Emerging Markets

Dear Client, Instead of our Weekly Report, we are sending you this Special Report written by my colleague Marko Papic, BCA's Chief Geopolitical Strategist. Marko argues that while there is considerable risk that NAFTA is abrogated, the Trump administration would quickly move to alleviate the effects to trade flows. The risk to our view is that President Trump is a genuine populist, a view that his actions thus far do not support. I hope you will find this report both interesting and informative. Best regards, Peter Berezin, Chief Strategist Global Investment Strategy Highlights NAFTA is truly at risk - as currency markets suggest; NAFTA's impact on the U.S. economy is positive but marginal; The key question is whether Trump is a true populist or a "pluto-populist"; If the former, then NAFTA's failure is likely and portends worse to come; NAFTA's collapse would be bearish MXN, bearish U.S. carmakers versus DM peers, and supportive of higher inflation in the U.S. Feature Fifty years ago at the end of World War II, an unchallenged America was protected by the oceans and by our technological superiority and, very frankly, by the economic devastation of the people who could otherwise have been our competitors. We chose then to try to help rebuild our former enemies and to create a world of free trade supported by institutions which would facilitate it ... Make no mistake about it, our decision at the end of World War II to create a system of global, expanded, freer trade, and the supporting institutions, played a major role in creating the prosperity of the American middle class. - President Bill Clinton, Remarks at the Signing Ceremony for the Supplemental Agreements to the North American Free Trade Agreement, September 14, 1993 No Free Trade Agreement (FTA) has been more widely maligned than the North American Free Trade Agreement (NAFTA). It is, after all, the world's preeminent FTA. Signed in December 1992 by President George H. W. Bush and implemented in January 1994, it preceded the founding agreements of the World Trade Organization (WTO) and launched a two-decade, global expansion of FTAs (Chart 1). By including environmental and labor standards, as well as dispute settlement mechanisms, it created a high standard for all subsequent FTAs. President Trump's presidency began with much fear that his populist preferences would imperil globalization and trade deals such as NAFTA. Other than his withdrawal from the Trans-Pacific Partnership deal, much of the concern has been proven to be misplaced - including our own.1 Even Sino-American trade tensions have eased, with President Trump and President Xi Jinping enjoying a good working relationship so far. So should investors relax and throw caution to the wind? Chart 1NAFTA: Tailwind To Globalization NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism Chart 2U.S. Economy: Largely Unaffected By NAFTA U.S. Economy: Largely Unaffected By NAFTA U.S. Economy: Largely Unaffected By NAFTA In this report, we argue that the answer is a resounding no. The White House rhetoric on NAFTA - a trade deal that has been mildly positive for the U.S. economy and, at worst, neutral for its workers - suggests that greater trade conflicts loom, not only within NAFTA but also with China and others. Furthermore, a rejection of NAFTA would be a symbolic blow to free trade at least as consequential as the concrete ramifications of nixing the deal itself. The deal with Mexico and Canada is not as significant to the U.S. economy as its proponents suggest (Chart 2), but by mathematical logic its detractors therefore overstate its negatives. The opposition to NAFTA by the Trump administration therefore reveals preferences that would become far more investment-relevant if applied to major global economies like China. If NAFTA negotiations are merely a ploy to play to the populist base, however, then the impact of its demise will be temporary and muted. At this time, however, it is unclear which preference is driving the Trump White House strategy and thus risks are to the downside. The Decaying Context Behind NAFTA The North American Free Trade Agreement is more than a trade deal: it is the symbolic beginning of late twentieth-century globalization. According to our trade globalization proxy, this period has experienced the fastest pace of globalization since the nineteenth century (Chart 3). Both NAFTA and the WTO enshrined new rules and standards for global trade upon which trade and financial globalization are based. Underpinning this surge in globalization was the apex of American geopolitical power and the collapse of the socialist alternative, the Soviet Union. As President Clinton's remarks from 1993 suggest (quoted at the beginning of the report), NAFTA was the culmination of a "creation myth" for an American Empire. The myth narrates how the geopolitical and economic decisions made by the U.S. in the aftermath of its victory in World War II laid a foundation for both American prosperity and a new global order. With the ruins of Communism still smoldering in the early 1990s, the U.S. decided to double-down on those same, globalist impulses. Today those impulses are waning if not completely dead. As we argued in our 2014 report, "The Apex Of Globalization - All Downhill From Here," three trends have conspired to turn the tides against globalization:2 Chart 3Globalization Has Peaked Globalization Has Peaked Globalization Has Peaked Chart 4Globalization And Its Indebted Discontents Globalization And Its Indebted Discontents Globalization And Its Indebted Discontents Multipolarity - Every period of intense globalization has rested on strong pillars of geopolitical "hegemony," i.e. the existence of a single world leader. Chart 3 shows that the most recent such eras consisted of British and American hegemony, respectively. However, the relative decline of American geopolitical power has imperiled this process, as rising powers look to carve out regional spheres of influence that are by definition incompatible with a globalized political and economic framework. In parallel, the hegemon itself - the U.S. - has begun to vacillate over whether the framework it designed is still beneficial to it, given its declining say in how the global system operates. Great Recession - The 2008 global financial crisis cracked the ideological, macroeconomic, and policy foundations of globalization. Deflation - Globalization is deflationary, which works swimmingly when real household incomes are rising and debts falling. Unfortunately, neither of those has been the case for American households over the past forty years (Chart 4). This is in large part the consequence of globalization, which opened trade with emerging markets and thus suppressed low-income wage growth in developed economies. What is striking about the U.S. is that its social safety net has done such a poor job redistributing the gains of free trade, at least compared to its OECD peers (Chart 5). Chart 5The "Great Gatsby" Curve NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism Chart 6America Belongs To The Anti-Globalization Bloc NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism President Donald Trump shrewdly understood that the tide had turned against free trade in the U.S. (Chart 6). Ahead of the 2016 election, no one (except BCA!) seriously believed that trade and globalization would become the fulcrum of the election.3 Candidate Trump, however, returned to it repeatedly, and singled out NAFTA as "the worst trade deal maybe ever signed anywhere."4 Bottom Line: President Trump's opposition to globalization did not fall from the sky. Trump is the product of his time and geopolitical and macroeconomic context. Trends we identified in 2014 are today headwinds to globalization. Myths About NAFTA The geopolitical and macroeconomic context may be dire for globalization, but does NAFTA actually fit that narrative? The short answer is no. The long answer is that there are three myths about NAFTA that the Trump administration continues to propagate. We assume that U.S. policymakers can do simple math. As such, their ignorance of the below data suggests a broad strategy toward free trade that is based in ideology, not factual reality. Alternatively, flogging NAFTA may be motivated by narrower, domestic, political concerns and may not be indicative of a deeply held worldview. Time will tell which is true. Myth #1: NAFTA Has Widened The U.S. Trade Deficit NAFTA has resulted in a huge trade deficit for the United States and has cost us tens of thousands of manufacturing jobs. The agreement has become very lopsided and needs to be rebalanced. We of course have a five-hundred-billion-dollar trade deficit. So, for us, trade deficits do matter. And we intend to reduce them. - Robert Lighthizer, U.S. trade representative, October 17, 2017 Chart 7Long-Term Trade Deficit Is About Commodities Long-Term Trade Deficit Is About Commodities Long-Term Trade Deficit Is About Commodities When it comes to the U.S. trade deficit, NAFTA has had a negligible impact. Three facts stand out: The U.S. has an insignificant trade deficit with Canada - 0.06% of GDP in 2016, or $12 billion. It has a larger one with Mexico - 0.33% of GDP, or $63 billion. However, when broken down by sectors, the deepest trade deficit has been in energy. The U.S. has actually run a surplus in manufactured products with Mexico and Canada for much of the post-2008 era, which only recently dipped back into deficit (Chart 7). The U.S. has consistently run a trade deficit with the rest of the world since 1980, but the size of its trade deficit with Mexico and Canada did not significantly increase as a share of GDP post-implementation of NAFTA. The real game changer has been the widening of the trade deficit with China and the rest of the EM economies outside of China and Mexico (Chart 8). The trade relationship with Mexico and Canada, relative to that with the rest of the world, therefore remains stable. The net energy trade balance with Mexico and Canada has significantly improved due to surging U.S. shale production (Chart 9). Rising shale production has accomplished this both by lowering the need for imports from NAFTA peers, surging refined product exports to Mexico, and by inducing lower global energy prices. In addition, Canada-U.S. energy trade is governed by NAFTA's Chapter 6 rules, which prohibit the Canadian government from intervention in the normal operation of North American energy markets.5 Chart 8U.S. Trade Imbalance Is Not About NAFTA NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism Chart 9Shale Revolution Is A Game Changer Shale Revolution Is A Game Changer Shale Revolution Is A Game Changer Myth #2: NAFTA Has Destroyed The U.S. Auto Industry Before NAFTA went into effect ... there were 280,000 autoworkers in Michigan. Today that number is roughly 165,000 - and would have been heading down big-league if I didn't get elected. - Donald Trump, U.S. President, March 15, 2017 Chart 10NAFTA Has Made U.S. Auto Manufacturing More Competitive NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism What about the charge that NAFTA has negatively impacted the U.S. automotive industry by shipping jobs to Mexican and, to lesser extent, Canadian factories? Again, this reasoning is flawed. In fact, NAFTA appears to have allowed the U.S. automotive industry to remain highly competitive on a global scale, more so than its Mexican and Canadian peers. U.S. exports outside of NAFTA as a percent of total exports have surged since the early 2000s and have remained buoyant recently. Meanwhile, Mexican exports to the rest of the world have fallen, suggesting that Mexico is highly reliant on servicing Detroit (Chart 10). The truth is that the American automotive industry's share of overall manufacturing activity has risen since 2008. In part, this is because American manufacturers have been able to integrate with Canadian and Mexican plants, allowing production to remain on the continent and move seamlessly across the value chain. In other words, Mexico serves as a low-wage outlet for the least-skilled part of the production chain, allowing the rest of the manufacturing process to remain in the U.S. and Canada. Without that cheap "escape valve," the entire production chain might have migrated to EM Asia. Or, worse, the American automotive industry would have become uncompetitive relative to European and Japanese peers. Either way, the U.S. would have potentially faced greater job losses were it not for easier access to Mexican auto production. Both European and Japanese manufacturers have similar low-skilled, low-cost, "labor escape valves" in the region. For Germany and France, this escape valve is in Spain and Central and Eastern Europe; for Japan, it is in Thailand. Myth #3: Mexico And Canada Cannot Retaliate Against The U.S. As far as I can tell, there is not a world oversupply of agricultural products. Unless countries are going to be prepared to have their people go hungry or change their diets, I think it's more of a threat to try to frighten the agricultural community. - Wilbur Ross, Commerce Secretary, October 11, 2017 Chart 11Mexico's Growing Population Is A Potential Market NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism U.S. exports to Canada and Mexico only account for about 2.6% of GDP, whereas exports to the U.S. from Mexico and Canada account for 28% and 18% of GDP respectively. Nonetheless, this does not mean that the U.S. suffers from NAFTA. As we discussed above, NAFTA has been a boon for the global competitiveness of the U.S. automotive industry. In addition, NAFTA gives American and Canadian exporters access to a large and growing Mexican middle class (Chart 11). Furthermore, the U.S. would gain little benefit from leaving NAFTA vis-à-vis Canada and Mexico. By reverting back to WTO tariff levels, the U.S. would be able to raise tariffs from 0% (under NAFTA) to the maximum of 3.4%, where the U.S. average "bound tariff" would remain. Bound tariffs differ across products and countries and represent the maximum rate of tariffs under WTO rules (i.e., without violating those rules). They are indicative of a hostile trade relationship, as trade would otherwise be set at much lower "most favored nation" tariff levels. As Table 1 shows, however, Canada and particularly Mexico have the ability to raise their bound tariffs considerably higher than the U.S. can do. Mexico, in fact, has one of the highest average bound tariff rates for an OECD member state, at a whopping 36.2%! This means that, if NAFTA were to be abrogated, the U.S. would be allowed to raise tariffs, on average, to 3.4%, whereas Mexico would be free to do so by ten times more. Given that Mexico is America's main export destination for steel and corn output, the retaliation would be non-negligible for these two politically powerful sectors. This aspect of the WTO agreement is a latent geopolitical risk, as it feeds into the Trump administration's broader antagonism toward the WTO itself. Table 1WTO Tariff Schedule NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism Despite the hard evidence, we suspect that the Trump administration is driven by ideological and strategic goals and therefore the probability of a calamitous end to the ongoing NAFTA negotiations is high. Nevertheless, the data shows: The North American Free Trade Agreement has allowed trade between its member states to accelerate at a faster pace than global trade for much of the first decade after its signing and at the average global pace over the past decade (Chart 12); U.S. manufacturing employment as a percent of total labor force has been declining for much of the past half-century, with absolute numbers falling off a cliff as China joined the WTO and, along with EM Asia, became integrated into the global supply chain (Chart 13); Employment in auto-manufacturing follows the same pattern as overall manufacturing employment (Chart 13, bottom panel), suggesting that it was not NAFTA that caused job flight but rather competition from the rest of the world along with automation. In fact, auto-manufacturing employment has recovered post-2008, as American car manufacturers underwent structural reforms to improve competitiveness. Chart 12NAFTA Trade Has Beaten Global Trade NAFTA Trade Has Beaten Global Trade NAFTA Trade Has Beaten Global Trade Chart 13Who Hurt U.S. Manufacturing Employment: China Or NAFTA? Who Hurt U.S. Manufacturing Employment: China Or NAFTA? Who Hurt U.S. Manufacturing Employment: China Or NAFTA? As with any free trade agreement, some wages in some sectors may have been lowered by NAFTA's implementation and some jobs were definitely lost due to the agreement. However, the vast majority of academic studies point out that the negative labor market impacts of NAFTA have been negligible. The most authoritative work on the subject, by economists Gary Clyde Hufbauer and Jeffrey J. Schott of the Peterson Institute for International Economics, found that the upper-bound of NAFTA-related job losses in the U.S. is 1.9 million over the first decade of the agreement. Given that U.S. employment rose by 34 million over the same period, the job losses represent "a fraction of one percent of jobs 'lost' through turnover in the dynamic U.S. economy over a decade."6 A June 2016 report by the U.S. International Trade Commission (USITC) provides a good review of academic studies on the trade deal since 2002. Overall, it concludes that NAFTA led "to a substantial increase in trade volumes for all three countries; a small increase in U.S. welfare [overall economic benefit]; and little to no change in U.S. aggregate employment."7 In addition, NAFTA had "essentially no effect on real wages in the United States of either skilled or unskilled workers." This academic work could, of course, be the product of a vast conspiracy by globalist, neo-liberal academics financed by the deep state and its corporate overlords. However, the other side of the debate has little to offer as a counter to the empirical evidence. For example, U.S. Trade Representative Robert Lighthizer, a notable trade hawk, posited that the U.S. government had "certified" that 700,000 Americans had lost their jobs owing to NAFTA. This would represent 30,000 job losses per year over the 24 years of NAFTA's existence. Lighthizer also did not say whether he was speaking in net or gross terms, probably because it is practically impossible to competently answer that question! If that is the best retort to the academic research, there is then no real counter to the conclusion that NAFTA has had a mildly positive effect on the U.S. economy and labor market. Bottom Line: NAFTA has had some positive effects on the U.S. automotive sector, allowing it to integrate the low-cost Mexican labor into its production chain and thus remain competitive vis-à-vis Asian and European manufacturers. It also holds the promise of future export gains to Mexico's growing middle class. Its overall effects on the U.S. budget deficit, wages, and employment are largely overstated. If the impact of NAFTA has largely been marginal to the U.S. economy outside of a select few sectors, why is the Trump administration so dead-set on renegotiating it? And why has the process been so acrimonious? What Does The Trump White House Want? Frankly, I am surprised and disappointed by the resistance to change from our negotiating partners ... As difficult as this has been, we have seen no indication that our partners are willing to make any changes that will result in a rebalancing and reduction in these huge trade deficits. - Robert Lighthizer, U.S. trade representative, October 17, 2017 Chart 14NAFTA Negotiations Are FX-Relevant NAFTA Negotiations Are FX-Relevant NAFTA Negotiations Are FX-Relevant Robert Lighthizer, the U.S. trade representative, closed the fourth round of negotiations with a bang, implying that Canada and Mexico would have to help the U.S. close its $500 billion trade deficit, even though the U.S. trade deficit with its two NAFTA partners is only 15% of the total. The Canadian dollar and the Mexican peso fell by 1.2% and 1.9%, respectively, in the subsequent week of trading. In fact, both the CAD and MXN have faced extended losses since the third round of NAFTA negotiations ended on September 27 (Chart 14). Is the market overreacting? We do not think so. First, the list of demands presented by the White House are quite harsh, with the first two below considered deal-breakers: Dispute Settlement: The White House wants to end the investor-state dispute settlement (ISDS) mechanism (under Chapter 11), which allows corporations to sue governments for breach of obligations under the treaty.8 More importantly, the U.S. also wants to eliminate trade dispute panels (under Chapter 19), which allow NAFTA countries to protest anti-dumping and countervailing duties. The real issue is that Chapter 19 trade dispute panels have acted as a constraint on the U.S. administration in imposing antidumping and countervailing duties in the past. Sunset clause: The White House has also proposed that NAFTA automatically expire unless it is approved by all three countries every five years. Buy American: The White House wants its "Buy American" rules in government procurement to be part of the new NAFTA deal, and yet for Canadian and Mexican government contracts to remain open to U.S. businesses. Rules of origin: The White House has called for an increase in NAFTA's regional automotive content requirement from the current 62.5% to 85%, including that 50% of the value of all NAFTA-produced cars, trucks, and large engines come from the U.S.9 Second, the U.S. Commerce Department - headed by trade hawk Wilbur Ross - has signaled that it is open to aggressively pursuing trade disputes on behalf of American companies. Since President Trump's inauguration, U.S. policy interventions have on balance harmed the commercial interests of its G20 trade partners by higher frequency than during the last three years of Barack Obama's presidency (Chart 15).1 0Specific to NAFTA partners, the Commerce Department has slapped a 20% tariff on Canadian softwood lumber in April and a 300% tariff on Bombardier C-Series in October. When combined with the demand to end trade dispute panels under NAFTA's Chapter 19 - which would resolve such trade disputes - the pickup in activity by the Commerce Department is a clear signal that the new U.S. administration intends to break the spirit of NAFTA whether the agreement remains in place or not. Chart 15Trump: Game Changer In U.S. Trade Policy NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism Third, and more broadly speaking, the Trump administration is playing a "two-level game."11 Two-level game theory posits that domestic politics creates acceptable "win-sets," which are then transported to the geopolitical theatre. Politicians cannot conclude foreign agreements that are outside of those domestic win-sets. For President Trump, his win-set on NAFTA negotiations is set by a domestic coalition that allowed him to win the election. This includes voters in the Midwest states of Wisconsin, Michigan, and Pennsylvania where Trump outperformed polls by 10%, 3%, and 3% respectively (Chart 16), and where Secretary Hillary Clinton garnered less votes in 2016 than President Barack Obama in 2012 (Chart 17). Trump promised this blue-collar base a respite from globalization and he has to deliver it if he intends to win in four years' time. Chart 16Trump Owes The Midwest Trump Owes The Midwest Trump Owes The Midwest Chart 17Hillary Lost Rust Belt Voters NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism At the same time, Trump's domestic policy has thus far fallen far short of other campaign promises. First, there has been no movement on immigration or the promised border wall. Second, the Obamacare repeal and replace effort has failed in Congress. Third, proposed tax cuts are likely to benefit the country's elites, as previous tax reform efforts have tended to do. As such, we fear that the Trump White House may double down on playing hardball with NAFTA in order to fulfill at least one of its promised strategies. But why single out NAFTA if its impact on U.S. jobs and wages is miniscule compared to, for example, the U.S.-China trade relationship?12 There are two ways to answer this question: Pluto-populist scenario: President Trump is in fact a pluto-populist and not a genuine populist, i.e. he is not committed to economic nationalism.13 As such, he does not intend to fulfill any of the demands he has promised to his voters, as the current corporate and household tax cuts suggest. Given NAFTA's limited impact on the U.S. economy, abrogating that deal would have far less detrimental impact than if President Trump went after other trade relationships. As such, the NAFTA deal will either be renegotiated, or, at worst, abrogated and quickly replaced with bilateral deals with both Canada and Mexico. It is a "cheap" and "safe" way to satisfy voter demands without actually hurting business or the economy. Genuinely populist scenario: President Trump is a genuine populist and NAFTA renegotiations are setting the stage for a 2018 in which trade protectionism becomes a genuine, global market risk. Bottom Line: President Trump's negotiation stance on NAFTA is non-diagnostic. We cannot establish with any certainty whether his demands mark the start of a broader, global, protectionist trend, or whether he is merely bullying two trade partners who will ultimately have to kowtow to U.S. demands. Nonetheless, we agree with the market's pricing of a higher probability that NAFTA is abrogated, as witnessed by the currency markets. In both of our political scenarios, NAFTA's fate is uncertain. If Trump is a pluto-populist, NAFTA is an easy target and its abrogation will score domestic political points with limited economic impact. If he is a genuine economic nationalist, failed NAFTA renegotiations are the first step on the path to clashing with the WTO and rewriting global trade rules. Investment And Geopolitical Implications Can President Trump withdraw from NAFTA unilaterally? The short answer is yes. As Table 2 illustrates, Congress has passed several laws that delegate authority to the executive branch to administer and enforce trade agreements and to exercise prerogative amid exigencies.14 Article 2205 of NAFTA states that any party to the treaty can withdraw within six months after providing notice of withdrawal. We see no evidence in U.S. law that the president has to gain congressional approval of such withdrawal. Table 2Trump Faces Few Constraints On Trade NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism Moreover, the past century has produced a series of laws that give President Trump considerable latitude - not only the right to impose a 15% tariff for up to 150 days, as in the Trade Act of 1974, but also unrestricted tariff and import quota powers during wartime or national emergencies, as in the Trading With The Enemy Act of 1917.15 The White House has already signaled that it considers budget deficits a "national security issue," which suggests that the White House is preparing for a significant tariff move in the future.16 Could President Trump's moves be challenged by Congress or the courts? Absolutely. However, time is on the executive's side. Even assuming that Congress or the Supreme Court oppose the executive, it will likely be too late to avoid serious ramifications and retaliations from abroad. Other countries will not wait on the U.S. system to auto-correct. Congress is unlikely to vote to overrule the president until the damage has already been done - especially given Trump's powers delegated from Congress. As for the courts, the executive could swamp them with justifications for its actions; the courts would have to deem the executive likely to lose every single one of these cases in order to issue a preliminary injunction against each of them and halt the president's orders. Any final Supreme Court ruling would take at least a year. International law would be neither speedy nor binding. What are the investment implications of a NAFTA collapse? Short term: Short MXN; short North American automotive sector relative to European/Asian peers. We would expect more downside risk to MXN from a collapse in NAFTA talks, similar in magnitude to the decline of the GBP after the Brexit vote. The Mexican central bank would likely take on a dovish stance towards monetary policy, creating a negative feedback loop for the peso. The automotive sectors across the three economies that make up NAFTA would obviously suffer, given the benefits of the integrated supply-chains, as would U.S. steel and select agricultural producers that export to NAFTA peers. Medium term: Canadian exports largely unaffected, buy CAD on any NAFTA-related dip. Given that 20% of Canadian exports to the U.S. are energy - and thus highly unlikely to come under higher tariffs post-NAFTA - we do not expect exports to decline significantly.17 In fact, the 1987 Canada-United States Free Trade Agreement, which laid the foundation for NAFTA, could quickly be resuscitated given that it was never formally terminated, only suspended. Canada and the U.S. have a balanced trade relationship, which means that it is highly unlikely that America's northern neighbor is in the sights of the White House administration. Long term: marginally positive for inflation. Economic globalization and immigration have both played a marginally deflationary role on the global economy. If abrogation of NAFTA is the first step towards less of both trends, than the economic effect should be mildly inflationary. This could feed into inflation expectations, reversing their recent decline. In broader terms, it is impossible to assess the long-term impact of NAFTA abrogation until we answer the question of whether the Trump administration is pluto-populist or genuinely populist. If pluto-populist, NAFTA's demise would be largely designed for domestic political consumption and would be the end of the matter. No long-term implications would really exist as, the Trump White House would conclude bilateral deals with Canada and Mexico to ensure that trade is not interrupted and that crucial constituencies - Midwest auto workers and farmers - do not turn against the administration. If genuinely populist, however, the White House would likely have to abrogate WTO rules as well in order to make a real dent to its trade deficit. The U.S. has no way to raise tariffs above an average bound tariff of 3.4%, other than for selective imports and on a temporary basis, or through a flagrant rejection of the WTO's authority. Given the likely currency moves post-NAFTA's demise, those levels would have an insignificant effect on U.S. trade with its North American neighbors. President Trump hinted as much when he sent a 336-page report to Congress titled "The President's Trade Policy Agenda," which argued that the administration would ignore WTO rules that it deems to infringe on U.S. sovereignty. The NAFTA negotiations, put in the context of that document, are a much more serious matter that might be part of a slow rollout of global trade policy that only becomes apparent in 2018.18 From a geopolitical perspective, ending NAFTA would make the U.S. less geopolitically secure. If the U.S. turned its back on its own neighbors, one of which is its closest military ally, then Canada and Mexico may seek closer trade relations with Europe and China. This could lead to the diversification of their export markets, including - most critically for U.S. national security - energy. In addition, Canada could allow significant Chinese investment into its technology sector, particularly in AI and quantum computing where the country is a global leader. Additionally, any negative consequences for the Mexican economy would likely be returned tenfold on the U.S. in the form of greater illegal immigration flows, a greater pool of recruits for Mexican drug cartels, and a rise in anti-Americanism in the country. The latter is particularly significant given the upcoming July 2018 presidential election and current solid polling for anti-establishment candidate Andrés Manuel López Obrador (Chart 18). Obrador is in the lead, but his new party - National Regeneration Movement (MORENA) - is unlikely to gain a majority in Congress (Chart 18, bottom panel). However, acrimonious NAFTA negotiations and a nationalist U.S. could change the fortunes for both Obrador and MORENA. Ultimately, everything depends on whether Trump's campaign rhetoric on trade is real. At this point, we lean towards Trump being a pluto-populist. The proposed tax cuts are clearly not designed with blue-collar workers in mind. They are largely a carbon-copy of every other Republican tax reform plan in the past and thus we assume that their consequences will be similar. If the signature legislation of the Trump White House through 2017-2018 will be a tax plan that skews towards the wealthy (Chart 19), than why should investors assume that its immigration and free trade rhetoric are real? Chart 18Populism On The March In Mexico NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism Chart 19Tax Cuts Are Not Populist Tax Cuts Are Not Populist Tax Cuts Are Not Populist If ending NAFTA is merely red meat for the Midwestern base, and is quickly replaced with bilateral "fixes," then long-term implications will be muted. If, on the other hand, it is pursued as a new U.S. policy, then the significance will be much greater: it will mark the dawn of a new trend of twenty-first century mercantilism coming from the former bulwark of international liberalism. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com. 3 Please see BCA Global Investment Strategy Special Report, "Trumponomics: What Investors Need To Know," dated September 4, 2015, available at gis.bcaresearch.com, and Geopolitical Strategy Special Report, "U.S. Election: The Great White Hype," dated March 9, 2016, available at gps.bcaresearch.com. 4 Candidate Donald Trump made this comment during his first debate with Secretary Hillary Clinton. The September 26 debate focused heavily on free trade and globalization. 5 Mexico is exempt from several crucial articles in Chapter 6 due to the political sensitivity of the domestic energy industry. 6 Please see Hufbauer, Gary Clyde and Jeffrey J. Schott, "NAFTA Revisited," dated October 1, 2007, available at piie.com, and Hufbauer, Gary Clyde and Jeffrey J. Schott, NAFTA Revisited, New York: Columbia University Press, 2005. 7 Please see United States International Trade Commission, "Economic Impact of Trade Agreements Implemented Under Trade Authorities Procedures," Publication Number: 4614, June 2016, available at usitc.gov. First accessed via Congressional Research Service, "The North American Free Trade Agreement (NAFTA)," dated May 24, 2017, available at fas.org. 8 Since 1994, Canada has been sued 39 times and has paid out a total of $215 million in compensation. The U.S. is yet to lose a single case! 9 On average, vehicles produced in NAFTA member states average 75% local content; therefore, the first part of the demand is reachable if the White House is willing to budge. 10 Please see Evenett, Simon J. and Johannes Fritz, "Will Awe Trump Rules?" Global Trade Alert, dated July 3, 2017, available at globaltradealert.org. 11 Please see Robert Putnam, "Diplomacy and domestic politics: the logic of two-level games," International Organization 42:3 (summer 1988), pp. 427-460. 12 Please see Autor, David H., David Dorn, and Gordon H. Hanson, "The China Shock: Learning from Labor-Market Adjustment to Large Changes in Trade," Annual Reviews of Economics, dated August 8, 2016, available at annualreviews.org. 13 Pluto-populists use populist rhetoric that appeals to the common person in order to pass plutocratic policies that benefit the elites. 14 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 15 See in particular the Trade Expansion Act of 1962 (Section 232b), the Trade Act of 1974 (Sections 122, 301), the Trading With The Enemy Act of 1917 (Section 5b), and the International Emergency Economic Powers Act of 1977. 16 Peter Navarro, director of the White House's National Trade Council, has argued throughout March that the U.S. chronic deficits and global supply chains were a threat to national security. 17 Unless President Trump and his advisors ignore the reality that the U.S. still imports 40% of its energy needs and will likely be doing so for the foreseeable future. 18 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights NAFTA is truly at risk - as currency markets suggest; NAFTA's impact on the U.S. economy is positive but marginal; The key question is whether Trump is a true populist or a "pluto-populist"; If the former, then NAFTA's failure is likely and portends worse to come; NAFTA's collapse would be bearish MXN, bearish U.S. carmakers versus DM peers, and supportive of higher inflation in the U.S. Feature Fifty years ago at the end of World War II, an unchallenged America was protected by the oceans and by our technological superiority and, very frankly, by the economic devastation of the people who could otherwise have been our competitors. We chose then to try to help rebuild our former enemies and to create a world of free trade supported by institutions which would facilitate it ... Make no mistake about it, our decision at the end of World War II to create a system of global, expanded, freer trade, and the supporting institutions, played a major role in creating the prosperity of the American middle class. - President Bill Clinton, Remarks at the Signing Ceremony for the Supplemental Agreements to the North American Free Trade Agreement, September 14, 1993 No Free Trade Agreement (FTA) has been more widely maligned than the North American Free Trade Agreement (NAFTA). It is, after all, the world's preeminent FTA. Signed in December 1992 by President George H. W. Bush and implemented in January 1994, it preceded the founding agreements of the World Trade Organization (WTO) and launched a two-decade, global expansion of FTAs (Chart 1). By including environmental and labor standards, as well as dispute settlement mechanisms, it created a high standard for all subsequent FTAs. President Trump's presidency began with much fear that his populist preferences would imperil globalization and trade deals such as NAFTA. Other than his withdrawal from the Trans-Pacific Partnership deal, much of the concern has been proven to be misplaced - including our own.1 Even Sino-American trade tensions have eased, with President Trump and President Xi Jinping enjoying a good working relationship so far. So should investors relax and throw caution to the wind? In this report, we argue that the answer is a resounding no. The White House rhetoric on NAFTA - a trade deal that has been mildly positive for the U.S. economy and, at worst, neutral for its workers - suggests that greater trade conflicts loom, not only within NAFTA but also with China and others. Furthermore, a rejection of NAFTA would be a symbolic blow to free trade at least as consequential as the concrete ramifications of nixing the deal itself. The deal with Mexico and Canada is not as significant to the U.S. economy as its proponents suggest (Chart 2), but by mathematical logic its detractors therefore overstate its negatives. Chart 1NAFTA: Tailwind To Globalization NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism Chart 2U.S. Economy: Largely Unaffected By NAFTA U.S. Economy: Largely Unaffected By NAFTA U.S. Economy: Largely Unaffected By NAFTA The opposition to NAFTA by the Trump administration therefore reveals preferences that would become far more investment-relevant if applied to major global economies like China. If NAFTA negotiations are merely a ploy to play to the populist base, however, then the impact of its demise will be temporary and muted. At this time, however, it is unclear which preference is driving the Trump White House strategy and thus risks are to the downside. The Decaying Context Behind NAFTA The North American Free Trade Agreement is more than a trade deal: it is the symbolic beginning of late twentieth-century globalization. According to our trade globalization proxy, this period has experienced the fastest pace of globalization since the nineteenth century (Chart 3). Both NAFTA and the WTO enshrined new rules and standards for global trade upon which trade and financial globalization are based. Chart 3Globalization Has Peaked Globalization Has Peaked Globalization Has Peaked Chart 4Globalization And Its Indebted Discontents Globalization And Its Indebted Discontents Globalization And Its Indebted Discontents Underpinning this surge in globalization was the apex of American geopolitical power and the collapse of the socialist alternative, the Soviet Union. As President Clinton's remarks from 1993 suggest (quoted at the beginning of the report), NAFTA was the culmination of a "creation myth" for an American Empire. The myth narrates how the geopolitical and economic decisions made by the U.S. in the aftermath of its victory in World War II laid a foundation for both American prosperity and a new global order. With the ruins of Communism still smoldering in the early 1990s, the U.S. decided to double-down on those same, globalist impulses. Today those impulses are waning if not completely dead. As we argued in our 2014 report, "The Apex Of Globalization - All Downhill From Here," three trends have conspired to turn the tides against globalization:2 Multipolarity - Every period of intense globalization has rested on strong pillars of geopolitical "hegemony," i.e. the existence of a single world leader. Chart 3 shows that the most recent such eras consisted of British and American hegemony, respectively. However, the relative decline of American geopolitical power has imperiled this process, as rising powers look to carve out regional spheres of influence that are by definition incompatible with a globalized political and economic framework. In parallel, the hegemon itself - the U.S. - has begun to vacillate over whether the framework it designed is still beneficial to it, given its declining say in how the global system operates. Great Recession - The 2008 global financial crisis cracked the ideological, macroeconomic, and policy foundations of globalization. Deflation - Globalization is deflationary, which works swimmingly when real household incomes are rising and debts falling. Unfortunately, neither of those has been the case for American households over the past forty years (Chart 4). This is in large part the consequence of globalization, which opened trade with emerging markets and thus suppressed low-income wage growth in developed economies. What is striking about the U.S. is that its social safety net has done such a poor job redistributing the gains of free trade, at least compared to its OECD peers (Chart 5). Chart 5The 'Great Gatsby' Curve NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism Chart 6America Belongs To The Anti-Globalization Bloc NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism President Donald Trump shrewdly understood that the tide had turned against free trade in the U.S. (Chart 6). Ahead of the 2016 election, no one (except BCA!) seriously believed that trade and globalization would become the fulcrum of the election.3 Candidate Trump, however, returned to it repeatedly, and singled out NAFTA as "the worst trade deal maybe ever signed anywhere."4 Bottom Line: President Trump's opposition to globalization did not fall from the sky. Trump is the product of his time and geopolitical and macroeconomic context. Trends we identified in 2014 are today headwinds to globalization. Myths About NAFTA The geopolitical and macroeconomic context may be dire for globalization, but does NAFTA actually fit that narrative? The short answer is no. The long answer is that there are three myths about NAFTA that the Trump administration continues to propagate. We assume that U.S. policymakers can do simple math. As such, their ignorance of the below data suggests a broad strategy toward free trade that is based in ideology, not factual reality. Alternatively, flogging NAFTA may be motivated by narrower, domestic, political concerns and may not be indicative of a deeply held worldview. Time will tell which is true. Myth #1: NAFTA Has Widened The U.S. Trade Deficit Chart 7Long-Term Trade Deficit Is About Commodities Long-Term Trade Deficit Is About Commodities Long-Term Trade Deficit Is About Commodities NAFTA has resulted in a huge trade deficit for the United States and has cost us tens of thousands of manufacturing jobs. The agreement has become very lopsided and needs to be rebalanced. We of course have a five-hundred-billion-dollar trade deficit. So, for us, trade deficits do matter. And we intend to reduce them. - Robert Lighthizer, U.S. trade representative, October 17, 2017 When it comes to the U.S. trade deficit, NAFTA has had a negligible impact. Three facts stand out: The U.S. has an insignificant trade deficit with Canada - 0.06% of GDP in 2016, or $12 billion. It has a larger one with Mexico - 0.33% of GDP, or $63 billion. However, when broken down by sectors, the deepest trade deficit has been in energy. The U.S. has actually run a surplus in manufactured products with Mexico and Canada for much of the post-2008 era, which only recently dipped back into deficit (Chart 7). The U.S. has consistently run a trade deficit with the rest of the world since 1980, but the size of its trade deficit with Mexico and Canada did not significantly increase as a share of GDP post-implementation of NAFTA. The real game changer has been the widening of the trade deficit with China and the rest of the EM economies outside of China and Mexico (Chart 8). The trade relationship with Mexico and Canada, relative to that with the rest of the world, therefore remains stable. The net energy trade balance with Mexico and Canada has significantly improved due to surging U.S. shale production (Chart 9). Rising shale production has accomplished this both by lowering the need for imports from NAFTA peers, surging refined product exports to Mexico, and by inducing lower global energy prices. In addition, Canada-U.S. energy trade is governed by NAFTA's Chapter 6 rules, which prohibit the Canadian government from intervention in the normal operation of North American energy markets.5 Chart 8U.S. Trade Imbalance Is Not About NAFTA NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism Chart 9Shale Revolution Is A Game Changer Shale Revolution Is A Game Changer Shale Revolution Is A Game Changer Myth #2: NAFTA Has Destroyed The U.S. Auto Industry Before NAFTA went into effect ... there were 280,000 autoworkers in Michigan. Today that number is roughly 165,000 - and would have been heading down big-league if I didn't get elected. - Donald Trump, U.S. President, March 15, 2017 What about the charge that NAFTA has negatively impacted the U.S. automotive industry by shipping jobs to Mexican and, to lesser extent, Canadian factories? Again, this reasoning is flawed. In fact, NAFTA appears to have allowed the U.S. automotive industry to remain highly competitive on a global scale, more so than its Mexican and Canadian peers. U.S. exports outside of NAFTA as a percent of total exports have surged since the early 2000s and have remained buoyant recently. Meanwhile, Mexican exports to the rest of the world have fallen, suggesting that Mexico is highly reliant on servicing Detroit (Chart 10). Chart 10NAFTA Has Made U.S. Auto##br## Manufacturing More Competitive NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism The truth is that the American automotive industry's share of overall manufacturing activity has risen since 2008. In part, this is because American manufacturers have been able to integrate with Canadian and Mexican plants, allowing production to remain on the continent and move seamlessly across the value chain. In other words, Mexico serves as a low-wage outlet for the least-skilled part of the production chain, allowing the rest of the manufacturing process to remain in the U.S. and Canada. Without that cheap "escape valve," the entire production chain might have migrated to EM Asia. Or, worse, the American automotive industry would have become uncompetitive relative to European and Japanese peers. Either way, the U.S. would have potentially faced greater job losses were it not for easier access to Mexican auto production. Both European and Japanese manufacturers have similar low-skilled, low-cost, "labor escape valves" in the region. For Germany and France, this escape valve is in Spain and Central and Eastern Europe; for Japan, it is in Thailand. Myth #3: Mexico And Canada Cannot Retaliate Against The U.S. As far as I can tell, there is not a world oversupply of agricultural products. Unless countries are going to be prepared to have their people go hungry or change their diets, I think it's more of a threat to try to frighten the agricultural community. - Wilbur Ross, Commerce Secretary, October 11, 2017 U.S. exports to Canada and Mexico only account for about 2.6% of GDP, whereas exports to the U.S. from Mexico and Canada account for 28% and 18% of GDP respectively. Nonetheless, this does not mean that the U.S. suffers from NAFTA. As we discussed above, NAFTA has been a boon for the global competitiveness of the U.S. automotive industry. In addition, NAFTA gives American and Canadian exporters access to a large and growing Mexican middle class (Chart 11). Furthermore, the U.S. would gain little benefit from leaving NAFTA vis-à-vis Canada and Mexico. By reverting back to WTO tariff levels, the U.S. would be able to raise tariffs from 0% (under NAFTA) to the maximum of 3.4%, where the U.S. average "bound tariff" would remain. Bound tariffs differ across products and countries and represent the maximum rate of tariffs under WTO rules (i.e., without violating those rules). They are indicative of a hostile trade relationship, as trade would otherwise be set at much lower "most favored nation" tariff levels. Table 1WTO Tariff Schedule NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism As Table 1 shows, however, Canada and particularly Mexico have the ability to raise their bound tariffs considerably higher than the U.S. can do. Mexico, in fact, has one of the highest average bound tariff rates for an OECD member state, at a whopping 36.2%! This means that, if NAFTA were to be abrogated, the U.S. would be allowed to raise tariffs, on average, to 3.4%, whereas Mexico would be free to do so by ten times more. Given that Mexico is America's main export destination for steel and corn output, the retaliation would be non-negligible for these two politically powerful sectors. This aspect of the WTO agreement is a latent geopolitical risk, as it feeds into the Trump administration's broader antagonism toward the WTO itself. Despite the hard evidence, we suspect that the Trump administration is driven by ideological and strategic goals and therefore the probability of a calamitous end to the ongoing NAFTA negotiations is high. Nevertheless, the data shows: The North American Free Trade Agreement has allowed trade between its member states to accelerate at a faster pace than global trade for much of the first decade after its signing and at the average global pace over the past decade (Chart 12); U.S. manufacturing employment as a percent of total labor force has been declining for much of the past half-century, with absolute numbers falling off a cliff as China joined the WTO and, along with EM Asia, became integrated into the global supply chain (Chart 13); Employment in auto-manufacturing follows the same pattern as overall manufacturing employment (Chart 13, bottom panel), suggesting that it was not NAFTA that caused job flight but rather competition from the rest of the world along with automation. In fact, auto-manufacturing employment has recovered post-2008, as American car manufacturers underwent structural reforms to improve competitiveness. Chart 12NAFTA Trade Has ##br##Beaten Global Trade NAFTA Trade Has Beaten Global Trade NAFTA Trade Has Beaten Global Trade Chart 13Who Hurt U.S. Manufacturing Employment:##br## China Or NAFTA? Who Hurt U.S. Manufacturing Employment: China Or NAFTA? Who Hurt U.S. Manufacturing Employment: China Or NAFTA? As with any free trade agreement, some wages in some sectors may have been lowered by NAFTA's implementation and some jobs were definitely lost due to the agreement. However, the vast majority of academic studies point out that the negative labor market impacts of NAFTA have been negligible. The most authoritative work on the subject, by economists Gary Clyde Hufbauer and Jeffrey J. Schott of the Peterson Institute for International Economics, found that the upper-bound of NAFTA-related job losses in the U.S. is 1.9 million over the first decade of the agreement. Given that U.S. employment rose by 34 million over the same period, the job losses represent "a fraction of one percent of jobs 'lost' through turnover in the dynamic U.S. economy over a decade."6 A June 2016 report by the U.S. International Trade Commission (USITC) provides a good review of academic studies on the trade deal since 2002. Overall, it concludes that NAFTA led "to a substantial increase in trade volumes for all three countries; a small increase in U.S. welfare [overall economic benefit]; and little to no change in U.S. aggregate employment."7 In addition, NAFTA had "essentially no effect on real wages in the United States of either skilled or unskilled workers." This academic work could, of course, be the product of a vast conspiracy by globalist, neo-liberal academics financed by the deep state and its corporate overlords. However, the other side of the debate has little to offer as a counter to the empirical evidence. For example, U.S. Trade Representative Robert Lighthizer, a notable trade hawk, posited that the U.S. government had "certified" that 700,000 Americans had lost their jobs owing to NAFTA. This would represent 30,000 job losses per year over the 24 years of NAFTA's existence. Lighthizer also did not say whether he was speaking in net or gross terms, probably because it is practically impossible to competently answer that question! If that is the best retort to the academic research, there is then no real counter to the conclusion that NAFTA has had a mildly positive effect on the U.S. economy and labor market. Bottom Line: NAFTA has had some positive effects on the U.S. automotive sector, allowing it to integrate the low-cost Mexican labor into its production chain and thus remain competitive vis-à-vis Asian and European manufacturers. It also holds the promise of future export gains to Mexico's growing middle class. Its overall effects on the U.S. budget deficit, wages, and employment are largely overstated. If the impact of NAFTA has largely been marginal to the U.S. economy outside of a select few sectors, why is the Trump administration so dead-set on renegotiating it? And why has the process been so acrimonious? What Does The Trump White House Want? Frankly, I am surprised and disappointed by the resistance to change from our negotiating partners ... As difficult as this has been, we have seen no indication that our partners are willing to make any changes that will result in a rebalancing and reduction in these huge trade deficits. - Robert Lighthizer, U.S. trade representative, October 17, 2017 Robert Lighthizer, the U.S. trade representative, closed the fourth round of negotiations with a bang, implying that Canada and Mexico would have to help the U.S. close its $500 billion trade deficit, even though the U.S. trade deficit with its two NAFTA partners is only 15% of the total. The Canadian dollar and the Mexican peso fell by 1.2% and 1.9%, respectively, in the subsequent week of trading. In fact, both the CAD and MXN have faced extended losses since the third round of NAFTA negotiations ended on September 27 (Chart 14). Chart 14NAFTA Negotiations Are FX-Relevant NAFTA Negotiations Are FX-Relevant NAFTA Negotiations Are FX-Relevant Is the market overreacting? We do not think so. First, the list of demands presented by the White House are quite harsh, with the first two below considered deal-breakers: Dispute Settlement: The White House wants to end the investor-state dispute settlement (ISDS) mechanism (under Chapter 11), which allows corporations to sue governments for breach of obligations under the treaty.8 More importantly, the U.S. also wants to eliminate trade dispute panels (under Chapter 19), which allow NAFTA countries to protest anti-dumping and countervailing duties. The real issue is that Chapter 19 trade dispute panels have acted as a constraint on the U.S. administration in imposing antidumping and countervailing duties in the past. Sunset clause: The White House has also proposed that NAFTA automatically expire unless it is approved by all three countries every five years. Buy American: The White House wants its "Buy American" rules in government procurement to be part of the new NAFTA deal, and yet for Canadian and Mexican government contracts to remain open to U.S. businesses. Rules of origin: The White House has called for an increase in NAFTA's regional automotive content requirement from the current 62.5% to 85%, including that 50% of the value of all NAFTA-produced cars, trucks, and large engines come from the U.S.9 Second, the U.S. Commerce Department - headed by trade hawk Wilbur Ross - has signaled that it is open to aggressively pursuing trade disputes on behalf of American companies. Since President Trump's inauguration, U.S. policy interventions have on balance harmed the commercial interests of its G20 trade partners by higher frequency than during the last three years of Barack Obama's presidency (Chart 15).10 Chart 15Trump: Game Changer In U.S. Trade Policy NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism Specific to NAFTA partners, the Commerce Department has slapped a 20% tariff on Canadian softwood lumber in April and a 300% tariff on Bombardier C-Series in October. When combined with the demand to end trade dispute panels under NAFTA's Chapter 19 - which would resolve such trade disputes - the pickup in activity by the Commerce Department is a clear signal that the new U.S. administration intends to break the spirit of NAFTA whether the agreement remains in place or not. Third, and more broadly speaking, the Trump administration is playing a "two-level game."11 Two-level game theory posits that domestic politics creates acceptable "win-sets," which are then transported to the geopolitical theatre. Politicians cannot conclude foreign agreements that are outside of those domestic win-sets. For President Trump, his win-set on NAFTA negotiations is set by a domestic coalition that allowed him to win the election. This includes voters in the Midwest states of Wisconsin, Michigan, and Pennsylvania where Trump outperformed polls by 10%, 3%, and 3% respectively (Chart 16), and where Secretary Hillary Clinton garnered less votes in 2016 than President Barack Obama in 2012 (Chart 17). Trump promised this blue-collar base a respite from globalization and he has to deliver it if he intends to win in four years' time. Chart 16Trump Owes The Midwest Trump Owes The Midwest Trump Owes The Midwest Chart 17Hillary Lost Rust Belt Voters NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism At the same time, Trump's domestic policy has thus far fallen far short of other campaign promises. First, there has been no movement on immigration or the promised border wall. Second, the Obamacare repeal and replace effort has failed in Congress. Third, proposed tax cuts are likely to benefit the country's elites, as previous tax reform efforts have tended to do. As such, we fear that the Trump White House may double down on playing hardball with NAFTA in order to fulfill at least one of its promised strategies. But why single out NAFTA if its impact on U.S. jobs and wages is miniscule compared to, for example, the U.S.-China trade relationship?12 There are two ways to answer this question: Pluto-populist scenario: President Trump is in fact a pluto-populist and not a genuine populist, i.e. he is not committed to economic nationalism.13 As such, he does not intend to fulfill any of the demands he has promised to his voters, as the current corporate and household tax cuts suggest. Given NAFTA's limited impact on the U.S. economy, abrogating that deal would have far less detrimental impact than if President Trump went after other trade relationships. As such, the NAFTA deal will either be renegotiated, or, at worst, abrogated and quickly replaced with bilateral deals with both Canada and Mexico. It is a "cheap" and "safe" way to satisfy voter demands without actually hurting business or the economy. Genuinely populist scenario: President Trump is a genuine populist and NAFTA renegotiations are setting the stage for a 2018 in which trade protectionism becomes a genuine, global market risk. Bottom Line: President Trump's negotiation stance on NAFTA is non-diagnostic. We cannot establish with any certainty whether his demands mark the start of a broader, global, protectionist trend, or whether he is merely bullying two trade partners who will ultimately have to kowtow to U.S. demands. Nonetheless, we agree with the market's pricing of a higher probability that NAFTA is abrogated, as witnessed by the currency markets. In both of our political scenarios, NAFTA's fate is uncertain. If Trump is a pluto-populist, NAFTA is an easy target and its abrogation will score domestic political points with limited economic impact. If he is a genuine economic nationalist, failed NAFTA renegotiations are the first step on the path to clashing with the WTO and rewriting global trade rules. Investment And Geopolitical Implications Can President Trump withdraw from NAFTA unilaterally? The short answer is yes. As Table 2 illustrates, Congress has passed several laws that delegate authority to the executive branch to administer and enforce trade agreements and to exercise prerogative amid exigencies.14 Article 2205 of NAFTA states that any party to the treaty can withdraw within six months after providing notice of withdrawal. We see no evidence in U.S. law that the president has to gain congressional approval of such withdrawal. Table 2Trump Faces Few Constraints On Trade NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism Moreover, the past century has produced a series of laws that give President Trump considerable latitude - not only the right to impose a 15% tariff for up to 150 days, as in the Trade Act of 1974, but also unrestricted tariff and import quota powers during wartime or national emergencies, as in the Trading With The Enemy Act of 1917.15 The White House has already signaled that it considers budget deficits a "national security issue," which suggests that the White House is preparing for a significant tariff move in the future.16 Could President Trump's moves be challenged by Congress or the courts? Absolutely. However, time is on the executive's side. Even assuming that Congress or the Supreme Court oppose the executive, it will likely be too late to avoid serious ramifications and retaliations from abroad. Other countries will not wait on the U.S. system to auto-correct. Congress is unlikely to vote to overrule the president until the damage has already been done - especially given Trump's powers delegated from Congress. As for the courts, the executive could swamp them with justifications for its actions; the courts would have to deem the executive likely to lose every single one of these cases in order to issue a preliminary injunction against each of them and halt the president's orders. Any final Supreme Court ruling would take at least a year. International law would be neither speedy nor binding. What are the investment implications of a NAFTA collapse? Short term: Short MXN; short North American automotive sector relative to European/Asian peers. We would expect more downside risk to MXN from a collapse in NAFTA talks, similar in magnitude to the decline of the GBP after the Brexit vote. The Mexican central bank would likely take on a dovish stance towards monetary policy, creating a negative feedback loop for the peso. The automotive sectors across the three economies that make up NAFTA would obviously suffer, given the benefits of the integrated supply-chains, as would U.S. steel and select agricultural producers that export to NAFTA peers. Medium term: Canadian exports largely unaffected, buy CAD on any NAFTA-related dip. Given that 20% of Canadian exports to the U.S. are energy - and thus highly unlikely to come under higher tariffs post-NAFTA - we do not expect exports to decline significantly.17 In fact, the 1987 Canada-United States Free Trade Agreement, which laid the foundation for NAFTA, could quickly be resuscitated given that it was never formally terminated, only suspended. Canada and the U.S. have a balanced trade relationship, which means that it is highly unlikely that America's northern neighbor is in the sights of the White House administration. Long term: marginally positive for inflation. Economic globalization and immigration have both played a marginally deflationary role on the global economy. If abrogation of NAFTA is the first step towards less of both trends, than the economic effect should be mildly inflationary. This could feed into inflation expectations, reversing their recent decline. In broader terms, it is impossible to assess the long-term impact of NAFTA abrogation until we answer the question of whether the Trump administration is pluto-populist or genuinely populist. If pluto-populist, NAFTA's demise would be largely designed for domestic political consumption and would be the end of the matter. No long-term implications would really exist as, the Trump White House would conclude bilateral deals with Canada and Mexico to ensure that trade is not interrupted and that crucial constituencies - Midwest auto workers and farmers - do not turn against the administration. If genuinely populist, however, the White House would likely have to abrogate WTO rules as well in order to make a real dent to its trade deficit. The U.S. has no way to raise tariffs above an average bound tariff of 3.4%, other than for selective imports and on a temporary basis, or through a flagrant rejection of the WTO's authority. Given the likely currency moves post-NAFTA's demise, those levels would have an insignificant effect on U.S. trade with its North American neighbors. President Trump hinted as much when he sent a 336-page report to Congress titled "The President's Trade Policy Agenda," which argued that the administration would ignore WTO rules that it deems to infringe on U.S. sovereignty. The NAFTA negotiations, put in the context of that document, are a much more serious matter that might be part of a slow rollout of global trade policy that only becomes apparent in 2018.18 From a geopolitical perspective, ending NAFTA would make the U.S. less geopolitically secure. If the U.S. turned its back on its own neighbors, one of which is its closest military ally, then Canada and Mexico may seek closer trade relations with Europe and China. This could lead to the diversification of their export markets, including - most critically for U.S. national security - energy. In addition, Canada could allow significant Chinese investment into its technology sector, particularly in AI and quantum computing where the country is a global leader. Additionally, any negative consequences for the Mexican economy would likely be returned tenfold on the U.S. in the form of greater illegal immigration flows, a greater pool of recruits for Mexican drug cartels, and a rise in anti-Americanism in the country. The latter is particularly significant given the upcoming July 2018 presidential election and current solid polling for anti-establishment candidate Andrés Manuel López Obrador (Chart 18). Obrador is in the lead, but his new party - National Regeneration Movement (MORENA) - is unlikely to gain a majority in Congress (Chart 18, bottom panel). However, acrimonious NAFTA negotiations and a nationalist U.S. could change the fortunes for both Obrador and MORENA. Ultimately, everything depends on whether Trump's campaign rhetoric on trade is real. At this point, we lean towards Trump being a pluto-populist. The proposed tax cuts are clearly not designed with blue-collar workers in mind. They are largely a carbon-copy of every other Republican tax reform plan in the past and thus we assume that their consequences will be similar. If the signature legislation of the Trump White House through 2017-2018 will be a tax plan that skews towards the wealthy (Chart 19), than why should investors assume that its immigration and free trade rhetoric are real? Chart 18Populism On The March In Mexico NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism Chart 19Tax Cuts Are Not Populist Tax Cuts Are Not Populist Tax Cuts Are Not Populist If ending NAFTA is merely red meat for the Midwestern base, and is quickly replaced with bilateral "fixes," then long-term implications will be muted. If, on the other hand, it is pursued as a new U.S. policy, then the significance will be much greater: it will mark the dawn of a new trend of twenty-first century mercantilism coming from the former bulwark of international liberalism. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, “The Apex Of Globalization – All Downhill From Here,” dated November 12, 2014, available at gps.bcaresearch.com. 3 Please see BCA Global Investment Strategy Special Report, “Trumponomics: What Investors Need To Know,” dated September 4, 2015, available at gis.bcaresearch.com, and Geopolitical Strategy Special Report, “U.S. Election: The Great White Hype,” dated March 9, 2016, available at gps.bcaresearch.com. 4 Candidate Donald Trump made this comment during his first debate with Secretary Hillary Clinton. The September 26 debate focused heavily on free trade and globalization. 5 Mexico is exempt from several crucial articles in Chapter 6 due to the political sensitivity of the domestic energy industry. 6 Please see Hufbauer, Gary Clyde and Jeffrey J. Schott, "NAFTA Revisited," dated October 1, 2007, available at piie.com, and Hufbauer, Gary Clyde and Jeffrey J. Schott, NAFTA Revisited, New York: Columbia University Press, 2005. 7 Please see United States International Trade Commission, "Economic Impact of Trade Agreements Implemented Under Trade Authorities Procedures," Publication Number: 4614, June 2016, available at usitc.gov. First accessed via Congressional Research Service, "The North American Free Trade Agreement (NAFTA)," dated May 24, 2017, available at fas.org. 8 Since 1994, Canada has been sued 39 times and has paid out a total of $215 million in compensation. The U.S. is yet to lose a single case! 9 On average, vehicles produced in NAFTA member states average 75% local content; therefore, the first part of the demand is reachable if the White House is willing to budge. 10 Please see Evenett, Simon J. and Johannes Fritz, "Will Awe Trump Rules?" Global Trade Alert, dated July 3, 2017, available at globaltradealert.org. 11 Please see Robert Putnam, "Diplomacy and domestic politics: the logic of two-level games," International Organization 42:3 (summer 1988), pp. 427-460. 12 Please see Autor, David H., David Dorn, and Gordon H. Hanson, "The China Shock: Learning from Labor-Market Adjustment to Large Changes in Trade," Annual Reviews of Economics, dated August 8, 2016, available at annualreviews.org. 13 Pluto-populists use populist rhetoric that appeals to the common person in order to pass plutocratic policies that benefit the elites. 14 Please see BCA Geopolitical Strategy Special Report, “Constraints & Preferences Of The Trump Presidency,” dated November 30, 2016, available at gps.bcaresearch.com. 15 See in particular the Trade Expansion Act of 1962 (Section 232b), the Trade Act of 1974 (Sections 122, 301), the Trading With The Enemy Act of 1917 (Section 5b), and the International Emergency Economic Powers Act of 1977. 16 Peter Navarro, director of the White House's National Trade Council, has argued throughout March that the U.S. chronic deficits and global supply chains were a threat to national security. 17 Unless President Trump and his advisors ignore the reality that the U.S. still imports 40% of its energy needs and will likely be doing so for the foreseeable future. 18 Please see BCA Geopolitical Strategy Weekly Report, “Political Risks Are Understated In 2018,” dated April 12, 2017, available at gps.bcaresearch.com.

Highlights China's mini-cycle has peaked, which has raised concerns among global investors that China may return to below-trend growth over the coming year, similar to what occurred in 2015. In our view, the severe slowdown in the Chinese economy in 2015 was due to overly tight monetary policy coupled with a severely weak external demand environment. A monetary conditions approach has done an excellent job of predicting industrial activity in China over the past several years. While monetary policy has tightened somewhat since the beginning of the year, none of the monetary conditions indexes that we track have come close to returning to 2015 levels. In short, an uncontrolled and sharp deceleration in the Chinese economy is not in the cards. This favors the performance of Chinese stocks, both in absolute and relative terms. Stay overweight. Feature Last week's report was replaced by a Special Report prepared by my colleague Matt Gertken, Associate Vice President of our Geopolitical Strategy team.1 The report presented a full "postmortem" on the Party Congress, and outlined how stepped up reform efforts in China are likely over the coming year, and beyond. By "reforms", our geopolitical team specifically means deleveraging in the financial sector accompanied by a more intense anti-corruption campaign focused on the shadow-banking sector, as well as ongoing restructuring in the industrial sector. The implications of the "reform reboot" scenario presented in last week's report are negative for emerging markets (EM) and other plays on China's industrial sector (such as industrial metals). We agree that a "status quo" scenario of no significant reforms is highly unlikely given that President Xi has succeeded in amassing tremendous political capital and that he has an agenda for reform. But the intensity of reforms pursued over the coming year will have to be closely monitored by policymakers, to avoid a repeat of the significant slowdown that occurred in 2014/2015. As such, the view of BCA's China Investment Strategy service is that the reform efforts over the coming year will be structured at a pace that is sufficient to avoid a meaningful deceleration in China's industrial sector, even though the momentum of China's "mini" economic cycle of the past two years has very likely peaked. However, the potential for a brisk pace of reforms to cause a more acute decline in industrial activity is a risk to our view that the slowdown in China's economy is likely to be benign and controlled. Monitoring reform progress is likely to be a key theme for this publication over the coming year. Over the nearer term, the potential impact of reform efforts is not the only risk to the economy, as many market participants appear to be worried that the peak in China's mini-cycle presages a destabilizing decline in economic activity. This week's report is the second of two parts examining the key differences facing China today from what prevailed in mid-2015,2 when the Chinese economy operated below what investors and market participants considered to be a "stable" pace of growth. In Part II we focus on monetary policy, and outline how the monetary environment remains stimulative despite a significant rise in corporate bond yields over the past year. China's Monetary Policy Stance: A Brief Review Chart 1 presents the one-year policy lending rate over the past decade, and highlights the four distinct phases that have prevailed since the global financial crisis in 2008: Chart 1A Brief Review Of China's Monetary Policy Stance A Brief Review Of China's Monetary Policy Stance A Brief Review Of China's Monetary Policy Stance A long period of significant easing that began during the Great Recession and lasted until late-2010 A material rate tightening cycle that began in late-2010 and ended in mid-2012 A half-reversal of the 2011/2012 rate cycle, which happened quickly in the summer of 2012 and was followed by a long pause until late-2014, and A significant series of rate cuts over the course of 2015, followed by a 2-year pause at current levels. We contend that policymakers were too timid in responding to economic weakness in China at the end of the third monetary policy phase highlighted in Chart 1, and that this hesitation magnified the impact of the serious deterioration in China's external demand environment that we discussed in Part I of this report. Chart 2Monetary Conditions Predict ##br##Chinese Industrial Activity Monetary Conditions Predict Chinese Industrial Activity Monetary Conditions Predict Chinese Industrial Activity Of course, in a large, trade-sensitive, economy like that of China, interest rates are not the only determinant of the degree of monetary accommodation. In order to capture the effects of the exchange rate and other factors affecting the efficacy of monetary policy, we have tended to show a Monetary Conditions Index (MCI) as a stand-in for the policy stance. As shown in Chart 2, the Bloomberg MCI has done an excellent job of leading industrial activity in China over the past several years, particularly during the mini-cycle of the past two years. While the MCI appears to have peaked early this year, it remains well above (i.e. more accommodative) the levels reached in mid-2015 when policymakers finally became serious about easing monetary conditions. Looking Forward Chart 3 presents a few alternative MCIs for China alongside Bloomberg's measure. Analysts tend to employ a variety of approaches when calculating monetary conditions indexes, but the real interest rate and the real effective exchange rate almost always feature prominently. Of the three alternative measures, Citigroup's MCI is the most bearish, as it includes the year-over-year growth rate of M2 which has recently languished. The remaining two measures are BCA calculations, one that deflates interest rates using producer prices, and one that uses core consumer prices. Both of our measures employ an equal split between the real interest rate and the exchange rate. Chart 3 highlights that all four MCIs have either peaked or are now falling, suggesting that a tightening in financial conditions earlier this year has somewhat reduced the degree of monetary accommodation to the economy. However, there are three key points to consider when judging the likely impact of monetary tightening on China's economy over the coming 6-12 months: None of the MCIs shown in Chart 3 have returned to their 2015 low, implying that the policy tightening that has occurred over the past year is not likely to cause Chinese industrial activity to crash in over the coming 6-12 months. Most of the appreciation in the RMB this year has occurred versus the dollar, not against the euro or in trade-weighted terms (Chart 4). In fact, in trade-weighted the RMB remains 6.5% below where it was in August 2015 prior to the currency devaluation. This highlights that the recent appreciation largely reflects dollar weakness, rather than policy-induced strength in the RMB. Chart 3Monetary Conditions Have Not Returned##br## To 2015 Levels Monetary Conditions Have Not Returned To 2015 Levels Monetary Conditions Have Not Returned To 2015 Levels Chart 4Recent RMB Appreciation##br## Reflects Dollar Weakness Recent RMB Appreciation Reflects Dollar Weakness Recent RMB Appreciation Reflects Dollar Weakness Average lending rates have only increased approximately 40 bps over the past year, in comparison to the 200 bps of easing that occurred from 2014 to 2016 (Chart 5). In real terms (when deflated by core consumer prices), average interest rate have barely risen at all this year. The still modest rise in average lending rates is an important consideration, because it contrasts with the rise in Chinese bond yields, both in the government and corporate sectors. For example, Chart 6 shows that corporate bond yields have risen by 160 bps since late-2016 and are 25 bps higher than they were in early-2015. Chart 5Average Lending Rates ##br##Have Risen Only Modestly Average Lending Rates Have Risen Only Modestly Average Lending Rates Have Risen Only Modestly Chart 6Corporate Bond Yields##br## Have Tightened Materially Corporate Bond Yields Have Tightened Materially Corporate Bond Yields Have Tightened Materially But our view is that average lending rates are a more important driver of debt service payments for China's non-financial sector. In fact, Table 1 highlights that while corporate bond financing is a growing component of Chinese private social financing, it is still quite small. The table presents a breakdown of adjusted social financing, which highlights that the sum of local currency loans, foreign currency loans in RMB, trust and entrusted loans equals roughly 85% of total social financial excluding equity issuance. Corporate bonds, by contrast, account for only about 10%, suggesting that the economic impact of the rise in bond yields this year will be relatively small. Table 1Corporate Bonds Account For A Small Percent Of China's Social Financing China's Economy - 2015 Vs Today (Part II): Monetary Policy China's Economy - 2015 Vs Today (Part II): Monetary Policy Investment Implications We noted in our October 12 Weekly Report that the acceleration in the Chinese economy that began in mid-2015 has likely peaked (Chart 7), ending the upswing of this "mini" economic cycle. Chart 7A Stylized View Of China's Recent China's Economy - 2015 Vs Today (Part II): Monetary Policy China's Economy - 2015 Vs Today (Part II): Monetary Policy The framework illustrated in Chart 7 presented three distinct scenarios for China over the coming 6-12 months: A re-acceleration of the economy and a continuation of the V-shaped rebound profile, A benign, controlled deceleration and settling of growth into the "stable" growth range, and An uncontrolled and sharp deceleration in the economy that threatens a return to the conditions that prevailed in early-2015 (or worse). In our view, the Chinese economy in early-2015 began to operate below the "stable" growth range shown in Chart 7, owing to a "double whammy" of excessively tight monetary conditions and a synchronized global downturn. While our research suggests that China's export growth will moderate over the coming year and that monetary conditions have tightened somewhat, the magnitude of these changes are not sufficiently large to return the Chinese economy back to 2015-like conditions. To us, this is consistent with the second scenario presented above. From an absolute equity perspective, this conclusion is positive for Chinese stock prices. Chart 8 highlights that the Li Keqiang index correlates fairly well with the growth in earnings for the MSCI China index ex technology; a moderate decline in the pace of growth in China's industrial sector would blunt the earnings growth of these firms, but not enough to cause an outright contraction. The combination of positive ex-tech earnings growth and very cheap valuation (Chart 9) suggests that the absolute uptrend in Chinese ex-technology stocks that began at the beginning of 2016 is likely to continue. Chart 8Ex-Tech EPS Growth Will Moderate, ##br##But Not Contract Ex-Tech EPS Growth Will Moderate, But Not Contract Ex-Tech EPS Growth Will Moderate, But Not Contract Chart 9Excluding Technology, ##br##China Is Extraordinarily Cheap Excluding Technology, China Is Extraordinarily Cheap Excluding Technology, China Is Extraordinarily Cheap In relative terms, the picture is somewhat cloudier, although for now we would continue to favor the China MSCI index versus global and emerging market stocks. Chart 10 highlights that Chinese equities have outperformed global stocks even when excluding tech companies, although it is clear that most of the recent outperformance is due to the IT sector. On the earnings front, while we expect Chinese ex-tech earnings growth to moderate over the coming year, this is also true of overall U.S. equities (Chart 11). Finally, Chart 12 highlights that while Chinese technology firms are richly priced vs their global counterparts, the multi-year relative outperformance trend has been fundamentally-driven, a situation that does not appear to be threatened by a slowdown in China's industrial sector (given the largely domestic & consumer orientation of Chinese technology firms). Chart 10China Is Beating Global,##br## Even Excluding Technology China Is Beating Global, Even Excluding Technology China Is Beating Global, Even Excluding Technology Chart 11U.S. Earnings Growth##br## Is Set To Moderate U.S. Earnings Growth Is Set To Moderate U.S. Earnings Growth Is Set To Moderate Chart 12China's Tech Rally Is ##br##Fundamentally-Driven China's Tech Rally Is Fundamentally-Driven China's Tech Rally Is Fundamentally-Driven Bottom Line: The economic momentum of China's 2-year mini-cycle has probably peaked, but an uncontrolled and sharp deceleration in the economy is not in the cards. This favors the performance of Chinese stocks, both in absolute and relative terms. Stay overweight. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see BCA Report, "China: Party Congress Ends ... So What?", dated November 2, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China's Economy - 2015 Vs Today (Part I): Trade", dated October 26, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Chart of the WeekChina Developments Significant##BR##To Base Metal Prices Shifting Gears In China: The Impact On Base Metals Shifting Gears In China: The Impact On Base Metals Reading the tea leaves following China's 19th National Communist Party Congress suggests a looming shift in President Xi Jinping's second term from pro-growth to pro-reform. Having consolidated power, Xi now has the capacity to implement his agenda over the next five years. Given China's outsized role in global base metals production and consumption, the direction of Xi's policy changes will have a profound impact on these markets (Chart of the Week).1 The Party Congress set the tone for economic policy and reforms going forward, from which we can extrapolate future policy direction. However, concrete plans and details will not be revealed until the National People's Congress, scheduled in March 2018. In this report we highlight the main takeaways of the Congress specifically those relevant to base metals. Broadly, these can be summarized as: Xi now has the political capital needed to implement real reform in his second term. Based on Xi's remarks at the Congress during his work-report commentary, we believe the environmental and supply-side reforms initiated during his first five-year term will be continued in his second term. Because these reforms will shrink the domestic production capacity for base metals and steel in China, they likely will be a tailwind for these commodities' prices. However, a focus on sustainable growth - i.e., organic growth that is not dependent on regular injections of credit to keep it going - and the elimination of GDP targets past 2021 risk weighing down base metals demand. Real-estate market fundamentals are more supportive than most perceive. This will prevent tighter policies from triggering a significant construction downturn, which will be supportive for steel and copper prices. China's efforts to expand its economic influence globally through the Belt and Road initiative (BRI) will be insufficient in offsetting a mainland slowdown, should one occur. Feature Balancing Stability And Reform Chart 2Stability Was A Priority...Not Anymore Stability Was A Priority...Not Anymore Stability Was A Priority...Not Anymore Despite reiterating a need for economic reforms, the focus of Xi's first term was maintaining stability and garnering the political capital necessary to implement his desired reforms. Emphasizing stability is a recurrent theme in Chinese politics, regardless of who is at the helm. The 2015-16 state interventions in the economy - including higher infrastructure spending, provincial government bailouts, currency depreciation and capital controls - illustrated the dominance of stability over reforms, during Xi's first term (Chart 2).2 The 19th Party Congress was the capstone event in Xi's effort to accumulate the support needed to implement long-sought reforms. BCA's Geopolitical Strategy points to three outcomes that support this assessment: With the inscription of Xi Jinping Thought on Socialism with Chinese Characteristics for a New Era in China's constitution, the president has cemented his position as one of the most powerful leaders of modern China. In fact, according to our geopolitical strategists, this induction signals that he is "second only to Chairman Mao as a philosophical guide in the party."3 Practically speaking, this means his economic initiatives will carry more weight than anything China has seen since at least the 1998-99 intense reform period. The leanings of members of the new Politburo Standing Committee (PSC) also are telling. Each of the three most recent presidents is represented by two protégés on the PSC. This is an almost-ideal configuration for reform.4 Finally, the appointment of Xi loyalist Zhao Leji as chief of the Central Commission for Discipline Inspection (CDIC), and the creation of the National Supervisory Commission to oversee the anti-corruption campaign give Xi the tools he needs to implement his policies. Thus, Xi has garnered sufficient ammunition to be much more effective in implementing reform policies during his second term. As such, we expect the pace of reform to accelerate. While the policy details are yet to be known, many of the takeaways from the party congress point toward supply- and demand-side changes. Supply-Side Reforms: Short-Term Sacrifice For Long-Term Benefit? While the aim for environmental regulation is not new - an "ecological" section was included in the work report for the first time by Xi's predecessor Hu Jintao in 2012 - we have reason to believe that, given Xi's focus on sustainable development, he will tackle environmental policies with more fervor than in the past. This signals that Xi may prioritize environmental preservation and pollution-reduction measures going forward, which would continue the efforts begun in his first term. In fact, environmental spending was the fastest growing category in central-government spending at the beginning of Xi's first term (Table 1). Table 1Xi Jinping Favors A Greener China Shifting Gears In China: The Impact On Base Metals Shifting Gears In China: The Impact On Base Metals Xi's environmental agenda will get an assist from his anti-corruption campaign. Our Geopolitical strategists highlight Xi's use of the CDIC - the anti-corruption watchdog - in enforcing the reforms as a signal of his resolve to implement change. The stakes are high for noncompliant managers who now risk not only financial penalties, but also arrest and jail time. Chart 3Shifting Gears: From Pro-Growth To Pro-Reform Shifting Gears: From Pro-Growth To Pro-Reform Shifting Gears: From Pro-Growth To Pro-Reform This reinforces the message that Xi is still keen on implementing the supply-side structural reforms first announced in 2015, and that he is willing to change the old-line economic model, forgoing potential growth drivers from traditional industries in favor of greener sectors (Chart 3). As the leading base metals producer in the world, a continuation - and potential intensification - of these reforms will weigh on global production and prop up base metal prices, as they have since last year. In fact, some of these reforms have already materialized in the form of earlier-than-anticipated winter production cuts. Steel production in Tangshan - China's largest steel-producing city - will be halved over the winter, with three other top steel producing cities - Shijiazhuang, Anyang, and Handan - expected to announce similar cuts.5 Similarly, the government of Shandong - a major producer of alumina and aluminum - recently instituted a crackdown program that includes production cuts during the winter months.6 Bottom Line: Xi used his platform at the Party Congress to reiterate his resolve to set China's economy on a more sustainable growth path through supply-side reform. Given that he has accumulated the political capital necessary to implement these changes, we expect to see a renewed push toward a "greener" China. Ceteris paribus, this will weigh on base metals production by reducing global supply and will support prices. "Houses Are Built To Be Inhabited, Not For Speculation" During the party congress, Xi reiterated his resolve to tighten control of the real estate market. In fact, the Chinese government has been trying for years to rein in demand for real estate, which typically involves raising mortgage rates. Tightening measures announced in late September include controls on home sales in eight major cities, which, among other things, prevent the resale of homes within five years of purchase. These controls have weighed on both prices and sales of real estate (Chart 4). More recently, the Ministry of Housing and Urban-Rural Development and the National Development and Reform Commission announced that they will jointly inspect real estate developers and commercial property sales agents, looking for "irregularities," including artificially inflating prices and hoarding unsold homes.7 Nonetheless, our China Investment Strategy desk does not foresee a major slowdown in construction activity.8 Simply put, they argue that strong demand amid declining inventories will prevent a construction slowdown, even in face of tighter policies (Chart 5). In fact, they do not see much excess in China's current property market to begin with, and thus doubt we will witness a major downturn. This will be important to bear in mind going forward, given that construction is the most important source of demand for base metals - copper in particular - and steel in China, accounting for about one-third of copper demand and half of steel demand. Chart 4Real Estate Policies Weigh##BR##On Prices And Sales Real Estate Policies Weigh On Prices And Sales Real Estate Policies Weigh On Prices And Sales Chart 5Housing Destocking Becomes Advanced Fundamentals##BR##Will Prevent A Major Real Estate Downturn Housing Destocking Becomes Advanced Fundamentals Will Prevent A Major Real Estate Downturn Housing Destocking Becomes Advanced Fundamentals Will Prevent A Major Real Estate Downturn Bottom Line: Despite efforts to tighten the property market, a sharp downturn in the construction sector, which is a major metals consumer, is unlikely. Structural tailwinds - most notably from China's continued urbanization - will eventually prevail, and the construction sector will remain a major contributor to China's economy, and base metals and steel consumption. Quality Over Quantity: Deleveraging The renewed focus on "sustainable and sound" growth, especially given the elimination of GDP growth targets beyond 2021, elevates the risk of a potential economic slowdown. The Xi administration has signaled that it is not afraid to prioritize financial regulation - targeting excessive risk and under-regulation - over economic growth. It is likely that it will continue doing so. In fact, Xi singled out systemic financial risk as a hazard to overall stability. While this is not China's first time to announce a deleveraging campaign, given that Xi has consolidated power and will use the CDIC to implement reforms, we expect these efforts to be more effective this time around. Furthermore, China has bounced back from the 2015 - 16 deflationary spiral so well that interest rate hikes and tighter financial controls are now on the table (Chart 6). Chart 6Interest Rate Hikes Are Now On The Table Interest Rate Hikes Are Now On The Table Interest Rate Hikes Are Now On The Table While the reforms are expected to improve Chinese productivity in the long-run, they may shake up the economy in the short run. We are somewhat reassured by the fact that traditionally, Chinese leaders have boosted fiscal spending when faced with slowing credit growth in periods when they aim to combat the negative effects of supply-side structural reforms and deleveraging. However, we remain cautious that, as Xi's priorities have shifted, fiscal stimulus may not be used with the same enthusiasm going forward. Given China's outsized role as a consumer of base metals, a slowdown would have serious repercussions on global markets. Researchers at the IMF find that surprises in the strength of China's economy - measured as the scaled deviation of year-on-year industrial production growth from the median Bloomberg consensus estimates immediately prior to the announcements - have significant impacts on base metals prices.9 This is true for all metals they studied - copper, nickel, lead, tin, and aluminum - with the exception of iron ore, which they put down to the relatively recent financialization of iron ore markets. In fact, they find that the more important China is to a specific base metal's fundamentals, the stronger the impact on prices. Using China's import share as a percent of world total as their measure of China's footprint in each individual market, they find that copper is most impacted by Chinese IP shocks, followed by nickel, lead, tin, and aluminum.10 Bottom Line: Beijing is continuously reassuring markets it will push for reforms - in the form of deleveraging the financial sector, restructuring industry, eliminating overcapacity, and environmental controls - without sacrificing growth. Nonetheless these reforms, which we believe are forthcoming following Xi's consolidation of power post-19th Congress, will be headwinds to growth. It is true that Xi may be willing to tolerate slower growth going forward in order to see his policies go through. Yet in all likelihood, fiscal stimulus will be used if social stability is threatened by reform measures. That said, reform is definitely in the cards. The Revival Of China's Silk Road - Enshrined In The Constitution Along with supply-side reforms, the Belt and Road initiative (BRI) - Xi's solution to a global slowdown through the physical integration of China's trading partners - was written into the constitution. This is a reiteration of Xi's intent to shift China away from being the factory of the world and toward playing a key role in global development. The ambition of the BRI plan is to connect many of China's trading partners in Asia, Europe, the Middle East, and Africa through a modern infrastructure of roads, ports, railway tracks, pipelines, airports, transnational electric grids, and fiber-optic lines. The objectives of the project, although speculative, are believed to be two-fold: It is an opportunity to create new markets for Chinese goods - giving the Chinese economy a push even in the event of a mainland slowdown. This is especially relevant, given the need to export excess capacity, most notably in the cases of steel and cement. In fact, Chinese industrial production will also benefit from the secondary effects of an improvement in demand for consumer goods from countries receiving economic aid from China. Furthermore, Xi hopes the project will help revive the economies of China's border regions. There is a possible ancillary benefit, in that heavy industry - e.g., steel mills and aluminum smelters - could be moved away from population centers to support the BRI. Chart 7BRI Investments On The Ascent bca.ces_wr_2017_11_09_c7 bca.ces_wr_2017_11_09_c7 Policymakers foresee the project - which was initiated in 2013 - injecting an estimated $150 billion annually into the construction of massive amounts of infrastructure (Chart 7). BCA's Frontier Markets Strategy (FMS) projects the value of Chinese BRI project investments will reach $168 billion in 2020.11 While this would boost China's economy in general, and base metals, steel and iron ore demand in particular, our FMS strategists argue that at ~ $102 billion, China-funded BRI investment expenditure in 2016 is dwarfed in comparison to China's gross fixed-capital formation (GFCF), which amounted to ~ $4.8 trillion last year. Simply put, the BRI is incapable of offsetting a general slowdown in China, were it to occur. In fact, our FMS desk estimates that a 0.4% contraction in GFCF is all that will be needed to offset BRI-related investments in 2018. Bottom Line: With the Belt and Road Initiative written into the constitution, we expect greater follow-through directed toward meeting the goals specified in it. On its own, this is positive for base metals, which will benefit from greater demand from infrastructure projects, as well as the secondary effects in the form of demand for consumer goods from trading partners. However, the BRI, in and of itself, will not super-charge base metals demand. The BRI will counteract some of the negative impacts of a slowdown in China growth on commodity markets generally. However, since the size of BRI investment expenditure accounts for only a small fraction of China's fixed capital formation, we are skeptical of the extent to which it can offset a slowdown, were it to occur in the mainland. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 In our modelling of base metal prices, we find China's PMI has a large and significant impact on metal prices. Using year-on-year growth rates since 2010, a 1% increase in China's PMI is associated with a 0.54% increase in the LMEX base metals price index. 2 Please see BCA Research's Geopolitical Strategy's Special Report titled "China: Party Congress Ends...So What?," dated November 1, 2017. It is available at gps.bcaresearch.com. 3 Please see BCA Research's Geopolitical Strategy Weekly Report titled "Xi Jinping: Chairman Of Everything," dated October 25, 2017, available at gps.bcaresearch.com. 4 Li Keqiang and Wang Yang are both from Hu Jintao's Communist Youth League, Han Zheng and Wang Huning are Jiang Zemin followers, and Li Zhanshu and Zhao Leji are Xi Jinping loyalists. 5 While this is positive for steel prices, it would dampen demand for iron ore, weighing down on its prices. 6 Alumina, aluminum, and carbon producers that meet emission discharge standards are ordered to cut production by over 30%, around 30%, and over 50%, respectively. Producers that do not meet emission discharge standards are ordered to halt production. 7 Please see "China to launch nationwide inspection on commercial housing sales," published October 25, 2017, available at www.chinadaily.com.cn. Noted "irregularities" include fabricating information on housing sales, publishing fake advertisements and artificially inflating housing prices, market manipulation, and hoarding unsold homes. 8 Please see BCA Research's China Investment Strategy Weekly Report titled "Chinese Real Estate: Which Way Will The Wind Blow?," dated September 28, 2017, available at cis.bcaresearch.com. 9 Please see IMF Spillover Notes, Issue 6 "China's Footprint in Global Commodity Markets," published September 2016, available at www.imf.org. 10 Interestingly, given the U.S.'s role as a harbinger of the global economy, U.S. IP surprises have a similar impact on commodity prices. 11 Please see BCA Research's Frontier Markets Strategy Special Report titled "China's Belt And Road Initiative: Can It Offset A Mainland Slowdown?," dated September 13, 2017, available at fms.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Shifting Gears In China: The Impact On Base Metals Shifting Gears In China: The Impact On Base Metals Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights The private sectors in Brazil, Russia and India have indeed experienced some deleveraging. Yet in China, deleveraging has not even begun. In fact, the money and credit excesses have become ever larger in the past two years. China's broad money (M3) is as large as the entire outstanding stock of broad money in the U.S. and euro area banking systems combined. In China, the triple tightening - higher corporate bond yields and money market rates, ongoing tightening by banking regulators and the anti-corruption campaign - will lead to lessened money and credit origination. That in turn will weigh on mainland capital spending and growth in general. Chart I-1Some Deleveraging In Brazil, Russia, And India Some Deleveraging In Brazil, Russia, And India Some Deleveraging In Brazil, Russia, And India Feature A judgment on the sustainability of the rally in EM/China-related risk assets, from a big picture perspective, should include whether deleveraging in these economies is in late stages - i.e., whether credit and debt excesses accumulated following the 2008 global financial crisis have been unwound, at least partially. The objective of this week's note is to provide an update on the status of deleveraging within EM/China. Herein, deleveraging is defined as a falling debt-to-GDP ratio. The private sectors within Brazil, Russia and India have indeed experienced some deleveraging, with their private sector debt-to-GDP ratio either falling or moving sideways (Chart I-1). However, in China, deleveraging has not yet even begun (Chart I-2). Excluding Korea, Taiwan, and the BRIC economies, the rest of EM has not seen much deleveraging either (Chart I-3) - we exclude Korea and Taiwan because their equity markets are contingent on global demand rather than domestic dynamics. Note that this debt-to-GDP aggregate is weighted by each country's respective market cap in the MSCI EM stock index. The latest stabilization in this ratio might be due to these countries' currency appreciation, which has reduced their foreign currency debt burden relative to GDP. While deleveraging in many individual developing economies will not affect the rest of the world, deleveraging in China will have an impact on global trade in general and EM economies in particular. This remains one of the most important reasons why we believe the current recovery in EM growth will not be sustained. Chart I-2Deleveraging Has Not Started Yet In China... Deleveraging Has Not Started Yet In China... Deleveraging Has Not Started Yet In China... Chart I-3...Nor In The Rest Of EM ...Nor In The Rest of EM ...Nor In The Rest of EM Some investors and commentators have remarked that in the U.S., the euro area and Japan, there was no deleveraging following their respective credit bubbles and crises. As such, they argue that there is no compelling reason to expect deleveraging in EM/China. The point about the lack of deleveraging in Japan, the U.S. and Europe following their credit bubbles is only true when one includes public debt (Chart I-4). Yet, their private sectors did deleverage as can be seen in Chart I-5. Chart I-4DM: Deleveraging Concealed By ##br##Acceleration In Public Credit DM: Deleveraging Concealed By Acceleration In Public Credit DM: Deleveraging Concealed By Acceleration In Public Credit Chart I-5Private Sector Deleveraged ##br##Meaningfully In DM Private Sector Deleveraged Meaningfully In DM Private Sector Deleveraged Meaningfully In DM In the U.S. and euro area, deleveraging lasted an average of about seven years. As to Japan - which had a larger credit bubble but never experienced an acute credit crisis - private sector deleveraging endured over more than 21 years (Chart I-5, bottom panel). Did deleveraging in these DM economies involve outright nominal contraction in private credit and bank loans, or only decline in private debt-to-GDP ratio? Both bank loans and private credit nominal growth contracted, as demonstrated in Chart I-6. In short, despite massive policy support - i.e. monetary and fiscal easing and various bank recapitalization programs - private credit growth shrunk in nominal terms in the U.S. and euro area for a couple of years, and for many more years in Japan. China An update on China's debt burden is in order: Despite the vast local government financing vehicle (LGFV) debt swap of about RMB13 trillion conducted over the past two years the corporate debt-to-GDP ratio has not dropped (Chart I-7, top panel). Chart I-6DM: Bank Loans & Private Sector Credit ##br##Contracted In Nominal Terms DM: Bank Loans & Private Sector Credit Contracted In Nominal Terms DM: Bank Loans & Private Sector Credit Contracted In Nominal Terms Chart I-7China's Breakdown ##br##Of Debt By Sector China's Breakdown Of Debt By Sector China's Breakdown Of Debt By Sector The corporate debt-to-GDP ratio has stopped rising because LGFV debt - which belonged to SOEs and was classified as corporate debt - has been converted into provincial government debt. Since the onset of the Chinese equity market crash in the summer of 2015, our measure of broad money (M3) has expanded by RMB38 trillion ($6 trillion). Similarly, total social financing excluding equity issuance and including local government debt issuance - our so-called TSF+ measure - has surged by RMB49 trillion ($7.4 trillion). In terms of annual growth rates, M3 and TSF+ are still expanding at 10% and 14%, respectively. Chart I-8China's Money Impulse Points ##br##To Growth Deceleration China's Money Impulse Points To Growth Deceleration China's Money Impulse Points To Growth Deceleration We do not expect China's credit growth to contract in nominal terms, but we do expect credit/money growth to slow further. If and when this occurs, the money and credit impulses - the second derivatives - will become negative. The growth rates of GDP, industrial production, capital spending, profits and imports are impacted by the second derivatives of money and credit, which have been declining. In fact, the M3 impulse is already negative, which is consistent with deceleration in China's business cycle (Chart I-8). Some commentators and strategists have argued that debt should be compared with debtors' assets not GDP. This is a very weak argument. The sustainability of debt is contingent on borrowers' ability to service it. In turn, the ability to service debt is determined by debtors' cash flow generation which can be measured / approximated by nominal GDP. This is why the debt-to-nominal GDP ratio is the best metric for debt sustainability on a macro scale. It factually measures debt relative to corporate nominal revenues and household income. What about assets? Just because a company has assets does not mean it can service its debt. Note that in China, debt sustainability concerns are primarily around companies not households or government. First, if a company's assets do not generate sufficient cash flow to service debt, the value of these assets will be low. Second, asset valuations in EM state-controlled companies in general and among Chinese SOEs in particular, where most of the debt is concentrated, cannot be taken at face value. When evaluating the creditworthiness of a debtor, should investors rely on the accounting value of buildings that a debtor owns, or on the cash flow that these assets generate? We believe the latter is a much more prudent approach to investment analysis than the former. Third, if assets indeed need to be liquidated to service debt across many debtors, the situation is already very dire. Finally, we acknowledge that the Chinese government has a lot of fiscal room to bail out corporate debtors. When the authorities do so and overall corporate debt declines, we will seriously contemplate changing our view and investment strategy. So far, corporate indebtedness has not declined. For all of the above reasons, the debt-to-nominal GDP ratio is a much more reasonable measure than the debt-to-assets ratio. To be clear, we are not suggesting that Chinese companies are heading into a massive default and liquidation cycle. Our key premise as it relates to China's debt burden is as follows: overleveraged companies that could potentially struggle to service their debt are unlikely to embark on major capital spending initiatives. And in fact, their creditors should not lend to these debtors. As a result, capital spending will slow, weighing on commodities and other related areas. Conclusions The credit and money excesses in China and EM have been increasingly getting larger. Not only does China have too much corporate debt, but its stock of outstanding broad money is very high compared to any other economy in the world (Chart I-9). Chart I-9China's 'Money Bubble' China's 'Money Bubble' China's 'Money Bubble' Money is created by banks "out of thin air" (subject to regulatory capital ratios and other constraints) when they lend or buy assets from non-bank entities. Banks' ability to originate money does not relate to or depend on consumers or national savings. We have explored these issues in detail in Trilogy of reports in the past.1 Chart I-10China: Beware Of Rising Inflation China: Beware Of Rising Inflation China: Beware Of Rising Inflation Chart I-9 illustrates that China's official broad money (M2) is equivalent to $25 trillion while our measure of broad money (M3) is equivalent to about $29 trillion. This compares with broad money of $14 trillion in each of the U.S. and the euro area. Hence, China's broad money (M3) is as large as the U.S. and euro area's aggregate broad money combined. Furthermore, as of January 1, 2009, China's M2 and M3 were only $7.3 trillion and $8 trillion, respectively. This entails that the Chinese banking system has increased the broad money supply by the equivalent of $18-21 trillion. The triple tightening - higher corporate bond yields and money market rates, ongoing tightening by banking regulators and the anti-corruption campaign that is moving into the financial system - will lead to lessened money and credit origination. This will weigh on capital spending and growth in general. The odds are that tightening will escalate. First, after the party Congress, President Xi has consolidated power and can now enact meaningful structural reforms. Second, as we documented several weeks ago, core consumer inflation is rising (Chart I-10). Producer prices inflation is holding up around 7%. This is not surprising, given the amount of money that has been created in the economy in the past two years. Even marginal policy tightening amid lingering credit excesses is very dangerous. Yet a moderate slowdown in credit growth can translate into a notable drop in the credit impulse, weighing on growth as a result. This is especially true for capital spending and construction and is one of the primary reasons why we maintain a negative stance on China-related and EM risk assets. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@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 Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Three factors point to stable or narrower USD cross-currency basis swap spreads: the improving health of global banks, the end of the adjustment to the regulatory change affecting prime-money market funds, and the relaxation to the Supplementary Leverage Ratio rules by the U.S. Treasury. Four factors point to wider basis swap spreads: BCA's forecast that U.S. loan growth will pick up, our view on U.S. inflation, the coming decline in the Federal Reserve's balance sheet, and the potential for U.S. repatriation. We expect USD basis swap spreads to widen again, which suggests increasing FX vol. This would hurt carry trades, EM currencies and dollar bloc currencies. Feature The rather arcane topic of cross-currency basis swap spreads has periodically surfaced in the news in the past few years. The widening in cross-currency basis swap spreads has been highlighted as one of the key factors explaining why covered interest rate parity relationships (the link between the price of FX forward, spot prices and interest rate differentials) have not held as closely after the Great Financial Crisis (GFC) as before. The widening of cross-currency basis swap spreads has also been highlighted as a factor behind the strength in the U.S. dollar in 2014 and 2015. Similarly, the recent narrowing in the cross-currency basis swap spread has been highlighted as a factor behind the weakness in the USD this year. This week we delve a little deeper into what cross-currency basis swap spread measures, and what some of its major determinants are. We ultimately expect the USD cross-currency basis swap spread to widen again, which should contribute to a stronger dollar and increased global FX volatility. What Is A Cross-Currency Basis Swap? To examine what drives cross-currency basis swap spreads, one first needs to understand what these instruments are. Let's begin with a regular FX swap. An FX swap in EUR/USD is a contract through which two counterparties agree to exchange EURs for USDs today, with a reversal of that exchange at the maturity of the contract - a reversal set at a predetermined exchange rate simply equal to the forward value of the EUR/USD. So, if counterparty A lends X million EURs to counterparty B, the former receives in U.S. dollars the equivalent of X million EURs times the prevalent EUR/USD spot rate from counterparty B today. The transaction does not end there. Simultaneously, the FX swap forces B to give back the X million EURs to counterparty A at maturity, while counterparty A gives back X million EUR times the EUR/USD forward rate in U.S. dollars to counterparty B. This forward rate is the rate prevalent when the contract was agreed upon. The transactions are illustrated in the top panel of Chart 1. Chart 1FX Swaps Vs. Cross Currency Basis Swaps It's Not My Cross To Bear It's Not My Cross To Bear The problem with regular FX swaps is that they offer little liquidity at extended maturities. If market players want to hedge long-term liabilities and assets, they tend to do so using a cross-currency basis swap, where much more liquidity is available at long maturities. A EUR/USD cross currency basis swap begins in the same way as a regular FX swap: counterparty A lends X million EURs to counterparty B, and the former receives in U.S. dollars the equivalent of X million EURs times the prevalent EUR/USD spot rate from counterparty B today. However, this is where the similarities end. A cross-currency basis swap has exchanges of cash flows through its term. Counterparty B, which provided USDs to counterparty A, receives 3-month USD Libor, while counterparty A, which provided EURs to counterparty B, received 3-month EUR Libor + a (alpha being the cross-currency basis swap spread). At the maturity of the contract, counterparty A and B both receive their regular intermediary cash flows, and also re-exchange their respective principal - but this time at the same spot rate as the one that existed at the entry of the contract (Chart 1, bottom panel). Chart 2A Bigger Funding Gap Equals##BR##A Wider Basis Swap Spread A Bigger Funding Gap Equals A Wider Basis Swap Spread A Bigger Funding Gap Equals A Wider Basis Swap Spread In both regular FX and cross-currency basis swaps, counterparties have removed their FX risks, except that in the latter, the interest differentials have been paid during the life of the contract instead of being factored through the forward premium/discount. This is fine and dandy, but it leaves a unexplained. The cross currency basis swap spread (a), is a direct function of the relative supply and demand for each currency. If investors demand a lot of EUR in the swap market relative to its supply, a will be positive. If they demand more USDs, a will be negative. A good example of this dynamic is the funding gap of banks. Let's take the Japanese example. Japanese banks have a surplus of domestic deposits (thanks to the massive savings of the Japanese corporate sector) relative to their yen lending. As a result, they have large dollar lending operations. To hedge their dollar assets, Japanese banks borrow USD in large quantities in the cross-currency swap market. This tends to result in a negative swap spread in the yen (Chart 2). This is particularly true if both the banking sector and the other actors in the economy (institutional investors and non-financial firms) also borrow dollars in the swap market to hedge dollar assets, which is the case in Japan (Chart 3). Chart 3Japanese Investors Are Accumulating Assets Abroad It's Not My Cross To Bear It's Not My Cross To Bear Additionally, if there are perceived solvency risks in the European banking sector, this should further weigh on the cross-currency basis swap spread, pushing it deeper into negative territory, as the viability of the main EUR counterparties becomes at risk. The same dance is true for any currency pair. The other factor that affects USD cross-currency basis swap spreads is the supply of U.S. dollars, especially the room on large banks' balance sheets to service these markets. The cross-currency basis swap spread could be close to zero if large arbitrageurs take offsetting positions to arbitrage the spread away, doing so until the spread disappears. However, with the imposition of Basel III and Dodd-Franks, banks have been constrained in their capacity to do this. Indeed, increased leverage ratio requirements (now banks need to post more capital behind repo transactions as well as collateralized lending and other derivatives) mean that arbitraging cross-currency basis swap spreads and deviations from covered interest rate parity has become much more expensive. Furthermore, the increase in Tier 1 capital ratios associated with these regulations has forced banks to de-lever; however, engaging in arbitrage activities still requires plenty of leverage (Chart 4). Chart 4The Structural Gap In The Basis Swap##BR##Spread Reflects Regulation The Structural Gap In The Basis Swap Spread Reflects Regulation The Structural Gap In The Basis Swap Spread Reflects Regulation Economic Factors Driving The Spread The factors that we look at essentially relate to the supply of USD available for lending in offshore markets, as well as determinants of relative counterparty risks between the U.S. and the rest of the world. Factors Arguing For Narrower Cross-Currency Basis Swap Spreads 1. Global Banks Health Chart 5Banks Perceived Health##BR##Determines Basis Swap Spreads Banks Perceived Health Determines Basis Swap Spreads Banks Perceived Health Determines Basis Swap Spreads The price-to-book ratio of global banks outside the U.S. has been largely correlated with USD cross-currency swap spreads. When global banks get de-rated, spreads widen, and it becomes more expensive to hedge USD positions in the swap market (Chart 5). This is because as investors perceive the solvency of global banks deteriorating, they impose a penalty as the Herstatt risk increases. Additionally, solvency problems can force banks to scramble to access USD funding, prompting deeper spreads. BCA is positive on global financials and sees continued improvement in European NPLs. This means that solvency risk concerns are likely to remain on the backburner for now, pointing to narrower basis swap spreads. 2. Supplementary Leverage Ratio Changes In June, the U.S. Treasury announced a relaxation of some of its rules on supplementary leverage ratios, lowering the amount of capital required to support activity in the repo market behind initial margins for centrally cleared derivatives, and behind holdings of Treasurys. This means that commercial banks in the U.S. can have bigger balance sheets and more room to engage in arbitrage activity, implying a greater supply of dollars in the USD cross-currency basis swap market. In response to last June's proposal, basis swap spreads narrowed by 11 basis points. BCA believes these changes will continue to support dollar liquidity, and will further help in narrowing cross-currency basis swap spreads. 3. Prime Money-Market Funds Debacle Is Over Chart 6More Expensive Bank Funding##BR##= Wider Basis Swap Spreads More Expensive Bank Funding = Wider Basis Swap Spreads More Expensive Bank Funding = Wider Basis Swap Spreads In October 2016, regulatory changes were implemented that allowed prime money market funds to have fluctuating net asset values. Obviously, this meant that prime money-market funds would be not-so-prime anymore. As a result, to remain the ultra-safe vehicles that they once were, prime money-market funds de-risked. As a result, they cut their exposure to risky activities in anticipation of these changes. In practice, a key source of short-term funding for banks evaporated from the market, putting upward pressure on bank financing costs. As the LIBOR-OIS spread increased, so did basis-swap spreads (Chart 6): as it became more expensive for banks to finance themselves, they had to curtail the supply of USDs provided to the swap market, an activity normally requiring intense demand on banks' balance sheets. This adjustment is now over, suggesting limited potential widening in USD basis swap spreads. Factors Arguing For Wider Cross-Currency Basis Swap Spreads 1. U.S. Loan Growth When U.S. banks increase their loan formation activity, USD cross-currency basis swap spreads widen (Chart 7). As banks increase their extension of credit through loans, they decrease the amount of securities they hold on their balance sheets (Chart 8). This means there is less supply of liquidity available for balance sheet activities, particularly providing dollar funding in the offshore market. In the Basel III / Dodd-Frank world, less-liquid bank balance sheets are synonymous with wider USD basis-swap spreads. As we argued last week, increasing U.S. capex, easing lending standards for firms and rising household income levels should result in increasing loan growth in the U.S. which will result in lower abundance of liquid assets and a widening basis swap spreads.1 Chart 7More Bank Loans Lead##BR##To Wider Swap Spreads More Bank Loans Lead To Wider Swap Spreads More Bank Loans Lead To Wider Swap Spreads Chart 8More Debt Equals Less##BR##Securities In Bank Credit More Debt Equals Less Securities In Bank Credit More Debt Equals Less Securities In Bank Credit 2. U.S. Inflation There is a fairly close relationship between U.S. inflation and the USD basis swap spread, where a higher core CPI tends to lead to a wider spread (Chart 9). The fall in U.S. inflation this year likely contributed to the narrowing in basis swap spreads. Our take on this is that as inflation falls, it gives an incentive for banks to hold low-yielding liquidity on their balance sheets as real returns on cash improve. This fuels a gigantic carry trade through the basis-swap market. We expect inflation to pick up meaningfully by mid-2018, which should widen cross-currency basis swap spreads.2 Chart 9When U.S. Inflation Increases, Swap Spreads Widen When U.S. Inflation Increases, Swap Spreads Widen When U.S. Inflation Increases, Swap Spreads Widen 3. Central Bank Balance Sheets When the Federal Reserve increases the size of its balance sheet relative to other balance sheets, this tends to lead to a narrowing of the USD basis swap spread as the global supply of dollars relative to other currencies increases. The opposite is also true. This relationship did not work after late 2016 (Chart 10). However, during that episode, as the change in prime money-market funds caused a dislocation in banks' funding, commercial banks exhibited cautious behavior and increased their reserves with the Fed. As Chart 11 illustrates, there is a tight relationship between the change in commercial banks' reserves held at the Fed and cross-currency basis swap spreads. Going forward, as the Fed lets it balance sheet run off, we expect to see a decrease in commercial banks' excess reserves. This could contribute to upward movement in the basis swap spread. Chart 10Smaller Fed Balance Sheet Leads##BR##To Wider Basis Swap Spreads Smaller Fed Balance Sheet Leads To Wider Basis Swap Spreads Smaller Fed Balance Sheet Leads To Wider Basis Swap Spreads Chart 11Fed Runoff Could Widen##BR##Basis Swap Spreads Fed Runoff Could Widen Basis Swap Spreads Fed Runoff Could Widen Basis Swap Spreads 4. U.S. Repatriations Chart 12U.s. Repatriations Support Wider##BR##Basis Swap Spreads U.s. Repatriations Support Wider Basis Swap Spreads U.s. Repatriations Support Wider Basis Swap Spreads The most revealing relationship unearthed in our study was that when U.S. entities repatriate funds at home, this tends to put strong widening pressure on the USD cross-currency basis swap spread (Chart 12). U.S. businesses hold large cash piles abroad - by some estimates more than US$2.5 trillion. However, most of these funds are held in highly liquid, high-quality U.S.-dollar assets offshore. These assets are perfect collaterals for various transactions in the interbank market. The funds held abroad by U.S. firms are a source of supply for U.S. dollars in the offshore markets. When U.S. entities bring assets back home, the widening in the basis swap spread essentially reflects a decline in the supply of USD in offshore markets, and vice versa when Americans export capital abroad. BCA's base case is that tax cuts are likely to hit the U.S. economy in 2018, even if the growing feud between Trump and the establishment Republican party members is a growing risk. BCA still views a tax repatriation as a higher-likelihood event, as it is the easiest way for the U.S. government to bring funds into its coffers. The 2004 tax repatriation under former President George W. Bush did result in substantial fund repatriation in the U.S. This time will not be different. We expect any such tax repatriation to cause a potentially large deficit of supply in the USD offshore markets, which could create a strong widening basis on the cross-currency basis swap spread in favor of the dollar. Bottom Line: Three factors argue for USD cross-currency basis swap spreads to stay at current levels, or even narrow further. These factors are the health of global banks, the easing in U.S. supplementary leverage ratios and the end of the adjustment of U.S. bank funding to new regulations affecting prime money-market funds. On the other hand four factors points to wider USD cross-currency basis swap spreads: BCA's positive outlook for U.S. credit growth; BCA's positive outlook on U.S. inflation; the run-off of the Fed's balance sheet; and the potential for U.S. entities repatriating funds from abroad. Potential Direction And Investment Implications We anticipate USD cross-currency basis swap spreads to widen over the coming 12 months. We think the easing in the Supplementary Leverage Ratios rules by the U.S. Treasury is the most important factor pointing to narrower USD cross-currency basis swap spreads. However, Basel III rules and most of Dodd-Frank are still in place, which suggest there remains large constraints on the balance-sheet activities of global banks, which will limit the potential for a narrowing of the USD basis swap spread as U.S. banks will remain constrained in their ability to supply U.S. dollars in the offshore market. Chart 13Wider Basis Swap Spreads Equals Higher Vol Wider Basis Swap Spreads Equals Higher Vol Wider Basis Swap Spreads Equals Higher Vol On the other hand many factors support wider USD cross-currency basis swap spreads, most important of which is the potential for more credit growth. This is in our view a very strong force as it requires banks to ration the use of their balance sheets, limiting their activity in the offshore market. Moreover, we do foresee a high probability of tax repatriation, which would put strong widening pressure on the swap spreads. In terms of implications, wider USD basis swap spreads tend to be associated with rising FX vols (Chart 13). As we highlighted in a Special Report last year, higher FX vols are poison for carry trades.3 As such, we think that widening swap spreads could spur a period of trouble for traditional carry currencies. This means EM and dollar-block currencies are likely to suffer in this environment. Additionally, in China, Xi Jinping is consolidating power and has taken control of the Politburo. This implies he now has more room to implement reforms. Removal of growth targets after 2020, removal of growth as a criterion for grading local officials, a focus on balanced growth, and a focus on combatting pollution all suggest that Chinese growth is unlikely to follow the same debt-fueled, capex-led model.4 This will weigh on Chinese imports of raw materials, and hurt export volumes and prices for many EM countries and commodities producers. This means these policies represent a headwind for many carry currencies. Moreover, historically, wider USD funding costs have been associated with a stronger dollar, as it makes it more expensive to hedge dollar assets. Thus, in an environment where U.S. interest rates are rising relative to the rest of the world - making U.S. assets attractive - wider basis swap spreads are an additional factor that could lift the dollar. Bottom Line: We anticipate the USD cross-currency basis swap spread to widen over the next 12 months. This will be associated with higher FX vols, which hurt carry trades, EM currencies and dollar-block currencies. Chinese reforms will reinforce these risks. Additionally, wider basis swap spreads will create support for the USD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "All About Credit", dated October 20, 2017, available at fes.bcaresearch.com. 2 Please see Foreign Exchange Strategy Weekly Report, titled "Conflicting Forces For The Dollar", dated September 8, 2017, and "Is The Dollar Expensive?", dated October 13, 2017, available at fes.bcaresearch.com. 3 Please see Foreign Exchange Strategy Special Report, titled "Carry Trades: More Than Pennies And Steamrollers", dated May 6, 2016, available at fes.bcaresearch.com. 4 Please see Geopolitical Strategy Weekly Report, titled "Xi Jinping: Chairman Of Everything", dated October 25, 2017 and Special Report, titled "How To Read Xi Jinping's Party Congress Speech", dated October 18, 2017, available at gps.bcaresearch.com. Appendix Implications For The Global Fixed Income Investor Chart A1FX Basis Swaps Boosting##BR##Hedged European Yields FX Basis Swaps Boosting Hedged European Yields FX Basis Swaps Boosting Hedged European Yields The outlook for cross-currency basis swap spreads has important implications for global fixed income investors. Chiefly, a wider (more negative) basis swap spread makes it more profitable for U.S. investors to lend U.S. dollars. For example, the top panel of Chart A1 shows that if a U.S.-based investor swaps dollars for euros on a 3-month horizon, and then invests those euros in 10-year German bunds, they will earn a hedged yield of 2.5% (annualized). This compares to a current yield of 2.3% on the 10-year U.S. Treasury note. If the basis swap spread were zero, then the U.S. investor would face a hedged German 10-year yield of only 2.1%. Conversely, a deeply negative basis swap spread works against non-U.S. investors looking to gain exposure to the U.S. bond market. If a Eurozone-based investor swaps euros for dollars on a 3-month horizon and then invests those dollars in 10-year U.S. Treasuries, he will earn a hedged yield of 0.1% (annualized). This compares to a current yield of 0.4% on 10-year German bunds. If the basis swap spread were zero, then the European investor would face a more enticing hedged U.S. 10-year yield of 0.6%. The middle three panels of Chart A1 show the 10-year yields in other Eurozone bond markets from the perspective of a U.S.-based investor who has hedged his currency risk on a 3-month horizon, as per the strategy explained above. The bottom panel of Chart A1 shows that the deviation of the EUR/USD basis swap spread from zero currently adds 42 basis points to the hedged yields faced by a U.S. investor. Charts A2, A3, A4 and A5 present the same analysis for other major bond markets, again from the perspective of a U.S. based investor.5 Chart A2FX Basis Swaps Boosting Hedged Gilt Yields FX Basis Swaps Boosting Hedged Gilt Yields FX Basis Swaps Boosting Hedged Gilt Yields Chart A3FX Basis Swaps Boosting Hedged JGB Yields FX Basis Swaps Boosting Hedged JGB Yields FX Basis Swaps Boosting Hedged JGB Yields Chart A4FX Basis Swaps Boosting##BR##Hedged Canadian Yields FX Basis Swaps Boosting Hedged Canadian Yields FX Basis Swaps Boosting Hedged Canadian Yields Chart A5FX Basis Swaps Are NOT Boosting##BR##Hedged Australian Yields FX Basis Swaps Are NOT Boosting Hedged Australian Yields FX Basis Swaps Are NOT Boosting Hedged Australian Yields The Impact Of Hedging Costs On Returns Of course, the basis swap spread is only one input to hedging costs. Once again, using the example of a U.S.-based investor looking for exposure in European bond markets, we calculate the hedging cost as: (1 + Hedging Cost) = (1 + 3-month EUR LIBOR + basis swap spread) / (1 + 3-month USD LIBOR) Right now the hedging cost in the above example is below zero. This is why German bund yields actually appear more attractive to U.S. investors after taking hedging costs into account. But what's more interesting is that total returns in 7-10 year German bunds (hedged into USD) relative to total returns in 7-10 year U.S. Treasury notes track hedging costs very closely over time (Chart A6). Chart A6Hedging Costs Will Continue To Boost Hedged German Bond Returns As The Fed Hikes Rates Hedging Costs Will Continue To Boost Hedged German Bond Returns As The Fed Hikes Rates Hedging Costs Will Continue To Boost Hedged German Bond Returns As The Fed Hikes Rates This is highly logical. As hedging costs become more negative, it means that U.S.-based investors make more money swapping U.S. dollars for euros. Therefore, a strategy of swapping dollars for euros, and then placing the proceeds in 7-10 year German bunds should continue to be a profitable one for U.S. investors as long as hedging costs continue to decline. Fortunately for U.S. investors, hedging costs should become even more negative during the next 12 months. In our base case scenario, we assume that the Federal Reserve will lift rates by 100bps by the end of 2018. We also assume that the ECB will not lift rates during this timeframe. That divergence in policy rates on its own will drive hedging costs further into negative territory, and it will only be exacerbated if the cross-currency basis swap spread widens as we anticipate. We illustrate the impact of the cross-currency basis swap spread on hedging costs in the bottom panel of Chart A6. The panel shows where hedging costs will go between now and the end of 2018, assuming policy rates move as we described above, and that the basis swap spread either widens to -100 bps or tightens back to zero. It is evident that a sharp widening in basis swap spreads would be a boon for U.S. investors in foreign bond markets. Bottom Line: Deeply negative basis swap spreads make it more profitable to lend dollars on a short-term horizon. This presents an opportunity for U.S. investors to swap dollars for foreign currencies and invest in non-U.S. bond markets. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 5 While the basis swap spread between the U.S. and most countries is negative, it is actually positive between the U.S. and Australia. So in this case the basis swap spread makes Australian bonds look less attractive to U.S. investors. Conversely, the basis swap spread makes U.S. bonds look slightly more attractive to Australian investors.

Highlights The three deflationary anchors of the global economy have abated: The U.S. private sector deleveraging is over, the euro area economy is escaping its post crisis hangover, and the destruction of excess capacity in China is advanced. This means that global central banks are in a better position than at any point this cycle to normalize policy, pointing to higher real rates. As a result, gold prices will suffer significant downside. The populist wave in New Zealand is based on inequalities and is here to stay. This will hurt the long-term outlook for the Kiwi. However, short-term NZD has upside, especially against the AUD. The BoE hiked rates, but upside surprises to policy is unlikely now. The pound remains at risk from Brexit negotiations. Feature Chart I-1Gold Is Setting Up For A Big Move Gold Is Setting Up For A Big Move Gold Is Setting Up For A Big Move Gold is at an interesting juncture. Gold prices, once adjusted for the trend in the U.S. dollar, have been forming a giant tapering wedge since 2011 (Chart I-1). This type of chart formation does not necessarily get resolved by an up-move, nor does it indicate a clear bearish pattern either. Instead, it points toward a potential big move in either direction. For investors, the key to assess whether this wedge will be resolved with a rally or a rout is the trend in global monetary conditions and real rates. In our view, the global economic improvement witnessed in 2017 suggests the world needs less accommodation than at any point since the onset of the great financial crisis. Thus, global accommodation will continue to recede, global real rates will rise and gold will suffer. The Exit Of The Great Deflationary Forces Since the financial crisis, in order to generate any modicum of growth, global monetary authorities have been forced to maintain an incredible degree of monetary accommodation in the global financial system. Central banks' balance sheets have expanded massively, with the Federal Reserve, the European Central Bank, the Bank of Japan, the Bank of England and the Swiss National Bank all increasing their asset holdings by 16% of GDP, 26% of GDP, 70% of GDP, 17% of GDP and 97% of GDP respectively. Real rates too have been left at unfathomable levels, with average real policy rates in the U.S., the euro area, Japan and the U.K. standing at 0.13%, -1.15%, -0.19%, and -2.12%, respectively. Despite all this easing, core inflation in the OECD has only averaged 1.68% since 2010, and real growth 2.05% - well below the averages of 2.3% and 2.44%, respectively, from 2001 to 2007. Explaining this extraordinary situation have been three key anchors that have conspired to create strong deflationary forces that have necessitated all this stimulus: the first was U.S. private sector deleveraging, with at its epicenter the rebuilding of household balance sheets. The second was the euro area crisis, which also caused a forced deleveraging in the Spanish and Irish private sector as well as in the Greek and Portuguese public sectors. The third was China's purging of excess capacity in the steel and coal sectors, as well as various heavy industries. These three deflationary anchors seem to have finally passed. In the U.S., nonfinancial private credit is slowly showing signs of recovering. Households have curtailed their savings rate, suggesting a lower level of risk aversion. Even more importantly, the growth in savings deposits is sharply decelerating, which historically tends to be associated with a re-leveraging of the household sector and increasing consumption (Chart I-2). Strong new home sales point toward these developments. The corporate sector is also displaying an important change in behavior. Share buybacks are declining, and both capex intentions and actual capex are recovering smartly - powered by strong profit growth (Chart I-3). This is crucial as it suggests firms are not recycling the liquidity they generate through their operations or their borrowings in the financial markets. Thus, with banks easing their lending standards, additional debt accumulation by firms is likely to support aggregate demand, eliminating a key deflationary force in the global economy. Chart I-2Household Deleveraging Is Over Household Deleveraging Is Over Household Deleveraging Is Over Chart I-3Companies Are Borrowing To Invest Companies Are Borrowing To Invest Companies Are Borrowing To Invest Moreover, Jay Powell's nomination to helm the Fed is also important. He is a proponent of decreasing bank regulation, especially for small banks that greatly rely on loan formation for their earnings. A softening in regulatory stance on these institutions could contribute to higher credit growth in the U.S. With aggregate liquidity conditions of the private sector - shown by the ratio of liquid assets to liabilities - having already improved, and indicating that a turning point in U.S. inflation will soon be reached, more credit growth could further stoke inflation (Chart I-4). Europe as well is also escaping its own morose state. ECB President Mario Draghi's fateful words in July 2012 resulted in a compression of peripheral spreads as investors priced away the risk of a breakup of the euro area (Chart I-5). As a result, the massive policy easing associated with negative rates and the ECB's expanded asset purchase program was transmitted to the parts of the euro area that really needed that easing: the periphery. Now, Europe is booming: Monetary aggregates have regained traction, real GDP growth is growing at a 2.3% annual pace, PMIs are growing vigorously, and even the unemployment rate has fallen back below 9%. European inflation remains low, but nonetheless the nadir of -0.6% hit in 2015 has also passed (Chart I-6). Chart I-4Liquid Private Balance Sheet Point To Inflation Liquid Private Balance Sheet Point To Inflation Liquid Private Balance Sheet Point To Inflation Chart I-5Draghi Held The Key To Help Europe Draghi Held The Key To Help Europe Draghi Held The Key To Help Europe Chart I-6Europe Past The Worst Europe Past The Worst Europe Past The Worst In China too we have seen important progress. Curtailment to excess capacity in the steel and coal sectors as well as across a wide swath of industries are bearing fruit (Chart I-7). China is not the source of deflation that it was as recently as 2015. Industrial profits have stopped contracting, industrial price deflation is over, and even core consumer prices are showing signs of vigor, growing at a 2.28% pace, the highest since the 2010 to 2011 period (Chart I-8). Thanks to these developments, global export prices have stopped deflating and are now growing at a 4.64% annual pace. With the three deflationary anchors having been slain, global growth is now able to escape its lethargy, with industrial activity at its strongest since 2003, while global capacity utilization has improved (Chart I-9). This is giving global central banks room to remove their easing. The Fed has already hiked rates four times and is embarking on decreasing its balance sheet; the Bank of Canada has followed suit two times, and the BoE, one time. Even the ECB is now beginning to taper its own asset purchases. We do anticipate this trend to continue with more and more central banks, with potentially the exception of the BoJ, joining the fray as the global environment remains clement. Even the People's Bank of China is likely to keep tightening policy due to the increasingly inflationary environment being experienced. Chart I-7Chinese Excess Capacity Purge Chinese Excess Capacity Purge Chinese Excess Capacity Purge Chart I-8China Doesn't Export Deflation Anymore China Doesn't Export Deflation Anymore China Doesn't Export Deflation Anymore Chart I-9Central Banks Can Normalize Central Banks Can Normalize Central Banks Can Normalize Bottom Line: The three anchors of global deflation have been slain. Private sector deleveraging in the U.S. is over, the euro area has healed and Chinese excess capacity has declined. As a result, global economic activity is at its strongest level in 14 years, and deflationary forces are becoming more muted. This is giving global central banks an opportunity to normalize policy without yet killing the business cycle. Implications For Gold Gold is likely to fare very poorly in this environment. Gold can be thought of as a zero coupon, extremely long-maturity inflation-indexed bond. This means that gold is a function of both inflation and real rates. Currently, gold offers little protection against outright inflation, having moved out of line with prices by a very large margin (Chart I-10). This leaves gold extremely vulnerable to development in real rates and liquidity. Saying that central banks can begin to normalize policy is akin to saying that central banks are in a position where letting real rate rise is feasible. As Chart I-11 illustrates, there has been a strong negative relationship between TIPS yields and gold prices. Moreover, when one looks beyond the price of gold in U.S. dollars, one can see that gold has been negatively affected by higher bond yields (Chart I-11, bottom panel). BCA currently recommends an underweight stance on duration, one that is synonymous with lower gold prices.1 Chart I-10Gold Is Expensive Gold Is Expensive Gold Is Expensive Chart I-11Higher Interest Rates Equal Lower Gold Higher Interest Rates Equal Lower Gold Higher Interest Rates Equal Lower Gold Moreover, the Fed's own research suggests that its asset purchases have curtailed the term premium by 85 basis points. The balance sheet run-off that the U.S. central bank is engineering will weaken that impact to a more meager 60 basis points by 2024. This also points to lower gold prices, as gold prices have displayed a negative relationship with the term premium (Chart I-12). An outperformance of financials in general but banks in particular is also associated with poor returns for gold (Chart I-13). Strong financials are associated with growing loan volumes, which mean a lesser need for policy easing, which puts upward pressure on the cost of money. Anastasios Avgeriou, who heads BCA's sectoral research, has an overweight on banks both globally and in the U.S. on the basis of the stronger loan growth we are beginning to see around the world.2 This represents a dangerous environment for gold. Chart I-12Normalizing Term Premium ##br##Is Dangerous For Gold Normalizing Term Premium Is Dangerous For Gold Normalizing Term Premium Is Dangerous For Gold Chart I-13Bullish Banks Equals ##br##Bearish Gold Bullish Banks Equals Bearish Gold Bullish Banks Equals Bearish Gold Finally, there is an interesting relationship between real stock prices and real gold prices. When stocks are in a secular bull market, gold prices are typically in a secular bear market (Chart I-14). A secular bull market in stocks tends to happen in an environment where there is more confidence that growth is becoming more durable, where there is less fear that currencies will have to be debased to support economic activity, or where inflation is not a destructive force like it was in the 1970s. These are environments where real rates tend to have upside. The continued strength in global equity prices, which are again in a secular bull market, would thus contribute to an increase in currently still-depressed global real yields, and thus, create downside in gold. One key risk to our view is that the Fed falls meaningfully behind the curve and lets inflation rise violently, which would put downward pressure on real rates and cause a violent correction in global equity prices - prompting investors to price in an easing in monetary policy. Geopolitics are another key risk, particularly a ratcheting up in North Korea tensions. With our bullish stance on the dollar, we are inclined to short the yellow metal versus the greenback. Moreover, for the past eight years, when net speculative positions in gold have been as elevated as they are today relative to net wagers on the DXY, gold in U.S. dollar terms has tended to weaken (Chart I-15). However, the analysis above suggests that gold could weaken against G10 currencies in aggregate. Thus investors with a more negative dollar view than ours could elect to sell gold against the euro. Agnostic players should short gold equally against the USD and the EUR. Chart I-14Gold And Stocks Don't Like Each Other Gold And Stocks Don't Like Each Other Gold And Stocks Don't Like Each Other Chart I-15Tactical Risk To Gold Tactical Risk To Gold Tactical Risk To Gold Bottom Line: The outlook for gold is negative. As the global economy escapes its deflationary funk and global central banks begin abandoning emergency easing measures, real interest rates will rise and term premia will normalize, which will put downward pressure on gold prices. Additionally, BCA's positive stance on banks is corollary with a negative outlook on gold. The continued bull market in stocks is an additional hurdle for gold. New Zealand: A New Hot Spot Of Populism The formation of the Labour/NZ First/Green coalition has sent ripples through the kiwi. The reaction of investors is fully rational, as the Adern government is carrying a very populist torch, sporting a program of limiting foreign investments in housing, limiting immigration, increasing the minimum wage and creating a dual mandate for the Reserve Bank of New Zealand. The key question is whether this is a fad, or whether something more profound is at play in New Zealand. We worry it is the latter. New Zealand has suffered from a profound increase in inequality since pro-market reforms were implemented in the 1980s. New Zealand's gini coefficient is very elevated, but even more worrisome has been the deteriorating trend. As Chart I-16 illustrates, the ratio of income of the top 20% of households relative to the bottom 20% has been in a steady uptrend. Additionally, this trend is sharper once the cost of housing is incorporated into the equation. Moreover, as Chart I-17 shows, New Zealand has experienced one of the most pronounced increases in housing costs among the G10. Chart I-16Growing Inequalities In New Zealand Reverse Alchemy: How To Transform Gold Into Lead Reverse Alchemy: How To Transform Gold Into Lead Chart I-17Kiwi Housing Is Expensive Reverse Alchemy: How To Transform Gold Into Lead Reverse Alchemy: How To Transform Gold Into Lead It is undeniable that the impact of immigration has been real. Net migration has averaged 24 thousand a year since 2000, on a population of 4.8 million. Moreover, the labor participation rate of immigrants has been higher than that of the general population, reinforcing the perception that immigration has contributed to keeping wage growth low (Chart I-18). The effect of low wage growth - whether caused or not caused by the increase in the foreign-born population - has been to boost household credit demand, pushing the national savings rate into negative territory, something that was required if households were to keep spending. These developments suggest that kiwi populism is not a fad, and is in fact a factor that will remain present in New Zealand politics. It also implies that policies designed to limit foreign investments into housing as well as immigration are indeed popular and will be implemented. What are the economic implications of these developments? Immigration was a key source of growth for New Zealand. As Chart I-19 shows, the growth of the kiwi economy since 1985 has been driven by an increase in the labor force. In fact, over the past five years, 86% of growth has been caused by labor force growth, with a very limited contribution from productivity gains. More concerning, as Chart I-20 shows, 44% of the increase in the population growth since 2012 has been related to immigration. Chart I-18The Narrative: Foreigners Steal Our Jobs The Narrative: Foreigners Steal Our Jobs The Narrative: Foreigners Steal Our Jobs Chart I-19Kiwi Growth: Labor Force Is Key Kiwi Growth: Labor Force Is Key Kiwi Growth: Labor Force Is Key Chart I-20Labor Force Growth Could Halve Reverse Alchemy: How To Transform Gold Into Lead Reverse Alchemy: How To Transform Gold Into Lead Additionally, according to the IMF's Article IV consultation for New Zealand, immigration has boosted output significantly, contributing to total hours worked as well as forcing an increase in the capital stock, which has boosted capex (Table I-1). Hence, lower intakes of foreign-born workers is likely to push down the country's potential growth rate. Limiting immigration in New Zealand could therefore have a significantly negative impact on the country’s neutral rate. As Chart 21 demonstrates, the real neutral rate for New Zealand, as estimated using a Hodrick-Prescott filter, is around 2%. A falling potential growth rate would push down the equilibrium policy rate in New Zealand, limiting how high the RBNZ's terminal policy rate will rise in the future. This points toward downward pressure on the NZD on a long-term basis. Shorting NZD/CAD structurally makes sense at current levels, especially as Canada remains open to immigration and immune to populism, as income inequalities are much more controlled there (Chart I-22). Table I-1Impact Of Immigration On Growth Reverse Alchemy: How To Transform Gold Into Lead Reverse Alchemy: How To Transform Gold Into Lead Chart I-21Kiwi Neutral Rate Has Downside Kiwi Neutral Rate Has Downside Kiwi Neutral Rate Has Downside Chart I-22NZD/CAD: Long-Term Heavy NZD/CAD: Long-Term Heavy NZD/CAD: Long-Term Heavy Limiting immigration in New Zealand could therefore have a significantly negative impact on the country's neutral rate. As Chart I-21 demonstrates, the real neutral rate for New Zealand, as estimated using a Hodrick-Prescott filter, is around 2%. A falling potential Shorter-term, the picture is slightly brighter for the NZD. Credit growth is strong, and is pointing toward an increase in the cash rate next year. Additionally, consumer confidence is high, and the labor market is showing signs of tightness, especially as the output gap stands at 0.87% of GDP (Chart I-23). This tightness in the labor market could easily be catalyzed into higher wage growth, especially as the new government is tabulating a 4.76% increase in the minimum wage in the coming quarters. Thus, BCA continues to expect an uptick in kiwi inflation and higher kiwi rates, even if a dual mandate for the RBNZ is implemented. Our favored way to play this strength in the kiwi remains going short the AUD/NZD. Our valuation model points to a strong sell signal in this cross (Chart I-24). Moreover, speculators are very long the AUD relative to the NZD, which historically has provided a contrarian signal to short it. Additionally, the concentration of power around Chinese President Xi Jinping points towards more reform implementations in China - reforms that we estimate will be targeted at decreasing the reliance of growth on debt-fueled investment while increasing the welfare of households, which should help Chinese consumption. As a result, metals could suffer relative to consumer goods. With New Zealand being a big exporter of foodstuffs and dairy products, this should represent a positive terms-of-trade shock for the kiwi relative to the Aussie. Chart I-23Short-Term Positives In New Zealand Short-Term Positives In New Zealand Short-Term Positives In New Zealand Chart I-24Downside Risk To AUD/NZD Downside Risk To AUD/NZD Downside Risk To AUD/NZD Bottom Line: The increase in populism in New Zealand is being fueled by a sharp increase in inequalities and rising housing costs. Immigration, rightly or wrongly, has been blamed in the public narrative for these ills. The measures announced by the Adern government target these issues head on, and we expect they will be implemented. This hurts New Zealand's long-term growth profile, and thus the terminal rate hit by the RBNZ this cycle. This could hurt the NZD on a structural basis. Tactically, it still makes sense to be short AUD/NZD. A Word On The BoE The BoE increased rates this week for the first time in a decade, but now acknowledges that current SONIA pricing is correct, removing its mention that risks are skewed toward higher rates than anticipated by the market. The pound sold off sharply on the news. Consumer confidence and retailer orders point to further slowdown in consumption. Thus, we think the British OIS curve is currently well priced, limiting any potential rebound in the GBP. Brexit continues to spook markets, rightfully. The political theater is far from over, and the continued uncertainty is likely to weigh further on the U.K. economy. This is likely to generate additional downside risk in the pound over the coming months. Thus, on balance, our current assessment is that the risks are too high to make a bullish bet on the GBP for now. A progress in the negotiations between the U.K. and the EU is needed before investors can buy the GBP, a currency that is cheap on a long-term basis. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant haarisa@bcaresearch.com 1 Please see Global Fixed Income Strategy Weekly Report, titled "Follow The Fed, Ignore The Bank Of England" dated September 19, 2017, available at gfis.bcaresearch.com 2 Please see Global Alpha Sector Strategy Weekly Report, titled "Buy The Breakout" dated May 5, 2017, available at gss.bcaresearch.com and U.S. Equity Strategy Weekly Report, titled "Girding For A Breakout?" dated May 1, 2017, available at uses.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: Core PCE was unchanged at 1.3%, and in line with expectations; Headline PCE was also unchanged at 1.6%; ISM Prices Paid came in at 68.5, beating expectations of 68; ISM Manufacturing came in weaker than expected. In other news, Jerome Powell is President Trump's pick as the next Fed chairman to replace Janet Yellen. Market reaction was muted as Powell is expected to continue in Yellen's footsteps and hike rates at a similar pace. While the Fed decided to leave rates unchanged this month, the probability of a December rate hike went up to 98%. We expect the USD bull market to strengthen next year when inflation re-emerges. Report Links: It's Not My Cross To Bear - October 27, 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 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Data out of Europe was mixed: German and Italian inflation underperformed expectations and weakened compared to last month, while French inflation beat expectations; Overall European headline and core inflation also mixed expectations, coming in at 1.4% and 1.1% respectively; European preliminary GDP, however, beat expectations of 2.4%, coming in at 2.5%; The unemployment rate dropped to 8.9% for the euro area; The euro was up on Thursday after the nomination of Jerome Powell as Fed chair. His nomination represents a continuity of monetary policy. Despite this, we believe the re-emergence of inflation will cause the Fed to continue hiking after the December hike, deepening downward pressure on the euro next year. Report Links: Market Update - October 27, 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 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 Japanese data has been mixed: Housing starts yearly growth came above expectations, coming in at -2.9%. However, housing starts did accelerate their contraction from August, when they were falling by 2% year-on-year. Industrial Production yearly growth came in above expectations, at 2.5%. However the jobs-to-applicants ratio came below expectations, staying put at 1.52. On Tuesday the BoJ left rates unchanged. Additionally the committee vowed to keep 10-year government bond yield around 0% and to continue their ETF purchases. More importantly, however, was the Bank of Japan's change to its outlook for inflation, which was decreased for this year. We continue to believe that deflation is too entrenched in Japan for the BoJ to change its policy stand. Thus, we expect USD/JPY to keep grinding higher, as U.S. monetary policy becomes more hawkish vis-à-vis Japan. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 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 surprised to the upside: Mortgage Approvals also outperformed expectations, coming in at 66.232 thousand. Moreover Nationwide house price yearly growth also outperformed, coming at 2.5% Both Markit Manufacturing PMI and Construction PMI outperformed, coming in at 56.3 and 50.8 respectively. The BoE hiked rates yesterday by 25 basis points as expected. Moreover, the committee also voted unanimously to maintain the stock of UK government bond purchases. However, the committee also acknowledged that inflation was not be the only effect of Brexit on the economy. They highlighted that uncertainty about the exit from the European Union was hurting activity despite a positive global growth backdrop. Overall, we think that the BoE will not deviate from the interest rate path priced into the OIS curve. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 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: HIA New Home Sales contracted by 6.1%; AiG Performance of Manufacturing Index came in at 51.1, less than the previous 54.2; Exports increased by 3%, while imports stayed flat at 0%; The trade balance increased to AUD 1.745 bn, compared to the expected AUD 1.2 bn, and above the previous AUD 873 mn. The AUD was up on the release of the trade balance. But underlying slack in the economy, which worries RBA officials, points to a low fair value for the AUD. The AUD will be the poorest performer out of the commodity currencies, due to the relative strength of those economies and of oil relative to metals. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 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 positive: The unemployment rate came below expectations at 4.6%, it also decreased from last quarter's 4.8% reading. The participation rate came above expectations, at 71.1%. It also increased from 70% on the previous quarter. The Labour cost Index came in line with expectations at 1.9% yearly growth. However it increased from 1.6% in the previous quarter. Overall the New Zealand economy looks very strong. This should warrant a hike by the RBNZ. However the new government create a new set of long-term risks. The elected government is a response to the high inequality and high migration that the country had experienced in the recent years. Overall the plans to reduce immigration and install a double mandate to the RBNZ are bearish for the NZD, as the neutral rate of New Zealand would be structurally lowered. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 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 has been weak recently: The raw material price index contracted by 0.1%; Industrial product prices contracted at a 0.3% monthly rate; GDP also contracted at a 0.1% monthly pace; Manufacturing PMI came out at 54.3, lower than the previous 55. In addition to this, Poloz identified several issues with the Canadian economy in his speech on Tuesday. These included the deflationary effects of e-commerce, slack in the labor market, subdued wage growth, and the elevated level of household debt. The probability of a rate hike has fallen to 22% for December, and it only rises above 50% in March next year. The CAD has lost a lot of its value since the BoC began hiking, but we believe it will resume hiking next year. Increasing oil prices will also mean that that CAD will outperform other G10 currencies. Report Links: Market Update - October 27, 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 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 positive: The SVME Purchasing Manager's Index came above expectations at 62 in October. It also increased from the September reading. The KOF leading indicator also outperformed expectations significantly, coming at 109.1. EUR/CHF continues to climb unabated and is now only 3% from where it was before the SNB let the franc appreciate in January of 2015. Overall we see little indication that the SNB would let the franc appreciate again in the near future. On Wednesday, SNB Vice President Zurbruegg continued to talk down the franc by stating that a stronger CHF would cause a growth slowdown and that the CHF is still highly valued. Thus we expect downside in EUR/CHF to be limited for the time being. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 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: Retail sales growth underperformed expectations, as they contracted by 0.8% in September. However Norway's credit indicator surprised to the upside, coming in at 5.8%. Since September USD/NOK has appreciated by nearly 6%. This has been in an environment where oil has rallied by nearly 20%. Although this divergence might seem counterintuitive, it confirms our previous findings: USD/NOK is much more sensitive to real rate differentials than to oil prices. Inflationary pressures are still very tepid in Norway, while inflation is set to go higher in the U.S. These factors will further amplify the monetary policy divergences between these 2 countries, and consequently propel USD/NOK higher. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 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 Manufacturing PMI decreased to 59.3 from 63.7, below the expected 62. EUR/SEK has appreciated to June levels, implying that markets have priced out any potential hawkishness by the Riksbank. Similarly, USD/SEK has risen by 6.2% from September lows. This is due to the re-chairing of Stefan Ingves, known for negative rates and quantitative easing. On the opposite side of the trade, President Trump elected Jerome Powell as the next Fed chair who will most likely continue the rate hike path highlighted by Janet Yellen. This will add further upward pressure on USD/SEK. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

Highlights The synchronized upturn lifting global GDPs will pull demand for stainless steel higher, as consumers increase purchases of autos, ovens, refrigerators, freezers and other household durables. That's good news for nickel, since roughly two-thirds of demand for the metal worldwide is accounted for by the stainless steel market. This means the current nickel supply deficit will persist into 2018, which will be supportive of prices over the next 3 - 6 months (Chart of the Week). Going into 2H18, however, we expect nickel supply growth to pick up, which is keeping us neutral on the metal for now. Chart of the WeekDeficit Will Further Support Prices Into 1H2018 Deficit Will Further Support Prices Into 1H2018 Deficit Will Further Support Prices Into 1H2018 Energy: Overweight. Leaders of OPEC 2.0 are strongly signaling they will extend their 1.8mm b/d production cuts to end-December 2018, when they meet at the end of the month. This could lift our 2018 Brent and WTI forecasts - $65/bbl and $63/bbl, respectively - by as much as $5.00/bbl, should it materialize. We remain long $55/bbl calls vs. short $60/bbl Brent and WTI call spreads expiring in May, July and December 2018; they are up an average 26.5%. In anticipation of a more pronounced backwardation arising from tighter supply-demand fundamentals in the WTI forward curve, we are getting long Jul/18 WTI vs. short Dec/18 WTI at tonight's close. Base Metals: Neutral. Nickel markets will remain in deficit into next year, as stainless steel demand is lifted on the back of the synchronized global upturn in GDP (see below). Precious Metals: Neutral. Gold markets appear to have fully discounted the appointment of Jerome Powell as the next Fed Chair, trading on either side of $1,280/oz since the beginning of October. Ags/Softs: Neutral. U.S. ag officials on the ground in Argentina reported corn production for the 2017/18 crop year is projected to be 40mm tons, or 2mm tons below the USDA's official estimate, due to smaller areas planted in that country. Wheat production is expected to be 16.8mm tons, 700k tons below the USDA's official forecast, due to excess rain. Directionally, these unofficial posts are supportive of our long corn vs. short wheat position, which is up 4% since inception on October 5, 2017. Feature Focus On Demand For Nickel Price Guidance Synchronized global GDP growth will fuel demand for consumer durables - autos, refrigerators, freezers, etc. - which will lift demand for stainless steel. This, in turn, will increase consumption of nickel, given the stainless steel market accounts for some two-thirds of nickel demand (Chart 2). Receding fears of an imminent slowdown in China, which accounts for 46% of global nickel demand, also is supportive: China's manufacturing PMI currently stands at multi-year highs (Chart 3). Likewise, the pace of investment in China's real estate, automobile, infrastructure, and transportation sectors - all of which are stainless steel end users - remains strong (Chart 4). Chart 2Consumer Durables Demand##BR##Will Lift Nickle Consumption Still Some Upside In The Nickel Market Still Some Upside In The Nickel Market Chart 3Easing Fears Of China##BR##Slowdown Also Supportive Easing Fears Of China Slowdown Also Supportive Easing Fears Of China Slowdown Also Supportive Chart 4Stainless Steel End-Use##BR##Markets Growing Stainless Steel End-Use Markets Growing Stainless Steel End-Use Markets Growing We do not foresee a near-term slowdown in China's consumer sector, following the conclusion of the 19th National Congress of the Communist Party of China. On the contrary, we expect stainless steel demand will remain strong, and a bullish factor in nickel fundamentals going into the beginning of next year.1 However, we are watching the evolution of China's economy closely, now that President Xi has consolidated power.2 Weak ore output from nickel mines was the main culprit behind the deteriorating nickel balance since 2014. Although the global deficit has contracted significantly from its 2016 record, declining consumption - rather than accelerating production - was the driver of the improvement in the supply-demand balance to this point. Increased Supply Won't Be Enough In The Short Run Over the short term, growth in stainless steel demand will outpace increased nickel ore output, which is slowly adjusting to the return of Indonesian ore exports following the 2014 ban. Indonesia's ban on nickel-ore exports fundamentally shifted the market in several ways. In 2013, just before the export ban, China's imports of Indonesian nickel ore stood at more than 41mm MT. Providing almost 60% of China's nickel ore imports, Indonesia was vital to China's thriving nickel pig iron (NPI) industry - which uses low grade nickel ores to produce a cheaper alternative to refined nickel. Output of NPI is then used in the production of stainless-steel. An immediate consequence of the Indonesian export ban was the emergence of the Philippines as China's main nickel ore supplier. It exported 29.6mm MT of nickel ores to China in 2013, accounting for the remaining 40% or so of China's nickel ore imports then. With the Indonesian export ban, the Philippines became China's top, and practically only, supplier of nickel ores (Chart 5). Although the Philippines captured almost all of China's nickel ore trade, it failed to grow the volume of its exports. This had a profound impact on China's domestic processing and refining market. Restricted access to nickel ores meant that China no longer had the necessary supply to keep its NPI industry churning. Instead, it turned to NPI imports, which grew more than 5-fold in the three years following the ban (Chart 6). Similarly, China's unwrought nickel net imports stand above pre-ban levels. The loss of access to Indonesian ores also coincided with a fall in China's laterite inventory.3 Chart 5Indonesia Export Ban Crippled China Imports Indonesia Export Ban Crippled China Imports Indonesia Export Ban Crippled China Imports Chart 6China NPI Imports Up 5-Fold Since 2013 China NPI Imports Up 5-Fold Since 2013 China NPI Imports Up 5-Fold Since 2013 Loss Of Ore Exports Created Refined Nickel Deficit The shrinking supply of nickel ores had a knock-on effect on refined supply. Global production of refined nickel - which was expanding by an average 11.4% yoy between 2011 - 2013 collapsed by 7.3% in 2014, and has remained largely unchanged since. At the same time, demand remained strong, growing by 11.4% and 7.4% in 2015 and 2016, respectively. The combined characteristics of shriveling production amid stable demand put nickel in a large deficit in 2016. This is also evidenced in LME inventory data, which by the end of last year was down 20% from its mid-2015 peak (Chart 7). Chart 7Inventory Draw On Shriveling Production Inventory Draw On Shriveling Production Inventory Draw On Shriveling Production However, Indonesia's export ban appears to have attracted some $6 billion in nickel smelter investments, which allowed it to capture value-added revenues above and beyond those associated with simply exporting raw ores. In fact, many of the NPI operating plants in Indonesia - now in excess of 20 - were built by Chinese companies looking to circumvent the ban by off-shoring NPI production. While Indonesia's minerals export ban was partially lifted in May of this year, we do not expect the market to suddenly return to its pre-2014 fundamentals. The government still maintains an export quota, and has limited the granting of exemptions to companies that have already constructed a value-add processing plant within Indonesia. Instead, we expect Indonesia will lift the quota gradually. Just this past week, the government granted state-owned miner Aneka Tambang additional export rights equal to 1.25mm MT of laterite ore over the next 12 months. The company's initial export capacity, approved in March, was 2.7mm MT.4 This would be a windfall for China's domestic nickel processing plants as their unrefined ore supplies from Indonesia would increase. However, longer term, the reversal of the country's export ban could eventually lead to nickel smelter closures in Indonesia. Virtual Dragon is a China-backed NPI smelter in Indonesia which shipped its first 10k MT to China in August and has a 600k MT annual output target in its first stage. Yet the smelter is concerned with the impact of the ban's reversal on its longer run plan, and reportedly put a $1.83 billion expansion on hold following the policy change.5 In any case, we expect the complete lifting of the ban to transpire gradually, rather than shock the market. Consequently, we do not foresee a sudden flooding of nickel ores to international markets. Bottom Line: Indonesia's ban on nickel ore exports altered trade flows and reversed production trends. While the eventual lifting of the export quotas will change the nickel market, we expect this to transpire gradually. Thus the policy U-turn is not a bearish force in our near term assessment of the nickel market. Stainless Steel Demand To Dominate In Near Term Despite Indonesia's move towards scraping its export ban, we expect strong consumption to drive the evolution of the market in the near term. Solid demand from the stainless steel sector will dominate over supply side growth, and we expect the market to remain in deficit until early next year. In fact, despite the partial return of Indonesian ores to global markets, nickel ore production grew by a modest 1.3% yoy while refined production fell 4.2% yoy in the first 8 months of 2017. A 65% increase in refined output from Indonesia could not offset declines from many of the top producers, including an 11.3%, 22%, and 18.5% yoy decrease in production from China, Russia, and Brazil, respectively. Chart 8Stainless Steel Demand To##BR##Recharge Nickel Market Stainless Steel Demand To Recharge Nickel Market Stainless Steel Demand To Recharge Nickel Market China's share of global stainless steel production has stalled at around 52% since Indonesia's export ban. Stainless steel production was strong - growing an average of 22.4% yoy prior to 2014 (Chart 8). Although it continues to grow, it is doing so at a slower rate. In fact, production stayed largely unchanged last year. We expect the re-emergence of Indonesia's nickel ores will recharge China's stainless steel market. Furthermore, reports of capacity closures in Shandong will stifle China's NPI production. These closures - which aim to reduce smog and pollution during the wintertime - are expected to begin next month and last until mid-March. Thus even with an increase in global ore exports, China's NPI production will be limited in the short run by domestic capacity closures and will continue to depend on imports. Eventually, we expect a supply boost from the return of Indonesian ores to global markets. Refined production has been falling by 2.5% per year since the ban, compared to an average annual production growth rate of 11.4% in the three years prior to the ban. However, we do not expect production to immediately return to the pre-2014 growth pace. While global production has been on the uptrend since June, a comeback in demand will keep nickel in shortage. In fact, the supply deficit would have been significantly wider were it not for declining consumption so far this year. Global refined nickel consumption fell a staggering 7.8% yoy in the first 8 months of 2017, reflecting the 24.8% yoy decline in Chinese consumption. Thus, nickel demand from its top user - the stainless steel sector - will determine the market's direction for the remainder of this year and the beginning of next. The main risk to this view comes from a stronger-than-expected U.S. dollar. This would make the commodity more expensive to holders of other currencies, reducing its demand. Furthermore, while we do not anticipate it, a sudden - rather than gradual - reversal of Indonesia's export ban would tilt the balance to a surplus. Bottom Line: Declining refined nickel production from top producers this year is worrying. However, a simultaneous fall in China's demand - the world's top consumer - means that the net effect on the nickel balance was a shrinking of the supply deficit. Going forward, we expect a gradual increase in supply on the back of a steady expansion of Indonesian ore export quotas. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Given the slow adoption of EVs we project over the next 20 years or so, we do not expect Electric Vehicle (EV) batteries to be a material source of demand growth for nickel for the next 3 - 5 years. Please see "Electric Vehicles Part 3: EVs' Impact on Oil Markets Muted Over Next 20 Years," part of a three-part Special Report jointly researched and written by BCA Research's Technology Sector Strategy, Energy Sector Strategy and Commodity & Energy Strategy. It was published August 29, 2017, and is available at ces.bcaresearch.com. EV battery demand currently accounts for 70k TH, or 3%, of nickel usage. According to estimates from UBS, nickel demand from EVs will reach 300-900k MT annually by 2025. Goldman Sachs are much more conservative in their nickel demand estimate, expecting it to remain under 100k MT prior to 2020, and to grow to 200k MT thereafter. 2 Please see BCA Research's Geopolitical Strategy and China Investment Strategy Special Report "China: Party Congress Ends ... So What?," published on November 1, 2017. Available at gps.bcaresearch.com and cis.bcaresearch.com. 3 Laterites are a type of soil containing nickel, and account for more than 70% of world nickel reserves, according to "Geology for Investors." Please see https://www.geologyforinvestors.com/nickel-laterites/ 4 Please see "PT Antam approved to export another 1.25m tonnes of nickel ore from Indonesia," dated October 26, 2017, available at metalbulletin.com. 5 Please see "Indonesia's Virtue Dragon smelter ships first nickel pig iron," dated September 28, 2017, available at reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Still Some Upside In The Nickel Market Still Some Upside In The Nickel Market Trades Closed in 2017 Summary of Trades Closed in 2016

Dear Client, The attached report on China’s just-completed nineteenth National Party Congress marks the culmination of six years of political analysis by BCA’s Geopolitical Strategy. In it, my colleague Matt Gertken posits that President Xi Jinping’s domestic political constraints have significantly eased, allowing his administration to intensify its preference for structural reform. Our cardinal analytical rule holds that policymaker preferences are optional and subject to constraints, whereas constraints are neither optional nor subject to preferences. As a matter of methodology, we focus on constraints. In China, Xi faced formidable constraints when he took power five years ago, which is why we pushed against the enthusiastic narrative at the time that he would transform China through supply-side reforms. This narrative, strongest in the wake of the October 2013 Third Plenum, has not materialized in line with investor expectations thus far. In this report, we argue that it is time to adjust the view on China. Xi has amassed substantial political capital thanks to his anti-corruption campaign, centralization of power, and other actions largely popular with the middle class. Investors are today missing this point because they are disappointed with the lack of genuine progress since 2012. We expect that President Xi will begin spending this political capital by favoring supply-side reforms, especially by reining in the rampant credit growth that has underpinned China’s investment-led economic model. In the short term, this means that politics in China will evolve from a tailwind to a headwind to growth. In the long term, it is too soon to say what it means. For investors, however, it means that today’s synchronized global growth recovery may be at risk of a policy-induced growth slowdown in China. I sincerely hope you enjoy our report. If you are interested in similar investment-relevant geopolitical analysis, please do not hesitate to contact us for a sample of our work. Kindest Regards, Marko Papic, Senior Vice President Chief Geopolitical Strategist Highlights Xi Jinping has shed domestic political constraints that have been in place since 2012; The lack of constraints suggests his reform agenda will intensify over the next 12 months; The use of anti-corruption agencies to enforce economic policy suggests that reform implementation will become more effective; Chinese politics are shifting from a tailwind to a headwind for global growth and EM assets. Feature Chart 1Stability Continues After Party Congress? Stability Continues After Party Congress? Stability Continues After Party Congress? China's nineteenth National Party Congress concluded on October 25 with the new top seven leaders - the members of the Politburo Standing Committee (PSC) - taking the stage in the Great Hall of the People. The party congress is a five-year leadership reshuffle that, in this case, marks the halfway point of President Xi Jinping's term in office.1 President Xi was the center of attention throughout the event. It is widely perceived that he is the most powerful Chinese leader since Deng Xiaoping. The Communist Party chose to elevate his personal power in conspicuous ways that raises political uncertainties about the succession in 2022 as well as about the future trajectory of Chinese policy, including economic policy. BCA's Geopolitical Strategy has awaited this transition since 2012, when President Xi and Premier Li Keqiang took over the top two positions in China.2 While we are inherently skeptical of Xi's grandiose reform agenda, we are also deeply aware of the importance of political constraints in determining economic policy outcomes - and Xi has just overcome significant domestic constraints. If Xi accelerates and intensifies his reforms next year - particularly deleveraging and industrial restructuring - he will add volatility to Chinese risk assets and create a drag on Chinese growth. Xi's personal concentration of power could be an enabling factor in driving reforms. But it will certainly be a source of higher political uncertainty over the next five years (Chart 1), especially as the 2022 succession approaches. Therefore a lack of reform would be a noxious combination. Finally, China's ascendancy increases the phenomenon of global multipolarity - it is a challenge to the U.S.-led system and will eventually produce a reaction, most likely a negative one.3 In short, Chinese political and geopolitical risk is understated. This situation presents a range of risks and opportunities for investors, but it is broadly a headwind for global growth and EM assets. A Chinese "policy mistake" is also a risk to our House View of being overweight equities and underweight bonds for the next 12 months. Back To 2012 When Xi rose to power in 2012, it was widely known that China's economy had reached a pivotal moment. Exports were declining as a share of GDP in the wake of the Great Recession and end of the U.S. "debt super-cycle," and investment was weakening as the country's massive fiscal and credit stimulus wore off (Chart 2). Meanwhile the Communist Party faced a crisis of legitimacy, with an emergent middle class making ever greater demands on the system (Chart 3). The rapid rise in household income over preceding years, combined with high income inequality and poor quality of life, raised the prospect of serious socio-political challenges to single-party rule.4 President Hu Jintao searched for ways to strengthen state control over an increasingly restless society, while outgoing Premier Wen Jiabao warned openly that China's economy was unsustainable and imbalanced and that political reform would be an "urgent task." Hu Jintao's farewell address at the eighteenth party congress (2012) reflected the party's grave concerns. His successor, Xi Jinping, was in charge of drafting the report. This relationship highlighted an important degree of party consensus. The report called for fighting corruption and disciplining the party, while doing more to protect households from the negative externalities of the past decade's rapid growth, including pollution (Chart 4). Chart 2Xi Took Power Amid Economic Transition Xi Took Power Amid Economic Transition Xi Took Power Amid Economic Transition Chart 3The Communist Party's Newest Constraint The Communist Party's Newest Constraint The Communist Party's Newest Constraint Chart 4Xi Took Power Amid Instability Risks Xi Took Power Amid Instability Risks Xi Took Power Amid Instability Risks It also outlined China's hopes of becoming a more consequential global player through acquiring naval power and forging a new, peer relationship with the United States. The overriding imperative was to win back support and legitimacy for the party, lest it fall victim to the fate of the world's other Marxist-Leninist regimes - i.e. internal socio-economic sclerosis and external pressure from the U.S.-led, democratic-capitalist world order. Xi Jinping took over at this juncture, using the 2012 work report as his guideline for an ambitious policy agenda. Xi's main goals centered on power: namely, ensuring regime survival at home and increasing China's international clout abroad. Specifically, the Xi administration sought to (1) centralize political control so that difficult choices could be made and implemented effectively; (2) improve governance so that public discontent could be mitigated over the long run; and (3) restructure the economy so that productivity growth could remain robust in the face of sharply declining labor force growth, thus stabilizing the potential GDP growth rate.5 Obviously there was no guarantee that Xi would be successful. China's response to the Global Financial Crisis had required a large-scale decentralization of control: local governments, banks, state-owned enterprises and shadow lenders were encouraged to lever up and grow amid the global collapse (Chart 5). This created imbalances and liabilities for the central leadership while also creating new economic (and hence political) centers of power outside Beijing. Chart 5aLocal Government Spending Unleashed... Local Government Spending Unleashed... Local Government Spending Unleashed... Chart 5b...And Shadow Lending Too ...And Shadow Lending Too ...And Shadow Lending Too The central leadership also seemed to be losing control of the provinces: regional and institutional powerbrokers had emerged, challenging the party's hierarchy, and there was even reason to believe that the armed forces were deviating from central leadership.6 Without control of the local governments and other key institutions, any reform agenda would get bogged down. Finally, the political cycle was not particularly favorable to Xi. While the line-up of the all-powerful PSC looked favorable from 2012-17, the next crop of Communist leaders set to move up the ladder in 2017 seemed likely to constrain him. Moreover, the previous two presidents had chosen Xi's successors for 2022, according to party norms. Xi had very little room for maneuver - and this was negative for his policy outlook overall. As such, BCA's Geopolitical Strategy poured cold water on the more enthusiastic forecasts of economic reforms throughout Xi's first term. Our assessment was that he would focus on anti-corruption and governance reforms first and only attempt genuine economic reforms once his political capital grew significantly. Bottom Line: Xi Jinping faced major obstacles to his policy agenda of centralization, governance and economic reform in 2012. He faced a large and restless middle class, the difficulty of reining in local governments and state institutions, and the likelihood that China's previous top leaders would constrain his maneuverability in 2017 and 2022. Xi's First Term A lot has changed over the past five years. First, both global demand for Chinese goods and Chinese domestic demand have held up rather well, giving China a badly needed cushion during its economic transition. Steady consumption growth has partially offset the blow from declining investment, while Chinese exports have grown well, often faster than global trade (Chart 6).7 Second, Xi has consolidated power extensively within the party, the army, and other institutions. He executed the most aggressive purge that the party has seen in decades, enabling him to rebuild some public trust among a middle class worn out by corruption, as well as to remove political rivals (Chart 7). He also launched an extensive restructuring of the People's Liberation Army, its organizational structure and personnel, ensuring that "the party controls the gun."8 And he intensified social control, particularly in the online realm. Chart 6Changing The Economic Model Changing The Economic Model Changing The Economic Model Chart 7Anti-Corruption Campaign Still Going Anti-Corruption Campaign Still Going Anti-Corruption Campaign Still Going Symbolically, Xi was anointed the "core" of the Communist Party by the political elite in late 2016. Economic reform, however, has been compromised by Xi's focus on consolidating political power. True, he and Premier Li Keqiang tinkered with various policies to cut red tape, simplify domestic taxes, attract foreign investment, and encourage better SOE management, but none of the reforms launched over the past five years were painful and thus none were significant.9 Nowhere was this more apparent than during 2015-16, when economic and financial instability caused the Xi administration to delay reform initiatives and focus on reforming the economy. Beijing increased infrastructure spending, bailed out the local governments, depreciated the RMB, and imposed capital controls (Chart 8). "Old China," state-owned China, was the primary beneficiary. The stimulus-fueled rebound helped stabilize the global economy in 2016-17, particularly commodity-producing emerging markets, but it exacerbated China's internal problems - slow productivity growth, excessive debt creation, weak private sector investment, and waning foreign investment (Chart 9). Chart 8State Interventions In 2015-16 State Interventions In 2015-16 State Interventions In 2015-16 Chart 9Economic Reforms Still Needed Economic Reforms Still Needed Economic Reforms Still Needed The upside, however, was stability, which enabled Xi to approach the nineteenth National Party Congress from a position of strength. Now that the party congress has concluded, we can say that Xi has notched a series of significant "victories" and that his political capital is overflowing: Xi Jinping Thought: The congress voted to enshrine Xi's name into its constitution (Table 1), with a phrasing that echoes "Mao Zedong Thought," hence elevating Xi to immense moral authority within the party. The name of Xi's philosophy, "Socialism with Chinese Characteristics for a New Era," makes a slight adjustment to Deng Xiaoping's market-friendly philosophy. In other words, Xi's authority stems from his providing a synthesis of the regime's greatest two leaders: Mao's single-party Communist rule is being reaffirmed, but Deng's attention to economic reality and the need for pragmatic policies has also been preserved. As we have argued, this constitutional change is a reflection of the fact that Xi has already positioned himself to be the most influential leader well into the 2020s. Table 1Xi Jinping Thought China: Party Congress Ends ... So What? China: Party Congress Ends ... So What? Xi removes his successors: Xi managed to exclude any of China's "sixth generation" of leaders from the Politburo Standing Committee. He thus broke a very important (albeit informal) party norm. The norm was created under Deng Xiaoping to ensure a smooth transition of power, unlike the power struggle that occurred upon Mao's death. Now Xi will have a greater hand in choosing his successor, or even staying in power beyond 2022. This aids in the process of centralization, but it may well prove a step backwards in terms of governance and reform - that remains to be seen. It is a source of higher political uncertainty going forward. Xi dominates the Politburo: Xi prevented his predecessor Hu Jintao's loyalists from gaining a majority on the Politburo Standing Committee, as they seemed lined up to do in 2012. The line-up of the new Politburo and Politburo Standing Committee broadly indicates that Xi and his faction are the dominant force (Table 2). Taken with Xi's personal power, this is significant political capital with which the new administration can push its priorities, whatever they may be. Xi gets a new inquisitor: The Central Commission for Discipline Inspection (CDIC) is the party's internal watchdog. It has taken the leading role in the sweeping party purge and anti-corruption campaign over the past five years. Xi removed its chief, the hugely influential Wang Qishan, by reinforcing the retirement age and two-term PSC limit - a notable case of institutional norms being upheld. He put one of his loyalists, Zhao Leji, in this role instead. The CDIC will have a huge role over the next five years, and a market-relevant one, as we discuss below. Table 2The Magnificent Seven: China's New Politburo Standing Committee China: Party Congress Ends ... So What? China: Party Congress Ends ... So What? The above conclusions raise the possibility that Xi has become excessively powerful, that political institutions in China are being eroded by personal rule, and that political risks are set to explode upward in the near future. However, it is too soon to declare that Xi has staged a Maoist "power grab." There are reasons to think that Xi's accumulation of power has not overturned the delicate internal balances within the top leadership bodies.10 The result is in keeping with what we expected in our Strategic Outlook last December: Xi Jinping has amassed formidable political capital, but he has not destabilized the Chinese political system.11 He is a strongman leader within the established political system of an authoritarian state - he is not a tyrant seizing power in a bloodless revolution. (At least, not yet.) This is broadly positive for China's policy continuity and political framework - and in this sense it is also broadly market-positive, being an outgrowth of the status quo rather than a disruptive break from it. China's leaders continue to be career politicians, trained in law or economics, with considerable executive experience in governing and limited business or military experience, all unified in the name of regime preservation (Chart 10). Over the long run, this suggests that China's "Socialist Put" remains intact, i.e. that the state will intervene to prevent a crash landing.12 Nevertheless, an important corollary of the above is that Xi holds the balance, and hence there are no longer any major domestic political or governmental constraints to prevent him from pursuing his policy agenda - especially over the next 12 months, when his political capital is still fresh and the economic backdrop is favorable. The fact that Xi emphasized "sustainable and sound" growth, deliberately excluded GDP growth targets beyond 2021, and altered the definition of the Communist Party's so-called "principal contradiction" in order to prioritize quality-of-life improvements, suggests that the reform agenda is about to get rebooted. Bottom Line: Xi Jinping has consolidated power extensively, but he has not staged a silent coup d' état or overthrown the balance of power within the Communist Party. This suggests that Xi's policies and reforms will intensify over the next year. Chart 10Characteristics Of Chinese Rulers Mostly Unchanged Since 2012 China: Party Congress Ends ... So What? China: Party Congress Ends ... So What? Xi's Second Term: What To Expect Instead of playing it safe in the lead-up to the all-important party congress over the past twelve months, Xi surprised the markets with a series of regulatory actions designed to tamp down the property bubble, regulate the financial markets, punish speculation, and reduce industrial overcapacity and pollution (Chart 11).13 This tightening of policy strongly signaled that Xi's appetite for political risk is rising in keeping with his growing political capital. Beijing is signaling that it aims to continue with tougher financial, industrial and environmental reforms in the aftermath of the party congress. In particular, systemic financial risk has been identified as a risk to the state's overall stability. Of course, China is unlikely to sharply reduce the ratio of total debt-to-GDP out of an ill-advised, self-imposed bout of austerity. But the Xi administration is likely to suppress its growth rate (Chart 12), as well as to continue cracking down on specific institutions and financial practices deemed to be excessively risky or under-regulated, as has occurred this year in insurance and shadow lending.14 Chart 11China's Borrowing Costs Rising China's Borrowing Costs Rising China's Borrowing Costs Rising Chart 12Debt Growth Faces Tougher Controls Debt Growth Faces Tougher Controls Debt Growth Faces Tougher Controls This financial focus is clear from top-level appointments and meetings in 2017, including a special Politburo meeting on financial risks in April and the once-in-five-years Central Financial Work Conference in July.15 The latter declared new regulatory powers for the central bank that will be put into place in the coming 12 months. The head of the new Financial Stability and Development Committee to oversee this work will likely be named, along with a replacement for the long-serving People's Bank of China Governor Zhou Xiaochuan. This change will initiate a new generation of leadership in the central bank, and one ostensibly directed at overseeing stricter macro-prudential controls.16 Another outcome of the financial conference was the warning that, going forward, local government officials will be held accountable over the course of their entire lives if they allow excessive financial risks and debt to build up under their watch.17 These developments suggest that policy will become a headwind to growth next year. We would expect downside risks to China's implicit 6.5% growth target. Why should the new deleveraging campaign have any more effect than similar efforts in the past? Aside from Xi's stronger position to enforce policies - explained above - the nineteenth party congress reinforced an important trend in policy implementation. The Xi administration has been using the CDIC, the party's anti-corruption unit, as a political tool to ensure broader policy enforcement. We have observed this trend over the past year both in the financial regulatory crackdown and the anti-pollution and overcapacity crackdown.18 Anti-corruption officials can compel more serious implementation from local governments, SOE managers, and others because they threaten to impose job losses or jail time, rather than mere fines. The CDIC appointed two new officials to oversee its operations in China's financial regulators just as the party congress was getting underway. Moreover, on the final day of the party congress, officials have announced that corruption investigations will be conducted into the commercial housing sector.19 The message is that the regulatory storm will expand - and will have teeth. Xi went a step further at the party congress by declaring the creation of a National Supervisory Commission, which will oversee the next phase of the anti-corruption campaign.20 This commission will expand the campaign outside the ranks of the Communist Party - where it has operated so far - to the government as a whole, i.e. the state administration and bureaucracy. It implies that every official from China's top ministries down to its lowest-level governments will be subjected to new forces of scrutiny. If this effort resembles the CDIC's role in hastening compliance in other areas of economic policy, then it will be a powerful tool for the Xi administration as it attempts to engineer a top-down restructuring of China's governance and economy. An aggressive new regulatory push, with the threat of corruption charges, in China's financial and industrial sectors would create a powerful drag on economic growth. It could easily send a chill down the spines of government officials, prompting them to cut or delay key investment decisions, as the initial anti-corruption campaign did in 2013-14.21 China's leaders will eventually attempt to offset any disorderly slowdown from reform measures with additional stimulus. However, given that the deleveraging campaign cuts to the heart of the financial sector, and that sharp new tools are being put to use, we would think that the probability of a "policy mistake" is going up. Bottom Line: Risks to Chinese economy and assets are rising as politics shifts from being a tailwind to a headwind. Xi Jinping faces few policy constraints and has shown appetite for greater political risk in the pursuit of his reform agenda. His administration has signaled that China's financial imbalances pose a threat to overall stability and require tougher regulation. New enforcement mechanisms - particularly those connected with anti-corruption efforts - threaten to bring the financial sector, as well as local government debt, under the spotlight and to create a chilling-effect among local officials. Investment Conclusions On one hand, any genuine attempt to hasten the transition of China's economy to consumer-led growth, de-emphasize GDP growth targets, and pare back overbuilt and heavy-polluting industry is highly consequential and will redistribute global growth.22 Table 3Post-Party Congress Scenarios And Probabilities China: Party Congress Ends ... So What? China: Party Congress Ends ... So What? Broadly speaking, the transition is negative for Chinese growth in the short term, but positive in the long term, as productivity trends would improve. It is negative for China's heavy industry, yet positive for technology, health and education; negative for commodities tied to the old economy (e.g. coal, iron ore, and diesel), but positive for commodities tied to consumers (oil/gasoline, aluminum, nickel, and zinc); negative for emerging markets that are commodity- and export-reliant and China-exposed, yet positive for domestic-oriented and/or China-insulated EMs. On the other hand, there is no longer a convincing excuse for poor implementation of central government policies. If China does not take concrete steps in pursuit of Xi's reform agenda - an agenda of "supply-side reform" that is now enshrined in the party's constitution - then it follows that Xi himself is unwilling to practice what he preaches. The first big test will be whether, when the economy starts to wobble, policymakers stimulate the "old economy" with the usual fervor, or whether they hold true to a course of re-ordering the economy and concentrating any stimulative credit flows more heavily into the social safety net and consumer-led industries and services. Given Xi's and China's rare opportunity, a failure to undertake difficult reforms in the coming months and years would be a clear sign that China will never pursue significant reforms of its own accord. It would have to be forced to do so by an internal or external crisis. This would mean that China's potential GDP would continue to decline for the foreseeable future (Table 3). Chart 13China's Ascendancy Challenges The U.S. China's Ascendancy Challenges The U.S. China's Ascendancy Challenges The U.S. If that were the case, declining potential GDP growth would combine with political uncertainty over Xi's 2022 succession to create a noxious brew of social malaise. A final and very important consideration is China's relationship with the United States and its allies, given the ongoing strains over U.S.-China trade, North Korea's nuclear and missile advances, China's militarization of the South China Sea, Taiwan's widening ideological distance from the mainland, and Japan's accelerating re-armament. The party congress was a highly visible display of Chinese power and self-confidence, in which Xi broke with the past to suggest that China is moving into "center stage" in the world. Xi not only reaffirmed state-led growth but also emphasized that China's foreign policy assertiveness is here to stay over the long run. This is a poignant reminder of our long-term investment theme of global multipolarity. The United States is not likely to relinquish global or even regional leadership easily. So while relations may be pacified in the short term, the risk of conflict, whether economic or military, is rising over time (Chart 13). Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "China's Nineteenth Party Congress: A Primer," dated September 13, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy, "China: Two Factions, One Party," dated September 2012, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 4 Popular unrest was boiling up due to grievances over corrupt officials, mismanagement of internal migration, local government land seizures, a weak justice system, and a host of labor disputes and environmental incidents. 5 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. See also BCA Geopolitical Strategy Monthly Report, "Reflections On China's Reforms," in "The Great Risk Rotation - December 2013," dated December 11, 2013. 6 The arrest and excommunication of Chongqing Party Secretary Bo Xilai in 2012 epitomizes the regional and institutional challenge, since Bo had a network of alliances that fell under Xi Jinping's anti-corruption dragnet and sprawled across the energy sector and public security agencies. The regional problem was highlighted again this year when one of Bo's successors, Chongqing Party Secretary Sun Zhengcai, was ousted for allegedly failing to extirpate Bo's influence. Meanwhile, the People's Liberation Army became more vocal and independent in ways that raised concerns among foreign observers, such as U.S. Defense Secretary Robert Gates, who suggested that the PLA took China's civilian leadership by surprise when it conducted a test flight of its stealth J-20 fifth generation fighter during Gates's visit to Beijing in January 2011. 7 Please see BCA China Investment Strategy Weekly Report, "China's Economy - 2015 Vs Today (Part I): Trade," dated October 26, 2017, available at cis.bcaresearch.com. 8 For the military reshuffle, please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at gps.bcaresearch.com. 9 The most important reform was the loosening of the one-child policy, which was a social change with long-term economic benefits. Reforms to household registration, land rights, the property sector, SOEs, fiscal policy, private property, and the judicial system have moved slowly. 10 The PSC has a three-way balance of sorts, with two representatives of each faction (Jiang Zemin, Hu Jintao, and Xi Jinping), plus Xi presiding over all. Please see Cheng Li, "The Paradoxical Outcome Of China's 19th Party Congress," Brookings Institution, October 26, 2017. Our own analysis of the 2017 result, drawing on Cheng Li's work, shows that the party bureaucracy, state bureaucracy and the military are represented at roughly the same levels as before on the 25-member Politburo. Further, the profile of the PSC members is relatively continuous with the previous PSC profiles. Namely, the relatively high share of leaders who have spent their careers ruling the provinces, or who have mostly worked in central government, is no higher than it was before, while the relatively low share of leaders who served on the military or managed state-owned enterprises is no lower than it was before. The division between rural and urban regions on the PSC is also the same as before. Thus, the only substantial change in the character profile of the PSC is the fact that China's leaders are increasingly coming from an educational background in the "soft sciences" rather than the "hard sciences": which is to be expected as the society evolves from manufacturing and construction to a services-oriented economy, even though it also suggests growing ideological orthodoxy. 11 Please see BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Monthly Report, "The Socialism Put," dated May 11, 2016, available at gps.bcaresearch.com. 13 Please see BCA China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010," dated October 13, 2016, available at cis.bcaresearch.com. 14 Please see BCA China Investment Strategy Weekly Report, "China: Financial Crackdown And Market Implications," dated May 18, 2017, available at cis.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. 16 Please see "China: A Preemptive Dodd-Frank," in BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017, available at gps.bcaresearch.com. 18 Please see note 15 above. See also Barry Naughton, “The General Secretary’s Extended Reach: Xi Jinping Combines Economics And Politics,” dated September 11, 2017, available at www.hoover.org. 19 Please see "China To Launch Nationwide Inspection On Commercial Housing Sales," Xinhua, October 25, 2017, available at www.chinadaily.com. 20 Supervisory commissions will be created at every level of administration in all regions to ensure that the anti-corruption campaign is enforced across all government, not only within the Communist Party. The commissions will be based on experiences gained from trial programs in Beijing, Zhejiang, and Shanxi. Please see Viola Zhou, "Super anti-graft agency pilot schemes extended across China," South China Morning Post, October 30, 2017, available at www.scmp.com. 21 Please see note 5 above, "Taking Stock," and BCA China Investment Strategy, "Policy Mistakes And Silver Linings," dated October 7, 2015, available at cis.bcaresearch.com. 22 Please see note 5 above, "Taking Stock," and BCA China Investment Strategy, "Understanding China's Master Plan," dated November 20, 2013, available at cis.bcaresearch.com.

Highlights Xi Jinping has shed domestic political constraints that have been in place since 2012; The lack of constraints suggests his reform agenda will intensify over the next 12 months; The use of anti-corruption agencies to enforce economic policy suggests that reform implementation will become more effective; Chinese politics are shifting from a tailwind to a headwind for global growth and EM assets. Feature Chart 1Stability Continues After Party Congress? Stability Continues After Party Congress? Stability Continues After Party Congress? China's nineteenth National Party Congress concluded on October 25 with the new top seven leaders - the members of the Politburo Standing Committee (PSC) - taking the stage in the Great Hall of the People. The party congress is a five-year leadership reshuffle that, in this case, marks the halfway point of President Xi Jinping's term in office.1 President Xi was the center of attention throughout the event. It is widely perceived that he is the most powerful Chinese leader since Deng Xiaoping. The Communist Party chose to elevate his personal power in conspicuous ways that raises political uncertainties about the succession in 2022 as well as about the future trajectory of Chinese policy, including economic policy. BCA's Geopolitical Strategy has awaited this transition since 2012, when President Xi and Premier Li Keqiang took over the top two positions in China.2 While we are inherently skeptical of Xi's grandiose reform agenda, we are also deeply aware of the importance of political constraints in determining economic policy outcomes - and Xi has just overcome significant domestic constraints. If Xi accelerates and intensifies his reforms next year - particularly deleveraging and industrial restructuring - he will add volatility to Chinese risk assets and create a drag on Chinese growth. Xi's personal concentration of power could be an enabling factor in driving reforms. But it will certainly be a source of higher political uncertainty over the next five years (Chart 1), especially as the 2022 succession approaches. Therefore a lack of reform would be a noxious combination. Finally, China's ascendancy increases the phenomenon of global multipolarity - it is a challenge to the U.S.-led system and will eventually produce a reaction, most likely a negative one.3 In short, Chinese political and geopolitical risk is understated. This situation presents a range of risks and opportunities for investors, but it is broadly a headwind for global growth and EM assets. A Chinese "policy mistake" is also a risk to our House View of being overweight equities and underweight bonds for the next 12 months. Back To 2012 When Xi rose to power in 2012, it was widely known that China's economy had reached a pivotal moment. Exports were declining as a share of GDP in the wake of the Great Recession and end of the U.S. "debt super-cycle," and investment was weakening as the country's massive fiscal and credit stimulus wore off (Chart 2). Meanwhile the Communist Party faced a crisis of legitimacy, with an emergent middle class making ever greater demands on the system (Chart 3). The rapid rise in household income over preceding years, combined with high income inequality and poor quality of life, raised the prospect of serious socio-political challenges to single-party rule.4 President Hu Jintao searched for ways to strengthen state control over an increasingly restless society, while outgoing Premier Wen Jiabao warned openly that China's economy was unsustainable and imbalanced and that political reform would be an "urgent task." Hu Jintao's farewell address at the eighteenth party congress (2012) reflected the party's grave concerns. His successor, Xi Jinping, was in charge of drafting the report. This relationship highlighted an important degree of party consensus. The report called for fighting corruption and disciplining the party, while doing more to protect households from the negative externalities of the past decade's rapid growth, including pollution (Chart 4). Chart 2Xi Took Power Amid Economic Transition Xi Took Power Amid Economic Transition Xi Took Power Amid Economic Transition Chart 3The Communist Party's Newest Constraint The Communist Party's Newest Constraint The Communist Party's Newest Constraint Chart 4Xi Took Power Amid Instability Risks Xi Took Power Amid Instability Risks Xi Took Power Amid Instability Risks It also outlined China's hopes of becoming a more consequential global player through acquiring naval power and forging a new, peer relationship with the United States. The overriding imperative was to win back support and legitimacy for the party, lest it fall victim to the fate of the world's other Marxist-Leninist regimes - i.e. internal socio-economic sclerosis and external pressure from the U.S.-led, democratic-capitalist world order. Xi Jinping took over at this juncture, using the 2012 work report as his guideline for an ambitious policy agenda. Xi's main goals centered on power: namely, ensuring regime survival at home and increasing China's international clout abroad. Specifically, the Xi administration sought to (1) centralize political control so that difficult choices could be made and implemented effectively; (2) improve governance so that public discontent could be mitigated over the long run; and (3) restructure the economy so that productivity growth could remain robust in the face of sharply declining labor force growth, thus stabilizing the potential GDP growth rate.5 Obviously there was no guarantee that Xi would be successful. China's response to the Global Financial Crisis had required a large-scale decentralization of control: local governments, banks, state-owned enterprises and shadow lenders were encouraged to lever up and grow amid the global collapse (Chart 5). This created imbalances and liabilities for the central leadership while also creating new economic (and hence political) centers of power outside Beijing. Chart 5aLocal Government Spending Unleashed... Local Government Spending Unleashed... Local Government Spending Unleashed... Chart 5b...And Shadow Lending Too ...And Shadow Lending Too ...And Shadow Lending Too The central leadership also seemed to be losing control of the provinces: regional and institutional powerbrokers had emerged, challenging the party's hierarchy, and there was even reason to believe that the armed forces were deviating from central leadership.6 Without control of the local governments and other key institutions, any reform agenda would get bogged down. Finally, the political cycle was not particularly favorable to Xi. While the line-up of the all-powerful PSC looked favorable from 2012-17, the next crop of Communist leaders set to move up the ladder in 2017 seemed likely to constrain him. Moreover, the previous two presidents had chosen Xi's successors for 2022, according to party norms. Xi had very little room for maneuver - and this was negative for his policy outlook overall. As such, BCA's Geopolitical Strategy poured cold water on the more enthusiastic forecasts of economic reforms throughout Xi's first term. Our assessment was that he would focus on anti-corruption and governance reforms first and only attempt genuine economic reforms once his political capital grew significantly. Bottom Line: Xi Jinping faced major obstacles to his policy agenda of centralization, governance and economic reform in 2012. He faced a large and restless middle class, the difficulty of reining in local governments and state institutions, and the likelihood that China's previous top leaders would constrain his maneuverability in 2017 and 2022. Xi's First Term A lot has changed over the past five years. First, both global demand for Chinese goods and Chinese domestic demand have held up rather well, giving China a badly needed cushion during its economic transition. Steady consumption growth has partially offset the blow from declining investment, while Chinese exports have grown well, often faster than global trade (Chart 6).7 Second, Xi has consolidated power extensively within the party, the army, and other institutions. He executed the most aggressive purge that the party has seen in decades, enabling him to rebuild some public trust among a middle class worn out by corruption, as well as to remove political rivals (Chart 7). He also launched an extensive restructuring of the People's Liberation Army, its organizational structure and personnel, ensuring that "the party controls the gun."8 And he intensified social control, particularly in the online realm. Chart 6Changing The Economic Model Changing The Economic Model Changing The Economic Model Chart 7Anti-Corruption Campaign Still Going Anti-Corruption Campaign Still Going Anti-Corruption Campaign Still Going Symbolically, Xi was anointed the "core" of the Communist Party by the political elite in late 2016. Economic reform, however, has been compromised by Xi's focus on consolidating political power. True, he and Premier Li Keqiang tinkered with various policies to cut red tape, simplify domestic taxes, attract foreign investment, and encourage better SOE management, but none of the reforms launched over the past five years were painful and thus none were significant.9 Nowhere was this more apparent than during 2015-16, when economic and financial instability caused the Xi administration to delay reform initiatives and focus on reforming the economy. Beijing increased infrastructure spending, bailed out the local governments, depreciated the RMB, and imposed capital controls (Chart 8). "Old China," state-owned China, was the primary beneficiary. The stimulus-fueled rebound helped stabilize the global economy in 2016-17, particularly commodity-producing emerging markets, but it exacerbated China's internal problems - slow productivity growth, excessive debt creation, weak private sector investment, and waning foreign investment (Chart 9). Chart 8State Interventions In 2015-16 State Interventions In 2015-16 State Interventions In 2015-16 Chart 9Economic Reforms Still Needed Economic Reforms Still Needed Economic Reforms Still Needed The upside, however, was stability, which enabled Xi to approach the nineteenth National Party Congress from a position of strength. Now that the party congress has concluded, we can say that Xi has notched a series of significant "victories" and that his political capital is overflowing: Xi Jinping Thought: The congress voted to enshrine Xi's name into its constitution (Table 1), with a phrasing that echoes "Mao Zedong Thought," hence elevating Xi to immense moral authority within the party. The name of Xi's philosophy, "Socialism with Chinese Characteristics for a New Era," makes a slight adjustment to Deng Xiaoping's market-friendly philosophy. In other words, Xi's authority stems from his providing a synthesis of the regime's greatest two leaders: Mao's single-party Communist rule is being reaffirmed, but Deng's attention to economic reality and the need for pragmatic policies has also been preserved. As we have argued, this constitutional change is a reflection of the fact that Xi has already positioned himself to be the most influential leader well into the 2020s. Table 1Xi Jinping Thought China: Party Congress Ends ... So What? China: Party Congress Ends ... So What? Xi removes his successors: Xi managed to exclude any of China's "sixth generation" of leaders from the Politburo Standing Committee. He thus broke a very important (albeit informal) party norm. The norm was created under Deng Xiaoping to ensure a smooth transition of power, unlike the power struggle that occurred upon Mao's death. Now Xi will have a greater hand in choosing his successor, or even staying in power beyond 2022. This aids in the process of centralization, but it may well prove a step backwards in terms of governance and reform - that remains to be seen. It is a source of higher political uncertainty going forward. Xi dominates the Politburo: Xi prevented his predecessor Hu Jintao's loyalists from gaining a majority on the Politburo Standing Committee, as they seemed lined up to do in 2012. The line-up of the new Politburo and Politburo Standing Committee broadly indicates that Xi and his faction are the dominant force (Table 2). Taken with Xi's personal power, this is significant political capital with which the new administration can push its priorities, whatever they may be. Xi gets a new inquisitor: The Central Commission for Discipline Inspection (CDIC) is the party's internal watchdog. It has taken the leading role in the sweeping party purge and anti-corruption campaign over the past five years. Xi removed its chief, the hugely influential Wang Qishan, by reinforcing the retirement age and two-term PSC limit - a notable case of institutional norms being upheld. He put one of his loyalists, Zhao Leji, in this role instead. The CDIC will have a huge role over the next five years, and a market-relevant one, as we discuss below. Table 2The Magnificent Seven: China's New Politburo Standing Committee China: Party Congress Ends ... So What? China: Party Congress Ends ... So What? The above conclusions raise the possibility that Xi has become excessively powerful, that political institutions in China are being eroded by personal rule, and that political risks are set to explode upward in the near future. However, it is too soon to declare that Xi has staged a Maoist "power grab." There are reasons to think that Xi's accumulation of power has not overturned the delicate internal balances within the top leadership bodies.10 The result is in keeping with what we expected in our Strategic Outlook last December: Xi Jinping has amassed formidable political capital, but he has not destabilized the Chinese political system.11 He is a strongman leader within the established political system of an authoritarian state - he is not a tyrant seizing power in a bloodless revolution. (At least, not yet.) This is broadly positive for China's policy continuity and political framework - and in this sense it is also broadly market-positive, being an outgrowth of the status quo rather than a disruptive break from it. China's leaders continue to be career politicians, trained in law or economics, with considerable executive experience in governing and limited business or military experience, all unified in the name of regime preservation (Chart 10). Over the long run, this suggests that China's "Socialist Put" remains intact, i.e. that the state will intervene to prevent a crash landing.12 Nevertheless, an important corollary of the above is that Xi holds the balance, and hence there are no longer any major domestic political or governmental constraints to prevent him from pursuing his policy agenda - especially over the next 12 months, when his political capital is still fresh and the economic backdrop is favorable. The fact that Xi emphasized "sustainable and sound" growth, deliberately excluded GDP growth targets beyond 2021, and altered the definition of the Communist Party's so-called "principal contradiction" in order to prioritize quality-of-life improvements, suggests that the reform agenda is about to get rebooted. Bottom Line: Xi Jinping has consolidated power extensively, but he has not staged a silent coup d' état or overthrown the balance of power within the Communist Party. This suggests that Xi's policies and reforms will intensify over the next year. Chart 10Characteristics Of Chinese Rulers Mostly Unchanged Since 2012 China: Party Congress Ends ... So What? China: Party Congress Ends ... So What? Xi's Second Term: What To Expect Instead of playing it safe in the lead-up to the all-important party congress over the past twelve months, Xi surprised the markets with a series of regulatory actions designed to tamp down the property bubble, regulate the financial markets, punish speculation, and reduce industrial overcapacity and pollution (Chart 11).13 This tightening of policy strongly signaled that Xi's appetite for political risk is rising in keeping with his growing political capital. Beijing is signaling that it aims to continue with tougher financial, industrial and environmental reforms in the aftermath of the party congress. In particular, systemic financial risk has been identified as a risk to the state's overall stability. Of course, China is unlikely to sharply reduce the ratio of total debt-to-GDP out of an ill-advised, self-imposed bout of austerity. But the Xi administration is likely to suppress its growth rate (Chart 12), as well as to continue cracking down on specific institutions and financial practices deemed to be excessively risky or under-regulated, as has occurred this year in insurance and shadow lending.14 Chart 11China's Borrowing Costs Rising China's Borrowing Costs Rising China's Borrowing Costs Rising Chart 12Debt Growth Faces Tougher Controls Debt Growth Faces Tougher Controls Debt Growth Faces Tougher Controls This financial focus is clear from top-level appointments and meetings in 2017, including a special Politburo meeting on financial risks in April and the once-in-five-years Central Financial Work Conference in July.15 The latter declared new regulatory powers for the central bank that will be put into place in the coming 12 months. The head of the new Financial Stability and Development Committee to oversee this work will likely be named, along with a replacement for the long-serving People's Bank of China Governor Zhou Xiaochuan. This change will initiate a new generation of leadership in the central bank, and one ostensibly directed at overseeing stricter macro-prudential controls.16 Another outcome of the financial conference was the warning that, going forward, local government officials will be held accountable over the course of their entire lives if they allow excessive financial risks and debt to build up under their watch.17 These developments suggest that policy will become a headwind to growth next year. We would expect downside risks to China's implicit 6.5% growth target. Why should the new deleveraging campaign have any more effect than similar efforts in the past? Aside from Xi's stronger position to enforce policies - explained above - the nineteenth party congress reinforced an important trend in policy implementation. The Xi administration has been using the CDIC, the party's anti-corruption unit, as a political tool to ensure broader policy enforcement. We have observed this trend over the past year both in the financial regulatory crackdown and the anti-pollution and overcapacity crackdown.18 Anti-corruption officials can compel more serious implementation from local governments, SOE managers, and others because they threaten to impose job losses or jail time, rather than mere fines. The CDIC appointed two new officials to oversee its operations in China's financial regulators just as the party congress was getting underway. Moreover, on the final day of the party congress, officials have announced that corruption investigations will be conducted into the commercial housing sector.19 The message is that the regulatory storm will expand - and will have teeth. Xi went a step further at the party congress by declaring the creation of a National Supervisory Commission, which will oversee the next phase of the anti-corruption campaign.20 This commission will expand the campaign outside the ranks of the Communist Party - where it has operated so far - to the government as a whole, i.e. the state administration and bureaucracy. It implies that every official from China's top ministries down to its lowest-level governments will be subjected to new forces of scrutiny. If this effort resembles the CDIC's role in hastening compliance in other areas of economic policy, then it will be a powerful tool for the Xi administration as it attempts to engineer a top-down restructuring of China's governance and economy. An aggressive new regulatory push, with the threat of corruption charges, in China's financial and industrial sectors would create a powerful drag on economic growth. It could easily send a chill down the spines of government officials, prompting them to cut or delay key investment decisions, as the initial anti-corruption campaign did in 2013-14.21 China's leaders will eventually attempt to offset any disorderly slowdown from reform measures with additional stimulus. However, given that the deleveraging campaign cuts to the heart of the financial sector, and that sharp new tools are being put to use, we would think that the probability of a "policy mistake" is going up. Bottom Line: Risks to Chinese economy and assets are rising as politics shifts from being a tailwind to a headwind. Xi Jinping faces few policy constraints and has shown appetite for greater political risk in the pursuit of his reform agenda. His administration has signaled that China's financial imbalances pose a threat to overall stability and require tougher regulation. New enforcement mechanisms - particularly those connected with anti-corruption efforts - threaten to bring the financial sector, as well as local government debt, under the spotlight and to create a chilling-effect among local officials. Investment Conclusions On one hand, any genuine attempt to hasten the transition of China's economy to consumer-led growth, de-emphasize GDP growth targets, and pare back overbuilt and heavy-polluting industry is highly consequential and will redistribute global growth.22 Table 3Post-Party Congress Scenarios And Probabilities China: Party Congress Ends ... So What? China: Party Congress Ends ... So What? Broadly speaking, the transition is negative for Chinese growth in the short term, but positive in the long term, as productivity trends would improve. It is negative for China's heavy industry, yet positive for technology, health and education; negative for commodities tied to the old economy (e.g. coal, iron ore, and diesel), but positive for commodities tied to consumers (oil/gasoline, aluminum, nickel, and zinc); negative for emerging markets that are commodity- and export-reliant and China-exposed, yet positive for domestic-oriented and/or China-insulated EMs. On the other hand, there is no longer a convincing excuse for poor implementation of central government policies. If China does not take concrete steps in pursuit of Xi's reform agenda - an agenda of "supply-side reform" that is now enshrined in the party's constitution - then it follows that Xi himself is unwilling to practice what he preaches. The first big test will be whether, when the economy starts to wobble, policymakers stimulate the "old economy" with the usual fervor, or whether they hold true to a course of re-ordering the economy and concentrating any stimulative credit flows more heavily into the social safety net and consumer-led industries and services. Given Xi's and China's rare opportunity, a failure to undertake difficult reforms in the coming months and years would be a clear sign that China will never pursue significant reforms of its own accord. It would have to be forced to do so by an internal or external crisis. This would mean that China's potential GDP would continue to decline for the foreseeable future (Table 3). Chart 13China's Ascendancy Challenges The U.S. China's Ascendancy Challenges The U.S. China's Ascendancy Challenges The U.S. If that were the case, declining potential GDP growth would combine with political uncertainty over Xi's 2022 succession to create a noxious brew of social malaise. A final and very important consideration is China's relationship with the United States and its allies, given the ongoing strains over U.S.-China trade, North Korea's nuclear and missile advances, China's militarization of the South China Sea, Taiwan's widening ideological distance from the mainland, and Japan's accelerating re-armament. The party congress was a highly visible display of Chinese power and self-confidence, in which Xi broke with the past to suggest that China is moving into "center stage" in the world. Xi not only reaffirmed state-led growth but also emphasized that China's foreign policy assertiveness is here to stay over the long run. This is a poignant reminder of our long-term investment theme of global multipolarity. The United States is not likely to relinquish global or even regional leadership easily. So while relations may be pacified in the short term, the risk of conflict, whether economic or military, is rising over time (Chart 13). Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "China's Nineteenth Party Congress: A Primer," dated September 13, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy, "China: Two Factions, One Party," dated September 2012, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 4 Popular unrest was boiling up due to grievances over corrupt officials, mismanagement of internal migration, local government land seizures, a weak justice system, and a host of labor disputes and environmental incidents. 5 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. See also BCA Geopolitical Strategy Monthly Report, "Reflections On China's Reforms," in "The Great Risk Rotation - December 2013," dated December 11, 2013. 6 The arrest and excommunication of Chongqing Party Secretary Bo Xilai in 2012 epitomizes the regional and institutional challenge, since Bo had a network of alliances that fell under Xi Jinping's anti-corruption dragnet and sprawled across the energy sector and public security agencies. The regional problem was highlighted again this year when one of Bo's successors, Chongqing Party Secretary Sun Zhengcai, was ousted for allegedly failing to extirpate Bo's influence. Meanwhile, the People's Liberation Army became more vocal and independent in ways that raised concerns among foreign observers, such as U.S. Defense Secretary Robert Gates, who suggested that the PLA took China's civilian leadership by surprise when it conducted a test flight of its stealth J-20 fifth generation fighter during Gates's visit to Beijing in January 2011. 7 Please see BCA China Investment Strategy Weekly Report, "China's Economy - 2015 Vs Today (Part I): Trade," dated October 26, 2017, available at cis.bcaresearch.com. 8 For the military reshuffle, please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at gps.bcaresearch.com. 9 The most important reform was the loosening of the one-child policy, which was a social change with long-term economic benefits. Reforms to household registration, land rights, the property sector, SOEs, fiscal policy, private property, and the judicial system have moved slowly. 10 The PSC has a three-way balance of sorts, with two representatives of each faction (Jiang Zemin, Hu Jintao, and Xi Jinping), plus Xi presiding over all. Please see Cheng Li, "The Paradoxical Outcome Of China's 19th Party Congress," Brookings Institution, October 26, 2017. Our own analysis of the 2017 result, drawing on Cheng Li's work, shows that the party bureaucracy, state bureaucracy and the military are represented at roughly the same levels as before on the 25-member Politburo. Further, the profile of the PSC members is relatively continuous with the previous PSC profiles. Namely, the relatively high share of leaders who have spent their careers ruling the provinces, or who have mostly worked in central government, is no higher than it was before, while the relatively low share of leaders who served on the military or managed state-owned enterprises is no lower than it was before. The division between rural and urban regions on the PSC is also the same as before. Thus, the only substantial change in the character profile of the PSC is the fact that China's leaders are increasingly coming from an educational background in the "soft sciences" rather than the "hard sciences": which is to be expected as the society evolves from manufacturing and construction to a services-oriented economy, even though it also suggests growing ideological orthodoxy. 11 Please see BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Monthly Report, "The Socialism Put," dated May 11, 2016, available at gps.bcaresearch.com. 13 Please see BCA China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010," dated October 13, 2016, available at cis.bcaresearch.com. 14 Please see BCA China Investment Strategy Weekly Report, "China: Financial Crackdown And Market Implications," dated May 18, 2017, available at cis.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. 16 Please see "China: A Preemptive Dodd-Frank," in BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017, available at gps.bcaresearch.com. 18 Please see note 15 above. See also Barry Naughton, “The General Secretary’s Extended Reach: Xi Jinping Combines Economics And Politics,” dated September 11, 2017, available at www.hoover.org. 19 Please see "China To Launch Nationwide Inspection On Commercial Housing Sales," Xinhua, October 25, 2017, available at www.chinadaily.com. 20 Supervisory commissions will be created at every level of administration in all regions to ensure that the anti-corruption campaign is enforced across all government, not only within the Communist Party. The commissions will be based on experiences gained from trial programs in Beijing, Zhejiang, and Shanxi. Please see Viola Zhou, "Super anti-graft agency pilot schemes extended across China," South China Morning Post, October 30, 2017, available at www.scmp.com. 21 Please see note 5 above, "Taking Stock," and BCA China Investment Strategy, "Policy Mistakes And Silver Linings," dated October 7, 2015, available at cis.bcaresearch.com. 22 Please see note 5 above, "Taking Stock," and BCA China Investment Strategy, "Understanding China's Master Plan," dated November 20, 2013, available at cis.bcaresearch.com.