Emerging Markets

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

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

Highlights Global bourses celebrated solid earnings growth and the passage of U.S. tax cuts heading into year-end. The direct effect of the tax cuts will likely boost U.S. real GDP growth in 2018 by 0.2 to 0.3 percentage points. It could be more, depending on the impact on animal spirits in the business sector and any fresh infrastructure spending. The good news on global growth continue to roll in. Real GDP growth is accelerating in the major advanced economies, driven in part by a surge in capital spending. Nonetheless, record low volatility and a flat yield curve in the U.S. highlight our major theme for 2018; policy is on a collision course with risk assets because output gaps are closing and monetary policy is moving away from "pedal to the metal" stimulus. We expect inflation to finally begin moving higher in the U.S. and some of the other advanced economies. This will challenge the consensus view that "inflation is dead forever", and that central banks will respond quickly to any turbulence in financial markets with an easier policy stance. The S&P 500 would suffer only a 3-5% correction if the VIX were to simply mean-revert. But the pain would likely be more intense if there is a complete unwinding of 'low-vol' trading strategies. We will be watching inflation expectations and our S&P Scorecard for signs to de-risk. Government yield curves should bear steepen, before flattening again later in 2018. Stay below benchmark in duration for now and favor bonds in Japan, Italy, the U.K. and Australia versus the U.S. and Canada (currency hedged). Interest rate differentials in the first half of the year should modestly benefit the U.S. dollar versus the other major currencies. Investors should remain exposed to oil and related assets, and bet on rising inflation expectations in the major bond markets. The intensity of forthcoming Chinese reforms will have to be monitored carefully for signs they have reached an economic 'pain threshold'. We do not view China as a risk to DM risk assets, but even a soft landing scenario could be painful for base metals and the EM complex. Bitcoin is not a systemic threat to global financial markets. Feature Chart I-1Policy Collision Course? Policy Collision Course? Policy Collision Course? Global bourses celebrated solid earnings growth and the passage of U.S. tax cuts heading into year-end. Ominously, though, a flatter U.S. yield curve and extraordinarily low measures of volatility hover like dark clouds over the equity bull market (Chart I-1). The flatter curve could be a sign that the Fed is at risk of tightening too far, which seems incompatible with depressed asset market volatility. This combination underscores the major theme of the BCA Outlook 2018 that was sent to clients in November; policy is on a collision course with risk assets because output gaps are closing and monetary policy is moving away from "pedal to the metal" stimulus. Analysts are debating how much of the decline in volatility is due to technical factors and how much can be pinned on the macro backdrop. For us, they are two sides of the same coin. Betting that volatility will remain depressed has reportedly become a yield play, via technical trading strategies and ETFs. Trading models encourage more risk taking as volatility declines, such that lower volatility enters a self-reinforcing feedback loop. The danger is that this virtuous circle turns vicious. On the macro front, many investors appear to believe that the structure of the advanced economies has changed in a fundamental and permanent way. Deflationary forces, such as Uber, Amazon and robotics are so strong that inflation cannot rise even if labor becomes very scarce. If true, this implies that central banks will proceed slowly in tightening, and that the peak in rates is not far away. Moreover, below-target inflation allows central banks to respond to any economic weakness or unwanted tightening in financial conditions by adopting a more accommodative policy stance. In other words, investors appear to believe in the "Fed Put". Implied volatility is a mean-reverting series. It can remain at depressed levels for extended periods, especially when global growth is robust and synchronized. Nonetheless, we believe that the "outdated Phillips curve" and the "Fed Put" consensus views will be challenged later in 2018, leading to an unwinding of low-vol yield plays. For now, though, it is too early to scale back on risk assets. Global Growth Shifts Up A Gear... The good news on global growth continue to roll in. Easy financial conditions and the end of fiscal austerity provide a supportive growth backdrop. A measure of fiscal thrust for the G20 advanced economies shifted from a headwind to a slight tailwind in 2016 (Chart I-2). Our short-term models for real GDP growth in the major countries continue to rise, in line with extremely elevated purchasing managers' survey data (Chart I-3). The major exception is the U.K., where our GDP growth model is rolling over as the Brexit negotiations take a toll. Chart I-2Fiscal Austerity Is Over Fiscal Austerity Is Over Fiscal Austerity Is Over Chart I-3GDP Growth Models Are Upbeat GDP Growth Models Are Upbeat GDP Growth Models Are Upbeat Much of the acceleration in our GDP models is driven by the capital spending components. Animal spirits appear to be taking off and it is a theme across most of the advanced economies. G3 capital goods orders pulled back a bit in late 2017, but this is more likely due to noise in the data than to a peak in the capex cycle (Chart I-4). Industrial production, the PMI diffusion index and advanced-economy capital goods imports confirm strong underlying momentum in investment spending. Chart I-4Capital Spending Helping To Drive Growth Capital Spending Helping To Drive Growth Capital Spending Helping To Drive Growth In the U.S., tax cuts will give business outlays and overall U.S. GDP growth a modest lift in 2018. The House and Senate hammered out a compromise on tax cuts that is similar to the original Senate version. The new legislation will cut individual taxes by about $680 billion over ten years, trim small business taxes by just under $400 billion, and reduce corporate taxes by roughly the same amount (including the offsetting tax on currently untaxed foreign profits). The direct effect of the tax cuts will likely boost U.S. real GDP growth in 2018 by 0.2 to 0.3 percentage points. However, much depends on the ability that the tax changes and immediate capital expensing to further lift animal spirits in the business sector and bring forward investment spending. Any infrastructure program would also augment the fiscal stimulus. The total impact is difficult to estimate given the lack of details, but it is clearly growth-positive. ...But The U.S. Yield Curve Flattens... Bond investors are unimpressed so far with the upbeat global economic data. It appears that long-term yields are almost impervious as long as inflation is stuck at low levels. In the U.S., a rising 2-year yield and a range-trading 10-year yield have resulted in a substantial flattening of the 2/10 yield slope (although some of the flattening has unwound as we go to press). Investors view a flattening yield curve with trepidation because it smells of a Fed policy mistake. It appears that the bond market is discounting that the Fed can only deliver another few rate hikes before the economy starts to struggle, at which point inflation will still be below target according to market expectations. We would not be as dismissive of an inverted yield curve as Fed Chair Yellen was during her December press conference. There are indeed reasons for the curve to be structurally flatter today than in the past, suggesting that it will invert more easily. Nonetheless, the fact that the yield curve has called all of the last seven recessions is impressive (with one false positive). The good news is that, in the seven episodes in which the curve correctly called a recession, the signal was confirmed by warning signs from our Global Leading Economic Indicator and our monetary conditions index. At the moment, these confirming indicators are not even flashing yellow.1 Our fixed-income strategists believe that the curve is more likely to steepen than invert over the next six months. If inflation edges higher as we expect, then long-term yields will finally break out to the upside and the curve will steepen until the Fed's tightening cycle is further advanced. If we are wrong and inflation remains stuck near current levels or declines, then the FOMC will have to revise the 'dot plot' lower and the curve will bull-steepen. In other words, we do not think the FOMC will make a policy mistake by sticking to the dot plot if inflation remains quiescent. Rising inflation is a larger risk for stocks and bonds than a policy mistake. A clear uptrend in inflation would shake investors' confidence in the "Fed Put" and thereby trigger an unwinding of the low-vol investment strategies. A sharp selloff at the long end of the curve in the major markets would send a chill through the investment world because it would suggest that the Phillips curve is not dead, and that central banks might have fallen behind the curve. ...As Inflation Languishes For now there is little evidence of building inflation pressure in either the CPI or the Fed's preferred measure, the core PCE price index. The latter edged up a little in October to 1.4% year-over-year, but the November core CPI rate slipped slightly to 1.7%. For perspective, core CPI inflation of 2.4-2.5% is consistent with the Fed's 2% target for the core PCE index. The Fed has made no progress in returning inflation to target since the FOMC started the tightening cycle. A risk to our view is that the expected inflation upturn takes longer to materialize. The annual core CPI inflation rate fell from 2.3 in January 2017 to 1.7 in November, a total decline of 0.55 percentage points. The drop was mostly accounted for by negative contributions from rent of shelter (-0.31), medical care services (-0.13) and wireless telephone services (-0.1). These categories are not closely related to the amount of slack in the economy, and thus might continue to depress the headline inflation rate in the coming months even as the labor market tightens further. Recent regulatory changes, for example, suggest that there is more downside potential in health care services inflation. We have highlighted in past research that it is not unusual for inflation to respond to a tight labor market with an extended lag, especially at the end of extremely long expansion phases. Chart I-5 updates the four indicators that heralded inflection points in inflation at the end of the 1980s and 1990s. All four leading inflation indicators are on the rise, as is the New York Fed's Underlying Inflation Indicator (not shown). Importantly, economic slack is disappearing at the global level. The OECD as a group will be operating above potential in 2018 for the first time since the Great Recession (Chart I-6). Finally, oil prices have further upside potential. Higher energy prices will add to headline inflation and boost inflation expectations in the U.S. and the other major economies. Chart I-5U.S. Inflation: Indicators Point Up U.S. Inflation: Indicators Point Up U.S. Inflation: Indicators Point Up Chart I-6Vanishing Economic Slack Vanishing Economic Slack Vanishing Economic Slack The bottom line is that we are sticking with the view that U.S. inflation will grind higher in the coming months, allowing the FOMC to deliver the three rate hikes implied by the 'dot plot' for 2018. In December, the FOMC revised up its economic growth forecast to 2.5% in 2018, up from 2.1%. The projections for 2019 and 2020 were also revised higher. Growth is seen remaining above the 1.8% trend rate for the next three years. The FOMC expects that the jobless rate will dip to 3.9% in 2018 and 2019, before ticking up to 4.0% in 2020. With the estimate for long-run unemployment unchanged at 4.6%, this means that the labor market is expected to shift even further into 'excess demand' territory. If anything, these forecasts look too conservative. It is unreasonable to expect the unemployment rate to stabilize in 2019 and tick up in 2020 if the economy is growing above-trend. This forecast highlights the risk that the FOMC will suddenly feel 'behind the curve' if inflation re-bounds more quickly than expected, at a time when the labor market is so deep in 'excess demand' territory. The consensus among investors would also be caught off guard in this scenario, resulting in a rise in bond volatility from rock-bottom levels. How Vulnerable Are Stocks? How large a correction in risk assets should we expect? One way to gauge this risk is to estimate the historical 'beta' of risk asset prices to mean-reversions in the VIX. The VIX is currently a long way below its median. Major spikes to well above the median are associated with recessions and/or financial crises. However, as a starting point, we are interested in the downside potential for risk asset prices if the VIX simply moves back to the median. Table I-1 presents data corresponding to periods since 1990 when the VIX mean-reverted from a low level over a short period of time. We chose periods in which the VIX surged at least to its median level (17.2) from a starting point that was below 13. The choice of 13 as the lower threshold is arbitrary, but this level filters out insignificant noise in the data and still provides a reasonable number of episodes to analyze.2 Table I-1Episodes Of VIX 'Mean Reversion' January 2018 January 2018 The episodes are presented in ascending order with respect to the starting point for the 12-month forward P/E ratio. This was done to see whether the valuation starting point matters for the size of the equity correction. The "VIX Beta" column shows the ratio of the percent decline in the S&P 500 to the change in the VIX. The average beta over the 15 episodes suggests that stocks fall by almost a half of a percent for every one percent increase in the VIX. Today, the VIX would have to rise by about 7½% to reach the median value, implying that the S&P 500 would correct by roughly 3½%. Investment- and speculative-grade corporate bonds would underperform Treasurys by 22 and 46 basis points, respectively, in this scenario. Interestingly, the equity market reaction to a given jump in the VIX does not appear to intensify when stocks are expensive heading into the shock. The implication is that a shock that simply returns the VIX to "normal" would not be devastating for risk assets. The shock would have to be worse. Chart I-7Market Reaction To 1994 Fed Shock Market Reaction To 1994 Fed Stock Market Reaction To 1994 Fed Stock The episodes of VIX "mean reversion" shown in Table I-1 are a mixture of those caused by financial crises and by monetary tightening (and sometimes both). The U.S. 1994 bond market blood bath is a good example of a pure monetary policy shock. It was partly responsible for the "tequila crisis", but that did not occur until late that year. Chart I-7 highlights that the U.S. equity market reacted more violently to Fed rate hikes in 1994 than the average VIX beta would suggest. The VIX jumped by about 14% early in the year, coinciding with a 9% correction in the S&P 500. Investors had misread the Fed's intension in late 1993, expecting little in the way of rate hikes over the subsequent year. A dramatic re-rating of the Fed outlook caused a violent bond selloff that unnerved equity investors. We are not expecting a replay of the 1994 bond market turmoil because the Fed is far more transparent today. Nonetheless, the equity correction could be quite painful to the extent that the VIX overshoots the median as the large volume of low-volatility trades are unwound. A 10% equity correction in the U.S. this year would not be a surprise given the late stage of the bull market and current market positioning. Yield Curves To Bear Steepen Upward pressure on inflation, bond yields and volatility will not only come from the U.S. We expect inflation to edge higher in the Eurozone, Canada, and even Japan, given tight labor markets and diminished levels of global spare capacity. The European economy has been a star performer this year and this should continue through 2018. Even the periphery countries are participating. The key driving factors include the end of the fiscal squeeze in the periphery and the recapitalization of troubled banks. The latter has opened the door to bank lending, the weakness of which has been a major growth headwind in this expansion. Taken at face value, recent survey data are consistent with about 3% GDP growth (Chart I-3). We would dis-count that a bit, but even continued 2.0-2.5% GDP growth in the euro area would compare well to the 1% potential growth rate. This means that the output gap is shrinking and the labor market will continue tightening. Despite impressive economic momentum, the ECB is sticking to the policy path it laid out in October. Starting in January, asset purchases will continue at a reduced rate of €30bn per month until September 2018 or beyond. Meanwhile, interest rates will remain steady "for an extended period of time, and well past the horizon of the net asset purchases." If asset purchases come to an end next September, then the first rate hike may not come until 2019 Q1 at the earliest. Thus, rate hikes are a long way off, but the deceleration of growth in the Eurozone monetary base will likely place upward pressure on the long end of the bund curve (shown inverted in Chart I-8). Chart I-8ECB Tapering Will Be Bond-Bearish ECB Tapering Will Be Bond-Bearish ECB Tapering Will Be Bond-Bearish Canada is another economy with ultra-low interest rates and rapidly diminishing labor market slack. The Bank of Canada will be forced to follow the Fed in hiking rates in the coming quarters. In Japan, strong PMI and capital goods orders are hopeful signs that domestic capital spending is picking up, consistent with our upbeat real GDP model (Chart I-3). Recent data on industrial production and retail sales were weak, but this was likely due to heavy storm activity; we expect those readings to bounce back. Nonetheless, it is still not clear that the Japanese economy has moved away from a complete dependency on the global growth engine. We would like to see stronger wage gains to signal that the economy is finally transitioning to a more self-reinforcing stage. It is hopeful that various measures of core inflation are slightly positive, but this is tentative at best. That said, the BoJ may be forced to alter its current "yield curve control" strategy by modestly lifting the target on longer-term JGB yields later in 2018, in response to pressures from robust growth and rising global bond yields. Thus, the pressure for higher bond yields should rotate away from the U.S. in the latter half of 2018 towards Europe, Canada and possibly Japan. This could eventually see the U.S. dollar head lower, but we still foresee a window in the first half of 2018 in which the dollar will appreciate on the back of widening interest rate differentials. We are less bullish than we were in mid-2017, expecting only about a 5% dollar appreciation. China: Long-Term Gain Or Short-Term Pain? The Chinese cyclical outlook remains a key risk to our upbeat view on risk assets. Significant structural reforms are on the way, now that President Xi has amassed significant political support for his reform agenda. These include deleveraging in the financial sector, a more intense anti-corruption campaign focused on the shadow-banking sector, and an ongoing restructuring in the industrial sector. The reforms will likely be positive for long-term growth, but only to the extent that they are accompanied by economic reforms. This month's Special Report, beginning on page 19, highlights that 2018 will be pivotal for China's long-term investment outlook. In the short term, reforms could be a net negative for growth depending on how deftly the authorities handle the monetary and fiscal policy dials. We witnessed this tension between growth and reform in the early years of President Xi's term, when the drive to curtail excessive credit growth and overcapacity caused an abrupt slowdown in 2015. Managing the tradeoff means that China's economy will evolve in a series of growth mini cycles. China is in the down-phase of a mini cycle at the moment, as highlighted by the Li Keqiang Index (LKI; Chart I-9). The LKI is a good proxy for the business cycle. BCA's China Strategy service recently combined the data with the best leading properties for the LKI into a single indicator.3 This indicator suggests that the LKI will end up retracing about 50% of its late 2015 to early 2017 rise before the current slowdown is complete. The good news is that broad money growth, which is a part of the LKI leading indicator, has re-accelerated in recent months. This suggests that the current economic slowdown phase will not be protracted, consistent with our 'soft landing' view. The intensity of forthcoming reforms will have to be monitored carefully for signs they have reached an economic pain threshold. We will be watching our LKI leading indicator and a basket of relevant equity sectors for warning signs. We do not view China as a risk to DM risk assets, but even a soft landing scenario could be painful for base metals and the EM complex (Chart I-10). Chart I-9China: Where Is The Bottom? China: Where Is the Bottom? China: Where Is the Bottom? Chart I-10Metals At Risk Of China Soft Landing Metals At Risk Of China Soft Landing Metals At Risk Of China Soft Landing Equity Country Allocation For now we continue to recommend overweight positions in stocks versus bonds and cash within balanced portfolios. We also still prefer Japanese stocks to the U.S., reflecting our expectation for rising bond yields in the latter and an earnings outlook that favors the former. Chart I-11 updates our earnings-per-share growth forecast for the U.S., Japan and the Eurozone. We expect U.S. EPS growth to decelerate more quickly in 2018 than in Japan, since the U.S. is further ahead in the earning cycle and is more exposed to wage and margin pressure. European earnings growth will also be solid in 2018, but this year's euro appreciation will be a headwind for Q4 2017 and Q1 2018 earnings. European and Japanese stocks are also a little on the cheap side versus the U.S., although not by enough to justify overweight positions on valuation grounds alone. We have extended our valuation work to a broader range of countries, shown in Chart I-12. All are expressed relative to the U.S. market. These metric exclude the Financials sector, and adjust for both differing sector weights and structural shifts in relative valuation. Mexico is the only one that is more than one standard deviation cheap relative to the U.S. Nonetheless, our EM team is reluctant to recommend this market given uncertainty regarding the NAFTA negotiations. Russia is not as cheap, but is in the early stages of recovery. Our EM team is overweight. Chart I-11Top-Down EPS Projection Top-Down EPS Projection Top-Down EPS Projection Chart I-12Valuation Ranking Of Nonfinancial Equity Markets Relative To The U.S. January 2018 January 2018 A Note On Bitcoin Finally, we have received a lot of client questions regarding bitcoin. The incredible surge in the price of the cryptocurrency dwarfs previous asset price bubbles by a wide margin (Chart I-13). As is usually the case with bubble, supporters argue that "this time is different." We doubt it. Chart I-13Bitcoin Bubble Dwarfs All The Rest January 2018 January 2018 BCA's Technology Sector Strategy weighed into this debate in a recent Special Report.4 In theory, blockchain technology, including cyber currencies, can be used as a highly secure, low cost, means of transfer value from one person to the next without an intermediary. However, the report highlights that bitcoin is highly subject to fraud and manipulation because it is unregulated. Liquidity and accurate market quotes are questionable on the "fly by night" exchanges. Its use as a medium of exchange is very limited, and governments are bound to regulate it because cryptocurrencies are a tool for money laundering, tax evasion and other criminal activities. Another fact to keep in mind is that, although the supply of new bitcoins is restricted, the creation of other cryptocurrencies is unlimited. Would the bursting of the bitcoin bubble represent a risk to the economy? The market cap of all cryptocurrencies is estimated to be roughly US$400 billion (US$250 billion for bitcoin alone). This is tiny compared to global GDP or the market cap of the main asset classes such as stocks and bonds. The amount of leverage associated with bitcoin is unknown, but it is hard to see that it would be large enough to generate a significant wealth effect on spending and/or a marked impact on overall credit conditions. The links to other financial markets appear limited. Investment Conclusions Our recommended asset allocation is "steady as she goes" as we move into 2018. The policy and corporate earnings backdrop will remain supportive of risk assets at least for the first half of the year. In the U.S., the recently passed tax reform package will boost after-tax corporate cash flows by roughly 3-5%. Cyclical stocks should outperform defensives in the near term. Nonetheless, we expect 2018 to be a transition year. Stretched valuations and extremely low volatility imply that risk assets are vulnerable to the consensus macro view that central banks will not be able to reach their inflation targets even in the long term. The consensus could be in for a rude awakening. We expect equity markets to begin discounting the next U.S. recession sometime in early 2019, but markets will be vulnerable in 2018 to a bond bear phase and escalating uncertainty regarding the economic outlook. If risk assets have indeed entered the late innings, then we must watch closely for signs to de-risk. One item to watch is the 10-year U.S. CPI swap rate; a shift above 2.3% would be consistent with the Fed's 2% target for the PCE measure of inflation. This would be a signal that the FOMC will have to step-up the pace of rate hikes and aggressively slow economic growth. We will also use our S&P Scorecard Indicator to help time the exit from our overweight equity position (Chart I-14). The Scorecard is based on seven indicators that have a good track record of heralding equity bear markets.5 These include measures of monetary conditions, financial conditions, value, momentum, and economic activity. The more of these indicators in "bullish" territory, the higher the score. Currently, four of the indicators are flashing a bullish signal (financial conditions, U.S. unemployment claims, ISM new orders minus inventories, and momentum). We demonstrated in previous research that a Scorecard reading of three or above was historically associated with positive equity total returns in the subsequent months. A drop below three this year would signal the time to de-risk. Our thoughts on the risks facing equities carry over to the corporate bonds space. Our Global Fixed Income Strategy service notes that uncertainty about future growth has the potential to increase interest rate volatility that can also push corporate credit spreads wider (Chart I-15).6 Elevated leverage in the corporate sector adds to the risk of a re-rating of implied volatility. For now, however, investors should continue to favor corporate bonds relative to governments for the (albeit modest) yield pickup. Chart I-14Watch Our Scorecard To Time The Exit Watch Our Scorecard To Time The Exit Watch Our Scorecard To Time The Exit Chart I-15Higher Uncertainty & ##br##Vol To Hit Corporate Bonds Higher Uncertainty & Vol To Hit Corporate Bonds Higher Uncertainty & Vol To Hit Corporate Bonds Overall bond portfolio duration should be kept short of benchmark. We may recommend taking profits and switching to benchmark duration after global yields have increased and are beginning to negatively affect risk assets. While yields are rising, investors should favor bonds in Japan, Italy, the U.K. and Australia within fixed-income portfolios (on a currency-hedged basis). Underweight the U.S. and Canada. German and French bonds should be close to benchmark. Yield curves should steepen, before flattening later in the year. Interest rate differentials in the first half of the year should modestly benefit the U.S. dollar versus the other major currencies. Finally, investors should remain exposed to oil and related assets, and bet on rising inflation expectations in the major bond markets. Mark McClellan Senior Vice President The Bank Credit Analyst December 28, 2017 Next Report: January 25, 2018 1 Please see BCA Global ETF Strategy service, "A Guide to Spotting And Weathering Bear Markets," August 16, 2017, available at etf.bcaresearch.com 2 Note that we are not saying that a rise in the VIX "causes" stocks to correct. Rather, we are assuming that a shock occurs that causes stocks to correct and the VIX to rise simultaneously. 3 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle," November 30, 2017, available at cis.bcaresearch.com 4 Please see BCA Technology Sector Strategy Special Report, "Cyber Currencies: Actual Currencies Or Just Speculative Assets?" December 12, 2017, available at tech.bcaresearch.com 5 Market Timing: Holy Grail Or Fool's Gold? The Bank Credit Analyst, May 26, 2016. 6 Please see BCA Global Fixed Income Strategy service, "Our Model Bond Portfolio Allocation In 2018: A Tail Of Two Halves," December 19, 2017, available at gfis.bcaresearch.com II. A Long View Of China 2018 is a pivotal year for China, as it will set the trajectory for President Xi Jinping's second term ... and he may not step down in 2022. Poverty, inequality, and middle-class angst are structural and persistent threats to China's political stability. The new wave of the anti-corruption campaign is part of Xi's attempt to improve governance and mitigate political risks. Yet without institutional checks and balances, Xi's governance agenda will fail. Without pro-market reforms, investors will face a China that is both more authoritarian and less productive. Hearts rectified, persons were cultivated; persons cultivated, families were regulated; families regulated, states were rightly governed; states rightly governed, the whole world was made tranquil and happy. - Confucius, The Great Learning Comparisons of modern Chinese politics with Confucian notions of political order have become cliché. Nevertheless, there is a distinctly Confucian element to Chinese President Xi Jinping's strategy. Xi's sweeping anti-corruption campaign, which will enter "phase two" in 2018, is essentially an attempt to rectify the hearts and regulate the families of Communist Party officials and civil servants. The same could be said for his use of censorship and strict ideological controls to ensure that the general public remains in line with the regime. Yet Xi is also using positive measures - like pollution curbs, social welfare, and other reforms - to win over hearts and minds. His purpose is ultimately the preservation of the Chinese state - namely, the prevention of a Soviet-style collapse. Only if the regime is stable at home can Xi hope to enhance the state's international security and erode American hegemony in East Asia. This would, from Beijing's vantage, make the whole world more tranquil and happy. Thus, for investors seeking a better understanding of China in the long run, it is necessary to look at what is happening to its governance as well as to its macroeconomic fundamentals and foreign relations.1 China's greatest vulnerability over the long run is its political system. Because Xi Jinping's willingness to relinquish power is now uncertain, his governance and reform agenda in his second term will have an outsized impact on China's long-run investment outlook. The Danger From Within From 1978-2008, the Communist Party's legitimacy rested on its ability to deliver rising incomes. Since the Great Recession, however, China has entered a "New Normal" of declining potential GDP growth as the society ages and productivity growth converges toward the emerging market average (Chart II-1). In this context, Chinese policymakers are deathly afraid of getting caught in the "middle income trap," a loose concept used to explain why some middle-income economies get bogged down in slower growth rates that prevent them from reaching high-income status (Chart II-2).2 Chart II-1The New Normal The New Normal The New Normal Chart II-2Will China Get Caught In The Middle-Income Trap? January 2018 January 2018 Such a negative economic outcome would likely prompt a wave of popular discontent, which, in turn, could eventually jeopardize Communist Party rule. The quid pro quo between the Chinese government and its population is that the former delivers rising incomes in exchange for the latter's compliance with authoritarian rule. The party is not blind to the fate of other authoritarian states whose growth trajectory stalled. The threat of popular unrest in China may seem remote today. The Communist Party is rallying around its leader, Xi Jinping; the economy rebounded from the turmoil of 2015 and its cyclical slowdown in recent months is so far benign; consumer sentiment is extremely buoyant; and the global economic backdrop is bright (Chart II-3). Yet these positive political and economic developments are cyclical, whereas the underlying political risks are structural and persistent. China has made massive gains in lifting its population out of poverty, but it is still home to 559 million people, around 40% of the population, living on less than $6 per day, the living standard of Uzbekistan. It will be harder to continue improving these workers' quality of life as trend growth slows and the prospects for export-oriented manufacturing dry up. This is why the Xi administration has recently renewed its attention to poverty alleviation. The government is on target in lifting rural incomes, but behind target in lifting urban incomes, and urban-dwellers are now the majority of the nation (Chart II-4). The plight of China's 200-250 million urban migrants, in particular, poses the risk of social discontent. Chart II-3China's Slowdown So Far Benign China's Slowdown So Far Benign China's Slowdown So Far Benign Chart II-4Urban Income Targets At Risk Urban Income Targets At Risk Urban Income Targets At Risk Moreover, while China knows how to alleviate poverty, it has less experiencing coping with the greatest threat to the regime: the rapid growth of the middle class, with its high expectations, demands for meritocracy and social mobility, and potential for unrest if those expectations are spoiled (Chart II-5). Democracy is not necessarily a condition for reaching high-income status, but all of Asia's high-income countries are democracies. A higher level of wealth encourages household autonomy vis-à-vis the state. Today, China has reached the $8,000 GDP per capita range that often accompanies the overthrow of authoritarian regimes.3 The Chinese are above the level of income at which the Taiwanese replaced their military dictatorship in 1987; China's poorest provinces are now above South Korea's level in that same year, when it too cast off the yoke of authoritarianism (Chart II-6). Chart II-5The Communist Party's Greatest Challenge The Communist Party's Greatest Challenge The Communist Party's Greatest Challenge Chart II-6China's Development Beyond Point At Which Taiwan And Korea Overthrew Dictatorship January 2018 January 2018 This is not an argument for democracy in China. We are agnostic about whether China will become democratic in our lifetime. We are making a far more humble point: that political risk will mount as wealth is accumulated by the country's growing middle class. Several emerging markets - including Thailand, Malaysia, Turkey and Brazil - have witnessed substantial political tumult after their middle class reached half of the population and stalled (Chart II-7). China is approaching this point and will eventually face similar challenges. Chart II-7Middle Class Growth Troubles Other EMs Middle Class Growth Troubles Other EMs Middle Class Growth Troubles Other EMs The comparison reveals that an inflection point exists for a society where the country's political establishment faces difficulties in negotiating the growing demands of a wealthier population. As political scientists have shown empirically, the very norms of society evolve as wealth erodes the pull of Malthusian and traditional cultural variables.4 Political transformation can follow this process, often quite unexpectedly and radically.5 Clearly the Chinese public shows no sign of large-scale, revolutionary sentiment at the moment. And political opposition does not necessarily result in regime change. Nevertheless, it is empirically false that the Chinese people are naturally opposed to democracy or representative government. After all, Sun Yat Sen founded a Republic of China in 1912, well before many western democratic transformations! And more to the point, the best survey evidence shows that the Chinese are culturally most similar to their East Asian neighbors (as well as, surprisingly, the Baltic and eastern European states): this is not a neighborhood that inherently eschews democracy. Remarkably, recent surveys suggest that China's millennial generation, while not wildly enthusiastic about democracy, is nevertheless more enthusiastic than its peers in the western world's liberal democracies (Chart II-8)! Chart II-8Chinese People Not Less Fond Of Democracy Than Others January 2018 January 2018 China is also home to one of the most reliable predictors of political change: inequality. China's economic boom is coincident with the rise of extreme inequalities in income, wealth, region, and social status. True, judging by average household wealth, everyone appears to be a winner; but the average is misleading because it is pulled upward by very high net worth individuals - and China has created 528 billionaires in the past decade alone. A better measure is the mean-to-median wealth ratio, as it demonstrates the gap that opens up between the average and the typical household. As Chart II-9 demonstrates, China is witnessing a sharp increase in inequality relative to its neighbors and peers. More standard measures of inequality, such as the Gini coefficient, also show very high readings in China. And this trend has combined with social immobility: China has a very high degree of generational earnings elasticity, which is a measure of the responsiveness of one's income to one's parent's income. If elasticity is high, then social outcomes are largely predetermined by family and social mobility is low. On this measure, China is an extreme outlier - comparable to the U.S. and the U.K., which, while very different economies, have suffered recent political shocks as a result of this very predicament (Chart II-10). Chart II-9Inequality: A Severe Problem In China Inequality: A Severe Problem In China Inequality: A Severe Problem In China Chart II-10China An Outlier In Inequality And Social Immobility January 2018 January 2018 "China does not have voters" unlike the U.S. and U.K., is the instant reply. Yet that statement entails that China has no pressure valve for releasing pent-up frustrations. Any political shock may be more, not less, destabilizing. In the U.S. and the U.K., voters could release their frustrations by electing an anti-establishment president or abrogating a trade relationship with Europe. In China, the only option may be to demand an "exit" from the political system altogether. Note that there is already substantial evidence of social unrest in China over the past decade. From 2003 to 2007, China faced a worrisome increase in "mass incidents," at which point the National Bureau of Statistics stopped keeping track. The longer data on "public incidents" suggests that the level of unrest remains elevated, despite improvements under the Xi administration (Chart II-11). Broader measures tell a similar story of a country facing severe tensions under the surface. For instance, China's public security spending outstrips its national defense spending (Chart II-12). Chart II-11Chinese Social Unrest Is Real Chinese Social Unrest Is Real Chinese Social Unrest Is Real Chart II-12China Spends More On ##br##Domestic Security Than Defense January 2018 January 2018 In essence, Chinese political risk is understated. This conclusion may seem counterintuitive, given Xi's remarkable consolidation of power. But is ultimately structural factors, not individual leaders, that will carry the day. The Communist Party is in a good position now, but its leaders are all-too-aware of the volcanic frustrations that could be unleashed should they fail to deliver the "China Dream." This is why so much depends upon Xi's policy agenda in the second half of his term. To that question we will now turn. Bottom Line: The Communist Party is at a cyclical high point of above-trend economic growth and political consolidation under a strongman leader. However, political risk is understated: poverty, inequality, and middle-class angst are structural and persistent and the long-term potential growth rate is slowing. If we assume that China is not unique in its historical trajectory, then we can conclude that it is approaching one of the most politically volatile periods in its development. Chart II-13Xi's Anti-Corruption Campaign Xi's Anti-Corruption Campaign Xi's Anti-Corruption Campaign The Governance And Reform Agenda Since coming to office in 2012-13, President Xi has spearheaded an extraordinary anti-corruption campaign and purge of the Communist Party (Chart II-13). The campaign has understandably drawn comparisons to Chairman Mao Zedong's Cultural Revolution (1966-76). Yet these are not entirely fair, as Xi has tried to improve governance as well as eradicate his enemies. As Xi prepares for his "re-election" in March 2018, he has declared that he will expand the anti-corruption campaign further in his second term in office: details are scant, but the gist is that the campaign will branch out from the ruling party to the entire state bureaucracy, on a permanent basis, in the form of a new National Supervision Commission.6 There are three ways in which this agenda could prove positive for China's long-term outlook. First, the regime clearly hopes to convince the public that it is addressing the most burning social grievances. Corruption persistently ranks at the top of the list, insofar as public opinion can be known (Chart II-14). Public opinion is hard to measure, but it is clear that consumer sentiment is soaring in the wake of the October party congress (see Chart II-3 above). It is also worth noting that the Chinese public's optimism perked up in Xi's first year in office, when the policy agenda on offer was substantially the same and the economy had just experienced a sharp drop in growth rates (Chart II-15). Reassuring the public over corruption will improve trust in the regime. Second, the anti-corruption campaign feeds into Xi's broader economic reform agenda. Productivity growth is harder to generate as a country's industrialization process matures. With the bulk of the big increases in labor, capital, and land supply now complete in China, the need to improve total factor productivity becomes more pressing (Chart II-16). Unlike the early stages of growth, this requires reaching the hard-to-get economic conditions, such as property rights, human capital, financial deepening, entrepreneurship, innovation, education, technology, and social welfare. Chart II-14Chinese Public Grievances January 2018 January 2018 Chart II-15Anti-Corruption Is Popular January 2018 January 2018 Chart II-16Productivity Requires Institutional Change Productivity Requires Institutional Change Productivity Requires Institutional Change On this count, the Xi administration's anti-corruption campaign has been a net positive. The most widely accepted corruption indicators suggest that it has made a notable improvement to the country's governance. Yet the country remains far below its competitors in the absolute rankings, notably its most similar neighbor Taiwan (Chart II-17 A&B). The institutionalization of the campaign could thus further improve the institutional framework and business environment. Chart II-17AAnti-Corruption Campaign Is A Plus... January 2018 January 2018 Chart II-17B...But There's A Long Way To Go January 2018 January 2018 Third, the anti-corruption campaign can serve as a central government tool in enforcing other economic reforms. Pro-productivity reforms are harder to execute in the context of slowing growth because political resistance increases among established actors fighting to preserve their existing advantages. If the ruling party is to break through these vested interests, it needs a powerful set of tools. Recently, the central government in Beijing has been able to implement policy more effectively on the local level by paving the way through corruption probes that remove personnel and sharpen compliance. Case in point: the use of anti-corruption officials this year gave teeth to environmental inspection teams tasked with trimming overcapacity in the industrial sector (Chart II-18). And there are already clear signs that this method will be replicated as financial regulators tackle the shadow banking sector.7 Chart II-18Reforms Cut Steel Capacity, ##br##Reduced Need For Scrap Reforms Cut Steel Capacity, Reduced Need For Scrap Reforms Cut Steel Capacity, Reduced Need For Scrap These last examples - financial and environmental regulatory tightening - are policy priorities in 2018. The coercive aspect of the corruption probes should ensure that they are more effective than they would otherwise be. And reining in asset bubbles and reducing pollution are clear long-term positives for the regime. Ideally, then, Xi's anti-corruption campaign will deliver three substantial improvements to China's long-term outlook: greater public trust in the government, higher total factor productivity, and reduced systemic risks. The administration hopes that it can mitigate its governance deficit while improving economic sustainability. In this way it can buy both public support and precious time to continue adjusting to the new normal. The danger is that these policies will combine to increase downside risks to growth in the short term.8 Bottom Line: Xi's anti-corruption campaign is being expanded and institutionalized to cover the entire Chinese administrative state. This is a consequential campaign that will take up a large part of Xi's second term. It is the administration's major attempt to mitigate the socio-political challenges that await China as it rises up the income ladder. Absolute Power Corrupts Absolutely? The problem, however, is that Xi may merely use the anti-corruption campaign to accrue more power into his hands. As is clear from the above, Xi's governance agenda is far from impartial and professional. The anti-corruption campaign is being used not only to punish corrupt officials but also to achieve various other goals. Xi has even publicly linked the campaign to the downfall of his political rivals.9 In essence, the campaign highlights the core contradiction of the Xi administration: can Xi genuinely improve China's governance by means of the centralization and personalization of power? Chart II-19China's Governance Still Falls Far Behind January 2018 January 2018 Over the long haul, the fundamental problem is the absence of checks and balances, i.e. accountability, from Xi's agenda. For instance, the National Supervision Commission will be granted immense powers to investigate and punish malefactors within the state - but who will inspect the inspectors? Xi's other governance reforms suffer the same problem. His attempt to create "rule of law" is lacking the critical ingredients of judicial independence and oversight. The courts are not likely to be able to bring cases against the party, central government, or powerful state-owned firms, and they will not be able to repeal government decisions. Thus, as many commentators have noted, Xi's notion of rule of law is more accurately described as "rule by law": the reformed legal system will in all probability remain an instrument in the hands of the Communist Party. Likewise, Xi's attempt to grant the People's Bank of China greater powers of oversight in order to combat systemic financial risk suffers from the fact that the central bank is not independent, and will remain subordinate to the State Council, and hence to the Politburo Standing Committee. This is not even to mention the lamentable fact that Xi's campaign for better governance has so far coincided with extensive repression of civil society, which does not mesh well with the desire to improve human capital and innovation.10 Thus it is of immense importance whether Xi sets up relatively durable anti-corruption, legal, and financial institutions that will maintain their legitimate functions beyond his term and political purposes. Otherwise, his actions will simply illustrate why China's governance indicators lag so far behind its peers in absolute terms. Corruption perceptions may improve further, but there will be virtually no progress in areas like "voice and accountability," "political stability and absence of violence," "rule of law," and "regulatory quality," each of which touches on the Communist Party's weak spots in various ways (Chart II-19). Analysis of the Communist Party's shifting leadership characteristics reinforces a pessimistic view of the long run if Xi misses his current opportunity.11 The party's top leadership increasingly consists of career politicians from the poor, heavily populated interior provinces - i.e. the home base of the party. Their educational backgrounds are less scientific, i.e. more susceptible to party ideology. (Indeed, Xi Jinping's top young protégé, Chen Miner, is a propaganda chief.) And their work experience largely consists of ruling China's provinces, where they earned their spurs by crushing rebellions and redistributing funds to placate various interest groups (Chart II-20). While one should be careful in drawing conclusions from such general statistics, the contrast with the leadership that oversaw China's boldest reforms in the 1990s is plain. Chart II-20China's Leaders Becoming More 'Communist' Over Time January 2018 January 2018 Bottom Line: Xi's reform agenda is contradictory in its attempt to create better governance through centralizing and personalizing power. Unless he creates checks and balances in his reform of China's institutions, he is likely to fall short of long-lasting improvements. The character profiles of China's political elite do not suggest that the party will become more likely to pursue pro-market reforms in Xi's wake. Xi Jinping's Choice Xi is the pivotal player because of his rare consolidation of power, and 2018 is the pivotal year. It is pivotal because it will establish the policy trajectory of Xi's second term - which may or may not extend into additional terms after 2022. So far, the world has gained a few key takeaways from Xi's policy blueprint, which he delivered at the nineteenth National Party Congress on October 18: Xi has consolidated power: He and his faction reign supreme both within the Communist Party and the broader Chinese state; Xi's policy agenda is broadly continuous: Xi's speech built on his administration's stated aims in the first five years as well as the inherited long-term aims of previous administrations; China is coming out of its shell: In the international realm, Xi sees China "moving closer to center stage and making greater contributions to mankind"; The 2022 succession is in doubt: Xi refrained from promoting a successor to the Politburo Standing Committee, the unwritten norm since 1992. Markets have not reacted overly negatively to these developments (Chart II-21), as the latter do not pose an immediate threat to the global rally in risk assets. The reasons are several: Chart II-21Market Not Too Worried About ##br##Party Congress Outcomes Market Not Too Worried About Party Congress Outcomes Market Not Too Worried About Party Congress Outcomes Maoism is overrated: While the Communist Party constitution now treats Xi Jinping as the sole peer of the disastrous ruler Mao Zedong, the market does not buy the Maoist rhetoric. Instead, it sees policy continuity, yet with more effective central leadership, which is a plus. Reforms are making gradual progress: Xi is treading carefully, but is still publicly committed to a reform agenda of rebalancing China's economic model toward consumption and services, improving governance and productivity, and maintaining trade openness. Whatever the shortcomings of the first five years, this agenda is at least reformist in intention. China's tactic of "seeking progress while maintaining stability" is certainly more reassuring than "progress at any cost" or "no progress at all"! Trump and Xi are getting along so far: Xi's promises to move China toward center stage threaten to increase geopolitical tensions with the United States in the long run, yet markets are not overly alarmed. China is imposing sanctions on North Korea to help resolve the nuclear missile standoff, negotiating a "Code of Conduct" in the South China Sea, and promoting the Belt and Road Initiative (BRI), which will marginally add to global development and growth. Trump is hurling threatening words rather than concrete tariffs. 2022 is a long way away: Markets are unconcerned with Xi's decision not to put a clear successor on the Politburo Standing Committee, even though it implies that Xi will not step down at the end of his term in five years. Investors are implicitly approving Xi's strongman behavior while blissfully ignoring the implication that the peaceful transition of power in China could become less secure. Are investors right to be so sanguine? Cyclically, BCA's China Investment Strategy is overweight Chinese investible equities relative to EM and global stocks. Geopolitical Strategy also recommends that clients follow this view and overweight China relative to EM. Beyond this 6-12 month period, it depends on how Xi uses his political capital. If Xi is serious about governance and economic reform, then long-term investors should tolerate the other political risks, and the volatility of reforms, and overweight China within their EM portfolio. After all, China's two greatest pro-market reformers, Deng Xiaoping and Jiang Zemin, were also heavy-handed authoritarians who crushed domestic dissent, clashed with the United States from time to time, and hesitated to relinquish control to their successors. However, if Xi is not serious, then investors with a long time horizon should downgrade China/EM assets - as not only China but the world will have a serious problem on its hands. For Deng Xiaoping and Jiang Zemin always reaffirmed China's pro-market orientation and desire to integrate into the global economic order. If Xi turns his back on this orientation, while imprisoning his rivals for corruption, concentrating power exclusively in his own person, and contesting U.S. leadership in the Asia Pacific, then the long-run outlook for China and the region should darken rather quickly. Domestic institutions will decay and trade and foreign investment will suffer. How and when will investors know the difference? As mentioned, we think 2018 is critical. Xi is flush with political capital and has a positive global economic backdrop. If he does not frontload serious efforts this year then it will become harder to gain traction as time goes by.12 If he demurs, the Chinese political system will not afford another opportunity like this for years to come. The country will approach the 2020s with additional layers of bureaucracy loyal to Xi, but no significant macro adjustments to its governance or productivity. It is not clear how long China's growth rate is sustainable without pro-productivity reforms. It is also not clear that the world will wait five years before responding to a China that, without a new reform push, will appear unabashedly mercantilist, neo-communist, and revisionist. Bottom Line: The long-run investment outlook for China hinges on Xi Jinping's willingness to use his immense personal authority and concentration of power for the purposes of good governance and market-oriented economic reform. Without concrete progress, investors will have to decide whether they want to invest in a China that is becoming less economically vibrant as well as more authoritarian. We think this would be a bad bet. Matt Gertken Associate Vice President Geopolitical Strategy Marko Papic Senior Vice President Chief Geopolitical Strategist Geopolitical Strategy 1 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 2 Chinese policymakers are expressly concerned about the middle-income trap. Please see the World Bank and China's Development Research Center of the State Council, "China 2030: Building A Modern, Harmonious, And Creative Society," 2013, available at www.worldbank.org. Liu He, who is perhaps Xi Jinping's top economic adviser, had a hand in drafting this report and is now a member of the Politburo and shortlisted to take charge of the newly established Financial Stability and Development Commission at the People's Bank of China. 3 Please see Indermit S. Gill and Homi Kharas, "The Middle-Income Trap Turns Ten," World Bank, Policy Research Working Paper 7403 (August, 2015), available at www.worldbank.org 4 Please see Ronald Inglehart and Christian Welzel, Modernization, Cultural Change and Democracy: the Human Development Sequence (Cambridge: CUP, 2005). 5 For example, the collapse of the Soviet Union and the Arab Spring, as well as the downfall of communist regimes writ large, were completely unanticipated. 6 Specifically, Xi is creating a National Supervision Commission that will group a range of existing anti-graft watchdogs under its roof at the local, provincial, and central levels of administration, while coordinating with the Communist Party's top anti-graft watchdog. More details are likely to be revealed at the March legislative session, but what matters is that the initiative is a significant attempt to institutionalize the anti-corruption campaign. Please see BCA Geopolitical Strategy Special Report, "China's Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 7 China has recently drafted top anti-graft officials, such as Zhou Liang, from the powerful Central Discipline and Inspection Commission and placed them in the China Banking Regulatory Commission, which is in charge of overseeing banks. Authorities have already imposed fines in nearly 3,000 cases in 2017 affecting various kinds of banks, including state-owned banks. On the broader use of anti-corruption teams for economic policy, please see Barry Naughton, "The General Secretary's Extended Reach: Xi Jinping Combines Economics And Politics," China Leadership Monitor 54 (Fall 2017), available at www.hoover.org. 8 Please see BCA Geopolitical Strategy Special Report, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 9 Please see Gao Shan et al, "China's President Xi Jinping Hits Out at 'Political Conspiracies' in Keynote Speech," Radio Free Asia, January 3, 2017, available at www.rfa.org 10 Xi has cranked up the state's propaganda organs, censorship of the media, public surveillance, and broader ideological and security controls (including an aggressive push for "cyber-sovereignty") to warn the public that there is no alternative to Communist Party rule. This tendency has raised alarms among civil rights defenders, lawyers, NGOs, and the western world to the effect that China's governance is actually regressing despite nominal improvement in standard indicators. This is the opposite of Confucius's bottom-up notion of order. 11 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 12 Xi faces politically sensitive deadlines in the 2020-22 period: the economic targets in the thirteenth Five Year Plan; the hundredth anniversary of the Communist Party in 2021; and Xi's possible retirement at the twentieth National Party Congress in 2022. At that point he will need to focus on demonstrating the Communist Party's all-around excellence and make careful preparations either to step down or cling to power. III. Indicators And Reference Charts Global equity indexes remained on a tear heading into year-end on the back of robust earnings growth in the major countries and U.S. tax cuts. There are some dark clouds hanging over this rally, as discussed in the Overview section. The technicals are stretched, but none of our fundamental indicators are warning of a market top. Implied equity volatility is very low, which can be interpreted in a contrary fashion. Investor sentiment is frothy and our Speculation Indicator is very elevated. Moreover, our equity valuation indicator has finally reached one standard deviation, which is our threshold of overvaluation. Valuation does not tell us anything about timing, but it does highlight the downside risks. Our monetary indicator also deteriorated a little more in December, although not by enough on its own to justify downgrading risk assets. On a positive note, earnings surprises and the net revisions ratio are not sending any warning signs for profit growth (although net revisions have edged lower recently). Moreover, our new Revealed Preference Indicator (RPI) continued on its bullish equity signal in November for the fifth consecutive month. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Our Willingness-to-Pay (WTP) indicators are also bullish on stocks in the U.S., Europe and Japan. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The small dip in the Japanese WTP in December is a little worrying, but we need to see more weakness to confirm that flows no longer favor Japanese equities. In contrast, Europe's WTP rose sharply in December, suggesting that investors are allocating more to their European equity holdings. We are overweight both Europe and (especially) Japan relative to the U.S. (currency hedged). U.S. Treasury valuation is still very close to neutral, even following December's backup in yields. There is plenty of upside potential for yields before they hit "inexpensive" territory. Similarly, our technical bond indicator suggests that technical factors will not be headwind to a further bond selloff in 2018. Little has change for the dollar. The technicals are neutral. Value is expensive based on PPP, but less so by other valuation metrics. We see modest upside for the greenback in 2018. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And ##br##Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And ##br##Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart II-9U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart II-10U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart II-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart II-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart II-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart II-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart II-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart II-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart II-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart II-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart II-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart II-20Euro Technicals Euro Technicals Euro Technicals Chart II-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart II-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart II-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart II-24Commodity Prices Commodity Prices Commodity Prices Chart II-25Commodity Prices Commodity Prices Commodity Prices Chart II-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart II-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart II-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart II-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart II-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart II-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart II-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart II-33U.S. Consumption U.S. Consumption U.S. Consumption Chart II-34U.S. Housing U.S. Housing U.S. Housing Chart II-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart II-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart II-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart II-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China

Dear Client, We are sending you this last issue of the year, a lighter fare than usual, highlighting 10 charts we find important. The first two charts tackle two of the key economic questions of the day: U.S. inflation and Chinese construction. The next seven charts are displays of technical action that has captured our attention for key currency pairs. The last chart tackles the topic du jour, bitcoin. We will resume regular publishing on January 5th, 2018. Finally, the Foreign Exchange Strategy team would like to thank you for your continued readership, and wishes you and your families a joyful holiday season as well as a healthy, happy and prosperous 2018. Warm Regards, Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Feature 1) U.S. Inflation Chart I-1AU.S. Inflation Is On Its Merry Way (I) U.S. Inflation Is On Its Merry Way (I) U.S. Inflation Is On Its Merry Way (I) Chart I-1BU.S. Inflation Is On Its Merry Way (II) U.S. Inflation Is On Its Merry Way (II) U.S. Inflation Is On Its Merry Way (II) U.S. inflation has been moribund in 2017, dismaying believers of the Philips curve, the Federal Reserve included. A few factors have been at play. The Fed sigma models show that the negative impact of a dollar rally on U.S. inflation is at its strongest with a two-year lag. Additionally, the fall in capacity utilization that happened following the industrial recession in late 2015/early 2016 continued to affect inflation negatively this year. These headwinds are passing. As the left panel of Chart I-1 illustrates, the easing in U.S. financial conditions this past year is likely to continue and become most salient for inflation in 2018. Meanwhile, the right panel of the chart shows that as the deceleration in money velocity growth forecasted the weakness in core inflation in 2017, its recent re-acceleration points to a pick-up in inflation next year. The Fed might be able to achieve its interest rate forecast of 3.1% in 2020 after all. 2) Chinese Housing Chart I-2AFrosty Outlook For Chinese Construction (I) Frosty Outlook For Chinese Construction (I) Frosty Outlook For Chinese Construction (I) Chart I-2BFrosty Outlook For Chinese Construction (II) Frosty Outlook For Chinese Construction (II) Frosty Outlook For Chinese Construction (II) Chinese monetary conditions have been tightened in 2017, fiscal expansion has been curtailed, and the growth of the M3 broad money supply has fallen to 8.8%. So far, the Chinese economy is hanging in, still benefiting from the fact that real interest rates have collapsed since November 2015 as producer price inflation rebounded from a 6% contraction to a 6% expansion today. This increase in producer prices has also helped industrial profits, which are expanding at a 23% pace, helping put a floor under industrial production. However, the outlook for residential investment needs to be monitored. Construction contributed 17% of GDP growth during the past two years. Chinese construction also contributed to 20% and 32% of the global consumption of refined copper and steel, respectively. This means that Chinese construction was a key driver of metal prices. Yet our leading indicator for Chinese house prices points toward a marked deceleration in the coming quarters. As the right panel of Chart I-2 shows, this could get translated into additional downside for iron ore. 3) EUR/USD Chart I-3The Euro Is At A Key Threshold The Euro Is At A Key Threshold The Euro Is At A Key Threshold 1.20 continues to represent a big hurdle to cross for EUR/USD. For the euro to punch above this mark, U.S. inflation will have to remain moribund in 2018. The rally in EUR/USD tracked an improvement in market estimates of the European Central Bank's terminal policy rate relative to the Fed's. Yet this improvement did not reflect an upgrade of the ECB's terminal rate itself, but rather a major downgrade of the Fed's, as U.S. inflation disappointed. If U.S. inflation rebounds as BCA anticipates, the dollar should be able to rally toward 1.10, especially as euro area inflation is unlikely to follow suit, as euro area financial conditions have tightened massively relative to the U.S. If U.S. inflation does not rebound, a move toward 1.30 is possible. Glimpsing at Chart I-3, it should also be obvious that any strength in the dollar next year is likely to prove a long-term buying opportunity for the euro. The EUR/USD has only traded below current levels when the U.S. dollar has been in the thralls of a major bubble. Additionally, global portfolios are deeply underweight euro area assets, therefore, a long-term rebalancing of portfolios toward euro area assets will support the euro down the road. Finally, when the next recession hits, the ECB is likely to have less room to stimulate its economy than the Fed will have. This means that during the next recession, the euro could behave like the yen has over the past 20 years: because the ECB will be impotent to fight deflationary pressures, falling euro area inflation will result in rising euro area real interest rates, especially against the U.S. This helped the yen then, and it could help the euro in the future, especially as the euro area's net international investment position is set to move into positive territory over the next 24 months. 4) EUR/GBP Chart I-4Brexit And Valuations Will Keep EUR/GBP Range-Bound For Now Brexit And Valuations Will Keep EUR/GBP Range-Bound For Now Brexit And Valuations Will Keep EUR/GBP Range-Bound For Now EUR/GBP is at an interesting juncture. EUR/GBP has rarely traded above current levels (Chart I-4). On one hand, Brexit would suggest that EUR/GBP could actually rise. The uncertainty around the U.K. leaving the EU has caused the U.K. economy to be among the rare ones to not accelerate in unison with global growth this year, despite the stimulative effect of a lower pound. This suggests that the hands of the Bank of England will remain tied, limiting its capacity to increase the cash rate. Moreover, U.K. politics continue to take an increasingly populist tone, and the growing popularity of Jeremy Corbyn suggests that the discontent is present on all sides of the political spectrum. Populist policies are rarely good for a currency. On the other hand, the GBP is trading at such a discount to its fair value against both the USD and the EUR that historically, buying the pound at current levels has generated gains for investors with investment horizons measured in years. Moreover, if the EUR weakens in the first half of 2018, historical antecedents argue that EUR/GBP would also weaken in this context. When taken altogether, these factors suggest that EUR/GBP is likely to remain stuck in its post-Brexit trading range for as long as political uncertainty remains, especially as it is unlikely that the U.K. will receive a sweetheart FTA deal from the EU. Thus, while we expect EUR/GBP to retest 0.84 over the course of the next three to six months, at these levels we would buy EUR/GBP with a target of 0.90. 5) EUR/SEK Chart I-5EUR/SEK Will Fall From 10 To 9 EUR/SEK Will Fall From 10 To 9 EUR/SEK Will Fall From 10 To 9 EUR/SEK flirted with 10 this month. As Chart I-5 illustrates, this only happened during the financial crisis. Sweden is a much more pro-cyclical economy than the euro area, hence EUR/SEK exhibits very strong counter-cyclical behavior. It only trades above 10 when global growth is in tatters, and below 9 when it is booming. The recent spate of strength in EUR/SEK is thus perplexing, since global growth has been very robust and broad-based this year. The very easy policy of the Riksbank has been the main culprit. Timing a reversal in EUR/SEK is tricky, as it remains a function of the rhetoric of the Riksbank. But today, Swedish inflation is on the rise, with the CPIF, the inflation gauge targeted by the Swedish central bank, being at target. Thus, the days of super easy monetary policy in Sweden are numbered, especially as the output gap is a positive 1%, unemployment stands nearly 1% below equilibrium, and resource utilization measures have spiked up. Today, it makes sense to buy the SEK versus the euro. However, EUR/SEK is unlikely to move below 9, as the best of the global business cycle is probably behind us. 6) USD/JPY Chart I-6A Big Move In USD/JPY Is On Its Way A Big Move In USD/JPY Is On Its Way A Big Move In USD/JPY Is On Its Way USD/JPY is at an interesting technical juncture. This pair has been forming a very large tapering wedge in recent years (Chart I-6). This type of formation can be resolved in either a bullish fashion or a bearish one. Our current inclination is to bet on a bullish resolution for USD/JPY, as global bond yields seem to finally be regaining some vigor, which historically has been poison for the yen. Supporting our bias is the fact that we see more interest rate increases in the U.S. than are currently priced in, as we foresee a pick-up in inflation in 2018. The one thing that keeps us awake at night when thinking about our bullish disposition for USD/JPY is that EM carry trades have begun to weaken. Historically, this has led to a softening in global activity which foments further EM-carry-trade reversals and weakness in USD/JPY. Investors should keep an eye on this space. 7) AUD/USD Chart I-7AUD/USD At 0.8 Is A Line In The Sand AUD/USD At 0.8 Is A Line In The Sand AUD/USD At 0.8 Is A Line In The Sand The Australian dollar possesses the poorest outlook among the G10 currencies. The Australian economy continues to be plagued by large amounts of overcapacity, inflation is still absent, and Australia is the economy most exposed to a slowdown in Chinese construction activity as Australian terms-of-trade shocks follow metals prices. Additionally, China's push to fight pollution points to weakening coal prices, another key export of Australia. Moreover, Chart I-7 illustrates that the AUD rarely trades above 0.8. To do so, it needs an especially robust global economy, with China firing on all cylinders. We do not think China is about to crash, but it is not about to accelerate either, especially when it comes to demand for metals. Thus, with AUD/USD trading at 0.77, we see more downside for this pair than upside. In fact, when observed in a broader, longer-term context, the rally since 2016 in the AUD looks like a consolidation within a larger downtrend. 8) AUD/CAD Chart I-8AUD/CAD Will Breakdown AUD/CAD Will Breakdown AUD/CAD Will Breakdown AUD/CAD seems to have hit its natural ceiling this year. Only in the first half of the 1990s and when China was reflating its economy with all its might right after the financial crisis was AUD/CAD able to punch above 1.03 (Chart I-8). We do not see a repeat of this performance in the coming two years. First, as we mentioned, BCA does not anticipate any re-acceleration in Chinese investment or EM demand. Second, AUD/CAD is expensive, trading 9% above its fair value. Third, BCA remains more bullish on oil prices than metals prices. Fourth, a weakening AUD/USD tends to be associated with a weakening AUD/CAD. Finally, if these four factors cause AUD/CAD to weaken below 0.964, a key upward trend line that has supported AUD/CAD since late 2008 will be broken, which should prompt additional selling in this cross. 9) AUD/NZD Chart I-9AUD/NZD: Buffeted Between China, Jacinda, And Valuations AUD/NZD: Buffeted Between China, Jacinda, And Valuations AUD/NZD: Buffeted Between China, Jacinda, And Valuations AUD/NZD is likely to remain stuck in its trading range established since 2013 (Chart I-9). To begin with, the Australian dollar is trading at a 10% premium to the NZD. This has happened three times over the previous 17 years. Each of these instances were followed by vicious corrections in this cross. Additionally, while the AUD is very exposed to a slowing in Chinese construction and the associated problems for base metals prices, the NZD is not. In fact, the NZD may even benefit from the new economic objectives set by China's leadership. One of these new key objectives is to rebalance the economy toward the consumer. Moreover, Chinese consumer preferences have seen a switch toward higher quality foodstuffs.1 Higher quality foodstuffs, meat and dairy in particular, are exactly what New Zealand exports. Thus, a relative negative terms-of-trade shock is likely to come for AUD/NZD. The one big negative to our view is the political situation in New Zealand. The recent wave of populism points toward a fall in the potential growth rate, and thus a fall in the terminal policy rate of the Reserve Bank of New Zealand. The limit on foreign investment in Kiwi housing is another negative.2 Thus, we are not yet willing to bet on AUD/NZD falling below parity. 10) Bitcoins Chart I-10Groupthink Points To A Bitcoin Correction Toward 11,000 Groupthink Points To A Bitcoin Correction Toward 11,000 Groupthink Points To A Bitcoin Correction Toward 11,000 Valuing bitcoins is an arduous exercise. A lack of clearly defined fundamentals is the key difficulty. It is also why bitcoin prices can move so violently. We have already covered the technological elements behind Bitcoin and the blockchain,3 but to uncover what could be driving investors' imaginations, we have to move back to the realm of economics and finance. One theory tries to value bitcoin by linking it to a mode of payment. Using this method, Dhaval Joshi, who writes our BCA European Investment Strategy service, estimates a fair value for BTC/USD. Using the quantity of money theory, he shows that if the market assumes that bitcoins can support US$0.5 trillion of global GDP, and if the velocity of money historically averages 1.5 times, with 21 million potential bitcoins in issuance, a bitcoin should be worth US$17,000.4 Changing estimates for velocity or how much of global GDP will be transacted using bitcoins varies this estimate. Another approach has been to value bitcoins as an asset with a limited supply, like gold. Using this methodology, the global gold stock is worth approximately US$7 trillion, but cryptocurrencies, with their high volatility, are unlikely to steal the yellow metal's entire market share. Instead, they might be able to carve out 25% of gold's current total market capitalization. In this case, cryptos would be worth US$1.75 trillion. Bitcoin could represent half of this amount, which equates to a total market capitalization of US$875 billion. With a stock of 21 million bitcoins, the "fair value" would be around US$42,000. A third approach exists, and it is the simplest (Occam Razor's alert?). As Peter Berezin argues in BCA's Global Investment Strategy service, global governments extract seigniorage benefits from issuing currency.5 As an example, by printing cash, the U.S. government can buy services and good worth roughly US$90 billion per year, at a near zero cost. This is a very significant amount. Governments are unlikely to ever give up this source of funding. Since crypto currencies are a direct threat to this, they will likely be made illegal as a result. This would imply a fair value of BTC/USD of zero. The current fair value is likely to be a probability weighted average of all three scenarios. We assign a 10% probability for the first case (mode of payment), a 10% probability to the second case (store of value), and an 80% probability to the last case (zero value due to illegality). This would give a current fair value of roughly US$6,000. At the current juncture, bitcoin trading is exhibiting strong herd-like tendencies. When groupthink takes over a market, as is the case right now with crypto-currencies in general and bitcoin in particular, a trend reversal is likely to materialize. Today, bitcoin's "fractal dimension" has hit the 1.25 neighborhood, where such reversals have tended to happen (Chart I-10). As such, a correction is very likely. The average correction since 2016 has been around 35%. Following similarly parabolic moves as the one observed over the past month, pullbacks have been closer to 45%. A retracement toward BTC/USD of 11,000 is very probable over the coming quarters. That being said, it is too early to call the ultimate top for bitcoin. With the narrative among the bitcoin investing public increasingly switching to bitcoin being a store of value akin to gold, a move to the US$40,000 neighborhood is, in fact, not a tail event. However, this is a move to play at one's own peril, since fair value is likely to be well below these levels. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Atkinson, Simon. "Why are China instant noodle sales going off the boil?" BBC News, BBC, 20 Dec. 2017, www.bbc.com/news/business-42390058. He, Laura. "China's growing middle class lose appetite for instant noodles." South China Morning Post, 20 Aug. 2017, www.scmp.com/business/companies/article/2107540/chinas-growing-middle-class-lose-appetite-instant-noodles. 2 For a more detailed discussion of the political situation in New Zealand as well as its potential impact, please see Foreign Exchange Strategy Weekly Report, titled "Reverse Alchemy: How to Transform Gold into Lead" dated November 3, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report, titled "Blockchain And Cryptocurrencies" dated May 12, 2017, available at fes.bcaresearch.com 4 Please see European Investment Strategy Weekly Report, titled "Bitcoins And Fractals" dated December 21, 2017, available at eis.bcaresearch.com 5 Please see Global Investment Strategy Weekly Report, titled "Don't Fear A Flatter Yield Curve" dated December 22, 2017, available gis.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 U.S. data was mixed: Housing starts increased by 1.3 million units, beating expectations, building permits also outperformed; Both the Philadelphia Fed Manufacturing Survey and Chicago Fed National Activity Index outperformed expectations; However, annualized Q3 GDP growth came in at 3.2%, less than the expected 3.3%; Growth in headline and core personal consumption deflators also failed to meet expectations, coming in at 1.5% and 1.3% respectively. Easier financial conditions are expected to slowly push the core PCE deflator back to the Fed's 2% target. This will allow Jerome Powell to continue in Janet Yellen's footsteps. As credit continues to grow, the large U.S. consumer sector will become an increasingly important tailwind to growth. The fiscal thrust from the new tax plan will could also accentuate growth and inflationary pressures. Therefore, investment and consumption activity are both likely to pick up next year. This will should support the Fed as well as the USD. Report Links: Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 The Xs And The Currency Market - November 24, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 European data was mixed: German ZEW Current Situation increased to 89.3, outperforming expectations of 88.5; European ZEW Current Situation slightly underperformed expectations of 18, coming in at 17.4; Manufacturing and services PMIs for Germany and Europe as a whole both outperformed expectations; European trade balance decreased to EUR 19 bn from EUR 25 bn, and the current account also underperformed; European CPI was in line with expectations, contracting at a monthly pace, and growing at a 0.9% annual pace, under the expected 1% rate. On the Back of strong momentum in activity indicators, the ECB upgraded its growth and inflation forecasts for the upcoming years. However, since inflation is expected to remain under target for the whole forecast horizon, the ECB is likely to tighten policy at a much slower pace than the Fed. Report Links: The Xs And The Currency Market - November 24, 2017 Temporary Short-Term Rates - November 10, 2017 Market Update - October 27, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: Annual Import growth came in at 17.2%, surprising to the downside. Moreover, the All Industry Activity Index monthly growth also underperformed expectations, coming in at 0.3%. However, export annual growth surprised to the upside, coming in at 16.2%, an acceleration relative to last month's reading. On Wednesday, the Bank of Japan left its policy rate unchanged at -0.1%. Furthermore, the yield curve control policy, in which 10-year yields are kept around 0%, has been maintained. We stay bullish on USD/JPY, as we expect U.S. bond yields to rise when inflation picks up next year. However the yen could appreciate against commodity currencies if a risk-off period is triggered by tightening in China. Report Links: Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 The Xs And The Currency Market - November 24, 2017 Temporary Short-Term Rates - November 10, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Gfk Consumer confidence underperformed expectations, coming in at -13. This measure also decline from the November reading. However, CBI industrial Trend Survey for orders, surprised to the upside, coming in at 17. Finally, public sector borrowing also surprised to the upside, coming in at 8.118 Billion pounds. The pound has been flat against the U.S. dollar this week. Overall we remain skeptical in the ability of the Bank of England to tighten much in the near future, given that real disposable income growth is very depressed, house price growth continues to be tepid, and uncertainty weighs on capex. Moreover, inflation will likely come down from present levels, as the pass through from the pound depreciation dissipates. All of these factors will limit any upside to cable in the next months. Report Links: The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The AUD rallied solidly in recent weeks thanks to buoyant data out of Australia and China. Last week's labor numbers were especially important in this regard. The growth in full-time employment has outperformed that of part-time since summer, while the underemployment rate has declined by 0.3% since 2017Q2.. Moreover, RBA officials identified further positives in the housing market: excessive price appreciation has slowed down considerably and household's balance sheets are improving. For now, the biggest risk to the Australian dollar remains the Chinese economy. Xi Jinping's commitment to clamp down on pollution, debt and inequalities is a bearish prospect for the AUD. Additionally, Chinese house prices could decline substantially - something which would have negative repercussions for the AUD. Report Links: The Xs And The Currency Market - November 24, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been mixed: The current account surprised to the downside, coming in at -2.6% of GDP. However this number did improve from last quarter's -2.8% reading. However, both imports and exports outperformed expectations, coming in at 5.82 billion and 4.63 billion respectively. Moreover, GDP growth outperformed expectations, coming in at 2.7%. However, this number did decline from the 2.8% reading in Q2. NZD/USD was flat this week, even as the USD weakened. We continue to believe that carry currencies like the NZD, will be affected by tightening of financial conditions in China. However, the NZD has upside against the AUD, as the New Zealand dollar is cheaper than the AUD, and it is not as levered to the Chinese industrial cycle as the Australian dollar is. Report Links: The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Canadian data was strong this week: Retail sales increased month-on-month by 1.5%, outperforming expectations by 0.8%; core retail sales also increased by a 0.8% monthly pace; Core inflation is at 1.3%, outperforming the expected 0.8%; Headline CPI is at 2.1%, above the expected 2%; The Canadian economy is growing in line with our expectations. A strong U.S. economy has allowed the export sector to flourish, while high demand for jobs has caused the labor market to tighten substantially. As labor shortages intensify, wages should gain traction in the near future, paving way for the BoC to tighten at least twice next year. Report Links: The Xs And The Currency Market - November 24, 2017 Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recently, the SNB released its 4th quarter quarterly bulletin. This report highlighted that the Swiss economy continues to recover, and GDP growth is expected to reach 2% in 2018, after a 1% expansion this year. Furthermore, the bulletin remarked that the labor market continues to tighten, with unemployment reaching 3% and employment growth finally hitting its long term average. The SNB also remarked that although the output gap continues to be negative, measures of capacity utilization are very close to reaching their long term average. However, the SNB continues to be unapologetically committed to its dovish bias and to intervention in currency markets, as inflation in Switzerland continues to be too weak for the SNB to change its stance. Thus, the CHF is likely to continue depreciating. Report Links: The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 USD/NOK has appreciated by nearly 1.5% since last week, even as Brent has rallied by more than 2.5%. This dynamic highlights the fact that USD/NOK continues to be more correlated to interest rate differentials between Norway and the U.S. than to oil prices. Inflationary pressures and economic activity continue to be too tepid for the Norges to adopt a much more hawkish tone than it did last week. Meanwhile, the Fed is likely to surprise the market next year, by following up on its "dot plot". These dynamics will continue to put upward pressure on USD/NOK. Nevertheless, foreign exchange investors can still use the krone to bet on higher oil prices resulting from the extension of the OPEC supply cuts. The way to do so is by shorting EUR/NOK, which is more correlated with oil prices. Report Links: Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Swedish data has bounced back considerably: Headline CPI increased by 1.9% annually and CPIF grew by 2% annually; The unemployment rate dropped substantially from 6.3% to 5.8%, while the seasonally adjusted figure dropped from 6.7% to 6.4%. This week, the Riksbank announced a formal end to additional bond purchases by the end of December. However, reinvestments will continue until the middle of 2019, which means that the Bank's holdings of government bonds will actually increase into 2019. Additionally, the Swedish central bank also forecasts the repo rate to begin gradually increasing in the middle of 2018. This makes sense as the Swedish economy is running beyond capacity conditions. Given Sweden's stellar growth period, an appreciation in the SEK is long-awaited, but this will have to wait until Governor Ingves convinces markets that his perennial dovish-bias is ebbing. At that point, any hint of hawkishness will cause a sharp appreciation in the SEK, especially against the euro. Report Links: Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Dear Client, This is our last report of 2017. We will be back on January 4, 2018, with our customary recap of recommendations made this year. We wish you and your loved ones the very best this lovely season has to offer. Sincerely, Robert P. Ryan, Chief Commodity Strategist Commodity & Energy Strategy Highlights With GDP growth accelerating in ~ 75% of countries monitored by the IMF, we expect commodity demand - particularly for crude oil and refined products - to remain strong in 2018. On the supply side, OPEC 2.0 - the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia - will maintain its production discipline, which will force commercial oil inventories lower in 2018. As a result, we expect oil markets to continue to tighten in 2018, keeping upside risk to prices from unplanned production outages acute. This was clearly demonstrated in separate incidents in the U.S. and North Sea in the past two months, which removed more than 400k b/d from markets since November. Geopolitical risk will remain elevated, particularly in Venezuela, where operations at the state oil company were paralyzed after senior military officers assumed leadership positions there. Beyond 2018, we believe OPEC 2.0 will endure as a coalition. It will manage production and provide forward guidance consistent with a strategy to keep WTI and Brent forward curves backwardated. This will provide a supportive backdrop for the Saudi Aramco IPO, expected toward the end of next year, and will limit the volume of hedging U.S. shale-oil producers are able to effect. In turn, this will limit the number of rigs U.S. E&Ps can profitably deploy. Energy: Overweight. Our Brent and WTI call spreads in 2018 - long $55/bbl calls vs. short $60/bbl calls - are up an average 53.8%. We will retain these exposures into 2018. Base Metals: Neutral. We expect base metals to be supported through 1Q18, after which reform measures in China could crimp supply and demand, as we discuss below. Precious Metals: Neutral. We remain long gold as a strategic portfolio hedge against inflation and geopolitical risk, even though inflation remains quiescent (see below). Ags/Softs: Underweight. Fed policy will be critical to ag markets in 2018. We expect as many as four rate hikes next year, as the Fed continues with rates normalization (see below). Feature Our updated balances model indicates global oil markets will continue to tighten in 2018, as demand growth accelerates and OPEC 2.0 - the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia - maintains production discipline (Chart of the Week). Earlier this week, IMF noted improving employment conditions globally, which will continue to support aggregate demand and the synchronized global expansion in manufacturing and trade (Chart 2 and Chart 3).1 This acceleration of GDP growth rates globally will continue to support income growth and commodity demand generally. Oil-exporters have not participated in the global economic expansion to the extent of other economies, according to the Fund, which can be seen in the trade data (Chart 3). However, imports by Middle East and African countries are moving higher, and look set to post year-on-year (yoy) growth in the near future. Chart of the WeekOil Balances Will Continue to Tighten In 2018 Oil Balances Will Continue to Tighten In 2018 Oil Balances Will Continue to Tighten In 2018 Chart 2Global Upturn Boosts Manufacturing, ##br##Commodity Demand... Global Upturn Boosts Manufacturing, Commodity Demand... Global Upturn Boosts Manufacturing, Commodity Demand... The combination of continued production discipline from OPEC 2.0 and expanding incomes boosting demand will force crude and product inventories lower, particularly those in the OECD, which are the primary target of the producer coalition (Chart 4). Chart 3...And Global Trade ...And Global Trade ...And Global Trade Chart 4OECD Inventories Will Fall Below 5-year ##br##Average In BCA's Supply-Demand Assessment OECD Inventories Will Fall Below 5-year Average In BCA's Supply-Demand Assessment OECD Inventories Will Fall Below 5-year Average In BCA's Supply-Demand Assessment Unplanned Outages Mounting; Risk Remains Acute Unlike many forecasters, we continue to expect inventories to draw in 1Q18. This expectation is the direct result of our supply-demand modelling, and also is supported by our expectation that the risk of unplanned outages is increasing. This already has been demonstrated in the U.S. and U.K. North Sea, where more than 400k b/d of pipeline flows in November and December were lost. Of far greater moment, however, is the potential for unplanned outages in Venezuela. We believe the state-owned oil company there is one systemic malfunction away from shutting down exports entirely - e.g., a breakdown in pumping stations - as happened in 2002. Reuters reports the government of Nicolas Maduro appears to be consolidating power via an "anti-corruption" campaign, and is installing senior military officials with little or no industry experience in leadership roles inside PDVSA.2 Reuters notes, "The ongoing purge, in which prosecutors have arrested at least 67 executives including two recently ousted oil ministers, now threatens to further harm operations for the OPEC country, which is already producing at 30-year-lows and struggling to run PDVSA units including Citgo Petroleum, its U.S. refiner." The news service goes on to report, "Executives that remain, meanwhile, are so rattled by the arrests that they are loathe to act, scared they will later be accused of wrongdoing." We have Venezuela output at just under 1.90mm b/d, and expect it to decline to a little more than 1.70mm b/d by the end of 2018. Brent Expected To Average $67/bbl In 2018 We continue to forecast average Brent prices of $67/bbl and WTI at $63/bbl next year, given our assessment of global supply-demand balances, which drive our fundamental price forecasts: We expect global crude and liquids supply to average 100.23mm b/d in 2018, vs 100.01mm b/d expected by the U.S. EIA, while we have global demand coming in at 100.29mm b/d on average next year, vs the 99.97mm b/d expected by EIA (Chart 5 and Chart 6). Chart 5BCA's Expected Crude Oil Supply Vs. EIA's BCA's Expected Crude Oil Supply Vs. EIA's BCA's Expected Crude Oil Supply Vs. EIA's Chart 6BCA's Expected Demand Exceeds EIA's In 2018 BCA's Expected Demand Exceeds EIA's In 2018 BCA's Expected Demand Exceeds EIA's In 2018 Our expectations translate into a 2.55mm b/d increase in supply next year, vs a 1.67mm b/d increase in demand yoy (Table 1). Running the EIA's supply-demand assessments through our fundamental pricing models produces average Brent and WTI prices of $49/bbl and $47/bbl, respectively. EIA is expecting a 2.04mm b/d increase in supply next year, vs a 1.63mm b/d increase in demand. Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Oil Fundamentals Remain Bullish Heading Into 2018 Oil Fundamentals Remain Bullish Heading Into 2018 In line with our House view, we are expecting some USD strengthening on the back of as many as four interest-rate hikes by the Federal Reserve in the U.S. (Chart 7). As we've noted in the past, we expect these effects to be felt more in 2H18. Along with higher U.S. shale-oil production driven by higher prices - we expect shale output to go up 0.97mm b/d next year to 6.64mm b/d - a stronger USD will keep Brent and WTI prices below $70/bbl next year. Oil Beyond 2018: OPEC 2.0 Endures OPEC 2.0 will remain an enduring feature of the oil market going forward, in our view. Allowing the coalition to fade away, and returning the global oil market to a production free-for-all once again serves neither KSA's nor Russia's interests. Following the IPO of Saudi Aramco toward the end of 2018, KSA will, we believe, want to maintain stability in the market, by demonstrating to capital markets that OPEC 2.0 can manage crude-oil supplies in a way that is not disruptive to its new-found investors. It is important to remember the Aramco IPO is only the beginning of the process of transforming KSA from a crude resource exporter into a vertically integrated global refining and marketing colossus. To eclipse Exxon as the world's largest refiner, Aramco would benefit from continued access to capital markets throughout the following decades, as well reliable cash flows to lower its cost of capital, service debt, and maintain whatever dividends it envisions. This cannot occur if oil markets are continually at risk of collapsing because production cannot be managed in a business-like manner. While Russia has not embarked on the same sort of transformation of its resource industry as KSA, it still has a very strong interest in maintaining stability in the crude oil markets, given its dependence on hydrocarbon exports. The Russian rouble moves in near-lock-step with Brent prices - since 2010, Brent prices explain ~80% of the movement in the rouble (Chart 8). It is obvious a collapse in global crude oil prices would, once again, have devastating effects on Russia's economy, as it did in 2009 and 2014. Such a collapse would trigger inflation domestically, as the cost of imports skyrockets, and threaten civil unrest as incomes and GDP are hobbled and foreign reserves evaporate. Chart 7Stronger USD Limits Oil-Price Appreciation In 2018 Stronger USD Limits Oil-Price Appreciation In 2018 Stronger USD Limits Oil-Price Appreciation In 2018 Chart 8Russia Cannot Afford An Oil Price Collapse Russia Cannot Afford An Oil Price Collapse Russia Cannot Afford An Oil Price Collapse Both KSA and Russia have a deep interest in maintaining oil's pre-eminent position as a transportation fuel for as long as possible. For this reason, neither wants to encourage prices that are too high - $100/bbl+ prices greatly encouraged the development of shale technology in the U.S. - nor too low, given the dire consequences such an outcome would have for both their economies. The common goals of KSA and Russia cannot be achieved by allowing OPEC 2.0 to dissolve, leaving member states to produce at will in the sort of production free-for-all that characterized the OPEC market-share war of 2014 - 15. To the extent possible, OPEC 2.0 must continue to manage member states' production in a manner that does not permit inventories to once again fill to the point where the only way to moderate over-production is to push prices through cash costs, so that enough output is shut in to clear the market. The most obvious way for these goals to be accomplished is by keeping markets relatively tight. This can be done by keeping commercial oil inventories worldwide low enough to keep Brent and WTI forward curves backwardated - particularly in highly visible OECD and U.S. storage facilities. A backwardated forward curve means the average price over a typical 2- or 3-year hedge horizon is lower than the spot price received by OPEC 2.0 producers. The deeper the backwardation, the lower the average price a U.S. shale producer can lock in by hedging. This limits the number of rigs that can be deployed by shale producers. This will require continual communication with markets to assure them sufficient spare capacity and easily developed production can be brought to market to alleviate any temporary shortage. In the meantime, OPEC 2.0 members with flexible storage will need to communicate these barrels will be readily available to the market. This management and forward-guidance should be easier for OPEC 2.0 to execute on, following its recent success in keeping some 1.0mm b/d of production off the market - largely in KSA and Russia - and member states' existing spare capacity and storage. We continue to expect the daily working dialogue of the OPEC 2.0 member states - most especially KSA and Russia - to deepen as time goes by, and for tactics and strategy to evolve as each gains comfort operating with the other. Whether OPEC 2.0 can pull this off remains to be seen. However, given the success of the coalition over the past two years, we are inclined to believe they will continue to develop a durable modus operandi supporting this outcome. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com Opposing Forces: Stay Neutral Metals In 2018 Chart 9Strong Global Demand Will Neutralize ##br##Impact of China Slowdown Strong Global Demand Will Neutralize Impact of China Slowdown Strong Global Demand Will Neutralize Impact of China Slowdown While we expect more upside to metal prices in the first half of 2018, slowing growth in China and a stronger USD will prevent a repeat of this year's stellar performance. While a deceleration in China is - ceteris paribus - most definitely a headwind to metal prices, we believe the impact may pan out differently this time around. The silver lining comes from the Communist Party's commitment to environmental reforms, which, in many cases, will manifest themselves in the form of less supply of the refined product, or demand for the ores. Either way, this alone is a positive for metals. China's Environmental Reforms Will Dominate in 1Q18 China's commitment to cleaning its air is currently shaping up in the form of winter cuts in major steel- and aluminum-producing provinces. While policies are hard to predict, we will keep monitoring the development and implementation of reforms from within China to assess how they will impact the markets. Outcomes from the Annual National People's Congress in March will give us a clearer indication of what to expect in terms of policy. For now, we see these reforms putting a floor under metal prices, at least in the beginning of 2018. Robust Global Demand Offsets Stronger USD & Slower Chinese Growth Xi's reforms will turn into a headwind for metal prices as they begin to impact the real economy in 2H18. Signs of weakness have already emerged in measures of industrial activity such as the Li Keqiang and Chinese PMI (Chart 9). In addition, the real estate sector has been showing some weakness since the beginning of the year. Annual growth rates in real estate investment and floor-space started are decelerating - a worrisome sign. Nonetheless, domestic demand remains robust, and policymakers in Beijing are approaching economic reforms gradually and with caution. Consequently we do not expect a major policy mistake to derail the Chinese economy. While Chinese growth will likely slow from above trend levels, a hard landing is most probably not in the cards. Another bearish risk comes from a stronger USD. We see the Fed as more committed to interest-rate normalization than markets expect, and consequently would not be surprised to see up to four rate hikes next year. Inverting the yield curve is a policy mistake incoming Chair Jerome Powell will try to avoid; however, we expect inflation to bottom in the first half of next year, giving the Fed room to accelerate its path of rate hikes. This will result in a stronger USD, which is bearish for commodities priced in U.S. dollars. In any case, these bearish factors will likely be offset by strong global growth, supported by a robust U.S. economy. Bottom Line: Xi's reforms will dominate metal markets in 2018 as bullish supply side environmental reforms duel against bearish demand-side economic reforms. Robust global growth will neutralize the impact of downside pressures. Stay neutral, but beware of modest USD strength. Low Inflation Retards Gold's Advance Once again, reality confounded theory: Inflation failed to emerge this year, even as systematically important central banks remained massively accommodative, and some 70% of the economies tracked by the OECD reported jobless rates below the commonly used estimate of the natural rate of unemployment (Chart 10). Chart 10Massive Monetary Accommodation Failed ##br##To Spur Inflation In The U.S. Massive Monetary Accommodation Failed To Spur Inflation In The U.S. Massive Monetary Accommodation Failed To Spur Inflation In The U.S. These fundamentals should be inflationary and supportive of gold. To date, they haven't been. We Expect Inflation To Revive The global economy has endured decades of low inflation going back at least to the 1990s. This has been driven by numerous factors. First, the expansion of the global value chain (GVC) over the past three decades has synchronized inflation rates worldwide, as our research and that of the BIS has found. As a result, U.S. wages and goods' inflation are now more dependent on global spare capacity. With the global output gap now almost closed, this disinflationary force will dissipate.3 Second, most measures of labor-market slack are now pointing toward tighter conditions, which, we expect, will strengthen the Phillips curve trade-off between inflation and unemployment next year. Inflation is a lagging indicator: Wage inflation lags the unemployment rate, and CPI inflation lags wage inflation. Investors should expect inflation to show up in 2018.4 Lastly, one-off technical factors, which depressed inflation last year - e.g. drop in cellphone data charges and prescription drug prices - also will fade. Once these big one-offs are no longer in annual percent-change calculations, inflation rates will rise. The Fed's Choppy Waters Against this backdrop, the Fed is embarking on a rates-normalization policy, which we believe will result in U.S. central bank's policy rate being increased up to four times next year. The risk of a policy error is high. Should the Fed proceed with its rate hikes while inflation remains quiescent, real interest rates will increase. This would depress gold prices, and, at the limit, threaten the current economic expansion by tightening monetary conditions well beyond current levels, potentially lifting unemployment levels. If, on the other hand, the Fed deliberately keeps rate hikes below the rate of growth in prices - i.e., it stays "behind the curve" - it risks being forced to implement steeper rate hikes later in 2018 or in 2019 to get stronger inflation under control. This could tighten monetary conditions suddenly, and threaten the expansion, pushing the U.S. economy into recession. There's a lot riding on how the Fed navigates these difficult conditions. Geopolitical Risks Will Support Gold On the geopolitical side, the risks we've identified in our October 12, 2017 publication - i.e. (1) U.S.-North Korea tensions, (2) trade protectionism of the Trump administration, and (3) ongoing conflicts in the Middle East-- will add a geopolitical risk premium to gold prices, supporting the metal's role as a safe haven.5 Bottom Line: We remain neutral precious metals, but still recommend investors allocate to gold as a strategic portfolio hedge against inflation and geopolitical risk. U.S. Policies Will Weigh On Ags In 2018 U.S. monetary and trade policy will dominate ags next year. Our modelling reveals that U.S. financial factors - real rates and the USD - are significant in explaining ag price behavior (Chart 11).6 Given that we expect the Fed to hike interest rates more aggressively than what the market is currently pricing in, we see grains as vulnerable to the downside. In addition, the risk that NAFTA is abrogated by the U.S. would weigh on ag markets, as Canada and Mexico are among the U.S.'s top three ag export destinations. Chart 11Bearish U.S. Monetary And Trade Policies ##br##Amid Healthy Inventories Will Weigh On Ags Bearish U.S. Monetary And Trade Policies Amid Healthy Inventories Will Weigh On Ags Bearish U.S. Monetary And Trade Policies Amid Healthy Inventories Will Weigh On Ags We expect ag markets will remain well supplied next year, and inventories will moderate the impact of supply-side shocks - most notably in the form of a La Nina event. The probability of a La Nina currently stands above 80%, and is expected to last until mid-to-late spring. U.S. Monetary Policy Is Relevant With U.S. inflation rates still subdued, there has been much talk about how soon the Fed will be able embark on its tightening cycle. A weaker-than-expected USD has been favorable for ag markets this year, and thus kept U.S. ag exports competitive. However, if and when the economy reaches the kink in the Philipps Curve, and inflation begins its ascent, the Fed will be able to proceed with its rate-hiking cycle. With the New York Fed's Underlying Inflation Gauge at a cycle high, we expect this scenario to unfold in the first half of 2018. This would give incoming Fed Chairman Jerome Powell ample room to hike rates which would - ceteris paribus - bear down on ag prices. FX Developments In Other Major Exporters Will Also Be Bearish The effects of higher U.S. interest rates are translated to ag markets via the exchange-rate channel. Commodities are priced in USD, thus a stronger USD vis-à-vis the currency of a major ag exporter will, all else equal, increase the profitability of farmers competing against U.S. exporters in international markets. Among the ag-relevant currencies, we highlight the Brazilian Real, EUR, Russian Rouble, and Australian Dollar as most likely to depreciate vis-à-vis the USD in 2018. Termination Of NAFTA Is A Risk For American Farmers U.S. farmers are keeping a close eye on NAFTA renegotiations, and rightly so. Canada and Mexico are the U.S.'s second and third largest agricultural export markets - accounting for 15% and 13% of U.S. agricultural exports in 2016, respectively. In fact, corn, rice, and wheat exports to Mexico accounted for 26%, 15%, and 11% share of U.S. exports of those commodities, respectively. However, as BCA Research's Geopolitical Strategy service points out, the long-run impact depends on the underlying reason for the termination of the trade agreement. If Trump is merely a "pluto-populist" - as they expect - NAFTA will simply be replaced by bilateral trade agreements, with no lasting economic disturbance. The risk is that Trump is a genuine populist. If this turns out to be the case, tariffs and a rejection of the WTO would make U.S. exports less competitive, and would become a bearish force in ag markets.7 The risk of a collapse in the NAFTA trade deal would be devastating for U.S. farmers. In fact, in a bid to reduce reliance on the U.S., Mexican Economic Minister Ildefonso Guajardo recently announced that they are working on a Mexico-European Union trade deal.8 In addition, Mexico signed the world's largest free trade agreement with Japan, and is currently exploring the opportunity to join Mercosur. Bottom Line: Weather-induced volatility is possible in the near term, as a La Nina event threatens to reduce yields. Nevertheless, U.S. financial conditions and trade policy will dominate ag markets in 2018. With markets underestimating the Fed's resolve regarding interest rate hikes, we see some upside to the USD. This will keep a lid on ag prices next year. 1 Please see "The year in Review: Global Economy in 5 Charts," published on the IMF Blog December 18, 2017. https://blogs.imf.org/2017/12/17/the-year-in-review-global-economy-in-5-charts/ 2 Please see "Paralysis at PDVSA: Venezuela's oil purge cripples company," published by reuters.com December 15, 2017. 3 The IMF estimates the median output gap for 20 advanced economies reached -0.1% in 2017 and will rise to +0.3% in 2018. Please see BIS https://www.bis.org/publ/work602.htm. The Bank for International Settlements in Basel describes the GVC as "cross-border trade in intermediate goods and services." 4 The U.S. unemployment has been under its estimated NAIRU for 9 consecutive months now. 5 Please see Commodity and Energy Strategy Weekly Report titled "Balance Of Risks Favors Holding Gold," dated October 12, 2017, available at ces.bcaresearch.com. 6 Our modelling indicates that U.S. financial factors are important determinants of agriculture commodity price developments. More specifically, a 1% move in the USD TWI and a 1pp change in 5 year real rates are associated with a 1.4%, and an 18% change in the CCI Grains & Oilseed Index, in the opposite direction. 7 Please see Global Investment Strategy Special Report titled "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gis.bcaresearch.com. 8 Please see "Mexico sees possible EU trade deal as NAFTA talks drag on," dated December 13, 2017, available at reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Oil Fundamentals Remain Bullish Heading Into 2018 Oil Fundamentals Remain Bullish Heading Into 2018 Commodity Prices and Plays Reference Table Trade Recommendation Performance In 3Q17 Oil Fundamentals Remain Bullish Heading Into 2018 Oil Fundamentals Remain Bullish Heading Into 2018 Trades Closed in Summary of Trades Closed in

Dear Clients, This is the final publication for the year, in which we recap some of the key developments in 2017. We will resume our regular publishing schedule on January 4, 2018 with a brief market update. The China Investment Strategy team wishes you a very happy holiday season and a prosperous New Year! Best regards, Jonathan LaBerge, CFA, Vice President Special Reports Highlights 2017 served as a prime example of the periodic oscillation of Chinese economic policy between pursuing painful reforms and stimulating demand. While policymakers are merely attempting to control the private sector debt-to-GDP ratio, the risk of a tightening overshoot should not be discounted. Recent economic activity in China appears to have been driven by highly-polluting industries, in the context of strong public demand for an improvement in air quality. This raises the risk that environmental reforms over the coming few years could seriously curtail growth. The incredible returns from Chinese stocks this year means that investable equities are no longer "exceptionally cheap". Still, the range of valuation among Chinese investable sectors has increased, suggesting increased opportunity for alpha generation over the coming 6-12 months. Feature Following the publication of our special year end Outlook report for 2018,1 BCA's China Investment Strategy service recently expanded on our global view by outlining our three key themes for China over the coming year.2 As a year-end tradition, we dedicate this week's report to recapping some important developments of the past year and their longer-term implications. China's Mini Cycle In Requiem, From A Bigger Picture Perspective Chart 1Some Modest Deleveraging Achieved ##br##In The Corporate Sector Some Modest Deleveraging Achieved In The Corporate Sector Some Modest Deleveraging Achieved In The Corporate Sector 2017 saw the growth momentum of China's recent "mini cycle" peak, following a tightening in monetary conditions that began late last year. Part of the tightening in monetary conditions reflected normal countercyclical actions by the PBOC, but it also signified a strong desire on the part of policymakers to avoid significant further leveraging of the economy. As such, 2017 served as a prime example of the periodic oscillation of Chinese economic policy between promoting painful supply-side reforms and pushing demand-side countercyclical policies. Chart 1 highlights that policymakers did manage to achieve some modest outright deleveraging in the non-financial corporate sector in the first two quarters of the year, but at least half of this gain occurred because nominal GDP growth accelerated (i.e. the denominator of the debt-to-GDP ratio improved). No such deleveraging occurred in the household sector, which continued to see year-over-year debt growth of 24%. The struggling of Chinese policymakers to control the pace of credit growth reflects the inherent difficulty of China's new de-facto growth model, which shifted significantly in 2010. Chart 2 presents a stylized timeline of China's economic history over the past 15 years; rather than painting the rise in China's debt-to-GDP ratio in a sinister light, it underscores the unenviable lose-lose position facing Chinese policymakers in 2010. The chart describes how China's extremely rapid growth phase from 2002-2008 was followed by the global financial crisis and a normal rise in the debt-to-GDP ratio. This rise occurred due to a significant deceleration in nominal GDP growth, and standard counter-cyclical economic policy during an extremely challenging time for the global economy. However, following the onset of the economic recovery in 2009, it became clear that China's export-enabled catchup growth phase was durably over, and policymakers were faced with a hard choice: Either replace exports as a growth driver with debt-fueled domestic demand in order to buy the economy time to move up the value-added chain and to transition to a services-led economy (the "reflate" path), or allow the labor market to suffer the consequences of a sharp slowdown in export growth while preserving fiscal and state-owned firepower for some uncertain future opportunity (the "stagnate" path). Chart 2A Stylized Timeline Of China's Recent Economic History Legacies Of 2017 Legacies Of 2017 The well-known legacy of China's choice to pursue the "reflation" path is the significant and persistent gap between the growth rates of private non-financial credit and nominal GDP since 2010 (Chart 3). It is significant that this gap almost entirely closed in the first half of 2017, but a further deceleration in credit growth will be necessary to keep it closed given that nominal GDP growth is likely to decline over in the coming year. Chart 3No Overall Deleveraging,##br## But A Halt To Rising Leverage No Overall Deleveraging, But A Halt To Rising Leverage No Overall Deleveraging, But A Halt To Rising Leverage Table 1 underscores the lasting economic impact of the "sudden stop" experienced by China's external sector, even given the choice to pursue the "reflate" path, by presenting the contribution to real GDP growth by broad expenditure categories. Relative to the 2002-2008 average, the largest negative contributor to growth during the global financial crisis and its aftermath was from net exports, made up by a stimulus-induced acceleration in investment. However, over the following five years most of the deceleration in growth came from gross capital formation, as private producers adjusted to the new export environment by rapidly slowing their additions to new capacity. Absent new investment from China's state-owned sector (which occurred as part of the reflation plan), Table 1 strongly suggests that gross capital formation in China would have slowed much more aggressively than it did had policymakers not chosen to reflate the economy. Given this, many investors have a sanguine view on the risks posed by China's massive increase in debt-to-GDP, and are likely to view policymaker efforts to durably close this gap as a policy mistake. According to this perspective, global investors would be far less concerned if the post-2010 rise in debt had occurred explicitly on the government's balance sheet, and since most of the rise in non-financial corporate debt is attributable to the state-owned sector, it is quasi-sovereign in nature and thus not likely to be the source of a financial crisis. Table 1The Global Financial Crisis Caused A Lasting Economic Impact, ##br##Even Given China's Choice To Reflate Legacies Of 2017 Legacies Of 2017 Chinese policymakers would argue that their goal is simply to control China's debt-to-GDP ratio and to stop continued leveraging, not to put the financial system on an active deleveraging path that would risk destabilizing the economy. But even within this policymaker framework, there are two clear potential risks, both of which will need to be tracked over the coming year. The first is that the monetary tightening that has already occurred (and is still underway) causes debt service payments to become unbearable for state-owned firms, which forces a crisis that inflicts considerable short-term pain on the economy. The second is that other reform initiatives, those intended to pare back heavy-polluting industry (see below), to hasten the transition of China's economy to "consumer-led" growth, and to continue to crack down on corruption and graft end up negatively impacting the economy in a way that policymakers did not intend. Both of these risks will need to be monitored closely in 2018 and beyond. Bottom Line: 2017 served as a prime example of the periodic oscillation of Chinese economic policy between promoting painful supply-side reforms and pushing demand-side countercyclical policies. While policymakers are merely attempting to control the private sector debt-to-GDP ratio and are not pushing for active deleveraging, the risk of a tightening overshoot should not be discounted. Bumping Up Against The Environmental "Red Line" Another legacy of 2017 is the environmental impact of the recent economic mini cycle, and the lasting effect that poor air quality is likely to have on the country's reform agenda. Chart 4 presents one commonly used measure of air quality, termed PM2.5. It represents the concentration of airborne particulate matter that is 2.5 microns in size or smaller (smaller particles are more of a health risk), rescaled into an index. When using this measure, a value less than 50 is deemed to be good, whereas values above 50 are not ideal. At an index value of 150, PM2.5 concentrations become unhealthy for the entire population, not just sensitive groups. Chart 4Chinese Air Quality Deteriorated During ##br##This Growth Mini Cycle Chinese Air Quality Deteriorated During This Growth Mini Cycle Chinese Air Quality Deteriorated During This Growth Mini Cycle The chart shows the rolling 3-month average PM2.5 index for Beijing since 2010, along with the year-over-year change in the index. Three points are noteworthy: Over the past 8 years, Beijing's air quality has never been ranked as "good" for any significant period of time, and has typically contained moderate amounts of harmful particulate matter. Interestingly, at the onset of the recent growth mini-cycle in 2015, China's air quality deteriorated rapidly, nearly into unhealthy territory. This occurred again earlier in 2017, suggesting that the type of economic activity associated with growth over the past two years has been particularly negative for the environment. The slowdown in the Li Keqiang index over the past 6-9 months has corresponded with the largest year-over-year decline in Beijing's PM2.5 concentration since early-2015, when economic activity in China was slowing sharply. Given this, it is not surprising that President Xi's speech during the Party Congress in October emphasized the need to scale back highly-polluting heavy industry over the coming years. But if recent economic activity in China has been driven by these industries, this raises an obvious risk that environmental reforms over the coming few years could seriously curtail growth. This is especially true given that the Chinese public appears to be willing to sacrifice growth for an improvement in air quality (Chart 5). When outlining our key themes for 2018,3 we noted that next year's reform announcements will be highly significant not just because of the "what", but also the "how". We expect to see more details emerge in the lead up to the National People's Congress in March, but for now we are playing this theme by being long China's investable environmental, social, and governance (ESG) leaders index and short the investable benchmark (Chart 6). This trade is up 2% since we initiated it on November 16, and we expect further gains in 2018 if environmental reform remains a key priority for Chinese policymakers. Chart 5The Public Is Willing To Sacrifice Growth ##br##To Improve The Environment Legacies Of 2017 Legacies Of 2017 Chart 6Further Gains Likely##br## If The Environment Remains A Priority Further Gains Likely If The Environment Remains A Priority Further Gains Likely If The Environment Remains A Priority Bottom Line: Recent economic activity in China appears to have been driven by highly-polluting industries, in the context of strong public demand for an improvement in air quality. This raises the risk that environmental reforms over the coming few years could seriously curtail growth. A Year Of Spectacular Returns From Chinese Stocks. Now What? As of December 19, Chinese investable stocks (in US$) earned just over 50% in total return terms this year. Chart 7 shows that this ranks as the third largest annual gain among all major equity markets since 2010, behind only Russia and Brazil's commodity-fueled performance in 2016 (which was the mirror image of their spectacular losses in 2014/2015). Chart 7A Red Letter Year For Chinese Stocks Legacies Of 2017 Legacies Of 2017 There are two implications from China's amazing year-to-date equity market performance. First, it serves as a testament to the importance of tracking and playing economic mini cycles in China. BCA's China Investment Strategy service highlighted in February of this year that the economy would remain buoyant in the near term,4 and that investors should be overweight Chinese investable equities over the coming 6-12 months. Clearly this recommendation has panned out well. Second, it implies that Chinese stocks have re-rated significantly, and are no longer "exceptionally cheap". This means that the job of earning outsized returns from Chinese equities over the coming years will become more difficult, with investors possibly at some point needing to be selective in their allocation. The good news is that the range of valuation within China's investable market has increased, which implies more potential for alpha generation. In fact, Chart 8 highlights that this a global phenomenon, which appears to be at least somewhat related to the decline in intra-equity market correlation (panel 2). We plan on following up on the issue of sector-based alpha in the New Year, but for now there are no signs of a turnaround in the significant underperformance of investable value vs growth stocks (Chart 9). But given that the style dividend yield gap has grown to an elevated level (Chart 10), going long Chinese investable value / short investable growth is one of several potential trade ideas that we will be evaluating in the coming months. Stay tuned. Chart 8Lower Correlation Means Higher Valuation Dispersion Lower Correlation Means Higher Valuation Dispersion Lower Correlation Means Higher Valuation Dispersion Chart 9Chinese Value Stocks May Soon Attract Attentio Chinese Value Stocks May Soon Attract Attentio Chinese Value Stocks May Soon Attract Attentio Chart 10Value Is Now Particularly Valuable Value Is Now Particularly Valuable Value Is Now Particularly Valuable Bottom Line: The incredible returns from Chinese stocks this year means that investable equities are no longer "exceptionally cheap". Still, the range of valuation among Chinese investable sectors has increased, suggesting increased opportunity for alpha generation over the coming 6-12 months. 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, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Three Themes For China In The Coming Year", dated December 7, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "Three Themes For China In The Coming Year", dated December 7, 2017, available at cis.bcaresearch.com. 4 Pease see China Investment Strategy Weekly Report "Be Aware Of China's Fiscal Tightening", dated February 16, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Feature It has been a Geopolitical Strategy tradition, since our launch in 2012, to include our best and worst forecasts of the year in our end-of-year Strategic Outlook monthly reports.1 Since we have switched over to a weekly publication schedule, we are making this section of our Outlook an individual report.2 It will also be the final publication of the year, provided that there is no global conflagration worthy of a missive between now and January 10, when we return to our regular publication schedule. The Worst Calls Of 2017 A forecasting mistake is wasted if one learns nothing from the error. Alternatively, it is an opportunity to arm oneself with wisdom for the next fight. This is why we take our mistakes seriously and why we begin this report card with the zingers. Overall, we are satisfied with our performance in 2017, as the successes below will testify. However, we made one serious error and two ancillary ones. Short Emerging Markets Continuing to recommend an overweight DM / underweight EM stance was the major failure this year (Chart 1). More specifically, we penned several bearish reports on the politics of Brazil, South Africa, and Turkey throughout the year to support our view.3 What did we learn from our mistake? The main driving forces behind EM risk assets in 2017 have been U.S. TIPS yields and the greenback (Chart 2). Weak inflation data and policy disappointments as the pro-growth, populist economic policy of the Trump Administration stalled mid-year supported the EM carry trade throughout the year. The post-election dollar rally dissipated, while Chinese fiscal and credit stimulus carried over into 2017 and buoyed demand for EM exports. Chart 1The Worst Call Of 2017: Long DM / Short EM The Worst Call Of 2017: Long DM / Short EM The Worst Call Of 2017: Long DM / Short EM Chart 2How Long Can The EM Carry Trade Survive? How Long Can The EM Carry Trade Survive? How Long Can The EM Carry Trade Survive? Our bearish call was based on EM macroeconomic and political fundamentals. On one hand, our fundamental analysis was genuinely wrong. Emerging markets were buoyed by Chinese stimulus and a broad-based DM recovery. On the other hand, our fundamental analysis was irrelevant, as the global "search-for-yield" overwhelmed all other factors. Chart 3The Dollar Ought ##br##To Rebound The Dollar Ought To Rebound The Dollar Ought To Rebound Chart 4Chinese Monetary Conditions Point##br## To Slowing Industrial Activity Chinese Monetary Conditions Point To Slowing Industrial Activity Chinese Monetary Conditions Point To Slowing Industrial Activity Going forward, it is difficult to see this combination of factors emerge anew. First, the U.S. economy is set to outperform the rest of the world in 2018, particularly with the stimulative tax cut finally on the books, which should be dollar bullish (Chart 3). Second, downside risks to the Chinese economy are multiplying (Chart 4) as policymakers crack down on the shadow financial sector and real estate (Chart 5). BCA's Foreign Exchange Strategy has shown that EM currencies are already flagging risks to global growth. Their "carry canary indicator" - EM currencies vs. the JPY - is forecasting a sharp deceleration in global growth within the next two quarters (Chart 6). Chart 5Chinese Growth ##br##Slowing Down? Chinese Growth Slowing Down? Chinese Growth Slowing Down? Chart 6After Carry Trades Lose Momentum,##br## Global IP Weakens After Carry Trades Lose Momentum, Global IP Weakens After Carry Trades Lose Momentum, Global IP Weakens That said, we have learned our lesson. We are closing all of our short EM positions and awaiting January credit numbers from China. If our view on Chinese financial sector reforms is correct, these figures should disappoint. If they do not, the EM party can continue. "Trump, Day One: Let The Trade War Begin" In our defense, the title of our first Weekly Report of the year belied the nuanced analysis within.4 We argued that the Trump administration would begin its relationship with China with a "symbolic punitive measure," but that it would then "seek high-level negotiations toward a framework for the administration's relations with China over the next four years." This was largely the script followed by the White House. We also warned clients that it would be the "lead up to the 2018 or 2020 elections" that truly revealed President Trump's protectionist side. Nonetheless, we were overly bearish about trade protectionism throughout 2017. First, President Trump did not name China a currency manipulator. Second, the border adjustment tax (BAT), which we thought had a 55% chance of being included in tax reform, really was dead-on-arrival. Third, the "Mar-A-Lago Summit" consensus lasted through the summer, buoying companies with relative exposure to China relative to the S&P 500 (Chart 7).5 Chart 7Second Worst Call Of 2017:##br## Alarmism On Protectionism Second Worst Call Of 2017: Alarmism On Protectionism Second Worst Call Of 2017: Alarmism On Protectionism Why did we get the Trump White House wrong on protectionism? There are three possibilities: Constraints error: We strayed too far from our constraints-based model by focusing too much on preferences of the Trump Administration. While we are correct that the White House lacks constraints when it comes to trade, tensions with North Korea this year - which we forecast correctly - were a constraint on an overly punitive trade policy against China. Preferences error: We got the Trump administration preferences wrong. Trade protectionism is the wool that Candidate Trump pulled over his voters' eyes. He is in fact an establishment Republican - a pluto-populist - with no intention of actually enacting protectionist policies. Timing error: We were too early. Year 2018 will see fireworks. Unfortunately for our clients, we have no idea which error we committed. But Trump's national security speech on Dec. 18 maintained the protectionist threat, and there are several key deadlines coming up that should reveal which way the winds are blowing: New Year: Trump will have to decide on January 12 and February 3 whether to impose tariffs on solar panels and washing machines, respectively, under Section 201 of the U.S. Trade Act of 1974. This ruling will have implications for other trade items. End of Q1: NAFTA negotiations have been extended through the end of Q1 2018. As we recently posited, the abrogation of NAFTA by the White House is a 50-50 probability.6 The question is whether the Trump administration follows this up with separate bilateral talks with Canada and Mexico, or whether it moves beyond NAFTA to clash directly with the WTO instead.7 The U.K. Election (Although We Got Brexit Right!) Our forecasting record of U.K. elections is abysmal. We predicted that Theresa May would preserve her majority in the House of Commons, although in our defense we also noted that the risks were clearly skewed to the downside given the movement of the U.K. median voter to the left.8 We are now 0 for 2, having also incorrectly called the 2015 general election (we expected the Tories to fail to reach the majority in that election).9 On the other hand, we correctly sounded the alarm on Brexit, noting that the probability was much closer to 50% than what the market was pricing at the time.10 What gives? The mix of U.K.'s first-past-the-post system and the country's unique party distribution makes forecasting elections difficult. Because the Tories are essentially the only right-of-center party in England, they tend to outperform their polls and win constituencies with a low-plurality of votes. As such, in 2017, we ignored the strong Labour momentum in the polls, expecting that it would stall. It did not (Chart 8). That said, our job is not to call elections, but to generate alpha by focusing on the difference between what the market is pricing in and what we believe will happen. If elections are a catalyst for market performance - as was the case with the French one this year - we track them closely in a series of publications and adjust our probabilities as new data comes in. For U.K. assets this year, by contrast, getting the Brexit process right was far more relevant than the general election. Our high conviction view that the EU would not be punitive, that the U.K. would accept all conditions, and that the May administration would essentially stick to the "hard Brexit" strategy it defined in January ended up being correct.11 This allowed us to call the GBP bottom versus the USD in January (Chart 9). Chart 8Third Worst Call Of 2018: The U.K. Election Third Worst Call Of 2018: The U.K. Election Third Worst Call Of 2018: The U.K. Election Chart 9But We Got Brexit - And Cable! - Right But We Got Brexit - And Cable! - Right But We Got Brexit - And Cable! - Right What did we learn from our final error? Stop trying to forecast U.K. elections! The Best Calls Of 2017 The best overall call in 2017 was to tell clients to buy the S&P 500 in April and never look back. Our "Buy In May And Enjoy Your Day!" missive on April 26 was preceded by our analysis of global geopolitical risks and opportunities.12 In these, we concluded that "Political Risks Are Overstated In 2017" and "Understated In 2018."13 As such, the combination of strong risk asset performance and low volatility did not surprise us. It was our forecast (Chart 10). U.S. Politics: Tax Cuts & Impeachment Not only did we forecast that President Trump would manage to successfully pass tax reform in 2017, but we also correctly called the GOP's fiscal profligacy.14 We get little recognition for the latter in conversations with clients and colleagues, but it was a highly contentious call, especially after seven years of austere rhetoric from the fiscal conservatives supposedly running the Republican Party. We were also correct that impeachment fears and the ongoing Mueller Investigation would have little impact on U.S. assets.15 Chart 11 shows that the U.S. dollar and S&P 500 barely moved with each Trump-related scandal (Table 1). Chart 10The Best Call Of 2017: Getting The Market Right The Best Call Of 2017: Getting The Market Right The Best Call Of 2017: Getting The Market Right Chart 11No Real Impact From Trump Imbroglio BCA Geopolitical Strategy 2017 Report Card BCA Geopolitical Strategy 2017 Report Card By correctly identifying the ongoing "Trump Put" in the market, we were able to remain bullish on U.S. equities throughout the year and avoid calling any pullbacks. Table 1An Eventful Year 1 Of The Trump Presidency BCA Geopolitical Strategy 2017 Report Card BCA Geopolitical Strategy 2017 Report Card Europe (All Of It) Our performance forecasting European politics and markets has been stellar this year. Instead of reviewing each call, the list below simply summarizes each report: "After Brexit, N-Exit?" - Although technically a call made in 2016, our view that Brexit would cause a surge in support for the EU was a view for 2017.16 Several anti-establishment populists failed to perform in line with their 2015-2016 polling, particularly Geert Wilders in the Netherlands. "Will Marine Le Pen Win?" - We definitely answered this question in the negative, going back to November 2016.17 This allowed us to recommend clients go long the euro vs. the U.S. dollar (Chart 12). Moreover, we argued that regardless of who won the election, the next French government would embark on structural reforms.18 As a play on our bullish view of France, we recommended that clients overweight French industrials vs. German ones (Chart 13). "Europe's Divine Comedy: Italy In Purgatorio" - We correctly assessed that Italian Euroskpetics would migrate towards the center on the question of the euro. However, we missed recommending the epic rally in Italian equities and bonds that should have naturally flowed from our political view.19 "Fade Catalan Risks" - Based on our 2014 net assessment, we concluded that the Catalan independence drive would be largely irrelevant for the markets.20 This proved to be correct this year. "Can Turkey Restart The Immigration Crisis?" - Earlier in the year, clients became nervous about a potential diplomatic breakdown between the EU and Turkey leading to a renewal of the immigration crisis.21 We reiterated our long-held view that the immigration crisis did not end because of Turkish intervention, but because of tighter European enforcement. Throughout the year, we were proven right, with Europeans becoming more and more focused on interdiction. Chart 12Second Best Call Of 2017: The Euro... Second Best Call Of 2017: The Euro... Second Best Call Of 2017: The Euro... Chart 13...And France In Particular ...And France In Particular ...And France In Particular China: Policy-Induced Financial Tightening Throughout 2016-17, in the lead-up to China's nineteenth National Party Congress, we argued that the stability imperative would ensure an accommodative-but-not-too-accommodative policy stance.22 In particular, we highlighted the ongoing impetus for anti-pollution controls.23 This forecast broadly proved to be correct, as the government maintained stimulus yet simultaneously surprised the markets with financial and environmental regulatory crackdowns throughout the year. Once these regulatory campaigns took off, we argued that they would remain tentative, since the truly tough policies would have to wait until after the party congress. At that point, Xi Jinping could re-launch his structural reform agenda, primarily by intensifying financial sector tightening.24 Over the course of the year, this political analysis began to be revealed in the data, with broad money (M3) figures suggesting that money growth decelerated sharply in 2017 (Chart 14). In addition, we correctly called several moves by President Xi Jinping at the party congress.25 Chart 14Third Best Call Of 2017:##br## Chinese Reforms? (We Will See In 2018!) Third Best Call Of 2017: Chinese Reforms? (We Will See In 2018!) Third Best Call Of 2017: Chinese Reforms? (We Will See In 2018!) Our view that Chinese policymakers will restart reforms after the party congress is now becoming more widely accepted, given Xi's party congress speech Oct. 18 and the news from the December Politburo meeting.26 Where we differ from the market is in arguing that Beijing's bite will be worse than its bark. We are concerned that there is considerable risk to the downside and that stimulus will come much later than investors think this time around. Our China view was largely correct in 2017, but the real market significance will be felt in 2018. There are still several questions outstanding, including whether the crackdown on the financial sector will be as growth-constraining as we think. As such, this is a key view that will carry over into 2018. Thankfully, we should know whether we are right or wrong by the March National People's Congress session and the data releases shortly thereafter. North Korea - Both A Tail Risk And An Overstated Risk We correctly identified North Korea as a key 2017 geopolitical risk in our Strategic Outlook and began signaling that it was no longer a "red herring" as early as April 2016.27 In April 2017, we told clients to prepare for safe haven flows due to the likelihood that tensions would increase as the U.S. established a "credible threat" of war, a playbook that the Obama administration most recently used against Iran.28 While we flagged North Korea as a risk that would move the markets, we also signaled precisely when the risk became overstated. In September, we told clients that U.S. Treasury yields would rise from their lows that month as investors realized that the North Korean regime was constrained by its paltry military capability.29 At the same time, we gave President Trump an A+ for his performance establishing a credible threat, a bet that worked not only on Pyongyang, but also on Beijing. Since this summer, China has begun to ratchet up economic pressure against North Korea (Chart 15). Chart 15Fourth Best Call Of 2017: North Korea Fourth Best Call Of 2017: North Korea Fourth Best Call Of 2017: North Korea Middle East And Oil Prices BCA Research scored a big win this year with our energy call. It would be unfair for us to take credit for that view. Our Commodity & Energy Strategy as well as our Energy Sector Strategy deserve all the credit.30 Nonetheless, we helped our commodity teams make the right calls by: Correctly forecasting that Saudi-Iranian and Russo-Turkish tensions would de-escalate, allowing OPEC and Russia to maintain the production-cut agreement;31 Emphasizing risks to Iraqi production as tensions shifted from the Islamic State to the Kurdish Regional Government; Highlighting the likely continued decline, but not sharp cut-off, of Venezuelan production, due to the regime's ability to cling to power even as the conditions of production worsened.32 In addition, we were correct to fade various concerns regarding renewed tensions in Qatar, Yemen, and Lebanon throughout the year. Despite the media narrative that the Middle East has become a cauldron of instability anew, our long-held view that all the players involved are constrained by domestic and material constraints has remained cogent. In particular, our view that Saudi Arabia would engage in serious social reforms bore fruit in 2017, with several moves by the ruling regime to evolve the country away from feudal monarchy.33 Going forward, a major risk to our view is the Trump administration policy towards Iran, our top Black Swan risk for 2018. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Ekaterina Shtrevensky, Research Assistant ekaterinas@bcaresearch.com 1 Due to the high volume of footnotes in this report, we have decided to include them at the end of the document. For a review of our past Strategic Outlooks, please visit gps.bcaresearch.com. 2 For the rest of our 2018 Outlook, please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, and "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy, "Turkey: Military Adventurism And Capital Controls," dated December 7, 2016, "South Africa: Back To Reality," dated April 5, 2017, "Brazil: Politics Giveth And Politics Taketh Away," dated May 24, 2017, "South Africa: Crisis Of Expectations," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "G19," dated July 12, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 7 The outcome at the WTO Buenos Aires summit last week offered a possible way out of confrontation between the Trump administration and the WTO. It featured Europe and Japan taking a tougher line on trade violations, namely China, to respond to the Trump administration grievances that, unaddressed, could escalate into a full-fledged Trump-WTO clash. 8 Please see BCA Geopolitical Strategy Weekly Report, "How Long Can The 'Trump Put' Last?" dated June 14, 2017 and "U.K. Election: The Median Voter Has Spoken," dated June 9, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "U.K. Election Preview," dated February 26, 2015, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me?' World?" dated January 25, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017 and "Political Risks Are Understated In 2017," dated April 12, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, "The French Revolution," dated February 3, 2017 and "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014 and "Why So Serious?" dated October 11, 2017, available at gps.bcaresearch.com. 21 Please see BCA Geopolitical Strategy Weekly Report, "Five Questions On Europe," dated March 22, 2017, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation)," dated July 13, 2016, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 24 Please see BCA Geopolitical Strategy We," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 25 We argued in our 2017 Strategic Outlook that while Xi's faction would gain a majority on the Politburo Standing Committee, he would maintain a reasonable balance and refrain from excluding opposing factions from power. We expected that factional struggle would flare back up into the open (as with the ouster of Sun Zhengcai), and that Xi would retire anti-corruption chief Wang Qishan, but not that Xi would avoid promoting a successor for 2022 to the Politburo Standing Committee. 26 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 27 Please see BCA Geopolitical Strategy "North Korea: A Red Herring No More?" in Monthly Report, "Partem Mirabilis," dated April 13, 2016 and "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 28 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 29 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 30 If you are an investor with even a passing interest in commodities and oil, you must review the work of our colleagues Robert Ryan and Matt Conlan. 31 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com. 32 Please see BCA Geopolitical Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 33 Please see BCA Geopolitical Strategy Special Report, "The Middle East: Separating The Signal From The Noise," dated November 15, 2017, available at gps.bcaresearch.com.

Highlights The financial system / banks cannot and do not lend out or intermediate national or households "savings". In any economy, new money/new purchasing power is originated by commercial banks "out of thin air". The term "savings" in macroeconomics denotes an increase in the economy's capital stock, not deposits at the banks. The Chinese banking system has enormous amount of deposits because banks have created them "out of nothing" not because households save a lot. Hence, the narrative that justifies China's money, credit and property market excesses by high national and household "savings" is incorrect. The maneuvering room for China is diminishing as inflationary pressures are rising, productivity is slowing and speculative leverage is high. Feature The debate on China's macro outlook continues to linger both within and outside BCA. The focal point of the debate centers on the role of national "savings" in China in spurring credit origination and debt formation. Many of my colleagues at BCA and the majority of commentators outside BCA argue that China's high "savings" rate, or so-called "excess savings", has been an important contributor to its exponential credit and money growth. Contrary to this narrative, we within BCA's Emerging Markets Strategy team maintain that the dramatic surge in credit and money in China has been the result of speculative behavior by banks and debtors. As such, the boom in money and credit growth has produced large imbalances and excesses, if not outright bubbles (Chart I-1). Chart I-1An Unprecedented Credit ##br##And Money Boom In China An Unprecedented Credit And Money Boom In China An Unprecedented Credit And Money Boom In China Every financial bubble in history has had its justifications. Last decade, the common narrative about U.S. real estate was that nationwide, U.S. house prices had historically never deflated in nominal terms. In the late 1990s, the tech bubble was vindicated by the "new productivity" era. In the meantime, in the 1980s in Japan and the mid-1990s in Hong Kong, sky high property prices were rationalized by limited amounts of land, given that these are islands. Despite these validations, all of these bubbles ultimately burst. We feel that vindicating China's enormous credit, money and property market excesses - which are all interrelated - by the nation's high "savings" is another attempt to endorse overextended and unsustainable macro imbalances. This report is a continuation of our series discussing these issues in great depth.1 The objective of this piece is to illuminate on the confusion between national "savings" and credit / deposits / money. Intuitively, many investors and commentators use the term "savings" to refer to bank deposits. Yet, in macroeconomics, national and household "savings" are not about deposits or money in the banking system at all. The term "savings" in macroeconomics denotes an increase in the economy's capital stock. Therefore, the financial system in general, and banks in particular, cannot and do not lend out or intermediate national or households "savings." The Chinese banking system has enormous amount of deposits because banks have created them "out of nothing" not because households save a lot. In an economy where banks exist, "savings" and financing are very different things. Commercial banks (hereafter referred to as banks) provide financing by expanding their balance sheets - creating deposits "out of thin air" as and when they originate loans. We previously elaborated on this money creation process,2 but given its importance to the topic of this report, we revisit it here. Banks Create New Purchasing Power "Out Of Thin Air" When a bank originates a loan, it simultaneously creates a deposit, or new money. Importantly, this does not represent a transfer of an existing deposit to the new borrower. This is a new deposit - new purchasing power - that did not previously exist (Figure 1). Figure I-1Credit / Money Creation Process The True Meaning Of China's Great 'Savings' Wall The True Meaning Of China's Great 'Savings' Wall The borrower can immediately use this new deposit to purchase goods and services or buy assets. At the same time, all owners of existing deposits at the bank still have their deposits too, and can use them as, when, and how they prefer. Thereby, the bank has created new purchasing power "out of nothing" when it originated a loan. Traditional macroeconomic theory presumes that for a person or company to invest in productive capacity, another person/unit must save. This assumption is true for a barter economy with no banks and money - where some entities produce but do not consume, so that others can acquire their output (goods) and in turn use them as investment. Nevertheless, in an economy with banks, one does not need to save in the form of a deposit in a bank in order for the latter to lend money to another entity. When a bank grants a loan or acquires an asset, it simultaneously creates new deposit/money - which is de facto new purchasing power originated by the bank "out of thin air." We use the terms deposit and money interchangeably because broad money supply is computed as the sum of all deposits in the commercial banks. Let's consider an example of how a bank loan leads to new income creation. A company borrows from a bank to build a bridge, it then pays its suppliers and contractors for their work. As a result, the suppliers and contractors, and consequently their employees and shareholders, earn income. Without this loan, the bridge would not have been built, and the suppliers, their employees and business owners would not have received income. In short, the loan comes first, then the investment - and only after the investment is carried out do employees and business owners earn income. Thereafter, they can consume, acquire assets and save in forms of bank deposits. Critically, this income is realized because the bank originated a loan / new purchasing power "out of nothing." Chart I-2 illustrates that the Chinese banking system has created RMB 140 trillion of broad money/deposits since January 2009. This is equivalent to US$21 trillion at today's exchange rate. This is twice as much as aggregate broad money - equivalent to $10.5 trillion - generated by commercial and central banks in the U.S., the euro area and Japan combined since early 2009 - even amid their respective QE programs. Chart I-2Helicopter Money In China Helicopter Money In China Helicopter Money In China The unprecedented new purchasing power of Chinese companies and households has been primarily due to this enormous balance sheet expansion by mainland commercial banks (Chart I-3). Chart I-3China: Commercial Banks ##br##Assets And Money Multiplier China: Commercial Banks Assets And Money Multiplier China: Commercial Banks Assets And Money Multiplier Bank Versus Financial Intermediaries Banks perform a unique function in the economy and financial system. There are considerable differences between a bank lending money or buying assets and a non-bank doing the same. This is unfortunately not reflected in mainstream economic theory and macro models. Unlike banks, non-banks - such as pension funds, insurance companies, households, businesses and all other non-bank entities - do not create new money/new purchasing power when they grant a loan or acquire an asset. The act of lending by non-banks simply constitutes a transfer of an existing deposit from a creditor to a borrower. Banks are not intermediaries of deposits into loans as the Loanable Funds Theory (LFT) alleges. They create deposits themselves by making loans and acquiring assets. The LFT, nonetheless, applies to non-bank lenders - the latter are indeed financial intermediaries, i.e., they channel existing deposits into loans or other assets. The institutional and legal differences that make commercial banks unique and allow them to create money are discussed in detail in "How Do Banks Create Money, and Why Can Other Firms Not Do the Same?," Werner (2014b).3 The theory of fractional banking is not applicable to modern banking as well.4 It is the theory of money creation by banks that we subscribe to and present here that accurately describes the process of money creation. Bottom Line: Banks differ vastly from non-bank financial institutions, and are unique in their ability to create money/new purchasing power by originating loans or acquiring assets. Money Versus Credit Remarkably, there is also an important analytical distinction between credit/leverage and money. New money matters when one is attempting to gauge the (nominal) growth outlook because it represents new purchasing power. New money can only be originated by banks, including the central bank. Central banks can create broad money in circulation (i.e. beyond central bank reserves) when they buy financial assets from or lend to non-bank entities. Doing so creates a deposit in the commercial banking system. By contrast, the degree of credit/leverage is critical when evaluating the risk of financial distress in both the economy and the financial system. Credit can be extended not only by banks but also by non-banks. Hence, lending or buying corporate bonds by non-banks creates leverage/credit but not new money. The banking system is the only one capable of originating new money, and in turn, new purchasing power. In China, the outstanding stock of total non-financial debt (private plus public) is close to the amount of money supply (Chart I-4). Even though non-bank credit growth has risen in importance since 2010, it seems that without banks' money creation, non-bank credit would not have expanded. Chart I-4China: Money Versus Credit/Debt China: Money Versus Credit/Debt China: Money Versus Credit/Debt On another note, household propensity to save alters the velocity of money, not the amount of money in the banking system. A decision by a household to spend more rather than save does not change the amount of deposits in the banking system. As an example, a person who gets paid $1000 might spend $800 of her income and decide to save the remaining $200. The amount of deposits in the banking system does not change; $800 will be transferred to another bank account as she pays for her purchases, while the remaining $200 stays in her existing bank account. Hence, there is no change in the amount of deposits and money supply in the banking system in this scenario. On the whole, the amount of deposits, and hence, broad money supply, in any banking system is equal to the cumulative net money creation by banks and the central bank over the course of their history. This has nothing to do with household and national "savings." The Chinese banking system has enormous amount of deposits because banks have created them "out of nothing" not because households save a lot. Interestingly, changes in household propensity to save are reflected not in money supply but in the velocity of money. When households or companies decide to spend their deposits, the velocity of money rises. Conversely, when households and companies decide to save (retain) their deposits, the velocity of money drops. Bottom Line: Money is distinct from credit and leverage. Changes in the propensity to save alter the velocity of money, but not the amount of deposits/money supply in the banking system. True Meaning Of "Savings" In Macroeconomics What is the true meaning of "savings"5 in macroeconomics, given the amount of deposits in the banking system has no bearing on "savings?" The confusion between national "savings" and deposit/money creation is dealt with nicely by Fabian Lindner. Having modelled it, Lindner6 argues: "... the aggregate economy's saving is equal to the newly produced tangible assets and inventories. That total saving is equal to just the increase in tangible assets ... (because) all changes in net financial assets in the economy add up to zero... Thus, for every economic agent increasing her net financial assets, there is a corresponding decrease in net financial assets of all other economic agents in the economy. Put in more general terms: An economic agent can only save financially if other agents dis-save financially by the same amount... That is why in the entire economy (that is the world economy or a closed economy) only the increase in tangible assets, thus investment, is saving (emphasis is added). Thus, saving and investment are equivalent in the aggregate... The equivalence of investment and saving however does not mean - as claimed by LFT - that household saving (or the sum of household and government saving) is equal to total saving and thus to investment. No matter how high one group's financial saving is, the financial dis-saving of the rest of the economy has to be just as high. The only thing remaining is the creation of tangible assets." (Lindner 2015) In another paper,7 Lindner asserts: "Investment is the production of any non-financial asset in an economy and thus is always directly and unambiguously savings: it increases the economy's net worth... The economy as a whole cannot change its net financial wealth since it always equals zero. The aggregate economy can only save in the form of non-financial assets...The only way an economy can save is by increasing its non-financial wealth, i.e., its physical capital stock." (Lindner 2012) Bottom Line: For a country to raise its domestic "savings" rate, it needs to build its capital stock by using domestically produced investment goods and raw materials. Thereby, domestic "savings" have nothing to do with the absolute level or changes in amount of deposits/money in the banking system. China's Great Wall Of "Savings" China has been investing tremendous amounts for many years, and its capital stock has been mushrooming (Chart I-5, top panel). Yet, the incremental capital-to-output ratio (ICOR) has surged and, its inverse, the output-to-capital ratio has plunged since 2010 (Chart I-5, middle and bottom panels). These developments signify deteriorating efficiency in the Chinese economy and worsening capital allocation. They also entail that companies might have difficulties servicing their debt. When its export machine faltered in 2008 due to the Global Financial Crisis, China offset it by boosting its domestic investments. These investments - incremental additions to the nation's capital stock - defined by macroeconomics as domestic "savings"- offset the decline in external "savings." As such, the composition of national "savings" has changed dramatically since 2008: the share of external "savings" (net exports) have declined while the share of domestic "savings" has risen (Chart I-6). Chart I-5China: Capital Stocks Has Surged China: Capital Stocks Has Surged China: Capital Stocks Has Surged Chart I-6China: Domestic And External 'Savings' China: Domestic And External 'Savings' China: Domestic And External 'Savings' In China, the augmentation of its capital stock and, hence, its domestic "savings," have been largely financed by loans from Chinese banks. This may sound like nonsense, but only because we are using the term "savings" in a way used in macroeconomics. Yet, new purchasing power originated by the banking system is not in and of itself a sufficient condition to generate domestic "savings." The sufficient condition for having high domestic "savings" is the ability to produce domestic capital goods and raw materials that go into investment. If a country does not build its capacity to produce capital goods and raw materials, it would need to rely on imports - in other words it has to acquire foreign "savings" to invest. Encouraging domestic "savings" entails enhancing capacity to produce goods that are used in capital spending like raw materials, chemicals, steel, cement, machinery, and various equipment and instruments. This is what China has done exceptionally well over the past 20 years. The following points illustrate how China achieved very high "savings" and investment rates (Chart I-7): China devalued its currency in January 1994 by 32% and relied on a cheap currency to produce large trade surpluses (Chart I-8). It used the foreign currency proceeds to purchase foreign technologies and equipment to boost its capital stock. Chart I-7Savings And Investment Ratios Savings And Investment Ratios Savings And Investment Ratios Chart I-8China: The 1994 Currency ##br##Devaluation Started New Era China: The 1994 Currency Devaluation Started New Era China: The 1994 Currency Devaluation Started New Era It also attracted FDI to build its productive capacity both for consumer goods as well as capital goods. FDI inflows surged since China's acceptance into the WTO in 2001. Since 2009, however, China has been relying on new purchasing power created by banks to expand its industrial capacity to produce commodities, raw materials, industrial equipment and machinery. Meanwhile, mainland banks have been originating new loans, and hence deposits/money - new purchasing power - to finance real estate development and infrastructure construction, utilizing these domestically produced raw materials and machinery. This has allowed China to sustain high levels of domestic "savings." On the whole, China indeed has had "excess savings" as its economy has been suffering from excess industrial capacity. Initially, China invested to create such excess capacity. Then, its banking system originated enormous amount of money/new purchasing power to support and keep zombie companies alive in these industries with excess capacity. The banking system is still involved in this function up until today. While this is a reasonable economic policy in the short run, it is not a good growth strategy in the long term. The problem is that easy money and credit support inefficient enterprises and encourage unproductive investment. As a result, productivity growth will slow and potential growth will decelerate considerably. Bottom Line: The countries that produce a lot of goods and services for domestic investment are said to have high domestic "savings." By definition, the more excess industrial capacity a country has, the more "excess savings" that economy will carry. Yet, uncontrolled money/credit origination to support zombie enterprises in over-capacity sectors entails inefficient allocation of capital that necessarily slows productivity growth and hence economic growth potential in the long term. Limits On Money Creation A natural question that arise from all this is what are the limits on money creation? We list some of major ones here, but these issues have been addressed in our previous three reports,8 and we will address them again in forthcoming reports. Inflation and/or deprecation pressures on the currency that could lead to monetary tightening; Bank regulation and various regulatory ratios; Shareholders of banks - who are highly leveraged to non-performing assets/loans - might order reduced lending; Removing the implicit government "put" that encourage irresponsible borrowing and lending. Inflationary pressures are presently rising and more entrenched in China now than at any time in the past decade or so (Chart I-9). In the context of negative real interest rates (Chart I-10) and barring major growth slowdown, the authorities are unlikely to stimulate anytime soon. Chart I-9Beware Of Rising Inflation In China... Beware Of Rising Inflation In China... Beware Of Rising Inflation In China... Chart I-10...Making Interest Rates Negative ...Making Interest Rates Negative ...Making Interest Rates Negative Negative real local interest rates undermine Chinese households' willingness to hold the currency. China's foreign exchange reserves at $3 trillion, while high, are equal only to 10% broad money (M3) and 14% of official M2. This signifies how much money the banking system has created. At the moment, mainland banking regulations are being tightened. This as well as liquidity tightening by the People's Bank of China and the government's anti-corruption crackdown that is moving into the financial industry will further dampen money creation and leverage expansion. This triple tightening amid lingering money and credit excesses constitutes the main rationale behind our negative stance on China's growth and China-related plays in global financial markets. Policy tightening is especially dangerous amid the existing credit, money and property market imbalances and excesses. Downgrade Chinese Stocks From Overweight To Neutral The Chinese MSCI Investable equity index - which unlike H-shares includes mega-cap tech companies - has rallied massively and outperformed the EM benchmark (Chart I-11). Chart I-11Downgrade Chinese Investable Stocks ##br##From Overweight To Neutral Downgrade Chinese Investable Stocks From Overweight To Neutral Downgrade Chinese Investable Stocks From Overweight To Neutral Relative performance is overbought, and we recommend dedicated EM equity portfolios downgrade their allocation from overweight to neutral. Our overweight position was initiated on November 26, 2014, and has generated an 18.5% gain. The freed-up capital should be allocated proportionally to our remaining overweights, which are Taiwan, Thailand, Korean tech stocks, Russia and central Europe. We are contemplating upgrading Chile. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Reports from October 26, 2016, November 23, 2016 and January 18, 2017; available on ems.bcaresearch.com 2 Please refer to the Emerging Markets Strategy Special Report titled "Misconceptions About China's Credit Excesses," dated October 16, 2016, available on available on ems.bcaresearch.com 3 Werner, R. (2014b), "How Do Banks Create Money, and Why Can Other Firms Not Do the Same?", International Review of Financial Analysis, 36, 71-77. 4 Werner, R. (2014a), "Can banks individually create money out of nothing? -- The theories and the empirical evidence", International Review of Financial Analysis, 36, 1-19. 5 We use "savings" in parenthesis because as this term does not really mean households' and companies' and governments' financial assets or deposits at the banks. "Savings" signifies the amount of goods and services produced but not consumed by an economy. 6 Lindner, F. (2015), "Did Scarce Global Savings Finance the US Real Estate Bubble? The Global Saving Glut thesis from a stock flow Consistent Perspective", Macroeconomic Policy Institute, Working Paper 155, July 2015. 7 Lindner, F. (2012), "Savings does not finance Investment: Accounting as an indispensable guide to economic theory", Macroeconomic Policy Institute, Working Paper 100, October 2012. 8 Please refer to the Emerging Markets Strategy Special Reports from October 26, 2016, November 23, 2016 and January 18, 2017; available on ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Feature It has been a Geopolitical Strategy tradition, since our launch in 2012, to include our best and worst forecasts of the year in our end-of-year Strategic Outlook monthly reports.1 Since we have switched over to a weekly publication schedule, we are making this section of our Outlook an individual report.2 It will also be the final publication of the year, provided that there is no global conflagration worthy of a missive between now and January 10, when we return to our regular publication schedule. The Worst Calls Of 2017 A forecasting mistake is wasted if one learns nothing from the error. Alternatively, it is an opportunity to arm oneself with wisdom for the next fight. This is why we take our mistakes seriously and why we begin this report card with the zingers. Overall, we are satisfied with our performance in 2017, as the successes below will testify. However, we made one serious error and two ancillary ones. Short Emerging Markets Continuing to recommend an overweight DM / underweight EM stance was the major failure this year (Chart 1). More specifically, we penned several bearish reports on the politics of Brazil, South Africa, and Turkey throughout the year to support our view.3 What did we learn from our mistake? The main driving forces behind EM risk assets in 2017 have been U.S. TIPS yields and the greenback (Chart 2). Weak inflation data and policy disappointments as the pro-growth, populist economic policy of the Trump Administration stalled mid-year supported the EM carry trade throughout the year. The post-election dollar rally dissipated, while Chinese fiscal and credit stimulus carried over into 2017 and buoyed demand for EM exports. Chart 1The Worst Call Of 2017: Long DM / Short EM The Worst Call Of 2017: Long DM / Short EM The Worst Call Of 2017: Long DM / Short EM Chart 2How Long Can The EM Carry Trade Survive? How Long Can The EM Carry Trade Survive? How Long Can The EM Carry Trade Survive? Our bearish call was based on EM macroeconomic and political fundamentals. On one hand, our fundamental analysis was genuinely wrong. Emerging markets were buoyed by Chinese stimulus and a broad-based DM recovery. On the other hand, our fundamental analysis was irrelevant, as the global "search-for-yield" overwhelmed all other factors. Chart 3The Dollar Ought ##br##To Rebound The Dollar Ought To Rebound The Dollar Ought To Rebound Chart 4Chinese Monetary Conditions Point##br## To Slowing Industrial Activity Chinese Monetary Conditions Point To Slowing Industrial Activity Chinese Monetary Conditions Point To Slowing Industrial Activity Going forward, it is difficult to see this combination of factors emerge anew. First, the U.S. economy is set to outperform the rest of the world in 2018, particularly with the stimulative tax cut finally on the books, which should be dollar bullish (Chart 3). Second, downside risks to the Chinese economy are multiplying (Chart 4) as policymakers crack down on the shadow financial sector and real estate (Chart 5). BCA's Foreign Exchange Strategy has shown that EM currencies are already flagging risks to global growth. Their "carry canary indicator" - EM currencies vs. the JPY - is forecasting a sharp deceleration in global growth within the next two quarters (Chart 6). Chart 5Chinese Growth ##br##Slowing Down? Chinese Growth Slowing Down? Chinese Growth Slowing Down? Chart 6After Carry Trades Lose Momentum,##br## Global IP Weakens After Carry Trades Lose Momentum, Global IP Weakens After Carry Trades Lose Momentum, Global IP Weakens That said, we have learned our lesson. We are closing all of our short EM positions and awaiting January credit numbers from China. If our view on Chinese financial sector reforms is correct, these figures should disappoint. If they do not, the EM party can continue. "Trump, Day One: Let The Trade War Begin" In our defense, the title of our first Weekly Report of the year belied the nuanced analysis within.4 We argued that the Trump administration would begin its relationship with China with a "symbolic punitive measure," but that it would then "seek high-level negotiations toward a framework for the administration's relations with China over the next four years." This was largely the script followed by the White House. We also warned clients that it would be the "lead up to the 2018 or 2020 elections" that truly revealed President Trump's protectionist side. Nonetheless, we were overly bearish about trade protectionism throughout 2017. First, President Trump did not name China a currency manipulator. Second, the border adjustment tax (BAT), which we thought had a 55% chance of being included in tax reform, really was dead-on-arrival. Third, the "Mar-A-Lago Summit" consensus lasted through the summer, buoying companies with relative exposure to China relative to the S&P 500 (Chart 7).5 Chart 7Second Worst Call Of 2017:##br## Alarmism On Protectionism Second Worst Call Of 2017: Alarmism On Protectionism Second Worst Call Of 2017: Alarmism On Protectionism Why did we get the Trump White House wrong on protectionism? There are three possibilities: Constraints error: We strayed too far from our constraints-based model by focusing too much on preferences of the Trump Administration. While we are correct that the White House lacks constraints when it comes to trade, tensions with North Korea this year - which we forecast correctly - were a constraint on an overly punitive trade policy against China. Preferences error: We got the Trump administration preferences wrong. Trade protectionism is the wool that Candidate Trump pulled over his voters' eyes. He is in fact an establishment Republican - a pluto-populist - with no intention of actually enacting protectionist policies. Timing error: We were too early. Year 2018 will see fireworks. Unfortunately for our clients, we have no idea which error we committed. But Trump's national security speech on Dec. 18 maintained the protectionist threat, and there are several key deadlines coming up that should reveal which way the winds are blowing: New Year: Trump will have to decide on January 12 and February 3 whether to impose tariffs on solar panels and washing machines, respectively, under Section 201 of the U.S. Trade Act of 1974. This ruling will have implications for other trade items. End of Q1: NAFTA negotiations have been extended through the end of Q1 2018. As we recently posited, the abrogation of NAFTA by the White House is a 50-50 probability.6 The question is whether the Trump administration follows this up with separate bilateral talks with Canada and Mexico, or whether it moves beyond NAFTA to clash directly with the WTO instead.7 The U.K. Election (Although We Got Brexit Right!) Our forecasting record of U.K. elections is abysmal. We predicted that Theresa May would preserve her majority in the House of Commons, although in our defense we also noted that the risks were clearly skewed to the downside given the movement of the U.K. median voter to the left.8 We are now 0 for 2, having also incorrectly called the 2015 general election (we expected the Tories to fail to reach the majority in that election).9 On the other hand, we correctly sounded the alarm on Brexit, noting that the probability was much closer to 50% than what the market was pricing at the time.10 What gives? The mix of U.K.'s first-past-the-post system and the country's unique party distribution makes forecasting elections difficult. Because the Tories are essentially the only right-of-center party in England, they tend to outperform their polls and win constituencies with a low-plurality of votes. As such, in 2017, we ignored the strong Labour momentum in the polls, expecting that it would stall. It did not (Chart 8). That said, our job is not to call elections, but to generate alpha by focusing on the difference between what the market is pricing in and what we believe will happen. If elections are a catalyst for market performance - as was the case with the French one this year - we track them closely in a series of publications and adjust our probabilities as new data comes in. For U.K. assets this year, by contrast, getting the Brexit process right was far more relevant than the general election. Our high conviction view that the EU would not be punitive, that the U.K. would accept all conditions, and that the May administration would essentially stick to the "hard Brexit" strategy it defined in January ended up being correct.11 This allowed us to call the GBP bottom versus the USD in January (Chart 9). Chart 8Third Worst Call Of 2018: The U.K. Election Third Worst Call Of 2018: The U.K. Election Third Worst Call Of 2018: The U.K. Election Chart 9But We Got Brexit - And Cable! - Right But We Got Brexit - And Cable! - Right But We Got Brexit - And Cable! - Right What did we learn from our final error? Stop trying to forecast U.K. elections! The Best Calls Of 2017 The best overall call in 2017 was to tell clients to buy the S&P 500 in April and never look back. Our "Buy In May And Enjoy Your Day!" missive on April 26 was preceded by our analysis of global geopolitical risks and opportunities.12 In these, we concluded that "Political Risks Are Overstated In 2017" and "Understated In 2018."13 As such, the combination of strong risk asset performance and low volatility did not surprise us. It was our forecast (Chart 10). U.S. Politics: Tax Cuts & Impeachment Not only did we forecast that President Trump would manage to successfully pass tax reform in 2017, but we also correctly called the GOP's fiscal profligacy.14 We get little recognition for the latter in conversations with clients and colleagues, but it was a highly contentious call, especially after seven years of austere rhetoric from the fiscal conservatives supposedly running the Republican Party. We were also correct that impeachment fears and the ongoing Mueller Investigation would have little impact on U.S. assets.15 Chart 11 shows that the U.S. dollar and S&P 500 barely moved with each Trump-related scandal (Table 1). Chart 10The Best Call Of 2017: Getting The Market Right The Best Call Of 2017: Getting The Market Right The Best Call Of 2017: Getting The Market Right Chart 11No Real Impact From Trump Imbroglio BCA Geopolitical Strategy 2017 Report Card BCA Geopolitical Strategy 2017 Report Card By correctly identifying the ongoing "Trump Put" in the market, we were able to remain bullish on U.S. equities throughout the year and avoid calling any pullbacks. Table 1An Eventful Year 1 Of The Trump Presidency BCA Geopolitical Strategy 2017 Report Card BCA Geopolitical Strategy 2017 Report Card Europe (All Of It) Our performance forecasting European politics and markets has been stellar this year. Instead of reviewing each call, the list below simply summarizes each report: "After Brexit, N-Exit?" - Although technically a call made in 2016, our view that Brexit would cause a surge in support for the EU was a view for 2017.16 Several anti-establishment populists failed to perform in line with their 2015-2016 polling, particularly Geert Wilders in the Netherlands. "Will Marine Le Pen Win?" - We definitely answered this question in the negative, going back to November 2016.17 This allowed us to recommend clients go long the euro vs. the U.S. dollar (Chart 12). Moreover, we argued that regardless of who won the election, the next French government would embark on structural reforms.18 As a play on our bullish view of France, we recommended that clients overweight French industrials vs. German ones (Chart 13). "Europe's Divine Comedy: Italy In Purgatorio" - We correctly assessed that Italian Euroskpetics would migrate towards the center on the question of the euro. However, we missed recommending the epic rally in Italian equities and bonds that should have naturally flowed from our political view.19 "Fade Catalan Risks" - Based on our 2014 net assessment, we concluded that the Catalan independence drive would be largely irrelevant for the markets.20 This proved to be correct this year. "Can Turkey Restart The Immigration Crisis?" - Earlier in the year, clients became nervous about a potential diplomatic breakdown between the EU and Turkey leading to a renewal of the immigration crisis.21 We reiterated our long-held view that the immigration crisis did not end because of Turkish intervention, but because of tighter European enforcement. Throughout the year, we were proven right, with Europeans becoming more and more focused on interdiction. Chart 12Second Best Call Of 2017: The Euro... Second Best Call Of 2017: The Euro... Second Best Call Of 2017: The Euro... Chart 13...And France In Particular ...And France In Particular ...And France In Particular China: Policy-Induced Financial Tightening Throughout 2016-17, in the lead-up to China's nineteenth National Party Congress, we argued that the stability imperative would ensure an accommodative-but-not-too-accommodative policy stance.22 In particular, we highlighted the ongoing impetus for anti-pollution controls.23 This forecast broadly proved to be correct, as the government maintained stimulus yet simultaneously surprised the markets with financial and environmental regulatory crackdowns throughout the year. Once these regulatory campaigns took off, we argued that they would remain tentative, since the truly tough policies would have to wait until after the party congress. At that point, Xi Jinping could re-launch his structural reform agenda, primarily by intensifying financial sector tightening.24 Over the course of the year, this political analysis began to be revealed in the data, with broad money (M3) figures suggesting that money growth decelerated sharply in 2017 (Chart 14). In addition, we correctly called several moves by President Xi Jinping at the party congress.25 Chart 14Third Best Call Of 2017:##br## Chinese Reforms? (We Will See In 2018!) Third Best Call Of 2017: Chinese Reforms? (We Will See In 2018!) Third Best Call Of 2017: Chinese Reforms? (We Will See In 2018!) Our view that Chinese policymakers will restart reforms after the party congress is now becoming more widely accepted, given Xi's party congress speech Oct. 18 and the news from the December Politburo meeting.26 Where we differ from the market is in arguing that Beijing's bite will be worse than its bark. We are concerned that there is considerable risk to the downside and that stimulus will come much later than investors think this time around. Our China view was largely correct in 2017, but the real market significance will be felt in 2018. There are still several questions outstanding, including whether the crackdown on the financial sector will be as growth-constraining as we think. As such, this is a key view that will carry over into 2018. Thankfully, we should know whether we are right or wrong by the March National People's Congress session and the data releases shortly thereafter. North Korea - Both A Tail Risk And An Overstated Risk We correctly identified North Korea as a key 2017 geopolitical risk in our Strategic Outlook and began signaling that it was no longer a "red herring" as early as April 2016.27 In April 2017, we told clients to prepare for safe haven flows due to the likelihood that tensions would increase as the U.S. established a "credible threat" of war, a playbook that the Obama administration most recently used against Iran.28 While we flagged North Korea as a risk that would move the markets, we also signaled precisely when the risk became overstated. In September, we told clients that U.S. Treasury yields would rise from their lows that month as investors realized that the North Korean regime was constrained by its paltry military capability.29 At the same time, we gave President Trump an A+ for his performance establishing a credible threat, a bet that worked not only on Pyongyang, but also on Beijing. Since this summer, China has begun to ratchet up economic pressure against North Korea (Chart 15). Chart 15Fourth Best Call Of 2017: North Korea Fourth Best Call Of 2017: North Korea Fourth Best Call Of 2017: North Korea Middle East And Oil Prices BCA Research scored a big win this year with our energy call. It would be unfair for us to take credit for that view. Our Commodity & Energy Strategy as well as our Energy Sector Strategy deserve all the credit.30 Nonetheless, we helped our commodity teams make the right calls by: Correctly forecasting that Saudi-Iranian and Russo-Turkish tensions would de-escalate, allowing OPEC and Russia to maintain the production-cut agreement;31 Emphasizing risks to Iraqi production as tensions shifted from the Islamic State to the Kurdish Regional Government; Highlighting the likely continued decline, but not sharp cut-off, of Venezuelan production, due to the regime's ability to cling to power even as the conditions of production worsened.32 In addition, we were correct to fade various concerns regarding renewed tensions in Qatar, Yemen, and Lebanon throughout the year. Despite the media narrative that the Middle East has become a cauldron of instability anew, our long-held view that all the players involved are constrained by domestic and material constraints has remained cogent. In particular, our view that Saudi Arabia would engage in serious social reforms bore fruit in 2017, with several moves by the ruling regime to evolve the country away from feudal monarchy.33 Going forward, a major risk to our view is the Trump administration policy towards Iran, our top Black Swan risk for 2018. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Ekaterina Shtrevensky, Research Assistant ekaterinas@bcaresearch.com 1 Due to the high volume of footnotes in this report, we have decided to include them at the end of the document. For a review of our past Strategic Outlooks, please visit gps.bcaresearch.com. 2 For the rest of our 2018 Outlook, please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, and "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy, "Turkey: Military Adventurism And Capital Controls," dated December 7, 2016, "South Africa: Back To Reality," dated April 5, 2017, "Brazil: Politics Giveth And Politics Taketh Away," dated May 24, 2017, "South Africa: Crisis Of Expectations," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "G19," dated July 12, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 7 The outcome at the WTO Buenos Aires summit last week offered a possible way out of confrontation between the Trump administration and the WTO. It featured Europe and Japan taking a tougher line on trade violations, namely China, to respond to the Trump administration grievances that, unaddressed, could escalate into a full-fledged Trump-WTO clash. 8 Please see BCA Geopolitical Strategy Weekly Report, "How Long Can The 'Trump Put' Last?" dated June 14, 2017 and "U.K. Election: The Median Voter Has Spoken," dated June 9, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "U.K. Election Preview," dated February 26, 2015, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me?' World?" dated January 25, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017 and "Political Risks Are Understated In 2017," dated April 12, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, "The French Revolution," dated February 3, 2017 and "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014 and "Why So Serious?" dated October 11, 2017, available at gps.bcaresearch.com. 21 Please see BCA Geopolitical Strategy Weekly Report, "Five Questions On Europe," dated March 22, 2017, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation)," dated July 13, 2016, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 24 Please see BCA Geopolitical Strategy We," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 25 We argued in our 2017 Strategic Outlook that while Xi's faction would gain a majority on the Politburo Standing Committee, he would maintain a reasonable balance and refrain from excluding opposing factions from power. We expected that factional struggle would flare back up into the open (as with the ouster of Sun Zhengcai), and that Xi would retire anti-corruption chief Wang Qishan, but not that Xi would avoid promoting a successor for 2022 to the Politburo Standing Committee. 26 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 27 Please see BCA Geopolitical Strategy "North Korea: A Red Herring No More?" in Monthly Report, "Partem Mirabilis," dated April 13, 2016 and "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 28 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 29 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 30 If you are an investor with even a passing interest in commodities and oil, you must review the work of our colleagues Robert Ryan and Matt Conlan. 31 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com. 32 Please see BCA Geopolitical Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 33 Please see BCA Geopolitical Strategy Special Report, "The Middle East: Separating The Signal From The Noise," dated November 15, 2017, available at gps.bcaresearch.com.

Highlights The dollar has decoupled from interest rate differentials, being hurt by buoyant global growth. For the dollar to weaken more in 2018, global growth will have to accelerate further from current lofty rates. The tightening in Chinese policy along with the poor performance of EM carry trades point to a slight slowdown, not an acceleration. A pick up in volatility would magnify the underperformance of EM carry trades, and thus, tighten global liquidity conditions. This will help the dollar, but could help the yen even more. Buy NOK/SEK. Feature This past Wednesday, the Federal Reserve increased its growth forecast through 2020. It also cut expectations for the U.S. unemployment rate in 2018 and 2019 to 3.9%, and finally it increased its interest rate forecast to 3.1% by 2020. Yet, the U.S. dollar weakened substantially. Even if we acknowledge that interest rate markets are skeptical that the Fed will be able to fulfill its promises, the U.S. dollar has also decoupled itself from market interest rates. While rate spreads between the U.S. and the rest of the world point to a higher USD, the dollar is in fact gaining no traction (Chart I-1). We think global growth has been the key to this conundrum. Global Growth Steals The Limelight Interest rate differentials are the most common driver of exchange rates, but sometimes, growth dynamics also play a role. Currently, strong global growth stands firmly in the driver's seat, explaining why the dollar is weakening. Generally, when non-U.S. activity improves, the dollar underperforms (Chart I-2). Chart I-1Dollar And Rates Spot The Disconnect Dollar And Rates Spot The Disconnect Dollar And Rates Spot The Disconnect Chart I-2The Dollar Doesn't Like Strong Global Growth The Dollar Doesn't Like Strong Global Growth The Dollar Doesn't Like Strong Global Growth The reason is straightforward, and has two main elements. First, the U.S. is a low-beta economy. When global growth accelerates, the U.S. does not benefit as much as Europe. The IMF estimates that a 1% gyration in EM activity affects euro area growth three times as much as it impacts the U.S. Not only is EM activity a key source of variance in the global industrial cycle, it has also been the key factor behind this upswing. Second, money tends to flow out of the U.S. when global growth accelerates. Since non-U.S. economies are more levered to the global industrial cycle than the U.S., so is their profit growth. Additionally, an accelerating global economy is associated with a rise in central bank foreign exchange reserves outside of the U.S. as global trade expands. This creates generous liquidity conditions in the rest of the world, which further favors economic growth and asset price expansion. Money flows where higher returns are to be found. In recent quarters, global reserves have indeed expanded, highlighting this easing in global liquidity conditions (Chart I-3). To bet on the U.S. dollar weakening is to bet on this set of conditions continuing. This is the wager market participants are currently making. Investors are very short the U.S. dollar index and very long the euro, the CAD, the AUD, gold and oil (Chart I-4). This suggests that even a mild slowdown in global growth would indeed be a surprise - one that would cause the dollar to move back toward levels implied by interest rate differentials (Chart I-5). Chart I-3Buoyant Growth Equals Reserves Accumulation Equals Strong EM Currencies Buoyant Growth Equals Reserves Accumulation Equals Strong EM Currencies Buoyant Growth Equals Reserves Accumulation Equals Strong EM Currencies Chart I-4Investors Are Short The Dollar Long Growth Investors Are Short The Dollar Long Growth Investors Are Short The Dollar Long Growth Chart I-5Dollar Is Cheap Relative To Rates Dollar Is Cheap Relative To Rates Dollar Is Cheap Relative To Rates Bottom Line: A key factor behind the dollar's weakness in 2017 has been the positive global growth surprise. This helps explain why the dollar has been much weaker than interest rate differentials would otherwise suggest. Since the dollar is trading at such a discount to interest rate differentials, for the greenback to weaken further global growth needs to continue to accelerate. Based on positioning, the surprise for investors would be if global industrial activity decelerates. Risks To Global Growth Chart I-6China Helped Australia China Helped Australia China Helped Australia The acceleration in global growth needed for the dollar to sell off more is unlikely to emerge. To the contrary, growing evidence indicates that a mild slowdown is likely to hit global industrial activity next year. One of the key pillars for global growth, China, is turning the corner. China has played an essential role in explaining the strong growth of many economies in 2017. The link for EM or commodity producers like Australia to Chinese growth is relatively self-evident. For example, the value of Australian exports received a strong fillip when Chinese industrial activity surged in 2016 and 2017. As such, the recent rollover in the Li Keqiang index - a key gauge of China's secondary sector - points to a reversal in Chinese growth (Chart I-6). Chinese activity also has important implications for the performance of growth in the euro area relative to the U.S. As Chart I-7 highlights, when Chinese monetary conditions ease or when the Chinese marginal propensity to save - as approximated by the gap between the growth rate of M2 and M1 - decreases, the Eurozone's economy accelerates relative to the U.S. Currently, Chinese monetary conditions are tightening and the marginal propensity to save is rising, highlighting that European growth will decelerate relative to the U.S. Chart I-7AChina Also Matters For The Distribution Of Growth Between Europe And The U.S. (I) China Also Matters For The Distribution Of Growth Between Europe And The U.S. (I) China Also Matters For The Distribution Of Growth Between Europe And The U.S. (I) Chart I-7BChina Also Matters For The Distribution Of Growth Between Europe And The U.S. (II) China Also Matters For The Distribution Of Growth Between Europe And The U.S. (II) China Also Matters For The Distribution Of Growth Between Europe And The U.S. (II) The outlook for Chinese growth suggests that the recent reversal in industrial activity could run a bit deeper. Arthur Budaghyan, who leads BCA's Emerging Markets Strategy service, has highlighted that Chinese broad money growth is decelerating, and that the Chinese fiscal impulse is slowing. This is normally associated with falling Chinese imports, which is China's direct footprint on the global economic cycle and global trade (Chart I-8). Moreover, Chinese borrowing costs are rising and the real estate sector is already showing signs of slowing. The amount of new floor space sold is now contracting, which often precedes serious decelerations in new house prices (Chart I-9, top panel). Thus, Chinese construction is likely to contribute less to global growth and to demand for commodities in the coming year than in the past two years. Chart I-8Slowing Chinese Money Is A ##br##Headwind For Global Activity bca.fes_wr_2017_12_15_s1_c8 bca.fes_wr_2017_12_15_s1_c8 Chart I-9Excess Investment Is A Real Problem China Fixed Capital Formation To Slow in 2018 Excess Investment Is A Real Problem China Fixed Capital Formation To Slow in 2018 Excess Investment Is A Real Problem China Fixed Capital Formation To Slow in 2018 Meanwhile, China has overinvested in its capital stock when compared with other EM economies at similar stages of development (Chart I-9, bottom panel). Therefore, the risk that capex will slow in response to policy tightening is high. This would further weigh on Chinese imports. Various Chinese leading economic indicators have also rolled over sharply. This portends a further fall in the Li Keqiang index (Chart I-10) and also gives more credence to our view that China's industrial activity and imports will slow in 2018. As BCA's Geopolitical Strategy team has argued, the willingness of the Chinese authorities to implement reforms and control credit growth next year will only solidify this negative impulse.1 It is not just Chinese variables that are deteriorating, but other key leading indicators of the global industrial cycle seem to be picking up on this impulse (Chart I-11). The recent deceleration in global money growth also confirms this insight (Chart I-12). Chart I-10Chinese Monetary Conditions ##br##Point To Slowing Industrial Activity Chinese Monetary Conditions Point To Slowing Industrial Activity Chinese Monetary Conditions Point To Slowing Industrial Activity Chart I-11Global Growth Gauges Corroborate ##br## Chinese Indicators Global Growth Gauges Corroborate Chinese Indicators Global Growth Gauges Corroborate Chinese Indicators Chart I-12Where Global Money Growth Goes, ##br##So Does Activity Where Global Money Growth Goes, So Does Activity Where Global Money Growth Goes, So Does Activity Most importantly, the performance of our EM Carry Canaries - how key EM carry currencies are performing against the quintessential funding currency, the yen, corroborates this picture. EM carry trades' total returns have sharply rolled over, a signal that has always led to a slowdown in global industrial activity for the past 20 years (Chart I-13). We argued two weeks ago that EM carry trades are beginning to weaken because of the negative impulse emanating from China. We also stressed that the relationship between EM carry trades and global industrial activity is strengthened by the role carry trades play in disseminating and enhancing global liquidity.2 Strongly performing EM carry trades are a symptom of liquidity making its way across the globe, leading to supportive conditions for risk assets and growth. On the other hand, an underperformance in EM carry trades is an early signal that liquidity is on the wane, pointing to an upcoming downturn in risk taking and economic activity. Going forward, there is a growing likelihood that policy within developed markets will amplify the weakness in EM carry trades that currently reflects mostly changing growth dynamics in China. Global volatility has been extremely muted in 2017, which normally helps carry trades perform well. However, as Chart I-14 illustrates, volatility tends to experience upside when U.S. inflation picks up. This is because as inflation picks up, not only does the Fed increase rates, which tightens global liquidity conditions and hampers risk taking, but the path for future growth also becomes trickier to discount, requiring higher volatility in the process. BCA expects U.S. inflation to pick up significantly in 2018. The rise in the growth of the velocity of money in the U.S. is one of the clearest indications of that risk (Chart I-15). Chart I-13EM Carry Trades Are Confirming These Trends EM Carry Trades Are Confirming These Trends EM Carry Trades Are Confirming These Trends Chart I-14Global Vol Will Rise With Inflation Global Vol Will Rise With Inflation Global Vol Will Rise With Inflation Chart I-15U.S. Core Inflation Has Upside U.S. Core Inflation Has Upside U.S. Core Inflation Has Upside The tax repatriation included in the U.S. Tax Cuts and Jobs Act represents an additional risk for global aggregate volatility. When U.S. entities repatriate dollars back home, this curtails the supply of USD collateral available in the offshore market. As a result, dollar funding becomes scarcer, creating widening pressures on USD cross-currency basis swap spreads (Chart I-16, top panel).3 The introduction in January of rules by the BIS for banks to hold greater collateral against OTC transactions will further exacerbate this potential dollar squeeze in the swap market, increasing the risk that the U.S. tax bill will result in wider USD basis-swap spreads. Historically, wider swap spreads haven been associated with rising volatility, a logical consequence of more expensive funding (Chart I-16, bottom panel). This rise in volatility is likely to aggravate the weakness in EM carry trades. This will amplify the risks to global liquidity. As this process unfolds, global growth will begin to slow, precisely at the time when investors are not positioned for it. Bottom Line: Global growth is being hit by the beginning of a slowdown in Chinese industrial activity. This slowdown does not constitute a crisis, nor a repeat of the 2015 period of elevated risks for China. However, it does nonetheless create a headwind for global industrial activity that is already being picked up by key reliable gauges of global growth. Moreover, EM carry trades, which have been an extremely reliable leading indicators of global growth, are already corroborating this picture. Since volatility is set to increase in 2018 as U.S. inflation picks up and U.S. tax repatriation dries global dollar funding, the downside in EM carry trades has further to go which will result in tighter global liquidity conditions, in turn increasing the probability that global growth will disappoint. Global Growth, U.S. Policy, And The Dollar We began this report by highlighting that since the dollar is now trading at a substantial discount to interest rate differentials, betting on a weaker dollar is akin to betting on additional strengthening in global growth. However, the factors highlighted above argue against an acceleration in global growth, especially in global industrial activity. Moreover, global growth is set to decelerate while the Fed is hiking rates - a scenario reminiscent of the late 1990s. In fact, the gap between growth indicators and the Fed's policy setting has in the past been a useful tool in pinpointing dollar bull and bear markets (Chart I-17). Chart I-16Tax Repatriation Leads To Wider ##br## Swap Spreads And Greater Volatility Tax Repatriation Leads To Wider Swap Spreads And Greater Volatility Tax Repatriation Leads To Wider Swap Spreads And Greater Volatility Chart I-17A USD-Positive ##br##Dichotomy A USD-Positive Dichotomy A USD-Positive Dichotomy Thus, we continue to follow the scenario we elaborated on in early September:4 The dollar will end the year having generated positive but uninspiring returns during the fourth quarter. It will only gather steam in Q1 2018, once U.S. inflation picks up significantly. This rebound in U.S. core inflation will help the Fed fulfill its promise to increase rates three times next year. It will also create a non-negligible headwind to global growth by pushing volatility higher, hurting global carry trades and global liquidity conditions in the process. At this point, any move in DXY to 93 should be used to build bullish bets on the dollar. Conversely, moves in EUR/USD to 1.18 should be used to sell the USD. We remain short commodity currencies and our portfolio is especially negative on the AUD. Finally, we have professed a negative view on the JPY on the basis of higher U.S. rates. While higher U.S. rates may continue to lift USD/JPY, the window to be short the JPY is likely closing. If volatility does pick up on the back of the risks highlighted in this report, the yen could buck the dollar's strength and rally. We thus remain short NZD/JPY to protect against this eventuality, and we will look to close our long USD/JPY position around the New Year. Bottom Line: As global growth is set to slow somewhat, the Fed is redoubling on its hawkish rhetoric. Since the dollar is trading at a discount to interest rate differentials and is being sold by speculators, this raises the risk that the USD will experience a significant rally in the first half of 2018. Any move in the DXY to 93 should be used to build significant long positions in the USD, whether through the index or by shorting EUR/USD, or by betting on further AUD weakness. The yen could benefit in this environment. An Uncorrelated Trade: Long NOK/SEK It is always important to find potentially uncorrelated trades within a portfolio, as it increases diversification benefits. The FX space is no exception to this rule. Such an opportunity seems to be emerging in the European currency space: buying Nokkie/Stokkie. NOK/SEK currently trades at a large 8% discount to purchasing power parity. More sophisticated models incorporating productivity differentials and terms-of-trade shocks also show that the krone is cheap relative to its neighbor (Chart I-18). Moreover, the IMF expects the Norwegian current account to stand at 5.5% of GDP for 2017, while Sweden's will be a more modest 3.9% of GDP. This gap is anticipated to be maintained in 2018. In terms of catalysts for a rally in NOK/SEK, Sweden's relative economic outperformance that has been so vital to this cross's weakness is ebbing. Norwegian real GDP and industrial production growth are both accelerating relative to Sweden's. This trend looks set to endure as the Norwegian leading economic indicator is displaying a similar profile (Chart I-19). Confirming this picture, the Norwegian economic surprise index is turning up from exceptionally depressed levels when compared to Sweden's. Historically, this tends to translate into a stronger NOK. Yesterday's comments by Norges Bank Governor Oystein Olsen pointing to a first hike in late 2018 are helping catalyze the pricing of these dynamics in the cross's price. Financial markets are telling a similar story. Norwegian equities have been outperforming their Swedish counterparts since the middle of 2017. Moreover, Norwegian nominal and real yields are rallying relative to Sweden, which normally puts upward pressure on NOK/SEK (Chart I-20). Chart I-18NOK/SEK Is Cheap NOK/SEK Is Cheap NOK/SEK Is Cheap Chart I-19Growth Momentum Moving In Favor Of Norway Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth Chart I-20Relative Yields Point To Higher NOK/SEK Relative Yields Point To Higher NOK/SEK Relative Yields Point To Higher NOK/SEK While a slowdown in global growth is a risk when holding a commodity currency like the NOK, NOK/SEK offers a healthy level of cushion against this eventuality. Overwhelmed by domestic fundamentals, NOK/SEK has decoupled from its historical relationship with EM equities, EM spreads, oil and global growth. Thus, this cross is not as levered to the global economic cycle as it normally is. In fact, BCA's view that oil prices have upside, especially relative to EM asset prices, points toward a higher NOK/SEK (Chart I-21). Finally, from a technical perspective, NOK/SEK looks interesting. The pair's 40-week rate-of-change measure is hitting oversold levels. More tellingly, NOK/SEK is forming an inverted head-and-shoulder pattern exactly as its 13-week rate of change loses downward momentum (Chart I-22). Chart I-21Liking Oil Relative To EM Stocks ##br##Is The Same Thing As Being Long NOK/SEK Liking Oil Relative To EM Stocks Is The Same Thing As Being Long NOK/SEK Liking Oil Relative To EM Stocks Is The Same Thing As Being Long NOK/SEK Chart I-22Favorable Technical ##br##Set Up Favorable Technical Set Up Favorable Technical Set Up Thus, we are buying NOK/SEK this week, with an entry point at 1.0163, a stop at 0.998, and an initial target at 1.08. Bottom Line: Buying NOK/SEK at current levels makes sense. Not only is it an uncorrelated trade with the dollar, but the pair is also cheap. Moreover, economic momentum, which was overwhelmingly in favor of the SEK, is now rolling in favor of the NOK, a message confirmed by financial market indicators. NOK/SEK is trading at cheap levels relative to global economic and financial variables, suggesting a cushion to negative shocks is in the price. Instead, NOK/SEK should benefit if oil prices outperform EM assets, a view held by BCA. Finally, the trade looks attractive from a technical perspective. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Geopolitical Strategy Special Reports, titled "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017, and "China: Party Congress Ends... So What?" dated November 1, 2017, available at gps.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "Canaries In The Coal Mine Alert: EM/JPY Carry Trades," dated December 1, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report, titled "It's Not My Cross To Bear," dated October 27, 2017, available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report, titled "Conflicting Forces For The Dollar," dated September 8, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 U.S. data has been mixed: Core CPI grew by 1.7% annually, lower than the expected 1.8%; Producer prices were strong annually at 3.1%, above the expected 2.9%; while the core measure also produced strong results of 2.4%, above the expected 2.3%; Retail sales were also quite positives, beating expectations by a wide margin. This week, in line with expectations, the Fed hiked rates to 1.25 - 1.5%. The FMOC also upgraded its growth forecasts while still penciling in three rate hikes for next year. However, Treasurys rallied and the DXY dropped 0.6%, showing that markets believe the Fed is potentially making a hawkish error inflation continues to underperform. We do agree with the Fed and we expect inflation be in the process of bottoming. Report Links: Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 The Xs And The Currency Market - November 24, 2017 It's Not My Cross To Bear - October 27, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 European data was generally positive: German ZEW Current Situation increased to 89.3 while economic sentiment declined to 17.4; European PMIs were very strong, with the manufacturing and services indices coming in at 60.6 and 58, respectively, both increasing and beating expectations. German inflation stayed steady and in line with expectations at 1.8%; French CPI underperformed expectations, growing at 1.2% annually; Italian inflation was in line with consensus at 1.1%; European growth is currently stellar, and markets have priced in this reality. The ECB agrees, and it has upgraded its growth and inflation forecasts up to 2020. Yet, even under the new set of forecasts, inflation fails to hit the ECB's target. With the end of the asset purchases program anticipated for the September 2018, the first hike could materialize in the second quarter of 2019, suggesting EONIA rates possess some genuine but limited upside from current levels. However, most importantly, we think that EONIA pricing will still lag the U.S. OIS going forward, putting downward pressure on EUR/USD. Report Links: The Xs And The Currency Market - November 24, 2017 Temporary Short-Term Rates - November 10, 2017 Market Update - October 27, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data has been mixed in Japan: Nikkei Manufacturing PMI outperformed expectations, coming in at 53.8. Machinery orders yearly growth also outperformed expectations, coming in at 5%. Moreover, gross domestic product growth also outperformed, coming in at 2.5% in the third quarter. This was a significant improvement from the 1.4% growth number registered in Q2. However labor cash earnings growth underperformed expectations, coming in at 0.6%, suggesting still muted inflation pressures. Finally, housing starts growth surprised to the downside, coming in at -4.8%. After rising throughout the week, USD/JPY collapsed following the FOMC rate decision, as U.S. Treasuries rallied. Overall we continue to be bullish on the yen against risk-on currencies like the NZD and the AUD, as tightening Chinese financial conditions should set the stage for a temporary slowdown in global growth. Report Links: Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 The Xs And The Currency Market - November 24, 2017 Temporary Short-Term Rates - November 10, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been positive: Markit Manufacturing PMI outperformed expectations, coming in at 58.2. This number also increased from the October reading. Construction PMI also outperformed expectations, coming in at 53.1, and also increasing from the previous month's number. Headline inflation also outperformed expectations, with a reading of 3.1%. Nevertheless, core inflation came in according to expectations at 2.7% Finally, the trade balance also outperformed expectations on the month of October, coming in at -1.405 Billion pounds. The BOE's MPC left policy rates unchanged at 0.5%. Overall, we believe that in the short term, the ability of the BoE to continue to hike is limited, given that consumption remains sluggish and leading indicators of house prices still flag some frailty. Furthermore, the uncertainty surrounding Brexit continues to make the BoE more cautious than otherwise. Report Links: The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Australian data was mixed: House prices contracted at a quarterly pace by 0.2%, less than the expected 0.5%; NAB Business Confidence went down from 9 to 6; NAB Business Conditions went down from 21 to 12; Westpac consumer confidence went up to 3.6% from -1.7%; However, employment increased by 61,600, beating expectations of 18,000, with full-time employment increasing by 41,900, outperforming part-time employment of 19,700; The AUD rallied on these data releases. Furthermore, faltering U.S. inflation and upbeat Chinese data fed into the AUD's rally. The Australian economy is still mired in substantial slack, and the RBA is likely to stay easy, putting a lid on AUD upside. Report Links: The Xs And The Currency Market - November 24, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been negative: Seasonally-adjusted building permits contracted by 9.6% in October. Furthermore, the terms of trade index, continued to fall in the third quarters, coming in at 0.7%. This number also surprised to the downside. Manufacturing sales grew by 0.3% in the third quarter, a slowdown from the 1% growth witnessed in Q2. Finally, the ANZ Business Confidence measure fell to -39.3, the lowest level in more than 9 years. The NZD/USD has rallied by roughly 3% in the past week. This mostly reflects weakness on the part of the USD yesterday following the FOMC interest rate decision as NZD is flat against the AUD on the weak. Overall, the long term outlook for NZD/USD, NZD/EUR, and NZD/JPY is negative, as decreased immigration and the addition of an employment mandate for the RBNZ, will structurally lower rates in New Zealand. However, NZD still possesses upside against the AUD. Report Links: The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Last week, the BoC left its policy rate unchanged at 1%. The Bank is delaying hiking as inflation and growth have slowed. The BoC also want to appraise the impact of its previous two interest rate hikes as well as the brewing risks surrounding NAFTA negotiations. That being said, inflation still is around 40 bps higher than it was in June. Employment data remains stellar, and the tightening labor market is pointing to a pickup in wages. Additionally, oil could offer additional upside as supply continues to be curtailed by Saudi Arabia and Russia. The CAD is likely to perform well next year, particularly against the SEK and the AUD. However, upside against the U.S. dollar will be limited. Report Links: The Xs And The Currency Market - November 24, 2017 Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been mixed: Headline inflation surprised to the downside, coming in at 0.8%. However it increased from 0.7% on the previous month. The unemployment rate came in below expectations, at 3%. Additionally, the SNB kept its -0.75% deposit rate unchanged. Furthermore, it continued to signal that it will stay active in the foreign exchange markets. Indeed, the SNB stated that although the overvaluation of the franc has decreased "the franc remains highly valued". On a more positive note, however, the SNB revised its inflation forecast for its coming quarters, suggesting an overshoot may even happen and be tolerated as this inflation upgrade mainly reflected the appreciation of oil and the depreciation of the franc. We continues to believe that the SNB will keep its ultra-dovish monetary policy in place as long as core inflation remains very low and the Swiss franc stays overvalued on a PPP basis. These negatives for the franc could get occasionally interrupted when volatility re-emerges global markets. Report Links: The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been mixed: Core inflation surprised to the downside, coming in at 1.1%. This number also declined from last week's number of 1.2%. Retail Sales growth also underperformed expectations, coming in at -0.2%. However this number improved from last month's 0.8% contraction. However manufacturing output outperformed expectations, coming in at 0.7%. However this number slowed down from last month's 2.8% growth. The Norges Bank kept rates unchanged at 0.5% at its latest monetary policy meeting. Overall, this release was less dovish than markets expected as the Norge Bank brought forward to late 2018 it expectations for a first hike. Essentially, despite a weak batch of data this week, the Norwegian economy is heeling, and is not experiencing the same debilitating deflationary pressures as has been experienced by other countries in Europe. Our favored way to play these improvements in the Norwegian economy, along with the change of tone at the Norges Bank helm is to buy NOK/SEK And short EUR/NOK. Report Links: The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Swedish data has recently taken a stronger turn: Industrial production increased by 6% annually, higher than the previous 2.7% growth rate; Manufacturing new orders increased by 3.8% annually; Inflation popped up to 1.9%, higher than the previous 1.7%, and outperforming the expected 1.7%. While inflation has picked back up, last quarter's disappointing GDP numbers still raises important question marks. The risks are still skewed toward the current Riksbank leadership maintaining a dovish stance, despite an economy that hardly needs it. This risk will only grow if our EM canaries are correct and global industrial activity turns around, a phenomenon that will impact Swedish growth and inflation negatively. Report Links: The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades