Emerging Markets

Highlights A broad survey on various valuation ratios suggests that Chinese investable equities' exceptional cheapness in the past several years has essentially vanished. Valuation is no longer a compelling reason for staying positive. Multiples of Chinese equities have been rerated in the past two years. This asset class is currently trading at a slight premium over its historical norms as well as other emerging markets, but it is still at discounts to developed bourses and the all-country-world averages. Remain bullish on Chinese investable equities due to our positive stance on the cyclical outlook of economy and profits. Feature Chinese industrial profits increased by 16.5% in July from a year ago, as released early this week. This is a mild deceleration compared with the 19.1% pace a month earlier, which the authorities attributed to temporary factory shutdowns due to extreme summer heat. Irrespective, the latest profit numbers confirm that the economy is passing its peak growth rate in this mini cycle upturn, but overall business activity remain fairly robust. Looking forward, we see limited downside in China's cyclical growth outlook, as discussed in various recent reports.1 Chinese equities have also experienced a mini melt-up in recent weeks. So far this year, Chinese investable stocks, measured by the MSCI China Free index, have rallied by almost 40% in dollar-terms, significantly outpacing all major global and EM benchmarks. Importantly, the total return index of Chinese investable stocks, price appreciation and dividend income combined has recently broken above a long-term resistance, reaching an all-time high (Chart 1). While the strong performance of Chinese equities has validated our positive stance on China's growth and profit profile, the sharp rally in prices also raises a red flag on potential froth and complacency. A closer look at the valuation picture of Chinese equities is well warranted. Conventional Valuation Indicators At the onset, conventional valuation indicators for the broad Chinese investable equity universe currently do not look demanding compared with historical norms (Chart 1, bottom panel). Our composite valuation indicator, which combines several conventional yardsticks such as trailing and forward price-to-earnings, price-to-book, price-to-cash and dividend yield, has crawled out of the "undervalued" extreme that lasted for several years, but it is not yet overvalued. Most conventional valuation indicators are currently roughly in line with their respective long-term averages (Chart 2). Chart 1Chinese Investable Stocks Are No Longer ##br##Exceptionally Cheap Chinese Investable Stocks Are No Longer Exceptionally Cheap Chinese Investable Stocks Are No Longer Exceptionally Cheap Chart 2Most Valuation Indicators ##br##Are Back To Historical Means Most Valuation Indicators Are Back To Historical Means Most Valuation Indicators Are Back To Historical Means Compared with other emerging bourses, Chinese investable equities have also been re-rated. In fact, Chinese equities' outperformance against the EM benchmark since mid-last year has been entirely driven by relative multiples expansion (Chart 3). Our relative composite valuation indicator suggests Chinese investable equities are trading at a moderate premium over the EM benchmark, after a few years of deep discount. Most valuation indicators of Chinese equities are slightly higher than the EM benchmark, but are still significantly lower than their peers in the developed market (Chart 4). Chart 3Chinese Equities Have Been Rerated ##br##Against EM Chinese Equities Have Been Rerated Against EM Chinese Equities Have Been Rerated Against EM Chart 4Chinese Equities Are Trading At Premium##br## Against EM, But Not DM Chinese Equities Are Trading At Premium Against EM, But Not DM Chinese Equities Are Trading At Premium Against EM, But Not DM Weight-Adjusted Valuation Indicators A major issue of conducting historical and cross-country comparisons of valuation indicators is the ever-changing constituents in the indexes. The benchmark to evaluate P/B ratios of tech companies should be categorically different from those of banks, as should the price-to-cash ratios for retailers and utility firms. A simple lump-sum aggregate of a conventional valuation indicator ignores the different sector weights among different markets, which could be misleading. This is particularly important for China, as its juvenile equity universe is constantly evolving and rapidly changing (Chart 5). The largest sector by weight in the Chinese investable market in the past 10 years has shifted from telecom to energy to banks, with the baton more recently being passed to information technology. Currently, IT firms account for over 40% of the MSCI China Free index, up from less than 10% three years ago, while banks have dropped from a peak of 44% to 25% currently. The shifting sector weights within the Chinese equity universe also reflect the rapidly changing structure of the underlying Chinese economy. Chart 5Chinese Investable Equities Sector Breakdown A Closer Look At Chinese Equity Valuations A Closer Look At Chinese Equity Valuations One way to deal with this issue is some sort of "controlled weight" valuation indicator by holding sector weights constant. Chart 6 shows the simple averages of various valuation ratios of the 10 Global Industry Classification Standard (GICS) sectors.2 With the exception of dividend yield, the equal-weighted valuation indicators are more expensive than their respective market weight-based versions, according to our calculation. This means that some smaller-weight sectors are more dearly valued compared with the large weights, particularly banks. However, none of the valuation ratios appear extreme in a historical context. How do Chinese equities compare with other markets? Table 1 summarizes equal-sector-weight valuation indicators. Overall, Chinese equities are trading at a slight premium over emerging markets, but are still at 10-20% discounts to developed bourses and the all-country-world averages. Table 1 A Closer Look At Chinese Equity Valuations A Closer Look At Chinese Equity Valuations Cyclically-Adjusted P/E Ratios The Cyclically Adjusted Price Earnings (CAPE) multiple (also known as the Shiller P/E) compares the equity price to the earnings in a full business cycle extended over many years, rather than just one random year. Typically, CAPEs are calculated by dividing the equity price by the 10-year average of real earnings, which smooths out the business cycle and theoretically better captures what equity investors are paying for companies' long term earning streams. Chart 7 shows that CAPEs are well above 20 times for the U.S. and Japanese markets, and around 16 times for U.K. and euro area stocks - all have experienced some multiples expansion since the global financial crisis. In China's case, the CAPE for investable equities has been hovering at around 10 times, near a record low and significantly below the level of the other major indexes. In fact, the CAPE of investable Chinese shares has barely stopped falling amid the rally in prices. Chart 6Average Versus Market-Weight Valuation Ratios Average Versus Market-Weight Valuation Ratios Average Versus Market-Weight Valuation Ratios Chart 7Cyclically Adjusted P/E: A Global Comparison Cyclically Adjusted P/E: A Global Comparison Cyclically Adjusted P/E: A Global Comparison Investment Conclusions Taken together, the valuation picture of Chinese investable stocks has become mixed, as its total return index has reached an all-time high. This asset class is no longer obviously undervalued compared with both historical norms and its EM peers. Some viewed Chinese equities' exceptional cheapness in the past several years as a "value-trap," which has proven to be a costly mistake and has been discredited. Now the "easy trade" is over, and valuation is no longer a compelling reason for staying positive on Chinese equities. On the other hand, a broad survey on various valuation ratios does yet not conjure up images of an overly extended market, both compared with historical averages and other global benchmarks, particularly DM bourses. Lack of valuation froth means Chinese investable shares are not yet subject to the pull of mean reversion. Cyclically, we remain optimistic on China's growth and earnings outlook, which should continue to push up stock prices. Valuation indicators are never good timing tools, but they should be closely monitored going forward to assess the risk-return tradeoff of holding Chinese equities. We will dig deeper into domestic A shares in an upcoming report. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Monitoring Chinese Capital Outflows And The RMB Internationalization Process", dated August 24, 2017, available at cis.bcaresearch.com. 2 Includes Consumer Discretionary, Consumer Staples, Energy, Financials, Health Care, Industrials, Information Technology, Materials, Telecommunication Services and Utilities. Real Estate is included in Financials, due to its limited data availability as a stand-alone GICS sector. Cyclical Investment Stance Equity Sector Recommendations

Highlights Hurricane Harvey will prove a bigger market-mover than North Korea's latest missile test; The worst flood in Houston's history will improve U.S. policymaking and remove domestic risks; North Korea justifies hedging against violent incidents, but actors are constrained from full-scale war; Insights from our travels in Asia suggest that U.S.-China cooperation is still meaningful. China's reform reboot faces constraints; Abenomics is not done yet. Feature As we go to press, two crises are developing. The one that has rattled the markets - and that we focus on in this Weekly Report - is the North Korean missile launch. However, we think the more investment-relevant one is the slow-moving Hurricane Harvey, which is about to inundate Houston - a metropolitan area with nearly 7 million people - with more rain. We cannot predict the ultimate impact on the economy of the developing natural disaster, but we do know that Houston is experiencing the greatest flood in its history. The scale of human suffering is likely being massively underestimated at present. Comparisons with Hurricane Katrina are not without merit, but Houston has a population about five times that of New Orleans. Investors may rightly ask, so what? The stock market actually rallied at the height of Hurricane Katrina and one would struggle to pick its date on a chart of the S&P 500. The impact on the economy and markets is likely to be tepid in the near term once again. The significance of Hurricane Harvey is its likely impact on politics. First, there is now no chance that the debt ceiling will be breached. We discussed the low odds last week and we reiterate them here. Second, odds are that a government shutdown is unlikely as well. It is unfathomable to shut down the government during an emergency. Imagine if the Federal Emergency Management Agency (FEMA) had to cease operations. Wall or no wall on the Mexican border, Republicans in Congress and the White House will fund the government. More than that, Americans suffering in a Red State that voted for President Trump could be the catalyst that Republicans need to put their intra-party differences aside and start working with vigor on legislation, including tax reform. We could even contemplate legislative action on a bipartisan infrastructure plan, although the ability of U.S. policymakers to put aside grief and focus back on partisan bickering never ceases to amaze. The bottom line for us is that in six months' time, when investors look back on late August 2017, it will be Hurricane Harvey that is cited as having been market-relevant in the long term, not North Korea's n-th missile launch. That said, North Korea remains relevant. It has launched an avowed ballistic missile over Japan for the first time (as opposed to a space launch vehicle, which it has done in 1998 and 2009). The launch originated near Pyongyang, a warning to the U.S. that any strikes against launch sites would be complex (involving civilians) and tantamount to an attack on the capital and a declaration of war. The United States and its allies will be forced to respond to this brinkmanship by trying harder to establish that the military option is indeed credible despite the well-known constraints (the decimation of Seoul). Therefore more market volatility will ensue in the coming months and year. We do not rule out major violent incidents, though full-scale war still seems highly unlikely due to hard constraints on the various actors. (Please see "Appendix" for our updated checklist on whether the U.S. will attack.) While we do not expect either Pyongyang or Hurricane Harvey to derail the bull market, we recognize that valuations are stretched, volatility is low, and the market may be looking for a reason to sell off significantly. In this report, we discuss insights on North Korea and other key issues gleaned from our recent travels abroad. BCA's Geopolitical Strategy went on the road this summer for five weeks. We visited the American Midwest, Australia, New Zealand, Singapore, Taiwan, China, Japan, South Korea and the U.K. There we had the pleasure of speaking with clients across the asset management industry. Each region had its own set of specific questions and concerns, as well as insights. Over the next two weeks, we plan to share these with our entire client base. Going on the road is critical for investment strategists. It is an opportunity to stress-test and sharpen one's view through interaction with sophisticated investors. Meeting clients also ensures that you are asking the right questions. We are happy to report that our three main questions - how stimulative will U.S. tax reform be; is China willing to deleverage; and is Italy a potential source of global risk-off - are indeed on all of our clients' minds. This does not mean that everyone came to the same conclusions that we did, but at least we know that we are looking for the same answers. Sino-American Split Is Overstated Investors are no longer as quick to dismiss one of our central geopolitical theses: that the U.S. and China are on a path likely to end in the "Thucydides Trap."1 However, one of our clients was not so sure that U.S.-China relations are deteriorating as rapidly as they appear to be. He observed a pattern in bilateral trade that suggested to him that the two countries are working together, under the table, to keep relations from collapsing despite the unprecedented challenges posed by the post-2008 global political and economic environment. He began with the simple point that the U.S.'s rising trade protectionism against Chinese steel in recent years actually made it easier for President Xi to take aim at overcapacity problems in the steel sector in China. After U.S. steel imports from China collapsed, from 20% of total in 2008 to 3% in 2016, China was able to embark on a long-delayed purge of excess steel capacity, shutting down a reported 87mmt over the past year and a half (Chart 1). China moved up the steel product value chain partly as a result of U.S. actions.2 China also appears to have responded promptly to U.S. complaints about agricultural imports. In late 2016, amid a heated and protectionist presidential campaign, the U.S. government threatened to impose tariffs on China's grain exports and demanded that subsidies be removed so that U.S. companies could compete on a level playing field in China's domestic market. Corn prices were at a nine-year low; Beijing was giving rebates to domestic corn exporters and had amassed large corn inventories. Within a few months, in March 2017, China launched the agricultural side of its supply-side reforms. It removed the supports for corn, allowing prices to plummet and making way for lower Chinese supply and thus more U.S. imports (Chart 2). Chart 1U.S. And China Attack Chinese Steel Capacity U.S. And China Attack Chinese Steel Capacity U.S. And China Attack Chinese Steel Capacity Chart 2China's Supply-Side Agriculture Reforms China's Supply-Side Agriculture Reforms China's Supply-Side Agriculture Reforms Most recently, the client emphasized, China launched one of its periodic crackdowns on intellectual property violations.3 Enforcement was observable in China's mainstream online services, which largely lost the ability to stream content for which they lacked the rights.4 As with steel, China has a self-interest in these reforms, especially as it generates its own intellectual property. But it cannot have detracted from China's urgency that the U.S. announced a formal investigation in early August to determine whether China's intellectual property violations deserve punitive actions.5 It is as if China anticipated the U.S.'s moves coming out of the U.S.-China Comprehensive Economic Dialogue in July. In these and many other cases, a pattern seems to emerge: U.S. trade grievances boil up, U.S. authorities threaten punitive actions, China responds to the threat by vowing retaliation and pushing through supply-side reforms that are already in its interest. The process appears to be a win-win, however precarious. The client also suggested that the U.S. may be offering to become more constructive toward certain Chinese initiatives. For instance, China is pressing forward on the long-delayed launch of an oil futures contract on the Shanghai International Energy Exchange in the second half of 2017. This new benchmark would ostensibly rival Brent and West Texas Intermediate contracts and be settled in RMB instead of USD. To our client, China's moving forward with this scheme, immediately after top-level trade negotiations with the U.S., seemed to reveal the U.S.'s tacit support for RMB internationalization. Certainly the U.S. nodded at the IMF including the RMB in its special drawing rights basket.6 Presumably, then, the U.S. and China have not entirely lost the ability to deal with each other on sensitive issues in an atmosphere fraught with distrust. Moreover, both sides can attempt to roll with the punches. China can blame the difficulties of necessary internal reforms on U.S. protectionism, while U.S. protectionist impulses can be mitigated via China's internal reforms. This dynamic could become the silver lining in Sino-American relations in 2018, a year in which Xi will have the best opportunity to push reforms while Trump may be most eager to take protectionist actions ahead of the midterm election. A silver lining to a black cloud, of course. Bottom Line: Risks to Sino-American relations remain serious, but the two sides still retain some ability to manage tensions. The question is how much ability? Our own view has been that 2017 would largely be a year of Trump issuing "a shot across the bow" and then negotiating. Concrete, aggressive action would be more likely to occur in 2018. This remains our baseline case. But silent coordination of the kind described above could perhaps improve trade relations enough to satisfy Trump in 2018 and delay a Sino-U.S. confrontation. China has long dealt with protectionist threats from the U.S. by conceding various reforms and policy adjustments, especially by increasing U.S. imports. The U.S. has long accepted such a response. We doubt that this tactic will be enough in this day and age, but maybe so. North Korea Could Cause A Recession What about U.S.-China cooperation on North Korea? It appears as if coordination has improved in the face of a potential conflict. At the peak of tensions this summer, China has offered to implement sanctions, cutting off some trade and joint ventures, while the U.S. has given reassurances about U.S. military intentions in the event of a conflict.7 However, judging by conversations with clients on the mainland, a large gap still exists between U.S. and Chinese perceptions. In particular, Chinese clients pushed back against any implication that China is responsible for reining in North Korea's bad behavior. They highlighted China's emphasis on national autonomy, the idea that every country should be left alone to address its own problems in its own jurisdiction. Otherwise countries should resolve differences through diplomacy and dialogue, conducted as equals. The threat or use of force always makes things worse. The current North Korean situation is, from this perspective, America's fault. The North Koreans pursue nuclear-tipped ballistic missiles in order to deter a U.S. attack, having seen what happened to other nuclear aspirants like Iraq, Syria, and most recently Libya.8 In short, China sympathizes with its formal ally North Korea. It demands peaceful negotiations and denounces the threat of regime change. And it does not believe U.S. officials when they renounce regime change as an option, as Secretary of State Rex Tillerson has recently done. "No one will believe that," one of our clients said, and least of all North Korea. (Quite reasonably, we would add.) This argument reinforces our view that China will not impose crippling sanctions on the North, even if it tries to pressure Pyongyang back to the negotiating table. Since the North cannot be expected to give up its nuclear weapons, the negotiations themselves will be limited from the outset. The U.S. essentially has to accept the status quo, possibly even the perpetual threat of a North Korean nuclear strike. This, in turn, increases the probability that the Trump administration will be disappointed with the outcome. Which is precisely why we expect the U.S. not only to bulk up its military alliance in the region but also to impose more "secondary sanctions" and trade tariffs on China. Sino-American tensions will get harder and harder to manage. While we can foresee skirmishes and violent incidents, we think the probability of a full-scale Second Korean War is low. Diplomacy is not exhausted, the U.S. alliance with regional powers remains intact, and, most importantly, North Korea has not committed an act of war (or acted as if it is about to, which would prompt U.S. preemption). Regarding the big picture, some of our clients are not so sanguine. One of them pointed out recent academic research arguing that armed conflict, as a cause of death in the human population, has declined. The number of violent deaths per 100,000 people has fallen from historic levels in the hundreds down to an average of 60 in the twentieth century, which includes two world wars, and down to the single digits in the post-WWII era (Chart 3). The client asks: Is this drop in war deaths sustainable? The implication is that the level of deaths has nowhere to go but up. Chart 3Human Deaths By War Have Collapsed In Post-WWII Era Insights From The Road - Asia Insights From The Road - Asia The client coupled this thought with another bearish theory. It is widely known that recessions are normally preceded by large financial or economic imbalances. Today many investors are encouraged by the apparent lack of any such imbalance. They read this as saying, "let the good times roll." Our client viewed it another way, suggesting that the imbalance that will cause the next major recession will be non-financial and non-economic, e.g. ecological, epidemiological, geopolitical, etc. Chart 4Global Conflicts Increasing In Frequency Global Conflicts Increasing In Frequency Global Conflicts Increasing In Frequency The client was not specifically hinting at a North Korean conflagration, though probably not ruling it out either. He was mostly concerned with the historic drop in deaths by conflict and how it might be reversed in the near future. Unfortunately this bleak suggestion that war might make a secular comeback is not incompatible with our view that geopolitical multipolarity goes hand in hand with a higher incidence of internationalized conflicts (Chart 4), which could be exacerbated by a decline in global trade. On the other hand, the fall in deaths is a product of a range of political, economic, social and scientific advances, and may not be reversed through geopolitical tensions alone. Bottom Line: The U.S. and China remain far apart in their perceptions of who is to blame for North Korea and what is to be done. China will not take responsibility for "solving" the problem as the U.S. demands. This reinforces our view that North Korean tensions have not yet peaked and remain market-relevant. We ultimately believe that a peaceful solution will prevail, but getting from here (tensions) to there (a negotiated settlement) entails further risks. China Will Try To Reform, But Won't Touch The Property Bubble "They've got to do something about the corporate leverage." This was the conclusion of a client who agreed with our view that President Xi Jinping will likely accelerate his reform agenda after the nineteenth National Party Congress this fall, and that deleveraging is the key indicator (Chart 5). Some clients in China - specifically banks - confirmed that they were under pressure from tightening financial regulation and as a result were both slowing the pace of lending and becoming more scrutinizing of borrowers' creditworthiness. Borrowing rates have ticked up (Chart 6). Chart 5High Time For Some Belt-Tightening High Time For Some Belt-Tightening High Time For Some Belt-Tightening Chart 6Chinese Cost Of Capital Ticks Up Chinese Cost Of Capital Ticks Up Chinese Cost Of Capital Ticks Up Clients also suggested that Chinese leaders would soon re-emphasize the country's transition away from GDP targets as a measure of successful governance and economic stewardship. When the Xi administration came to power, it sought to de-emphasize GDP targets and introduced new and alternative targets - such as urban and rural income per capita, labor productivity, corruption, air pollution - into its assessments of economic progress. But the administration was forced to return to GDP targets amid growth fears in 2015, prompting Premier Li Keqiang to promise "at least" 6.5% growth for the next five years. Now the attempt to elevate qualitative measures of governance looks set to resume. Xi held two meetings of the Central Leading Group for Deepening Overall Reform this summer, in which he noticeably prioritized "green growth" rather than plain old growth, and pushed for replicating and applying more broadly the pilot reforms that have been implemented since his reform agenda was first laid out in 2013. In mid-July, at the National Financial Work Conference, Xi called for local officials to be held accountable for local government debt - even beyond their term in office. And in late July, Yang Weimin, a key economic policymaker who reports to Xi, said, "we won't allow the leverage ratio to rise for the sake of maintaining growth."9 The implication is that GDP growth will be allowed to fall as the government attempts to make progress on difficult reform initiatives. Chart 7Bonds More Important In China Bonds More Important In China Bonds More Important In China Several clients also expressed confidence that China would resume economic "opening up" before long. It is well known that, over the past year, Beijing has sought to attract FDI by promising to implement a nationwide "negative list" and removing certain sub-sectors from that list, in a bid to counter recent weak FDI inflows and ongoing capital outflow pressure. Beijing has also taken steps to deepen its financial sector, such as by expanding and regularizing its bond markets (Chart 7) in preparation for opening the Hong Kong-Shanghai "bond connect," which will allow foreign investors to buy Chinese bonds and, we think, generate strong demand. To add to this list, clients stressed that China is beginning to think about what happens after it lifts the capital controls put in place last year to halt outflows. A number of institutions are interested in expanding their overseas portfolios when they get the "all clear." We would expect the re-opening to come after the central government completes a round of reforming, recapitalizing, and restructuring banks and SOEs, which could push the timing well into 2018 or 2019. But clients are clearly chomping at the bit - which may suggest that they anticipate capital controls to be lifted sooner rather than later. One important reform item that we were told not to expect is the imposition of a nationwide property tax. Chinese authorities delayed the implementation of the tax in 2016 due to the desire to reflate the property market. Presumably they will return to this initiative now that the economy has recovered: it makes long-term sense to give local governments a more stable source of revenue and to suck some air out of the property bubble gradually so that it does not burst (Chart 8). However, clients are skeptical about any reforms that could harshly suppress real estate prices due to the heavy concentration of household wealth in the property sector (Chart 9). Chart 8Provinces To Be Weaned Off Of Land Sales? Provinces To Be Weaned Off Of Land Sales? Provinces To Be Weaned Off Of Land Sales? Chart 9Chinese Wealth Stored In Housing Insights From The Road - Asia Insights From The Road - Asia If the property bubble should be popped, people's life savings would vanish into thin air and there would be chaos in the streets. A client in Hong Kong remarked that the Chinese public will pretty much accept anything as long as property prices continue to rise. Since everyone agrees that social stability is the critical aim of the ruling party, it stands to reason that reforms will not be allowed to threaten the property sector, at least not directly. If the property sector prevents serious attempts at deleveraging, then the environmental agenda will become all the more significant as the focus of the Xi administration in its second five-year term. The administration began by increasing central government spending for environmental regulation more than for any other category of spending (Table 1). And Xi's statements in July, previewing the National Party Congress, emphasized fighting pollution as one of three chief focal points (the others were controlling systemic risks and fighting poverty). Table 1Fiscal Priorities Of Recent Chinese Presidents Insights From The Road - Asia Insights From The Road - Asia In recent months, central inspectors have fanned out across the country to conduct local pollution inspections ahead of end-of-year deadlines. These have fueled market speculation about deep curbs coming to industrial overcapacity, causing the prices of certain commodities that China produces, like aluminum, to surge (Chart 10). These commodity prices have likely already seen the biggest moves - given China's sharp slowdown in 2014 and reflation in 2015-16 - but they are still sensitive to the policy mix in China, i.e. the relative amounts of capacity cuts and deleveraging that take place. Chart 10Supply-Side Reform Has Boosted Metals Supply-Side Reform Has Boosted Metals Supply-Side Reform Has Boosted Metals Bottom Line: Clients across the Asia-Pacific region were focused on the question of Chinese structural reforms. We got the sense that there was much skepticism over whether they would indeed be growth-constraining. But when pushed, clients focused on real estate prices as the one threshold policymakers would not dare to cross in China. What About Japan? A Visit With Mr. K One of our most esteemed clients is a seasoned Japanese global investor who shall go by the moniker of "Mr. K" in the following dialogue (and for future reference). Mr. K opened the dialogue with us by asking us for our view of Japan. Mr. K: What is your view on my country, on Japan? GPS: We tend to think that the current reflationary policy will continue. The Tokyo metropolitan elections did not sound the death knell for Prime Minister Shinzo Abe (Chart 11). The BoJ has become more, not less, dovish, and is not likely to follow other central banks in tightening policy anytime soon. Abe retains control of both houses of the Diet and can increase government spending to boost the economy. And the LDP will continue reflation even if Abe falls. Mr. K: This may be true, reflation will continue. However, the Japanese economy is reaching a plateau after five years of Abenomics. The recent strong GDP numbers were not well-received because consumers feel the stagnation (Chart 12). Global demand, and Chinese demand, have provided a positive backdrop for Japanese manufacturers, but the domestic outlook is not wildly optimistic. Chart 11Abe No Longer In Free-Fall Insights From The Road - Asia Insights From The Road - Asia Chart 12Japanese Feel Stagnant Despite Strong Growth Japanese Feel Stagnant Despite Strong Growth Japanese Feel Stagnant Despite Strong Growth With economic policy, the key phrase is "TINA," There Is No Alternative. There is no alternative to Abe at the moment. If you look back at the Democratic Party of Japan's support in 2011 under Prime Minister Yoshihiko Noda, it was a real contender. Today, it is far from rivaling the LDP (Chart 13). The voting population is, apparently, comfortable. It is true that if Abe leaves, it will not make much of a difference, as long as the LDP remains in power. The younger generations do not seem troubled by the current state of affairs. They are well-trained to endure economic stagnation. There is a sense that those who stand out feel uncomfortable. College graduates looking for jobs are very conservative. While with Generation X there was always the expectation that tomorrow would be a brighter day, Generation Millennial has come not only to accept stagnation, but even to like the stability of flat growth. GPS: Isn't this kind of stagnation a good thing? Isn't it a case of Japan being in a "Goldilocks" phase? Mr. K: Stability and stagnation can be good for markets. First, the macro environment is decent. Corporations have large cash balances, external demand is strong, wage demand is subdued, and the exchange rate is weak. However, risk-taking is not prized, whether in the education system or the media. Public discourse tends to discourage high-risk investments. And risk-takers have not been properly rewarded over the past two decades in Japan (Chart 14), so confidence and risk-appetite are weak. Also, deflation is hard to defeat. The "100 Yen Shop" (dollar store) retail model is a good example. The goods are all cheap, but as long as you can bring more people in, you can make a profit. This is almost all deflationary. Moreover, the Japanese have nothing to spend on! They no longer need new cars, or big computers; they just need mobile phones, maybe a Nintendo Switch, etc. Second, as to the financial markets, greater deregulation is necessary to attract non-Japanese capital flows. Maybe then valuations will normalize (Chart 15). It is essential to see if leading companies continue to gain global competitiveness, in anything from Internet services to gaming. Watch valuations and watch cash flow. Chart 13Opposition Still Can't Touch Ruling LDP Opposition Still Can’t Touch Ruling LDP Opposition Still Can’t Touch Ruling LDP Chart 14Risk-Takers Punished In Japan Risk-Takers Punished In Japan Risk-Takers Punished In Japan Chart 15Japanese Valuations Still Low Japanese Valuations Still Low Japanese Valuations Still Low The key firms are not necessarily the keiretsu, but secondary or new manufacturers that are driving growth. Small caps are more leveraged to foreign exchange, whereas neither the Japanese domestic economy nor the value of the yen matter much to large multinationals anymore. To capitalize on the internal economy you want to be long small caps. Or better yet, long semi-large caps: those companies equivalent to the U.S. companies that make the difference between the S&P 500 and the S&P 600. These are some of the best plays in Japan because they are domestic-oriented and sensitive to the weaker yen. This will provide a tailwind for stocks elsewhere. Local property markets also offer a very good return over the risk-free rate. GPS: What do you make of our view that Abe will push reflationary policy ahead of his efforts to revise the constitution? Given that he needs a strong economy to pass the popular referendum? Mr. K: It is harder to increase fiscal spending in Japan than one might think. However, the North Korean threat is not going anywhere. And the media love "tensions." GPS: So it seems like you are positive about the markets in Japan, but are not yet sold on Abenomics? Mr. K: I suppose the lesson is, if it isn't too cold, stay on the ski slopes. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 For this term, please see Graham Allison, "The Thucydides Trap: Are The U.S. And China Headed For War?" The Atlantic, September 24, 2015, as well as Allison's new book, Destined For War: Can America and China Escape Thucydides's Trap? (New York: Houghton Mifflin Harcourt, 2017). 2 Please see BCA China Investment Strategy Weekly Report, "China-U.S. Trade Relations: The Big Picture," dated November 17, 2016, available at cis.bcaresearch.com. 3 Please see BCA China Investment Strategy Weekly Report, "China's Geopolitical Pressure Points: Knowns, Unknowns And A Hedge," dated August 17, 2017, available at cis.bcaresearch.com. 4 Please see "China cracks down on distribution of illegal publications," Xinhua, July 25, 2017, available at news.xinhuanet.com. China also highlighted the BRICS countries' joint efforts at enforcing intellectual property as it prepared to host the BRICS conference in Xiamen, Fujian in September. Please see Ministry of Commerce, "Ministry Of Commerce Holds Press Conference on 2017 BRICS Trade Ministers' Meeting," August 4, 2017, available at english.mofcom.gov.cn. 5 Please see the Office of the United States Trade Representative, "USTR Announces Initiation of Section 301 Investigation of China," August 2017, available at ustr.gov. 6 Other examples of U.S. cooperation with Chinese initiatives include the U.S. sending a small delegation to take part in the One Belt One Road (OBOR) conference in May. 7 In particular, Chairman of the Joint Chiefs of Staff Dunsford visited China, met with the Central Military Commission, and vowed to improve military-to-military relations. 8 Or a country like Ukraine, which agreed to give up its nuclear arsenal as soon as it became independent in 1994, only to see its territory carved up by global powers 20 years later (13 years after it emptied its missile silos). 9 Please see Sidney Leng, "China shifts gear from growth to debt cuts in race against rising tide of red ink," South China Morning Post, July 27, 2017, available at www.scmp.com. Appendix Table 2Will The U.S. Attack North Korea? Insights From The Road - Asia Insights From The Road - Asia Geopolitical Calendar

Highlights The global economic recovery has been driven by demand in China, the U.S. and Europe, while domestic demand in EM ex-China has not recovered much. Going forward, the key to EM financial markets performance will be Chinese imports and commodities prices. Our negative outlook for China's capital spending and imports will be wrong if the money velocity or the money multiplier or productivity growth rise materially. If any one of these were to occur, relying on money growth to forecast economic growth will prove futile. That said, assumptions about a substantial rise in either money velocity, the money multiplier or productivity would be highly speculative and unreasonable. With respect to capital flows, EM currencies have been supported by portfolio flows, not FDI inflows. Hence, any reduction or reversal in these portfolio flows is a major risk to EM exchange rates. Feature Chart I-1EM Share Prices Are ##br##Facing A Technical Hurdle EM Share Prices Are Facing A Technical Hurdle EM Share Prices Are Facing A Technical Hurdle In this week's report we elaborate on the following interrelated questions: Where do EM economies stand in terms of their respective business cycles? What are the key drivers and risks to our view? EM share prices in U.S. dollar terms are facing another technical hurdle (Chart I-1). Even though EM risk assets have been trading well, we still find their risk-reward profile unattractive, and below we elaborate why. The EM Business Cycle EM economic data have differed greatly over the course of the current rally, and various economic parameters presently exhibit very different phases of the business cycle in developing economies. For example, Asian export growth has rolled over having expanded at a double-digit pace early this year (Chart I-2). In general, EM exports have posted a broad-based recovery: the recovery in Chinese, U.S. and European imports has helped Asian exports, while higher commodities prices have boosted export revenues of commodities producers. On the flip side, domestic demand in EM ex-China has been rather mediocre. In fact, there has been very little domestic demand recovery, as evidenced by retail sales and auto sales (Chart I-3). Importantly, bank loan growth has not recovered at all (Chart I-3, bottom panel). Based on the above, we can summarize the above divergences as follows: the global economic recovery has been driven by demand in China, the U.S. and Europe, while domestic demand in EM ex-China has not recovered much. Chart I-2Asian Export Growth ##br##Has Rolled Over Asian Export Growth Has Rolled Over Asian Export Growth Has Rolled Over Chart I-3EM ex-China: Domestic ##br##Demand Has Not Yet Recovered EM ex-China: Domestic Demand Has Not Yet Recovered EM ex-China: Domestic Demand Has Not Yet Recovered In turn, China's imports surge has been due to the revival in new money/credit origination that has been in play since the middle of 2015. China's commercial banks have originated about RMB 43 trillion of new money/credit in the past two years. This has greatly helped many developing countries selling to China, boosted commodities prices, creating fertile ground for capital flows to EM financial markets. Going forward, the pertinent question for the EM business cycle is which of the following two scenarios will likely play out: (1) China's imports relapse materially soon, weighing on commodities and other EMs and capping the recovery in their domestic demand; or (2) Chinese import growth holds and the recovery in EM ex-China domestic demand gains momentum. The first scenario entails a bearish outcome for EM share prices, while the second would imply a continuation of the EM rally. BCA's Emerging Markets Strategy team envisages the first scenario. The basis of our argument is that the deceleration that has already occurred in Chinese money growth combined with ongoing monetary tightening are about to cause a considerable slowdown in China's real economy and imports (Chart I-4). What about the other two pillars of global imports - the U.S. and Europe? U.S. imports have in the past year outpaced final sales to domestic purchasers (Chart I-5). As can be seen in this chart, imports are more volatile than domestic demand and this discrepancy is reflective of inventory cycles. After outpacing final domestic demand for the past seven months, odds are U.S. imports growth will moderate in the next 12 months. That said, we do not expect a contraction in U.S. imports. Even if European imports remain robust, a material slowdown in China and some moderation in U.S. imports will be sufficient to produce a slump in EM aggregate exports. The rationale is twofold: First, for many developing countries, China as a destination for shipments is larger than or as large as the U.S. and Europe combined. Chart I-4China: Money Growth And Business Cycle China: Money Growth And Business Cycle China: Money Growth And Business Cycle Chart I-5U.S. Import Growth to Moderate U.S. Import Growth to Moderate U.S. Import Growth to Moderate Second, mainland demand for raw materials is critical for their prices. In turn, the trend in commodities prices often defines EM financial markets dynamics. This is why we focus so much on China's credit/money cycle, which in turn drives China's capital spending and an overwhelming majority of its imports. Notably, the reason why Chinese imports are much more sensitive to credit compared to other EM and DM economies is because the mainland's imports consist of 42% of commodities and raw materials and 55% of capital goods. Hence, 97% of imports is for investment spending, with the latter financed and driven by money/credit. Bottom Line: The global economic recovery has been driven by demand in China, the U.S. and Europe, while domestic demand in EM ex-China has not recovered much. Going forward, the key to EM financial markets performance will be Chinese imports and commodities prices. The Key Pillar Of Our View The key area where we differ from the bullish consensus on EM/China is our expectation that Chinese growth will slow before year-end due to a combination of ongoing policy tightening and lingering credit excesses. Regardless of which broad money measure we use - official M2, money calculated using commercial banks' liabilities (we refer to it as deposit-money or M3 hereafter) or banks' assets (we refer to this as credit-money) - the current message is the same: broad money growth has fallen to historic lows (Chart I-6). An imperative question is: what does the recent gap between broad money (our calculation of M3) and private (corporate and household) credit growth, as evidenced by the top panel of Chart I-7A, mean for investors? Chart I-6China: Various Versions Of Broad Money China: Various Versions Of Broad Money China: Various Versions Of Broad Money Chart I-7Comparing Broad Money And Credit Growth Comparing Broad Money And Credit Growth Comparing Broad Money And Credit Growth From the perspective of the outlook for growth, it is the aggregate of private and public credit that matters. When we substitute private credit with the aggregate of private and public credit, there does not appear to be much decoupling (Chart I-7, bottom panel). Readers should note that the historical time series for aggregate private and public credit is from BIS and the data for 2017 are our estimates based on general government fiscal deficit and total social financing. If past correlations between money, credit and economic growth and their respective time lags hold, the cyclical parts of the Chinese economy should slow down before year-end (Chart I-8). This differs from the consensus view on the street that a slowdown is not in the cards until well into next year (or later). China's currently flat yield curve also supports our view on imminent growth deceleration (Chart I-9). In fact, Chinese money market rates and onshore corporate bond yields have begun drifting higher following two to three months of consolidation. Chart I-8China: A Slowdown Before Year-End? China: A Slowdown Before Year-End? China: A Slowdown Before Year-End? Chart I-9China: Yield Curve And PMI China: Yield Curve And PMI China: Yield Curve And PMI Finally, we believe the depth of the impending slowdown will be material because ongoing liquidity tightening is occurring amid lingering credit excesses/credit bubble. While policymakers do not plan to push the economy into a vicious downturn, they may be open to the idea of attempting mild short-term deleveraging to contain risks in the long run. Furthermore, the Chinese authorities - like in any other country - may not have perfect foresight about the magnitude of a potential slowdown. Hence, their reversal of tightening policies is likely to be late, resulting in a rough spot in growth. Bottom Line: The key difference between our stance and the bullish view on EM is on China's growth trajectory and commodities prices. Risks To Our View Given that the main pillar of our view is that China's credit and money growth is driving mainland capital spending and imports, our recommended investment strategy will be wrong if the already transpiring slowdown in money growth does not translate into investment spending deceleration. This could happen because of the following: Strong nominal growth can coincide with slower money growth only if the velocity of money accelerates. In short, our view will be wrong if China's nominal output growth holds up or quickens, despite the slowdown in broad money growth that has already occurred. This could happen if the velocity of money suddenly shoots up - i.e., the same amount of money simply turns faster facilitating faster expansion of nominal output. There is no way to forecast changes in money velocity in any country in any period with any precision. As a rule, we (and the vast majority of other market participants) simply assume money velocity will be constant over our forecast horizons. Money velocity is calculated as nominal GDP divided by broad money supply. From a historical perspective, Chart I-10 demonstrates that China's money velocity has actually drifted lower in the past 10 years or so. Therefore, a material rise in China's money velocity would be an exception from the trend of past decade. Consequently, before assuming a rising money velocity, one needs to prove why it will escalate going forward. This does not mean it is impossible or could not happen, but it is reasonable to challenge the nature and timing of it. Our view will be wrong if money growth accelerates sharply from current levels without more liquidity (banks' excess reserves) provisioning by the People's Bank of China (PBoC). In such a scenario, broad money growth acceleration amid low levels of banks' excess reserves would signify a spike in the money multiplier. However, the money multiplier for China - measured as broad money divided by commercial banks' excess reserves at the central bank - is already at the second highest of the past ten years (Chart I-11, top panel). In level terms, there is currently about RMB 212 trillion of broad money - measured by commercial banks' liabilities/deposits (our measure of M3) versus RMB 2 trillion of commercial banks' excess reserves at the end of June. Chart I-10China: Velocity Of Money ##br##Has Been Drifting Lower China: Velocity Of Money Has Been Drifting Lower China: Velocity Of Money Has Been Drifting Lower Chart I-11China: Money Multiplier ##br##Is Already Elevated China: Money Multiplier Is Already Elevated China: Money Multiplier Is Already Elevated We assume the money multiplier will be flat to down in China over the next 12-18 months. Banks have already become overextended with respect to the money multiplier, and are operating on thin liquidity/excess reserves (Chart I-11, bottom panel). With interest rates rising and regulatory tightening forcing banks to bring off-balance-sheet assets onto their balance sheets, it is reasonable to assume a flat-to-down money multiplier. Finally, another risk to our view stems from productivity. If productivity growth is set to accelerate considerably in China, it will boost real output growth despite the slump in money/credit. Chart I-12China: Structural Slowdown ##br##In Productivity Growth China: Structural Slowdown In Productivity Growth China: Structural Slowdown In Productivity Growth It is hard to measure productivity ex-post, let alone to forecast it. This is especially true for developing economies. This is why we assume that productivity growth in China will be stable in the medium term but will decelerate in the long run if structural reforms are not implemented and the economy's reliance on abundant money/credit is not reduced. Simply put, when money/credit are plentiful, people and companies make a lot of money without working hard and innovating. This is why money/credit deluges and asset bubbles often lead to a considerable productivity slowdown in any country. Provided that China's economy has been primarily fueled by copious amounts of money and credit since early 2009, it is reasonable to assume that productivity growth has slowed (Chart I-12). Without structural reforms, the quality of capital allocation will not improve. Therefore, productivity growth is bound to slow rather than accelerate. We will discuss the structural outlook for China including productivity and economic rebalancing toward the service sector in a special report to be published in the coming weeks. Bottom Line: Our negative outlook for China's capital spending and imports will be wrong if the money velocity rises considerably or the money multiplier shoots up or productivity growth accelerates materially. If any one of these were to occur, relying on money growth to forecast economic growth will prove futile. That said, assumptions about a substantial rise in either money velocity, the money multiplier or productivity from current levels would be highly speculative and unreasonable. Risk Off And Fund Flows Into EM Last week we downgraded Korean stocks due to expectations that geopolitical tensions are set to rise in the near term. BCA's Geopolitical Strategy service does not expect war on the Korean peninsula as long-standing constraints to conflict are still in place, starting with Pyongyang's ability to cause massive civilian casualties north of Seoul via an artillery barrage. As such, the ultimate resolution to the conflict will be a peaceful one. However, getting from here (volatility) to there (negotiated resolution) requires more tensions. The U.S. has to establish a "credible threat" of war in order to move China and North Korea towards a negotiated resolution.1 And that process could take more time, which means more volatility in the markets.2 The risk-off dynamics in EM due to tensions in the Korean Peninsula is a near-term risk and might become a trigger for a rollover in EM risk assets via reversal of portfolio flows. One of the narratives supporting the EM rally has been the changing composition of foreign capital flows into EM. This narrative argues3 that international flows to EM have been dominated by foreign direct investment (FDI) rather than portfolio inflows. This presages that EM risk assets are much less exposed to portfolio outflows than before. However, this is factually wrong. The composition of international capital flows into EM has been dominated by portfolio flows rather than FDI. In fact, FDI inflows have not yet recovered (Chart I-13). For the calculation of this aggregate we exclude not only China, Korea and Taiwan - which have large current account surpluses and do not require FDI inflows - but also Brazil. We exclude Brazil because its FDI and portfolio flows data have been distorted due to disadvantageous tax treatment of portfolio flows relative to FDIs. Chart I-14 illustrates that FDIs inflows have been robust and net portfolio inflows have been negative in the past 18 months. The latter does not pass our smell test because Brazil's financial markets have rallied tremendously since early 2016. This appears simply non-credible and confirms lingering speculation that a lot of foreign capital inflows have been registered in Brazil as FDI inflows to get preferential tax treatment - and were subsequently invested in financial markets, specifically in domestic bonds, not the real economy. Chart I-13EM ex-China, Korea, Taiwan And Brazil: ##br##FDI Inflows Have Not Recovered EM ex-China, Korea, Taiwan And Brazil: FDI Inflows Have Not Recovered EM ex-China, Korea, Taiwan And Brazil: FDI Inflows Have Not Recovered Chart I-14Brazil: The Puzzle of FDI ##br##Inflows And Portfolio Flows Brazil: The Puzzle of FDI Inflows And Portfolio Flows Brazil: The Puzzle of FDI Inflows And Portfolio Flows Chart I-15Brazil: Strong FDI Inflows ##br##And Collapsing Capital Spending Brazil: Strong FDI Inflows And Collapsing Capital Spending Brazil: Strong FDI Inflows And Collapsing Capital Spending Consistently, capital spending has not recovered at all, despite the preceding collapse (Chart I-15). All in all, excluding Brazilian data, there has been little recovery in EM FDI inflows (Chart 16A and Chart I-16B). Chart I-16AFDI Inflows Into Various EM Countries FDI Inflows Into Various EM Countries FDI Inflows Into Various EM Countries Chart I-16BFDI Inflows Into Various EM Countries FDI Inflows Into Various EM Countries FDI Inflows Into Various EM Countries Bottom Line: With respect to capital flows, EM currencies have been supported by portfolio flows, not FDI inflows. Hence, any reduction or reversal in these portfolio flows is a major risk to EM exchange rates. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," April 19, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?," August 16, 2017, available at gps.bcaresearch.com. 3 Please see, "Globalisation in retreat: capital flows decline since crisis", August 21, 2017, available at https://www.ft.com/content/ade8ada8-83f6-11e7-94e2-c5b903247afd Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights China's tightened control on capital account transactions has played a key role in slowing down capital outflows, particularly outward FDIs. Meanwhile, investors' panic over the RMB has also abated substantially, likely due to a combination of greater policy transparency and improved growth conditions. The PBoC's capital account control measures will not be permanent. Cross-border capital flows are by nature volatile and highly pro-cyclical, while China's capital account control measures are imposed as a counter-cyclical mechanism. The stabilization in China's official reserves is accompanied by a notable setback in the RMB's internationalization process. The internationalization of the RMB will resume, but it is impossible to challenge the role of the dollar as the world's dominant reserve currency in the foreseeable future. Feature Chart 1The Decline In Chinese Official Reserves##br## Has Halted The Decline In Chinese Official Reserves Has Halted The Decline In Chinese Official Reserves Has Halted Amid recent soft growth numbers, an important positive development is that official foreign reserves in China have been increasing for six consecutive months, which is being perceived as a sign of the country's re-gained macro stability (Chart 1). A closer look at China's foreign reserves and balance-of-payment statistics suggests capital outflows have slowed considerably. Confidence in the RMB appears to have improved, but expectations of further RMB depreciation have not completely reversed. This means capital outflows may still accelerate, especially if the dollar bull market resumes.1 The RMB internationalization process has also suffered a notable setback in recent quarters due to investors' weakened confidence in the currency. The RMB will continue to gain broader adoption beyond China's borders over time, but the process will be gradual and hesitant, and it will not challenge the mighty dominance of the U.S. dollar anytime soon. Capital Flows: What Has Changed? Chinese official reserves have stabilized around US$3 trillion since early this year, bottoming from a prolonged decline from a peak of over US$4 trillion in mid-2014. The broad dollar weakness in recent months has boosted the value of Chinese official holdings of non-dollar assets, which has helped stabilize the level of overall reserves. Nonetheless, the country's balance-of-payment data shows major changes in the patterns of cross-border capital flows, yielding some important information. Chart 2Inward Portfolio Investment Has "Normalized" Monitoring Chinese Capital Outflows And The RMB Internationalization Process Monitoring Chinese Capital Outflows And The RMB Internationalization Process In terms of capital inflows, the messages are mixed (Chart 2). On one hand, portfolio inflows have rebounded sharply since the second quarter of 2016 after a deep decline in the previous three consecutive quarters. Foreign investors aggressively pulled out of Chinese markets, particularly bonds, between the third quarter of 2015 and the first quarter of 2016, spooked by the People's Bank of China's surprise moves to devalue the RMB in August 2015 and in January 2016. It appears that foreign investors have become more comfortable with the RMB's "new normal" in recent quarters. Foreign purchases of Chinese onshore bonds have largely returned to normal, but stock purchases have remained subdued compared with previous years. The dramatic boom-bust in the Chinese domestic stock market in 2015 also dampened foreign investors' appetite towards this volatile asset class. It remains to be seen whether the newly established "bond connect" program and the MSCI's recent decision to include A shares in its indexes will be able attract more foreign portfolio investors. On the other hand, foreign direct investment (FDI) inflows have continued to decline. Inbound FDI dropped to a mere US$21 billion in the last quarter, near the levels at the height of the global financial crisis (Chart 3). FDIs are largely strategic decisions and are less influenced by near-term exchange rate fluctuations. Therefore, the sharp decline in FDI is a worrying sign that foreign investors' confidence in the Chinese business environment has weakened significantly, which is consistent with numerous surveys that show a gradual drop in China's ranking in global company's investment plans (Chart 4). For the Chinese authorities, how to improve the country's business environment and re-gain investors' confidence should be taken much more seriously. Chart 3FDI Has Fallen Sharply FDI Has Fallen Sharply FDI Has Fallen Sharply Chart 4China Is Losing Lure Among Global Firms China Is Losing Lure Among Global Firms China Is Losing Lure Among Global Firms On capital outflows, all channels have slowed of late, which is the key reason behind the stabilizing official reserves. Outbound FDI has fallen sharply since the fourth quarter of 2016 (Chart 5). Corporate China's overseas investments averaged almost US$60 billion for six consecutive quarters between the third quarter of 2015 and the fourth quarter of 2016, and has dropped to less than US$20 billion in the past two quarters. Repayment of overseas liabilities by the corporate sector, another major reason for capital outflows in previous years, has also slowed substantially (middle panel, Chart 5). Corporate China's deleveraging of dollar debt quickened sharply in 2015, as the RMB began to fall against the dollar. It has eased considerably of late, either due to re-gained stability of the exchange rate or as the deleveraging process has become advanced. The balance-of-payment statistics shows that total outstanding foreign loans and trade credit currently stand at US$620 billion, down from a peak of over US$1 trillion in the second quarter of 2014. Rampant "hot money" outflows in previous quarters have reversed recently (bottom panel, Chart 5). In fact, inbound "currency and deposits," which we label as "hot money," as it is most liquid and historically has been highly volatile, have reached a new record high. Taken together, the Chinese regulators' tightened rein on capital account transactions have clearly played a key role in slowing down capital outflows, particularly outward FDIs. Meanwhile, investors' panic over the RMB has also abated substantially, likely due to a combination of greater policy transparency and improved growth conditions. In essence, cross-border capital flows are by nature volatile and highly pro-cyclical, while China's capital account control measures are imposed as a counter-cyclical mechanism to regulate capital flows. In this vein, the PBoC's capital account control measures will not be permanent - they will be eased as capital outflows ease. It is important to note that China still runs a current account surplus, which means the country, public and private sectors combined, is still accumulating net foreign assets. Chart 6 shows that China's official reserves have declined substantially from their 2014 peak, but the country's total foreign assets have continued to climb - an indication that the private sector has been taking a greater share in the country's total foreign claims. For years, the PBoC's key challenge was to persuade the private sector to hold more assets in foreign currencies, and the trend has suddenly changed in recent years. It is wrong, however, to assume that the change is permanent. Chart 5Capital Outflows Have Eased Significantly Capital Outflows Have Eased Significantly Capital Outflows Have Eased Significantly Chart 6Private Sector Is Taking A Greater Share ##br##Of China's Foreign Claims Private Sector Is Taking A Greater Share Of China's Foreign Claims Private Sector Is Taking A Greater Share Of China's Foreign Claims The RMB Internationalization Scorecard Chart 7Setback In The RMB Internationalization Process Setback In The Rmb Internationalization Process Setback In The Rmb Internationalization Process The stabilization in China's official reserves is accompanied by a notable setback in the RMB's internationalization process. Measured by two key functions of money, the role of the RMB as an international currency has declined. As a medium of exchange, the RMB's role in cross-border settlement has dropped sharply (top panel, Chart 7). Currently the RMB accounts for about 15% of China's foreign trade settlement, down from over 30% at the peak of early 2016. The RMB's share as an international payments currency dropped to 1.98% in July, down from 2.45% in January 2016, according to SWIFT. The share of the RMB as a trade settlement currency has also stabilized in recent months, as the RMB exchange rate has stabilized. As a store of value, the RMB's role has likely also dropped, particularly among private investors, as evidenced by the sharp decline in RMB deposits in Hong Kong (bottom panel, Chart 7). Among official reserve managers, however, the role of the RMB may have begun to increase. The European Central Bank converted the equivalent of €500 million of its foreign reserves into RMBs in the first half of 2017. Since March 2017, the International Monetary Fund (IMF) has begun to include holdings of RMB in its currency composition of official foreign exchange reserves (COFER). The IMF identified US$88.5 billion of RMB-denominated official foreign reserve assets held by reserve managers in the first quarter of 2017, about 1% of total allocated reserve holdings (Table 1). From a big-picture perspective, the internationalization of the RMB will continue, even though the process will be hesitant and halting, with temporary setbacks. China is the largest trade partner of a growing number of countries with tightly-linked supply chains. This generates natural demand for RMB settlement in bilateral trade. In fact, the correlation between the RMB and the currencies of some of China's Asian neighbors has increased significantly in recent years, which is effectively creating a "RMB currency bloc" (Chart 8). Meanwhile, the Chinese government's ongoing "one-belt one-road" initiative involves financing for infrastructure in some less-developed countries, which will further boost demand for the RMB in these regions. All of this will inevitably broaden the reach of the RMB beyond China's borders. Table 1Composition Of Global Reserve Assets Monitoring Chinese Capital Outflows And The RMB Internationalization Process Monitoring Chinese Capital Outflows And The RMB Internationalization Process Chart 8The RMB Currency Bloc The RMB Currency Bloc The RMB Currency Bloc Nonetheless, it is impossible for the RMB to challenge the role of the dollar as the world's dominant reserve currency in the foreseeable future. The dollar's dominant status is not only supported by America's strong and open economy, but also by its deep, liquid and highly efficient financial markets, which are simply impossible for China to replicate anytime soon. The dramatic volatility in China's financial markets, regulators' shaky handling of the stock market boom-bust and the RMB's volatility in recent years are all indicative of a primitive financial infrastructure. China's legal and administrative frameworks will likely take even longer to converge to western standards. In short, the role of the RMB as an international currency will likely remain marginal for a long time. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China: What Could Go Wrong?" dated August 3, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Copper's impressive rally leaves prices out in front of fundamentals. We are expecting a correction going forward, given our view that reduced mine output results from transitory disruptions, and China's growth appears to be stalling: industrial output, investment, retail sales, and trade all grew less than expected last month. Energy: Overweight. Crude oil prices remain fairly well supported this week on signs U.S. production growth may not be as strong as expected, and continued production discipline by OPEC 2.0 keeps global inventories from building too rapidly. We remain long Brent and WTI $50/bbl vs. $55/bbl call spreads in Dec/17, which are up 99.1% and 18.9%, respectively. Base Metals: Neutral. Copper prices appear to be getting out ahead of fundamentals, particularly as regards Chinese demand, which could stall on the back of slower economic growth. Precious Metals: Neutral. In line with our House view, we expect the Fed to remain dovish on the inflation front, which, over time, will mean the central bank finds itself behind the curve on inflation. This means real rates remain relatively low for the foreseeable future, which will be supportive of gold. Ags/Softs: Underweight. We remain bearish, although we are not aggressively shorting any of the ags. Feature Chart of the WeekCopper 2017H1: Exceptional Performance Copper 2017H1: Exceptional Performance Copper 2017H1: Exceptional Performance Copper futures traded on COMEX rallied by almost 10% from the beginning of May, when spot was trading just under $2.50/lb, until late July, then shot up by an additional 9% on news of a potential ban on scrap imports by China; 4% of that increase was recorded on July 25 alone (Chart of the Week). Spot copper settled at $2.9865/lb Tuesday. Part of this rally can be put down to a renewed focus on China's environmental policies, which we expect to continue following the 19th National Congress of China's Communist Party later this year, and the better-than-expected performance of the Chinese economy in 2017H1. This occurred as supply side disruptions at some of the world's largest copper mines caused markets to discount possible near-term shortages, along with rumors of an import ban on so-called Category 7 scrap metals. These stories supercharged the copper market. Supply/Demand Imbalances Are Transitory While labor-related disruptions at major copper mines led to a production cutback in 2017H1, supply has, for the most part, recovered. Furthermore, these are one-off events that we do not foresee persisting or having a lasting impact on markets.1 Production of copper ores and concentrates fell a negligible 0.1% year-on-year (yoy) in H1, following a 6.7% yoy increase in global output in 2016. Year-to-date (ytd) production growth lies significantly below the 5.63% average for the same period 2013-2016 (Chart 2). Similarly, in a marked slowdown from the four-year average growth of ~ 4% yoy in refined copper production, output remained largely unchanged in the first 4 months of 2017 compared to last year. However, there is evidence of relief in May and June, which registered a 6.08% yoy increase in output. The slowdown in production is mainly driven by supply-side shocks at some of the world's largest mines in Chile, Peru, and Indonesia. Contract Renegotiations and Weather Disruptions in Chile: The respective 1% and 6.6% yoy fall in global ores and concentrates output in February and March can be attributed to a corresponding year-on-year 17% and 23% declines in production from Chile - the world's leading copper producer. At BHP Billiton's Escondida mine, the world's largest, 2,500 workers staged a 43-day strike over contract renegotiations, which ended without resolution in late March. Although the end of the strike has brought relief to copper output, talks will resume in 18 months, raising the possibility of another strike - and an accompanying production cut - in a year's time. However, President Marcelo Castillo has somewhat calmed these worries, expressing his intent to revise the mine's operating model so that it will be minimally impacted by such disputes in the future. The decline in Chilean output was compounded by heavy snow and rain in May, which forced the Caserones mine to halt production for three weeks. This was reflected in a ~ 1.7% yoy decline in national output in May. Caserones has since resumed production and is now reported to have reached 90% of capacity. Nationwide Strikes in Peru Not Expected to Show up in July Data: Labor reforms proposed at the end of July led to a three-day walk-out by unionized workers across Peru. The strike impacted operations at major deposits including Antamina, Cerro Verde, Cuajone among others. However, according to the National Society of Mining, Petroleum and Energy, absenteeism was insignificant and the impact on copper output was limited. This followed a five-day strike at Cerro Verde - Peru's second largest mine - in March due to dissatisfaction with labor conditions. Peru ramped up output by almost 25% in 2015, surpassing China as the second largest producer of copper, and accounted for 11.4% of global output in 2016. Dispute Over Export Rights and Worker Dissatisfaction at Grasberg: In an effort to promote its domestic smelting industry, Indonesian authorities imposed a temporary ban on exports of copper concentrates in January. However, in April, Freeport McMoRan was granted an eight-month license to resume exports from its Grasberg mine - the second largest in the world. Furthermore, CEO Richard Adkerson expressed confidence that Freeport will succeed in securing an agreement by October, allowing it to implement a major multi-billion-dollar underground mine development plan. Labor unrest remains a problem for the company, nonetheless. Angered by redundancies and enforced furloughs, a strike by 5,000 workers was extended for a fourth month, until the end of August. Output data until May shows production remained largely unchanged compared to last year and follows a 3.82% yoy increase in Q1. Indonesian output accounted for 3% of global copper production in 2016. This will have to be resolved for the company's development plans to proceed unchallenged. Despite these supply-side shocks and ensuing Q2 inventory draw, copper remains well stocked at the major warehouses (Chart 3). Furthermore, COMEX inventories are at their highest level since 2004. As long as the global market remains well stocked, we expect it will be capable of withstanding volatility induced by labor markets and government policy with minimal impacts on prices. Chart 2Supply Disruptions Subsiding,##BR##Copper Market Back In Balance Supply Disruptions Subsiding, Copper Market Back in Balance Supply Disruptions Subsiding, Copper Market Back in Balance Chart 3Copper Inventories##BR##Can Withstand Volatility Copper Inventories Can Withstand Volatility Copper Inventories Can Withstand Volatility Scrap Imports Kick In Amidst Elevated Prices Chart 4China Copper Demand Weakening China Copper Demand Weakening China Copper Demand Weakening A dip in Chinese demand was also partly to blame for the minimal impact of the production cutbacks on inventories. Chinese consumption single-handedly makes up ~ 50% of global copper demand. The 1.46% yoy decline in global refined copper consumption during 2017H1 is, in large part, due to a 4.57% yoy drop in Chinese consumption (Chart 4). In fact, consumption during February and April fell 10% and 11%, respectively. Weak demand is also evident in China's import of copper ores and concentrates data. Although imports grew by 2.72% yoy in 2017H1, this is a marked slowdown from the 33.66% growth rate witnessed during the same period last year, and the average H1 growth of 22.6% since 2012. Similarly, China's imports of refined copper, copper alloy, and products fell 18.32% yoy in 2017H1 before increasing by 8.33% yoy last month. However, it appears that scrap copper may have helped fill the void - China's imports of copper scraps and wastes increased by 18.56% in the first half of this year compared to the same period last year. This marks a turning point in the trend, as copper scrap imports have been on the decline since 2013, and is likely a direct result of speculation over the impact of China's environmental policies on base metals. China's Scrap Import Ban: Overplayed Last week, China confirmed intentions to ban some forms of scrap copper imports beginning as early as the end of the year. This is part of measures taken to support sustainable growth and environmental protection. While rumors swirled in late July suggesting "Category 7" (i.e. old) scrap copper would be included in the import ban, the list of banned waste imports released last week by the Ministry of Environmental protection did not include copper. However, copper scrap from automobiles, ships and electronic devices were included in a "limited import" category, with no further details of the import constraints to be imposed on these products. Scrap impacts the copper market in two main ways: It provides smelter-refineries an alternative input, in addition to ores and concentrates, thus enhancing total refined copper supply. The International Copper Study Group (ICSG) estimates global production of refined copper increased by 2% in January due to increased production from scrap, which rose by 13% yoy. It acts as a substitute for refined copper, providing first-stage manufacturers a lower-cost alternative input. This means that when prices are up, as they have been since late 2016, the impact on refined copper production is somewhat muted because scrap usage kicks in (Chart 5). Furthermore, because of this response, the effect of supply-side shocks on refined copper output are - to some extent - restrained. Chart 5Scrap Imports Kick In When Prices Are Up Scrap Imports Kick In When Prices Are Up Scrap Imports Kick In When Prices Are Up This explains why the market has been in somewhat of a frenzy since late July after hearing that the Chinese authorities will likely implement an import ban on some types of scrap copper, which caused copper prices to jump to levels last seen in 2015Q2. Copper futures traded on COMEX have rallied by 10% from the beginning of May to late July, then shot up an additional 9% on rumors of an import ban; 4% of that increase was recorded on July 25 alone. Markets are clearly buying into the news, and are optimistic the ban will hike demand for other forms of copper. However, we believe this optimism is unfounded, and that the impact on copper markets is overplayed. Although the ICSG estimates that ~ 30% of annual copper usage comes from 'secondary' or recycled sources, a much smaller ratio originates from 'old' scrap copper. This type of scrap is derived from end-of-life electronics, households, cars, and industrial products. While data on old-scrap copper supply is not readily available, researchers at Antaike estimated that out of the 3.35mm MT of scrap copper imports in 2016, old-scrap copper imports made up ~ 0.3mm MT of copper-equivalent. This accounts for a very small fraction of China's 17.05mm MT of imports of copper ores and concentrates and 4.94mm MT imports of refined copper last year. Thus, even if a ban on all old-scrap copper were to materialize, we do not believe it will create a supply deficit, or even threaten one. In addition, there has been speculation that a ban would reroute old scrap metal to other countries for dismantling and processing before being imported by China, diminishing its impact on the copper market. Given that the market's reaction to news of the ban has been favorable, we expect to see a correction as the market responds to information that the ban is less bullish than expected. Chinese Demand Will Ease As Tailwinds Die Down In 2017H1, China surprised with better-than-expected economic performance, which supported copper prices. China's infrastructure and equipment industries are especially important to the copper market, consuming, respectively, 43% and 19% of the red metal domestically. However, as our colleagues on BCA Research's China desk foresaw, recent data gives some early-warning signs of a slowdown in growth.2 Industrial output, investment and retail sales figures came in below expectations amid a cooling property market. Furthermore, restrictions on riskier types of lending will continue slowing credit growth going forward. The property market - residential and commercial construction - accounts for ~ one-third of copper consumption. After reaching three-year highs late last year, the official manufacturing PMI and the Keqiang index - both used as key measures of the state of China's economy - show evidence that the economy is stabilizing (Chart 6). In fact, the Keqiang index has come down significantly from its peak earlier this year. In particular, signs of cooling in China's property sector are playing into the possibility of weaker industrial metals generally. Steel-making commodities and base metals have been in high demand ever since China relaxed housing policies, reviving the property market. However, in an effort to cool this market, Chinese authorities announced measures to raise down payments and control speculative buying in 20 cities last September. These measures are beginning to show up in property-market construction and sales data (Chart 7). Chart 6Early Warning Signs Of China Slowdown Early Warning Signs of China Slowdown Early Warning Signs of China Slowdown Chart 7China Property Sector: Cooling China Property Sector: Cooling China Property Sector: Cooling New floor space started contracted by almost 5% yoy in July, potentially signaling early warning signs of what could come ahead. It marks a reversal of a 10.55% expansion in 2017H1. New floor space completed declined in July, registering a 13.54% fall yoy. This follows 5% growth in 2017H1 - a marked slowdown from the 20.05% pace of growth in 2016H1. Furthermore, floor space under construction has been steadily easing, growing just 3.17% yoy in July. In terms of floor space sold, July's yoy growth of 2% follows a 21.37% yoy growth rate in June, and marks a pronounced slowdown from the 15.82% average yoy growth rate in 2017H1. Chart 8China's Economic Structure##BR##Deviates From Trend China's Economic Structure Deviates From Trend China's Economic Structure Deviates From Trend While near term growth does not appear to be threatened, earlier this month the IMF warned against China's "reliance on stimulus to meet targets," and a "credit expansion path that may be dangerous," which could cause a medium-term adjustment. When this eventually weighs down on industrial activity - as we expect - it will reverberate throughout the economy, discouraging investment projects, and eventually taking its toll on commodities generally, base metals in particular. Even so, in a small change of pace, China's share of secondary sector (i.e. manufacturing) as a percent of GDP crept up in July (Chart 8). This is a deviation from the trend in the evolving structure of China's economy, where the tertiary sector (services) has been making up an increasing share of GDP. While it is still too early to determine whether this is the beginning of a change in trend, or a one-off case, this development is positive for metals short term, since manufacturing activity is industrial-metal intensive. Bottom Line: We expect a correction in copper prices near term, as markets adjust to revelations that the market impact of China's environmental policies is less than expected. Our longer-term outlook is neutral: The synchronized economic upturn in global demand will partially offset waning economic activity in China, as tailwinds from accelerating export growth and easing monetary conditions die down. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 We discuss some of these developments during 2017Q1 in BCA Research's Commodity & Energy Strategy Weekly Report "Copper's Price Supports Are Fading," published by March 23, 2017. It is available at ces.bacresearch.com. 2 Please see BCA Research's China Investment Strategy Weekly Report titled "China Outlook: A Mid-Year Revisit", dated July 13, 2017, It is available at cis.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Copper's Getting Out Ahead Of Fundamentals, Correction Likely Copper's Getting Out Ahead Of Fundamentals, Correction Likely Commodity Prices and Plays Reference Table Copper's Getting Out Ahead Of Fundamentals, Correction Likely Copper's Getting Out Ahead Of Fundamentals, Correction Likely Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights Social unrest and populism are on a secular rise in the U.S.; However, the "Breitbart clique" has suffered a critical defeat in the current Administration; This will make headway for upcoming tax legislation and resolution of the debt ceiling imbroglio; We continue to stress that domestic politics will not hurt U.S. equities, but more downside to USD may exist this year; India-China military tensions are not strategic or market relevant, yet. Feature "Most Americans do not find themselves actually alienated from their fellow Americans or truly fearful if the other party wins power. Unlike in Bosnia, Northern Ireland or Rwanda, competition for power in the U.S. remains largely a debate between people who can work together once the election is over." - Newt Gingrich, January 2, 2001 This is the second time we have begun a report with this classic Gingrich quote from 2001, which now seems to come from a different era. On November 9, 2016 we used it to open our election post-mortem in which we argued that American party identifications were ossifying into tribal markers that could cause run-of-the-mill polarization to mutate into something scarier.1 Chart 1 shows that party identification (Republicans vs. Democrats) is now responsible for the greatest difference in attitudes towards 48 values, something historically determined by race and education. Over the long term, these trends are concerning and may spur further social unrest in the U.S. As we wrote in June, the gulf between America's patricians and plebeians has never been as wide as it is now. It is being complemented by a gulf in ideology and worldview.2 Part of the problem is that migration from the traditionally liberal-leaning coastal America as well as the Great Lakes region have significantly altered the demographic makeup of the American South (Chart 2). The combination of pro-business regulation, low taxes, sunshine, affordable real estate, southern charm, and excellent higher-education institutions has been difficult to resist.3 Thus, an influx of young and educated migrants has altered the political makeup of many traditionally conservative states. There are many cities - much like Charlottesville, Virginia - where these recent migrants will come into conflict with the values and traditions of the south. Chart 1Rise Of A Tribal America Is The "Trump Put" Over? Is The "Trump Put" Over? Chart 2Internal Migration Is A Risk... Is The "Trump Put" Over? Is The "Trump Put" Over? Given America's history of internal population movements, these patterns of migration should not be a problem. However, today's polarization is extreme (Chart 3), and it is deepening thanks to radically different information and media streams made available by cable television and especially the Internet (Chart 4). Chart 3... In A Polarized Context... ... In A Polarized Context... ... In A Polarized Context... Chart 4... Where 'Fake News' Proliferates ... Where 'Fake News' Proliferates ... Where 'Fake News' Proliferates What does all of this mean for investors? America is geopolitically very well endowed. It has benign neighbors, strong demographics, and almost all the natural resources it needs. However, hegemons are not born out of plenty, but rather out of need and want. The U.K. built a global empire largely because its rain-drenched island lacked basic materials for superpower status. Spain and Portugal discovered new worlds because stronger empires barred lucrative trading routes. Geography does not preordain hegemony. Strong domestic institutions, luck, and guts and glory do. The USD remains weak despite the fact that the Fed was the first major central bank to start hiking this cycle and despite strong economic data out of the U.S. relative to the rest of the world (Chart 5). Perhaps investors have caught the whiff of something rotten in the American Empire? If so, we may be seeing the beginning of a major USD bear market. Chart 5USD Should Be Outperforming In The Current Global Macro Context USD Should Be Outperforming In The Current Global Macro Context USD Should Be Outperforming In The Current Global Macro Context BCA's Foreign Exchange Strategy sees the current DXY weakness as temporary. We agree, given that the current trajectory of BCA's ECB months-to-hike measure is discounting way too much hawkishness (Chart 6). The dollar index will likely rally in 2018 as inflation data improves and risks in Europe (Italian election) and Asia (Chinese structural reforms) deepen. Chart 6The ECB Hawkishness Is Overstated The ECB Hawkishness Is Overstated The ECB Hawkishness Is Overstated The scope and pace of the 2018 USD rally, however, will depend on whether investors have confidence in America's economy and institutions. If the Republican tax reform agenda stalls later this year, and if social unrest continues, sovereign and long-term investors may begin to think about diversifying away from the dollar. The "Trump Put" Continues We do not expect domestic politics to play a role in an equity correction. At least not yet. First, investors seem to be completely discounting any possibility of tax reform judging by the performance of the high tax-rate basket (Chart 7). This is likely a mistake. Tax reform is a major component of both Trump's and congressional Republicans' agenda. If it fails, Republicans will have to go to their home districts empty-handed to campaign for the November 2018 midterm elections. Second, the market fell 1.58% after President Trump's combative press conference on August 15. The move was not a reprimand for Trump's rhetoric, but concern that Gary Cohn, the scion of the "Goldman clique" and likely the next Fed Chair, would resign over the comments.4 These concerns have now been allayed by the firing of Stephen Bannon, the White House Chief Strategist and leader of the "Breitbart clique." Bannon's departure puts Cohn, Treasury Secretary Steven Mnuchin, and Commerce Secretary Wilbur Ross firmly in charge of economic policy. Meanwhile, three generals are now in charge of foreign and national policy: Defense Secretary James Mattis, National Security Advisor H.R. McMaster, and Chief of Staff John F. Kelly. Between the six of them, and Secretary of State Rex Tillerson, there is not a drop of populism left in the White House. Chart 7What Tax Reform? What Tax Reform? What Tax Reform? Although nationalists and populists may be on the retreat, it is still not clear what form tax legislation will take. The only thing that has certainly changed since earlier this year is that the border adjustment tax is officially dead, which would have raised ~$1 trillion in revenue over ten years.5 This requires the GOP either to moderate its tax cuts by the same amount, or to add more to the deficit, which, according to legislative rules, would make the cuts temporary. It is likely at this point that whatever bill the GOP passes, it will expire after a "budget window" of around ten years. The divergence between the White House and Congress remains the same: the White House wants gigantic tax cuts, while Congress wants tax reform, i.e. to broaden the tax base and reduce inefficiencies and distortions. The White House would blow out the budget deficit by more than would the House GOP. There are two key questions that investors want to know from the upcoming tax legislation. First, how significant will the fiscal thrust be? This will determine the impact to the economy and hence will affect the Federal Reserve's response. The GOP Plan: Both the White House and the House GOP claim that they will reduce the budget deficit over the next ten years despite cutting taxes. They project an average budget deficit of 1.3%-1.4% from 2018-2027, down from a 3%-4% baseline. This projection is rationalized via expectations of faster economic growth as well as "dynamic scoring" to capture the macroeconomic feedback of the tax cuts. The White House and GOP claim that economic feedback will reduce the deficit by $1.5-$2 trillion over the ten-year budget window, which is 26%-37% of the total deficit reduction they are proposing (i.e., likely very optimistic).6 The Tax Policy Center Response: Outside analysis of the budget plan argues the opposite. The Tax Policy Center argues that the White House plan, insofar as the details are known, would add a minimum of $3.4 trillion to the deficit over the next ten years, and that the macroeconomic feedback could even be negative (i.e., add to the deficits). The deficit would rise from 3.2% of GDP to 6.4% by 2026, if we factor in the Congressional Budget Office assumptions that a 4% real growth rate leads to a GDP of $26.9 trillion in 2026.7 The GOP Retort: Republicans claim they will reduce the deficit by means of proposed "revenue offsets," or savings measures, over the ten-year period. The Tax Policy Center highlights the following in particular: $1.6 trillion from repealing personal exemptions; $1.5 trillion from abolishing all itemized deductions (other than the politically sensitive mortgage interest deduction and charity deduction); $622 billion from treating some income from pass-through businesses as dividends; $272 billion from repealing corporate tax breaks; $208 billion from repealing the "head of household" status for tax filers; $49 billion from taxing capital gains upon death (above the $5 million threshold). The total is $4.3 trillion in savings, against $7.8 trillion of losses, for a total deficit that is increased by $3.4 trillion over the ten years. This would amount to around $340 billion of "stimulus" each year, with the biggest thrust felt in 2018-19. We very much doubt that the White House will achieve this slate of proposals. It has not shown an inkling of the ability to coordinate such a difficult legislative feat. Therefore, we expect the tax legislation to be watered down. The budget deficit may rise to something closer to 6%, over the next ten years, than to the gigantic 12% of GDP implied by Trump's proposals on the campaign trail (Chart 8). Chart 8Question Of The Year: Will Tax Reform Be Stimulative? Question Of The Year: Will Tax Reform Be Stimulative? Question Of The Year: Will Tax Reform Be Stimulative? The second question asked by investors is about the impact of tax legislation on assets. It is clearly positive for inflation and growth given that even tepid tax cuts will provide economic stimulus when unemployment is already very low. Our colleagues at BCA already believe, without a tax bill, that inflation is likely to surprise to the upside in 2018-19.8 Fiscal stimulus via tax cuts would obviously add to that. The equity market will cheer any promising developments on tax cuts or reform, especially given that so little is currently priced in. However, whether the USD rallies as it did on hopes of tax legislation earlier this year will largely depend on how the Fed reacts to the legislation. There is a lot of uncertainty, particularly if President Trump decides to go with Gary Cohn as the next Fed chair. Bottom Line: Congressional Republicans cannot gamble with tax legislation. The failure to cut taxes, or reform the tax code, would be a major policy misstep ahead of the midterm elections. If legislation passes, we expect that Congress will have had greater control over the plan than the White House, reducing the eventual magnitude of the tax cut and the fiscal stimulus. Congress controls the purse strings and will reassert that authority in the context of an ineffective executive. Should You Care About The Debt Ceiling? Clients are beginning to fret about the upcoming debt ceiling fight. There is good reason to be nervous. The Republican-held Congress has failed to pass legislation, notably on this year's priority item, Obamacare. The last thing Republicans want is to shut down the government or cause a technical default entirely of their own doing! Clients should note that while government shutdowns have occurred in the past, the debt ceiling has never been breached. This is because the debt ceiling is an anachronism. In other countries, when a budget is passed it automatically contains the implicit authority to issue whatever debt is required to finance the resulting deficit.9 To require separate legislation for a budget and an authorized level of debt is a product of politics and has little bearing on the actual financing needs of the U.S. government. At the end of the day, the debt ceiling will almost inevitably be raised in the U.S. because no government could stand the popular pressure that would result from social security checks not being mailed out to seniors (who vote!) or a halt to other entitlement programs. Only a disastrous chain of events resulting from polarization and brinkmanship, even worse than in the Obama years, would lead to such an outcome. Today, given that Republicans control both chambers of Congress and the White House, there is no way for the Republicans to share the blame with the Democrats, as they did under Obama. Investors are therefore mistaking the game-theoretical paradigm: It is not a "game of chicken," but rather a cooperative game given that Republicans in Congress are largely on the same side. Members of the GOP are starting to "get it," including the fiscally conservative House Freedom Caucus. David Schweikert, influential member of the Freedom Caucus who sits on the House Ways and Means Committee, said last week that he is in favor of a clean bill to raise the debt ceiling. Mark Meadows, North Carolina representative who chairs the group, has also said that he is "bullish" on raising the debt limit, although he added that he preferred to attach some reforms to the bill. On August 2, he said "Either that will get done [some spending cuts attached to the debt ceiling bill] or a clean debt ceiling will get done. We will raise the debt ceiling and there shouldn't be any fear of that." Other members of the Caucus, including its founder Jim Jordan of Ohio, have retorted that no debt limit hike without spending cuts should be contemplated, prompting the media to focus on the brinkmanship. But we note that the Freedom Caucus, the most fiscally conservative grouping in the House, is itself considerably divided on the issue. This augurs well for a clean bill since the Republican majority in the House is 22 and the Freedom Caucus has 31 members. If Schweikert and Meadows are indicative of how the group will vote, the fiscal conservatives may not have enough votes to deprive the GOP of a majority. (The latter would force GOP moderates to go to the Democrats for votes, complicating the negotiations and increasing the risk of mistakes.) What about the Democrats in the Senate? To pass a clean bill on the debt ceiling, Republicans would need at least eight Democrat Senators to get to 60 votes, and probably more given that Rand Paul (R-Kentucky) would likely vote against a clean bill. We doubt that Democrats would remain united in voting against a clean bill. It would allow President Trump and Republicans in Congress to accuse them of hypocrisy and holding U.S. credit hostage, much as Democrats did to Republicans between 2011-2016. As such, the market's fear that Democrats could play the spoiler is a red herring. While some grassroots activists in the Democratic Party are sure to want a confrontation, its median voters tend to be educated and well-informed. The worst-case scenario for the market would be a two-week shutdown, between October 1, when the current funding for the government expires, and sometime in mid-October when the debt ceiling is hit, according to the Congressional Budget Office. Odds of such a scenario are probably around 25%. But the contingent probability of a debt ceiling failure following a government shutdown would be reduced, not increased, given that it would focus public attention on Republican incompetence. In other words, if a shutdown occurs on October 1, we would expect the odds of a debt ceiling crisis to be reduced. Finally, our assessment that the "Goldman Sachs clique" has reasserted control over White House economic policy should also be positive for the likelihood of a clean debt ceiling bill. While we have no evidence that Stephen Bannon was in favor of using the debt ceiling for fiscal cuts (given his opposition to government spending cuts in toto), he did say following his resignation that Trump would be "moderated" by remaining White House staffers. He went on to say "I think he'll sign a clean debt ceiling; I think you'll see all this stuff." The only remaining holdover in the White House on the debt ceiling issue is the Office of Management and Budget Director Mick Mulvaney. Mulvaney has suggested earlier in the year that Republicans should try to tie spending restraint to a debt ceiling bill. However, at a meeting between President Trump and GOP leaders in early June, President Trump said that congressional leaders should take Steven Mnuchin's position as the White House position. "Mnuching is that guy," Trump told party leaders at the meeting, according to GOP sources who spoke to Politico in the summer. Mulvaney's office has also confirmed that the Treasury Department "has point on the debt ceiling," i.e., that Mnuchin is in charge. Bottom Line: Concern over the debt ceiling is natural, given the failure of Republican-held Congress to pass any legislation of note this year. However, it is also overstated. The U.S. government would default on its obligations to its voters, first and foremost. Such a scenario - given Republican control of all branches of government - would put the final nail in the coffin of the Republican-held Congress ahead of the midterm elections. Fade any fear of a U.S. default. Will India And China Fight A War? Clients, particularly in China, have shown considerable concern about geopolitical conflict between China and India. Since early June, a border dispute between China and India has flared up in the Doklam region. Doklam, or rather the India-China-Bhutan border region, is one of three main border disputes in the Himalayas that flare-up from time to time - along with Kashmir and Arunachal Pradesh. The 1962 border war between the two Asian behemoths over the latter two areas marked the biggest flare in recent memory. Today, India is fearful of China's growing military and logistical capabilities and concerned about the long-term security of the Siliguri Corridor, the narrow stretch of land connecting the subcontinent to the Northeast (Map 1). Control of the Doklam Plateau and Chumbi Valley would give China access to Siliguri; they are therefore important areas to monitor.10 India is also threatened by China's improving bilateral relations with neighbors like Pakistan,Bangladesh, Sri Lanka, Nepal, and potentially Bhutan. The latter does not have formal relations with China, has always been under India's sphere of influence, and is at the center of the current dispute. And ultimately, India fears that China seeks to create an economic corridor through Bangladesh to the Indian Ocean, which would, in combination with the Pakistan corridor, surround India. Map 1Too Close For Comfort: Tensions Threaten India's Control Over Vital Siliguri Corridor Is The "Trump Put" Over? Is The "Trump Put" Over? The current dispute ostensibly began - as many do - with contested infrastructure construction. India built some bunkers at a forward outpost in Lalten in 2012; China allegedly bulldozed them on June 6-8 of this year. The same month, Indian troops confronted Chinese troops building a road along the border with Bhutan that would have connected an existing road to a People's Liberation Army outpost and to the border crossing of Doka La. While the territorial dispute is old, China is expanding its pressure tactics on Bhutan, while India has sent troops into disputed Sino-Bhutanese territory in a more assertive defense of Bhutan. Broadly, China is making inroads with infrastructure as it develops its far-flung western regions and seeks to improve connectivity with neighbors via the One Belt One Road (OBOR) initiative. China is capital-rich and can afford to improve its access to regions of strategic value that yield access to key Indian territories or supply water and hydropower to India. India is capital-poor and downstream, so its ability to respond is often limited to military gestures. India also wants to retain its dominance over Bhutanese foreign policy, in place since 1949 and especially 1960, and this dispute is marked by India taking an active military role on Bhutanese territory on Bhutan's behalf. There are several reasons we do not expect this conflict to be market-relevant. First, the Himalayas are isolated and poor, so that China or India would have to make a very dramatic move that poses a genuine strategic threat (e.g., to the Siliguri Corridor, or Chinese control of Tibet, or Indian relations with Pakistan, or Indian water sources) to trigger a larger conflict. Second, while it is true that nationalism is flaring up on both sides, China has a clear interest in pursuing some "rallying around the flag" strategy amid the standoff over North Korea, and ahead of the Communist Party's nineteenth National Party Congress. That it chose to do so in Doklam, where conflict is more easily contained than in the Koreas or the East or South China Seas, suggests that political opportunism and China's desire to make incremental gains, rather than a sweeping Chinese plan to seize strategic territory, is driving the current episode. Meanwhile, India needs to attract capital to build its manufacturing base, and Prime Minister Narendra Modi has reached out to China for this reason. India will undoubtedly defend its strategic interests if attacked, but otherwise it is not eager to clash with China, which has bulked up its military far more than India has done in recent decades. Chart 9India Would Bolster Containment Of China India Would Bolster Containment Of China India Would Bolster Containment Of China However, we do see India-China relations as fitting into the larger, negative geopolitical dynamic where the U.S. and its allies encourage India as a balance to China, while China suspects the U.S. alliance of using India and others to encircle and entrap China (Chart 9). Not that the U.S. stirred up the current dispute, but that the U.S. (and Japan) will generally seek to improve relations with India and to strengthen its military and economy, and China will use its regional influence to try to keep India off balance.11 This structural dynamic, in addition to China's territorial assertiveness, is likely to keep generating frictions. Bottom Line: A conflict between India and China is only market-relevant if it extends beyond disputed territories in the Himalayas to affect core strategic interests like the Siliguri Corridor, Tibetan stability, the Indo-Pakistani balance of power, or water supply and hydropower. It could also become market-relevant by worsening U.S.-China relations - and delaying Chinese economic reforms - if China should come to feel embattled on all geopolitical fronts. For instance, should an adventurous, "lame duck" Donald Trump attempt to combine with India and other neighbors in ways that threaten to cause problems in China's western regions as well as in its East Asian periphery. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Martin H. Barnes, Senior Vice President Economic Advisor mbarnes@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 3 Hook 'em Horns! 4 We recently argued that the White House is torn between two groups, the "Goldman" and the "Breitbart" cliques. The Goldman clique is led by Gary Cohn, Director of the National Economic Council and is pragmatic, un-ideological, and focused on passing tax reform and pro-business regulation. The Breitbart clique is populist, nationalist, and leans to the left on economic matters. Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "Will Congress Pass The Border Adjustment Tax?" dated February 8, 2017, available at gps.bcaresearch.com. 6 Please see Congressional Budget Office, "An Update to the Budget and Economic Outlook: 2017 to 2027," June 2017, available at www.cbo.gov and U.S. Office of Management and Budget, "Budget of the U.S. Government: A New Foundation For American Greatness, Fiscal Year 2018," available at www.whitehouse.gov. 7 Please see the Tax Policy Center, "The Implications Of What We Know And Don't Know About President Trump's Tax Plan," July 12, 2017, and Benjamin R. Page, "Dynamic Analysis of the House GOP Tax Plan: An Update," June 30, 2017, available at www.taxpolicycenter.org. Using White House growth assumptions of 4.7% would lead to a deficit of 5.7% in 2026. 8 Please see BCA U.S. Bond Strategy Portfolio Allocation Summary, "On Hold, But Not For Long," dated August 8, 2017, and U.S. Bond Strategy Weekly Report, "Two Challenges For U.S. Policymakers," dated May 23, 2017, available at usbs.bcaresearch.com. 9 Denmark also has a debt ceiling, but it has set it so high that it does not need to be addressed. 10 Please see Sudha Ramachandran, "Bhutan's Relations With China And India," Jamestown Foundation, China Brief (17:6), April 20, 2017, available at Jamestown.org. 11 In fact, Japan already waded into the India-China dispute. The Japanese ambassador to India issued a statement critical of China, which the Chinese Foreign Ministry immediately rebuked.

Highlights Beware of asset managers' and leveraged funds' large net long positions in EM currencies. Overextended net long positions in EM and commodities currencies signify overbought conditions in EM risk assets in general. This in tandem with the poor outlook for EM/China growth makes the risk-reward of EM financial markets unattractive. Downgrade Korean equities from overweight to neutral, but continue to overweight Korean technology stocks relative to the EM benchmark. Also, maintain the short KRW / long THB trade. Take profits on the long Indian / short Indonesian stocks position. Consistently, downgrade Indian stocks to neutral and upgrade Indonesian bourses to neutral within an EM equity portfolio. Feature Investor positioning in EM currencies is elevated. From a contrarian perspective, this at minimum warrants a correction. Chart I-1 illustrates that asset managers' and leveraged funds' combined net long positions in the Mexican peso, the Brazilian real, the Russian ruble and South African rand are very elevated.1 This aggregate is weighted by notional value of outstanding open interest of each currency, and is shown as a percentage of open interest. Importantly, we have refined positioning data to separate asset managers and leveraged funds from other non-commercial and commercial institutions. Asset managers and leveraged funds reflect investment community sentiment the best. Besides, they are the most inclined to scale back their net long positions if and when these currencies begin to depreciate, i.e., they are more momentum driven. By doing so, they will reinforce the selloff. Currently bullish sentiment on EM and commodities is corroborated by the fact that asset managers' and leveraged funds' aggregate net long positions in non-EM commodities currencies such as the CAD, the AUD and the NZD are at the highest level since 2011 (Chart I-2). Typically, these currencies are at risk of a correction when positioning reaches such excessive levels. Chart I-1Asset Manager's And Leveraged Funds' Net Long Positions In EM Currencies Are Large Asset Manager's And Leveraged Funds' Net Long Positions In EM Currencies Are Large Asset Manager's And Leveraged Funds' Net Long Positions In EM Currencies Are Large Chart I-2Asset Manager's And Leveraged Funds' Net ##br##Long Positions In Commodities Currencies Asset Manager's And Leveraged Funds' Net Long Positions In Commodities Currencies Asset Manager's And Leveraged Funds' Net Long Positions In Commodities Currencies Chart I-3A and Chart I-3B show the same for individual currencies such as the MXN, the BRL, the RUB, the ZAR, the CAD, the AUD and the NZD. The overarching message is that investors' net long exposure to both EM and commodities currencies is large and depreciation risk for these exchange rates is substantial, at least in the near term. Chart I-3AAsset Managers And Leveraged Funds' Net ##br##Long Positions In Select Currencies Asset Managers And Leveraged Funds' Net Long Positions In Select Currencies Asset Managers And Leveraged Funds' Net Long Positions In Select Currencies Chart I-3BAsset Managers And Leveraged Funds' Net ##br##Long Positions In Select Currencies Asset Managers And Leveraged Funds' Net Long Positions In Select Currencies Asset Managers And Leveraged Funds' Net Long Positions In Select Currencies Yet, these positioning data do not reveal whether potential weakness will be a bull market correction or the beginning of bear market. Our bias remains that the potential selloff will evolve into a new phase of the bear market in EM currencies that began in 2011. In turn, as EM currencies depreciate, they will erode foreign investors' returns and trigger a selloff in other EM risk assets such as stocks, domestic bonds and credit markets. In short, investor sentiment on EM risk assets correlates with sentiment toward both EM and commodities currencies. Hence, bullish sentiment and overextended net long positions in EM and commodities currencies signify overbought conditions in EM risk assets in general. The Cyclical Outlook Chart I-4EM Currency Valuations Are Close To Neutral EM Currency Valuations Are Close To Neutral EM Currency Valuations Are Close To Neutral We are negative on the cyclical outlook for EM currencies for the following reasons: With a few minor exceptions, EM currencies are not cheap; their valuations are close to neutral Chart I-4 demonstrates the real effective exchange rate for aggregate EM excluding China, Korea and Taiwan. This is an equity market cap-weighted aggregate. It shows that EM exchange rate valuations are not depressed. The reason why we remove China, Korea and Taiwan from the calculation is because their respective bourses have large equity market-cap weights in the MSCI EM stock index, and thereby dominate the EM aggregate. Excluding these three markets, we get a less skewed perspective on EM currency valuations and assign higher weight to the high-yielding ones. Importantly, the best measure of currency valuation is, in our opinion, the real effective exchange rate based on unit labor costs (ULC). The rationale is that this measure captures changes in wages and productivity. The latter two are critical to competitiveness and, hence, reveal the true valuation of currencies. Unfortunately, there is no available ULC-based real effective exchange rate data for all individual EM currencies. Chart I-5A and Chart I-5B presents the measure for countries where data from reputable sources are available. By and large, the message is that, with the exception of the Mexican peso, EM currencies are not particularly cheap. Chart I-5AReal Effective Exchange Rates ##br##Based On Unit Labor Costs Real Effective Exchange Rates Based On Unit Labor Costs Real Effective Exchange Rates Based On Unit Labor Costs Chart I-5BReal Effective Exchange Rates ##br##Based On Unit Labor Costs Real Effective Exchange Rates Based On Unit Labor Costs Real Effective Exchange Rates Based On Unit Labor Costs The outlook for EM exchange rates has historically been contingent on growth and corporate profitability in developing economies. That said, EM exchange rate fluctuations have in recent years become dependent on U.S. real interest rates as the importance of portfolio fixed-income flows into EM has dramatically surged. Both drivers - EM growth and U.S. real yields - are likely to become headwinds for EM exchange rates going forward. EM growth will relapse anew as Chinese growth slows and EM shipments to China decline. Our new money impulse for China2 has historically been a good leading indicator for EM exchange rates, and it points to potentially considerable EM currency depreciation in the next six to nine months (Chart I-6). Meanwhile, U.S. interest rate expectations are very depressed. It will take only slightly stronger U.S. growth and inflation readings or some non-dovish guidance from the Federal Reserve for U.S. interest rate expectations to move higher. The latter will support the U.S. dollar and hurt EM currencies. Although industrial metals prices have recently spiked to new cyclical highs, we believe commodities prices - both for energy and industrial materials - will be lower in the medium term. Global oil stocks are breaking to new cyclical lows, heralding weakness in crude prices (Chart I-7). The fact that oil has failed to post gains amid a notable rally in the euro could be a sign of fundamental vulnerability. Chart I-6China's Money Impulse And EM Currencies China's Money Impulse And EM Currencies China's Money Impulse And EM Currencies Chart I-7Oil Prices Are Vulnerable Oil Prices Are Vulnerable Oil Prices Are Vulnerable As for industrial metals prices, our analysis has not changed: the considerable slowdown in China's broad money heralds a major top in industrial metals prices, as per Chart I-8. The mainland accounts for 50% of global industrial metals consumption, and its capex cycle is of critical importance. What explains the latest spike in base metals prices? Chart I-9 reveals that since early this year, iron ore prices have been negatively correlated with Chinese money market rates (interest rates are shown inverted and are advanced by 30 days Chart I-9). This year's correction and subsequent rebound in iron ore prices might be attributed to changes in mainland traders' positioning due to swings in domestic interest rates. Chart I-8China-Plays Are At Risk China-Plays Are At Risk China-Plays Are At Risk Chart I-9Chinese Interest Rates And Iron Ore Prices Chinese Interest Rates And Iron Ore Prices Chinese Interest Rates And Iron Ore Prices Going forward, either China's growth will decelerate sufficiently enough to weigh on industrial metals prices, or the authorities will resume policy tightening to rein in financial excesses. All in all, the risk-reward for iron ore and other industrial metals is negative. On the whole, lower energy and industrial metals prices will weigh on EM commodities currencies. As for Asian currencies, they are sensitive to global trade. We expect global trade and tradable goods prices to relapse due to the resumption of a slowdown in China/EM demand. Manufacturing-based Asian currencies will depreciate amid budding weakness in their manufacturing sector (Chart I-10). In addition, Chart I-11 shows global auto sales lead global semiconductor sales by several months. The basis for this correlation is that autos nowadays use a lot of semiconductors, and therefore auto cycles affect semiconductor demand. The boom in semi-cycle has been one of the pillars of Asian exports recovery. As the former moderates, the latter will relapse weighing on Asian non-commodities currencies. Chart I-10Asian Manufacturing ##br##And Exchange Rates Asian Manufacturing And Exchange Rates Asian Manufacturing And Exchange Rates Chart I-11Global Auto Sales Lead ##br##Global Semiconductor Sales Global Auto Sales Lead Global Semiconductor Sales Global Auto Sales Lead Global Semiconductor Sales Bottom Line: Our bet remains that EM currencies will depreciate versus both the U.S. dollar and the euro - and regardless of euro/U.S. dollar exchange rate fluctuations. We recommend a short position in a basket of the following EM currencies: ZAR, TRY, COP, CLP, BRL, IDR, MYR and KRW. For market-neutral portfolios, our currency overweights are MXN, RUB, PLN, CZK, TWD, INR and THB. Korean Equities: Downgrading To Neutral We recommend downgrading Korea to neutral from overweight within EM equity portfolios. North Korea will likely remain a source of uncertainty and volatility. BCA's Geopolitical Strategy service does not expect war on the Korean peninsula as long-standing constraints to conflict are still in place, starting with Pyongyang's ability to cause massive civilian casualties north of Seoul via an artillery barrage. As such, the ultimate resolution to the conflict will be a peaceful one. However, getting from here (volatility) to there (negotiated resolution) requires more tensions. The U.S. has to establish a "credible threat" of war in order to move China and North Korea towards a negotiated resolution.3 And that process could take more time, which means more volatility in the markets.4 The overwhelming portion of Korea's equity rally has been driven by a phenomenal surge in one company's share price: Samsung. Excluding technology companies, the performance of MSCI Korea stock prices and their EPS has been mediocre. Samsung's explosive rally has been partially due to the exponential surge in DRAM prices (Chart I-12). On a macro level, we cannot forecast prices of individual semiconductors (such as DRAM). Nevertheless, our assessment is that the global semi cycle is entering a soft patch as per Chart I-11 above. Furthermore, Korea's cyclical growth has already peaked, and will slow going forward (Chart I-13). Broad money growth is still decelerating, entailing that no turnaround is in the cards (Chart I-13, bottom panel). Chart I-12Samsung Share Prices And DRAM Samsung Share Prices And DRAM Samsung Share Prices And DRAM Chart I-13Korea: Cyclical Profile Korea: Cyclical Profile Korea: Cyclical Profile Importantly, the new government has enacted a law to boost minimum wages by 16% in January 2018 and would need to increase by a similar rate annually to reach its 2020 target. Even though there are fiscal subsidies for businesses and minimum wages affect smaller businesses much more than larger ones, odds are that this will still boost overall wage growth, and hence weigh on companies' profit margins. Chart I-14Korean Won Is Expensive Versus The Yen Korean Won Is Expensive Versus The Yen Korean Won Is Expensive Versus The Yen Finally, the Korean won is modestly expensive, based on the unit labor costs-based real effective exchange rate (Chart I-14, top panel). The won is especially expensive versus the yen (Chart I-14, bottom panel). This is negative for Korean manufacturers and the currency. Investment Recommendations Downgrade Korean stocks from overweight to neutral, but continue to overweight Korean technology stocks relative to the EM benchmark. Close long Korea / short EM equities and long Korean banks / short Indonesian banks positions. These positions have produced small gains since their initiation (details on all our open positions are available at the end of each week's report on page 17). Maintain a short KOSPI / long Nikkei in common currency terms trade: Either the won will depreciate substantially versus the yen or the KOSPI will underperform the Nikkei in local currency terms. In both cases, this trade will be profitable. Continue to bet on lower bond yields in Korea via receiving 10-year swap rates. Deflationary pressures from weaker exports - that make up 35% of GDP - will weigh on economic growth, and the central bank will be forced to cut rates. Maintain a short Korean won / long Thai baht position. The won is a high-beta currency and will underperform the Thai baht in a selloff / Asian exports slowdown. The Thai currency will likely trade in a low beta fashion due to the country's large current account surplus and low exposure to both China and commodities. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Take Profits On Long Indian / Short Indonesian Equities Position This recommendation has generated 8.4% gain since its initiation on July 30, 2014, and we recommend booking profits. Indian share prices have outperformed their Indonesian peers over the past year (Chart II-1) but the outlook for top line growth appears to be slightly better in Indonesia than in India. Specifically: We have combined bank credit to businesses and households with government expenditures to calculate a credit and fiscal spending impulse for both countries. Chart II-2 illustrates that this impulse heralds a more positive outlook for listed companies' revenues in the case of Indonesia than India. Chart II-1Book Profits On Long Indian / ##br##Short Indonesian Stocks Position Book Profits On Long Indian / Short Indonesian Stocks Position Book Profits On Long Indian / Short Indonesian Stocks Position Chart II-2Credit And Fiscal Spending ##br##Impulse Favor Indonesia Over India Credit And Fiscal Spending Impulse Favor Indonesia Over India Credit And Fiscal Spending Impulse Favor Indonesia Over India Other cyclical variables are mixed in both economies: vehicle and two-wheeler sales are sluggish, manufacturing PMIs have rolled over, but imports of capital goods are improving (Chart II-3). In regard to valuation and profitability, both bourses are expensive in absolute terms (Chart II-4, top panel) but India's return on equity (RoE) is well below Indonesia's (Chart II-4, bottom panel). Such a 14% premium of Indian stocks over Indonesian ones along with a poor revenue outlook and lower RoE might prevent further share price outperformance by India. Chart II-3Mixed Cyclical Growth Dynamics Mixed Cyclical Growth Dynamics Mixed Cyclical Growth Dynamics Chart II-4India And Indonesian Equities: P/E Ratios And RoEs India And Indonesian Equities: P/E Ratios And RoEs India And Indonesian Equities: P/E Ratios And RoEs Although our negative outlook for commodities prices and expensive equity valuations entail a negative stance on Indonesian risk assets in absolute terms, we believe this bourse's underperformance versus the EM overall equity index and Indian stocks is late. It makes sense to reduce/eliminate an underweight allocation to Indonesian equities. Bottom Line: We recommend booking gains on the long Indian / short Indonesia equity position initiated on July 30, 2014. Consistently, we downgrade Indian stocks from overweight to neutral and upgrade Indonesian ones from underweight to neutral within an EM equity portfolio. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 CFTC is the U.S. Commodity Futures Trading Commission. The data on South African rand is available from May 2015. 2 Presented and discussed in detail in July 26, 2017 and August 16, 2017 reports; the links are available on page 18. 3 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," April 19, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?," August 16, 2017, available at gps.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights U.S. Tax Cuts: The ongoing turmoil in the White House, and the negative impact it is having on the popularity ratings of both President Trump and the Republican-led U.S. Congress, will intensify efforts to get a tax cut package done as quickly as possible. Success on this front will help buoy U.S. business confidence and lead to stronger U.S. economic growth, and likely more Fed rate hikes, in 2018. Fed vs. ECB: Economic growth is solid, and inflation expectations remain stable, on both sides of the Atlantic. We expect a December rate hike by the Fed, with more likely in 2018, and a tapering of asset purchases by the ECB beginning in January. Maintain a defensive stance on portfolio duration. U.S. Corporates vs. EM: Emerging market (EM) hard currency debt, both sovereign and corporate looks fully valued, even with a positive global growth backdrop. Reduce EM sovereign and corporate debt in favor of U.S. Investment Grade corporates in global fixed income portfolios. Feature Who's In Charge Here? Table 1A Rough Month For Risk A Lack Of Leadership A Lack Of Leadership Financial markets are sailing without a rudder at the moment. A clear risk-off flavor has swept over most risk assets, as can be seen in the returns seen so far in August in so many asset classes (Table 1). There have been a number of negative news events for investors to process, from President Trump's Charlottesville controversy to the never-ending staff changes in the White House to the North Korean tensions to last week's terror attack in Spain. On top of that, some of the major central banks have become a bit more wishy-washy in their guidance to the markets, even going as far as questioning their own understanding of the inflation process (does the Philips curve even work anymore?). Investors always prefer a clean narrative when it comes to the "big picture" macro backdrop. Right now, they are not getting that from political leaders and policymakers, especially in the U.S. (Chart of the Week). Trump's popularity rating is steadily declining, even now among Republican voters. This has raised concerns that any of his business-friendly policies tax cuts or initiatives to boost growth like infrastructure spending can be successfully enacted. At the same time, and perhaps for similar reasons, the gap between the market expectation and the Fed's projection for the funds rate is widening with only 24bps of hikes priced over the next year. This is driven largely by investors' persistent lack of belief that U.S. inflation will hit to the Fed's target in the next few years. Simply put, the market is saying that the Fed's current tightening cycle is essentially complete unless there is a turnaround in U.S. inflation and/or a sizeable fiscal stimulus enacted in D.C. On that latter point, we think it is critical to monitor measures of U.S. business confidence. The current cyclical upturn in global growth and corporate profits has certainly lifted optimism among business leaders. Yet it is clear that there was also a boost to business sentiment after the U.S. election (Chart 2) last November as it was believed that Trump's victory, and the likely policies that would follow, would be good for American companies. Right now, business optimism remains at strong levels whether looking at small business measures like the NFIB survey (top panel) or the big business series like the Conference Board CEO confidence index of the Duke University/CFO Magazine indicator for confidence among chief financial officers (middle panel). There has been a slight recent pullback from the post-election peak in all the business sentiment indicators, however, and any sign that Trump will have difficulty pushing his tax cuts through Congress could result in a bigger loss of confidence that could impact future hiring and capital spending activity. Our colleagues at BCA Geopolitical Strategy continue to believe that a tax reform package, including significant tax cuts, is still the most likely outcome. Congressional Republicans will not want to go into the 2018 U.S. mid-term elections "empty-handed". With Congress and the White House on the same page, focused by fears of losing seats next year, even an embattled and unpopular president should be able to get his tax cuts implemented. Any fiscal boost in the U.S. can only help to support the current global cyclical economic upturn. While growth indicators like our global PMI index have come off the highs a bit (Chart 3), the OECD's global leading economic indicator is still rising and pointing to rising real developed market bond yields (middle panel). In addition, the global data surprise index has bottomed out, leaving global bond yields exposed to any improvement in economic momentum (bottom panel). Chart of the WeekLosing Faith In##BR##Trump & The Fed Losing Faith In Trump & The Fed Losing Faith In Trump & The Fed Chart 2U.S. Businesses##BR##Are Still Confident U.S. Businesses Are Still Confident U.S. Businesses Are Still Confident Chart 3Global Bond Yields Are##BR##Vulnerable To Faster Growth Global Bond Yields Are Vulnerable To Faster Growth Global Bond Yields Are Vulnerable To Faster Growth The fiscal news flow out of D.C. is likely to remain volatile once Congress returns from its summer recess, particularly with regards to tax cut negotiations and the looming debt ceiling. Yet the big news that investors want to hear, regarding U.S. tax cuts, is more likely to be positive for growth and risk assets and negative for bond yields. Bottom Line: The ongoing turmoil in the White House, and the negative impact it is having on the popularity ratings of both President Trump and the Republican-led U.S. Congress, will intensify efforts to get a tax cut package done as quickly as possible. Success on this front will help buoy U.S. business confidence and lead to stronger U.S. economic growth, and likely more Fed rate hikes, in 2018. The Fed & ECB: Still Sticking To Their Script Chart 4Inflation Expectations Are##BR##Stable In The U.S. & Europe Inflation Expectations Are Stable In The U.S. & Europe Inflation Expectations Are Stable In The U.S. & Europe The markets continue to underestimate the likelihood of more Fed rate hikes in the next year. The odds of a hike in December now sit at only 32%, while essentially no hikes in 2018 are currently discounted. This is far too low, given the steady (if unspectacular) growth in the U.S. and tightening labor conditions. The market has clearly responded to the dip in realized U.S. inflation since March as a sign that the real fed funds rate is now close to equilibrium - a point that has also been suggested by some FOMC members - and that the Fed's inflation forecasts are hence unlikely to be realized. Yet measures of U.S. inflation expectations, both survey-based and market-based, have been fairly stable at levels consistent with the Fed's inflation target in recent months, even as headline U.S. inflation has slowed (Chart 4, 2nd panel).1 A similar dynamic is playing out in Europe. Both survey-based and market-based measures of inflation expectations have been stable at levels close to the ECB's inflation target of "just below" 2% on headline inflation (bottom panel), despite the dip in realized inflation. Stable inflation expectations are something that central bankers take very seriously as a sign that their monetary policies are seen as credible. If the recent dip in realized inflation also showed up as an equivalent decline in expected inflation, this would give policymakers in D.C. and Frankfurt second thoughts about making any policy changes in a less dovish/more hawkish direction. The latest readings on realized inflation in both the U.S. and Euro Area suggest some stabilization of the current downturn may be underway. Headline CPI inflation ticked higher from 1.6% to 1.7% in July, ending a streak of four consecutive months of deceleration since March. Core CPI inflation has been stable at 1.7% for three consecutive months up to July, after falling for four consecutive months from January. Data released last week for July inflation in Europe showed a similar dynamic, with core HICP inflation ticking up to 1.2%, the third consecutive month of faster year-over-year inflation. With growth on both sides of the Atlantic maintaining a steady, above-potential pace, amid stable inflation expectations and with realized inflation showing signs of bottoming out, we see both the Fed and the ECB sticking with their current messaging and forward guidance. That means one more rate hike this year by the Fed, most likely in December, following an announcement on beginning the process of reducing the Fed's balance sheet at the September FOMC meeting. After that, at least another 25-50bps of hikes in 2018 will be delivered, which is currently not discounted by the market. As for the ECB, expect a shift to a slower pace of asset purchases for 2018, to be announced at either the September or October monetary policy meetings. Chart 5Has The Euro Already Overshot? Has The Euro Already Overshot? Has The Euro Already Overshot? The Kansas City Fed's annual Jackson Hole conference, set to take place this weekend, is unlikely to produce any major surprises for investors. Both Fed Chair Janet Yellen and ECB President Mario Draghi will give speeches to an audience of their peers - other global central bankers. Much is being made of Draghi's speech, since he has not spoken at Jackson Hole since 2014 when he gave strong indications of the introduction of the ECB's asset purchase plan in 2015. After his speech at the ECB Forum in Portugal in late June of this year - also to an audience of central bankers - where he mentioned a "reflationary" impulse in Europe that could require some "adjustments" to the ECB's policy settings, investors will be on high alert for any indications that the ECB is about to announce a tapering of its asset purchases. The Account of the July ECB meeting released last week suggested some concern within the ECB Governing Council regarding the potential for an "overshoot" of the euro in response to any policy shift.2 Some are interpreting those comments as a sign that the ECB might be getting cold feet over making any changes to its asset purchase program given the 11% rise in the euro seen this year. However, we think that there was too much attention focused on the fears that a strong euro could derail any plans for an ECB taper, for two reasons: The ECB did note in the July Account that the rise in the euro was a reflection of both the relatively stronger growth seen in the Euro Area this year and the reduction in political risk premia after the French presidential elections in the spring. The Account also noted that the ECB was looking at the totality of its monetary policy measures - policy rates, forward guidance & asset purchases - when assessing its policy stance. This specific quote from the Account, shown with our emphasis on the key passages, highlights that the ECB thinks that a tapering of asset purchases, done on its own with no hikes in short-term interest rates, will still leave monetary policy at very accommodative settings: "...the point was made again that the overall degree of accommodation was determined by the combination of all the monetary policy measures implemented by the ECB, and that the Governing Council's assessment of progress regarding a sustained adjustment in the path of inflation should apply to the overall design and direction of the ECB's monetary policy stance as a whole, and not with reference to any particular instrument in isolation, such as the duration and pace of APP asset purchases." Investors should understandably be worried about the impact of the rising in the euro, which was one of the fastest rates of acceleration seen in the currency's history (Chart 5). Yet given that extreme in price momentum, the lack of support from higher short-term Euro Area interest rates, and with speculative positioning on the euro at very bullish levels, it is unlikely that much further gains in the currency can be expected. This is especially true for the euro versus the U.S. dollar if the Fed delivers additional rate hikes, as we expect. Unless there is decisive evidence that the latest rise in the euro was seriously dampening Euro Area economic growth or inflation, which is not currently visible in the data (bottom panel), then the ECB is still likely to downshift to a slower pace of asset purchases in 2018. Bottom Line: Economic growth is solid, and inflation expectations remain stable, on both sides of the Atlantic. The Fed and ECB remain on course to shift to a less accommodative policy stance towards year-end. That means a December rate hike by the Fed, with more likely in 2018, and a tapering of asset purchases by the ECB beginning in January. Maintain a defensive stance on portfolio duration. Trim EM Debt Exposure Versus U.S. Investment Grade Corporates Emerging market (EM) debt has been one of the strongest performing asset classes so far in 2017. EM USD-denominated sovereign bonds have delivered a total return of 7.5%, while USD-denominated EM corporates have returned 8.7%, according to Bloomberg Barclays index data. These returns have handily surpassed the majority of all other major USD-denominated fixed income sectors. A robust pace of inflows into EM debt, a record $48.6 billion year-to-date to August 9th according to the Wall Street Journal, has helped drive EM debt spreads to tight levels (Chart 6).3 The outperformance of EM debt, both versus its own history and compared with other pro-risk fixed income classes like U.S. corporates, would be justified if EM economic growth was faster than that seen in developed markets. Yet that is not currently the case. An EM (excluding China) PMI Index put together by our colleagues at BCA Emerging Markets Strategy has shown a sharp deceleration of EM growth for most of 2017 (Chart 7, top panel). This stands in sharp contrast to the improving growth seen in both the U.S. and Europe. Chart 6EM Debt Looks##BR##Fully Valued EM Debt Looks Fully Valued EM Debt Looks Fully Valued Chart 7Stronger U.S. Growth Favors##BR##U.S. IG Vs EM Sovereigns... Stronger U.S. Growth Favors U.S. IG Vs EM Sovereigns... Stronger U.S. Growth Favors U.S. IG Vs EM Sovereigns... The gap between the U.S. and EM (ex China) PMIs has widened to the largest level since 2014. This PMI gap has been a good directional indicator for the spread between U.S. corporate bond spreads (both for Investment Grade and High-Yield) and EM debt spreads (bottom two panels). Right now, it appears that U.S. High-Yield looks fairly valued versus EM USD-denominated sovereign debt but U.S. Investment Grade spreads still look a bit too wide relative to EM sovereigns. A similar story can be told when comparing U.S. corporates to EM USD-denominated corporate debt (Chart 8). Arthur Budaghyan, BCA's Chief Emerging Market strategist, recently made a trade recommendation to go short EM sovereign and corporate debt versus U.S. Investment Grade corporate debt.4 His argument was based on the relatively expensive valuations on EM debt, coming at a time when the outlook for economic growth and corporate profits looks healthier in the U.S. We could not agree more - especially if the Fed begins to hike rates, as we expect, and the U.S. dollar begins to strengthen anew, potentially triggering outflows from EM. Arthur has also pointed out that the gap between the option-adjusted spread (OAS) on EM corporates and U.S. corporates (both Investment Grade and High-Yield) has been an excellent leading indicator of the total return differential between the asset classes (Chart 9). The current relationships show that there is upside potential for U.S. Investment Grade versus EM corporates over the next 12 months, but not for U.S. High-Yield versus EM. Chart 8...And Vs. EM Corporates ...And Vs. EM Corporates ...And Vs. EM Corporates Chart 9Downgrade EM Debt Vs U.S. IG Corporates Downgrade EM Debt Vs U.S. IG Corporates Downgrade EM Debt Vs U.S. IG Corporates Thus, this week, we are cutting our allocations to both EM sovereign and corporate debt in our model bond portfolio, and increasing our allocation to U.S. Investment Grade corporates (see page 12). While this does move us into an asset class with a longer duration, the increase in our overall portfolio duration from this shift is very small given the small weight of EM debt in our custom benchmark. More importantly, U.S. Investment Grade is less risky than EM corporates using the duration-times-spread metric - our preferred measure for spread product risk. Bottom Line: Emerging market (EM) hard currency debt, both sovereign and corporate looks fully valued, even with a positive global growth backdrop. We see better value in U.S. higher-quality corporates vs. EM debt at current spread levels. Reduce EM sovereign and corporate debt in favor of U.S. Investment Grade corporates in global fixed income portfolios. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The inflation expectations data shown in Chart 4 is based off the U.S. Consumer Price Index (CPI) measure of inflation, while the Fed targets growth in the headline Personal Consumption Expenditure (PCE) deflator of 2%. The spread between the two measures have averaged around 50bps in recent years, which suggests that the current CPI-based inflation expectations around 2.5% are in line with the Fed's 2% PCE inflation target. 2 https://www.ecb.europa.eu/press/accounts/2017/html/ecb.mg170817.en.html 3 https://blogs.wsj.com/moneybeat/2017/08/17/emerging-market-bonds-attract-record-inflows/?mg=prod/accounts-wsj 4 Please see BCA Emerging Markets Strategy Weekly Report, "EM: The Focus Is On Profits", dated August 16th 2017, available at ems.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index A Lack Of Leadership A Lack Of Leadership

Highlights Despite a tightening in Chinese monetary conditions, dollar bloc currencies have continued to rally. Rising global reserves and strong carry inflows into EM prompted by low global financial volatility have created plentiful liquidity conditions in EM, supporting dollar-bloc currencies. The beginning of the Fed's balance-sheet runoff could reverse these dynamics, hurting the AUD, CAD and NZD in the process. Monitor U.S. inflation, cross-currency basis swap spreads, gold, EM currencies and Chinese monetary conditions to judge when a break in dollar-bloc currencies will materialize. Feature The rally in the dollar-bloc currencies since July 2016 has been nothing short of stunning. We did highlight in April last year that commodity currencies had room to appreciate, but we did not anticipate such a prolonged move.1 In fact, the up leg that began in April 2017 caught us by surprise. At this juncture, it is essential to analyze whether or not the bull move in commodity currencies has further to run, or whether it is in its final innings. A principal component analysis of the returns of the AUD, the CAD, and the NZD shows that despite differing central bank postures in the three countries, a simple common factor explains 86% of their variability against the USD since 2010 (Chart I-1). Because of this result, our focus in this week's report are the global forces that may be driving this factor. Today, the key risk to the dollar-bloc currencies is global liquidity tightening. Behind this danger lies the removal of policy accommodation in the U.S., and the risks to carry trades created by the already-very-low volatility of risk assets. A China-Fueled Rebound, But Something Is Amiss... The key reason behind the rally in commodity currencies has been improvement in EM growth relative to DM economies since 2016 (Chart I-2). This growth outperformance has been underpinned by a few factors. Chart I-1One Factor To Drive Them All One Factor To Drive Them All One Factor To Drive Them All Chart I-2Commodity Currencies And EM Growth Commodity Currencies And EM Growth Commodity Currencies And EM Growth China has played an essential role. As the Chinese economy decelerated in 2015, Beijing implemented a large amount of fiscal stimulus, which saw government spending grow at a 25% annual rate in November 2015. Due to the lags of stimulus on the economy, the full force of that stimulus was felt in 2016. Direct fiscal goosing was not the only road taken by Beijing. The Chinese authorities also applied a considerable amount of monetary pressure on China. After tightening massively through 2015, Chinese monetary conditions eased greatly in 2016 as real borrowing costs collapsed from a peak of 10.5% in the fall of 2015 to a trough of -3.5% earlier this year (Chart I-3). Directed expansion of credit through banking channels was also used to support the economy, resulting in a surge in the Chinese credit impulse. However, in recent months these positives have dissipated. Chinese money growth has slowed, and the combined credit and fiscal impulse has been lessened. Yet EM equity prices, copper prices and commodity currencies are all continuing their rally, and are now re-testing their May 2015 levels - levels last experienced right before EM assets and related plays entered a vicious tailspin that lasted all the way until January 2016 (Chart I-4). Chart I-3China: From Tailwind ##br##To Headwind China: From Tailwind To Headwind China: From Tailwind To Headwind Chart I-4EM, Copper, Dollar Bloc: ##br##Back To May 2015 Levels EM, Copper, Dollar Bloc: Back To May 2015 Levels EM, Copper, Dollar Bloc: Back To May 2015 Levels Bottom Line: The rally in dollar-bloc currencies that begun in January 2016 was powered by improving growth performance within EM economies. The original driver behind this move was Chinese monetary and fiscal stimulus. However, even once the easing faded, EM plays, including the AUD, the CAD and the NZD continued to appreciate. Another factor is currently at play. ...And This Something Is Global Liquidity Our view is that global liquidity is now the key factor supporting EM plays in general and dollar-bloc currencies in particular. Since the end of 2016, we have seen a rebound in the Federal Reserve's custody holdings - one that has happened as foreign central banks resumed their purchases of Treasury securities (Chart I-5). Fed custodial holdings for other monetary authorities are a key component of our dollar-based liquidity indicator. A rebound in this indicator tends to be associated with a surge in high-powered money globally. The capital outflows from China have dissipated, helping high-powered money find its way into EM plays and the commodity-currency complex. Private FX settlements - a proxy for the Chinese private sector's selling of yuan - was CNY -43 billion in July, a massive improvement compared to the CNY 800 billion in outflows experienced in August 2015 (Chart I-6). Through stringent administrative controls and a lessening of deflation, China gained the upper hand over its capital account. This development has two implications: it means that China does not need to sell reserves anymore, and in fact has been accumulating Treasurys since February 2017. It also means that investors are now less afraid of a sudden devaluation in the CNY, which has heartened risk-taking globally - especially in assets most exposed to China, which includes EM, commodities and dollar-bloc currencies. Chart I-5Easing Global Liquidty In 2017 Easing Global Liquidty In 2017 Easing Global Liquidty In 2017 Chart I-6Chinese Capital Account Under Control Chinese Capital Account Under Control Chinese Capital Account Under Control The collapse in the volatility of risk assets has been an additional element helping global liquidity make its way into EM plays and commodity currencies. As Chart I-7 illustrates, there is a relationship between the realized volatility of the U.S. stock market and the performance of dollar-bloc currencies. The first hunch is to dismiss the relationship as an artifact of the fact that both stock prices and commodity currencies are "risk-on" instruments. But there is an economic underpinning behind this relationship. As we argued in a Special Report on carry trades last year, the main reason carry trades have been able generate high Sharpe ratios since the 1980s is because they offer investors a risk premium for taking on exposure to unforeseen spikes in volatility.2 As a result, when the volatility of risk assets collapses, as has been the case recently, carry currencies outperform. The opposite holds true when volatility spikes back up. Chart I-7Dollar Bloc Currencies Like Low Vol Dollar Bloc Currencies Like Low Vol Dollar Bloc Currencies Like Low Vol When carry trades do well, investors end up aggressively buying EM currencies. As a result of these purchases, they inject funds - i.e. liquidity - into these economies. These injections of liquidity end up boosting money growth and supporting their economic activity, which stimulates global trade, commodity prices, and thus commodity currencies - even if these are not currently "high-yielders." Bottom Line: Chinese monetary conditions have deteriorated, creating a handicap for EM assets and the dollar-bloc currencies. Nonetheless, an increase in high-powered money growth, a decline in the risk premium to compensate investors for the risk of sudden new Chinese devaluation, and a collapse in global financial volatility have reinforced each other to create the ideal breeding ground for a rally in the AUD, the CAD and the NZD. The Sweet Spot Is Passing At the current juncture, the sweet spot for the dollar-bloc currencies may be passing. To begin with, commodity currencies are trading at a significant premium to underlying commodity prices, suggesting they are expensive and vulnerable to a decrease in global liquidity (Chart I-8). The AUD and the NZD stand out as especially expensive, while the CAD is only trading at a small premium to its long-term fair value (Chart I-9). This suggests that the Canadian dollar is likely to continue to outperform the Australian and New Zealand currencies, as it has been doing in choppy fashion since November 2016. Chart I-8Dollar Bloc Currencies Are Expensive Dollar Bloc Currencies Are Expensive Dollar Bloc Currencies Are Expensive Chart I-9AUD And NZD Are Expensive AUD And NZD Are Expensive AUD And NZD Are Expensive Another problem for dollar-bloc currencies is that they have greatly overshot global liquidity metrics. Historically, the commodity currencies have moved in lockstep with the evolution of global central bank reserves - a key measure of global liquidity (Chart I-10). While global reserves have improved, the average of the AUD, the CAD and the NZD has over-discounted this positive, pointing to potential vulnerability once liquidity ebbs. The problem with this overshoot is that liquidity is likely to decline with the imminent reduction in the Fed's balance sheet size. As Chart I-11 shows, the USD has been closely linked to changes in the reserves of commercial banks held at the Fed. As commercial banks accumulate excess reserves, this provides fuel for the repo market and the Eurodollar market, creating a supply of globally available USD for offshore markets. However, mechanically, once the Fed lets the assets on its balance sheet run off (its holdings of Treasurys), a liability will also have to decrease. This liability is most likely to be excess reserves as banks buy the Treasurys sold by the Fed. A fall in the accumulation of reserves of commercial banks in the U.S. is also directly linked with weaker dollar-bloc currencies (Chart I-12). This is because falling reserves push up the dollar and hurt commodity prices - a negative terms-of-trade shock for the AUD, the CAD and the NZD. Moreover, less reserves point to less liquidity making its way into EM economies. This also hurts the expected returns of holding assets in dollar-bloc economies. This therefore means that not only is there less liquidity available to move into these markets, the rationale to do so also dissipates. Without this dollar-based liquidity support, the tightening in Chinese monetary conditions could finally show its true impact on commodity currencies. Chart I-10Commodity Currencies Have##br## Overshot Global Liquidity Commodity Currencies Have Overshot Global Liquidity Commodity Currencies Have Overshot Global Liquidity Chart I-11Falling Excess Bank Reserves##br## Equals Strong Greenback Falling Excess Bank Reserves Equals Strong Greenback Falling Excess Bank Reserves Equals Strong Greenback Chart I-12Falling Excess Reserves Equals##br## Falling Commodity Currencies Falling Excess Reserves Equals Falling Commodity Currencies Falling Excess Reserves Equals Falling Commodity Currencies The last worrisome development for the dollar-bloc currencies is the volatility of financial assets. When volatility falls, it creates a wonderful environment for these currencies. But today, historical volatility is near the bottom of its distribution of the past 28 years. Being a highly mean-reverting series, it is thus more likely to rise than fall further going forward. There are three fundamental factors pointing to a potential reversal. First, share buyback activity has been declining, which historically points to rising volatility. Second, the U.S. yield curve slope also points toward a higher level of volatility. Volatility tends to bottom before the stock market peaks, and the stock market tends to peak before the economy enters recession. The yield curve itself tends to invert a year or so before a recession emerges. As a result, the yield curve begins to flatten around two years before volatility picks up (Chart I-13). Third, the anticipated decline in bank reserves - an important factor that has supported risk-taking around the globe - is likely to be the key catalyst supporting the relationship between the yield curve and volatility. If volatility increases, carry trades are likely to perform poorly, which will hurt EM currencies and result in outflows from these markets. This will cause liquidity conditions in EM economies to dry out, hurting their growth outlook. EM M1 growth has already weakened considerably, and is currently pointing to problems for commodity currencies (Chart I-14). The dry out in liquidity resulting from a reversal in carry trades will only amplify this phenomenon. Chart I-13Listen To The Yield Curve: ##br##Volatility Will Pick Up Listen To The Yield Curve: Volatility Will Pick Up Listen To The Yield Curve: Volatility Will Pick Up Chart I-14EM M1 Growth Is Becoming ##br##A Headwind For The Dollar Bloc EM M1 Growth Is Becoming A Headwind For The Dollar Bloc EM M1 Growth Is Becoming A Headwind For The Dollar Bloc Bottom Line: Global liquidity conditions are set to begin to tighten. While it is probably not enough to cause the bull market in stock prices to end now, it could be enough to affect the area of the global economy most exposed to this risk factor: carry trades and the dollar-bloc currencies. Specifically, commodity currencies are likely to be negatively affected by their elevated valuations, their strong sensitivity to excess bank reserves, and their high responsiveness to changes in financial market volatility. Key Indicators To Monitor After the surge that the dollar-bloc currencies have experienced since the spring and the large increase in the long exposure of speculators to these currencies, they are naturally at risk of experiencing a period of weakness. However, what worries us is not a retracement of 3-4%, but rather a 10-15% move. We suggest monitoring the following: First, watch U.S. inflation closely. The U.S. dollar is only likely to genuinely rally once the market believes the Fed can actually increase rates. So long as inflation remains tepid, investors will continue to second-guess the Fed. The market's response to this week's release of the most recent Federal Open Market Committee minutes only confirmed this. Mentions of debate on inflation within the FOMC was enough to send bond yields and the dollar reeling. However, based on the dynamics in the U.S. velocity of money, we continue to expect inflation to pick up in the second half of 2017 (Chart I-15).3 Second, follow cross-currency basis swap spreads. The cost of hedging U.S. assets back into euro or yen has normalized somewhat after hitting record levels in early 2016 (Chart I-16). If the removal of excess bank reserves in the U.S. system does affect global liquidity conditions, this market will be one of the first to be affected. Third, scrutinize the price of gold. The yellow metal remains a key gauge of global liquidity. Moreover, it is extremely sensitive to real rates and the dollar - two major determinants of the cost of global liquidity. In the summer of 2015, EM and dollar-bloc currencies severely suffered once gold broke below 1150. Today, a break below 1200 would be a sign of danger ahead. Fourth, watch EM currencies. A breakdown in EM currencies would be a key indication that carry trades are being reversed, and that global liquidity is no longer making its way into EM and EM-related plays. Commodity currencies are currently trading at a premium to their historical relationship with EM currencies, suggesting they would be highly vulnerable to such an event (Chart I-17). Chart I-15Watch U.S. Inflation Watch U.S. Inflation Watch U.S. Inflation Chart I-16Monitor Cross-Currency Basis Swap Spreads Monitor Cross-Currency Basis Swap Spreads Monitor Cross-Currency Basis Swap Spreads Chart I-17Dollar-Bloc Currencies At The Mercy Of EM FX Dollar-Bloc Currencies At The Mercy Of EM FX Dollar-Bloc Currencies At The Mercy Of EM FX Finally, keep an eye on Chinese monetary conditions. If Chinese monetary conditions improve from here, it would alleviate some of the negative pressure exercised on dollar-bloc currencies by the upcoming deterioration in global liquidity. However, if Chinese monetary conditions deteriorate further, this would negatively affect commodity prices, EM returns and the commodity currency complex. It would also hurt expected returns on Chinese assets, re-kindling outflows out of China and thus raising the risk premium associated with what would become a growing risk of CNY depreciation. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled, "Pyrrhic Victories", dated April 29, 2016, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report titled, "Carry Trades: More Than Pennies And Steamrollers", dated May 6, 2016, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report titled, "Fade North Korea, And Sell The Yen", dated August 11, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 U.S. data has been mixed this week: The Empire State Manufacturing Index increased to 25.2, a significant jump and beat Retail Sales increased at a 0.5% monthly pace, with the ex. Autos measure increasing at 0.5%, both beating expectations; The Import Price Index increased by 1.5% since last year; Initial jobless claims dropped to 232,000, beating expectations significantly; However, housing starts and building permits both underperformed expectations. While the DXY has rebounded, the FOMC's July minutes discussed the recent shortfall of inflation, which was interpreted bearishly by markets. The Fed is likely to begin normalizing its balance sheet very soon, as well as raising rates again by the end of this year. The greenback will likely continue its ascent when firmer inflation data emerges. Report Links: Fade North Korea, And Sell The Yen - August 11, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 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 Improving euro area growth prospects have propelled the euro 12% higher since the beginning of the year. However, the market seems to begin questioning the ECB's hawkishness. In its minutes, the ECB expressed worries about a potential euro overshoot. Additionally, rumors emerged that Mario Draghi will not give much guidance in Jackson Hole. Together, these stories have reversed some of the euphoria that had engulfed the euro. The tightening in euro area financial conditions relative to the U.S. has prompted a roll over in relative economic and inflation surprises, justifying these budding doubts. Furthermore, U.S. inflation should begin to meaningfully accelerate in the fall. This is likely to add to the euro's weakness, as the greenback will resume its upward trend. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 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 Data in Japan was mixed this week: Annualized gross domestic product growth grew by 4% on an annualized basis, crushing expectations. Additionally the month-to-month growth of industrial production came in at 2.2%, also beating expectations. However both export and import growth underperformed, coming in at 13.4% and 16.3% respectively. On cue, after we placed a long USD/JPY trade last week, USD/JPY rallied half percentage point, even if it gave up some of the gain now. We continue to be bearish on the yen as we expect U.S. yields to start picking up, in an environment where market expectations are very depressed. But could a correction in EM caused by the rise in the dollar help the yen? Not in the short term, given that historically the yen only gains in very sharp EM selloffs that themselves weigh on bond yields. Report Links: Fade North Korea, And Sell The Yen - August 11, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 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 Data in the U.K. was mixed this week: Retail sales prices increased by 3.6% year-on-year, outperforming expectations. However, The trade balance not only worsened since last month but also came in below expectations, at -4.564 Billion pounds Crucially, most inflation metrics came in below expectations, with headline inflation coming in at 2.6% while PPI core output inflation came in at 2.4%. Overall, we continue to believe that the market's rate expectations for the BoE remain too hawkish. As the pass through from the currency dissipates, inflation should also start to come down. Furthermore, one has to remember that the BoE has a higher hurdle for raising rates than other central banks due to the unique situation in which the U.K. is currently in. Lowered rate expectations will be negative for cable in the short term. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 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 Despite initially weak data, a risk-on environment and increasing copper prices have fueled a rally in the AUD. Data from China has been soft, and Australian data has been neutral: Chinese retail sales increased annually by 10.4%, less than expected; Chinese industrial production also underperformed at 6.4%; Australian wages increased at a 1.9% annual pace, in line with expectations; Australian unemployment dropped to 5.6%; participation rate increased to 65.1%; and a net of 27,900 jobs were filled. However, full-time employment went down by 20,300 while part-time employment increased by 48,200, so hours worked contracted. This development is likely to comfort the RBA in its dovish stance. In its minutes, the RBA discussed its worries concerning the housing market, and that "borrowers investing in residential property had been facing higher interest rates". This further worries the RBA regarding the impact of higher interest rates, limiting the room for more hawkish speeches. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 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: Retail sales and retail sales ex-autos Quarter-on-quarter growth strengthened relatively to the previous quarter, coming in at 2% and 2.1% respectively. Moreover quarter-on-quarter inflation both for producer prices in outputs and inputs outperformed expectations, coming in at 1.3% and 1.4%. Currently, differences in perception adjustment between the dovishness of the RBNZ and the RBA have pushed Australian rate expectations to the point that the market is now pricing a hike in Australia before New Zealand. Overall, this seems like a mispricing, as the kiwi economy is on a stronger footing than the aussie one. Moreover, a slowdown in China would be more harmful for Australia as iron ore is more sensitive to the Chinese industrial cycle than dairy products. Thus we remain bearish on AUD/NZD. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 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 The CAD has regained some composure despite weak oil prices. Even with the U.S. dollar weakening and inventories drawing massively, oil dropped. This dynamic is particularly worrying for oil, as the markets are doubting the durability of the curtailment in global oil production. While this could be worrying for the CAD, we still believe the USD 40-60/bbl equilibrium price level, as postulated by the BoC, will have a limiting effect on the oil-based currency, which has been driven by interest rate differentials. Both central banks are now hiking, but we believe that markets are underpricing Fed hikes. Thus, the CAD should weaken against USD. However, it will outperform other G10 currencies. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 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 has continued to show a mixed picture for the Swiss economy: Consumer prices inflation, increased slightly from the previous month, coming in at 0.3%, in line with expectations. The unemployment rate also came in in line of expectations at 3.2%, unchanged from the previous month. However, producer prices contracted by 0.1%, underperforming expectations. EUR/CHF has been weakening since its August second overbought extreme. For the moment, we expect the SNB to stand pat in its ultra-dovish monetary policy, at least until inflation and other economic indicators start to strengthen considerably. USD/CHF however might appreciate, given that the euro might fall the ECB minutes this week showed that the ECB is concerned by a potential euro overshoot. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 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 Data in Norway this week was mixed: Headline inflation came in at 1.5% in July, outperforming expectations. However, it softened from June's 1.9% reading. Core inflation came at 1.2% in July, in line with expectations, decreasing from 1.6% in June. Moreover, manufacturing output contracted by 0.6% year-on-year. We continue to be bullish on USD/NOK, as the increasing gap in real rate differentials between the United States and Norway should outweigh any oil rally. Indeed, the recent numbers in Norway illustrate the lack of inflationary pressures in this Scandinavian country. This should keep a lid on rates, and thus help USD/NOK. On the other hand EUR/NOK should follow the path of oil. Thus, the OPEC supply cuts will ultimately support oil prices and thus, weigh on this cross. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 A Market Update: June 23, 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 The SEK has had a particularly strong week, as inflation surprised to the upside on both a monthly and a yearly basis, coming in at 0.5% and 2.2% respectively. While it initially appreciated against all currencies, the uptick in commodity currencies on Wednesday made it lose its gains against AUD, CAD, NZD and NOK. As inflationary pressures grow, the SEK is likely to appreciate further, especially against the EUR and GBP. Additionally, with current Riskbank governor Stefan Ingves' term coming to an end by the end of this year, the hawkish rhetoric is likely to only increase. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017 Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

Highlights Geopolitical tensions will stay elevated. We are not changing our strategic views. So long as the situation does not degenerate into a major military conflict or escalating trade wars with significant economic damages, the impact on both the broader growth outlook and financial markets should be limited. President Trump's recent decision to probe China's IPR practices is his first direct trade measure against China, and therefore is of important symbolic significance, but the near term impact should be limited. There is enough common ground for the two sides to avoid direct confrontation. We expect Beijing to cooperate with the U.S. administration to intensify pressure on North Korea. Short KRW/JPY as a hedge against geopolitical risk in The Korean Peninsula. There is an economic case for the trade, even without geopolitical considerations. Feature The Chinese economy is experiencing a summer lull, as most recent growth figures have disappointed, albeit slightly. Exports, production, investment and retail sales have all decelerated, underscoring that growth momentum is softening across the board. Investors have largely shrugged off the weaker-than-expected numbers, a sign that the market is not overly concerned about a major relapse down the road. We share investors' optimism, as discussed in some recent reports,1 but are watchful for signs of market complacency.2 After the most recent rally, multiples of Chinese equities are no longer exceptionally cheap by historical norms, even though they are still a lot cheaper compared with most other major global and EM bourses. We will discuss Chinese equity valuations in greater detail in the coming weeks. Geopolitical risks have dominated Greater China markets of late. The escalation of tensions surrounding North Korea briefly took their toll in the past week. On Monday, U.S. President Donald Trump authorized U.S. Trade Representative Robert Lighthizer to determine whether to launch an investigation into China's alleged theft of intellectual property. Overall, both events underscore rising geopolitical tensions globally, particularly around China. So long as the situation does not degenerate into a major military conflict or an escalating trade war that causes major economic damage, the tensions should not have a material impact on the outlook for the Chinese and global economy, as well as financial markets. A short position on the Korean won versus the Japanese yen offers a low-risk hedge against a sudden escalation of geopolitical tensions in the region. Intellectual Property Investigation: The Knowns And Unknowns It is unclear at the moment whether Trump is simply using the investigation as a bargaining chip to seek concessions/cooperation from China, or to start a trade war with lose-lose outcomes. The situation needs to be closely monitored and assessed continuously. For now, a few observations are in order: This is the first direct trade measure by the Trump administration against China, and therefore is of important symbolic significance, but the near-term impact should be limited. President Trump has only authorized his administration to determine whether or not to formally investigate Chinese policies and practices. It may take a year to finalize the decision, and even longer to begin negotiations and discussions with Chinese officials for solutions and remedies. Previous similar investigations against Chinese products resulted in bilateral agreements rather than all-out confrontations. Trump's decision is based on Section 301 of the Trade Act of 1974, which allows the president to unilaterally impose tariffs or other trade restrictions to protect U.S. industries from "unfair trade practices" of foreign countries. This was a popular trade tool in the 1980s and was used to impose tariffs against certain Japanese and Korean products, but has been rarely used in the past decade. In 2010 the Obama administration also accepted a petition under Section 301 to investigate China's state support for clean-energy exports, particularly solar panels and wind turbines, and the Chinese government later promised to limit some of these practices through bilateral negotiations. The World Trade Organization (WTO) has ruled that taking any such actions against other member countries without first securing approval under WTO rules is, in of itself, a violation of the WTO Agreement, and can be challenged under the WTO framework. In fact, section 301 investigations have not resulted in any trade sanctions since the WTO was set up in 1995. Table 1Top Challenges Doing Business In China China's Geopolitical Pressure Points: Knowns, Unknowns And A Hedge China's Geopolitical Pressure Points: Knowns, Unknowns And A Hedge More importantly, we see common ground enabling the U.S. and China to work together to improve China's Intellectual Property Rights, or IPR practices. From the U.S.'s perspective, while Trump's blunt accusations on China's trade policies are not completely justified and will not solve the massive trade imbalances between the two countries, his challenge on China's IPR infringement has legitimate ground, and resonates well within the broader American business community. American companies doing business in China have long listed intellectual property rights infringement and protectionism as top challenges, especially among industrial and resources businesses (Table 1). In other words, Trump's complaints on China's IPR practices reflects corporate America's rational voice rather than a sensational rant. China's own practices are also in conflict with its intentions to build a more open and market-friendly policy environment. Indeed, China has also been making notable progress to enhance IPR protections. In September 2015, in his state visit to the U.S., President Xi promised to limit the scope of national security reviews on investment, refrain from cyber-enabled IP theft, and uphold WTO agreements regarding market access for information and communications technology (ICT) products. China's deficits in IP royalty fees has increased sharply in recent years, while America's royalties surpluses have been expanding (Chart 1). Furthermore, 90% of American firms doing business in China believe that China's IPR enforcement has improved over the last five years, according to American Chamber Of Commerce In China (AmCham China) surveys.3 In short, there is certainly room for further improvement in China's IPR practices, and the broad direction fits with Trump's expectations, creating common ground for the two sides to avoid direct confrontation. We expect China's IPR practices will continue to converge towards international standards going forward. Chart 2 shows Chinese patent applications have exploded in recent years. As the country's technology continues to advance and local businesses are growing more aware of the value of intellectual property, China will develop a keen interest to safeguard its own IPRs. We are hopeful that Trump's investigation will provide a catalyst for further improvement in Chinese IPR practices, rather than derail broader bilateral trade. Chart 1China's Widening Deficits In IPR Royalty China's Widening Deficits In IPR Royalty China's Widening Deficits In IPR Royalty Chart 2China's Exploding Patent Applications ##br##Will Demand Stricter IPR Protections China's Exploding Patent Applications Will Demand Stricter IPR Protections China's Exploding Patent Applications Will Demand Stricter IPR Protections North Korea Tensions, And Short KRW/JPY As A Crisis Hedge The escalation of geopolitical tensions surrounding North Korea briefly took a toll on global and Greater China markets in the past week. The situation remains highly fluid, and the stakes are exceedingly high - both of which will put investors on edge in the weeks and months ahead. Our Geopolitical team in their latest assessment concludes that the U.S. is not likely to preemptively attack North Korea. However, the U.S. has an interest in signaling that it may conduct precisely such an attack, and brinkmanship could last for a long time.4 As far as China is concerned, there is genuine interest among the Chinese leadership to de-escalate tensions on the Korean Peninsula, but there is no easy solution. On one hand, it is absolutely against the country's best interests to collapse the North Korea regime. Such an outcome could see a surge of refugees to its densely populated and economically struggling Northeast region. Moreover, it could also potentially lead to a strong and unified Korea at the Chinese border that is a military ally to the United States. On the other hand, Beijing also feels that it has fallen victim to North Korea's nuclear ambitions, and has become growingly frustrated by its escalating provocations. China also fears that North Korea's nuclear program could encourage countries in the region, particularly Japan, to develop their own nuclear arsenals, which would be viewed as strategically threatening to China's national security. For now, we expect Beijing to cooperate with the U.S. administration to intensify pressure on North Korea. Already, China has supported the United Nations Security Council in imposing new sanctions on North Korea last week. Early this week, the Commerce Ministry announced a ban on imports of iron ore, iron, lead and coal from North Korea. These actions may have contributed to the softened tones from North Korea since, but it remains to be seen whether the impact will be long-lasting. The upshot is that the shared interests between China and the U.S. on various major global issues mean that the risk of an escalating trade war between the two countries should remain under control. For investors, bouts of geopolitical tension will likely bid up traditional safe-haven assets such as gold and the Swiss franc going forward. Another way to play the geopolitical risk is to short the Korean won (KRW) and long the Japanese yen (JPY). The KRW will obviously suffer devastating losses in even mild military skirmishes between the U.S. and North Korea, while the JPY may benefit from any "risk-off" unwinding of the yen carry trade. More importantly, economic fundamentals are not supportive of a stronger KRW, especially against the JPY, which means the downside risk in shorting the KRW/JPY is quite low, even without geopolitical considerations. Chart 3The Won Is Expensive Against The Yen The Won Is Expensive Against The Yen The Won Is Expensive Against The Yen The KRW is expensive against the JPY, based on a purchasing power parity (PPP) assessment (Chart 3). The 30% rally of KRW/JPY since 2012 has pushed it to an over two-sigma overshoot above its PPP fair value. Historically the won has rarely been sustainable at such elevated levels. Korea's economic outlook remains uninspiring. Capacity utilization has continued to decline, pricing power is weak, money growth is decelerating and real retail sales growth has stalled (Chart 4). Exports have been the bright spot in the overall growth picture, recovering strongly from last year's slump, but it is unrealistic to expect the export sector to continue to accelerate if growth numbers in China downshift. Softening exports will further weigh on Korea's growth outlook. In contrast, the latest growth numbers confirm that the Japanese economy has improved notably (Chart 5). Real GDP expanded by 1% in the second quarter compared with the previous three months, significantly beating expectations. While it remains to be seen whether Japan is able to maintain its regained momentum going forward, its growth gap with Korea has narrowed considerably of late, which will also lend support to the yen against its Korean counterpart. Chart 4Korea Growth Is Set To Moderate Korea Growth Is Set To Moderate Korea Growth Is Set To Moderate Chart 5Japan And Korea: Growth Gap Has Narrowed Japan And Korea: Growth Gap Has Narrowed Japan And Korea: Growth Gap Has Narrowed The bottom line is that geopolitical tensions in the Korean Peninsula will stay elevated. We are not changing our strategic views. So long as the situation does not degenerate into a significant military conflict that causes major economic damage, the geopolitical skirmishes should not have a material impact on both the broader growth outlook and financial markets. Investors may consider shorting the KRW/JPY as a hedge for geopolitical risks. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Reports, "China Outlook: A Mid-Year Revisit", dated July 13, 2017, and "Rising Odds Of PBoC Rate Hikes", dated July 20, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China: What Could Go Wrong?" dated August 3, 2017, available at cis.bcaresearch.com. 3 AmCham In China 2016 White Paper 4 Please see Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, available at gps.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations