Emerging Markets

Highlights December's money and trade data releases were not positive, but they do not likely herald a more aggressive economic slowdown than our base case view would suggest. Conventional methods of gauging the tightness of China's monetary policy stance tend to ignore the fact that market-based interest rates have already increased over the past year. Meaningful increases to the benchmark lending rate are therefore unwarranted barring a significant improvement in China's growth momentum. Despite several identifiable risk factors, investors should remain overweight Chinese investable stocks versus the emerging market and global benchmarks. Feature Several highly-watched Chinese data releases are being published as we go to press, including Q4 GDP growth, and December retail sales, industrial production, and fixed asset investment. We are inclined to agree with Bloomberg's consensus expectations that these series will come in flat-to-modestly down, given our base case view of a benign, controlled economic slowdown. While we cannot rule out the potential for significantly positive surprises from this data, our November 30 Special Report noted in detail that these types of activity indicators tend to lag (or are not correlated with) the Li Keqiang index, which we have shown continues to act as an important predictor of the growth in investable EPS and nominal import growth.1 As such, the series in today's release do not rank highly on our list of important data to watch over the coming 6-12 months. Instead, we remain focused on the components of our BCA Li Keqiang Leading Indicator, as well as the evolution of the relationship between the Li Keqiang index and the growth in earnings and imports. December: A Bad Month For Money & Trade Chart 1A Non-Trivial Deceleration##br## In Money Growth A Non-Trivial Deceleration In Money Growth A Non-Trivial Deceleration In Money Growth Among the December data released in the first half of this month, the most important series in our view have been the Caixin Manufacturing PMI, imports/exports, and the money supply. The PMI was a bright spot; after having decelerated since August, the index unexpectedly increased from 50.8 in November to 51.5 in December. The Caixin Services PMI also surprised to the upside. The year-over-year (YoY) growth rate of nominal imports, however, fell sharply in December, and significantly missed expectations. In addition, supply of money (measured either as M2 or BCA-defined M3) also fell on a YoY basis, with the 3-month annualized rate of change declining meaningfully (Chart 1). Given that M2 and M3 are components of our BCA Li Keqiang Leading Indicator, and that nominal imports directly impact China's contribution to global growth, this raises the question of whether December's economic data suggest that China is slowing at a more aggressive pace than we expect. For now, our answer is no. Several points are worth considering: China's trade data is highly volatile, and a smoothed version of nominal import growth is behaving exactly as the Li Keqiang index suggests that it should (Chart 2). In addition, while import growth significantly missed the street's expectations, negative surprises of this magnitude have frequently occurred in the past (Chart 3). Chart 2Despite A Weak December, ##br##Smoothed Nominal Imports Look As They Should Despite A Weak December, Smoothed Nominal Imports Look As They Should Despite A Weak December, Smoothed Nominal Imports Look As They Should Chart 3Negative Import Surprises ##br##Are Fairly Common Negative Import Surprises Are Fairly Common Negative Import Surprises Are Fairly Common Money supply measures form just one-third of our Li Keqiang Leading Indicator, and the other factors aren't nearly as negative as these measures imply. Chart 4 illustrates that the indicator would be considerably higher if M2 and M3 were excluded, and that the overall indicator is not falling at a sharp or aggressive pace. Even though we did not include it in our composite indicator, we noted in our November 30 Special Report that the manufacturing PMI is an important signal for the Chinese economy, so it is encouraging that it ticked higher. While 51.5 may not seem like an elevated reading when compared with developed economies, it ranks in the 91st percentile of the data since mid-2011. Export growth remained buoyant, which will provide the industrial sector with some reflationary offset. We noted in a previous report that strong export growth would likely decelerate and converge to global industrial production growth over the coming year,2 but a regression-based approach to modelling Chinese export growth suggests that it may stay strong if leading indicators of global economic activity remain robust (Chart 5). Chart 4Severely Weak Money Measures ##br##Are In Contrast To Other Indicators Severely Weak Money Measures Are In Contrast To Other Indicators Severely Weak Money Measures Are In Contrast To Other Indicators Chart 5Chinese Export Growth ##br##May Stay Strong Chinese Export Growth May Stay Strong Chinese Export Growth May Stay Strong Bottom Line: December's money and trade data releases were not positive, but they do not likely herald a more aggressive economic slowdown than our base case view would suggest. Some Approaches To Gauging The Stance Of Chinese Monetary Policy While we do not regard December's economic data as a deviation from our base case view, that view does acknowledge that a gradual, controlled slowdown is occurring. There are two drivers of this ongoing economic slowdown. The first is the past imposition of "supply side" constraints on some industrial sectors, which have been part of the government's efforts to cut excess capacity and reduce pollution. For example, we noted in our October 5 Special Report that coal, base metals and cement producers have chronically underperformed in recent years, and have also hurt the overall performance of the industrial sector.3 Similarly, capital spending in the mining sector, historically highly sensitive to moves in global metals prices, have continued to contract, despite the sharp increase in metals prices since 2016 (Chart 6). The more obvious catalyst for a slowdown in the economy is, however, the tightening in monetary policy that began in late-2016. We have strongly emphasized the importance of monetary conditions in our approach to tracking the end of China's mini-cycle, and part of the tightening in these conditions can be linked to the end of material RMB depreciation. But a variety of interest rates have also increased substantially over the past year, which has been worrying to some investors. These concerns have been magnified recently by quite a bit of hawkish rhetoric from the PBOC, including an ultimately retracted statement from a leading PBOC researcher last week that stronger economic conditions have created enough room for a hike in the benchmark one-year lending rate. The current environment naturally raises the question of what would constitute tight policy in China. Chart 7 presents two conventional methods of answering this question, both of which aim to compare the benchmark 1-year policy lending rate to a fair, neutral, or equilibrium level. The first method uses a Taylor Rule approach with the IMF's output gap, headline consumer price inflation, and the IMF's assumptions of a 6% nominal equilibrium interest rate and a 3% headline inflation target.4 The second method simply compares the benchmark lending rate to that prescribed by our BCA China Interest Rate Model, which is a proprietary indicator based on China's growth momentum relative to its recent average, Chinese inflation, U.S. interest rates, and the CNY/USD exchange rate. Chart 6Policy Constraints Weigh Heavily On ##br##Some Sectors Policy Constraints Weigh Heavily On Some Sectors Policy Constraints Weigh Heavily On Some Sectors Chart 7Conventional Methods Say The Benchmark##br## Lending Rate Should Rise... Conventional Methods Say The Benchmark Lending Rate Should Rise... Conventional Methods Say The Benchmark Lending Rate Should Rise... At first blush, Chart 7 seems to imply that a significant increase in the benchmark 1-year policy lending rate is warranted. But these approaches ignore the fact that market-based interest rates have already increased over the past year, in some cases materially. A comprehensive understanding of the framework and mechanics of China's new monetary policy era is still elusive to many investors, and is an area of ongoing research at BCA. But for now, it is important to note that the benchmark lending rate merely acts as a reference point for Chinese banks when determining the actual interest rate charged on new loans. Chart 8 highlights that the percentage of loans issued above the benchmark rate correlates strongly with, and is led by, the 3-month interbank lending rate. Given the significant increase in 3-month SHIBOR over the past year, it is not surprising that China's weighted average lending rate has recently been increasing, even though the benchmark rate has remained constant. The rise in the average lending rate has so far been moderate, with our Q4 estimate showing only a 35% cumulative retracement of the 180bps decline that occurred from 2014 - 2016. But Chart 9 illustrates what would likely occur to the average lending rate if the PBOC were to hike the benchmark rate by 50bps over the coming year, based on two different scenarios: 1) an unchanged 3-month SHIBOR rate, and 2) a 50bps rise in 3-month SHIBOR (i.e. a parallel shift with the benchmark rate). The chart makes it clear that such a move would push average lending rates above the midpoint of the 2014-2016 range, which from our perspective is a reasonable estimate of the threshold between easy and tight monetary policy. Chart 8...But This Ignores The Recent Rise##br## In Market-Based Interest Rates ...But This Ignores The Recent Rise In Market-Based Interest Rates ...But This Ignores The Recent Rise In Market-Based Interest Rates Chart 9Even Modest Hikes To The Benchmark Rate ##br##Will Create Tight Policy Even Modest Hikes To The Benchmark Rate Will Create Tight Policy Even Modest Hikes To The Benchmark Rate Will Create Tight Policy A rise into tight monetary policy territory would be exacerbated even further if the 3-month SHIBOR rate rose disproportionately to any increase in the benchmark rate, which is not a trivial risk given the extent of their rise since late-2016. In short, given that China's economy is already slowing, this analysis underscores that any meaningful increases to the benchmark rate are likely unwarranted, and would be greeted negatively by global investors were they to occur. Bottom Line: Conventional methods of gauging the tightness of China's monetary policy stance tend to ignore the fact that market-based interest rates have already increased over the past year. Meaningful increases to the benchmark lending rate are therefore unwarranted barring a significant improvement in China's growth momentum. Monetary Policy And Investment Strategy We presented a "decision tree" for Chinese stocks in our January 4 Weekly Report,5 and noted that signs of significant further tightening of monetary policy should be met with a downgrade bias towards Chinese equities. We argued that the "bark" of monetary authorities would be worse than their "bite" over the coming several months, given that growth momentum and house price appreciation has already peaked. Recent market performance suggests that global investors agree with our assessment that the PBOC will refrain from any meaningful increases to the benchmark lending rate, and that any further rise in the average lending rate will be modest. Chart 10 shows that while the performance of Chinese investable ex-tech stocks versus global ex-tech did challenge its 200-day moving average in mid-December, the selloff has been completely reversed over the past month. In addition, Chart 11 shows that bottom-up 12-month forward EPS growth expectations remain solid and net earnings revisions remain close to a seven-year high, suggesting that there is no imminent fundamental basis for a major decline in Chinese investable equity prices. Chart 10Investors Aren't Worried##br## By The Specter Of Tight Policy Investors Aren't Worried By The Specter Of Tight Policy Investors Aren't Worried By The Specter Of Tight Policy Chart 11There Is Fundamental Support ##br##For Chinese Stocks There Is Fundamental Support For Chinese Stocks There Is Fundamental Support For Chinese Stocks Accordingly, while further monetary policy tightening remains a risk to be monitored over the course of the year, our "decision tree" framework continues to suggest that investors should be overweight Chinese stocks. We regard this as a recommendation to be cautiously bullish, a stance that we will be continually evaluating over the course of the year as more information about the risk factors that we have identified presents itself. Stay tuned! Bottom Line: Despite several identifiable risk factors, investors should remain overweight Chinese investable stocks versus the emerging market and global benchmark. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability of China's Business Cycle", dated November 30, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report "China's Economy - 2015 Vs Today (Part I): Trade", dated October 26, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report "On A Higher Note", dated October 5, 2017, available at cis.bcaresearch.com. 4 IMF Country Report No. 17/247, People's Republic of China : 2017 Article IV Consultation, August 8, 2017. 5 Please see China Investment Strategy Weekly Report, "The "Decision Tree" For Chinese Stocks", dated January 4, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights We are upgrading our allocation to Indian stocks from neutral to overweight within EM equity portfolios. India's public banks are much further along in their necessary adjustment process, and the credit cycle downturn is much more advanced relative to China's. To capitalize on this theme, we recommend going long Indian banks and shorting Chinese bank stocks. India's public bank recapitalization program will allow them to slowly augment credit origination, assisting the economic recovery. Feature Chart I-1Favor Indian Banks Versus Chinese Ones Favor Indian Banks Versus Chinese Ones Favor Indian Banks Versus Chinese Ones Our report this week highlights the results from stress tests we conducted on Indian and Chinese public banks, and also compares their respective equity valuations. Based on our findings, we are initiating a new relative equity trade: long Indian / short Chinese bank stocks (Chart I-1). The health of the banking system, the credit cycle outlook as well as the performance of bank share prices hold the key to relative performance of any bourse in the EM universe. Provided our positive bias toward Indian banks relative to their EM peers on all the above parameters, we are upgrading our allocation to India from neutral to overweight within EM equity portfolios. Indian Versus Chinese Public Banks From 2003 to 2012, India went through a large credit binge and capital misallocation cycle in its industrial and infrastructure sectors. During this period, banks' loans to companies and bank assets rose from 12% to 23% and 63% to 85% of GDP, respectively (Chart I-2A). By comparison, Chinese (ex-policy) commercial banks' claims on companies and their total assets have surged from 85% to 110% and from under 180% to 230% of GDP, respectively, since 2009 (Chart I-2B). In both countries, the banking sector remains dominated by public banks that hold more than 50% of banking system assets. Chart I-2ACredit Boom In Perspective: India Credit Boom In Perspective: India Credit Boom In Perspective: India Chart I-2BCredit Boom In Perspective: China Credit Boom In Perspective: China Credit Boom In Perspective: China Today, Indian public banks - who were the main lenders to industrial companies during the corporate credit binge in the 2003-12 period - have been experiencing mushrooming bad loans. Total public banks' NPLs and distressed asset ratios have reached 13.5% and 2.7% of total loans, respectively (Chart I-3). By contrast, for all Chinese banks, the current NPL ratio is at a mere 1.7%, while the distressed loan ratio stands at only 3.6% of total loans. Chart I-3NPL Ratios In Perspective: India & China NPL Ratios In Perspective: India & China NPL Ratios In Perspective: India & China Further, under pressure from the central bank, Indian public banks have been raising provisioning levels for bad assets very aggressively. On the flip side, Chinese regulators have been following tolerant policies toward their own commercial banks. As such, the provisions-to-loans ratio at all public banks now stands at 3% in China, compared with 5.6% in India. In addition, Chinese banks have bought a lot of corporate bonds that are not provisioned for at all. Does this higher NPL ratio in India relative to China mean that credit allocation is much worse in India? Not quite. The thesis that Indian public banks are more poorly managed than Chinese public banks is not accurate. These banks are managed by public sector executives who often allocate credit to support government growth policies. This is why it is reasonable to assume that the quality of credit allocation among Chinese and Indian public banks is probably similar. As such, we presume that Chinese banks' current NPL ratio is severely understated, and has the potential to rise to levels currently being reported by Indian public banks. The basis is that the Chinese credit boom has dramatically exceeded that of India (see Chart I-2A and I-2B on page 2). Typically, the resulting NPL ratio is proportional to the magnitude of the preceding credit frenzy. Finally, India's central government announced a major recapitalization plan in October 2017 to assist the country's public banks in cleaning up their balance sheets and to also support them in expanding credit. It is likely, therefore, that these banks are now approaching the final stages of their balance sheet repair and deleveraging process. Bottom Line: India's public banks are much further along in their necessary adjustment, and their credit cycle downturn is also much more advanced relative to Chinese banks. The latter have been postponing the inevitable balance sheet clean-up process. To capitalize on this theme, we recommend going long Indian banks and shorting Chinese bank stocks. Banking Stress Test For India And China We have conducted stress tests for India's top seven and China's top five listed public banks. We used the following assumptions for the three scenarios we considered: Non-performing risk-weighted assets (NPA) ratios to rise to 14% (pessimistic), 12% (baseline) and 10% (optimistic scenario) of risk-weighted assets for both Indian and Chinese public banks. Risk-weighted assets adjust banks' various types of assets based on their degree of riskiness. In that way, the risk-weighted asset values are comparable between the two banking systems. We assume a 30% recovery rate in all three NPA scenarios for both countries. The recovery rate on Chinese banks' NPAs in the 2001-2005 period was 20% amid a booming economy. The assumed recovery rate of 30% is therefore not low. The outcome of the stress tests is as follows: In the baseline scenario of 12% NPA, the losses post recovery and provisions would amount to 1.3 trillion rupees in India (0.9% of GDP) and RMB 3.4 trillion in China (4.2% of GDP). This would translate into a 33% equity impairment for India's seven public banks, and 48% for China's five public banks (Table I-1 and I-2, column 7). Table I-1Stress Test For Top 7 Indian Public Banks Long Indian / Short Chinese Banks Long Indian / Short Chinese Banks Table I-2Stress Test For Top 5 Chinese Public Banks Long Indian / Short Chinese Banks Long Indian / Short Chinese Banks From a valuation standpoint, the post-impairment price-to-book value (PBV) ratio would jump to 1.44 and 1.62 for Indian- and Chinese-listed public banks, respectively. Assuming a fair PBV ratio of 1.3 - which is the average PBV ratio for all EM banks since 2011 - Indian public banks are 11% overvalued and Chinese ones are about 25% overvalued. In other words, if one were to calculate the true PBV ratio of these banks after a comprehensive "clean-up" has been done, then Indian public bank stocks would be cheaper than Chinese ones. It is important to note that the above valuation exercise does not take into consideration banks' future profits. As such, we account for their recurring profits in the following manner: Table I-3 calculates the ratio of NPA losses to banks' recurring net profits before provisioning. Losses are the amount to be written-off post provisioning and recovery. In the baseline scenario of a 12% of NPA, this ratio is 2.5 for India and 3.4 for China. In other words, it will take 2.5 and 3.4 years of net profits before provisions close the "black hole" of NPA losses (post provisions and recovery) in India and China, respectively. Hence, on this measure as well, India's listed public banks appear more appealing than those in China. Table I-3Profit Coverage Of Loan Losses Long Indian / Short Chinese Banks Long Indian / Short Chinese Banks There is a caveat regarding Chinese banks' stress and their post-impairment book value. Our analysis is performed based on risk-weighted assets, and does not include off-balance-sheet assets. Therefore, any losses from off-balance-sheet assets will make losses for Chinese public banks greater than our analysis captures. Further, the Chinese financial authorities are currently tightening regulations, which will likely curtail banks' off-balance-sheet activities and by extension their profitability. These risks are not present in India, where banks have less off-balance-sheet assets. Bottom Line: Public bank stocks are currently overvalued by about 11% and 25% in absolute terms in both India and China, respectively. This favors Indian bank share prices outperforming their Chinese peers. The fact that the "clean-up" has not yet begun in China reinforces this trade. Banks' Recapitalization In India Saddled with NPLs, Indian public banks have not been willing to lend in recent years. Chart I-4 demonstrates that their loan growth has stalled. Credit to large industrial companies has in particular suffered (Chart I-4, bottom panel), as most of this type of credit is typically extended by public banks. Chart I-4India: Public Bank Loan Growth Has Slumped India: Public Bank Loan Growth Has Slumped India: Public Bank Loan Growth Has Slumped Consequently, India's capital expenditures have languished in recent years, weighing not only on cyclical growth but also depressing long-term productivity and potential growth. In October, the Indian government announced an estimated 2.11 trillion rupees public bank recapitalization program that will be implemented over the next two years. The program is for all public banks, while the above stress test was performed for only the top seven listed public banks. The latter account for around 60% of all public banks' assets, so we assume they will get around 60% of the stated recapitalization amount. The recapitalization program is designed as follows: The central government plans to inject 180 billion rupees of equity capital into all public banks via budgetary allocations. The public banks will in turn raise 580 billion rupees from the market. The remaining 1,350 billion rupees will come from government-issued Bank Recapitalization Bonds. The government will issue bonds to banks and then use the funds to buy more shares from public banks. It is important to note that in the stress test above and for the calculation of post-impairment PBV ratios, we assume the government will not subsidize existing shareholders when it injects money into public banks. This means the government will provide equity capital to public banks at post-impairment equity value - i.e., at a fair market price. It will be difficult for the Indian government to bail out its public banks without making current shareholders bear losses. If the government bails out public banks' private and foreign shareholders, the opposition parties will use the bank recapitalization program against Prime Minister Narendra Modi's government in the general elections scheduled to be held in 2019. Many investors and commentators assume that India's bank recapitalization program is automatically bullish for bank share prices. While it is positive for banks' ability to lend and drive growth in the medium and long term, the program is not necessarily bullish for share prices, particularly at their current high levels. The same is true for potential recapitalization programs in China. Overall, odds are that current shareholders of public banks will likely shoulder meaningful losses in India and possibly in China as well. How well off will capitalized public banks in India be after implementation of the recapitalization program? In the case of the seven Indian public banks we performed the stress test on, Table I-4 estimates that post-impairment and recovery, the total equity capital-to-risk-weighted assets ratio will be 8% in our baseline scenario. This is lower than the regulatory minimum of 9%. Table I-4Capital Ratios For India's Top 7 Public Banks Long Indian / Short Chinese Banks Long Indian / Short Chinese Banks The recapitalization will bring this equity capital adequacy ratio to 11.3%, which exceeds the regulatory minimum of 9%. Hence, after the program is completed, Indian public banks will likely become well capitalized and will be able to resume their lending and expand their assets. This in turn will facilitate the economic recovery. Bottom Line: The Indian government's recapitalization program is sufficient to raise public banks' capital adequacy ratio above the regulatory minimum. This will allow public banks to resume their lending. India's Cyclical Growth Outlook India's cyclical outlook will be one of muted recovery. Yet it is superior to other EMs, where we expect meaningful deceleration due to a potential slowdown in China and a rollover in commodities prices. Public banks' recap program will be slow in India - to be conducted over the next two years - and banks' ability to boost lending will improve only gradually. Meanwhile, private banks have and will probably continue to concentrate their lending efforts on consumers rather than on industrial companies and infrastructure. In the next 12-18 months, a slow improvement in public banks' ability to originate credit will allow only moderate improvement in capital spending growth. The latter is required to resolve bottlenecks and unleash the nation's productivity potential. Several indicators of capital spending are lukewarm (Chart I-5, top panel). However, new capex project announcements and the number of investment proposals have been dropping (Chart I-5, middle panel). Surprisingly, companies' foreign external borrowing is still contracting, despite booming capital inflows into EM (Chart I-5, bottom panel). On the consumer side, the outlook remains bright. Motorcycle sales have recovered sharply and commercial vehicle sales are beginning to pick up (Chart I-6). Chart I-5India's Capital Spending Is Sluggish India's Capital Spending Is Sluggish India's Capital Spending Is Sluggish Chart I-6Indian Consumer Health Is Strong Indian Consumer Health Is Strong Indian Consumer Health Is Strong Consumer/personal loans are accelerating from an already strong growth rate, largely thanks to the aggressiveness of private sector banks (Chart I-6, bottom panel). In turn, the employment outlook is finally beginning to show signs of improvement (Chart I-7). The manufacturing PMI has also risen substantially, and is currently in expansion territory (Chart I-8). Likewise, the service sector PMI has bounced above 50. Chart I-7India's Employment Is Turning The Corner India's Employment Is Turning The Corner India's Employment Is Turning The Corner Chart I-8India: PMIs Are Positive India: PMIs Are Positive India: PMIs Are Positive Finally, India is less exposed to China's growth and a retracement in commodities prices than many other emerging economies. This makes us upbeat on India's cyclical economic dynamics and relative equity and currency performance versus other EMs. Bottom Line: India's cyclical outlook is better than that of many other EMs. Structural Tailwinds And Impediments India holds huge promise for investors as it is a much-underinvested economy, and potential return on capital is considerably higher in those countries than in relatively overinvested ones. In addition, its population and labor force growth are among the highest in mainstream developing countries. On the other hand, for such potential to be realized, the country needs to be able to boost its productivity. On this count, the outlook is less positive. India's share of global goods and services exports has declined substantially since 2011 (Chart I-9). This should not be surprising, given weak investment spending has led to stagnation in trade competitiveness. Chart I-10 reveals that based on the UNCTAD1 dataset, India has been losing market share in both low- and high-skilled labor sectors export markets worldwide. Chart I-9India's Share In Global Trade India's Share In Global Trade India's Share In Global Trade Chart I-10India Has Been Losing Export Market Share India Has Been Losing Export Market Share India Has Been Losing Export Market Share While certain reforms such as the introduction of a sales tax will have a positive impact on the economy, other much-needed changes, such as land and labor market reforms, have so far remained unattainable. Moreover, the agriculture sector still faces material challenges. Without these vital reforms, it will be difficult to boost efficiency and productivity and build global competitiveness. Finally, in terms of education enrollment, India lags other EMs, especially China, in tertiary education (Chart I-11). This makes it even more difficult to boost productivity and growth potential. Bottom Line: India has great secular potential, but the structural advance has stalled since 2011. The jury is still out on whether it can implement additional reforms to realize this potential. Investment Conclusions India's banking sector outlook is brighter, and the deleveraging cycle is much more advanced, compared with many other EMs in general and China in particular. Therefore, we recommend a new relative equity trade: long Indian banks / short Chinese banks. Investors could buy Indian public banks or all banks with the understanding that private banks are typically in better shape than their state-owned peers, but are also much more expensive. We will be tracking this trade's performance using the Bankex index for India and the MSCI bank index for China. The Bankex index has a larger share of market cap of public banks than the MSCI India bank index. Within China, we are maintaining our short small and medium / long large banks position initiated on October 26th 2016. We are also recommending EM equity investors upgrade the Indian bourse from neutral to overweight. We shifted Indian stocks from overweight to neutral on August 23rd 2017, but the risk-reward has improved since then (Chart I-12). Chart I-11India's Education Improvement Is Lagging India's Education Improvement Has Stalled India's Education Improvement Has Stalled Chart I-12Upgrade Indian Bourse Within EM Universe Upgrade Indian Bourse Within EM Universe Upgrade Indian Bourse Within EM Universe Our primary concerns with EM stocks are a China slowdown, a rollover in commodities prices and a rebound in the U.S. dollar. Associated strains in countries with large foreign debt levels or wide current account deficits as well as lack of credit deleveraging and bank recapitalization will define EM financial markets' performance in the next 12-18 months. On all of these counts, India scores better than many EMs, justifying this equity upgrade. The absolute outlook for Indian stocks, however, is not inspiring. This equity market is rather expensive and overbought in absolute terms. If EM risk assets experience a setback in 2018, as we expect, Indian equities will also relapse in absolute terms. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com   1 United Nations Conference on Trade and Development.   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Controversial gaffes aside, President Trump has started 2018 by moving to the middle; This comes at a time when animal spirits are reawakening thanks to tax cuts; And the path of least resistance for fiscal policy points towards more profligacy; Meanwhile, Chinese growth is imperiled by structural reform efforts; With money growth and import data showing signs of stress; The combination of upside growth risks in the U.S. and downside growth risks in the rest of the world should revive the U.S. dollar and threaten EM performance in 2018. Feature In just the first two weeks of 2018, U.S. President Donald Trump has: Hosted a meeting on immigration policy with Republican and Democratic leaders during which he said that the upcoming legislation should be a "bill of love," while encouraging congressional leaders to think big and pursue comprehensive immigration reform; Claimed that he has a "very good relationship" with Kim Jong-Un, while refusing to deny that he has already spoken privately with the North Korean leader; Supported bringing back "earmarks" in order to grease the wheels of bipartisanship in Congress - i.e., new spending that allocates funds to specific projects; Extended sanction relief to Iran, albeit with the caveat that it would be the last time he does so without demanding modifications to the Joint Comprehensive Plan of Action (the Iran nuclear deal); Broken with his former chief political strategist Steve Bannon - dubbing him "Sloppy Steve" in the process - while disparaging Bannon's penchant for scorched-earth tactics.1 On the whole, Trump's actions in January suggest a move towards the political center. Meanwhile, the media and political opponents continue to dwell on Trump's alleged comments where he disparaged immigrants from certain countries, obscuring the subtle shift in political strategy. What would be the reason for a Trump shift to the middle? As we wrote last week, the Pocketbook Voter Theory in political science suggests that Trump's Republican Party should be benefiting from a surge in popular support amid strong economic data and record-setting market performance.2 However, the 2018 generic congressional ballot still points to a very challenging midterm election for the Republican Party (Chart 1). Trump has two choices. First, he can ignore the poor GOP polling, as well as his own (Chart 2) in the face of stellar economic performance, and plow into an electoral disaster. This would make him the earliest "lame duck" president in recent U.S. history. As we wrote in December, this choice is a serious market risk for investors.3 Lame duck presidents have often sought relevancy abroad, given the lack of constitutional constraints to executive action in the foreign policy realm. In the case of Trump, we could think of three avenues by which he might increase geopolitical risk premiums: Protectionist policies towards China, the abrogation of NAFTA, or military tensions with Iran. Chart 1History Favors The Opposition History Favors The Opposition History Favors The Opposition Chart 2Trump Is Extraordinarily Unpopular Upside Risks In U.S., Downside Risks In China Upside Risks In U.S., Downside Risks In China The second option for President Trump is to move to the middle ahead of the midterms. This would be unexpected in every way other than that Trump is the master of the unexpected. We happen to agree with his supporters that he is a political genius. Unless, that is, he continues to waste an extraordinary bull market, strong economy, and soaring consumer/business confidence by refusing to woo the median voter. What would a shift towards the center mean for the equity market? First, the already low probability that domestic political intrigue will upend the ongoing rally would get even lower in a world where Trump moves to the center. Second, the risk of market-moving geopolitical risks prompted by White House policy would decline as Trump would presumably seek and follow the advice of his establishment advisers. In other words, it would be pure nectar for the already buoyant markets. This is not to say that there would not still be reason for a pullback in U.S. equities. The bull-bear ratio is dangerously high (Chart 3), and consumer confidence is ominously stretched (Chart 4). Chart 3Investor Bullishness Is At Record High... Investor Bullishness Is At Record High... Investor Bullishness Is At Record High... Chart 4...And So Is Consumer Confidence ...And So Is Consumer Confidence ...And So Is Consumer Confidence U.S.: Business Owners Are Republican While some of our clients in the financial community may fret about Trump's unorthodoxy, our clients in the corporate world clearly do not. This is not merely an offhand observation, it is an empirical fact (Chart 5). America's business leaders have given President Trump the benefit of the doubt since he was elected. Bill Dunkelberg, the Chief Economist of the National Federation of Independent Business (NFIB), which publishes the Small Business Optimism survey, went on to comment this month: "we've been doing this research for nearly half a century ... and I've never seen anything like 2017 ... The 2016 election was like a dam breaking."4 It is dangerous, therefore, to be overly mathematical about U.S. growth prospects in 2017. While we agree with our colleague Peter Berezin that, on face value, the strict growth impact of the tax cuts may merely add 0.3% of GDP growth in 2018, the qualitative impact of unleashing animal spirits is incalculable.5 The risk to growth in the U.S. is therefore very much tilted to the upside. First, as we discussed in a Special Report published with our U.S. Equity Strategy colleague Chris Bowes, a crucial, yet under-reported change in the corporate tax bill allows the immediate expensing of capital investment.6 Most market observers have overlooked this part of the legislation as it is simply a shift in the "time value of money." The IRS already allows significantly accelerated depreciation of capex; this reform merely brings it forward. Our analysis, however, suggests that the impact of bringing it forward could, at the margin, change spending behavior for firms and drive the next upleg in capex. This comes at a time when the prospects for business investment are already positive (Chart 6).7 Chart 5Business Owners Are Depressed When##br## Democrats Control The White House Business Owners Are Depressed When Democrats Control The White House Business Owners Are Depressed When Democrats Control The White House Chart 6Animal Spirits Will ##br##Spur CAPEX Animal Spirits Will Spur CAPEX Animal Spirits Will Spur CAPEX Second, investors are underestimating the probability that the current budget impasse - which could lead to a government shutdown in late January - gets resolved through more, not less, federal spending. Trump surprised legislators during a meeting on immigration when he offered his support for "earmarks" - i.e., legislative tags that direct funding to special interests in representatives' home districts. Earmarks were done away with in 2011 by the GOP following the Tea Party-inspired 2010 midterm victory, but they have crept back into the discussion through different guises (Chart 7). Chart 7Pork-Barrel Prohibition Is Ending Upside Risks In U.S., Downside Risks In China Upside Risks In U.S., Downside Risks In China The timing of Trump's statement on earmarks is interesting as the House Rules Committee is holding public hearings on the originally GOP-instituted earmark ban. In fact, the 115th Congress (the current one) almost reinstated earmarks at the beginning of 2017, only to be held back by House Speaker Paul Ryan and the newly elected White House. In January 2017, Ryan and the White House agreed that it would be unseemly to approve "pork barreling" so quickly after the election of a man who promised to "drain the swamp." Apparently, a year later, the appropriate amount of time has passed to make the move okay! What about the fears that the budget deficit is unsustainable? Investors may be fretting about a problem that does not exist (at least not yet). Chart 8 shows that budget deficits have decreased in almost every case ahead of a recession by 1.16% on average in the eight quarters before a downturn. This is because revenues are very important in determining deficit dynamics. Only just before the recession hits, as growth slows, does the deficit start to flatline or expand. If the risk to the U.S. economy is to the upside, as we believe it is, then deficits will come down regardless of tax or spending policy. Chart 8The Deficit Is Not A Problem... Yet The Deficit Is Not A Problem... Yet The Deficit Is Not A Problem... Yet Fiscal policy rhetoric may alone be far more important to the equity, bond, and currency markets than the market is currently pricing. Talk of draconian spending cuts - remember the May 2017 White House budget? Anyone? - could very quickly be replaced with an appropriation bill in late January that combines higher defense spending with higher discretionary spending. Given the current low levels of discretionary spending (Chart 9), the move towards greater spending could be sizeable and surprising. And if earmarks make a comeback, look out! Chart 9Government Spending Is Bottoming Government Spending Is Bottoming Government Spending Is Bottoming Chart 10Global Economy Is Firing On All Cylinders Global Economy Is Firing On All Cylinders Global Economy Is Firing On All Cylinders This fiscal fuel is coming when the fire of the U.S. economy is already well lit. Yes, global growth is strong (Chart 10), but U.S. growth is likely to beat it in 2018 (Chart 11). The global and U.S. economy may diverge just as the BCA's two-factor 10-year Treasury yield model is showing that U.S. long-dated bonds are expensive (Chart 12), while dollar bearishness is overcrowded (Chart 13). Chart 11U.S. May Outperform Global Growth U.S. May Outperform Global Growth U.S. May Outperform Global Growth Chart 12More Room For Yields To Rise More Room For Yields To Rise More Room For Yields To Rise Chart 13The Dollar Will Be Great Again The Dollar Will Be Great Again The Dollar Will Be Great Again Bottom Line: Tax cuts will unleash animal spirits in the U.S. in 2018. Meanwhile, the political path of least resistance on fiscal policy is towards profligacy. Fade any talk of austerity or entitlement reform, earmarks are back! A combination of easy fiscal policy and tax cuts should be good for equity markets, bad for Treasuries, and good for the greenback in 2018. Technical indicators flag some near-term risks to the dollar, but over the course of the year, our assessment is that it will hold at current levels or rally. China: Reform Reboot Is Growth-Constraining Unlike the U.S. economy, where risks lie to the upside, China is our top candidate for growth disappointments in 2018. Premier Li Keqiang has announced that China's GDP grew by 6.9% in 2017, slightly above expectations at the beginning of the year. However, growth momentum is already slowing due to cyclical factors, the waning of fiscal and credit stimulus, and the government's financial tightening measures that were implemented over the past year (Chart 14). Chinese imports are what really matter from a global macro perspective, and the latest import data suggest that the domestic economy is slowing more abruptly than expected. Import growth fell sharply to 5% year-on-year in December and 0.46% month-on-month. Import volume growth fell from 27.1% in early 2017 to 9.3% in December (Chart 15). Chart 14Chinese Economy: Weakness Ahead Chinese Economy: Weakness Ahead Chinese Economy: Weakness Ahead Chart 15What Happens In China, Does Not Stay In China What Happens In China, Does Not Stay In China What Happens In China, Does Not Stay In China Policy changes are highly likely to add to this slowdown. There can no longer be much doubt about the reformist turn in government policy that we highlighted last year.8 All of the policy announcements that came out of the nineteenth National Party Congress in October so far have had a reformist bent. The market agrees, as the sectors of the equity market most likely to benefit from reforms - health care, IT, energy and consumer staples - have outperformed the broad market significantly since President Xi's five-year policy speech on October 18, 2017 (Chart 16). Two separate news items that caused market jitters over the past week reflect the reformist turn. First came unconfirmed rumors that China would make its exchange rate more flexible by abandoning a "counter-cyclical factor" in its daily fixing rate; second came a "fake news" report that China planned to diversify its foreign exchange reserves away from U.S. Treasuries (Chart 17). The rumors were not significant in themselves, at least not without more information, but they were significant in suggesting that debates on major macro policies are intensifying.9 The question is how much resolve will China's central government have in executing its renewed reform agenda? President Xi obviously does not want to self-impose a recession, yet meaningful reform will constrain credit, investment, and growth. For instance, the current financial regulatory crackdown has caused a precipitous drop in the growth of wealth management products (WMPs), which are investment products that make up about 60% of the burgeoning non-bank credit flows; non-bank credit, for its part, makes up 28% of total credit (total social financing). And regulators have gone on to tackle entrusted loans, corporate bonds, and other innovative financial products as well (Chart 18). The impact could be material over the course of this year. Chart 16Markets Believe In China Reforms Markets Believe In China Reforms Markets Believe In China Reforms Chart 17Chinese Treasury Reserves Can Be Weaponized Chinese Treasury Reserves Can Be Weaponized Chinese Treasury Reserves Can Be Weaponized Chart 18China's Dodd-Frank Moment China's Dodd-Frank Moment China's Dodd-Frank Moment We strongly urge clients to fade the narrative that China is already "easing up" on reforms. In the three months since China's party congress we have seen a handful of false media narratives about how the government is backtracking on its policy agenda. For instance, both The Wall Street Journal and The New York Times declared that the outcome of the major annual economic policymaking meeting - the Central Economic Work Conference - included a turn away from deleveraging. This was not only a misreading of the high-level policy priorities but also a mistranslation of the Economic Work Conference documents, which argued that deleveraging remains a key policy focus.10 It would be humiliating for President Xi - who, not incidentally, has achieved Mao-like authority within the Communist Party - to backtrack on his second-term economic agenda before he has even officially been elected to his second term. Xi will be re-elected in March and he is looking at 2020-21 deadlines for progress on key reforms according to the thirteenth Five Year Plan (2015-20) and his own three-year plan to fight the "Three Battles" of systemic financial risk, poverty, and pollution. The only way to meet these deadlines while ensuring that the country is strong and stable for the 100th anniversary of the Communist Party in 2021 is to frontload the reform push in 2018-19.11 In Table 1 we update our "Reform Reboot Checklist" to reflect the reality that the Central Economic Work Conference produced a strikingly reform-oriented outcome. This is significant because it was billed as the first major statement of economic policy under "Xi Jinping Thought on Socialism with Chinese Characteristics for the New Era." Table 1How Do We Know China Is Reforming? Upside Risks In U.S., Downside Risks In China Upside Risks In U.S., Downside Risks In China The money growth (M2) target for 2018, for instance, is rumored to be the lowest in China's history after that meeting (supposedly it will be 9%, down from the low- to mid-teens seen in previous years). Now all we need to confirm that serious reforms are afoot is slower bank loan growth (which will likely be tipped in January numbers due in early February), or substantially tighter interbank rates, plus the announcement of significant reform initiatives at the annual "Two Sessions" in early March. It is very common in China for central government decrees to be too draconian initially and then to be modified after an outcry from industry. This year, however, we would advise clients to avoid confusing the inevitable back-and-forth between the central and local governments for a lack of resolve from the central government.12 China's bark will have bite this time around because the political and macroeconomic constraints to the core leadership are lower than they have been at any point in the past ten years. Table 2 shows the issues that we are watching to gauge the reform process and its impact on growth. In light of the above initiatives, we give a 30% subjective probability that China's policymakers will overtighten this year, which could lead to a global risk-off move in financial assets. Table 2China Is Rebooting Economic Reforms Upside Risks In U.S., Downside Risks In China Upside Risks In U.S., Downside Risks In China Even in our baseline case - China slows abruptly but remains stable - we believe financial markets have yet to understand the shift in Chinese policymaker thinking, which means that China is the prime candidate for negative surprises in a year in which markets are priced for perfection. Chart 19China's Trade Surplus Is A Geopolitical Risk China's Trade Surplus Is A Geopolitical Risk China's Trade Surplus Is A Geopolitical Risk Finally, China is still a major geopolitical risk this year. It scored the largest trade surplus ever with the U.S. in 2017 (Chart 19) and several key U.S. trade rulings are looming that could trigger a tit-for-tat conflict. This was, of course, the real reason behind the rumors about halting U.S. Treasury purchases. We will discuss the trade and geopolitical tensions in a forthcoming report. Bottom Line: China's reform reboot is gaining steam. It will threaten to constrain growth via the anti-corruption campaign, financial and regulatory tightening, corporate and industrial restructuring, and local government scrutiny. In combination with a stronger U.S. economy, China's downward-sloping business cycle and reform-capable political cycle spell disappointments for global markets this year. Investment Implications A faster growing U.S. economy and a slower growing China is beneficial for DM versus EM, the USD versus the RMB and other EM and commodity-linked currencies, U.S. stocks relative to DM stocks (because China's slower growth will weigh on Japanese and European earnings), and Chinese stocks relative to EM. It is bearish for China/EM corporate bonds. It will have varying impacts on commodity prices, depending on the role of Chinese supply-side reforms, but in the long term - as overcapacity cuts are priced in - it should be marginally bearish base metals as a result of China's desired switch of the growth model to a less investment-intensive model.13 Could stronger U.S. growth compensate for slower Chinese growth? We doubt it very much. China is alone expected to make up a third of all global economic growth in 2018, with China-leveraged EM making up the other 45%, according to the latest IMF World Economic Outlook (Chart 20). It is unfathomable to see how the U.S., which is expected to contribute just 10% of all growth, can compensate for slower growth in developing nations. Even if U.S. growth massively surprised to the upside, the U.S. economy is far too domestically driven to make a genuine difference through higher imports. Chart 20Chinese Growth Outweighs U.S. Globally Upside Risks In U.S., Downside Risks In China Upside Risks In U.S., Downside Risks In China As for the U.S. economy and markets, a global slowdown may be precisely what the doctor ordered. With stretched valuations, a foreign-induced correction may be healthy from a valuation perspective while having no impact on domestic economic fundamentals. Meanwhile, a dollar rally combined with some market volatility later in the year may be enough to give the Fed just enough pause to slow down the pace of hikes. Technical indicators are flagging some near-term risks to the dollar, but over the course of the year our assessment is that it will hold at current levels or rally. While this is not our base case, it would be the type of event that could prolong the current economic cycle. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jim Mylonas, Vice President Client Advisory & BCA Academy jim@bcaresearch.com 1 In his official statement on the break with Mr. Bannon, President Trump concluded with an important paragraph: "We have many great Republican members of Congress and candidates who are very supportive of the Make America Great Again agenda. Like me, they love the United States of America and are helping to finally take our country back and build it up, rather than simply seeking to burn it all down." The statement was important as it aligned President Trump firmly with Congressional Republicans in their opposition to the Bannon/Breitbart Clique. 2 Please see BCA Geopolitical Strategy Weekly Report, "The American Pocketbook Voter," dated January 10, 2018, 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 Please see NFIB, "December 2017 Report: Small Business Optimism Index," dated December 12, 2017, available at www.nfib.com. 5 Please see BCA Global Investment Strategy Weekly Report, "Four Key Questions On The 2018 Global Growth Outlook," dated January 5, 2018, available at gis.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and U.S. Equity Strategy Special Report, "Tax Cuts Are Here - Equity Sector Implications," dated December 11, 2017, available at gps.bcaresearch.com. 7 The biggest pushback against our view comes from the oft-repeated anecdote of a meeting between Gary Cohn, the Director of the National Economic Council, and American business leaders. Apparently, when Cohn asked the attendees how many would invest if their corporate taxes were cut, only one executive raised their hand. We have now heard this anecdote repeated to us so many times by clients that it has become clear that it is essentially the only evidence that U.S. corporations have no intention of increasing capex. Needless to say, we do not base our analysis on a single anecdote! 8 For this theme, please see BCA Geopolitical Strategy Weekly Report, "China Down, India Up?" dated March 15, 2017, available at gps.bcaresearch.com. 9 The change to the RMB fixing method is not confirmed, while the rumor of a change in the forex reserve portfolio management came from an unreliable media report that was denied by China's State Administration of Foreign Exchange (SAFE). China's purchases of U.S. Treasuries peaked in 2011; China would harm itself if it sold its Treasuries rapidly. However, it may want to highlight this threat in response to U.S. President Donald Trump's threats of broad tariffs on Chinese imports. 10 The official communique from the 2017 Central Economic Work Conference did not specifically use the term "deleveraging," as in the 2015 and 2016 statements. This omission triggered U.S. news reports claiming that Beijing was backing off its deleveraging goal. However, the 2017 communique clearly emphasized preventing financial risk, including the first of the administration's "three battles" for the next three years. It also indirectly referred to "deleveraging" by citing the "Three De's, One Lower, and One Make Up," which is shorthand for the policy phrase "De-capacity, de-stocking, deleveraging, lowering costs and making up for weaknesses," which has been a fixture in rhetoric on China's supply-side reforms. 11 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 12 For instance, the central government is facing pushback on new asset management regulations that are set to be fully in force by June 2019. While there may be some compromise, we do not expect the regulations themselves to be watered down too much. 13 Please see BCA Commodity & Energy Strategy Weekly Report, "China's Environmental Reforms Drive Steel & Iron Ore," dated January 11, 2018, available at ces.bcaresearch.com; and BCA Emerging Markets Strategy Special Report "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017, available at ems.bcaresearch.com.

Highlights An increase in the "synthetic" supply of bitcoins via financial derivatives, along with the launch of bitcoin-like alternatives by large established tech companies, will cause the cryptocurrency market to collapse under its own weight. Other areas that could see supply-induced pressures over the coming years include oil, high-yield debt, global real estate, and low-volatility trades. In contrast, the U.S. stock market has seen an erosion in the supply of shares due to buybacks and voluntary delistings. Investors should consider going long U.S. equities relative to high-yield credit, while positioning for higher volatility. Such an outcome would be similar to what happened in the late 1990s, a period when the VIX and credit spreads were trending higher, while stocks continued to hit new highs. A breakdown in NAFTA talks remains the key risk for the Canadian dollar and Mexican peso. Feature Bubbles Burst By Too Much Supply The "cure" for higher prices is higher prices. The dotcom and housing bubbles did not die fully of their own accord. Their demise was expedited by a wave of new supply hitting the market. In the case of the dotcom bubble, a flood of shares from initial and secondary public offerings inundated investors in 2000 (Chart 1). This put significant downward pressure on the prices of internet stocks. The housing boom was similarly subverted by a slew of new construction - residential investment rose to a 55-year high of 6.6% of GDP in 2006 (Chart 2). Chart 1Burst By Too Much Supply: Example 1 Burst By Too Much Supply: Example 1 Burst By Too Much Supply: Example 1 Chart 2Burst By Too Much Supply: Example 2 Burst By Too Much Supply: Example 2 Burst By Too Much Supply: Example 2 Is bitcoin about to experience a similar fate? On the surface, the answer may seem to be "no." As more bitcoins are "mined," the computational cost of additional production rises exponentially. In theory, this should limit the number of bitcoins that can ever circulate to 21 million, about 80% of which have already been created (Chart 3). Yet if one looks beneath the surface, bitcoin may also be vulnerable to a variety of "supply-side" factors. Chart 3Bitcoin: Most Of It Has Been Mined Bitcoin: Most Of It Has Been Mined Bitcoin: Most Of It Has Been Mined First, the expansion of financial derivatives tied to the value of bitcoin threatens to create a "synthetic" supply of the cryptocurrency. When someone writes a call option on a stock, the seller of the option is effectively taking a bearish bet while the buyer is taking a bullish bet. The very act of writing the option creates an additional long position, which is exactly offset by an additional short position. Moreover, to the extent that a decision to sell a particular call option will depress the price of similar call options, it will also depress the underlying price of the stock. This is simply because one can have long exposure to a stock either by owning it outright or owning a call option on it. Anything that hurts the price of the latter will also hurt the price of the former. As bitcoin futures begin to trade, investors who are bearish on bitcoin will be able to create short positions that cause the effective number of bitcoins in circulation to rise. This will happen even if the official number of bitcoins outstanding remains the same. Imitation Is The Sincerest Form Of Flattery An increase in synthetic forms of bitcoin supply is one worry for bitcoin investors. Another is the prospect of increased competition from bitcoin-like alternatives. There are now hundreds of cryptocurrencies, most of which use a slight variant of the same blockchain technology that underpins bitcoin. Chart 4Governments Will Want Their Cut Governments Will Want Their Cut Governments Will Want Their Cut So far, the proliferation of new currencies has been largely driven by technologically savvy entrepreneurs working out of their bedrooms or garages. But now companies are getting in on the act. The stock price of Kodak, which apparently is still in business, tripled earlier this week when it announced the launch of its own cryptocurrency. That's just a small taste of what's to come. What exactly is stopping giants such as Facebook, Amazon, Netflix, and Google from issuing their own cryptocurrencies? After all, they already have secure, global networks. Amazon could start giving out a few coins with every sale, and allow shoppers to purchase goods from the online retailer using its new currency. It's simple.1 The only plausible restriction is a legal one: The threat that governments will quash upstart cryptocurrencies for fear that will drive down demand for their own fiat monies. As we noted several weeks ago, the U.S. government derives $100 billion per year in seigniorage revenue from its ability to print currency and use that money to buy goods and services (Chart 4).2 As large companies get into the cryptocurrency arena, governments are likely to respond harshly - sooner rather than later. This week's news that the South Korean government will consider banning the trading of cryptocurrencies on exchanges is a sign of what's to come. Who Else? What other areas are vulnerable to an eventual tsunami of new supply? Four come to mind: Oil: BCA's bullish oil call has paid off in spades. Brent has climbed from $44 last June to $69 currently. Further gains may not be as easily attainable, however. Our energy strategists estimate that the breakeven cost of oil for U.S. shale producers is in the low-$50 range.3 We are now well above this number, which means that shale supply will accelerate. This does not mean that prices cannot go up further in the near term, but it does limit the long-term potential for crude. Real estate: Ultra-low interest rates across much of the world have fueled sharp rallies in home prices. Inflation-adjusted home prices in Canada, Australia, New Zealand, and parts of Europe are well above their pre-Great Recession levels (Chart 5). U.S. real residential home prices are still below their 2006 peak, but commercial real estate (CRE) prices have galloped to new highs (Chart 6). Rent growth within the U.S. CRE sector is starting to slow, suggesting that supply is slowly catching up with demand (Chart 7). Chart 5Where Low Rates Have ##br##Fueled House Prices Where Low Rates Have Fueled House Prices Where Low Rates Have Fueled House Prices Chart 6Commercial Real Estate Prices Have ##br##Surpassed Pre-Recession Levels Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Chart 7Rent Growth Is Cooling Rent Growth Is Cooling Rent Growth Is Cooling Corporate debt: Low rates have also encouraged companies to feast on credit. The ratio of corporate debt-to-GDP in the U.S. and many other countries is close to record-high levels (Chart 8A and Chart 8B). Credit spreads remain extremely tight, but that may change as more corporate bonds reach the market. Chart 8ACorporate Debt-To-GDP ##br##Is Close To Record Highs Corporate Debt-To-GDP Is Close To Record Highs Corporate Debt-To-GDP Is Close To Record Highs Chart 8BCorporate Debt-To-GDP ##br##Is Close To Record Highs Corporate Debt-To-GDP Is Close To Record Highs Corporate Debt-To-GDP Is Close To Record Highs Low-volatility trades: A recent Bloomberg headline screamed "Short-Volatility Funds Are Being Flooded With Cash."4 The number of volatility contracts traded on the Cboe has increased more than tenfold since 2012. Net short speculative positions now stand at record-high levels (Chart 9). Traders have been able to reap huge gains over the past few years by betting that volatility will decline. The problem is that if volatility starts to rise, those same traders could start to unload their positions, leading to even higher volatility. In contrast to the aforementioned areas, the stock market has seen an erosion in the supply of shares due to buybacks and voluntary delistings. The S&P divisor is down by over 8% since 2005. The number of U.S. publicly-listed companies has nearly halved since the late 1990s (Chart 10). This trend is unlikely to reverse any time soon, given the elevated level of profit margins and the temptation that many companies will have to use corporate tax cuts to step up the pace of share repurchases. Chart 9Low Volatility Is In High Demand Low Volatility Is In High Demand Low Volatility Is In High Demand Chart 10Erosion Of Supply In The Stock Market Erosion Of Supply In The Stock Market Erosion Of Supply In The Stock Market Bet On Higher Equity Prices, But Also Higher Volatility And Higher Credit Spreads The discussion above suggests that the relationship between equity prices and both volatility and credit spreads may shift over the coming months. This would not be the first time. Chart 11 shows that the VIX and credit spreads began to trend higher in the late 1990s, even as the S&P 500 continued to hit new record highs. We may be entering a similar phase now. Continued above-trend growth in the U.S. and rising inflation will push up Treasury yields. We declared "The End Of The 35-Year Bond Bull Market" on July 5, 2016 - the exact same day that the 10-year Treasury yield hit a record closing low of 1.37%.5 Higher interest rates will punish financially-strapped borrowers, leading to wider credit spreads. Equity volatility is also likely to rise as corporate health deteriorates and the timing of the next downturn draws closer. Our baseline expectation is that the U.S. and the rest of the world will fall into a recession in late 2019. Financial markets will sniff out a recession before it happens. However, if history is any guide, this will only happen about six months before the start of the recession (Table 1). This suggests that global equities can continue to rally for the next 12 months. With this in mind, we are opening a new trade going long the S&P 500 versus high-yield credit. Chart 11Volatility Can Increase And Spreads ##br##Can Widen As Stock Prices Rise Volatility Can Increase And Spreads Can Widen As Stock Prices Rise Volatility Can Increase And Spreads Can Widen As Stock Prices Rise Table 1Too Soon To Get Out Will Bitcoin Be DeFANGed? Will Bitcoin Be DeFANGed? Four Currency Quick Hits Four items buffeted currency and fixed-income markets this week. The first was a news story suggesting that China will slow or stop its purchases of U.S. Treasury debt. China's State Administration of Foreign Exchange (SAFE) decried the report as "fake news." Lost in the commotion was the fact that China's holdings of Treasurys have been largely flat since 2011 (Chart 12). China still has a highly managed currency. Now that capital is no longer pouring out of the country, the PBoC will start rebuilding its foreign reserves. Given that the U.S. Treasury market remains the world's largest and most liquid, it is hard to see how China can avoid having to park much of its excess foreign capital in the United States. The second item this week was the Bank of Japan's announcement that it will reduce its target for how many government bonds it buys. This just formalizes something that has already been happening for over a year. The BoJ's purchases of JGBs have plunged over the past twelve months, mainly because its ¥80 trillion target is more than double the ¥30-35 trillion annual net issuance of JGBs (Chart 13). Chart 12China's Holdings Of Treasurys: ##br##Largely Flat Since 2011 China's Holdings Of Treasurys: Largely Flat Since 2011 China's Holdings Of Treasurys: Largely Flat Since 2011 Chart 13BoJ Has Been Reducing ##br##Its Bond Purchases BoJ Has Been Reducing Its Bond Purchases BoJ Has Been Reducing Its Bond Purchases Ultimately, none of this should matter that much. The Bank of Japan can target prices (the yield on JGBs) or it can target quantities (the number of bonds it owns), but it cannot target both. The fact that the BoJ is already doing the former makes the latter irrelevant. And with long-term inflation expectations still nowhere near the BoJ's target, the former is unlikely to change. What does this mean for the yen? The Japanese currency is cheap and its current account surplus has swollen to 4% of GDP (Chart 14). Speculators are also very short the currency (Chart 15). This increases the likelihood of a near-term rally, as my colleague Mathieu Savary flagged this week.6 Nevertheless, if global bond yields continue to rise while Japanese yields stay put, it is hard to see the yen moving up and staying up a lot. On balance, we expect USD/JPY to strengthen somewhat this year. Chart 14Yen Is Already Cheap... Yen Is Already Cheap... Yen Is Already Cheap... Chart 15...And Unloved ...And Unloved ...And Unloved The third item was the revelation in the ECB's December meeting minutes that the central bank will be revisiting its communication stance in early 2018. The speculation is that the ECB will renormalize monetary policy more quickly than what the market is currently discounting. If that were to happen, EUR/USD would strengthen further. All this is possible, of course, but it would likely require that euro area growth surprise on the upside. That is far from a done deal. The euro area economic surprise index has begun to edge lower, and in relative terms, has plunged against the U.S. (Chart 16). Unlike in the U.S., the euro area credit impulse is now negative (Chart 17). Euro area financial conditions have also tightened significantly relative to the U.S. (Chart 18). Chart 16Euro Area Economic ##br##Surprises Edging Lower Euro Area Economic Surprises Edging Lower Euro Area Economic Surprises Edging Lower Chart 17Negative Credit Impulse In The Euro ##br##Area Will Weigh On Growth Negative Credit Impulse In The Euro Area Will Weigh On Growth Negative Credit Impulse In The Euro Area Will Weigh On Growth Chart 18Diverging Financial Conditions ##br##Favor U.S. Over The Euro Area Diverging Financial Conditions Favor U.S. Over The Euro Area Diverging Financial Conditions Favor U.S. Over The Euro Area Meanwhile, EUR/USD has appreciated more since 2016 than what one would expect based on changes in interest rate differentials (Chart 19). Speculative positioning towards the euro has also gone from being heavily short at the start of 2017 to heavily long today (Chart 20). Reasonably cheap valuations and a healthy current account surplus continue to work in the euro's favor, but our best bet is that EUR/USD will give up some of its gains over the coming months. Chart 19The Euro Has Strengthened More Than ##br##Justified By Interest Rate Differentials The Euro Has Strengthened More Than Justified By Interest Rate Differentials The Euro Has Strengthened More Than Justified By Interest Rate Differentials Chart 20Euro Positioning: From Deeply ##br##Short To Record Long Euro Positioning: From Deeply Short To Record Long Euro Positioning: From Deeply Short To Record Long Lastly, the Canadian dollar and Mexican peso came under pressure this week on news reports that the U.S. will be pulling out of NAFTA negotiations. Of the four items discussed in this section, this is the one that worries us most. The global supply chain has become highly integrated. Anything that sabotages it would be greatly disruptive. At some level, Trump realizes this, but he also knows that his base wants him to get tough on trade, and unless he does so, his chances of reelection will be even slimmer than they are now. Ultimately, we expect a new NAFTA deal to be reached, but the path from here to there will be a bumpy one. Housekeeping Notes Our long global industrials/short utilities trade is up 12.4% since we initiated it on September 29. We are raising the stop to 10% to protect gains. We are also letting our long 2-year USD/Saudi Riyal forward contract trade expire for a loss of 2.9%. Given the recent improvement in Saudi Arabia's finances, we are not reinstating the trade. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 My thanks to Igor Vasserman, President of SHIG Partners LLC, for his valuable insights on this topic. 2 Please see Global Investment Strategy Special Report, "Bitcoin's Macro Impact," dated September 15, 2017; and Global Investment Strategy Weekly Report, "Don't Fear A Flatter Yield Curve," dated December 22, 2017. 3 Please see Energy Sector Strategy Weekly Report, "Breakeven Analysis: Shale Companies Need ~$50 Oil To Be Self-Sufficient," dated March 15, 2017. 4 Dani Burger, "Short-Volatility Funds Are Being Flooded With Cash," Bloomberg, November 6, 2017. 5 Please see Global Investment Strategy Special Alert, "End Of The 35-year Bond Bull Market," dated July 5, 2016. 6 Please see Foreign Exchange Strategy, "Yen: QQE Is Dead! Long Live YCC!" dated January 12, 2018. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Environmental reforms in China continue to reduce steelmaking capacity. The shuttering of illegal induction facilities in China also is tightening markets. Although official Chinese steel output is higher, this likely reflects the fact that output from illegal induction mills went unreported - and thus uncounted - while production from legal mills is increasing to fill the gap left by closures. Steelmakers' profits are surging, which means demand for iron ore in China will remain stout at least through 1H18. Copper has been well bid since June 2017, following supply disruptions and strong demand growth driven by the global economic upturn. We expect it will get an additional lift in 1H18, as wiring and plumbing in construction projects now absorbing steel in China get underway. Later, global growth will make up for any slowdown in China. Our analysis indicates the global steel market will be tightening in 1H18, as it already is doing in China. Consistent with this, we are opening a tactical long position in Mar/18 steel rebar futures on the Shanghai Futures Exchange, which are quoted in RMB/ton. We are including a 10% stop loss on this recommendation. Energy: Overweight. Our once-out-of-consensus oil view is now the consensus, so we are taking profits on Brent and WTI $55 vs. $60/bbl call spreads on May- and July-delivery oil at tonight's close. These positions were up 109.2% and 123.5% at Tuesday's close. Any sell-offs will present an opportunity to re-establish length along these forward curves. Base Metals: Neutral. Copper will remain well bid this year as the global economic recovery rolls on. A large number of contract renegotiations at mines is an additional upside risk to copper prices this year. Precious Metals: Neutral. Given our expectation of four rate hikes by the Fed, it is difficult to get too bullish gold. However, any indication the central bank is tilting dovish - particularly if we fail to see higher inflation this year - will rally the metal. Ags/Softs: Underweight. Markets will tread water until Friday's USDA WASDE. We remain underweight, except for corn. Feature Chart of the WeekIron Ore And Steel Prices Diverged In 2017 Iron Ore And Steel Prices Diverged In 2017 Iron Ore And Steel Prices Diverged In 2017 China's environmental policy actions have reduced world steel-making capacity by 100 mm MT between 1H16 and 1H18. This is most visible in Chinese steel prices, which gained more than 30% in 2017, following an almost 80% increase in 2016. The total gain in steel prices since the start of Beijing's focus on steel-market reforms is a resounding 135%. Iron ore prices posted similar gains to steel in 2016 but diverged sharply in 2017, slumping more than 40% between mid-March and mid-June - ending almost 8% lower year-on-year (yoy) (Chart of the week). Soaring steel prices pushed profit margins at Chinese mills higher, which, of course, fed through to demand for iron ore, the critical steel-making ingredient in China, toward year-end: Iron ore prices were up 20% in the last two months of 2017. How Did We Get Here? A Recap Of China's Steel Sector Reforms As part of its reforms aimed at reducing air pollution by eliminating outdated, excess industrial capacity, Beijing pledged to eliminate 100-150 mm MT of steel capacity over the 2016-2020 period. To date it has shuttered an estimated 100 mm MT of capacity. In addition to these reforms Beijing pledged to shut down smaller induction furnaces in China, which melt scrap steel, and produce steel of shoddy quality. These induction furnaces are estimated to account for 80-120 mm MT worth of annual capacity, although their actual output is far less: They produced an estimated 30-50 mm MT in 2016, according to S&P Global Platts.1 This is less than 7% of China's total crude-steel output. Production cuts from induction mills are not evident in official data - China's crude steel production figures have continued to rise amid these cuts, as we discussed in previous research (Chart 2).2 Data from the International Iron and Steel Institute shows global steel output was at a record high for the first 11 months of 2017, increasing by more than 5% yoy. Likewise, crude steel output from China - which accounts for 50% of global output - peaked in August: Output over the same period was the highest on record, increasing by 5.28% compared to the same period in 2016. This production paradox can be put down to the fact that many Chinese induction furnaces are illegal, and, as a result their output is not accounted for in official production data. As legal steelmakers ramped up their output to offset declines from the closed down induction furnaces, official crude production figures climbed. In fact, further examination of Chinese steel data makes it clear that China's steel market is in fact tighter than what can be inferred from the crude production figures (Chart 3). The following observations point to a strained market: While China's crude steel production has been paving new record highs, China Stat Info data reveals a contradictory picture about steel products. Output of steel products in the March to November period of 2017 came in 3.46% lower yoy, marking the first yoy decline for that period since 1995! While crude steel produced by induction furnaces would not be included in official crude steel figures, the metal would eventually be used to manufacture steel products - wires, rods, rails and bars, and are represented in this data. Thus the decline in steel products indicates that lower crude supply has weighed down on the output of steel products. China's steel exports have been on a downtrend. In theory, this can be due to either an increase in domestic demand or a decrease in foreign demand. Given the healthy state of the global economy, and what we know about steel production in China, we are believers in the former theory. China's exports of steel products are down 30% yoy in the first 11 months of 2017. Aside from the 3.04% yoy decline in 2016, these mark the first annual declines in exports since 2009. In face of lower domestic supply, China has likely reduced its exports in order to satisfy demand from local steel users. China's scrap steel imports fell in 2H17. Unlike blast furnaces which use iron ore as the main input in steelmaking, the shuttered illegal steelmakers use scrap steel which they melt in an induction furnace. Coincident with the elimination of these furnaces, China's imports of scrap steel fell 14.35% yoy in 2H17. This is further evidence of reduced demand for the scrap steel from these furnaces. China steel inventories are falling. In fact steel product inventories in major industrial cities are at record lows (Chart 4). This is a symptom of a tight market with demand outpacing supply, contradicting China's crude steel production figures. Chart 2Record Chinese Production Of Crude Steel##BR##Amid Falling Steel Products Output Record Chinese Production Of Crude Steel Amid Falling Steel Products Output Record Chinese Production Of Crude Steel Amid Falling Steel Products Output Chart 3China Trade Data Evidence##BR##Of Tight Market China Trade Data Evidence Of Tight Market China Trade Data Evidence Of Tight Market Chart 4Steel Inventories##BR##In China Are Falling Steel Inventories In China Are Falling Steel Inventories In China Are Falling Furthermore, according to World Steel Association (WSA), capacity utilization in the 66 countries for which they collect data increased by 3.12 percentage points yoy for the July to November 2017 period to average 72.64%, up from the 69.52% average in the same period of 2016. These observations are evidence that despite the increase in official crude steel production figures, the actual output has in fact fallen and supply is tighter. Whether steel prices will remain buoyed by tight supply hinges on whether China is successful in permanently shuttering excess capacity and shoddy steel producers, or if induction furnace operators are able to circumvent these policies and bring illegal steel back to the market. China's Reforms To Dominate Steel Market, At Least This Winter Following the conclusion of the mid-December Central Economic Work Conference, Chinese authorities announced the "three tough battles" for the next three years, which they see as crucial for future economic prosperity. These battles are summarized as (1) preventing major risks, (2) targeted poverty alleviation, and (3) pollution control. The International Energy Agency (IEA) estimates that air pollution has led to ~1 million premature deaths while household air pollution caused an additional 1.2 million premature deaths in China annually.3 Because of this, improving China's air quality is a chief social and health target for China. Chart 5Lower Chinese Steel Production##BR##Will Impact Global Output Lower Chinese Steel Production Will Impact Global Output Lower Chinese Steel Production Will Impact Global Output This will mean that measures to reduce pollution and clear China's skies will be critically important to the steel sector. According to the Ministry of Environmental Protection, China has pledged a 15% yoy reduction in the concentration of airborne particles smaller than 2.5 microns in diameter - known as PM2.5 - in 28 smog-prone northern cities. The steel industry, which is mostly concentrated in the northern China region of Beijing-Tianjin-Hebei, is one of the top sources of air polluting emissions in that region. In fact, industrial emissions - most notably from the steel and cement sectors - are reportedly responsible for 40-50% of these small airborne particles. China's winter smog "battle plan" will target these polluting industries by mandating cuts on steel, cement, and aluminum production during the smog-prone mid-November to mid-March months, as well as restricting household coal use, diesel trucks and construction projects. Steel production cuts target a range between 30-50%, which, according to Platts estimates, will take 33 mm MT of steel production - equivalent to ~3.9% of China's projected 2017 crude steel output - offline during the winter. In fact, according to China's environment minister, Li Ganjie, "these special campaigns are not a one-off, instead it is an exploration of long-term mechanisms."4 Thus, these cuts may become a recurring event in China's steel sector. China's official crude steel figures are beginning to show the impact of these cuts with November crude production falling 8.6% month-on-month (mom) and growing by just 2.2% yoy - significantly slower than the 7.6% yoy average experienced since July. As a consequence, although crude production in the rest of the world grew in line with previous months, global steel output fell almost 6% month-on-month in November, while yoy production grew 3.7% – a significant deceleration from the average 6.6% yoy rate witnessed since the beginning of 2H17 (Chart 5). Risks to this outlook come from weak compliance with these cuts. There are recent reports of evasions by aluminum and steel producers in Shandong. Nonetheless, given China's focus on these reforms, we do not foresee widespread violations. Another risk comes from the demand side. As part of its environmental agenda, Beijing announced plans put off the construction of major public projects in the city - road and water projects - until springtime. The suspension is not intended to impact "major livelihood projects" such as railways, airports, and affordable housing. Construction is the largest end user for steel - according to WSA more than half of global steel is used for buildings and infrastructure - a slowdown in the construction sector would weigh on steel demand.5 If other major construction zones adopt a similar policy, the impact of lower steel supply will be offset by weak demand, muting the overall effect on the steel market. Bottom Line: We expect to see lower steel production and exports from China in the coming months. Given Xi Jinping's resolve to improve air quality, we expect compliance to environmental reforms among steelmakers to be strong this winter. This, along with lower output from induction furnaces in China, indicates the market could be tighter than is commonly supposed at least in 1H18. The likelihood the global economic recovery and expansion persists through 2018 suggests steel markets could remain well bid in 2H18, particularly if, as we expect, growth ex-China picks up the slack resulting from any slowdown in China. However, we will need to see what the actual reforms for the industry look like following the National People's Congress in March 2018.6 Steel Profit Margins Spur Iron Ore Demand Given steel's exceptional price gains over the past two years, and iron ore's lackluster performance in 2017, profit margins at China's steel producers reached multi-year highs (Chart 6). Ordinarily, this would normally encourage steel production, which would flood the market with supply and push prices down. However, China's environmental reforms will cap output from the country's most productive steelmaking region in coming months. Consequently, unless there are mass policy violations by steel producers this winter, we do not anticipate a swift price adjustment lower. Instead, steel producers are preparing to run on all cylinders when production restrictions are lifted in the spring. As such, they are filling iron ore inventories and taking advantage of weaker iron ore prices, before the iron ore market catches up with steel. China's iron ore imports reached an all-time record in September, while the latest data shows a 19% month-on-month (mom) jump in imports, corresponding with a 2.8% yoy increase (Chart 7). Chart 6Healthy Steel##BR##Profit Margins Healthy Steel Profit Margins Healthy Steel Profit Margins Chart 7Steel Producers Stocking Up On Iron Ore##BR##In Preparation For Spring Steel Producers Stocking Up On Iron Ore In Preparation For Spring Steel Producers Stocking Up On Iron Ore In Preparation For Spring This runs counter to what we expect during a period of muted steel production. Especially in an environment of healthy iron ore inventories, as China is in currently. Although Chinese inventories came down from mid-year peaks, they resumed their upward trend in 4Q17. This coincides with the steel winter capacity cuts, and is likely due to reduced demand for the ore from steel mills. There are two theories to explain this phenomenon: 1. Chinese steelmakers are taking advantage of lower iron ore prices and locking in higher profit margins, in anticipation of higher iron ore prices once steel production picks up again in the spring. 2. Amid the winter cuts, China's steelmakers are demanding high-grade iron ore, imported from Brazil and Australia. This will help them ensure that they are able to maximize their output without violating environmental policies. Environmental Consciousness Widens Iron Ore Spreads A consequence of the steel winter capacity cuts is stronger demand for higher grade raw materials to cut down on the most polluting phases of steel production. Higher-grade iron ore, which is defined by its purity or iron content, is more efficient for blast furnaces to use, allowing them to produce more steel from each tonne of iron ore they consume, maximizing output and profit. This is especially true in a tight steel market, with healthy profit margins: Steelmakers are able to afford the higher grades and are favoring productive efficiency. The discount for lower grade iron ore fines - 58% iron content - as well as the premium for higher grade 65% iron content have widened (Chart 8). This is because mills have found a way to legally circumvent the winter environmental restrictions, and still remain compliant. Furthermore, purer ores are less polluting, which helps serve China's environmental agenda. In addition, the premiums for iron ore pellets and iron ore lumps have also widened. Unlike lumps and pellets which can be fed directly into blast furnaces, fines require a sintering process which is highly polluting. Thus, China's environmental reforms have increased demand for higher grade, less polluting ores. An additional factor that could be driving up spreads is higher metallurgical coke prices (Chart 6). Higher grade iron ore contains less silica and thus requires less met coke to purify the ores. According to anecdotal evidence from China, Carajas fines from Brazil - which have the highest iron ore content and lowest silica content- are reportedly in high demand.7 Furthermore, China's imports show a decline in iron ore from India - which is of the lower grades. In the July to October period, imports fell 11.26% yoy with October imports falling almost 25% yoy and 30% mom. This is consistent with the theory that steel makers are shunning lower grade ores. On the other hand, imports from Brazil and Australia are expected to remain strong (Chart 9). The latest Australian Resources and Energy Quarterly forecasts Australian and Brazilian iron ore exports to grow 5.4% and 4.2% respectively in 2018, while Indian exports are projected to fall 57.5% yoy. Chart 8Wide Iron Ore##BR##Price Spreads Wide Iron Ore Price Spreads Wide Iron Ore Price Spreads Chart 9Environmental Concerns Will Support##BR##Demand For High Grade Iron Ore Environmental Concerns Will Support Demand For High Grade Iron Ore Environmental Concerns Will Support Demand For High Grade Iron Ore Bottom Line: In an effort to keep production high and profit from strong steel prices in face of the winter production cuts, steel producers are turning to higher-grade iron ore, pushing up the spread between high vs. low grade ores. The extent to which steel producers are able to successfully keep production going on the back of higher-grade ores will dampen the impact of the winter production cuts on the steel sector. Given that China's environmental focus is a long term plan, we expect these spreads to remain wide, rather than reverting back to their historic average. Steel Prices And Copper Markets Chart 10Steel Consumption Helps##BR##Predict Copper Prices Steel Consumption Helps Predict Copper Prices Steel Consumption Helps Predict Copper Prices The copper market had a roller coaster fourth quarter. Prices for the red metal were on a general uptrend since May, and first peaked in early September at $3.13/lb before bottoming at $2.91/lb by the second half of that month. Shortly thereafter, copper prices peaked at a new high of $3.22/lb by mid October - their highest in more than three years. Fears of a slowdown in China following messaging from the 19th Communist Party Congress caused the metal to lose almost 10% of its value, when it bottomed for the second time in early December. In fact, this coincided with a 4.65% decline in the price on December 5. While there is no clear justification for this fall, it can be put down to a mix of factors including a ~10 th MT increase in LME inventories, worries about a China slowdown, as well as a liquidation of positions ahead of the new year. Nonetheless, copper has since regained these losses to end the year at $3.28/lb. In our modelling of copper, we find that steel consumption is significant in forecasting future copper price behavior. More specifically, China's steel consumption has a significant positive relationship with copper prices 6 months into the future (Chart 10). This can be explained by the importance of the construction sector as an end user of both materials. However, each metal goes into the construction site at different time frames. While steel products are used in the construction of the structures, and thus are needed at the beginning of the project, copper is used in the electrical wiring and plumbing, and is thus needed later (6 months or so) in the project. This is in line with our findings that steel is most significant with a six-month lag - reflecting the average time period between which the structure is built and the plumbing and wiring are needed. Steel consumption in China is a useful leading indicator of copper markets when demand side fundamentals are dominating steel and copper markets. Government stimulus and a solid construction sector boosted China's steel demand in 2017. However, according to the WSA Short Range Outlook, demand for steel will moderate this year on the back of reflation in China, partially offset by strong global growth. WSA notes that the closure of induction furnaces skewed up steel demand growth figures to 12.4% yoy, and instead cite a more reasonable estimate along the lines of 3% yoy steel demand growth from China in 2017, bringing the global steel demand growth rate to 2.8%. While steel demand outside of China grew by an estimated 2.6% in 2017, they foresee it reaching 3% in 2018. In contrast, they expect flat demand from China in 2018, bringing world steel demand growth to 1.6% in 2018 (Table 1). Table 1Steel Demand (yoy Growth Rates) China's Environmental Reforms Drive Steel & Iron Ore China's Environmental Reforms Drive Steel & Iron Ore Moderating demand from China and the stability (or lack thereof) of the supply-side will dominate the copper market this year. On the demand side, China's steel market offers insight about the future direction of the red metal. Bottom Line: Given China's appetite for steel has remained healthy to date and is projected to maintain its 2017 level this year, we do not expect a demand-induced plunge in copper prices in the 6 month horizon. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see "Will China's induction furnace steel whac-a-mole finally come to an end?" published by S&P Global Platts March 6, 2017. 2 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Slow-Down In China's Reflation Will Temper Steel, Iron Ore In 2018," published September 7, 2017, available at ces.bcaresearch.com. 3 Please see IEA World Energy Outlook 2016 Special Report titled "Energy and Air Pollution," available at iea.org. 4 Please see "Provincial China officials used fake data to evade aluminium, steel capacity curbs - China Youth Daily," published on December 26, 2017, available at reuters.com. 5 Please see "Steel Markets" at worldsteel.org. 6 For additional discussion, please see "Shifting Gears in China: The Impact On Base Metals," in the November 9, 2017, issue of BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 7 Please see "High-medium grade iron ore fines spread widens to all-time high of $23.55/dmt," published August 22, 2017, available at platts.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table China's Environmental Reforms Drive Steel & Iron Ore China's Environmental Reforms Drive Steel & Iron Ore Trades Closed in 2017

Highlights The beta of Chinese stocks has been steadily increasing over the past few years, versus both emerging markets and global stocks. Rising relative currency volatility has likely durably increased the cyclicality of Chinese stock prices. The high-beta nature of Chinese investable stocks suggests that they should be favored when the EM and global stock benchmarks are rising. This supports our current overweight stance. A portfolio strategy that favors equity sectors with high alpha significance has outperformed the broad investable market by a non-trivial amount over time, without adding to portfolio risk. Barring a few exceptions, the model's current allocation is generally consistent with our theme of a benign slowdown in Chinese economic growth. Feature Chart 1Beta Matters, But So Does Alpha Beta Matters, But So Does Alpha Beta Matters, But So Does Alpha While concepts such as alpha, beta, and correlation are frequently applied by investment managers at the security or sector level, they are less commonly employed from a top-down regional equity perspective and are rarely examined as a time series. In addition, the concept of alpha persistence (i.e. alpha that is persistently positive or negative) is also frequently ignored by investors, despite it having significant implications for portfolio returns. This is vividly illustrated by the relative performance of developed commodity markets during the last economic expansion: these countries resoundingly outperformed a rising global benchmark from 2000 to 2007, despite having a market beta that averaged one over the period (Chart 1). This seeming inconsistency is explained by persistent volatility-adjusted outperformance throughout the period (panel 3), underscoring the importance of tracking this measure from a top-down perspective. In this report we examine the recent evolution of MSCI China's alpha and beta versus both the emerging market (EM) and global benchmarks. We conclude that China is no longer a low-beta market (supporting an overweight stance), and also present a simple alpha-based sector model for Chinese investable stocks that has generated impressive outperformance over time without adding to portfolio risk. The Evolution Of China's Alpha & Beta Chart 2 presents the evolution of alpha and beta for Chinese investable stocks since 2010, versus the emerging market and global index. Given the significant outperformance of the technology sector over the past year, we also present this analysis in ex-tech terms. The values shown in Chart 2 are calculated using a standard single-factor model approach to estimating alpha and beta, namely a regression of weekly stock price returns in US$ terms in excess of the return from U.S. short-term Treasury bills on excess returns of the benchmark index.1 The chart yields the following observations: The beta of Chinese stocks has been steadily increasing over the past few years, versus both emerging markets and global stocks, regardless of whether the tech sector is removed from the picture. Chinese stocks had a beta of 1.4 versus their global peers in 2017, placing it in the 80th percentile of all country equity market betas for the year. Chinese stocks earned a modestly negative alpha vs global stocks in 2016, which was even larger when compared to the EM benchmark. This likely occurred because of lower exposure to resource-oriented sectors, given the significant rebound in commodity prices in 2016. Chinese stocks experienced a surge in alpha in 2017, even excluding technology stocks. In 2017, in all cases (vs EM and global, including or excluding tech) Chinese equities moved into the top right alpha/beta quadrant, which is the quadrant that offers the highest return to investors when the benchmark is rising. This is a remarkable development given that there were indications of a peak in Chinese economic momentum in the first half of the year, and suggests that investors do not view the ongoing slowdown as being problematic for investable equity performance. Chart 2 raises the obvious question of why China has become a higher beta market. We have two theories, but only the second one appears to fit the data. The first theory is that the establishment of the stock connect in late-2014 caused a volatility spillover from China's domestic stock market into the investable market. But while it is true that A-shares were considerably riskier than investable stocks in late-2015 / early-2016, Chart 3 makes it clear that A-shares have not historically been much more volatile than investable stocks. In addition, Chart 2 underscores that the rise in China's market beta since 2014 has been persistent, whereas A-shares in 2017 recorded their lowest share price volatility in over 15 years. So to us, this does not appear to be the most probable explanation. Chart 2China Has Become A High-Beta Market China: No Longer A Low-Beta Market China: No Longer A Low-Beta Market The second theory, which seems much more likely, is that the rising currency volatility has increased the cyclicality of Chinese stock prices. China's decision to devalue the RMB in August 2015 clearly led to a period of significantly increased capital controls, but Chart 4 highlights that the CNY/USD exchange rate has steadily become more volatile. This is especially true when compared with a basket of emerging market currencies, with CNY/USD actually being more volatile than the basket over the past year. Chart 3The Stock Connect Does Not Explain##br## The Rise In China's Beta The Stock Connect Does Not Explain The Rise In China's Beta The Stock Connect Does Not Explain The Rise In China's Beta Chart 4Rising Relative Currency Volatility ##br##= Higher Beta Rising Relative Currency Volatility = Higher Beta Rising Relative Currency Volatility = Higher Beta While it is certainly true that Chinese policymakers have stepped up their management of the currency by tightening capital controls over the past year, the PBOC's decision to pursue its "partial" version of the impossible trinity still implies, in our view, that RMB volatility will now be structurally higher than what prevailed on average prior to August 2015.2 This suggests that China's equity market beta will be durably higher than before, absent a presently negative correlation between CNY/USD and EM or global stock prices. Bottom Line: The beta of Chinese stocks has been steadily increasing over the past few years, versus both emerging markets and global stocks. Rising relative currency volatility has likely durably increased the cyclicality of Chinese stock prices. Investment Implications Of China's Recent Relative Performance There are two clear investment strategy implications from Chinese equities becoming a high-beta asset. The first is that Chinese investable stocks are now a pro-risk asset to be favored when the EM and global stock benchmarks are rising. Chart 5 shows that both are currently well above their 200-day moving averages, which supports our overweight stance towards China. The second is that when comparing the performance of China's overall investable index versus that excluding technology, it is clear that a non-trivial amount of the alpha earned by China's overall index in 2017 came from the tech sector. This suggests that a reversal of the high-flying performance of Chinese technology stocks is a material risk to our overweight stance towards Chinese equities. For now, this high-alpha outperformance appears to be fundamentally-based: Chart 6 highlights that forward earnings for Chinese tech shares have risen enormously relative to the investable benchmark over the past three years, a trend that we have noted appears to be driven by Chinese consumer demand (and thus unlikely to decline over the coming year).3 In addition, the relatively modest but positive alpha earned by Chinese ex-tech stocks in 2017 was likely driven by extremely cheap valuation, and these multiples remain quite low relative to other countries. We highlighted in our December 7 Weekly Report that the relative re-rating of Chinese investable ex-tech stocks was a key theme for 2018,4 suggesting that there is room for further re-rating/alpha if China's economic slowdown remains benign (as we expect). Chart 5Investors Should Overweight ##br##Chinese Stocks In This Environment Investors Should Overweight Chinese Stocks In This Environment Investors Should Overweight Chinese Stocks In This Environment Chart 6Tech's Recent Alpha Appears ##br##Fundamentally-Based Tech's Recent Alpha Appears Fundamentally-Based Tech's Recent Alpha Appears Fundamentally-Based Bottom Line: The now high-beta nature of Chinese investable stocks suggests that they are a pro-risk asset to be favored when the EM and global stock benchmarks are rising. This supports our current overweight stance. Alpha, Applied: A Simple Sector Model For Chinese Investable Stocks We noted earlier that the concept of alpha has had significant implications for regional equity portfolio returns in the past. In order to test the predictive power of alpha within the context of a Chinese equity portfolio, we evaluate the returns of an investment strategy that allocates to China's investable equity sectors based on the significance of alpha. Table 1 presents statistics summarizing the performance of this sector alpha portfolio relative to the overall investable market, Table 2 shows the portfolio's current sector allocation, and Chart 7 illustrates the cyclical behavior of the portfolio's relative performance trend since 2004. Several important conclusions emerge: Table 1An Alpha-Based Sector Model Has Historically Outperformed ##br##China's Investable Stock Market China: No Longer A Low-Beta Market China: No Longer A Low-Beta Market Table 2Sector Alpha Portfolio Weights Are Generally Consistent With ##br##A Benign Growth Slowdown China: No Longer A Low-Beta Market China: No Longer A Low-Beta Market The model has outperformed the broad investable market by an impressive 235 bps per year without appearing to take on any additional risk. Measured either as volatility or drawdown, the riskiness of the portfolio appears to be the same as that of the overall investable market. The outperformance of the model occurs in spurts, but sustained periods of underperformance are not common. The 2007-2009 period served as an exception to this rule, but even in this case the cumulative underperformance of the model vs the investable index was not large (roughly 6%). Chart 7Impressive Outperformance Over Time Impressive Outperformance Over Time Impressive Outperformance Over Time The model is currently underweight financials (significantly), energy, industrials, telecoms, and utilities. Overweights are concentrated in the tech sector, real estate, health care, and consumer stocks. For now, these weights are generally consistent with our benign slowdown scenario, although there are some potential exceptions to monitor (such as the overweight stance towards real estate and materials). Bottom Line: A portfolio strategy that favors equity sectors with high alpha significance has outperformed the broad investable market by a non-trivial amount over time, without adding to portfolio risk. Barring a few exceptions, the model's current allocation is generally consistent with our theme of a benign slowdown in Chinese economic growth. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 China: No Longer A Low-Beta Market China: No Longer A Low-Beta Market 2 Please see China Investment Strategy Weekly Report, "How Will China Manage The Impossible Trinity", dated December 8, 2016, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability of China's Business Cycle", dated November 30, 2017, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report, "Three Themes For China In The Coming Year", dated December 7, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Chinese policymakers are walking a tightrope, attempting to balance contradictory objectives. While their task is not impossible, we find that financial markets are overly complacent. Recent price action in EM risk assets resembles a final bear capitulation phase, and a classic top formation. Currency appreciation and moderation in export growth will damp corporate profits of exporters in Korea and Taiwan. Stay short KRW versus THB and short MYR versus RUB and USD. Feature "...at first, a stick may bend under strain, ready all the time to bend back, until a certain point is reached, when it breaks." Irving Fisher, The Debt-Deflation Theory of Great Depressions (1933) China continues to tighten financial regulations1 and onshore corporate bond yields keep marching higher. Yet EM and China-related financial markets have been extremely buoyant, completely ignoring the tightening dynamics underway. This reminds us of the above quote from Irving Fisher. The Chinese economy has been able to "...bend under strain, ready all the time to bend back..." In other words, growth has so far done well, despite ongoing liquidity and regulatory tightening (Chart I-1). This has led many investors and commentators to proclaim that the economy is healthy and will slow only a bit, or not at all. Chart I-1China: Will Economy Continue ##br##Defying Weak Credit Impulse? China: Will Economy Continue Defying Weak Credit Impulse? China: Will Economy Continue Defying Weak Credit Impulse? Yet, financial market risks linger. At a certain point, cumulative pressure from policy tightening will cause China's recovery to falter - "break," as per Fisher's quote above - impacting the rest of the world in general and EM in particular. This precept is pertinent to China at present because its money, credit and property markets are frothy, as we have written repeatedly in recent years, making them especially vulnerable to tightening. We thought such a deceleration in China's business cycle would occur in 2017, but it has not yet transpired. Forward-looking indicators such as money supply growth and the yield curve have been heralding a growth slowdown for many months (see Chart I-1). Nevertheless, this recovery has proved to be enduring; even though some segments have slowed, overall nominal growth, corporate pricing power and profits have done well. Does such growth resilience warrant an upgrade on China's outlook? An economy's past performance does not guarantee its future performance. This is relevant to China now, especially given the cumulative impact of the ongoing triple policy tightening - liquidity, regulatory and anti-corruption efforts in the financial industry2 - which will likely be substantial. Walking A Tightrope China's policymakers are walking a tightrope trying to balance contradictory objectives such as curbing financial speculation and credit excesses, capping inflation and maintaining a stable currency on the one hand, and maintaining robust growth on the other. Inflationary pressures are escalating in the mainland economy. Chart I-2 demonstrates that pricing power for 5,000 industrial companies - a diffusion index for producer prices compiled by the People's Bank of China - is approaching its 2007 and 2010 highs, while nominal interest rates are currently much lower than they were in 2007 and 2010 (Chart I-2, bottom panel). Notably, most of China's nominal recovery in the past two years has been due to prices, not volumes (Chart I-3). Given that rising prices benefit corporate profits much more than rising volumes, Chinese corporate profits have surged. Yet, the flip side of these dynamics is rising inflation. Chart I-2China: Inflationary Pressure Are Rising, ##br##While Interest Rates Are Low China: Inflationary Pressure Are Rising, While Interest Rates Are Low China: Inflationary Pressure Are Rising, While Interest Rates Are Low Chart I-3China: It Has Been Nominal (Price) Not ##br##Volume Manufacturing Recovery China: It Has Been Nominal (Price) Not Volume Manufacturing Recovery China: It Has Been Nominal (Price) Not Volume Manufacturing Recovery Mounting inflation amid enormous money excesses - the Chinese banking system has originated RMB 142 trillion (equivalent to $22 trillion) since January 20093 - risks triggering rising inflation expectations, which would then feed back into inflation. With real interest rates already extremely low (Chart I-4), increasing inflation expectations could lead to growing demand for foreign currency, in turn exerting downward pressure on the RMB exchange rate. Chart I-4China: Inflation-Adjusted ##br##Interest Rates Are Low China: Inflation-Adjusted Interest Rates Are Low China: Inflation-Adjusted Interest Rates Are Low Chinese households have been uneasy about the real (inflation-adjusted) value of their deposits, and have been opting for speculative investments that promise higher yields than bank deposits. Hence, policymakers cannot ignore households' desire for higher real interest rates if they aim to cool down speculative investment activities and contain systemic risks in the system. Overall, the authorities need to tread carefully, balancing between the need to preserve decent growth while keeping inflation at bay. Falling behind the inflation curve is as dangerous as being too aggressive in tightening. For now, rising domestic inflationary pressures, robust DM growth and the resilience of financial markets will justify further policy tightening in China. Controlling leverage, curbing financial market excesses and limiting speculation in the real estate market are all major components of the structural reforms agenda that China's top policymakers committed to at the Party Congress in October. Bottom Line: Chinese policymakers are walking a tightrope, trying to balance contradictory objectives. While their task is not impossible, we find that financial markets are overly complacent. The odds of successfully navigating these contradictory objectives amid lingering money, credit and property market imbalances are 30% or lower. In the meantime, financial markets seem priced for perfection. This gap between the market's views and our perception of risks leads us to maintain a negative investment stance. EM's Blow-Out Phase EM stocks and currencies have gone vertical in recent weeks, despite being overbought and not cheap. The recent price actions in EM and global risk assets looks like a final bear capitulation phase and a classic top formation. The EM overall equity and small-cap indexes have reached their 2011 high (Chart I-5, top and middle panels). Meanwhile, EM high-yield (junk) corporate and quasi-sovereign bond yields are at their historical lows (Chart I-5, bottom panel). Economic data, corporate profits and news flows are typically extremely positive at tops of cycles, and very negative at bottoms. Given that share prices have surged and credit spreads are extremely low, a lot of good news has already been discounted. In particular, EM long-term EPS growth expectations have shot up above their previous highs (Chart I-6). This indicator can serve as a proxy for investor sentiment on EM stocks, at the moment suggesting extreme bullishness. EM stocks topped out in the past when this indicator reached the current levels. Chart I-5Are EM At Their Zenith? Are EM At Their Zenith? Are EM At Their Zenith? Chart I-6Analysts Are Super Bullish On EM Profits Growth Analysts Are Super Bullish On EM Profits Growth Analysts Are Super Bullish On EM Profits Growth Needless to say, global investors' positioning is stretched in favor of risk assets. Chart I-7 entails that U.S. individual investors' holdings of cash was at a record low as of December, while their exposure to equities was not far from record highs. Apart from China-related risks, a potential rise in U.S. bond yields and/or the U.S. dollar, could spoil the EM party. Many investors have invested in EM on the assumption of continued weakness in the greenback and subdued U.S. bond yields. It would be unusual if this current robust global growth does not lead to higher inflation expectations or higher bond yields. With respect to market signals, Chart I-8 illustrates that global steel stocks in absolute terms, and the relative performance of emerging Asian stocks versus DM equities have approached their very long-term moving averages. The latter might become a major technical resistance. Failure to break above this resistance level would be consistent with EM share prices rolling over at their 2011 highs (see Chart I-7). Altogether, this could signal a major top in EM risk assets. Chart I-7Asset Allocation Of ##br##U.S. Individual Investors Asset Allocation Of U.S. Individual Investors Asset Allocation Of U.S. Individual Investors Chart I-8Select Segments Are At Their ##br##Long-Term Technical Resistances Select Segments Are At Their Long-Term Technical Resistances Select Segments Are At Their Long-Term Technical Resistances Bottom Line: The EM rally has endured much longer and has gone much farther than we envisioned. However, we maintain our cautious stance, and recommend underweighting EM stocks, currencies and credit versus their DM counterparts. Emerging Asia: Currencies And Business Cycle Chart I-9Geopolitics And Asian Currencies Geopolitics And Asian Currencies Geopolitics And Asian Currencies Emerging Asian currencies have recently been on the fly, surging versus the U.S. dollar. Apart from strong global manufacturing, one reason behind the emerging Asian currency appreciation has been geopolitics. We suspect political leaders in Taiwan and Korea have instructed their central banks to allow their currencies to appreciate to gratify the Trump administration's aspirations of a weaker greenback. The top panel of Chart I-9 shows that the Taiwanese dollar's sharp appreciation coincided with Trump's controversial phone call with the Taiwanese president on December 3rd, 2016. Similarly, Trump's visit to South Korea on November 7th, 2017 jives with the latest up leg in the Korean won (Chart I-9, bottom panel). It seems President Trump's geopolitical assurances to Taiwan and Korea are somewhat tied to these policymakers' increased tolerance for currency appreciation. Notably, foreign exchange reserves in both Taiwan and Korea have risen little, despite their strong trade surpluses and foreign capital inflows over the past year. This confirms that their central banks have been reluctant to purchase U.S. dollars and in turn cap their currencies' appreciation. In addition to the political context, there are a number of other important drivers of Asian exchange rates and the region's business cycle: The growth rate of Korean and Taiwanese total exports in U.S. dollars has moderated (Chart I-10). This, along with KRW and TWD appreciation, implies a meaningful deceleration in exporters' revenue growth in local currency terms. Besides, China's container freight index - the price to ship containers worldwide - has relapsed and it correlates well with Asia's export cycle (Chart I-11). Chart I-10Moderation In Asian Exports Growth Moderation In Asian Exports Growth Moderation In Asian Exports Growth Chart I-11A Negative Signal For Asian Exports A Negative Signal For Asian Exports A Negative Signal For Asian Exports Even though DRAM prices are rising, other semiconductor prices have rolled over (Chart I-12). Semiconductor prices and volumes are vital for the tech-heavy Taiwanese and Korean manufacturing sectors. The RMB rally is also late. Enormous pent-up demand for foreign assets from Chinese residents due to low mainland real interest rates creates the potential for capital outflows to cap RMB strength. This would weigh on the ongoing Asian currency rally. Finally, net EPS revisions of Korean and Taiwanese technology companies' have rolled over (Chart I-13), probably reflecting a dampening effect of currency appreciation. This could in turn lead to foreign capital outflows from their equity markets causing currency selloffs. Chart I-12Divergence In Semiconductor Prices Divergence In Semiconductor Prices Divergence In Semiconductor Prices Chart I-13Asia Tech Companies: Net EPS Revisions Asia Tech Companies: Net EPS Revisions Asia Tech Companies: Net EPS Revisions Corroborating budding signs of a slowdown in exports and corporate profits, emerging Asian stocks have begun underperforming DM equities, as shown in Chart I-8 on page 7. The deceleration in export revenues and currency appreciation are adverse developments for share prices in export-related sectors of Korea and Taiwan. Nevertheless, for dedicated EM equity portfolios, we recommend overweighting the Taiwanese bourse and Korean technology stocks (and being neutral on the rest of KOSPI). The basis is that share prices of hardware tech manufacturers have less downside than other EM sectors. Their attractive relative valuations combined with prospects for robust growth in DM warrant their outperformance against the overall EM equity index in common currency terms. As to exchange rates, the Trump factor will delay and mitigate Asian currency depreciation, but will not preclude it if export growth slows, as we expect. In such a scenario, policymakers in Asia will opt for modest currency depreciation, reversing their recent gains. In terms of investment strategy, we have been shorting the Korean won versus the Thai baht. This trade has so far been flat, but we are maintaining it because the won is a higher-beta currency than the baht, and the former will underperform the latter as Asia's business cycle eventually slows. In addition, we are also shorting the Malaysian ringgit versus the U.S. dollar and the Russian ruble due to weak domestic fundamentals in Malaysia. Bottom Line: Currency appreciation will damp corporate profits of exporters in Korea and Taiwan. This will weigh on EM share prices in aggregate, given that the Korean and Taiwanese markets together account for 27% of the MSCI EM market cap, compared with an 12% share of the entire Latin American region. The 12-month outlook for Asian currencies is downbeat: continue shorting the MYR versus both the U.S. dollar and the RUB, and stay long the THB versus the KRW. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 This week the China Banking Regulatory Commission (CBRC) announced a set of sweeping new rules to control banks' entrusted lending (Source: Caixin). This is in addition to a slew of regulatory measures for financial institutions that have been introduced over the past year. 2 We discussed these in details in Emerging Markets Strategy Weekly Report, titled "Questions For Emerging Markets," dated November 29, 2017, a link available on page 13. 3 Please see Emerging Markets Strategy Special Report, titled "The True Meaning Of China's Great 'Savings' Wall," dated December 20, 2017, a link available on page 13. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights A "decision tree" for the allocation to Chinese stocks highlights several key questions for investors over the coming year. The equity allocation decision hinges on the condition of the global economy, the stance of monetary policy, the pace of structural reforms, and the character of the ongoing economic slowdown. Despite several identifiable risks, our "decision tree" suggests that investors should be overweight Chinese vs global stocks. Feature Unlike in past years, BCA's China Investment Strategy service published its 2018 themes report in December, as an addendum to BCA's special year end Outlook report.1 Our final report for 2017 echoed our key themes by recapping some of the most important developments in China last year, as well as their longer-term implications.2 These reports outline our framework for evaluating China's economy in 2018, and will serve as an important reference point over the coming months relating to the pace of China's economic slowdown, policymakers' actions and priorities, and investor attitudes toward Chinese assets. In today's brief report, we begin the New Year by walking through the Chinese equity "decision tree" that flows from the framework that we detailed in our themes piece noted above (Chart 1). The chart presents a set of questions that should be answered over the coming 6-12 months in order to decide on the ideal allocation to Chinese equities within a global portfolio. We elaborate on the decision tree below. Chart 1The Chinese Equity "Decision Tree" The "Decision Tree" For Chinese Stocks The "Decision Tree" For Chinese Stocks Is The Global Economy Slowing Significantly?: Developments in China need to be considered within a global context. We have noted in previous reports that a synchronized global economic slowdown was a key factor behind China's economic slowdown in 2015.3 If global growth were to slow significantly this year, it would bode poorly for the relative performance of Chinese stocks. Next week's report will discuss the evolution of the alpha and beta characteristics of China's investable stock market; while our research is still ongoing, the evidence suggests that Chinese equities in US$ terms have become a high-beta market that would likely suffer in relative terms if the global equity market stumbles. Chart 1 highlights that the appropriate allocation to Chinese equities vs global stocks is underweight if the answer to this first question is yes, with the upgrade/downgrade bias determined simply by whether there has been an appropriate response from Chinese and global policymakers. Is Significant Further Monetary Policy Tightening Likely?: Overly tight monetary policy was the second ingredient that contributed to the 2015 slowdown. Monetary conditions tightened somewhat in the first half of 2017 (Chart 2), but the overall stance is not restrictive. Taken alone, hawkish rhetoric from the PBOC would imply that significant further tightening is imminent. However our sense is that the bark of monetary authorities will be worse than their bite over the coming months, especially since growth momentum and house price appreciation has already peaked. Is The Pace Of Renewed Structural Reforms Likely To Be Aggressive?: October's Party Congress heralded stepped-up reform efforts in 2018 and beyond, which we have highlighted is a risk to a constructive stance towards Chinese stocks. While the "status quo" scenario of no significant reforms is highly unlikely, the intensity of reforms pursued over the coming year will have to be closely monitored by policymakers to avoid a repeat of the 2015 experience. Even if policymakers feel that their threshold for pain will be higher in 2018 than has previously been the case, they are very likely to avoid a significant slowdown as it would raise the risk of returning to the exact set policies that they are trying to turn away from. In other words, an intense pace of reform would risk turning a "two steps forward, one back" situation into a full-blown retreat from structural reform momentum. For now, our China Reform Monitor continues to suggest that reform intensity will be consistent with a rising equity market (Chart 3). Chart 2Chinese Monetary Conditions ##br##Have Tightened Chinese Monetary Conditions Have Tightened Chinese Monetary Conditions Have Tightened Chart 3Investors Don't Believe That Reforms##br## Will Upset The Apple Cart Investors Don't Believe That Reforms Will Upset The Apple Cart Investors Don't Believe That Reforms Will Upset The Apple Cart Is The Existing Slowdown In China's Growth Momentum Metastasizing? Our view of China's significant growth slowdown in 2015 suggests that the end of the recent economic "mini-cycle" is likely to be benign and controlled, absent a policy mistake or a major global shock. However, it is possible that the lagged effect of a deceleration in export growth and tighter monetary policy, both of which have already occurred, could cause a broader or deeper slowdown in economic growth beyond what we have already observed. In order to gauge this risk, we tested a wide range of commonly-watched macro data series for signs that they reliably lead economic activity in China,4 using the Li Keqiang index as our proxy for the business cycle. We concluded that measures of money & credit are among the most important predictors, and presented a composite leading indicator of the Li Keqiang index based on six series that passed our test criteria (Chart 4). For now, our indicator suggests that the Chinese economy will continue to slow over the coming months, but that the pace and magnitude of the decline will be benign and controlled. The first question in our decision tree is the easiest to answer: The highly synchronized nature of global economic growth suggests that a significant slowdown is not imminent, even if the pace of growth becomes narrower or slows modestly (Chart 5). While our decision tree highlights that answering "yes" to any of the last three questions means that investors should have a negative bias towards Chinese investable stocks (and should downgrade them in response to a technical breakdown), these questions are still addressing risks rather than probable events. This supports our current recommendation of being overweight Chinese investable equities with a positive bias. Chart 4The Chinese Economy##br## Will Gradually Slow The Chinese Economy Will Gradually Slow The Chinese Economy Will Gradually Slow Chart 5No Sign Of A Significant ##br##Global Economic Slowdown No Sign Of A Significant Global Economic Slowdown No Sign Of A Significant Global Economic Slowdown As a final point, some investors and market participants have noted that investable Chinese stocks experienced a non-trivial selloff at the end of 2017, with some questioning whether it is a harbinger of a more pronounced economic slowdown. Our answer is no, for two reasons. First, there is some evidence to suggest that the selloff was technical in nature, as the sectors that had experienced the largest gains prior to the selloff also experienced the largest declines (Chart 6). Second, the timing of the relative selloff in Chinese stocks coincided exactly with a relative selloff in the global tech sector (Chart 7), which is strongly indicative of a common, global, factor. But given the underlying strength in the global economy, we regard this event as idiosyncratic and do not view it as a threat to the relative performance of Chinese vs global stocks over the coming year. Chart 6The Late-Year Selloff Was Partially ##br##Driven By Technical Conditions The "Decision Tree" For Chinese Stocks The "Decision Tree" For Chinese Stocks Chart 7Global Tech Also Drove The Selloff##br## In Chinese Relative Performance Global Tech Also Drove The Selloff In Chinese Relative Performance Global Tech Also Drove The Selloff In Chinese Relative Performance Bottom Line: While there are several identifiable risks that need to be monitored in 2018, for now our "decision tree" for the relative allocation to Chinese equities suggests that investors should be overweight within a global equity portfolio. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see BCA Special Report, "2018 Outlook - Policy And The Markets: On A Collision Course," dated November 20, 2017, and Weekly Report, "Three Themes For China In The Coming Year", dated December 7, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Legacies Of 2017", dated December 21, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "Tracking The End Of China's Mini-Cycle", dated October 12, 2017, and "China's Economy - 2015 vs Today (Part 1): Trade", dated October 26, 2017, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle", dated November 30, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Feature Chilean stocks have surged recently following the victory of conservative businessman Sebastian Pinera in the presidential elections. Odds are that we could be witnessing the beginning of a period of Chilean outperformance against the EM equity benchmark, rather than just a short-term political relief rally. Pieces have fallen into place to produce a re-rating in Chilean equities relative to other emerging markets, as illustrated by the top panel of Chart I-1. The cyclically adjusted P/E ratio shows that Chilean stocks are cheap relative to their EM peers. Furthermore, Chilean stocks in common currency terms are presently near a 20-year bottom relative to EM equities (Chart I-1, bottom panel). Hence, just from a mean reversion perspective, Chile's performance relative to EM stocks has the potential to rise. Besides the above points, Chile's business cycle and monetary policy also warrant this bourse's outperformance versus the EM benchmark. A Sweet Spot For Equities There are several signs that the business cycle has passed its bottom and is slowly recovering (Chart I-2). Chart I-1Chilean Stocks Relative To EM Chilean Stocks Relative To EM Chilean Stocks Relative To EM Chart I-2Chilean Economy Is Reviving... Chile: Money And Economic Activity Are Bottoming Out Chilean Economy Is Reviving... Chile: Money And Economic Activity Are Bottoming Out Chilean Economy Is Reviving... Moreover, there are also several factors that will lead the Central Bank of Chile (CBC) to keep monetary policy easy for the coming 6-12 months. This will create a sweet spot for share prices where economic growth starts to pick up but the central bank does not tighten. Capital expenditures in real terms and the bank loan impulse to corporations - the second derivative of outstanding commercial loans - might have bottomed although they are still very weak (Chart I-3, top panel). Furthermore, residential and non-residential construction starts are still shrinking while the improvement in the housing loan impulse seems to be stalling (Chart I-3, bottom panel). This suggests that the capex and credit cycles - the two most interest rate-sensitive segments of the economy - remain feeble, justifying low interest rates for a while. Most importantly, there are no signs of inflationary pressures: the output gap is negative and widening, which historically has led to falling core inflation (Chart I-4). Chart I-3...But Interest Rate Sensitive Sectors Are Still Weak ...But Interest Rate Sensitive Sectors Are Still Weak ...But Interest Rate Sensitive Sectors Are Still Weak Chart I-4Chile: The Output Gap And Inflation Chile: The Output Gap And Inflation Chile: The Output Gap And Inflation A wide range of inflation measures - consumer services and trimmed mean inflation rates - are low and remain in a downtrend (Chart I-5). The key driver and measure of underlying genuine inflation is wages. Overall and key sectors' wage growth are either slowing or muted (Chart I-6). Chart I-5Chile: Inflation Is Low CHILE: INFLATION IS LOW CHILE: INFLATION IS LOW Chart I-6Chile: Wage Growth Is Tame CHILE: WAGE GROWTH IS TAME CHILE: WAGE GROWTH IS TAME Notably, the number of unemployed people is still rising while the number of job vacancies has plummeted to very low levels (Chart I-7). This heralds low wage growth and disinflationary pressures ahead. Chilean local rates, unlike high-yielding EM local fixed-income markets, will not rise if commodities prices relapse and the Chilean peso depreciates. On the contrary, the CBC can and probably will cut interest rates if the economic recovery is endangered. Therefore, we expect money supply in Chile to continue outgrowing the same measure for aggregate EM. This tends to help Chilean stocks outperform the EM equity benchmark (Chart I-8). Chart I-7Chile: A Lot Of Slack In Labor Market Chile: A Lot Of Slack In Labor Market Chile: A Lot Of Slack In Labor Market Chart I-8Upgrade Chilean Stocks Versus EM Upgrade Chilean Stocks Versus EM Upgrade Chilean Stocks Versus EM Finally, the health of the Chilean banking system is better than that of some other EM peers as the former is well provisioned and not exposed to foreign currency risk. This will also help this equity market to outperform. As to absolute performance in U.S. dollar terms, it depends on copper prices and the trend in EM absolute performance. Our base case remains that copper prices will relapse due to a deceleration in Chinese capital expenditures in general and construction (both infrastructure and property development) in particular (Chart I-9). This will drive both the Chilean peso (and probably equity prices) down. In a nutshell, the equity valuations in absolute terms are neutral. Chart I-10 illustrates that the cyclically adjusted P/E ratio for the MSCI Chile index is 21, around its fair value. Barring a reversal in EM risk assets (which we expect to start sooner rather than later), share prices could rise further. Chart I-9Downside Risks To Copper Prices bca.ems_wr_2018_01_03_s1_c9 bca.ems_wr_2018_01_03_s1_c9 Chart I-10Chile: Cyclically-Adjusted P/E Ratio Chile: Cyclically-Adjusted P/E Ratio Chile: Cyclically-Adjusted P/E Ratio Investment Conclusions We recommend EM dedicated equity investors to upgrade their allocation to Chile from neutral to overweight. The macro backdrop favors Chilean assets over their emerging markets peers. As such we recommend an overweight allocation in equity and corporate credit portfolios within their respective EM benchmarks. Can Chilean stocks outperform EM when copper prices fall? Chart I-11 suggests yes: historically there were periods when copper prices and Chile's relative equity performance versus EM were not correlated or even negatively correlated. Hence, our decision to upgrade Chilean stocks to an overweight while being negative on copper prices is not inconsistent. Chart I-11Copper Prices & Chilean Equities Versus EM: Not Always Positively Correlated Copper Prices & Chilean Equities Versus EM: Not Always Positively Correlated Copper Prices & Chilean Equities Versus EM: Not Always Positively Correlated For absolute return investors, the risk-reward profile for Chilean assets is not attractive if our baseline negative view on EM and industrial commodities prices plays out. Finally, we have been recommending to complement a short position in copper with a long leg in the Chilean peso. This allows traders to earn a bit of carry while waiting for copper prices to gap down. The CLP has lagged the recent spike in copper prices but we reiterate this position as risks to copper prices remain to the downside over the next six months. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The Li Keqiang Index (LKI) is particularly relevant for global investors, who are most concerned with China's investable stock performance and the country's impact on global exports. BCA's view is that the LKI will retrace about 50% of its rise from late-2015 to early-2017. This is consistent with our call that China's economy will experience a benign, controlled deceleration. U.S. financial assets tend to perform better when the LKI is rising, than when it is decelerating. Correlations between China's economy and the S&P 500 have increased in the past few decades. Feature In the past three months, BCA's China Investment Strategy team has significantly heightened its focus on the cyclical condition of China's economy. Our colleagues presented their framework for tracking the end of China's mini-cycle in an October Weekly Report.1 This was followed by a two-part report that examined the key differences between China today and mid-20152 when the economy operated below what investors and market participants considered a stable pace of growth. These articles were anchored by BCA's view that in 2015 China's economy suffered from a double whammy: a weak external demand environment and overly tight monetary conditions. In a Special Report released in late November, BCA's China Investment Strategy took a different approach to gauge the slowdown in China's economy. The strategist tested a wide range of commonly watched macro data series for signs that reliably lead economic activity.3 The study surprisingly showed that measures of money and credit have been the most reliable predictors of China's economy since 2010. A composite leading indicator of these predictors suggests that the country's economy will continue to slow in the coming months. However, the pace and magnitude of the decline are consistent with BCA's view that China will experience a benign, controlled deceleration, and will not repeat its 2015 uncontrolled slowdown. A Brief Methodological Overview We provide a brief overview of our approach and address two questions: what are we trying to predict and what series do we use as predictors,4 to explain the Chinese business cycle? What are we trying to predict? We use the Li Keqiang Index (LKI) as a proxy for China's business cycle for three reasons: Despite the potential to become a consumer-oriented society, the economy remains highly geared to investment (and the industrial sector). Investors are familiar with the LKI since a 2007 U.S. diplomatic cable (leaked in late-2010) quoted Li, then Communist Party Secretary of Liaoning, telling U.S. Ambassador Randt that China's GDP figures were man-made and unreliable. Li's focus on electricity consumption, rail cargo volume and bank loans subsequently became a standard metric for China analysts. Most importantly, we use the LKI as a proxy because it continues to provide key information about China's economy. Chart 1 highlights that LKI leads China's nominal import growth. The index is particularly relevant for global investors who are concerned with China's investable stock performance and the country's impact on global exports. Chart 1The Li Keqiang Index Predicts Chinese Import Growth The Li Keqiang Index Predicts Chinese Import Growth The Li Keqiang Index Predicts Chinese Import Growth What series were used in our approach? To test the predictability of China's business cycle, we compiled a list of 40 highly tracked macroeconomic variables (presented in Appendix Table 1) and grouped them into six categories: Economy-wide measures, such as composite LEIs and models of GDP growth. Measures related to investment and the corporate sector, such as PMIs, fixed-asset investment and industrial production. Variables related to the consumer sector, such as consumer confidence, retail sales and the employment component of official PMIs. Housing indicators, such as house price indexes and residential floor space sold. Government spending. A variety of measures including money, credit and financial conditions. All series, including the LKI, were smoothed with a three-month moving average. The exception was government spending, which was smoothed with a six-month average. Chart 2Measures Of Money & Credit Are ##br## The Best Predictors Of The LKI Measures Of Money & Credit Are The Best Predictors Of The LKI Measures Of Money & Credit Are The Best Predictors Of The LKI Money And Credit: Results From The Data Lab Chart 2 presents the average correlation profiles for the six data categories described above, alongside the ideal profile. The chart allows us to draw several important conclusions: First, it highlights that while economy-wide measures and those related to investment and the corporate sector tended to have a high correlation with the LKI, their correlation profiles lag rather than lead. In other words, the LKI predicts these variables, not vice versa. The Markit/Caixin and NBS manufacturing PMIs are notable exceptions. Furthermore, variables related to both consumer spending and government expenditures appear to have little ability to predict China's business cycle. In the case of government spending, the evidence suggests that the LKI reliably leads expenditures by approximately a year. This implies that fiscal policy in China is responsive and countercyclical (but not leading). Finally, measures of money and credit, and housing to a lesser degree, appear to fulfill our first two criteria to be good leading indicators of the LKI. Both profiles peak in advance of t=0, and at least in the case of money and credit, have a strong relationship (Chart 2). BCA's results show that it is more accurate to state that money supply measures cause the LKI than vice versa, which means that money growth should be closely watched as an economic indicator. Chart 3 presents a composite leading indicator for the LKI based on the six variables presented above. The indicator is advanced by four months and suggests that the LKI will retrace about 50% of its rise from late-2015 to early-2017. This is consistent with our call that China's economy will experience a benign, controlled deceleration. An additional factor that strengthens our conviction is that the weakest components of the indicator on a year-over-year basis, M2 and M3 (as defined by BCA's Emerging Markets Strategy service), have increased more rapidly in the past three months (Chart 4). Chart 3Our Composite LKI Indicator Suggests ##br## A Benign Slowdown In Growth bca.usis_sr_2018_01_02_c3 bca.usis_sr_2018_01_02_c3 Chart 4Money Supply Growth ##br## Has Recently Rebounded Money Supply Growth Has Recently Rebounded Money Supply Growth Has Recently Rebounded BCA's stance is that investors should remain overweight Chinese investable stocks relative to the EM and global benchmarks. However, what does a retracement of the LKI and a slowdown in China's economy mean for U.S. asset classes? Charts 5 and 6 and Tables 1 and 2 show how several key financial markets have performed in periods when the LKI decelerated and accelerated. Chart 5Performance Of U.S. Financial Assets As The LKI Decelerates Performance Of U.S. Financial Assets As The LKI Decelerates Performance Of U.S. Financial Assets As The LKI Decelerates Chart 6Performance Of U.S. Financial Assets As The LKI Accelerates Performance Of U.S. Financial Assets As The LKI Accelerates Performance Of U.S. Financial Assets As The LKI Accelerates Table 1Performance Of U.S. Financial Assets As The LKI Decelerates China: Critical For U.S. Portfolio Allocation? China: Critical For U.S. Portfolio Allocation? Table 2Performance Of U.S. Financial Assets As The LKI Accelerates China: Critical For U.S. Portfolio Allocation? China: Critical For U.S. Portfolio Allocation? The Implications For U.S. Assets U.S. risk assets tend to perform better when the LKI accelerates. BCA has identified seven episodes since 1988 when the LKI slowed (Table 1) and an equal number when the LKI climbed (Table 2). The median returns for the S&P 500, high-yield and investment-grade corporates, small caps, gold, and oil, are all higher when the LKI speeds up. However, the dollar is apt to fall when the LKI accelerates and S&P 500 EPS growth is only one third as fast when the LKI gathers speed versus when the LKI is decelerating. The improved performance of U.S. risk assets when the LKI climbs is noteworthy, given that three U.S. recessions overlap with intervals of escalating LKI, and only one of seven phases of falling LKI intersects with an economic downturn in the U.S. There are pitfalls using LKI data before 2000. The basic structure of China's economy has shifted several times since the late 1980s. This first occurred during the early-to-mid-2000s as China transitioned from its rural roots to a manufacturing and export-led economy. In 2010, Chinese growth slowed as the government guided the economy toward a more consumer-led profile. Nonetheless, even if we exclude the pre-2000 interval, we draw the same conclusions about the performance of U.S. assets as the LKI picks up the pace and slows down. The LKI provided an excellent roadmap for U.S. assets from 2013-2017. The LKI index lost speed as the dollar rose, and oil prices peaked and then rolled over in late 2013 through September 2015. Then it began to reaccelerate in September 2015, five months before oil prices and U.S. equities prices bottomed in early 2016, and moved higher through early 2017. BCA's stock-to-bond ratio, the S&P 500, investment-grade and high-yield bonds, all performed better from September 2015 through early 2017 than in the 2013-2016 episode. As the LKI picked up pace between 2015 and 2017, the performance of small caps, gold, S&P 500 earnings growth and oil were also better than during the 2013-2015 timeframe when the LKI was in a lull. Rising Correlations The S&P 500 has become more sensitive to China's economy over time. Chart 7 presents the relationship between year-over-year shifts in the LKI and annual changes in the S&P 500 in three different eras: Chart 7Correlations Between LKI And S&P 500 Since 2000 China: Critical For U.S. Portfolio Allocation? China: Critical For U.S. Portfolio Allocation? 2000-2005, as China entered the world stage as an economic power after joining the WTO in the early 2000s; 2005 through 2007, after China revalued the yuan, but before the onset of the Great Recession; and 2007-2009, during and immediately following the Great Recession. It is difficult to find any positive correlation between the LKI and the S&P 500 in the early 2000s. However, a relationship began unfolding between 2005 and 2007, and from 2007 to 2009, the positive connection became even more defined. Many asset classes were highly correlated during and just after 2009, but the jump in the correlation between 2005-2007 and 2007-2009 is unmistakable. More recently (2009-present) the link weakened slightly, but it remains stronger than in the 2000-2007 period (not shown). The rise in foreign earnings as a share of total S&P 500 profits in recent years helps to explain the stronger link between China and U.S. equities. China has become a key driver of globally-sourced earnings as China share of global GDP has risen in the past two decades. Bottom Line: China's economy and financial markets play a much more critical role in the performance of U.S. financial assets than in the recent past. History suggests that U.S. assets perform better when the LKI picks up speed. However, BCA's stance is that the LKI is poised to decelerate modestly. This is consistent with our view that China's economy will experience a benign, controlled slowdown and not a sudden downturn, such as in late 2015 and early 2016. History suggests that U.S. assets perform better when the LKI is accelerating, not decelerating. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Appendix Appendix Table 1List Of Macroeconomic Data Series Included In Our Study China: Critical For U.S. Portfolio Allocation? China: Critical For U.S. Portfolio Allocation? 1 Please see China Investment Strategy Weekly Report, "Tracking The End Of China's Mini-Cycle," published October 12, 2017. Available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China's Economy - 2015 Vs. Today (Part II): Monetary Policy", published November 9, 2017. Available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report, "The Data Lab: Testing the Predictability Of China's Business Cycle," published November 30, 2017. Available at cis.bcaresearch.com. 4 The original China Investment Strategy Special Report also explains how we judge which series are "useful" in explaining the Chinese business cycle.