariffs anyway. This kind of delayed retribution could become a pattern. Bottom Line: China has the means to prevent a trade war through significant compromises that Trump can advertise as "wins" to his domestic audience this November. If Trump accepts these concessions, the risk of trade war will effectively be removed until the next major electoral test in 2020. However, Trump lacks constitutional and legal constraints on the use of tariffs, which means that he can override China's offers and instigate a trade war anyway. This risk has a fair probability, given midterm politics and the fact that overall U.S.-China interdependency, the key economic constraint to conflict, has eroded over the past decade. A Bellwether: The Intellectual Property Investigation The immediate bellwether for the Trump administration's appetite for trade war will be Trump's handling of the Section 301 investigation on technology transfer, intellectual property (IP), and innovation. A ruling is due no later than August 18, but reports indicate action could come quickly.9 Section 301 of the U.S. Trade Act of 1974 is the prime law by which the U.S. seeks to enforce trade agreements, resolve disputes, and open markets. Under this law, the U.S. executive - i.e. the president - can impose trade sanctions against countries deemed to be violating trade agreements or engaging in unreasonable or discriminatory trade practices. The law is specific in addressing intellectual property violations and closed market access, and yet broad in giving the executive leeway to interpret "unjustifiable" practices and mete out punishment. It does, however, require negotiations with the foreign trading partner to remedy the situation before the U.S. imposes duties or other remedies. We expect the U.S. to draw a hard line. A close look reveals that this Section 301 probe is primarily addressing strategic problems, not trade problems. To be fair, the U.S.'s trade grievances have merit. Clearly there is room for China to improve the IP trade balance. The ratio of IP receipts versus IP payments shows that the U.S. is a world-leader, while China is an extreme IP laggard, as one would expect (Chart 9). And yet the U.S. barely runs a trade surplus with China in IP, and far less of a surplus than with Taiwan and Korea, which are more advanced than China and thus ought to be more competitive with the U.S. than China (Chart 10). The U.S. appears particularly disadvantaged in the Chinese market when it comes to computer software and trademarks (Chart 11), judging by its IP exports to similar Asian partners. Chart 9China Is An Innovation Laggard... Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Chart 10... Yet Its IP Deficit With U.S. Is Small Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Also, in many cases Chinese companies have gained a dominant share of new markets, like e-commerce, where the U.S. would have a larger share if it had been allowed to compete fairly in the nascent stages. The U.S. wants to prevent this from happening again. The "Made In China 2025" program, for example, combines ambitious goals in supercomputers, robotics, medical devices, and smart cars, while setting domestic localization targets that would favor Chinese companies over foreigners (Chart 12). China will have to compromise on this program to stave off tariffs. Chart 11China Skirting Fees On U.S. Software? Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Chart 12China's High-Tech Protectionism Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Nevertheless, China is a large and growing market for U.S. high-tech goods, intellectual property, and services exports (Chart 13). A comparison with Taiwan and South Korea suggests that China could open up greater access to these U.S. exports (Chart 14). The truth is that, unlike with staunch ally Japan, the U.S. harbors deep misgivings about China's strategic intentions. This is why it limits high-tech exports to China - which, as Beijing often points out, creates an abnormal imbalance in this column of the trade book (Chart 15). Chart 13U.S. Tech And IP Exports To China Growing Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Chart 14China Could Give U.S. More Market Share Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Chart 15U.S. Deficit Due To Security Concerns Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Thus while the trade concerns above are not to be scoffed at, the Section 301 probe is clearly about U.S. security. The main practices under investigation are: Forced technology transfer by means of joint-venture (JV) requirements, ownership caps, government procurement, and administrative or regulatory interventions; Unfair licensing and contracting pricing, and abuses of proprietary technology; State-backed investment and/or acquisitions in the U.S. to acquire cutting-edge tech and IP; Cyber-espionage and intrusion to acquire tech and IP. Only one of these is about market pricing. The others speak to the U.S. belief that the Communist Party has orchestrated a "techno-nationalist" agenda that combines aggressive and illegal acquisitions with domestic protectionism. In particular, Chinese companies have made strategic acquisitions in the U.S. through shell companies with state funds or state guidance to access critical technologies and IP, while forcing American companies operating in China to transfer over the same as a precondition to operate there.10 Washington fears that if Beijing' strategy continues unabated, high-tech Chinese companies will be able to gain the best western technology, grow uninhibited in the massive domestic market with state financial support, and then launch competitive operations on a global scale. Moreover, the lack of division between China's ruling party, state apparatus, and corporate sector means that technologies acquired by Chinese companies can be directly appropriated by the country's military and intelligence apparatus to the detriment of the strategic balance with the U.S. How will the U.S. retaliate? We are unsure, and therein lies the risk for the market.11 Trump has floated the idea of levying a large "fine" or indemnity on China for past IP violations. The U.S. believes that IP theft amounts to a "second trade deficit" with China, with estimates of annual losses ranging from $200 billion to nearly $600 billion.12 U.S. remedies will become clearer when the USTR offers its recommendations. Bottom Line: The Section 301 probe is not about the trade deficit alone. It is about the growing tension between U.S. and China in a broader strategic context. We would expect the USTR to propose trade remedies that are more significant than the recent steel and aluminum tariffs. And we would expect Trump to impose some punitive measures. This is a source of near-term risk to markets, as the U.S. and China are less likely to manage their disputes smoothly than in the past. We are short China-exposed U.S. stocks relative to their domestic-oriented peers. China's NPC Session: On Track For Downside Risk Surprises Chart 16Downward Revisions In Chinese Growth Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin China's NPC session is not yet over but some preliminary takeaways are in order. The headlines focused on Xi Jinping's power grab, but for us the real relevance was economic policy. Signs of economic policy tightening are not as hawkish as we expected, but the bias remains in favor of slower growth and tighter monetary, fiscal, and financial policy. The 6.5% GDP growth target was not a surprise. China has various economic targets to meet in 2020 under existing economic plans; only after that does it say it will scrap GDP targets altogether. The GDP target is a fabrication but the point is that the direction is down. Local government GDP targets suggest downward revision as well (Chart 16). To put a point on it, there is no evidence that China's cyclical slowdown is on the cusp of reversing (Table 2).13 Table 2No Convincing Signs Of An Impending Upturn In China's Economy Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin In this context, it is notable that the government got rid of official targets for monetary growth (M2). This confirms the view of our colleagues at BCA's Emerging Markets Strategy that China has been targeting interest rates instead of the quantity of money since 2015 (Chart 17).14 This means that M2 growth can rise or fall as high or as low as necessary to meet the PBoC's interest rate targets. The takeaway for now is that M2 growth can go lower than the recent 8%-9% range in which it has been moving, since the current policy is to "control" money growth and avoid systemic risk. The new leadership at the People's Bank of China will have a challenge to establish its credibility, which means that accommodative compromises may not come as quickly as some expect. Chart 17A New Monetary Policy Regime A New Monetary Policy Regime A New Monetary Policy Regime On the fiscal front, China implied some tightening by lowering its official budget deficit target to 2.6%. Past reports show that China always meets its budget deficit targets perfectly (Chart 18), suggesting that the target is either meaningless or Beijing has a steely discipline unseen in the rest of the world. The IMF publishes an augmented budget deficit which, at 12% of GDP, gives a better indication of why authorities want to maintain control, if not outright tighten the reins (Chart 19).15 The Finance Ministry rushed to dampen speculation that this budget deficit reduction would amount to austerity. Approximately 550 billion yuan of additional "special purpose bonds" - issued by local governments to finance infrastructure projects - will be issued in 2018. This could amount to new spending worth 2% of last year's total spending, i.e. not a negligible sum. The purpose may be to smooth over the conclusion of the local government debt swap program that began in 2014. The debt swap program was a "game changer" by allowing local governments to exchange high-interest or short-term debt for low-interest, long-term, government-backed debt. Now Beijing is winding down the program and telling local governments that new bond issuance will not have the implicit guarantee of the central government, and will face higher interest rates. Chart 18China's Budget Deficit Target Is Meaningless Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Chart 19China's Real Budget Deficit Is Large Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Similarly, Beijing has been attempting to provide formal banks more freedom to lend to offset its crackdown on shadow banks. Pursuant to this goal, it announced that required provisions for non-performing loans (NPLs) will be reduced from 150% of NPLs to 120%. Banks are already holding excess provisions, and provisions have been trending upwards. Meanwhile China's official NPL count is unbelievably low, warranting higher provisions. So it is not clear to what extent banks will lend more as a result of lower requirements. January and February credit numbers imply that credit policy remains tight even aside from the wind-down of the local government debt swap (Chart 20). The dust has not yet settled on the NPC session and we will soon examine some of the other policy announcements, like tax cuts for small businesses and infrastructure spending reductions. However, the implication so far is that the Communist Party wants to keep the fiscal deficit and total social financing flat this year. If this policy were executed faithfully, the fiscal and credit impulse would be zero this year. Simultaneously, new data revealed that, in keeping with the reform reboot, the Xi administration is allowing creative destruction to improve efficiency in the corporate sector. Bankruptcies rocketed upward in 2017 and this trend should continue (Chart 21). This is a notable development given the widespread perception that China does not know how to deal with social consequences of structural reforms. It suggests that policymakers have a higher threshold for economic pain. Chart 20Credit Growth Is Slowing Credit Growth Is Slowing Credit Growth Is Slowing Chart 21Creative Destruction Is Rising Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Finally, the new anti-corruption super-ministry, the National Supervisory Commission, has now received legislative clearance. It is still unclear how the new body will operate in practice. We maintain that on the margin it should be negative for economic growth due to the micro-level impact of corruption probes on local government officials and local state enterprises. Notably, some of the provinces whose GDP-weighted economic growth targets were the most aggressively revised downwards (Tianjin, Chongqing, Inner Mongolia) are also provinces that have been hit heavily with anti-corruption probes, accusations of falsifying data, and canceled infrastructure projects over the past year. The anti-corruption campaign is a tool for enforcing central party dictates more effectively, and at present those dictates call for minimizing systemic financial risk, including misallocation of capital by local authorities (Chart 22). Chart 22Anti-Corruption Campaign Encourages Downward GDP Revisions? Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Bottom Line: Policy settings in China will continue to constrain growth this year. Now that the policy shift toward accelerated reform is more evident, the downside risks of that move will become apparent. We are closing our long China H-shares versus EM trade for a gain of 3%. North Korea: This Time Is Different A brief concluding word on North Korea. While we did not expect that Trump and Kim would arrange to meet so soon, we are not surprised by the fact that the diplomatic track is moving forward. As we wrote in January, Trump demonstrated a credible military threat, forcing China to implement sanctions, which subsequently caused North Korea to stop testing missiles. Trump effectively called Kim Jong Un's bluff, daring him to go beyond missile and nuclear device tests. Instead of ratcheting up tensions, Kim declared victory on the nuclear deterrent and proclaimed the end of the crisis. This is the "Arc of Diplomacy" about which we have written (Chart 23).16 We reject the view in the media that Trump's policy has been erratic and that China is getting left on the sidelines of a Trump-Kim meet-up. China has cut off exports to North Korea (Chart 24), which in turn has cut off the regime's access to hard currency. Because of China, Kim literally cannot afford not to negotiate. Chart 23Credible Threat Cycle: North Korea Mirrors Iran Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Chart 24China Gives Kim To Trump China Gives Kim To Trump China Gives Kim To Trump For the same reason, Kim is not likely to be bluffing or stalling: with limited conventional military capabilities, Kim cannot dial up and dial down the level of tensions at will. If he provokes the U.S. anew, he risks provoking a war that would destroy his regime. Moreover, from the moment he came to power, Supreme Leader Kim established a desire to elevate the importance of economic reforms within state policy, which is impossible without dealing with China and the U.S. to create a favorable international setting. From the U.S. side, Trump has likely notched up a major national security victory that will enhance his credibility in the 2018 midterms and especially 2020 elections. A clear risk to our view that Trump will take protectionist action toward China this year is that he will need China's continued cooperation, as it could relax sanctions enforcement. However, the strategic significance of the Section 301 investigation means that Trump cannot afford to sacrifice his trade agenda so soon. While bad news from North Korea seldom has a substantial impact on markets, our South Korean curve steepener benefited. So far it has returned 2.9%. The JPY/EUR has fallen back from a strong February rally, but we remain long. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, Weekly Report, "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017, and Special Report, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 2 In September we highlighted that the North Korean threat cycle had peaked. Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, and Special Report, "BCA Geopolitical Strategy 2017 Report Card," dated December 20, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 4 The Apprentice-style personnel reshuffle that has seen Peter Navarro, director of the National Trade Council, elevated above the departed Gary Cohn, has signaled the return of the protectionist agenda. 5 Please see BCA Global Investment Strategy Weekly Report, "Trump's Tariffs: A Q&A," dated March 9, 2018, available at gis.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 8 Not $1 billion, as Trump erroneously tweeted! 9 One year after the date of initiation is likely August 18, the date used in the USTR's description in the Federal Register, although President Trump signed off on August 14 which could mark an earlier deadline. Please see Andrew Restuccia and Adam Behsudi, "Trump Eyes Another Trade Crackdown," Politico, March 7, 2018, available at www.politico.com. Note that according to the text of the law, by late May, the U.S. Trade Representative could report that China is making sufficient progress and further action unnecessary (but this is unlikely). The recent handling of the Section 232 investigation into steel and aluminum suggests that punitive measures will be foreshadowed by public statements from U.S. officials. 10 For detailed assessments, please see USTR, "2017 Special 301 Report," which puts China at the top of the priority watch list; USTR, "2017 Report To Congress On China's WTO Compliance," January 2018; U.S.-China Economic and Security Review Commission, "2017 Report To Congress," November 2017. 11 As a frame of reference, in the dispute over U.S. beef exports to the EU, a prominent Section 301 case, the U.S. imposed 100% ad valorem tariffs on 34 products from the EU in 1999 until 2009. However, Trump's actions are likely to go well beyond this due to the strategic nature of the dispute. Not only can he impose tariffs on 100 or more specific goods - since Chinese IP violations run the gamut - but also he can impose restrictions on Chinese investment through the Committee on Foreign Investment in the U.S. (CFIUS), which is tightening scrutiny on China in general. 12 The $600 billion "high water mark" estimate comes from the former Director of National Intelligence Dennis C. Blair and former director of the National Security Agency Keith Alexander. They also emphasize that the U.S. has additional retaliatory options (outside of the 1974 trade law) under the Economic Espionage Act, Section 5 of the Federal Trade Commission Act, and the National Defense Authorization Act. Please see "China's Intellectual Property Theft Must Stop," The New York Times, August 15, 2017, available at www.nytimes.com. 13 Please see BCA China Investment Strategy Weekly Report, "China And The Risk Of Escalation," dated March 7, 2018, available at cis.bcaresearch.com. 14 Please see BCA Emerging Markets Strategy Special Report, "China's Money Creation Redux And The RMB," dated November 23, 2016, available at ems.bcaresearch.com. 15 At the same time, the government issued guidelines suggesting that scrutiny of local government budgets, and specifically expenditures, will get stricter. The cancellation of subway/metro projects is already a trend that is well underway, but other inefficient projects and capital misallocation could be targeted next. 16 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. Geopolitical Calendar