Emerging Markets

Feature Turkey's banking system has in recent years relied on enormous liquidity provisions by the central bank (Chart I-1) to sustain its ongoing credit boom, and hence economic growth. Since early this year, the authorities have doubled down: they have also begun using fiscal policy to prop up growth. Chart I-1Turkey: Central Bank Large Liquidity Injections Turkey: Central Bank Large Liquidity Injections Turkey: Central Bank Large Liquidity Injections On the whole, this combination of colossal credit and fiscal stimulus is indisputably bearish for the currency. Despite strong performance by Turkish stocks this year, we are maintaining our bearish call on the lira. The lira is set to depreciate by 20-25% in the next 12 months or so versus both an equally-weighted basket of the U.S. dollar and the euro. Bringing Fiscal Stimulus Into Play The Turkish authorities have recently begun using fiscal means to stimulate growth: Last summer, a sovereign wealth fund was set up by presidential decree to pool shares in companies owned by the government and use them as collateral to raise debt and initiate spending on various infrastructure projects. The target size of the fund is US$ 200 billion, compared with the government non-interest expenditure of US$ 165 billion in the last 12 months. This would effectively allow the government to issue debt and increase expenditures off-balance sheet. In addition, this past March, the government decided to recapitalize the Credit Guarantee Fund. This initiative allowed it to underwrite US$ 50 billion, or 7% of GDP, worth of credit to Turkish companies. This is considerable as it compares with US$ 93 billion worth of loan origination by commercial banks last year. By assuming credit risk on these loans, the government is effectively encouraging banks to lend, in turn boosting economic growth. In effect, this has lowered lending standards and given a green light to banks to flood the economy with credit. Even though interest rates have risen since last November, credit growth has accelerated as banks have provided loans covered by government guarantees (Chart I-2). On top of this quasi-fiscal stimulus, government expenditures excluding interest payments have accelerated (Chart I-3). Chart I-2Bank Loan Growth Has Accelerated ##br##Despite Higher Interest Rates Bank Loan Growth Has Accelerated Despite Higher Interest Rates Bank Loan Growth Has Accelerated Despite Higher Interest Rates Chart I-3Turkey: Fiscal Spending Has Surged Turkey: Fiscal Spending Has Surged Turkey: Fiscal Spending Has Surged Such a rise in government spending has been financed by commercial banks whose holdings of government bonds have risen sharply. Essentially, government spending has also been funded by commercial banks' money creation. In short, fiscal and credit stimulus have boosted domestic demand, thereby widening the country's current account deficit once again (Chart I-4A and Chart I-4B). Chart I-4AWidening Twin Deficit Widening Twin Deficit Widening Twin Deficit Chart I-4BWidening Twin Deficit Widening Twin Deficit Widening Twin Deficit Given that the starting point of the government's fiscal position is good - public debt stands at only 28% of GDP - the authorities have ample room to rely on fiscal levers to promote growth. However, a widening fiscal deficit will be bearish for the currency. Bottom Line: Widening twin (current account and fiscal) deficits (Chart I-4A and Chart I-4B) are a bad omen for the lira. Monetary Tightening? What Monetary Tightening? Chart I-5Turkey: Money/Credit Growth Is Too Strong Turkey: Money/Credit Growth Is Too Strong Turkey: Money/Credit Growth Is Too Strong Although interbank and lending rates have risen in recent months, money and credit growth have been booming (Chart I-5). This does not support the idea that monetary policy is tight. On the contrary, thriving money and credit growth suggest that the policy stance is very easy. The Central Bank of Turkey (CBT) raised various policy rates and capped the overnight liquidity facility at the beginning of this year. However, commercial banks' usage of the late liquidity window facility - the one facility that has been left uncapped - has literally gone exponential - it has risen from zero to TRY 70 billion in the past 8 months. On the whole, the central bank’s net liquidity injections into the banking system continue to make new highs, even though the price of liquidity has been rising. Adding all the liquidity facilities – the intraday, overnight and late window facilities – the CBT's outstanding funding to banks is 90 billion TRY, or 3% of GDP, more than ever recorded (Chart 1, bottom panel). This entails that monetary policy is loose rather than tight. On the whole, commercial banks are requiring more and more liquidity, and the CBT is continuously supplying it. These injections maintain liquidity in the banking system to a sufficiently high level to allow aggressive money/credit creation among commercial banks. Bottom Line: The CBT is facilitating/accommodating an economy-wide credit binge by providing copious amounts of liquidity to commercial banks. The Victim Is The Lira The lira will inevitably depreciate in the months ahead: Chart I-6Turkey: Central Bank's Foreign ##br##Reserves Have Been Depleted Turkey: Central Bank's Foreign Reserves Have Been Depleted Turkey: Central Bank's Foreign Reserves Have Been Depleted The lira's exchange rate versus an equally-weighted basket of the U.S. dollar and the euro has been mostly flat year-to-date, despite the CBT intervening in the market to support the lira by selling U.S. dollars. Aggressive selling of CBT foreign exchange reserves has so far prevented much steeper lira depreciation in Turkey. However at this stage, the central bank is literally running out of reserves and will soon lose its ability to support the currency (Chart I-6). A developing country with foreign exchange reserves worth less than three months' imports is considered vulnerable. Therefore, at 0.5 months of imports coverage, or US$ 9.7 billion, the CBT has little capacity to continue supporting the currency via interventions. Economic growth has recovered: export volumes are very strong, driven by shipments to Europe, while loan growth is supporting private domestic demand and government expenditures have mushroomed. The ongoing economic recovery will boost inflation, and strong domestic demand will assure the current account deficit widens. This will weigh on the exchange rate. Core inflation measures have subsided from 10% to 7%, but remain well above the central bank's target of 5%. Provided inflation is a lagging variable, the acceleration in money growth and domestic demand this year will lead to higher inflation in the months ahead. Wage growth remains high and our profit margin proxy for both manufacturing and service industries - calculated as core CPI divided by unit labor costs - has relapsed signifying deteriorating corporate profitability (Chart I-7). This in turn will force businesses to raise prices. Provided demand is strong, companies will likely succeed in passing through higher prices to customers. In brief, odds are that inflation will rise significantly soon. Escalating unit labor costs also offsets the benefit of nominal currency depreciation. Chart I-8 illustrates that the real effective exchange rate is not cheap based on consumer prices, or unit labor costs. Chart I-7Companies Profit Margins Are Shrinking Companies Profit Margins Are Shrinking Companies Profit Margins Are Shrinking Chart I-8The Lira Is Not Cheap At All The Lira Is Not Cheap At All The Lira Is Not Cheap At All As inflation rises, residents' desire to convert their deposits from local to foreign currency will increase. In fact, this is already happening - households' foreign currency deposit growth is accelerating. In short, lingering high inflation will continue to weigh on the currency's value. Bottom Line: The authorities have doubled down on fiscal and credit stimulus, warranting a doubling down on bearish bets on the lira. Investment Implications On the whole, the authorities will continue resorting to fiscal and monetary stimulus to sustain economic growth. According to the Impossible Trinity theory, in countries with an open capital account structure, the authorities can control either interest rates or the exchange rate, but not both simultaneously. Chart I-9Bank Stocks Have Rallied Despite ##br##Shrinking Net Interest Margins Bank Stocks Have Rallied Despite Shrinking Net Interest Margins Bank Stocks Have Rallied Despite Shrinking Net Interest Margins In Turkey, policymakers will eventually opt to control interest rates, meaning they will not have much control over the exchange rate. We suggest currency traders who are not shorting the lira do so at this time. We remain short the lira versus the U.S. dollar. A weaker lira will undermine U.S. dollar returns on Turkish stocks and domestic bonds. Dedicated EM equity investors as well as those overseeing EM fixed income and credit portfolios should continue to underweight Turkish assets within their respective EM universes. Bank stocks have rallied strongly, and have decoupled from interest rates (Chart I-9). This reflects the recent credit binge, where banks are making profits on loan originations while the government is holding responsibility for bad loans. These dynamics could persist for a while. However, both loan growth and banks' profitability will be hurt if the credit guarantee scheme is not renewed. So far, it is estimated that TRY 200 billion of an announced TRY 250 billion of this credit guarantee scheme has been utilized. Continuous credit guarantee schemes and accumulation of off-balance-sheet liabilities by the government will widen sovereign credit spreads. In many EM countries, including Turkey, bank share prices have historically correlated with sovereign spreads. Hence, rising sovereign risk will weigh on banks stocks too. Finally, as the lira begins to depreciate and inflation rises, local interest rates will have to climb. This will also weigh on bank share prices. In brief, we are reiterating our negative/underweight stance on Turkish banks. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The Mueller investigation is part of the "Trump Put;" General White House disarray and congressional incompetence combine to produce Goldilocks conditions for U.S. equities; Mexico's frontrunner in the upcoming elections, Andres Manuel Lopez Obrador, is no Chavez; Malaysian political risks are overstated, the ruling Barisan Nasional has pushed through painful reforms; With economic growth stabilizing, cheap valuations, and overstated political risks, Malaysia could be an intriguing investment opportunity. Feature This week, we turn to two emerging markets: Mexico and Malaysia. Our approach to EMs is to look for opportunities where politics may emerge as the alpha amidst appealing valuations. We rely on our sister strategy, BCA's Emerging Market Strategy, for fundamental analysis, to which we then add our political research. We find it striking that these two EMs are the very two that stood to suffer the most should U.S. Congress have passed a border adjustment tax (Chart 1). Not only have the Republicans forsworn the border tax, but these countries will benefit from other trends, as we explain below. Before we dive into Malaysia and Mexico, however, a short note on the latest developments in the White House is in order. Clients from St. Louis, Missouri to Auckland, New Zealand are asking us the same question this summer: when does the Mueller investigation become a headwind for the SPX? Chart 1Vulnerability To U.S. Import Tariffs And Border Adjustment Taxes Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Update On Emerging Markets: Malaysia, Mexico, And The United States Of America The "Trump Put" Continues Our answer is that Special Counsel Robert Mueller's investigation may already be a tailwind to the U.S. equity market. The investigation, along with general White House disarray and congressional incompetence, makes up the ongoing "Trump Put."1 The American political imbroglio has combined with decent earnings and steady global growth to produce Goldilocks conditions for U.S. equities, while simultaneously weakening the USD and supporting Treasuries. The political fulcrum upon which all these assets turn is the failure of the Trump administration to deliver its promised fiscal stimulus (Chart 2). Tax reform, which was supposed to be the main vehicle of such stimulus, is increasingly looking like it will fail to live up to its hype. We still think it will pass, for three broad reasons: Chart 2Handcuffed Trump The Most Likely Scenario Handcuffed Trump The Most Likely Scenario Handcuffed Trump The Most Likely Scenario Trump's low popularity remains an albatross around the neck of GOP candidates in the November 2018 elections, with potentially ominous results. Our simple "line-of-best-fit" model between a Republican president's approval rating and the GOP's midterm performance produces a 38-seat loss in the upcoming election (Chart 3). Republicans need a legislative win and need it fast. The House has laid the groundwork for tax reform, passing the FY2018 budget resolution with reconciliation instructions focused on tax legislation. This means that the Obamacare replace and repeal effort has until October 1 to be resolved.2 Investors are conflating replacing and repealing Obamacare with tax reform. The former is an entitlement program, the latter a more popular measure that Republicans have always tried to move through Congress. It is very rare for U.S. policymakers to successfully reduce or remove an entitlement program. Cutting, even reforming, taxes is easier to justify politically. Chart 3The Clock Is Ticking For The GOP On Tax Reform Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Although we still maintain that tax reform, or mere tax cuts, will happen, they are unlikely to be as stimulative as originally advertised. Corporate and household tax rates are unlikely to be lowered by as much as originally touted. That is because Republicans in the House will demand "revenue offsets" to accomplish rate reduction, yet they have already lost key offsets like Obamacare repeal and the border adjustment tax.3#fn_3 The White House could change all that by using its considerable political capital among conservative grassroots voters and the bully pulpit to get fiscally conservative Republicans in the House to move a stimulative tax reform through Congress. But, as we noted two weeks ago, factional fighting in the White House and an ineffective chief of staff are considerable hurdles.4 A few days after we published that report, President Trump replaced Reince Priebus with retired General and Homeland Security Secretary John Kelly. While Kelly is likely to introduce some discipline into the White House, we doubt he will make the executive more effective in cajoling House Representatives to toe the administration's line on tax reform. This is because Kelly adds no legislative experience to a White House that is already quite low on it by recent historical standards (Chart 4). Chart 4Trump Administration Is On The Low End Of Congressional Experience Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Additionally, the Trump Administration continues to drag its feet on presidential appointments, hurting the effectiveness of the executive. Only 220 appointments had been sent to the Senate by July 19, compared to the average 309 during the same time period by the previous four presidents (Chart 5). The Senate is very slow in confirming the candidates, perhaps because of their unorthodox backgrounds and resumes. The average time to confirm a Trump nominee is 45 days, which is astonishing given that the Senate is controlled by Republicans. Chart 5The Trump Administration Is Dragging Its Feet On Appointments Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Update On Emerging Markets: Malaysia, Mexico, And The United States Of America In addition to the ineffectiveness of the White House, investors fret that the ongoing Mueller investigation, which has just impaneled a grand jury, could undercut the rally in risk assets. By summoning a grand jury Mueller can subpoena documents and obtain testimony of witnesses under oath. Doing so will accelerate the investigation and perhaps take it down new avenues. For example, the Kenneth Starr investigation initially focused on the suicide of deputy White House counsel Vince Foster and the Whitewater real estate investments by Bill Clinton. But the trail led elsewhere. Ultimately, the "Starr Report" alleged that Clinton lied under oath regarding his extramarital affair with Monica Lewinsky. Impeachment proceedings ensued. That said, we are sticking with our conclusion from May that investors should look through any risk of impeachment or indictment for President Trump, at least as long as Republicans hold the House of Representatives (i.e., at least until the midterms in 2018).5 In particular, there are three main reasons to fade any near-term equity market volatility: President Mike Pence - Under both impeachment rules and the 25th amendment, the U.S. president would be replaced by the vice president. Vice President Pence's approval rating largely tracks that of President Trump and is in the 40% area, but investors should note that he once stood at nearly 60% during the campaign (Chart 6). As such, the worst-case scenario for investors in the event of a post-midterm impeachment is that Trump is replaced by Pence, an orthodox Republican, and that Pence has to deal with a split Congress. And that is not bad! It would grind reforms to a halt, but at least tax reform would be out of the way by then. Midterm Election - If the Trump White House becomes engulfed in scandal, Republicans in the House will fear losing their majority. Yes, the partisan drawing of electoral districts - "gerrymandering" - has reduced the number of competitive U.S. House districts from 164 in 1998 to 72 in 2016 (Chart 7). But the Democrats managed to win the House in 2006 and the Republicans managed to take it back in 2010, so there is no reason the roles cannot be reversed yet again. However, this is not a risk, it is an opportunity. It will motivate the GOP in Congress to lock in tax and health care reform well ahead of the midterm elections. Counter-Revolution - With Trump embattled and facing impeachment, the market may let out a sigh of relief because it would mark a clear defeat of populist politics in the U.S. Much as with electoral outcomes in Europe, investors may want to cheer the defeat of an unorthodox, anti-establishment movement in the U.S. As such, we would push against any "Russia scandal"-induced volatility in the U.S. markets, at least until the midterm election. We think the market would digest the volatility and realize that Trump's impeachment, were it to occur after midterm elections, would not arrest the Republican agenda before the midterms. After all, the GOP has waited over 15 years to make Bush-era tax cuts permanent and the opportunity to do so may evaporate within the next 12 months. In addition, given the performance of high tax-rate S&P 500 equities (Chart 8), investors appear to have already discounted the failure of meaningful tax reform in the market. This means that the "Trump Put" is in full effect: investors are bidding up risk assets not because they expect something to happen (tax reform, fiscal stimulus, financial deregulation, etc.), but because they expect nothing to happen (no fiscal stimulus, no fast Fed rate hikes, no onerous regulation for businesses, etc.). Chart 6Could Be Worse ##br##Than Pence Could Be Worse Than Pence Could Be Worse Than Pence Chart 7Gerrymandering Reduces##br## Competitive House Seats Gerrymandering Reduces Competitive House Seats Gerrymandering Reduces Competitive House Seats Chart 8Investors No Longer##br## Expect Tax Reform Investors No Longer Expect Tax Reform Investors No Longer Expect Tax Reform What about the long term? A scandal-ridden White House, escalating leaks against the administration, and a mounting bureaucratic revolt against the executive cannot be good for the U.S., can they? The news flow out of Washington increasingly looks like news from Ankara, Brasilia, or Pretoria. There are two diametrically opposed directions the U.S. can take. The first is deepening polarization and policy gridlock that leads to President Trump being replaced by an even greater bout of populism in 2020 or 2024. We described this scenario recently in a pessimistic note about the coming social unrest in America.6 The alternative is that Democrats and Republicans in Congress (particularly the Senate), representing the country's elites, decide to work together on legislation. Both parties recently united to pass veto-proof sanctions on Russia with a 98-2 vote that has bound the executive to future review by Congress. And some green shoots of bipartisanship appeared over the past two weeks on tax reform and even on health care. It is too soon to say which path American policymakers will take. Investors may have to wait until after the midterm election for genuine cooperation. But it would be very positive for the U.S. economy and prospects of reform if genuine bipartisanship emerged as a reaction to the incompetence, scandal, nationalism, and populism of the White House. Bottom Line: The intensifying Mueller investigation and ongoing White House incompetence will only further fuel the "Trump Put." This is positive for U.S. equities, neutral for bonds, and bad for the dollar, ceteris paribus. A significant pickup in inflation could overwhelm the "Trump Put" and cause the dollar to rally. As such, investors should focus on inflation prospects more than politics in the White House. What If Mexico Builds A Wall First? For every action, there is an equal and opposite reaction. The election of President Donald Trump, an unabashed nationalist who campaigned on an anti-immigrant platform, is spurring the campaign of Andres Manuel Lopez Obrador, also known as AMLO, in the upcoming July 1, 2018 elections in Mexico. Obrador has been a left-wing firebrand of Mexican politics for years. He was the Head of Government of Mexico City (essentially the city's mayor) from 2000 to 2005 and contested a close election against Felipe Calderon in 2006, which he narrowly lost. He lost the 2012 election by a much wider margin, but still came second to current president Enrique Pena Nieto of the Institutional Revolutionary Party (PRI). Obrador's election campaign calls for a confrontational attitude towards President Trump, the renegotiation of NAFTA, an increase to farm subsidies, and limitations on foreign investment in Mexico. He has said that he would reverse the opening of the energy sector to foreign investment through a referendum, but that he is in favor of public-private partnerships in the sector. That said, his left-wing firebrand persona is more PR than substance. In 2012, for example, he also campaigned on cutting government expenditure and ending monopolies - not exactly Chavista credentials. Nonetheless, he quit the left-leaning Party of the Democratic Revolution (PRD) to form a more left-wing movement. Obrador's new party, the National Regeneration Movement (MORENA), did well in the 2015 midterms and is currently leading in the polls ahead of the 2018 election (Chart 9). MORENA also did well in the State of Mexico, a PRI stronghold and Nieto's home state, in the June 4 election. The ruling PRI held the state for 90 years and is accused of election-rigging in order to, only narrowly, defeat an unknown MORENA candidate this year. Chart 9MORENA Has Lead In The Polls Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Given that the election is a year away, it is too soon to make a forecast. Nonetheless, it is clear that Obrador is the frontrunner for the presidency. There are three reasons why his election may be an over-hyped risk: The Congress: For much of Mexico's twentieth century history, the president was essentially a dictator due to the one-party rule of PRI. In the twenty-first century, however, Congress has become plural, forcing the president to cooperate with the body or see his reforms stalled. Given recent elections (Chart 10), it is highly unlikely that Obrador would have a congressional majority behind him, thus forcing him to temper his policies. Chart 10Mexico's Rising Political Plurality Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Update On Emerging Markets: Malaysia, Mexico, And The United States Of America The PAN-PRD Alliance: An unlikely alliance of the conservative National Action Party (PAN) and the center-left PRD has emerged as a reaction to the rise of MORENA in the polls. (These two parties have a history of cooperating against PRI presidents.) The two parties come from completely opposite ideological spectrums, but successfully joined forces in several state elections in 2016. It is unlikely that the two parties will unify sufficiently to field a single candidate - they failed to do so in the June 4 State of Mexico elections - but they may get enough votes to form a plurality in Congress. Mexicans do not lean left: Unlike most of Latin America, Mexico is a conservative country. Most Mexicans either think of themselves as centrist or lean right (Chart 11). While our data stops in 2015, the historical trend is clear: Mexico is a right-leaning country. As such, it is highly unlikely that AMLO will be able to manipulate the country's democratic institutions - which have been strengthened over the past twenty years - to turn Mexico into Venezuela. Chart 11Mexicans Lean Right Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Update On Emerging Markets: Malaysia, Mexico, And The United States Of America We would therefore fade any politically induced volatility in Mexican assets. Next year, investors should prepare to "sell the rumor and buy the news" (you read that right), as Mexican election fever grips the markets. Given current macroeconomic fundamentals, an entry point in Mexican assets may develop if they sell off ahead of the election - but they are not a buy at the moment. BCA's Emerging Market Strategy has pointed out in a recent report that:7 Inflation is well above the central bank's target and is broad based (Chart 12). Notably, wage growth is elevated (Chart 13). Given meager productivity growth, unit labor costs - calculated as wage-per-hour divided by productivity (output-per-hour) - are rising. This will depress companies' profit margins and make them eager to hike selling prices. This will, in turn, prevent inflation from falling and, consequently, hamper Banxico's ability to cut rates for now. Chart 12Inflation is Above Target Inflation is Above Target Inflation is Above Target Chart 13Wage Inflation Is High Wage Inflation Is High Wage Inflation Is High Meanwhile, the impact of higher interest rates will continue filtering through the economy. High interest rates entail a further slowdown in money and credit growth and, hence, in domestic demand. Both consumer spending and capital expenditure by companies are set to weaken a lot (Chart 14). This will weigh on corporate profits and share prices. Even though non-oil exports and manufacturing output are accelerating (Chart 15), non-oil exports - which make about 30% of GDP - are not large enough to offset the deceleration in domestic demand from monetary tightening. That said, the positive for Mexico is that the Mexican peso remains cheap (Chart 16) and may rally against other EM currencies. Our EM strategists suggest that investors should overweight MXN versus ZAR and BRL. Chart 14Domestic Demand to Buckle Domestic Demand to Buckle Domestic Demand to Buckle Chart 15Exports are Robust Exports are Robust Exports are Robust Chart 16Peso is Cheap Peso is Cheap Peso is Cheap If EM currencies depreciate or oil prices drop, it would be difficult to see MXN rally against the USD. However, MXN should outperform other currencies, especially given that political risks in Mexico are far lower than they are in Brazil and South Africa. Bottom Line: The Mexican markets may get AMLO-fever in 2018. Obrador is a clear frontrunner in the election to be held a year from now. However, AMLO will face off against constitutional, political, and societal constraints. As such, we would fade any politically induced risks in Mexican markets. Go strategically long MXN versus BRL and ZAR and look for an entry point into Mexican risk assets over the next 12 months. Malaysia: Hold Your Nose And Buy We have been broadly bearish on Malaysia since August 2015, but the upcoming elections - due by August 2018, but we expect to occur sooner rather than later - are likely to cause the markets to re-price Malaysian assets (Chart 17). The country's fundamentals are not rosy, and it remains vulnerable to a slowdown in China, a drop in commodities prices, and bad loans. Nevertheless, its underperformance is late, and this fact, combined with the political outlook, suggests that it will outperform for a while. Malaysia is in the midst of a long saga of party polarization that began amid the Asian Financial Crisis, when Prime Minister Mahathir Mohamad ousted his ambitious deputy, Anwar Ibrahim. Both men hailed from the dominant party of the country's ethnic Malay majority: the United Malay National Organization (UMNO), which is the center of Barisan Nasional (BN). The BN is a multi-ethnic coalition that has held power in one form or another since independence in 1957. Anwar went on to lead the reformasi (reform) movement, creating an opposition coalition of strange bedfellows: his own urban Malay People's Justice Party (PKR), the ethnic Chinese DAP, and the Islamist PAS. In the 2008 general elections, the opposition shocked the BN, depriving it of a two-thirds super-majority for the first time since 1969. In the 2013 general elections, the opposition won the popular vote, though BN retained control of parliament due to inherent advantages in the electoral system (Chart 18). Hence the past two elections, particularly the last one in 2013, have shaken the political system to the core. Since the 2013 shock, the opposition has had its sights set on the 2018 election, and a series of blows to the Najib government have given cause for hope. First, exports and commodity prices plunged from 2014 to 2016, damaging the economy and giving the opposition a grand opportunity to attack the administration (Chart 19). Second, Najib was personally implicated in a massive scandal involving 1MDB, a sovereign wealth fund that Najib helped create and from which he allegedly embezzled $700 million (!). Street protests emerged in 2015 and suddenly Najib faced a revolt from the old guard within his own party (including Mahathir himself). Chart 17Malaysian Underperformance Is Late Malaysian Underperformance Is Late Malaysian Underperformance Is Late Chart 18Opposition Threatens UMNO's Dominance Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Chart 19Commodities Should Help Malaysian Exports Commodities Should Help Malaysian Exports Commodities Should Help Malaysian Exports The problem for the opposition, however, is timing. The 2008 election occurred before the worst of the global financial crisis had been felt; the 2013 election occurred before the full impact of the commodity bust; and now the ruling coalition's fortunes are recovering in time for the upcoming election - which, of course, the prime minister schedules to his advantage. Thus, the opposition once again faces an uphill battle in this election cycle: The Malaysian economy has beaten expectations, growing by 5.6% in the first quarter of 2017, the fastest rate in two years. This was driven mainly by exports and the manufacturing sector (Chart 20). Money supply growth is strong while the credit impulse has bottomed and is approaching positive territory (Chart 21). The 1MDB scandal has mostly dissipated. Najib publicly confessed that the $700 million found in his personal account was a donation from a foreign government, and Saudi Arabian authorities confirmed this, prompting Najib to return the money. Malaysia's attorney general, anti-corruption commission, and central bank have all cleared Najib of wrongdoing, and his popular support has recovered from the fever pitch of the scandal in 2015-16, as demonstrated by the net-gain for BN in by-elections since 2013, and the fact that the BN saw its share of seats rise from 27% to 37% in the 2016 Sarawak State Assembly elections. This state's local elections have tended to foreshadow national elections, and it has the largest representation of any state in the national parliament (31/222). The opposition is split. Najib has courted the Islamist opposition party, PAS, peeling it away from the opposition coalition. Without PAS, the opposition falls from 89 seats in parliament to 71 seats, which is 41 shy of a majority. Even in the best case scenario for the opposition in the upcoming election, in which the opposition holds all seats from 2013 and Bersatu gains all of UMNO's seats in Kedah and Johor, the opposition would still fall 16 seats shy of a majority. Chart 20Growth Is Strong Growth Is Strong Growth Is Strong Chart 21Credit Cycle Is Picking Up Credit Cycle Is Picking Up Credit Cycle Is Picking Up Bottom Line: Our baseline case holds that Najib and BN will retain control of the government in the upcoming election on the back of the fading scandal, economic recovery, and a shrewd practice of dividing political enemies. What Does A Najib Win Mean? Is a Najib/BN victory positive for Malaysian risk assets? We think so, at least relative to other EMs. While Malaysia would benefit in the long run from breaking the BN's monopoly over parliament, the immediate consequence of an opposition victory would be confusion as the various opposition parties have widely divergent interests ... and zero governing experience. On the other hand, Najib's government has undertaken some significant reforms, expanded infrastructure, and improved government finances, making his corrupt and pseudo-authoritarian government not as market unfriendly as one might expect: As a result of weak commodities, cuts in subsidies, and the introduction of a goods and services tax (GST) and a tourism tax, Malaysia's fiscal deficit has improved from 5.5% in 2013, when Najib took office, to 3.1% today (Chart 22). The government is on a path to close the deficit by the end of the decade. The GST has allowed the government to reduce its dependency on oil revenues. Non-tax revenues, which include oil royalties, have decreased from 35% in 2010 to only 20% of total revenue, while indirect taxes (which include GST) have increased from 17% to 28% of revenue (Chart 23, top three panels). There are plans to increase the goods covered by the GST in the near future. The government has cut subsidies in fuel and cooking gas, taking advantage of low oil prices. The government had also eliminated subsidies in cooking oil and sugar. Subsidies as a percent of total expenditures have declined from almost 20% in 2014 to only 9% today (Chart 23, bottom panel). The government has expanded infrastructure, completing a mass rail transit extension in Kuala Lumpur, connecting the two East Malaysian states of Sabah and Sarawak via a 2,000 km highway, and attracting Chinese investment from the One Belt One Road program. The latter entails China building an East Coast Rail Link to connect the west and east coasts. Upon completion, this link will enable shippers to circumvent the port of Singapore and reach the South China Sea in a shorter time period. Chart 22Austerity Works Austerity Works Austerity Works Chart 23Tax Reforms Paid Off Tax Reforms Paid Off Tax Reforms Paid Off One perceived drawback of Najib's government is that in order to stay in power, he has had to court the Islamist PAS party, as mentioned above, specifically by allowing it to promote aspects of shariah law in the country's parliament. However, Malaysia is not at risk of being swept away by an imaginary rising tide of Islamic extremism. The country is very diverse, and Malay Muslims make up only a little more than half of the population. Malaysians are highly religious, but they are also highly tolerant, as they have lived among other races and religions since independence (Chart 24). Moreover, Islam is regulated and bureaucratized in Malaysia, which discourages the emergence of charismatic, anti-establishment religious leaders and the development of extremist movements. Finally, the government has an absolute need to win votes both in the Borneo states of Sabah and Sarawak, which have sizable Christian and non-Malay populations (adding up to more than half), and in the population centers of Kuala Lumpur and Penang. This means that it is not likely to allow PAS (or other Islamist movements) to go too far. Chart 24Malaysians Are Tolerant Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Update On Emerging Markets: Malaysia, Mexico, And The United States Of America Bottom Line: Najib's government is corrupt and has authoritarian leanings, but has improved its management of the economy and public finances, and is not getting out of control with Islamism or populism. We would not expect a sustained market sell off in the face of a BN victory in upcoming polls. By contrast, if the opposition coalition wins a majority, it offers the long-term promise of a more inclusive and competitive political system that would be good for Malaysia, but would bring greater policy uncertainty in the short term. The opposition would likely have a low probability of achieving major reforms, as the BN party-state conglomerate would fight tooth and nail against it. A positive knee-jerk market response to an opposition win - on the expectation that "regime change" raises the probability of pro-market reforms - would likely be ephemeral. Investment Conclusion A key internal risk to the Malaysian economy stems from the country's fairly sizable debt, which may eventually become unsustainable. Yet at the moment, household and government debt are both rolling over even as growth is improving (Chart 25). A key external risk stems from China. Chinese politics are likely to shift from a tailwind for Chinese growth - fiscal stimulus and the need for stability ahead of the National Party Congress - to a headwind, as stimulus subsides and reforms are rebooted in 2018.8 We do not expect China's investment in Malaysia to fall sharply, since it is tied to a broad, long-term, strategic plan; nor do we see Malaysia as overexposed to Chinese imports or tourism. Nevertheless, Malaysia would suffer to some extent, and it is indirectly vulnerable as Malaysian exports to ASEAN and tourists from ASEAN are significant, and ASEAN would suffer from a Chinese slowdown. In short, China is a risk, albeit not as direct or major as one might think. The Malaysian ringgit has already become the best-performing currency this year. Yet this recent appreciation has not come near to reversing the currency's roughly 20% depreciation since 2014. A cheap currency, combined with robust external demand, should be a tailwind for Malaysian exports and the broader economy (Chart 26). Moreover, the rising price of key Malaysian exports like energy and palm oil should be positive for Malaysian equities (Chart 27). Chart 25Debt Is High, But Is Rolling Over Debt Is High, But Is Rolling Over Debt Is High, But Is Rolling Over Chart 26Cheap Currency Is A Tailwind For Exports Cheap Currency Is A Tailwind For Exports Cheap Currency Is A Tailwind For Exports Chart 27Commodities Support Equity Prices Commodities Support Equity Prices Commodities Support Equity Prices At the same time, valuations are attractive. Malaysian equities have underperformed the EM universe and its ASEAN peers since 2013 (see Chart 17 above). Malaysian equities have lost considerable value relative to their EM peers, and are trading at a discount relative to ASEAN peers. Compared to historical valuations, Malaysian equities are also trading at a discount (Chart 28 A and B). Chart 28aMalaysia Is Cheap Compared To Peers... Malaysia Is Cheap Compared To Peers... Malaysia Is Cheap Compared To Peers... Chart 28b...And Its Historical Valuation ...And Its Historical Valuation ...And Its Historical Valuation Bottom Line: The likely start of a new credit cycle, improving government finances, a persistently cheap currency, and the likelihood of an acceptable policy status quo should put a tailwind behind Malaysian risk assets. We recommend going long Malaysian equities relative to their EM peers. Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Stephan Gabillard, Senior Analyst Emerging Markets Strategy stephang@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "How Long Can The 'Trump Put' Last?" dated June 14, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," dated May 31, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Will Congress Pass The Border Adjustment Tax?," dated February 8, 2017, available at gps.bcaresearch.com. 4 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 Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 6 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. 7 Please see BCA Emerging Market Strategy Weekly Report, "The Case For A Major Top In EM," dated July 12, 2017, available at ems.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com.

Highlights Investors are becoming less concerned about China's growth outlook, but there is no sign of euphoria. Monitor three risk factors that could disrupt the positive growth outlook and the bull market in Chinese stocks. For now, the risks appear reasonably contained, and the lack of a complacency in the marketplace means it is too early to bet against the herd. Remain positive and stay invested. Feature The latest purchasing managers surveys released early this week confirm that the Chinese economy remains buoyant. The manufacturing and service PMIs from both official and private sources remain comfortably in expansionary territory, and there are no signs of a material deterioration from the readings of the sub-indices. Improving growth also appears to be reflected in the stock market. Chinese investable equities have rallied by over 30% so far this year, beating the major global and EM benchmarks (Chart 1). Despite the improvement in the growth numbers and the rally in stock prices, there is no sign of euphoria among investors with respect to China. On the contrary, Chinese stocks' multiples are still among the lowest of the major global bourses (Chart 2). Importantly, ETFs investing in Chinese assets are still witnessing net redemptions: China-focused ETFs listed in the U.S. and Hong Kong have been witnessing constant net capital outflows since 2013 (Chart 3). Even in the first half of this year, these ETFs have continued to lose capital despite rising stock prices - which means retail investors have not participated in the rally. Attractive valuations and lack of "irrational exuberance" suggest the rally in Chinese investable stocks should have further to run. Chart 1Chinese Equities Have Outperformed... Chinese Equities Have Outperformed... Chinese Equities Have Outperformed... Chart 2...But Still With Much Lower Multiples ...But Still With Much Lower Multiples ...But Still With Much Lower Multiples Chart 3... And Net ETF Redemptions China: What Could Go Wrong? China: What Could Go Wrong? Overall, we remain positive on both Chinese equities and the economy's cyclical outlook, and see limited downside risks in the near term, as discussed in detail in recent weeks.1 However, as growth and stock market performance have been largely in line with our expectations, it is always useful to reflect on risk factors. We see three potential risks that could upset the economy and the ongoing rally in Chinese stocks that need to be closely monitored. Will The Trump Wildcard Strike Again? There are increasing signs that tensions between the U.S. and China are on the rise again after a period of relative tranquility. The first round of U.S.-China Comprehensive Economic Dialogue (CED) resulted in no material progress or concrete plans to improve bilateral trade imbalances. U.S. President Donald Trump has continued to pull "China hawks" into his trade policy team, naming Dennis Shea, well known for being highly critical of China's trade practices, as deputy U.S. Trade Representative. Furthermore, the U.S. State Department recently approved a major weapon package to Taiwan, the first arms sales to the Island since 2015. More recently, President Trump has openly accused China of not helping deal with the North Korea nuclear issue after the country tested an intercontinental ballistic missile (ICBM) that it claims can reach continental America. In addition, the Trump administration is reportedly planning trade measures to force Beijing to crack down on intellectual-property theft and ease requirements that American companies share advanced technologies to gain entry to the Chinese market. Overall, it is widely viewed that the brief "honeymoon" in U.S.-China relations following the April Summit between the leaders of the two countries has decisively ended, and the odds for protectionism tactics against Chinese products have increased. The "Trump wildcard" has always been a key risk with respect to our outlook for China2 - the latest developments suggest this risk remains firmly in place. President Trump and his inner circle appear genuinely convinced that punitive tactics could solve the country's chronic trade deficit. Moreover, President Trump has been increasingly bogged down by domestic policy, and he may lash out on the international front in an effort to boost his popularity. Furthermore, the U.S. President has few legal constitutional constraints to using tariffs against trade partners, giving him maneuvering room. From a big-picture perspective, the conflict between the U.S. and China has deep ideological and geopolitical roots, which are even harder to deal with than trade issues. Chart 4Steel Is No Longer Relevant For ##br##U.S.-China Trade China: What Could Go Wrong? China: What Could Go Wrong? Nonetheless, we maintain our guarded optimism that unilateral protectionism measures will not materially undermine Chinese exports, at least in the near term. On the U.S. side, even though President Trump has toughened his rhetoric on China and trade issues of late, it is still far less extreme compared to the promises he made on the campaign trail, in which he pledged to slap a 45% tariff on all imports from China and to label the country a currency manipulator on "day one." So far, the U.S. administration has mainly been focusing on specific industries, particularly steel, rather than broad-based tariffs, the impact of which should be marginal. For example, China accounts for only 3% of American steel imports. Sales to the U.S. account for less than 1% of China's massive steel output (Chart 4). In other words, steel appears to be a highly symbolic sector in Trump's trade policy, but the real impact on China-U.S. trade is negligible. On the Chinese side, the authorities have hard-drawn redlines on political and sovereign issues, but have much greater flexibility on trade-related issues. Chinese officials understand that the country's large surplus with the U.S. puts it at a near-term disadvantage in a trade war, and therefore will likely cave to pressure from the U.S. Moreover, the sectors that President Trump has been complaining about, namely steel and some other base metals, are the same sectors the Chinese government wants to restrict. Therefore, China will not fight for its own "out of favor" industries to disrupt the broader picture in exports. Taken together, President Trump's trade policy has once again become unpredictable, and some punitive measures on specific products appear likely in the near term. However, we still assign low odds of a drastic escalation in trade frictions, and we expect the Chinese authorities to refrain from tit-for-tat retaliation that could lead to a trade war. Protectionism risks, however, will remain a long-term structural issue that complicates the global trade and growth outlook. Deflationary Pressures And The Risk Of Policy Overkill? Chart 5Headline CPI Is Set To Drop Further Headline CPI Is Set To Drop Further Headline CPI Is Set To Drop Further A key feature of the Chinese economy is strong disinflationary/deflationary pressures, despite robust growth and job creation. Headline inflation to be released next week will likely once again surprise to the downside, mainly due to food prices (Chart 5). Wholesale prices of agricultural products have weakened substantially in recent months, pointing to sharply lower food CPI. Core CPI remains around 1%, underscoring incredibly low inflationary pressures. The key challenge for the Chinese authorities is figuring out how to manage economic policies to achieve the delicate balance between growth and disinflation/deflation. We have long viewed that one of the critical reasons behind China's sharp growth deterioration between 2012 and 2015 was a policy mistake, in which the authorities allowed monetary conditions to tighten dramatically. We are hopeful that the authorities have realized the cost of policy overkill, and will avoid similar mistakes down the road, but the risk certainly cannot be dismissed entirely. For now, we see low odds of policy overkill that could lead to price deflation and negative growth surprises. First, as growth has improved, some policy tightening is warranted. The authorities recently reported that the economy added 7.35 million new jobs in the first half of the year, far exceeding the government's target, pushing the registered urban unemployment rate to 3.95%, the lowest in recent years. In fact, the People's Bank of China may still be behind the curve, meaning that further tightening is simply a "catch-up" and is not immediately restrictive. Chart 6Another Sharp Rally ##br##In The Trade Weighted RMB is Unlikely Another Sharp Rally In The Trade Weighted RMB is Unlikely Another Sharp Rally In The Trade Weighted RMB is Unlikely Second, a major factor behind China's drastic tightening in monetary conditions in previous years was the sharp rally in the trade-weighted RMB, which appreciated by almost 30% between mid-2011 and early/late 2015 - a massive deflationary shock to Chinese exporters (Chart 6). Looking forward, it is extremely unlikely that the PBoC will allow the RMB to rise by a similar magnitude anytime soon. Finally, from investors' perspective, producer output prices are more important to watch for pricing power and profitability. On this front, PPI inflation has also rolled over and will likely continue to downshift, but will not turn to outright deflation in our view. It is important to note that the sharp decline in producer prices in previous years was due to a multi-year deterioration in Chinese growth, which has historically been an anomaly. The only other period in China's post-reform history with falling PPI happened in the late 1990s in the aftermath of the Asian crisis (Chart 7). In other words, falling PPI only occurs under rather extreme growth difficulties. Our model suggests that PPI inflation may decelerate to 3% by year end. Our PPI diffusion index, which measures the percentage of industrial sectors experiencing rising prices, suggests the majority of sectors are still witnessing higher prices both compared with previous months and a year ago (Chart 8). We are monitoring the PPI diffusion index closely to heed a leading signal on corporate pricing power and overall deflationary pressures in the corporate sector. Chart 7Producer Prices: A Historical Perspective Producer Prices: A Historical Perspective Producer Prices: A Historical Perspective Chart 8PPI Watch PPI Watch PPI Watch Bottom Line: A policy mistake of overtightening by the Chinese authorities remains a key threat to the near-term growth outlook, but is not our base case scenario. The Resumption Of The Dollar Bull Market? The U.S. dollar has rapidly dropped out of favor among global investors. The dollar index has fallen by 10% so far this year, the weakest among the major currencies. The weak U.S. dollar has provided a Goldilocks scenario for both the Chinese economy and financial markets: a weaker dollar depreciates the RMB in trade-weighted terms, which is reflationary for the Chinese economy. For investors, the broad dollar weakness also alleviates downward pressure on the CNY/USD, and a stable CNY/USD in turn reduces investors' anxiety on China's macro conditions, pushing up stock prices. This Goldilocks scenario could once again be disrupted if the dollar bull market resumes, and the positive feedback loop goes into reverse. A stronger dollar tends to strengthen the trade-weighted RMB, which is bad news for exporters. Meanwhile, it could rekindle downward pressure on the CNY/USD, re-intensifying domestic capital outflows, which could be viewed as a sign of China's macro troubles. Fears of an economic hard landing would quickly resurface. In our view, Chinese stocks are more vulnerable if the dollar's strength resumes, but the real damage on the broader economy should not be material. It is highly unlikely that Chinese policymakers would allow the trade-weighted RMB to rise alongside the dollar, and will tighten capital account controls to stop domestic capital flight. Chinese equities will suffer in this scenario, as investors' risk aversion increases. However, so long as the Chinese economy and corporate profits do not suffer a major relapse, the rally in stocks should eventually resume. All in all, the three risk factors should be closely monitored in the coming months, especially if investors become increasingly comfortable with the Chinese growth outlook. For now, the risks appear reasonably contained, and the lack of a complacency in the marketplace means it is too early to bet against the herd. We remain positive on Chinese growth, and favor Chinese equites both in absolute terms and against global/EM benchmarks. 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, "Rising Odds Of PBoC Rate Hikes", dated July 20, 2017, and Special Report, "Focusing On Chinese Money Supply", dated July 27, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China: The 2017 Outlook, And The Trump Wildcard", dated January 12, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Chart I-1The Economy Has Stabilized##br## But Has Not Recovered The Economy Has Stabilized But Has Not Recovered The Economy Has Stabilized But Has Not Recovered Brazil desperately needs to boost nominal growth to avoid public debt spiraling out of control1. We do not think it is possible without resorting to meaningful currency depreciation and much lower interest rates. The Brazilian economy has stabilized, but it has not yet recovered (Chart I-1). To stage a sustainable recovery, much easier monetary conditions and fiscal stance are required. However, monetary conditions remain tight and fiscal policy is tightening: Feature Real interest rates are about 5.5-6% - as high as they were before the current rate-cut cycle commenced (Chart I-2). The Brazilian central bank's aggressive rate cuts have largely matched the drop in the inflation rate, keeping real borrowing costs elevated. Besides, household debt servicing costs (interest payments and principal) are high, above 20% of disposable income (Chart I-3) and employment conditions remain extremely poor. In this environment, households will not be inclined to expand leverage considerably. The Brazilian real is not cheap. In fact, the real effective exchange rate is slightly above its fair value (Chart I-4). Nominal GDP growth is currently running close to 4%, while the government's budget assumption for nominal GDP growth in 2017 is 5-5.5%. Not surprisingly, government revenues are disappointing and the budget deficit is above its target (Chart I-5). Furthermore, the improvement in government revenues in the past 12 months has been due to one-off measures such as non-recurring privatization revenue, repayment by the national development bank (BNDES) of 100 billion BRL and tax amnesty/capital repatriation programs that will not be repeated. In brief, more tax hikes are needed to achieve revenue targets but higher taxes will in turn jeopardize the economic revival. Taxes on fuel have been raised in recent weeks. Chart I-2Interest Rates Are##br## Still Very High Interest Rates Are Still Very High Interest Rates Are Still Very High Chart I-3Household Debt Servicing##br## Ratio Has Not Yet Declined Household Debt Servicing Ratio Has Not Yet Declined Household Debt Servicing Ratio Has Not Yet Declined Chart I-4The Real Is Not Cheap The Real Is Not Cheap The Real Is Not Cheap Chart I-5Brazil: No Improvement In Fiscal Accounts Brazil: No Improvement In Fiscal Accounts Brazil: No Improvement In Fiscal Accounts Given that fiscal policy is straightjacketed by high and rapidly rising public debt levels, the onus of boosting nominal growth is squarely on the central bank. Not only have the monetary authorities cut interest rates, they have also been monetizing government debt. Chart I-6 shows that the central bank's holdings of government securities have skyrocketed, i.e., the central bank has bought BRL531 billion of government paper since January 2015. While it has partially sterilized its debt monetization by using these securities as reverse repos with banks, the amount of high-powered money/liquidity withdrawal via repos has been much smaller than the central bank's liquidity injections. Chart I-6aBrazil: Central Bank Has##br## Been Monetizing Public Debt... Brazil: Central Bank Has Been Monetizing Public Debt... Brazil: Central Bank Has Been Monetizing Public Debt... Chart I-6b...And Sterilizing It ##br##Only Partially ...And Sterilizing It Only Partially ...And Sterilizing It Only Partially This has helped liquidity in the banking system considerably, and smoothed the banking system adjustment at a time of surging non-performing loans. However, it has not generated enough purchasing power in the economy to boost nominal growth. Notably, broad money growth is slowing (Chart I-7). Even though bank loan growth may have troughed (Chart I-7, bottom panel), it is unlikely to recover strongly due to high real rates. Broad money captures the stance of credit and fiscal policies because broad money reflects purchasing power created by commercial banks and central bank when lending to and buying government bonds from non-banks. Remarkably, the broad money impulse - which is the second derivative of outstanding broad money - points to weakness in nominal GDP growth (Chart I-8). Chart I-7Brazil: Broad Money##br## And Bank Loans Brazil: Broad Money And Bank Loans Brazil: Broad Money And Bank Loans Chart I-8Broad Money And Terms Of Trade Point ##br## To Weaker Nominal Growth Broad Money And Terms Of Trade Point To Weaker Nominal Growth Broad Money And Terms Of Trade Point To Weaker Nominal Growth In addition, nominal GDP growth correlates with terms of trade, and the latter has also relapsed (Chart I-8, bottom panel). Furthermore, high-frequency data reveal that manufacturing PMI and consumer confidence have also rolled over lately, pointing to stalling improvement in both the manufacturing sector and consumer spending (Chart I-9). All in all, policymakers are behind the curve. The central bank could continue cutting interest rates, increase its purchases of government bonds, and also use other measures to inject more money – both high-powered money and broad money – into circulation. If they do so, it will eventually help the economy recover and boost inflation, yet it is bearish for the exchange rate. However, if the exchange rate relapses on its own (due to other factors), that will limit the authorities' ability to reduce interest rates further. This is on top of heightened political uncertainty that does not bode well for Brazilian financial markets. In a nutshell, Brazil needs to engineer currency depreciation to boost nominal growth and make public debt sustainable. This is true especially as Argentina is opting to keep its currency competitive, and it will be even more critical if commodities prices relapse, as we expect (Chart I-10). Provided the share of foreign currency public debt is low, reflating via currency depreciation is the least painful way out for Brazil. Bottom Line: Policymakers are desperate to boost nominal growth to stabilize public debt. Yet, in our opinion, nominal growth will not improve without further sizable rate cuts and meaningful currency depreciation. Eventually, policymakers will allow the BRL to depreciate 20%-plus, which will hurt foreign investments in local asset markets. We remain negative on/underweight Brazil equities, currency and sovereign debt. That said, we recommend fixed-income investors to bet on the 3/1-year yield curve flattening: receive 3-year / pay 1-year swap rate (Chart I-11). Chart I-9High-Frequency Indicators:##br## Improvement Has Stalled High-Frequency Indicators: Improvement Has Stalled High-Frequency Indicators: Improvement Has Stalled Chart I-10Other Headwinds##br## For BRL Other Headwinds For BRL Other Headwinds For BRL Chart I-11A New Trade: ##br## Bet On 3/1-Year Yield Curve Flattening A New Trade: Bet On 3/1-Year Yield Curve Flattening A New Trade: Bet On 3/1-Year Yield Curve Flattening Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Report titled, "Has Brazil Achieved Escape Velocity?", dated February 8, 2017, link available on page 11 - we argued that Brazil's public debt dynamics is unsustainable without strong nominal growth and/or social security reforms. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights This report ranks developing economies according to their potential to achieve higher productivity growth as well as overall growth. Yet, this ranking does not incorporate the cyclical economic outlook. Taking into consideration both long-term growth potential and the current equity valuations, the stock markets in Colombia, Poland, the United Arab Emirates, Singapore, Malaysia, and the Philippines offer the highest potential returns in the next three to five years. On the opposite spectrum, share prices in South Africa, Russia, Brazil, and Turkey offer the least appealing long-term opportunities. Feature Why do some nations develop economically and prosper, while others stagnate and fail to climb out of poverty? The answer is productivity growth - a function of investment and innovation. Without it, every growth story peters out and fails to become a benchmark of success. While demographics matter for overall economic growth, productivity is the defining factor for per-capita income growth and prosperity. This report is not intended to answer all pertinent questions on economic development. It also does not incorporate our qualitative assessment. Finally, this ranking does not include the cyclical economic outlook. The objective of this report is to produce an EM country ranking based on parameters that matter from a structural perspective and test how this ranking aligns with current equity valuations. Chart 1 illustrates that Potential Growth Scores calculated based on data available in 2012 did in fact correlate with EM individual country performance since early 2013 to date. Chart 1Growth Potential Score Historically Mattered To Equity Returns Ranking EM Countries Based On Structural Variables Ranking EM Countries Based On Structural Variables Institutions Matter Various theories and explanations have been proposed to explain why some countries get rich while many others fail. According to Daron Acemoglu and James A. Robinson, an economist and political scientist respectively and authors of Why Nations Fail,1 a nation's success or failure highly depends on the quality of its political and economic institutions. Acemoglu and Robinson characterize political and economic institutions as either inclusive or extractive. By institutions they mean the structures and systems that govern the behaviors of communities. Inclusive institutions operate under pluralistic rules, which means they allow multiple groups in society to access the institutional decision-making process. These pluralistic rules force elites to constantly bargain and negotiate with one another, leading to rules that provide a level playing field amongst members of society. In other words, inclusive institutions allow those at the bottom of the pyramid to petition the government to change the rules of the game and climb the social ladder. This process incentivizes entrepreneurs, innovators and ambitious members of society to seek to monetize their efforts with little or no fear that their proceeds will be expropriated or nationalized. Ultimately, such inclusiveness leads to innovation and major technological changes which drive productivity gains. This process, nevertheless, comes at the cost of creative destruction, which threatens the interests and privileges of well-established elites and leaders. To protect their privileges, this group attempts to impede progress by placing obstacles in the face of creative destruction. In a political system with inclusive institutions, attempts to impede are put to a stop through the presence of checks and balances, and creative destruction is allowed to take place uninterruptedly. By contrast, in nations governed by extractive institutions - where checks and balances are absent - powerful elites reap substantial economic and political gains by presiding over these institutions. In turn, because of the elites' vast political and economic powers, they resist inclusive policies that would make their countries collectively wealthier and stronger. The basis for this resistance lies in their desire to protect their privileges and ultimately the economic rent (excessive profit) they extract. This causes an innovation deficit, weak productivity and ultimately economic stagnation. The eventual outcomes of these extractive systems are low social mobility and persistent income inequality among various social groups that in extreme cases can lead to state failure and civil wars.2 Gauging Potential Productivity To rank developing economies according to their potential for boosting productivity, we evaluated both the quality of their institutions and innovation aptitude. We used data from the World Bank Governance Indicators to construct an Institutional Strength Score and data from The Atlas of Economic Complexity to construct an Economic Complexity and Innovation Score. Then, we aggregated these two scores to derive an overall Potential Productivity Score. The basis for using both these measures and aggregating them is that these measures are, on their own, incomplete and subjective. Consequently, on an individual basis they might not capture all the necessary drivers of productivity. Adding them up together reveal more information and improve the outcome. In other words, Economic Complexity captures elements that Institutional Strength does not and vice versa. Furthermore, Economic Complexity also sheds light on broader variables such as the quality of advanced education as well as its attainment level, and the ability to apply such education in an economically productive and value-added manner. The latter is something that cannot be captured by education variables alone. What follows is a detailed description of the framework. Institutional Strength We constructed an Institutional Strength Score that reflects the quality of institutions in EM and ranks countries from best to worst. The score is based on the following World Bank Government Indicators: Rule of Law (20%) Regulatory Quality (20%), Government Effectiveness (20%) Political Stability (20%) Control of Corruption (10%) Voice and Accountability (10%). For a brief description of each of these components, please refer to Appendix I: We first calculated the weighted average measure of these indicators using the aforementioned weights. Please see Appendix II for more information on why we chose a five-year period. Importantly, this score incorporates both the level and marginal change in these parameters. We aggregated the two variations of the measure (change and level) to derive an Institutional Strength Score. Please see Appendix III for calculation details. Table 1 ranks the developing countries from best to worst according to their Institutional Strength Score. United Arab Emirates, Singapore, Sri Lanka and Poland have the highest Institutional Strength Score, while Egypt, Russia, Bangladesh, Pakistan, and Turkey have the lowest. Economic Complexity And Innovation We also constructed the Economic Complexity Score which ranks EM countries according to their economic complexity and innovation. We used the data from The Atlas of Economic Complexity which measures economic complexity by evaluating a country's ability to produce unique/rare as well as diverse sets of products. Countries that have higher complexity - measured via their ability to produce diverse and rare products - have developed high levels of productive knowledge and networks that enable their people and organizations to collaborate, share information/knowledge, and collectively build more complex and diverse products. This process of producing complex products makes their countries wealthier. In a nutshell, by assessing a country's ability to produce more diverse and more sophisticated goods that not many countries can produce - one can assess a country's level of accumulated knowledge, its networks that allow collaboration, as well as the presence of industry and businesses that allow the application of this knowledge. Please see Appendix IV for more information: As with the Institutional Strength Score, we calculated the Economic Complexity and Innovation Score by aggregating both the level and change in economic complexity - calculation is described in Appendix III. Table 2 shows the country rankings based on the Economic Complexity Score. Malaysia, South Korean, the Philippines and China are ranked the highest, while Kenya, Peru, South Africa and Pakistan have the worst scores. Table 1 Ranking EM Countries Based On Structural Variables Ranking EM Countries Based On Structural Variables Table 2 Ranking EM Countries Based On Structural Variables Ranking EM Countries Based On Structural Variables Potential Productivity = Institutional Strength + Complexity and Innovation Countries with strong and improving institutions as well as high and rising complexity are positioned able to achieve strong productivity growth. Chart 2 illustrates a scatter plot of Institutional Strength Score on the X-axis and Economic Complexity and Innovation Score on the Y-axis. The Philippines, Poland, Singapore, Malaysia, Sri Lanka and the United Arab Emirates have the highest potential productivity, while Russia, Brazil and South Africa are among the lowest. Chart 2Matching Institutional Strength With Economic Complexity And Innovation Ranking EM Countries Based On Structural Variables Ranking EM Countries Based On Structural Variables We also combined the Institutional Strength Score and Economic Complexity and Innovation scores together to generate a Potential Productivity Score and ranking. The rankings are shown in Table 3. A higher ranking implies that a country has the potential to achieve a higher sustainable growth rate in the next three to five years. Combining Potential Productivity With Demographics To achieve higher potential growth, an economy needs not only robust productivity but also a demographic tailwind - i.e. a growing labor force. We thus combined the Potential Productivity Score with growth projections for working age population. The latter projections are from the United Nations. Chart 3 shows a scatter plot of the Potential Productivity Score against the five-year projection of working-age population growth and Table 4 shows the combined total scores of Potential Productivity with working age population growth. We call this measure the Potential Growth Score. Chart 3Matching Potential Productivity With Demographics Ranking EM Countries Based On Structural Variables Ranking EM Countries Based On Structural Variables Table 3 Ranking EM Countries Based On Structural Variables Ranking EM Countries Based On Structural Variables Table 4 Ranking EM Countries Based On Structural Variables Ranking EM Countries Based On Structural Variables The Philippines, Malaysia, the UAE, Saudi Arabia, Indonesia, and Singapore offer the strongest demographic dividend and the highest potential productivity. On the flip side, Russia, South Africa and Brazil offer the lowest demographic dividend and potential productivity. Prospective Equity Returns Great companies and countries do not always make for great investments, and vice versa. To identify long-term investment opportunities, we have brought into the analysis equity valuations. An economy can offer great potential, but markets may have already priced in the bullish outlook. The opposite can also be true. We incorporate equity valuations into the analysis by comparing the Potential Growth Score against the current price-to-book value ratio of non-financial stocks. Chart 4 is a scatter plot of the Potential Growth Score on the X-axis against the current price-to-book ratio for non-financial corporations of the 20 bourses on the Y-axis. Chart 4Potential Growth Versus Equity Valuations Ranking EM Countries Based On Structural Variables Ranking EM Countries Based On Structural Variables We excluded financials from our calculations of price-to-book because many EM banks' earnings and, hence, book value have been unduly inflated in the recent years. This has, in turn, resulted in artificially low price-to-book value ratio. Many banks across EM have expanded their loan book enormously in the past eight to 10 years - boosting their earnings, retained earnings and the book value in the process, but have not yet provisioned sufficiently for non-performing loans (NPLs). All in all, the bourses in Colombia, Poland, the United Arab Emirates, Singapore, Malaysia, and the Philippines offer the highest potential returns in the next three to five years when incorporating potential productivity, demographics and the starting point of equity valuations. On the opposite end of the spectrum, equity markets in South Africa, Russia, Brazil, and Turkey promise the least in terms of returns in the coming years. It is important to note that this framework should be used as a broad guide, and serves to supplement our regular cyclical and structural analysis of various EMs. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Appendix I Below is a brief description of the World Bank Governance Indicators that we used as components in our Institutional Strength Score: Rule of Law: This measure evaluates how strong and fair the laws that govern a nation are and assesses the independence of the judicial system. Regulatory Quality: The measure of a government's ability to conceive sound regulations that promote private sector activity. Government Effectiveness: This component assesses the quality of public service and a government's ability to implement policy. In essence, this component looks at the government's ability to apply and enforce fair laws and regulations. Political Stability: This measure looks at the perceived likelihood of political instability, political violence or terrorism - all of which impede policy implementation. As with government effectiveness, political stability also assesses a government's ability to enforce laws. A country consumed with violence will have a weak state that is unable to maintain law and order. Control of Corruption: The corruption component assesses the extent to which public offices and government power are used for personal gains. Voice and Accountability: This measures the involvement of citizens in political life and assesses various types of freedoms. It also looks at how independent the media are. In other words, this component evaluates the ability for citizens to petition the government, and voice their concerns. Appendix II We incorporated the five-year change (2010 to 2015) and not a longer period because we wanted to capture institutional changes that have occurred since the global financial crisis (GFC). The GFC has led to major distortions in financial markets, and a deterioration in institutional and governance quality in EM. Five years are also sufficient to show meaningful changes in institutional quality. Appendix III In order to calculate the Institutional Strength Score: We started by ranking the countries from lowest to highest - first based on their five-year change in their weighted average measure, and then based on their 2015 level measure. For each variation in the measure, the lowest ranking country received a rank of 1 while the highest ranked country received a rank of 28 (we included 28 countries in our framework). We then summed up the rankings of the five-year change in the measure with those of the 2015 measure level for each country to derive the Institutional Strength Score. The Economic Complexity and Innovation Score follows the same methodology. It is based on the aggregation of the rankings of the two variations - change and level - of the economic complexity ranking. Appendix IV Countries that are able to produce (1) knowledge-intensive products (scarce products that are not produced by many other countries) as well as (2) diverse sets of products (many types of products), have complex societies and economies. Therefore, by looking at what a country produces, one can assess its complexity. In order to rise in complexity, a country should develop a network that enables its people to share their specialized knowledge and produce more value-added products. This process of sharing specialized knowledge leads to more gains in total knowledge that further spread to various areas and increases the country's ability to produce even more diverse and scarce products and get richer. It is important, however, to differentiate between types of scarce products. The United States produces advanced medical equipment, which are scarce, and Sierra Leone produces diamonds, which are also a scarce product. This does not make Sierra Leone a complex economy with advanced knowledge because, if it was, it would also have more product diversity, which it lacks.

Feature Recommended Allocation Monthly Portfolio Update Monthly Portfolio Update When Central Banks Turn Hawkish It seems almost as though, when central bank governors gathered in Portugal for the ECB's annual confab in late June, they agreed to start sounding more hawkish. ECB President Mario Draghi's speech included the line: "The threat of deflation is gone and reflationary forces are at play." Bank of Canada Governor Stephen Poloz went ahead and on July 12 announced Canada's first rate hike in seven years. Indeed, BCA's Central Bank Monitors (Chart 1) suggest that, with the exceptions of Japan and possibly the euro area, all major developed central banks need to tighten monetary policy. Does this matter for risk assets, such as equities? Historical evidence suggests not, as long as the central bank is tightening because it is confident about the outlook for growth and unconcerned about financial risks (rather than, for example, reacting to a sharp rise in inflation). Equity markets typically move up in the early stages of a tightening cycle (Chart 2); it is only when the central bank tightens excessively (usually later in the cycle) that risk assets start to anticipate that this will trigger a recession. Even in the U.S. which, after four rate hikes since December 2015, is the furthest advanced in tightening, the real effective Fed Funds Rate is still -0.3%, below the 0.3% that the Fed believes to be the neutral real rate at the moment (Chart 3). The Fed expects the neutral rate to rise to 1% in the longer run. Chart 1Most Central Banks Need To Tighten Most Central Banks Need To Tighten Most Central Banks Need To Tighten Chart 2Equities Usually Rise During Rate Hike Cycle Equities Usually Rise During Rate Hike Cycle Equities Usually Rise During Rate Hike Cycle Chart 3Fed Policy Is Still Accommodative Fed Policy Is Still Accommodative Fed Policy Is Still Accommodative But the order in which central banks tighten will be a major driver of currencies (as has been clear with the sharp appreciation of the CAD and AUD in recent weeks). Our current asset recommendations are based on the belief that the market has become too complacent about the speed at which the Fed will tighten (with futures pricing only 26 bp of hikes over the next 12 months), and too nervous about the ECB (Chart 4). As the market starts to understand that the Fed has fallen a little behind the curve, and that the ECB will remain cautious (given continuing weakness in peripheral economies, and a lack of underlying inflationary pressures), we expect to see the dollar begin to appreciate again. A key to all this is whether the recent softness in U.S. inflation data (core PCE inflation has fallen from 1.8% YoY to 1.4% since January) proves to be temporary. A rebound in inflation would allow the Fed to continue to hike without bringing the real rate close to the neutral level yet. It is worth remembering that inflation is a lagging indicator: the recent weakness is largely a reflection of last year's soggy GDP growth (Chart 5), as well as some transitory technical factors (particularly drug and wireless data prices). The recent dollar depreciation should also boost inflation via the import price channel over the coming months (Chart 6). Chart 4Markets Views On Fed And ECB Have Diverged Markets Views On Fed And ECB Have Diverged Markets Views On Fed And ECB Have Diverged Chart 5Inflation Lags GDP Growth Inflation Lags GDP Growth Inflation Lags GDP Growth Chart 6Dollar Deprecation Will Raise Prices Dollar Deprecation Will Raise Prices Dollar Deprecation Will Raise Prices However, with global equities having produced a total return of 35% since their recent bottom in February last year, and 17% year to date, valuations are unattractive and, on some measures, sentiment is quite optimistic (Chart 7). What catalysts are there left to give risk assets further upside? We see two. First, earnings. The Q2 U.S. results season has seen 77% of S&P 500 companies surprising on the upside at the sales line, with EPS rising 7% compared to the same quarter in 2016. Most of our indicators suggest that earnings have further to rise this year (Chart 8), yet the consensus EPS forecast for 2017 as a whole remains at just over 10%, where it has been since January. Strong earnings momentum is likely to remain a positive at least through the end of the year. Second, tax cuts. Our Geopolitical Strategy service1 remains optimistic that the U.S. Congress will pass tax legislation to come into effect in early 2018. The failure to repeal Obamacare means that the Republican Party will need a big legislative win going into the mid-term elections in November 2017. Tax cuts (which the market is no longer pricing in - Chart 9) is one policy on which there is little disagreement within the GOP. Chart 7Are Investors Getting Too Optimistic? Are Investors Getting Too Optimistic? Are Investors Getting Too Optimistic? Chart 8Earnings Can Still Surprise On Upside Earnings Can Still Surprise On Upside Earnings Can Still Surprise On Upside Chart 9No One Expects Tax Cuts Any More No One Expects Tax Cuts Any More No One Expects Tax Cuts Any More None of the recession indicators we highlighted in our most recent Quarterly 2 (global PMIs, the shape of the yield curve, or credit spreads) are pointing to a downturn in the next 12 months. So, given the environment described above, we are happy to remain overweight equities versus bonds, and to maintain our pro-risk and pro-cyclical tilts. But we continue to warn of the risk of a recession in 2019 - probably triggered by the Fed needing to tighten more aggressively - and might look to lower our risk profile in the first half of next year. Equities: We favor DM equities over EM. An appreciating dollar, rising interest rates, weak industrial metals prices this year and uncertain growth prospects for China all represent headwinds for EM equities. Our strong dollar view points to an overweight in U.S. equities in USD terms but, in local currencies, our preference is for euro area and Japanese equities. Both are relatively high-beta, have strongly cyclical earnings momentum, and central banks that are likely to stay dovish. In Japan, the falling popularity rating of the Abe administration might compel it to ramp up fiscal spending to boost the economy, which would help the Bank of Japan in its efforts to rekindle inflation. Chart 10Everyone Has Turned Bullish On The Euro Everyone Has Turned Bullish On The Euro Everyone Has Turned Bullish On The Euro Fixed Income: Our macro outlook, with faster rate hikes and rebounding inflation in the U.S., is very negative for rates. We are underweight government bonds, short duration and prefer inflation-linked bonds to nominal ones. Valuations in credit are no longer particularly attractive but, with a 100 bp spread for U.S. investment grade bonds and a 230 bp default-adjusted spread for high-yield, returns are likely to be satisfactory as long as the economic cycle continues to improve. Currencies: Our fundamental view of the dollar is that relative monetary policy and interest rates point to further appreciation, especially against the yen and euro. The timing of the dollar's rebound, though, is harder to pinpoint. The euro could rise further over the next couple of months. However, given speculators' large net long positions in the euro - a big turnaround from the start of the year (Chart 10) - the likely announcement by the ECB in September or October of a reduction in its asset purchases might be the catalyst for a reversal (as a classic "buy the news, sell the rumor" event), particularly if Mario Draghi dresses it up as a "dovish tapering." Commodities: Oil inventories have begun to draw down in line with our expectations (Chart 11). Continued discipline by OPEC producers until next March, combined with a slowdown in the growth of U.S. shale production (reflecting the weaker crude price this year) should bring inventories down further (despite production increases in such countries as Libya and Iran), and push the price of WTI above $55 a barrel by year end. Industrial commodity prices have rebounded somewhat in the past six weeks, mainly on the back of moderately brighter economic data out of China (Chart 12). But, given uncertain prospects about the sustainability of this growth, especially beyond the Communist Party Congress in the fall, and amid some signs of weakness in Chinese monetary and credit aggregates,3 we remain cautious about the outlook for metals prices over the next 12 months. Chart 11Oil Inventories Will Draw Down Further in Oil Inventories Will Draw Down Further in Oil Inventories Will Draw Down Further in Chart 12Tick-Up In Chinese Data? Tick-Up In Chinese Data? Tick-Up In Chinese Data? Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bca.research.com. 2 Please see BCA Global Asset Allocation, "Quarterly Portfolio Review," dated July 3, 2107, available at gaa.bcaresearch.com. 3 Please see BCA Emerging Markets Strategy Weekly Report, "Follow The Money, Not The Crowd," dated July 26, 2017, available at ems.bcaresearch.com. Recommended Asset Allocation

This week we are sending you two Special Reports (both included in this document) that were previously published in the May and June editions of The Bank Credit Analyst. Both reports discuss the long-term outlook for global bond yields. The first report emphasizes the importance of demographics and the second focuses on the outlook for productivity growth. We are also sending a Weekly Report published jointly by our Global Fixed Income Strategy and U.S. Bond Strategy services. Highlights The fundamental drivers of the low rate world are considered by many to be structural, and thus likely to keep global equilibrium bond yields quite depressed by historical standards for years to come. However, some of the factors behind ultra-low interest rates have waned, while others have reached an inflection point. The age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool. Global investment needs will wane along with population aging, but the majority of the effect on equilibrium interest rates is in the past. In contrast, the demographic effects that will depress desired savings are still to come. The net impact will be bond-bearish. Moreover, the massive positive labor supply shock, following the integration of China and Eastern Europe into the world's effective labor force, is over. Indeed, this shock is heading into reverse as the global working-age population ratio falls. This may improve labor's bargaining power, sparking a shift toward using more capital in the production process and thereby placing upward pressure on global real bond yields. It is too early to declare globalization dead, but the neo-liberal trading world order that has been in place for decades is under attack. This could be inflationary if it disrupts global supply chains. Anti-globalization policies could paradoxically be positive for capital spending, at least for a few years. As for China, the fundamental drivers of its savings capacity appear to rule out a return to the days when the country was generating a substantial amount of excess savings. Technological advance will remain a headwind for real wage gains, but at least the transition to a world that is less labor-abundant will boost workers' ability to negotiate a larger share of the income pie. We are not making the case that real global bond yields are going to quickly revert to pre-Lehman averages. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations for bond yields are too low. Investors should have a bond-bearish bias on a medium- and long-term horizon. Feature In the September 2016 The Bank Credit Analyst, we summarized the key drivers behind the major global macroeconomic disequilibria that have resulted in deflationary pressure, policy extremism, dismal productivity, and the lowest bond yields in recorded history (Chart I-1). The disequilibria include income inequality, the depressed wage share of GDP, lackluster capital spending, and excessive savings. Chart I-1Global Disequilibria Beware Inflection Points In The Secular Drivers Of Global Bonds Beware Inflection Points In The Secular Drivers Of Global Bonds The fundamental drivers of the low bond yield world are now well documented and understood by investors. These drivers generally are considered to be structural, and thus likely to keep global equilibrium bond yields and interest rates at historically low levels for years to come according to the consensus. Based on discussions with BCA clients, it appears that many have either "bought into" the secular stagnation thesis or, at a minimum, have adopted the view that growth headwinds preclude any meaningful rise in bond yields. However, bond investors might have been lulled into a false sense of security. Yields will not return to pre-Lehman norms anytime soon, but some of the factors behind the low-yield world have waned, while others have reached an inflection point. Most importantly, the age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool. We have reached the tipping point. Equilibrium real bond yields will gradually move higher as a result. But before we discuss what is changing, it is important to review the drivers of today's macro disequilibria. Several of them predate the Great Financial Crisis, including demographic trends, technological advances, and the integration of China's massive workforce and excess savings into the global economy. Ultra-Low Rates: How Did We Get Here? (A) Demographics And Global Savings The so-called Global Savings Glut has been a bullish structural force for bonds for the past couple of decades. We won't go through all of the forces behind the glut, but a key factor is population aging in the advanced economies. Ex-ante desired savings rose as baby boomers entered their high-income years. The Great Financial Crisis only served to reinforce the desire to save, given the setback in the value of boomers' retirement nest eggs.1 The corporate sector also began to save more following the crisis. Chart I-2Global Shifts In The Saving ##br##And Investment Curves Beware Inflection Points In The Secular Drivers Of Global Bonds Beware Inflection Points In The Secular Drivers Of Global Bonds Even more importantly, the surge in China's trade surplus since the 1990s had to be recycled into the global pool of savings. While China's rate of investment was very high, its propensity to save increased even faster, resulting in a swollen external surplus and a massive net outflow of capital. Other emerging economies also made the adjustment from net importers of capital to net exporters following the Asian crisis in the late 1990s. By leaning into currency appreciation, these countries built up huge foreign exchange reserves that had to be recycled abroad. In theory, savings must equal investment at the global level and real interest rates shift to ensure this equilibrium (Chart I-2). China's excess savings, together with a greater desire to save in the developed countries, represented a shift in the saving schedule to the right. The result was downward pressure on global interest rates. (B) Demographics And Global Capital Spending Demographics and China's integration also affected the investment side of the equation. A slower pace of labor force growth in the developed countries resulted in a permanently lower level of capital spending relative to GDP. Slower consumer spending growth, as a result of a more moderate expansion in the working-age population, meant a reduced appetite for new factories, malls, and apartment buildings. Chart I-3 shows that the growth rate of global capital spending that is required to maintain a given capital-to-output ratio has dropped substantially, due to the dramatic slowdown in the growth of the world's working-age population.2 Keep in mind that this estimate refers only to the demographic component of investment spending. Actual capital expenditure growth will not be as weak as Chart I-3 suggests because firms will want to adopt new technologies for competitive or environmental reasons. Nonetheless, the point is that the structural tailwind for global capex from the post-war baby boom has disappeared. Chart I-3Demographics Are A Structural Headwind For Global Capex Beware Inflection Points In The Secular Drivers Of Global Bonds Beware Inflection Points In The Secular Drivers Of Global Bonds (C) Labor Supply Shock And Global Capital Spending While the working-age population ratio peaked in the developed countries years ago, it is a different story at the global level (Chart I-4). The integration of the Chinese and Eastern European workforces into the global labor pool during the 1990s and 2000s resulted in an effective doubling of global labor supply in a short period of time. Relative prices must adjust in the face of such a large boost in the supply of labor relative to capital. The sudden abundance of cheap labor depressed real wages from what they otherwise would have been, thus incentivizing firms to use more labor and less capital at the margin. The combination of slower working-age population growth in the advanced economies and a surge in the global labor force resulted in a decline in desired global capital spending. In terms of Chart I-2, the leftward shift of the investment schedule reinforced the impact of the savings impulse in placing downward pressure on global interest rates. (D) Labor Supply Shock And Income Inequality The wave of cheap labor also aggravated the trend toward greater inequality in the advanced economies and the downward trend in labor's share of the income pie (Chart I-5). Chart I-4Working-Age Population Ratios Have Peaked Working-Age Population Ratios Have Peaked Working-Age Population Ratios Have Peaked Chart I-5Labor Share Of Income Has Dropped Labor Share Of Income Has Dropped Labor Share Of Income Has Dropped In theory, a surge in the supply of labor is a positive "supply shock" that benefits both developed and developing countries. However, a recent report by David Autor and Gordon Hanson3 highlighted that trade agreements in the past were incremental and largely involved countries with similar income levels. The sudden entry of China to the global trade arena, involving a massive addition to the effective global stock of labor, was altogether different. The report does not argue that trade has become a "bad" thing. Rather, it points out that the adjustment costs imposed on the advanced economies were huge and long-lasting, as Chinese firms destroyed entire industries in developed countries. Chart I-6Hollowing Out Hollowing Out Hollowing Out The lingering adjustment phase contributed to greater inequality in the major countries. Management was able to use the threat of outsourcing to gain the upper hand in wage negotiations. The result has been a rise in the share of income going to high-income earners in the Advanced Economies, at the expense of low- and middle-income earners (Chart I-6). The same is true, although to a lesser extent, in the emerging world. Greater inequality, in turn, has weighed on aggregate demand and equilibrium interest rates because a larger share of total income flowed to the "rich" who tend to save more than the low- and middle-income classes. (E) The Dark Side Of Technology Advances in technology also contributed to rising inequality. In theory, new technologies hurt some workers in the short term, but benefit most workers in the long run because they raise national income. However, there is evidence that past major technological shocks were associated with a "hollowing out" or U-shaped pattern of employment. Low- and high-skilled employment increased, but the proportion of mid-skilled workers tended to shrink. Wages for both low- and mid-skilled labor did not keep up with those that were highly-skilled, leading to wider income disparity. Today, technology appears to be resulting in faster, wider and deeper degrees of hollowing-out than in previous periods of massive technological change. This may be because machines are not just replacing manual human tasks, but cognitive ones too. A recent IMF report made the case that technology and global integration played a dominant role in labor's declining fortunes. Technology alone explains about half of the drop in the labor share of income in the developed countries since 1980.4 Falling prices for capital goods, information and communications technology in particular, have facilitated the expansion of global value chains as firms unbundled production into many tasks that were distributed around the world in a way that minimized production costs. Chart I-7 highlights that the falling price of capital goods in the advanced economies went hand-in-hand with rising participation in global supply chains since 1990. Falling capital goods prices also accelerated the automation of routine tasks, contributing especially to job destruction in the developed (high-wage) economies. In other words, firms in the developed world either replaced workers with machinery in areas where technology permitted, or outsourced jobs to lower-wage countries in areas that remained labor-intensive. Both trends undermined labor's bargaining power, depressed labor's share of income, and contributed to inequality. The effects of technology, global integration, population aging and China's economic integration are demonstrated in Chart I-8. The world working-age-to-total population ratio rose sharply beginning in the late 1990s. This resulted in an upward trend in China's investment/GDP ratio, and a downward trend in the G7. The upward trend in the G7 capital stock-per-capita ratio began to slow as a result, before experiencing an unprecedented contraction after the Great Recession and Financial Crisis. Chart I-7Economic Integration And ##br##Falling Capital Goods Prices Economic Integration And Falling Capital Goods Prices Economic Integration And Falling Capital Goods Prices Chart I-8Macro Impact Of ##br##Labor Supply Shock Macro Impact Of Labor Supply Shock Macro Impact Of Labor Supply Shock The result has been a deflationary global backdrop characterized by demand deficiency and poor potential real GDP growth, both of which have depressed equilibrium global interest rates over the past 20 to 25 years. Transition Phase It would appear easy to conclude that these trends will be with us for another few decades because the demographic trends will not change anytime soon. Nonetheless, on closer inspection the global economy is transitioning from a period when cyclical economic pressures and all of the structural trends were pushing equilibrium interest rates in the same direction, to a period in which the economic cycle is becoming less bond-friendly and some of the secular drivers of low interest rates are gradually changing direction. First, the massive labor supply shock of the past few decades is over. The world working-age population ratio has peaked according to United Nations estimates. This ratio is already declining in the major advanced economies and is in the process of topping out in China. The absolute number of working-age people will shrink in China and the G7 countries over the next five years, although it will continue to grow at a low rate for the world as a whole (Chart I-9). Unions are unlikely to make a major comeback, but a backdrop that is less labor-abundant should gradually restore some worker bargaining power, especially as economies regain full employment. The resulting upward pressure on real wages will support capital spending as firms substitute toward capital and away from (increasingly expensive) labor. Consumer demand will also receive a boost if inequality moderates and the labor share of income begins to rise. Globalization On The Back Foot Second, it is too early to declare globalization dead, but the neo-liberal trading world order that has been in place for decades is under attack. Global exports appear to have peaked relative to GDP and average tariffs have ticked higher (Chart I-10). The World Trade Organization has announced that the number of new trade restrictions or impediments outweighed the number of trade liberalizing initiatives in 2016. The U.K. appears willing to sacrifice trade for limits to the free movement of people. The new U.S. Administration has ditched the Trans-Pacific Partnership (TPP) and is threatening to impose punitive tariffs on some trading partners. Chart I-9Working-Age Population To Shrink In G7 And China Working-Age Population To Shrink in G7 and China Working-Age Population To Shrink in G7 and China Chart I-10Globalization Peaking? Globalization Peaking? Globalization Peaking? Anti-globalization policies could paradoxically be positive for capital spending, at least for a few years. If the U.S. were to impose high tariffs on China, for example, it would make a part of the Chinese capital stock redundant overnight. In order for the global economy to produce the same amount of goods and services as before, the U.S. and other countries would need to invest more. Any unwinding of globalization would also be inflationary as it would disrupt international supply chains. Demographics And Saving: From Tailwind To Headwind... Chart I-11Income And Consumption By Age Cohort Income And Consumption By Age Cohort Income And Consumption By Age Cohort Third, the impact of savings in the major advanced economies and China on global interest rates will change direction as well. In the developed world, aggregate household savings will come under downward pressure as boomers increasingly shift into retirement. Economists are fond of employing the so-called life-cycle theory of consumer spending. According to this theory, consumers tend to smooth out lifetime spending by accumulating assets during the working years in order to maintain a certain living standard after retirement. The U.N. National Transfer Accounts Project has gathered data on spending and labor income by age cohort at a point in time. Chart I-11 presents the data for China and three of the major advanced economies. The data for the advanced economies suggest that spending tends to rise sharply from a low level between birth and about 15 years of age. It continues to rise, albeit at a more modest pace, through the working years. Other studies have found that consumer spending falls during retirement. Nonetheless, these studies generally include only private spending and therefore do not include health care that is provided by the government. The data presented in Chart I-11 show that, if government-provided health care is included, personal spending rises sharply toward the end of life. The profile is somewhat different in China. Spending rises quickly from birth to about 20 years of age, and is roughly flat thereafter. Indeed, consumption edges lower after 75-80 years of age. These data allow us to project the impact of changing demographics on the average household saving rate in the coming years, assuming that the income and spending profiles shown in Chart I-11 are unchanged. We start by calculating the average saving rate across age cohorts given today's age structure. We then recalculate the average saving rate each year moving forward in time. The resulting saving rate changes along with the age structure of the population. The results are shown in Chart I-12. The saving rates for all four economies have been indexed at zero in 2016 for comparison purposes. The aggregate saving rate declines in all cases, falling between 4 and 8 percentage points between 2016 and 2030. Germany sees the largest drop of the four countries. Chart I-12Aging Will Undermine Aggregate Saving Aging Will Undermine Aggregate Saving Aging Will Undermine Aggregate Saving The simulations are meant to be suggestive, rather than a precise forecast, because the savings profile across age cohorts will adjust over time. Moreover, governments will no doubt raise taxes to cover the rising cost of health care, providing a partial offset in terms of the national saving rate.5 Nonetheless, the simulations highlight that the major economies are past the point where the baby boom generation is adding to the global savings pool at a faster pace than retirees are drawing from it. The age structure in the major advanced economies is far enough advanced that the rapid increase in the retirement rate will place substantial downward pressure on aggregate household savings in the coming years. It is well known that population aging will also undermine government budgets. Rising health care costs are already captured in our household saving rate projection because the data for household spending includes health care even if it is provided by the public sector. However, public pension schemes will also be a problem. To the extent that politicians are slow to trim pension benefits and/or raise taxes, public pension plans will be a growing drain on national savings. Could younger, less developed economies offset some of the demographic trends in China and the Advanced Economies? Numerically speaking, a more effective use of underutilized populations in Africa and India could go a long way. Nevertheless, deep-seated structural problems would have to be addressed and, even then, it is difficult to see either of these regions turning into the next "China story" given the current backlash against globalization and immigration. ...And The Capex Story Is Largely Behind Us Demographic trends also imply less capital spending relative to GDP, as discussed above. In terms of the impact on global equilibrium interest rates, it then becomes a race between falling saving and investment rates. Some analysts point to the Japanese experience because it is the leading edge in terms of global aging. Bond yields have been extremely low for many years even as the household saving rate collapsed, suggesting that ex-ante investment spending shifted by more than ex-ante savings. Nonetheless, Japan may not be a good example because the deterioration in the country's demographics coincided with burst bubbles in both real estate and stocks that hamstrung Japanese banks for decades. A series of policy mistakes made things worse. Economic theory is not clear on the net effect of demographics on savings and investment. The academic empirical evidence is inconclusive as well. However, a detailed IMF study of 30 OECD countries analyzed the demographic impact on a number of macroeconomic variables, including savings and investment.6 They estimated separate demographic effects for the old-age dependency ratio and the working-age population ratio. Applying the IMF's estimated model coefficients to projected changes in both of these ratios over the next decade suggests that the decline in ex-ante savings will exceed the ex-ante drop in capex requirements by about 1 percentage point of GDP. This is a non-trivial shift. Moreover, our simulations highlight that timing is important. The outlook for the household saving rate depends on the changing age structure of the population and the distribution of saving rates across age cohorts. Thus, the average saving rate will trend down as populations continue to age over the coming decades. In contrast, the impact of demographics on capital spending requirements is related to the change in the growth rate of the working-age population. Chart I-13 once again presents our estimates for the demographic component of capital spending. The top panel presents the world capex/GDP ratio that is necessary to maintain a constant capital/output ratio, and the bottom panel shows the change in that ratio. The important point is that the downward adjustment in world capex/GDP related to aging is now largely behind us because most of the deceleration in the growth rate of the working-age population is done. This is in contrast to the household saving rate adjustment where all of the adjustment is still to come. China Is Transitioning Too China must be treated separately from the developed countries because of its unique structural issues. As discussed above, household savings increased dramatically beginning in the mid-1990s (Chart I-14). This trend reflected a number of factors, including: Chart I-13Demographics And Capex Requirements Beware Inflection Points In The Secular Drivers Of Global Bonds Beware Inflection Points In The Secular Drivers Of Global Bonds Chart I-14China's Savings Rates Have Peaked... China's Savings Rates Have Peaked... China's Savings Rates Have Peaked... the rising share of the working-age population; a drop in the fertility rate, following the introduction of the one-child policy in the late 1970s that allowed households to spend less on raising children and save more for retirement; health care reform in the early 1990s required households to bear a larger share of health care spending; and job security was also undermined by reform of the state-owned enterprises (SOE) in the late 1990s, leading to increased precautionary savings to cover possible bouts of unemployment. These savings tailwinds have turned around in recent years and the household saving rate appears to have peaked. China's contribution to the global pool of savings has already moderated significantly, as measured by the current account surplus. The surplus has withered from about 9% in 2008 to 2½% in 2016. A recent IMF study makes the case that China's national saving rate will continue to decline. The IMF estimates that for every one percentage-point rise in the old-age dependency ratio, the aggregate household saving rate will fall by 0.4-1 percentage points. In addition, the need for precautionary savings is expected to ease along with improvements in the social safety net, achieved through higher government spending on health care. The household saving rate will fall by three percentage points by 2021 according to the IMF (Chart I-15). Competitive pressure and an aging population will also reduce the saving rates of the corporate and government sectors. Chart I-15...Suggesting That External Surplus Will Shrink ...Suggesting That External Surplus Will Shrink ...Suggesting That External Surplus Will Shrink Of course, investment as a share of GDP is projected to moderate too, reflecting a rebalancing of the economy away from exports and capital spending toward household consumption. The IMF expects that savings will moderate slightly faster than investment, leading to a narrowing in the current account surplus to almost zero by 2021. A lot of assumptions go into this type of forecast such that we must take it with a large grain of salt. Nonetheless, the fundamental drivers of China's savings capacity appear to rule out a return to the days when the country was generating a substantial amount of excess savings. Moreover, a return to large current account surpluses would likely require significant currency depreciation, which is a political non-starter given U.S. angst over trade. The risk is that China's excess savings will be less, not more, in five year's time. Tech Is A Wildcard It is extremely difficult to forecast the impact of technological advancement on the global economy. We cannot say with any conviction that the tech-related effects of "hollowing out", "winner-take-all" and the "skills premium" will moderate in the coming years. Nonetheless, these effects have occurred alongside a surge in the world's labor force and rapid globalization of supply chains, both of which reinforced the erosion of employee bargaining power. Looking ahead, technology will still be a headwind for some employees, but at least the transition from a world of excess labor to one that is more labor-scarce will boost workers' ability to negotiate a larger share of the income pie. We will explore the impact of technology on productivity, inflation, growth, and bond yields in a companion report to be published in the next issue. Conclusion: The main points we made in this report are summarized in Table I-1. All of the structural factors driving real bond yields were working in the same (bullish) direction over the past 30-40 years. Looking ahead, it is uncertain how technological improvement will affect bond prices, but we expect that the others will shift (or have already shifted) to either neutral or outright bond-bearish. Table I-1Key Secular Drivers Beware Inflection Points In The Secular Drivers Of Global Bonds Beware Inflection Points In The Secular Drivers Of Global Bonds No doubt, our views that globalization and inequality have peaked, and that the labor share of income has bottomed, are speculative. These factors may not place much upward pressure on equilibrium yields. Nonetheless, it seems likely that the demographic effect that has depressed capital spending demand is well advanced. We see it shifting from a positive factor for bond prices to a neutral factor in the coming years. It is also clear that the massive positive labor supply shock is over, and is heading into reverse as the global working-age population ratio falls. This may improve labor's bargaining power and the resulting boost consumer spending will be negative for bonds. This may also spark a shift toward using more capital in the production process and thereby place additional upward pressure on global real bond yields. Admittedly, however, this last point requires more research because theory and empirical evidence on it are not clear. Perhaps most importantly, the aging of the population in the advanced economies has reached a tipping point; retirees will drain more from the pool of savings than the working-age population will add to it in the coming years. We have concentrated on real equilibrium bond yields in this report because it is the part of nominal yields that is the most depressed relative to historical norms. The inflation component is only a little below a level that is consistent with central banks meeting their 2% inflation targets in the medium term. There is a risk that inflation will overshoot these targets, leading to a possible surge in long-term inflation expectations that turbocharges the bond bear market. This is certainly possible, as highlighted by a recent Global Investment Strategy Quarterly Strategy Outlook.7 Pain in bond markets would be magnified in this case, especially if central banks are forced to aggressively defend their targets. Please note that we are not making the case that real global bond yields will quickly revert to pre-Lehman averages. It will take time for the bond-bullish structural factors to unwind. It will also take time for inflation to gain any momentum, even in the United States. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations suggest that investors have adopted an overly benign view on the outlook for yields. For example, implied real short-term rates remain negative until 2021 in the U.S. and 2026 in the Eurozone, while they stay negative out to 2030 in the U.K. (Chart I-16). We doubt that short-term rates will be negative for that long, given the structural factors discussed above. Another way of looking at this is presented in Chart I-17. The market expects the 10-year Treasury yield in ten years to be only slightly above today's spot yield, which itself is not far above the lowest levels ever recorded. Market expectations are equally depressed for the 5-year forward rate for the U.S. and the other major economies. Chart I-16Market Expects Negative Short-Term Rates For A Long Time Market Expects Negative Short-Term Rates For A Long Time Market Expects Negative Short-Term Rates For A Long Time Chart I-17Forward Rates Very Low Vs. History Forward Rates Very Low Vs. History Forward Rates Very Low Vs. History The implication is that investors should have a bond-bearish bias on a medium- and long-term horizon. Mark McClellan, Senior Vice President The Bank Credit Analyst MarkM@bcaresearch.com 1 It is true that observed household savings rates fell in some of the advanced economies, such as the United States, at a time when aging should have boosted savings from the mid-1990s to the mid-2000s. This argues against a strong demographic effect on savings. However, keep in mind that we are discussing desired (or ex-ante) savings. Ex-post, savings can go in the opposite direction because of other influencing factors. As discussed below, global savings must equal investment, which means that shifts in desired capital spending demand matter for the ex-post level of savings. 2 Arithmetically, if world trend GDP growth slows by one percentage point, then investment spending would need to drop by about 3½ percentage points of GDP to keep the capital/output ratio stable. 3 David H. Autor, David Dorn, and Gordon H. Hanson, "The China Shock: Learning from Labor Market Adjustment to Large Changes in Trade," Annual Review of Economics, Vol. 8, pp. 205-240 (October 2016). 4 Please see "Understanding The Downward Trend In Labor Income Shares," Chapter 3 in the IMF World Economic Outlook (April 2017). 5 In other words, while the household savings rate, as defined here to include health care spending by governments on behalf of households, will decline, any associated tax increases will blunt the impact on national savings (i.e. savings across the household, government and business sectors). 6 Jong-Won Yoon, Jinill Kim, and Jungjin Lee, "Impact Of Demographic Changes On Inflation And The Macroeconomy," IMF Working Paper no. 14/210 (November 2014). 7 Please see Global Investment Strategy, "Strategy Outlook: Second Quarter 2017: A Three Act Play," dated March 31, 2017, available at gis.bcaresearch.com. Is Slow Productivity Growth Good Or Bad For Bonds? Productivity growth has declined in most countries. This appears to be a structural problem that will remain with us for years to come. In theory, slower productivity growth should reduce the neutral rate of interest, benefiting bonds in the process. In reality, countries with chronically low productivity growth typically have higher interest rates than faster growing economies. The passage of time helps account for this seeming paradox: Slower productivity growth tends to depress interest rates at the outset, but leads to higher rates later on. The U.S. has reached an inflection point where weak productivity growth is starting to push up both the neutral real rate and inflation. Other countries will follow. The implication for investors is that government bond yields have begun a long-term secular uptrend. The market is not at all prepared for this. Slow Productivity Growth: A Structural Problem Productivity growth has fallen sharply in most developed and emerging economies (Chart II-1). As we argued in "Weak Productivity Growth: Don't Blame The Statisticians," there is little compelling evidence that measurement error explains the productivity slowdown.1 Yes, the unmeasured utility accruing from free internet services is large, but so was the unmeasured utility from antibiotics, indoor plumbing, and air conditioning. No one has offered a convincing explanation for why the well-known problems with productivity calculations suddenly worsened about 12 years ago. Chart II-1Productivity Growth Has Slowed In Most Major Economies Beware Inflection Points In The Secular Drivers Of Global Bonds Beware Inflection Points In The Secular Drivers Of Global Bonds If mismeasurement is not responsible for the productivity slowdown, what is? Cyclical factors have undoubtedly played a role. In particular, lackluster investment spending has curtailed the growth in the capital stock (Chart II-2). This means that today's workers have not benefited from the improvement in the quality and quantity of capital to the same extent as previous generations. However, the timing of the productivity slowdown - it began in 2004-05 in most countries, well before the financial crisis struck - suggests that structural factors have been key. These include: Waning gains from the IT revolution. Recent innovations have focused more on consumers than businesses. As nice as Facebook and Instagram are, they do little to boost business productivity - in fact, they probably detract from it, given how much time people waste on social media these days. The rising share of value added coming from software relative to hardware has also contributed to the decline in productivity growth. Chart II-3 shows that productivity gains in the latter category have been much smaller than in the former. Chart II-2The Great Recession Hit ##br##Capital Stock Accumulation The Great Recession Hit Capital Stock Accumulation The Great Recession Hit Capital Stock Accumulation Chart II-3The Shift Towards Software Has ##br##Dampened IT Productivity Gains The Shift Towards Software Has Dampened IT Productivity Gains The Shift Towards Software Has Dampened IT Productivity Gains Slower human capital accumulation. Globally, the fraction of adults with a secondary degree or higher is increasing at half the pace it did in the 1990s (Chart II-4). Educational achievement, as measured by standardized test scores in mathematics and science, is edging lower in the OECD, and is showing very limited gains in most emerging markets (Chart II-5). Test scores tend to be much lower in countries with rapidly growing populations (Chart II-6). Consequently, the average level of global mathematical proficiency is now declining for the first time in modern history. Chart II-4The Contribution To Growth ##br##From Rising Human Capital Is Falling Beware Inflection Points In The Secular Drivers Of Global Bonds Beware Inflection Points In The Secular Drivers Of Global Bonds Chart II-5Math Skills Around The World Beware Inflection Points In The Secular Drivers Of Global Bonds Beware Inflection Points In The Secular Drivers Of Global Bonds Decreased creative destruction. The birth rate of new firms in the U.S. has fallen by half since the late 1970s and is now barely above the death rate (Chart II-7). In addition, many firms in advanced economies are failing to replicate the best practices of industry leaders. The OECD reckons that this has been a key reason for the productivity slowdown.2 Chart II-6The Best Educated EMs Have The Worst Demographic Outlooks Beware Inflection Points In The Secular Drivers Of Global Bonds Beware Inflection Points In The Secular Drivers Of Global Bonds Chart II-7Secular Decline In U.S. Firm Births Secular Decline In U.S. Firm Births Secular Decline In U.S. Firm Births Productivity Growth And Interest Rates Investors typically assume that long-term interest rates will converge to nominal GDP growth. All things equal, this implies that faster productivity growth should lead to higher interest rates. Most economic models share this assumption - they predict that an acceleration in productivity growth will raise the rate of return on capital and incentivize households to save less in anticipation of faster income gains.3 Both factors should cause interest rates to rise. The problem is that these theories do not accord with the data. Chart II-8 shows that interest rates are far higher in regions such as Africa and Latin America, which have historically suffered from chronically weak productivity growth. In contrast, rates are lower in regions such as East Asia, which have experienced rapid productivity growth. One sees the same negative correlation between interest rates and productivity growth over time in developed economies. In the U.S., for example, interest rates rose rapidly during the 1970s, a decade when productivity growth fell sharply (Chart II-9). Chart II-8Emerging Markets: Interest Rates Tend To ##br##Be Higher Where Productivity Growth Is Weak Beware Inflection Points In The Secular Drivers Of Global Bonds Beware Inflection Points In The Secular Drivers Of Global Bonds Chart II-9U.S. Interest Rates Soared In ##br##The 1970s While Productivity Swooned U.S. Interest Rates Soared In The 1970s While Productivity Swooned U.S. Interest Rates Soared In The 1970s While Productivity Swooned Two Reasons Why Slower Productivity Growth May Lead To Higher Interest Rates There are two main reasons why slower productivity growth may lead to higher nominal interest rates over time: Slower productivity growth may eventually lead to higher inflation; Slower productivity growth may deplete national savings, thereby raising the neutral real rate of interest. We discuss each reason in turn. Reason #1: Slower Productivity Growth May Fuel Inflation Most economists agree that chronically weak productivity growth tends to be associated with higher inflation. Even Janet Yellen acknowledged as much, noting in a 2005 speech that "the evidence suggests that the predominant medium-term effect of a slowdown in trend productivity growth would likely be higher inflation."4 In theory, the causation between productivity and inflation can run in either direction: Weak productivity gains can fuel inflation while high inflation can, in turn, undermine growth. With respect to the latter, economists have focused on three channels: First, higher inflation may make it difficult for firms to distinguish between relative and absolute price shocks, leading to suboptimal resource allocation. Second, higher inflation may stymie capital accumulation because investors typically pay capital gains taxes even when the increase in asset values is entirely due to inflation. Third, high inflation may cause households and firms to waste time and effort on economizing their cash holdings. There are also several ways in which slower productivity growth can lead to higher inflation. For example, sluggish productivity growth may increase the likelihood that a country will be forced to inflate its way out of any debt problems. In addition, central banks may fail to recognize structural declines in productivity growth in real time, leading them to keep interest rates too low in the errant belief that weak GDP growth is due to inadequate demand when, in fact, it is due to insufficient supply. There is strong evidence that this happened in the U.S. in the 1970s. Chart II-10 shows that the Fed consistently overestimated the size of the output gap during that period. Chart II-10The Fed Continuously Overstated ##br##The Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s Reason #2: Slower Productivity Growth May Deplete National Savings, Leading To A Higher Neutral Real Rate Imagine that you have a career where your real income is projected to grow by 2% per year, but then something auspicious happens that leads you to revise your expected annual income growth to 20%. How do you react? If you are like most people, your initial inclination might be to celebrate by purchasing a new car or treating yourself to a lavish vacation. As such, your saving rate is likely to fall at the outset. However, as the income gains pile up, you might find yourself running out of stuff to buy, resulting in a higher saving rate. This is particularly likely to be true if you grew up poor and have not yet acquired a taste for conspicuous consumption. Now consider the opposite case: One where you realize that your income will slowly contract over time as your skills become increasingly obsolete. The logic above suggests that your immediate reaction will be to hunker down and spend less - in other words, your saving rate will rise. However, as time goes by and the roof needs to be changed and the kids sent off to college, you may find it hard to pay the bills - your saving rate will then fall. The same reasoning applies to economy-wide productivity growth. When productivity growth increases, household savings are likely to decline as consumers spend more in anticipation of higher incomes. Meanwhile, investment is likely to rise as firms move swiftly to expand capacity to meet rising demand for their products. The combination of falling savings and rising investment will cause real rates to increase. As time goes by, however, it may become increasingly difficult for the economy to generate enough incremental demand to keep up with rising productive capacity. At that point, real rates will begin falling. The historic evidence is consistent with the notion that higher productivity growth causes savings to fall at the outset, but rise later on. Chart II-11 shows that East Asian economies all had rapid growth rates before they had high saving rates. China is a particularly telling example. Chinese productivity growth took off in the early 1990s. Inflation accelerated over the subsequent years, while the country flirted with current account deficits - both telltale signs of excess demand. It was not until a decade later that the saving rate took off, pushing the current account into a large surplus, even though investment was also rising at the time (Chart II-12). Chart II-11Asian Tigers: Growth Took Off First, ##br##Followed By Higher Savings Asian Tigers: Growth Took Off First, Followed By Higher Savings Asian Tigers: Growth Took Off First, Followed By Higher Savings Chart II-12China: Productivity Growth Accelerated, ##br##Then Savings Rate Took Off China: Productivity Growth Accelerated, Then Savings Rate Took Off China: Productivity Growth Accelerated, Then Savings Rate Took Off Today, Chinese deposit rates are near rock-bottom levels, and yet the household sector continues to save like crazy. This will change over time. The working-age population has peaked (Chart II-13). As millions of Chinese workers retire and begin to dissave, aggregate household savings will fall. Meanwhile, Chinese youth today have no direct memory of the hardships that their parents endured. As happened in Korea and Japan, the flowering of a consumer culture will help bring down the saving rate. Meanwhile, sluggish income growth in the developed world will make it difficult for households to save much. Population aging will only exacerbate this effect. As my colleague Mark McClellan pointed out in last month's edition of The Bank Credit Analyst, elderly people in advanced economies consume more than any other age cohort once government spending for medical care on their behalf is taken into account (Chart II-14).5 Our estimates suggest that population aging will reduce the household saving rate by five percentage points in the U.S. over the next 15 years (Chart II-15). The saving rate could fall as much as ten points in Germany, leading to the evaporation of the country's mighty current account surplus. As saving rates around the world begin to fall, real interest rates will rise. Chart II-13China's Very High Rate Of National Savings ##br##Will Face Pressure From Demographics China's Very High Rate Of National Savings Will Face Pressure From Demographics China's Very High Rate Of National Savings Will Face Pressure From Demographics Chart II-14Income And Consumption By Age Cohort Income And Consumption By Age Cohort Income And Consumption By Age Cohort Chart II-15Aging Will Reduce Aggregate Savings Aging Will Reduce Aggregate Savings Aging Will Reduce Aggregate Savings The Two Reasons Reinforce Each Other The discussion above has focused on two reasons why chronically low productivity growth could lead to higher interest rates: 1) weak productivity growth could fuel inflation; and 2) weak productivity growth could deplete national savings, leading to higher real rates. There is an important synergy between these two reasons. Suppose, for example, that weak productivity growth does eventually raise the neutral real rate. Since central banks cannot measure the neutral rate directly and monetary policy affects the economy with a lag, it is possible that actual rates will end up below the neutral rate. This would cause the economy to overheat, resulting in higher inflation. Thus, if the first reason proves to be true, it is more likely that the second reason will prove to be true as well. The Technological Wildcard So far, we have discussed productivity growth in very generic terms - as basically anything that raises output-per-hour. In reality, the source of productivity gains can have a strong bearing on interest rates. Economists describe innovations that raise the demand for labor relative to capital goods as being "capital saving." Paul David and Gavin Wright have argued that the widespread adoption of electrically-powered processes in the early 20th century serves as "a textbook illustration of capital-saving technological growth."6 They note that "Electrification saved fixed capital by eliminating heavy shafts and belting, a change that also allowed factory buildings themselves to be more lightly constructed." In contrast, recent technological innovations have tended to be more of the "labor saving" than "capital saving" variety. Robotics and AI come to mind, but so do more mundane advances such as containerization. Marc Levinson has contended that the widespread adoption of "The Box" in the 1970s completely revolutionized international trade. Nowadays, huge cranes move containers off ships and place them onto waiting trucks or trains. Thus, the days when thousands of longshoremen toiled in the great ports of Baltimore and Long Beach are gone.7 If technological progress is driven by labor-saving innovations, real wages will tend to grow more slowly than overall productivity (Chart II-16). In fact, if technological change is sufficiently biased in favour of capital (i.e., if it is extremely "labor saving"), real wages may actually decline in absolute terms (Chart II-17). Owners of capital tend to be wealthier than workers. Since richer people save more of their income than poorer people, the shift in income towards the former will depress aggregate demand (Chart II-18). This will result in a lower neutral rate. Chart II-16U.S.: Real Wages Have Been ##br##Lagging Productivity Gains U.S.: Real Wages Have Been Lagging Productivity Gains U.S.: Real Wages Have Been Lagging Productivity Gains Chart II-17Examples Of Capital-Biased ##br##Technological Change Beware Inflection Points In The Secular Drivers Of Global Bonds Beware Inflection Points In The Secular Drivers Of Global Bonds It is difficult to know if the forces described above will dissipate over time. Productivity growth is largely a function of technological change. We like to think that we are living in an era of unprecedented technological upheavals, but if productivity growth has slowed, it is likely that the pace of technological innovation has also diminished. If so, the impact that technological change is having on such things as the distribution of income and global savings - and by extension on interest rates - could become more muted. To use an analogy, the music might remain the same, but the volume from the speakers could still drop. Capital In A Knowledge-Based Economy Labor-saving technological change has not been the only force pushing down interest rates. Modern economies are transitioning away from producing goods towards producing knowledge. Companies such as Google, Apple, and Amazon have thrived without having to undertake massive amounts of capital spending. This has left them with billions of dollars in cash on their balance sheets. The price of capital goods has also tumbled over the past three decades, allowing companies to cut their capex budgets (Chart II-19). Chart II-18Savings Heavily Skewed ##br##Towards Top Earners Savings Heavily Skewed Towards Top Earners Savings Heavily Skewed Towards Top Earners Chart II-19Falling Capital Goods Prices Have Allowed ##br##Companies To Slash Capex Budgets Falling Capital Goods Prices Have Allowed Companies To Slash Capex Budgets Falling Capital Goods Prices Have Allowed Companies To Slash Capex Budgets In addition, technological advances have facilitated the emergence of "winner-take-all" industries where scale and network effects allow just a few companies to rule the roost (Chart II-20). Such market structures exacerbate inequality by shifting income into the hands of a few successful entrepreneurs and business executives. As noted above, this leads to higher aggregate savings. Market structures of this sort could also lead to less aggregate investment because low profitability tends to constrain capital spending by second- or third-tier firms, while the worry that expanding capacity will erode profit margins tends to constrain spending by winning companies. The combination of higher savings and decreased investment results in a lower neutral rate. As with labor-saving technological change, it is difficult to know how these forces will evolve over time. The growth of winner-take-all industries has benefited greatly from globalization. Globalization, however, may be running out of steam. Tariffs are already extremely low in most countries, while the gains from further breaking down the global supply chain are reaching diminishing returns (Chart II-21). Perhaps more importantly, political pressures for greater income distribution, trade protectionism, and stronger anti-trust measures are likely to intensify. If that happens, it may be enough to reverse some of the downward pressure on the neutral rate. Chart II-20A Winner-Take-All Economy A Winner-Take-All Economy A Winner-Take-All Economy Chart II-21The Low-Hanging Fruits Of ##br##Globalization Have Been Picked The Low-Hanging Fruits Of Globalization Have Been Picked The Low-Hanging Fruits Of Globalization Have Been Picked Investment Conclusions Is slow productivity growth good or bad for bonds? The answer is both: Slow productivity growth is likely to depress interest rates at the outset, but is liable to lead to higher rates later on. The U.S. has likely reached the inflection point where slow productivity is going from being a boon to a bane for bonds. Chart II-22 shows that the U.S. output gap would be over 8% of GDP had potential GDP grown at the pace the IMF projected back in 2008. Instead, it is close to zero and will likely turn negative if growth remains over 2% over the next few quarters. Other countries are likely to follow in the footsteps of the U.S. Chart II-22Output Gap Has Narrowed Thanks ##br##To Lower Potential Growth Output Gap Has Narrowed Thanks To Lower Potential Growth Output Gap Has Narrowed Thanks To Lower Potential Growth To be clear, productivity is just one of several factors affecting interest rates - demographics, globalization, and political decisions being others. However, as we argued in our latest Strategy Outlook, these forces are also shifting in a more inflationary direction.8 As such, fixed-income investors with long-term horizons should pare back duration risk and increase allocations to inflation-linked securities. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 2 Dan Andrews, Chiara Criscuolo, and Peter N. Gal,"The Best versus the Rest: The Global Productivity Slowdown, Divergence across Firms and the Role of Public Policy," OECD Productivity Working Papers, No. 5 (November 2016). 3 Consider the widely-used Solow growth model. The model says that the neutral real rate, r, is equal to (a/s) (n + g + d), where a is the capital share of income, s is the saving rate, n is labor force growth, g is total factor productivity growth, and d is the depreciation rate of capital. All things equal, an increase in g will result in a higher equilibrium real interest rate. The same is true in the Ramsey model, which goes a step further and endogenizes the saving rate within a fully specified utility-maximization framework. In this model, consumption growth is pinned down by the so-called Euler equation. Assuming that utility can be described by a constant relative risk aversion utility function, the Euler equation states that consumption will grow at (r-d)/h where d is the rate at which households discount future consumption and h is a measure of the degree to which households want to smooth consumption over time. In a steady state, consumption increases at the same rate as GDP, n+g. Rearranging the terms yields: r=(n+g)h+d. Notice that both models provide a mechanism by which a higher g can decrease r. In the Solow model, this comes from thinking about the saving rate not as an exogenous variable, but as something that can be influenced by the growth rate of the economy. In particular, if s rises in response to a higher g, r could fall. Likewise, in the Ramsey model, a higher g could make households more willing to forgo consumption today in return for higher consumption tomorrow (equivalent to a decrease in the rate of time preference, d). This, too, would translate into a lower neutral rate. 4 Janet L. Yellen, "The U.S. Economic Outlook," Presentation to the Stanford Institute of Economic Policy Research, February 11, 2005. 5 Please see The Bank Credit Analyst, "Beware Inflection Points In The Secular Drivers Of Global Bonds," April 28, 2017, available at bca.bcaresearch.com. 6 Paul A. David, and Gavin Wright,"General Purpose Technologies And Surges In Productivity: Historical Reflections On the Future Of The ICT Revolution," January 2012. 7 Marc Levinson, "The Box: How the Shipping Container Made the World Smaller and the World Economy Bigger," Princeton University Press, 2006. 8 Please see Global Investment Strategy, "Strategy Outlook Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com.

Highlights The recent "abnormal" weakness in both M1 and M2 is due to various one-off factors. Removing these factors, Chinese money supply growth rates have been largely stable. Money and credit growth is currently slower than historical norms, but is far from alarming. The one-off factors have created enormous noise in Chinese money and credit numbers in recent years, rendering the effectiveness of various money "impulse" indicators. As the Chinese financial sector becomes more diversified and financial intermediation less bank-centric, the significance of money supply will diminish over time. It is increasingly important to take a broader view on the overall economy than solely relying on money and credit numbers to make a judgment on China's business cycle. Feature China's growth figures have mostly surprised to the upside in recent months, with one disconcerting exception: a deceleration in money supply. M1 money growth, after a sharp spike in 2015-2016, has slowed considerably. Broad M2 appears even more worrisome, decelerating to 9.4% in June, a record low since the data became available in the early 1980s. Historically, growth rates of monetary aggregates have been excellent leading indicators for the Chinese economy. In this vein, the downturn in money supply clearly raises a red flag and deserves closer scrutiny. The Alphabet Soup Of Money Supply Chart 1Three Layers Of Money Supply Three Layers Of Money Supply Three Layers Of Money Supply The People's Bank of China (PBoC) reports three measures of money supply that differ in terms of liquidity, i.e. the ease to make payments (Chart 1). M0, or the most liquid form of money supply, consists of bank notes and coins in circulation. M1 adds demand deposits of enterprises and government entities on top of M0, which is China's narrow money supply that can be readily used to make payments. The broader M2, besides M1, also includes deposits from households, savings deposits from enterprises, government entities and non-bank financial institutions. As China's funding channels have become increasingly diversified in recent years, the PBoC has been considering even broader aggregates, dubbed "M2 plus" or M3, to incorporate new financial instruments, though no such measures have been published yet. Chinese M0 has historically demonstrated strong seasonal patterns associated with the Chinese Spring Festival (Chart 2). Typically demand for cash increases sharply during the holiday season for shopping and gifting, and the PBoC injects fresh cash into circulation ahead of the festival, and withdraws it afterwards. Chinese M0 growth has been downshifting in recent years, and the trend is set to continue going forward, especially as Chinese consumers increasingly adopt mobile-payment tools. Empirically, there has been little correlation between M0 and economic variables. Conventional monetary economics suggests that the growth of broader money supply is an important variable in predicting the outlook for the business cycle and inflation. The reasons behind the predictive power of money supply, however, have not been entirely clear. Some have attributed it to the "transaction motive" - if the corporate sector anticipates improvement in the business cycle, it increases holdings of liquid assets so that it can take quicker action to expand. Others, however, suggest that companies may also increase holdings of liquid assets as "precautionary move" - when businesses and households feel insecure about the growth outlook, they will hold on to more liquid assets as a safeguard against unexpected setbacks, and postpone investments and expenditures. Regardless, empirically Chinese M1 has been tightly linked with numerous economic and financial variables over the past two decades (Chart 3). We suspect the linkage is likely driven by bank loans, which in turn are driven by the authorities' monetary and credit policies. Easing monetary and credit policies encourage bank lending, which replenishes the corporate coffers to expand, and vice versa. Chart 2Not Much Economic Information In M0 Not Much Economic Information In M0 Not Much Economic Information In M0 Chart 3M1 As A Leading Indicator M1 As A Leading Indicator M1 As A Leading Indicator Therefore, M1 and bank lending have historically largely been in sync (Chart 4). In this vein, the recent divergence is a glaring exception: M1 accelerated sharply since early 2015 and has decelerated notably since mid-last year, while credit growth has been largely stable. The divergence, in our view, is likely due to the local government "debt swap" program that debuted in early 2015, when local governments were allowed to issue municipal bonds to pay back the liabilities borrowed by "local government financing vehicles (LGFVs)."1 Chart 5 shows a dramatic increase in outstanding "muni bonds" in early 2015, coinciding with a sharp increase in M1. We suspect the proceeds of muni-bond issuance were temporarily parked on LGFVs' balance sheets, boosting M1. Subsequently, the cash hoard has been gradually withdrawn to retire maturing loans, while muni bond issuances have moderated, leading to a slowdown in M1 growth. Chart 4M1 And Bank Credit M1 And Bank Credit M1 And Bank Credit Chart 5M1 Was Boosted By Muni-Bond Issuance M1 Was Boosted By Muni-Bond Issuance M1 Was Boosted By Muni-Bond Issuance The important point here is that the sharp swings in M1 growth since early 2015 likely reflect exogenous one-off factors rather than real changes in credit flows and business activity. Therefore, the latest slowdown in M1 is likely noise rather than a signal for impending growth deceleration. A Closer Look At M2 Chinese M2 is the broadest measure of Chinese money supply that includes cash in circulation and various forms of deposits in commercial banks. The scope of M2 has been gradually evolving over time. In 2001, investors' deposits in brokerage accounts were included in M2, and in October 2011 it was further expanded to cover non-bank financial institutions' (NBFI) deposits in commercial banks as well as households' deposits in their "housing provident fund" accounts. Both moves led to abrupt changes in the M2 growth rate. Chart 6M2 And Bank Credit M2 And Bank Credit M2 And Bank Credit As deposits and loans are by far the largest items on each side of commercial banks' balance sheets, historically China's M2 growth rate has tracked bank loans closely, as they both reflect changes in commercial banks' balance sheets. However, there are two episodes of notable divergences between these two variables (Chart 6). In the late 1990s, in the aftermath of the Asian financial crisis, Chinese commercial banks were reluctant to lend amid a deflationary shock, and the government opened the fiscal tap on infrastructure investments through bond issuances, which kept money supply largely stable. More recently, Chinese M2 has decelerated sharply since early 2016 to a new record low. Credit growth, on the other hand, has also drifted lower but has remained considerably more buoyant. A closer look at the component of M2 sheds lights on the recent divergence between money and credit. In its current form, M2 includes cash in circulation, deposits from non-financial sectors (households, enterprises and government agencies) and NBFIs (Chart 7), accounting for 4%, 80% and 10% of M2, respectively. Importantly, even though NBFI deposits with commercial banks only account for 10% of total M2, they have been much more volatile, creating greater swings in the overall monetary aggregates. NBFI deposits increased dramatically between 2014 and 2015, have slowed sharply since early 2016 and have actually been contracting in recent months. Indeed, the contraction in NBFI deposits has contributed to the lion's share of the recent M2 slowdown. Excluding NBFI deposits, the other two components of M2 have also moderated in recent months, but are not nearly as alarming (Chart 8). Chart 7Closer Look At M2 Closer Look At M2 Closer Look At M2 Chart 8Boom-Bust In NFIB Deposits Distorted M2 Growth Boom-Bust In NFIB Deposits Distorted M2 Growth Boom-Bust In NFIB Deposits Distorted M2 Growth In other words, the dramatic swings in NBFI deposits have distorted the M2 statistics in recent years. The massive increase in NBFI deposits in previous years stoked up concerns among the Chinese authorities about financial excesses that triggered the regulatory and liquidity crackdown - and their recent contraction is the intended consequence of the government's policy tightening efforts. This, in fact, is one of the key reasons that the PBoC's liquidity tightening appears to have de-escalated of late.2 What Does It All Mean? We are usually unwilling to bore clients with the technical details of economic data, preferring instead to focus on the big picture. However, understanding the intricacies is of critical importance in understanding the recent "abnormal" developments in China's money supply. Still, several big-picture observations can be made. First, the recent "abnormal" weakness in both M1 and M2 is due to various one-off factors. Removing these factors, Chinese money supply growth rates have been largely stable, albeit slower than historical norms, as overall economic growth has downshifted. Meanwhile, various credit measures - both bank lending and "total social financing" - have also been steady (Chart 9). More importantly, longer-term loans to households and businesses have accelerated notably since early this year, which likely underscores improvement in capital spending. In short, there are no signs that the economy is facing an immediate material downturn. Second, the one-off factors in Chinese money and credit data in recent years have had a particularly large impact on various money "impulse" indicators, which attempt to measure changes in money and credit flows, simply because even if these one-off factors are marginal to the total outstanding amount of money stock, they could easily overwhelm the "flows" in any given timeframe. In recent years Chinese money and credit numbers have been frequently distorted by these factors, such as the muni bond-debt swap program, market-intervention by the Chinese government to rescue the stock market collapse in 2015, and the boom-bust in financial excesses in the interbank market. All of these factors have created enormous noise in money and credit numbers, but the impact on the real economy should be much less dramatic. Chart 9Credit Growth Has Been Largely Stable Credit Growth Has Been Largely Stable Credit Growth Has Been Largely Stable Chart 10M1 Is No Longer An Important##br## Leading Indicator For The US M1 Is No Longer An Important Leading Indicator For The US M1 Is No Longer An Important Leading Indicator For The US Third, a closer look at China's monetary statistics suggests that money and credit growth has been in a gradual downtrend in recent years. This confirms our view that China's growth recovery since early 2016 was to a greater extent due to significant improvement in monetary conditions rather than a massive increase in money and credit stimuli.3 On this front, growth improvement will likely push the authorities to tighten, creating economic headwinds going forward.4 We maintain our positive assessment on China's cyclical outlook, but the PBoC policy and the country's overall monetary conditions need to be closely monitored. Finally, the predictive power of money and credit for business cycles is contingent on the role a country's banking system plays in the economy. For example, money supply was a reliable leading indicator for the U.S. economy before the 1980s, but its correlation to the business cycle has become increasingly weaker in the past several decades, as capital markets have become more developed and the dominance of banks has been reduced (Chart 10). Currently, Chinese banks still plays a far more important role in the economy than their American counterparts, and therefore, "counting the money" remains critical. However, as the Chinese financial sector becomes more diversified and financial intermediation less bank-centric, the significance of money supply will diminish over time. In fact, bank lending currently accounts for about 70% of "total social financing," down from about 90% a decade ago. For investors, it is increasingly important to take a broader view on the overall economy than solely relying on money and credit numbers to make a judgment on China's business cycle. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "A Game Changer?" dated March 31, 2015, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Chinese Financial Tightening: Passing The Phase Of Maximum Strength", dated June 22, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "A Chinese Slowdown: How Much Downside?" dated June 8, 2017, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report, "Rising Odds Of PBoC Rate Hikes", dated July 20, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Strengthening income growth is apparent in DM and EM trade volumes, real wages in the U.S., and industrial commodity prices, chiefly oil and copper. This indicates inflation at the consumer level will move higher in the near future, most likely in 2H2018. We believe 10-year U.S. Treasury Inflation-Indexed securities (TIPS) trading below 0.52 do not reflect the risk of higher inflation and are, therefore, going long at tonight's close. Energy: Overweight. Crude oil prices rallied 4.6% this week, following the OPEC 2.0 meeting in St. Petersburg. Although ministers did not announce additional cuts to the 1.8mm b/d agreed at the end of last year, Saudi Energy Minister Khalid al-Falih said the Kingdom would reduce August exports to 6.6mm b/d, which is more than 300k b/d below May's level, the latest month for which data are available from JODI. Given strong global demand, if this export reduction persists - and if others join the Kingdom - it would speed the drawdown in global inventories. Base Metals: Neutral. Copper pushed through $2.80/lb on the COMEX, a level not seen since May 2015. Underlying strength in EM economic activity - seen most recently in global trading activity (discussed below) - and a weaker USD are supporting base metals. Precious Metals: Neutral. Gold fell below $1,257/oz earlier this week, and was trading ~ $1,250/oz going to press Wednesday. We remain long gold as a portfolio hedge; the position is up 1.7% since it was initiated on May 4, 2017. Ags/Softs: Underweight. Harsh weather is impacting grains. The USDA rated 62% of the U.S. corn crop in the 18 states comprising 92% of total output good or excellent last week, down from 76% in 2016. For beans, the split was 58% last week vs. 71% last year. Feature The expansion in global trade that began toward the end of last year continues, which, based on our modeling, indicates inflation at the consumer level likely will move higher in the short run (Chart of the Week). Trade expansion, particularly in EM economies, is consistent with rising incomes, which, all else equal, will keep industrial commodities - oil and copper, in particular - well supported, given income and demand for these commodities are closely aligned.1 These fundamentals dovetail with other indications of stronger growth, particularly in DM economies, where trade volumes also are growing (Chart 2). In the U.S., for example, wage growth continues to outpace inflation, and monetary conditions remain benign (Chart 3). Our colleagues at BCA Research's Global Investment Strategy believe the Fed actually may be behind the curve in reacting to nascent inflationary pressures emerging in the U.S.2 Chart of the WeekRising EM Trade Volumes Consistent##BR##With Higher U.S. CPI Inflation Rising EM Trade Volumes Consistent With Higher U.S. CPI Inflation Rising EM Trade Volumes Consistent With Higher U.S. CPI Inflation Chart 2DM Trade Volumes Are Expanding##BR##At ~ 5% Pace ... DM Trade Volumes Are Expanding At ~ 5% Pace ... DM Trade Volumes Are Expanding At ~ 5% Pace ... Chart 3U.S. Labor Market Tightening,##BR##Financial Conditions Remain Loose U.S. Labor Market Tightening, Financial Conditions Remain Loose U.S. Labor Market Tightening, Financial Conditions Remain Loose Trade Growth Supports Higher Inflation U.S. CPI is highly correlated with EM trade volumes (imports and exports) as shown in the Chart of the Week. In recent research into inflation and trade, we also showed EM oil demand and world base metals demand are highly correlated with EM trade volumes.3 Chart 4EM Trade Volumes##BR##Continue To Strengthen Growth EM Trade Volumes Continue To Strengthen Growth EM Trade Volumes Continue To Strengthen Growth EM import growth continues to expand at a faster pace than DM growth (Chart 4). Year-on-year (yoy) EM import growth came in at 7.7%, a full 2 percentage points above DM growth. This is not to minimize DM growth - it finally broke out of its lethargy in May with a sharp advance of close to 6%, which will lift the trend rate of growth (the 12-month moving average, or 12mma) higher going forward. EM export growth in May was only slightly above DM growth for the month - 5.4% yoy vs. 5.2% yoy. These stout monthly trade performances will, in the next few months, offset the lethargic growth seen in EM and DM prior to the expansion begun at the end of 2016, as weaker monthly performance falls off the trend calculations. Over the year ended in May, within EM markets the annual trend in imports (the 12mma to May 2017) has barely grown more than 1% yoy, dragged down by a 6% contraction in the Middle East and Africa (MEA) and a 2.1% contraction in Latin American growth. The trend in EM - Asia's imports is up, rising 3.2% over the same period. For the year ended in May, imports into central and Eastern Europe were mostly flat; however, since November 2016, the trend turned sharply positive with 3.3% yoy growth. The trend in export volumes is expanding for in MEA and Latin America economies - 3.5% yoy trend growth (12mma) in MEA, and 4.4% growth in Latin America, which is slightly higher than the overall 2.2% rate of trend growth in EM exports. Still, lower oil and commodity prices, along with reduced volumes are curtailing an income recovery in these regions. Central and Eastern Europe's rate of export expansion leads EM generally at close to 4% yoy trend growth. Favor Gold And TIPS Ahead Of Higher Inflation As the labor market tightens and real-wage growth continues to outpace productivity growth, we expect U.S. inflation to pick up. Growth in trade volumes also will support growth in EM oil demand and world base metal demand, as noted above. This will feed into U.S. core PCE, the Fed's preferred inflation gauge (Chart 5). As we've highlighted in the past, there is very strong co-movement among these variables: We've found that, all else equal, a 1% increase in the non-OECD oil demand implies an increase in the core PCE of slightly less than 50bp. If the trend in overall EM trade volumes persists, the likelihood we will be increasing our estimate of non-OECD oil consumption for 2H17 and 2018 increases. U.S. CPI and EM trade volumes show similar co-movement properties, as the Chart of the Week shows. A 1% increase in EM import volumes translates into a 0.53% increase in the U.S. CPI, while a 1% increase in EM export volumes implies a 0.49% increase in the CPI. EM import volumes over the January - May 2017 interval have been growing at slightly more than 8% yoy, while exports have been growing at slightly more than 3%. Continued strength in the EM trade data implies U.S. CPI could grow well above what's currently being priced in inflation markets and by Fed policymakers. This leads us to favour gold and TIPS as inflation hedges. If we do get a larger-than-expected move in the U.S. CPI, gold should respond well. The modelling depicted in Chart 6 shows a 1% increase in the CPI translates into a 4.1% increase in gold. Chart 5Core PCE Will Pick Up##BR##As Commodity Demand Grows Core PCE Will Pick Up As Commodity Demand Grows Core PCE Will Pick Up As Commodity Demand Grows Chart 6Gold Will Pick Up##BR##Larger-Than-Expected CPI Moves Gold Will Pick Up Larger-Than-Expected CPI Moves Gold Will Pick Up Larger-Than-Expected CPI Moves For this reason we recommend getting long U.S. Treasury Inflation-Protected Securities (TIPS), which will appreciate as the U.S. CPI moves higher.4 We will be getting long as of tonight's close. We remain long low-risk calls spreads in Dec/17 WTI and Brent - long $50/bbl strikes vs. short $55/bbl strikes. We are up 39.3% and 32.9% on the Brent and WTI positions, respectively, from last week, and 47.2% and 89.2% since inception. U.S. Monetary Policy Remains A Huge Risk To EM Trade As we've noted in the past, U.S. monetary policy can have an outsized effect on EM trade volumes. In an update of an earlier model using U.S. M2 and the broad trade-weighted USD (TWIB), we find a 1% increase in the broad trade-weighted USD translates into a 1.1% drop in EM imports, while a 1% increase in U.S. M2 (broad money) implies an 85bp increase in EM imports (Chart 7).5 Chart 7EM Trade Volumes Highly Sensitive##BR##To U.S. Monetary Policy EM Trade Volumes Highly Sensitive To U.S. Monetary Policy EM Trade Volumes Highly Sensitive To U.S. Monetary Policy This demonstrates the feedback loop we've identified between U.S. monetary policy and EM trade. EM trade volumes affect inflation at a global level. We've found inflation in the U.S., EU and China to be co-integrated - i.e., these price gauges all follow the same long-term trend. Inflation and inflation expectations drive Fed policy, which drives the price formation of the USD - i.e., the FX rates included in the USD TWIB - and affect Fed policy on M2. These U.S. monetary variables, in turn, affect EM trade volumes. And so it goes ... Too-aggressive a tightening by the Fed as it normalizes its interest-rate policy regime could destabilize EM economies - either via too-sharp an appreciation in the USD TWIB, a larger-than-expected deceleration in M2 growth, or both - and negatively affect trade flows. At the end of the day, this would redound to the detriment of the U.S. economy, as the different feedback mechanisms kick in. This says the Fed's policy doesn't just affect the U.S. economy, or that EM economies essentially are on their own in the policy tools they deploy to adjust to Fed innovations. Like it or not, the Fed has to consider these types of feedback loops in its decision-making, since the Open Market Committee will be dealing with the fallout of its earlier policies. Bottom Line: EM trade volumes continue to grow yoy, continuing the trend that began at the end of last year. This performance, coupled with a tightening labor market in the U.S. and a still-loose financial backdrop, raises the odds inflation will exceed what's currently priced into market and Fed expectations. We are getting long U.S. 10-year TIPS at tonight's close, and remain long gold as a strategic portfolio hedge. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 The income elasticity for industrial commodities in EM economies is ~ 1.0, according to the OECD. Please see "The Price of Oil - Will It Start Rising Again?" OECD Economics Department Working Paper No. 1031, p. 6 (2013). 2 Please see BCA's Global Investment Strategy Weekly Report titled "Are Central Banks Behind The Curve Or Ahead Of It?," published on July 21, 2017. It is available at gis.bcaresearch.com. Among other things, the Global Investment Strategy team notes labor-market slack is dissipating, real wages are increasing, and easier financial conditions are spurring credit growth. Our colleagues note, "The prospect of stronger growth over the next few quarters implies that the unemployment rate is likely to fall below 4% early next year, possibly breaking through the 2000 low of 3.8%." BCA's Global Investment Strategy believes U.S. inflation could move higher by 2H18. 3 Please see BCA Commodity & Energy Strategy Weekly Reports titled "EM Trade Volumes Continue Trending Higher, Supporting Metals" and "Strong EM Trade Volumes Will Support Oil," published June 29, and June 8, 2017. Both are available at ces.bcaresearch.com. 4 U.S. TIPS increase in value as the Consumer Price Index (CPI) rises, and fall in value as the index declines. Please see "TIPS: Rates & Terms" on the UST's TreasuryDirect web page (https://www.treasurydirect.gov/indiv/research/indepth/tips/res_tips_rates.htm). 5 This model covers 2000 to the present, using monthly data. The R2 for the cointegrating regression is 0.96. These variables do not explain EM exports, which are not cointegrated with U.S. monetary variables. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade And Commodity Data Point To Higher Inflation Trade And Commodity Data Point To Higher Inflation Commodity Prices and Plays Reference Table Trade And Commodity Data Point To Higher Inflation Trade And Commodity Data Point To Higher Inflation Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights To shed light on the dichotomies that have surfaced in China's money and credit variables, we have calculated a new credit-money. This new measure is currently corroborating a very downbeat outlook for Chinese growth and China-related plays. We do not mean that investors should put all of their faith in this new measure. Yet, other measures of money and credit such as M1, M2 and banks' total assets all point to an impending deceleration in economic growth in China. While many global investors take for granted that the central government will underwrite credit risk in the entire economy, the top leadership in Beijing is sending the opposite message, at least for now. A new fixed income trade: pay Czech / receive Polish 10-year swap rates. Feature Chart I-1China: A Business Cycle Top Is In The Making China: A Business Cycle Top Is In The Making China: A Business Cycle Top Is In The Making Typically, the phrase 'Follow The Money' is used in the investment community to advise in favor of chasing investment flows. Today, we use this phrase in the context of not following investor crowds, per se, but money growth - especially in China. Judging from market actions and elevated inflows into EM assets and investable Chinese stocks, we can infer that investor consensus on China/EM is rather bullish. In the meantime, China's money/credit growth is sending a bearish signal. Investors should heed the downbeat message from Chinese money/credit and not chase EM risk assets higher. To reconcile the different messages from various measures of Chinese money and credit aggregates (more on the differences below), we calculated a new measure of money/credit creation - commercial banks' total credit (referred to below as banks' credit-money). Banks' credit/-oney is the sum of commercial banks' claims on companies, households, non-bank financial institutions, and all levels of government, as well as commercial banks'' and PBoC's foreign assets. Also, we deduct government deposits at the central bank (see below for the rationale). This measure, a de-facto aggregate of credit/money originated by banks and the PBoC, is computed using the asset side of banks' balance sheets. The key message from this report is that mainland banks' credit-money growth has already decelerated meaningfully, and points to a considerable slump in China's business cycle and imports in the months ahead (Chart I-1). Notably, banks' credit-money growth is at the lowest level of the past 10 years, excluding the Lehman crisis. It is also well below 2015 lows when the economy was acutely struggling. Exploring Money And Credit Dichotomies In China There has lately been a puzzling divergence between the growth rates of banks' credit-money, M2, and total social financing (TSF) (Chart I-2). Chart I-2Dichotomy Among Various Credit And Money Aggregates In China Dichotomy Among Various Credit And Money Aggregates In China Dichotomy Among Various Credit And Money Aggregates In China In 2016, banks' credit-money growth accelerated to 20%, while the pick-up in M2, and bank loan growth was modest. At the same time, TSF and corporate and household credit growth was largely flat. Lately, M1 growth has slowed, M2 and banks' total asset growth have dropped to all-time lows, while banks' loan and total social financing have remained flat. So, what is the true picture of money and credit growth in China? What are these critical variables telling us about the growth outlook? Our measure of banks' credit-money should by and large match broad money (M2) because the former is calculated by adding up various assets, and the latter by aggregation of various liabilities. Indeed, both were correlated well in the past, but decoupled in 2013 (Chart I-3, top panel). There has been another money/credit paradox: banks' credit-money on the one hand, and TSF and banks' RMB loans on the other, also have decoupled since 2013 (Chart I-3, middle and bottom panels). Overall, neither M2 nor TSF and banks' RMB loans mirrored the surge in banks' money-credit origination in 2015 and 2016, as portrayed in Chart I-3. We have been relying on the M2 and TSF aggregates published by China's central bank. Their tame readings in 2016 were the main reason we underestimated the duration and magnitude of China's economic recovery in the past year or so, as well as its impact on the rest of EM and commodities. As to components of banks' credit-money, Chart I-4 demonstrates that the deceleration has been due to the claims on non-financial organizations (companies), non-bank financial institutions and government. In brief, the slowdown has been broad-based; only claims on households continue expanding at a robust rate of 25% from a year ago (Chart I-4, bottom panel). Chart I-3M2 And Total Social Financing Have Not ##br##Reflected Money Created by Banks M2 And Total Social Financing Have Not Reflected Money Created by Banks M2 And Total Social Financing Have Not Reflected Money Created by Banks Chart I-4Individual Components Of Commercial ##br##Banks' Money Origination Individual Components Of Commercial Banks' Money Origination Individual Components Of Commercial Banks' Money Origination We suspect burgeoning financial engineering in China, credit shenanigans, and the non-encompassing nature of the People's Bank of China's broad money (M2) calculation along with the local government debt swap conducted in 2015 have all distorted credit and money data in recent years, producing the above dichotomies. To shed light on these dichotomies and calculate what has been true money/credit origination in China, we have revisited the basics of money and credit creation and have attempted to make sense of the data and the underlying trends. Overall, we have the following observations and comments: New nominal purchasing power in any economy is created by banks when they originate new loans. Hence, measuring properly the amount of new credit/money origination is of paramount importance to forecasting business cycle dynamics in any country. As we argued in our trilogy of Special Reports on Money, Credit and Savings, banks do not need savings or deposits to originate loans.1 They simultaneously create an asset (a loan) and a liability (a deposit) when extending credit to a borrower, which creates purchasing power in the economy. Importantly, there is no need for someone to save (i.e., forego consumption) in order for a bank to create a new loan / originate new money. In the case of China, commercial banks have an enormous amount of deposits - not because households and companies save a lot but because the banking system altogether has originated a lot of credit/money. The household and national savings rates quoted by economists refer to excess production/overcapacity in the real economy and not deposits in the banking system. We have discussed this issue in the past2 and will revisit it in future reports. The restraining factors for banks to originate new credit/money are their capital, regulations, loan demand, and liquidity - but not deposits. Liquidity is banks' excess reserves at the central bank. Commercial banks create deposits but they cannot engender reserves at the central bank, i.e., liquidity. Only the central bank can expand or shrink the amount of liquidity/reserves commercial banks hold with it. Finally, commercial banks do not lend their reserves; they use the reserves to settle transactions with other banks. In turn, central banks do not create new money/purchasing power unless they lend to or buy assets from governments and non-bank entities or issue currency. Central banks have a monopoly over the creation of bank reserves and currency in circulation - high-powered money. A liquidity crunch at a bank occurs when a bank runs out of excess reserves at the central bank, and it cannot borrow/attract additional reserves. Nowadays, many central banks targeting interest rates supply reserves and lend to commercial banks unlimited amounts of reserves on demand to assure interbank rates stay close to their policy target rate. Therefore, in such settings one can infer that banks are not restrained by liquidity to produce new money/expand their assets. In the case of China, the PBoC's claims on banks have skyrocketed - they have surged by 4.5-fold since 2014 (Chart I-5) - entailing that the former has supplied a lot of liquidity to commercial banks. Such liquidity expansion by the PBoC has in turn allowed banks to create tremendous amounts of new money (new purchasing power). To put the amount of money/credit originated by Chinese commercial banks in context, we have calculated the ratio of their credit/money stock to China's nominal GDP and global nominal GDP (Chart I-6). Chart I-5The PBoC Has Injected A Lot Of##br## Liquidity/Reserves Into The System The PBoC Has Injected A Lot Of Liquidity/Reserves Into The System The PBoC Has Injected A Lot Of Liquidity/Reserves Into The System Chart I-6Chinese Banks' Colossal ##br##Money Creation Chinese Banks' Colossal Money Creation Chinese Banks' Colossal Money Creation The broad measure of banks' credit/money created presently stands at 250% of Chinese GDP and 32% of global GDP, or US$29 trillion. The latter compares with the U.S. Wilshire 5000 equity market cap of US$ 26 trillion at a time when American share prices are at all-time highs, and the median P/E ratio is at a record high as well. In 2016 alone, Chinese banks' originated RMB 21 trillion, or US$1.7 trillion in new money-credit. Since January 2009, when the credit boom commenced, mainland commercial banks have cumulatively generated RMB 141 trillion, or US$21.12 trillion, of new money/credit. Banks create new money/deposits when they lend or acquire assets. Exceptions are when banks lend to the central bank or to other commercial banks. In those circumstances, a bank draws on its reserves at the central bank, and no new money - and by extension purchasing power - is created. Fluctuations in reserves/liquidity affect purchasing power in an economy indirectly rather than directly. Expanding reserves/liquidity encourage banks money/credit creation and vice versa. In China, commercial banks' excess reserves at the PBoC are presently contracting and stand at historically low level relative to outstanding stock of credit/money (Chart I-7). This is one of the reasons why banks have been scaling back their credit/money origination. Chart I-7China: Banks' Liquidity/##br##Excess Reserves Are Thin China: Banks' Liquidity/Excess Reserves Are Thin China: Banks' Liquidity/Excess Reserves Are Thin The fiscal authorities play a unique role in money creation. Because of the authorities typically have accounts at both the central bank and commercial banks, they can alter the money supply by shifting deposits back and forth between their accounts at the central bank and commercial banks. By transferring deposits from a commercial bank to the central bank, the fiscal authorities can destroy money; by the same token, they can create money by doing the opposite. This is why when computing Chinese banks' credit-money aggregate we have deducted from the credit/money aggregate government deposits at the PBoC. Finally, there is a difference between credit-money originated by banks, and non-bank credit. Non-banks are financial intermediaries that transfer existing deposits into credit. By doing so they do not create new purchasing power. When banks lend or acquire various assets, they do generate new purchasing power - i.e., they create new deposits that did not exist before. This is why banks are not financial intermediaries. This is true for any country and financial system. For more detailed analysis on the difference between banks and non-banks, please refer to the linked paper.3 When examining leverage in the system, one should consider bank and non-bank credit. Yet, when looking to gauge the outlook for growth and inflation, one should consider new credit/money originated by banks. The purpose of this report is to examine and compute new credit-money that determine nominal economic growth in China rather than discuss leverage even though they are often interlinked. Therefore, we are focused on new credit-money originated by banks, and not on the amount of and changes in leverage in the economy. Bottom Line: Whether one prefers M2, banks' total assets or our new measure of banks' credit/money, the message is by and large the same: money-credit growth is slowing and is very weak. Credit-Money And Business Cycle Chart I-8Comparing Two Impulse Indicators Comparing Two Impulse Indicators Comparing Two Impulse Indicators How good is the bank credit-money in terms of being an indicator for China's business cycle? We have one caveat to mention before we illustrate its relevance: Banks' credit-money is a stock variable, and our goal is to gauge business cycle trends - i.e., changes in flow variables such as output, capital spending, profits and imports. Also, the first derivative of a stock variable is a flow, while the second derivative of a stock variable is a change in its flow. Therefore, we have calculated credit/money impulse as the second derivative of outstanding credit/money, or a change in annual change, to align it with the growth rate of flow variables. The following illustrates that banks' credit-money impulse has been an extremely good leading indicator for many economic and financial variables. The new impulse of banks' credit-money has since 2014 diverged from the nation's credit and fiscal impulse (Chart I-8). Nevertheless, the new credit-money impulse leads numerous business cycle variables such as nominal GDP, producer prices, electricity output, machinery sales, freight volumes, and manufacturing PMI (Chart I-9A and Chart I-9B). Chart I-9AChina's Growth To Decelerate A Lot (II) China's Growth To Decelerate A Lot (I) China's Growth To Decelerate A Lot (I) Chart I-9BChina's Growth To Decelerate A Lot (I) China's Growth To Decelerate A Lot (II) China's Growth To Decelerate A Lot (II) Not surprisingly, this impulse also leads property sales and starts as well as construction nominal GDP (Chart I-10). This impulse often precedes swings in the LMEX industrial metals index and iron ore prices (Chart I-11). Further, it is also a reasonably good indicator for EM EPS growth (Chart I-11, bottom panel). As discussed above, banks' new credit-money creation determines nominal - not real - growth. Chart I-10China: Property / Construction ##br##Are At A Major Risk China: Property / Construction Are At A Major Risk China: Property / Construction Are At A Major Risk Chart I-11Downbeat Message For Industrial ##br##Metals And EM Profits Downbeat Message For Industrial Metals And EM Profits Downbeat Message For Industrial Metals And EM Profits By expanding their assets, banks generate new purchasing power, but they do not have any control over whether this new purchasing power is used to boost real output or prices. The recovery of the past 12 months have in some cases boosted prices more than volumes. It might be that China is inching closer to an inflation inflection point. We are not saying that China has runaway inflation at the moment, but persistent enormous overflow of money-credit will inevitably produce higher inflation. If inflation does indeed rise materially, policymakers will have no choice but to tighten. Monetary tightening will be devastating for an economy with already high leverage. Bottom Line: The new measure of banks' credit-money is currently corroborating a very downbeat outlook for Chinese growth and China-related plays. Beijing's Priorities And Investment Implications It is generally believed in the global investment community that China's authorities will not allow the economy to slump - they will boost credit/money growth and fiscal spending to ensure solid growth. It is true that no government wants to see their economy crumble, and China is no exception. However, there are several reasons to expect growth to slump considerably before the government responds: The central bank has been guiding interest rates higher across the entire yield curve. Short-term interbank rates (7-day Interbank Fixing Rate) and 5-year AA domestic corporate bond yields have risen by about 100 and 200 basis points, respectively, since November 2016. In addition, financial regulators are clamping down on off-balance-sheet and fancy financial engineering practices of banks and other financial institutions. Monetary policy works with a time lag, and the current tightening along with the government's regulatory clampdown will impact economic growth in the months ahead. The sharp deceleration in banks' credit/money confirms this. Even though interest rates have recently stopped rising, the damage to banks' credit/money growth has been done as shown in Chart I-12. Business activity is lagging money/credit and will be next to suffer. The central government in Beijing has largely lost control over credit creation/leverage build-up since 2009. The top leadership in Beijing did not want credit to explode and speculative behavior to profligate. Two recent articles by Caixin news agency (links are in footnote4) corroborate that Beijing is unhappy with credit creation and allocation practices prevailing in the financial system as well as among SOEs and local governments. The top leadership appears decisive, at least for now, in clamping down on ballooning credit/money growth and the ensuing misallocation of capital and bubbles. Interestingly, while many global investors take for granted that the central government will underwrite credit risk in the entire economy, or at least among state-owned companies, Beijing is sending the opposite message for now. True, when an economy and financial system crumbles, the central government will undoubtedly step in. However, investors do not want to be on the long side of China-related markets when this occurs. Buying opportunities may occur at that point, but for now the risk-reward profile is extremely poor. The authorities in Beijing tolerated colossal money/credit creation and misallocation of capital when growth in the advanced economies was extremely feeble. Now, with DM economies expanding at a solid pace and China's growth having recovered, they are comfortable tightening. As for the resulting investment strategy conclusions, it is too late to chase this rally in EM risk assets and other China-related assets. We do not mean that investors should put all of their faith in our new measure of China's credit/money. Yet, other measures of money and credit such as M1, M2 or banks' total assets all point to an impending deceleration in economic growth in China. In EM ex-China, narrow (M1), broad money and private credit growth have been and remain lackluster (Chart I-13). As China's growth and imports slump, the majority of EM economies will be materially affected. Chart I-12China: Interest Rates And Money Creation China: Interest Rates And Money Creation China: Interest Rates And Money Creation Chart I-13EM Ex-China: Subdued Money / Credit Growth EM Ex-China: Subdued Money / Credit Growth EM Ex-China: Subdued Money / Credit Growth There is no change in our overall investment strategy. Specific country recommendations and positions across all asset classes are always presented at the end of our reports, presently on pages 18-19. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Caitlynn Qi Zeng, Research Assistant caitlynnz@bcaresearch.com Central Europe: A New Fixed-Income Trade In a Special Report titled Central Europe: Beware Of An Inflation Outbreak from June 21st 2017 - the link is available on page 20, we argued that labor shortages in central Europe have been pushing up wage growth, generating genuine inflationary pressures. The Polish, Czech and Hungarian economies are overheating, warranting imminent monetary policy tightening. We elaborated on the reasons why this is happening in that report and as such we will not go through it in detail again here. Based on this theme, our primary investment recommendation was in the currency market: go long the PLN and CZK versus the euro and/or EM currencies. This recommendation remains intact. Today we recommend a new trade based on the same theme: pay Czech / receive Polish 10-year swap rates (Chart II-1). The negative 143 basis points yield gap between Czech and Polish 10-year swap rates is unsustainable and it will mostly close for the following reasons: The relative output gap between the Czech Republic and Poland is showing that the Czech economy is overheating faster than in Poland (Chart II-2). This will eventually lead to inflation rising faster in Czech Republic than in Poland as per Chart II-2. Markedly, relative trend in headline inflation warrants shrinking swap spread between Czech and Polish swap rates (Chart II-3). In effect, the Czech National Bank (CNB) will be forced to hike rates at a faster pace and more than the National Bank of Poland (NBP). The CNB has been artificially depressing the value of its exchange rate by pegging it to the euro since November 2013. Despite the fact that the CNB abandoned its peg in April of this year, the CNB continues to artificially suppress the exchange rate by printing money and accumulating foreign exchange reserves. Chart II-1Pay Czech / Receive Polish ##br##10-year Swap Rates Pay Czech / Receive Polish 10-year Swap Rates Pay Czech / Receive Polish 10-year Swap Rates Chart II-2Czech Economy Will Overheat ##br##Faster Than Poland's Czech Economy Will Overheat Faster Than Poland's Czech Economy Will Overheat Faster Than Poland's Chart II-3Inflation Dynamics Warrant ##br##Smaller Swap Spread Inflation Dynamics Warrant Smaller Swap Spread Inflation Dynamics Warrant Smaller Swap Spread Foreign exchange reserves, measured in euros, in the Czech Republic are growing at an astronomical 60% annually while growth and inflation are already in full upswing (Chart II-4, top panel). Due to the ongoing foreign currency accumulation - accompanied by insufficient sterilization - the CNB has generated an overflow of liquidity and money/credit in the Czech economy (Chart II-4, middle panels). Chart II-4Monetary Conditions Are Easier In ##br##Czech Republic Relative To Poland Monetary Conditions Are Easier In Czech Republic Relative To Poland Monetary Conditions Are Easier In Czech Republic Relative To Poland In turn, this liquidity overflow has led a real estate boom and has super-charged overall growth (Chart II-4, bottom panel). On the contrary, the NBP has been much less aggressive in easing monetary conditions. The policy rate in Poland is at 1.5% while it is 0.05% in Czech Republic. Therefore, any potential upside in inflation and bond yields will be more limited in Poland than in the Czech Republic. Even though both Czech and Polish economic growth are robust, the Czech economy is showing more imminent signs of overheating and inflationary outbreak than Poland. The CNB is further behind the curve than the NBP. When a central bank is behind the curve, its yield curve should be steeper than a central bank that is not. However, the 10/1-year swap curve is as steep in Poland as it is in the Czech Republic. With the policy rate at a mere 0.05%, the Czech economy is sitting on the verge of an inflationary precipice. The longer the CNB maintains such a low policy rate, the higher long-term bond yields will rise. The basis being that the longer policymakers wait, the more they will have to tighten to slow growth and bring down inflation. Finally, this relative trade offers a hefty 143 basis points carry and is thus very attractive. Investment Conclusions In the fixed income and currency space in central Europe, we have been and continue recommending the following relative positions: A new fixed income trade: pay Czech / receive Polish 10-year swap rates Continue betting on yield curve steepening in Hungary: Receive 1-year / paying 10-year Hungarian swap rates Long Polish and Hungarian 5-year local currency bonds / short South African and Turkish domestic bonds. Long PLN and CZK versus EM currencies and/or the euro - we are long the following crosses: PLN/HUF, PLN/IDR, CZK/EUR For dedicated EM equity investors, we continue to recommend overweighting central Europe within an EM equity portfolio. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Reports titled, "Misconceptions About China's Credit Excesses", dated October 26, 2016; "China's Money Creation Redux And The RMB", dated November 23, 2016; "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017; links available on page 20. 2 Please refer to the Emerging Markets Strategy Special Report titled, "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017; link available on page 20. 3 Werner, R. (2014b), "How Do Banks Create Money, and Why Can Other Firms Not Do the Same?", International Review of Financial Analysis, 36, 71-77. 4 Please see, "Local Officials Now Liable for Bad Debt-Management Decisions for Life", July 17th 2017, Caixin Global, available at http://www.caixinglobal.com/2017-07-17/101117307.html Please see, "Local Governments Find New Ways to Play Debt Game", July 14th 2017, Caixin Global, available at http://www.caixinglobal.com/2017-07-14/101116048.html Equity Recommendations Fixed-Income, Credit And Currency Recommendations