Emerging Markets

Highlights Commercial oil inventories finished the first quarter with a minimal draw. This was largely due to a surge in production and sales by Gulf producers and Russia at the end of 2016 and earlier this year, as well as slightly lower demand. Despite reports floating storage and more opaque inventories - e.g., Caribbean storage - drew significantly, OPEC 2.0 remains well short of its goal to get visible oil stocks down to five-year-average levels by year-end. If drawing storage down to more normal levels remains OPEC 2.0's goal, then the production-cutting deal negotiated by Saudi Arabia and Russia will have to be extended when OPEC meets next month. We expect this to happen. Even so, risk-reversals in options markets indicate investors and hedgers are willing to pay more for downside put protection than upside call exposure. We recommend fading this bias, and buying out-of-the-money calls and selling out-of-the-money puts using Dec/17 options. Energy: Overweight. We closed our long Dec/17 WTI vs. short Dec/18 WTI position last Thursday with a 583.3% gain. We remain long Dec/17 Brent vs. short Dec/18 Brent, which is up 242.1%. Our long GSCI position is down 1.3%. We are recommending a long Dec/17 Brent $65/bbl call vs. a short Dec/17 Brent $45/bbl put, which we will put on at tonight's close. This is driven by our analysis of the need to extend OPEC 2.0's production-cutting deal into the end of the year to reduce OECD commercial oil inventories. We continue to expect Brent and WTI prices to trade on either side of $60/bbl by year-end. Base Metals: Neutral. Copper traded lower this week, on the back of news Freeport McMoRan is poised to resume exports from its Indonesian facilities. Precious Metals: Neutral. Gold traded higher, but remains range-bound. Our long volatility gold options play is up 2.9%. We will leave this trade on as a hedge, going into the French elections. Ags/Softs: Underweight: Despite heavy rains, grains (excluding rice) and beans were well offered this past week. Feature The surge in oil production and sales by Gulf producers and Russia at the end of last year and earlier this year, along with a reported slowing of demand - down ~ 100k b/d from our March estimates - combined to leave estimated supply and demand roughly balanced for 2017Q1 (Chart of the Week). These dynamics left visible OECD inventories above year-end 2016 levels (Chart 2). Chart of the WeekVisible Inventories Barely Budge In 2017Q1, ##br##As Supply Surge And Lower Demand Collide Visible Inventories Barely Budge In 2017Q1, As Supply Surge And Lower Demand Collide Visible Inventories Barely Budge In 2017Q1, As Supply Surge And Lower Demand Collide Chart 2Visible Inventories Will Reach 5-year Average##br## If OPEC 2.0 Production Cuts Are Extended Visible Inventories Will Reach 5-year Average If OPEC 2.0 Production Cuts Are Extended Visible Inventories Will Reach 5-year Average If OPEC 2.0 Production Cuts Are Extended Less-visible floating storage, along with oil stockpiles in China and Japan, drew more than 70mm barrels (bbls), according to Morgan Stanley, while Caribbean storage fell by some 10 - 20mm bbls during the last quarter.1 In addition, major trading companies are actively looking for buyers to take unwanted physical storage capacity off their hands. Nonetheless, OPEC 2.0 - the states banded together under the leadership of the Kingdom of Saudi Arabia (KSA) and Russia to remove some 1.8mm b/d of oil production from the market in 2017H1 - remains well short of its goal to get visible inventories down to five-year-average levels. Failure to reduce inventories almost surely requires producers allied in the production-cutting deal to extend their pact into 2017H2. We think they will, given the oft-stated desire of the Saudi and Russian energy ministers, Khalid Al-Falih and Alexander Novak, to see inventories continue to draw. Their desire was re-stated recently at a hastily called news conference in Houston last month.2 This message has remained constant from other OPEC leaders as well. The Logic Of Extending OPEC 2.0's Deal To 2017H2 Reducing the global storage overhang is imperative for the OPEC 2.0 coalition. It is the driving force behind the unlikely alliance KSA and Russia forged at the end of last year. Without pulling storage down to more normal levels, inventories remain too close to topping out, which puts markets at higher risk of the sort of price collapse seen in 2015 - 16. At the beginning of 2016, global oil markets were close to pricing in the approach of a full-storage event. In such an event, as global inventories approach capacity, prices trade below the cash-operating costs of the most expensive producers, until enough supply is forcibly knocked off line to drain excess stocks. This is an extremely high-risk scenario for states like KSA, Russia and their allies, which are heavily dependent on oil-export revenues to fund government budgets and much of the private sector.3 After the last such event at the beginning of 2016, these states were left reeling, as fiscal spending was slashed, projects were canceled and governments burned through foreign reserves in an effort to make up for lost revenue. Entering the second quarter of this year, KSA and its allies continue to over-deliver on their pledges to cut ~ 1.2mm b/d of production. Markets are expecting Russian cuts to increase to ~ 300k b/d, in line with their pledges under the OPEC 2.0 production-cutting Agreement negotiated last year (Chart 3 and Chart 4). Chart 3KSA Continues To Over-Deliver; ##br##Russian Cuts Expected to Increase KSA Continues To Over-Deliver; Russian Cuts Expected to Increase KSA Continues To Over-Deliver; Russian Cuts Expected to Increase Chart 4KSA Allies Continue to Deliver;##br## Iran And Iraq Continue To Under-Deliver KSA Allies Continue to Deliver; Iran And Iraq Continue To Under-Deliver KSA Allies Continue to Deliver; Iran And Iraq Continue To Under-Deliver However, if the OPEC 2.0 production deal to remove ~ 1.8mm b/d of production is not extended beyond its end-June deadline, storage levels will remain uncomfortably high for the KSA - Russia alliance. By our reckoning, allowing the deal to expire without extending it would only reduce visible OECD inventories by a little over 170mm barrels by year-end. This can be inferred from our assessment of balances (Chart of the Week). Not extending OPEC 2.0's deal leaves OECD commercial oil inventories close to 130mm barrels above the targeted 300mm-barrel drawdown required to return OECD inventories to more normal (i.e., five-year average) levels. With U.S. shale production coming on strong, this could be precarious for OPEC 2.0 next year. Extending the OPEC 2.0 production-cutting deal to the end of 2017H2 will reduce visible commercial inventories in the OECD by slightly more than the 300mm barrels being targeted (Chart 5). This should put storage levels back at more normal, five-year average levels, and give OPEC 2.0 some breathing room to craft a strategy to contain U.S. shale production going forward.4 For this reason, extending the 1.8mm b/d production cuts to end-2017 is almost a foregone conclusion for us, particularly as KSA needs to clean up the market, so to speak, ahead of the IPO of Saudi Aramco next year. Among other potential investors with a keen interest in the potential $100 billion floatation is a state-led consortium of Chinese banks and oil companies.5 We Think Upside Risks Dominate Oil Markets The logic of extending the OPEC 2.0 deal is compelling. But the market does not share this view. Oil speculators have significantly reduced their net long position as a percent of total open interest in the dominant crude-oil futures markets, WTI and Brent (Chart 6). This, after the specs were chastened following their huge increase in upside exposure earlier this year. Chart 5Extending OPEC 2.0'S Production Deal Reduces ##br##OECD Oil Stocks By 300mm+ Barrels By End-2017 Extending OPEC 2.0'S Production Deal Reduces OECD Oil Stocks By 300mm+ Barrels By End-2017 Extending OPEC 2.0'S Production Deal Reduces OECD Oil Stocks By 300mm+ Barrels By End-2017 Chart 6Specs Are Retreating From Oil Specs Are Retreating From Oil Specs Are Retreating From Oil We can also see a lack of conviction in oil options markets. Option markets provide a useful gauge of fear and greed called "skew," which is nothing more than the difference between implied option volatilities (IOV) for puts and calls.6 When the skew favors puts - shown by a negative number in the risk-reversal shown in Chart 7 - markets are signaling they value downside protection more than upside exposure, and vice versa when call IOVs exceed put IOVs. Chart 7Option Skew Favors Downside Puts ##br##Over Upside Call Exposure Option Skew Favors Downside Puts Over Upside Call Exposure Option Skew Favors Downside Puts Over Upside Call Exposure Given the logic we laid out above, we are recommending investors fade the put skew in the options markets. Specifically, we are getting long out-of-the-money Dec/17 $65/bbl Brent calls and selling out-of-the-money Dec/17 $45/bbl Brent puts against them, to express our view. We will be doing so at the close of trading today, and will report our strikes and net premium in next week's publication.7 Bottom Line: We expect the OPEC 2.0 production deal to be extended when OPEC meets on May 25 in Vienna. This will significantly raise the odds OECD commercial oil stocks will be drawn down to more normal levels, giving the OPEC 2.0 petro-states more breathing room to develop a strategy to regain a modicum of control over prices. This is critical for KSA, which still is on track to IPO Saudi Aramco next year. Given our expectation, we are recommending investors buy out-of-the-money Dec/17 $65/bbl Brent calls and sell out-of-the-money Dec/17 $45/bbl Brent puts. This allows investors to fade what appears to be a consensus - given put skews and spec positioning - and capitalize on what we believe is an all-but-certain extension of the OPEC 2.0 production deal. We expect WTI and Brent to trade on either side of $60/bbl by December, and to average $55/bbl to 2020. As has been mentioned often, our level of conviction in that forecast is low beyond 2018, given the large capex cuts for projects that would have been funded between 2015 and 2020 absent the 2014 - 2016 oil-price collapse. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "OPEC's Barkindo Sees Progress in Oil Cuts as Stockpiles Drop," and "Oil Traders Drain Hidden Caribbean Hoards as OPEC Cuts Bite," published by Bloomberg.com on April 2 and 3, 2017, respectively. 2 Please see "Saudi Arabia, Russia Offer United Front on Oil Supply Cuts," published by Bloomberg.com on March 7, 2017, and "Saudi energy minister says oil market fundamentals improving," published by reuters.com on the same day. 3 BCA Research's Commodity & Energy Strategy examined this in our feature article published on September 8, 2016, entitled "Ignore The KSA - Russia Production Pact, Focus Instead On Their Need For Cash." It is available at ces.bcaresearch.com. 4 We discuss this at length in "KSA's, Russia's End Game: Contain U.S. Shale Oil," and "The Game's Afoot In Oil, But Which One," published by BCA Research's Commodity & Energy Strategy Weekly Report April 6 and March 30, 2017, Both are available at ces.bcaresearch.com. 5 Please see "Exclusive: China gathers state-led consortium for Aramco IPO - sources," published by Reuters.com on April 19, 2017. We speculated on just such an event in "Desperate Times, Desperate Measures: Aramco And The Saudi Security Dilemma," published by BCA Research's Commodity & Energy Strategy and its Geopolitical Strategy January 14, 2016. We noted, "While inviting Western investors and energy firms to take a stake in Aramco would make obvious sense for Saudi Arabia, we would speculate that the real target for the IPO will be Chinese state-owned enterprises (SOEs). China has overtaken the U.S. as the main importer of crude from Saudi Arabia ... but it continues to free-ride on Washington's security guarantees and commitments in the region. By giving China a stake in Saudi Arabia's energy infrastructure, Riyadh would force Beijing to start caring about what happens in the region." 6 "Implied option volatility" is market jargon for the standard deviation of expected returns. It is used as an input for option-pricing models. The "implied," as it's known colloquially in markets, solves an option-pricing model like Fischer Black's, once the option's premium is discovered via trading. Market participants can determine whether puts (i.e., the right, but not the obligation, to sell) are more highly valued than calls (the right to buy) in relative terms by differencing the implied volatilities of puts and calls that are equidistant from at-the-money options. This is referred to as the options' "skew." We use the IOVs for puts and calls that both change by $0.25/bbl for every $1.00/bbl move in oil futures (i.e., 25-delta puts and calls) to calculate skew. Please see Fischer Black's seminal article, "The Pricing of Commodity Contracts," in the Journal of Financial Economics, Vol. 3, (1976), pp. 167-79. 7 We employed a similar strategy in March 2016 - getting long Dec/16 Brent $50/bbl calls vs. selling $25/bbl puts, which registered a 103.5% gain between March 3 and April 14, following a rally in Brent prices. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016 OPEC 2.0 Cuts Will Be Extended Into 2017H2; Fade The Skew And Get Long Calls Vs. Short Puts OPEC 2.0 Cuts Will Be Extended Into 2017H2; Fade The Skew And Get Long Calls Vs. Short Puts

Dear Client, I am travelling in Asia talking to investors and doing some field research. As such, there will be no CIS report next week. The next report will be sent to you on May 5th. Best regards, Yan Wang, Senior Vice President China Investment Strategy Feature A special report I co-authored with my colleagues Arthur Budaghyan and Peter Berezin, and the webcast we all participated in with Caroline Miller late last month, focused on China's debt situation - a critical global macro issue that has been heatedly debated around the globe as well as within BCA.1 Economists rarely agree with one another, and financial markets are constant battles between buyers and sellers with diametrically opposed views. Similarly, it is not possible for senior research staff within BCA to always have uniform opinions. Our intention was to bring an internal debate on a critical global macro issue in front of clients in a straightforward and comprehensive way, which hopefully can enhance clients' own understanding of the topic. Our report and webcast received higher-than-normal questions and feedback. This week's report serves as a follow-up to clarify some of the more common questions we received. But It Is The Rapid Pace Of Increase In China's Debt-To-GDP Ratio That Is Alarming!! Even for clients that agree with Peter and myself and view Chinese debt from the savings investment identity perspective, a common pushback is that the pace of increase in China's debt-to-GDP ratio is alarmingly rapid, which is bound to create misallocations and financial risks (Chart 1). My arguments emphasizing the micro debt situation within the corporate sector and cross-country comparisons of efficiency ratios were reassuring, but not enough to alleviate all the concerns on the apparently rapid increase in debt relative to economic output in recent years. A few further points are in order: Chart 1The GDP Factor In China's Rising ##br##Debt-To-GDP Ratio The GDP Factor In China's Rising Debt-To-GDP Ratio The GDP Factor In China's Rising Debt-To-GDP Ratio First, the rapid increase in debt reflects the rapid increase in capital spending, which means the economy has become more capital intensive compared with before - i.e. it takes more capital to produce one unit of GDP. This could indicate declining efficiency in capital spending in terms of generating "growth." It could also mean the Chinese economy may have arrived at a much more capital intensive phase in its economic development curve. Dramatic improvement in the country's transportation infrastructure and urban development in recent years are tell-tale signs. Accumulating capital stock is the ultimate way for a developing country to improve productivity and lift living standards. China's growth path should be viewed as a norm rather than an anomaly. Second, the Chinese economy has directed massive financial resources toward infrastructure investment post the global financial crisis, largely undertaken by state-owned corporate entities such as state-owned enterprises and local government financing vehicles. These investments are not much different from the massive increase in fiscal deficits in other countries to finance social spending programs and welfare expenditures, as both were designed to support domestic demand during an economic downturn. The difference is that China's social welfare system is poorly developed and not large enough to make a meaningful contribution in supporting aggregate demand- and therefore the state sector must explicitly ramp up capex. Another important difference is that government expenditures on social benefit programs distributed to households in most other countries are ultimately consumed, whereas in China, state investment in infrastructure occurs on an accumulated physical asset. This is a key reason why I believe focusing only on the liabilities side of the balance sheet misses an important big-picture point. Finally, the apparently alarming increase in China's debt-to-GDP ratio is also partially attributable to how this ratio itself is calculated, in which the slowdown of China's nominal GDP growth rather than its increase in debt has played a much bigger role. Chinese nominal GDP growth dropped from almost 20% in 2010-'11 to close to 6% in 2015-early 2016. In a division calculation in mathematics, a falling denominator (nominal GDP) increases the result exponentially, while a rising numerator (debt) increases the result linearly. If nominal GDP growth had stayed stable, the pace would have been a lot less alarming. This also suggests that the best way to bring down the "debt-to-GDP" ratio is to increase the denominator - i.e. boosting growth either in real or nominal terms. In fact, Chinese nominal GDP expanded by 11.8% in the first quarter from a year ago, as reported early this week - the gap between credit growth and nominal GDP growth has already narrowed significantly. Has China Ever Delevered, And How To Delever Going Forward? In our joint report, Arthur cautioned that China in the past has had periods of deleveraging, and warned that a similar episode would be inevitable going forward, in which the Chinese authorities would have to rein in credit growth below nominal GDP growth, leading to a lower credit-to-GDP ratio (Chart 2). In my view, this diagnosis is misguided, and the policy prescription is dangerous. Chart 2Deleveraging Versus Inflation Deleveraging Versus Inflation Deleveraging Versus Inflation First, it is worth noting that China's credit-to-GDP ratio has been on an ever-rising trend ever since the data became available, which in my view reflects the accumulation of capital stock through savings and investments. There have indeed been a few short-lived periods when the ratio has declined, as Arthur pointed out, or the economy appeared to "delever," such as in the late 1980, early 1990s, early 2000s and prior to the global financial crisis. However, it is immediately clear that the periods of "deleveraging" in the 1980s and 1990s were both mainly due to massive increases in inflation, which artificially boosted nominal GDP growth. An inflation outbreak is hardly an ideal way to delever that policymakers should aim for. Inflation also picked up between 2003 and 2008, but not nearly as much as the previous two episodes, and the Chinese economy was characterized as experiencing "low inflation boom". However, it is important to note that the country's current account surplus jumped from 2% in 2003 to as high as 10% in 2007. This means Chinese savers collectively did not lend to domestic companies, and therefore debt was not accumulated within the country and shown in the debt-to-GDP ratio. Rather, they lent to foreign entities, such as the U.S. government, in the form of increased holdings of U.S. Treasurys. By the same token, after the global financial crisis, China's current account surplus tumbled back to 2% of GDP, which indicated a significant reduction in the pace of increase in foreign lending but simultaneously a sharp increase in domestic investment and credit. This is precisely what one would expect from the savings-investment identity in conceptualizing China's debt dynamics. In fact, the only period in which China's corporate sector indeed "delevered" in the "classic" textbook sense was the early 2000s, amid aggressive reforms of state-owned enterprises and the banking system. Mass bankruptcies of state-owned firms unleashed by the SOE reform efforts led to mounting losses in the banking sector. The government set up state-owned asset management companies as "bad banks" to take over the non-performing loans of commercial banks - financed by the issuance of special-purpose government bonds. Therefore, the government essentially engineered a "debt swap" in which corporate sector debt was exchanged for government debt - but the country's overall total outstanding debt hardly dropped. It is also noteworthy that the overall economy remained reasonably resilient throughout the "deleveraging" process, even though it was also hit by multiple severe external shocks such as the tech-bubble bust, terrorist attacks in New York City and the SARS crisis. In other words, the playbook of the early 2000s suggests that "deleveraging" will not necessarily hurt growth. In my view, "deleveraging" solely for the purpose of it is not only ineffective, but also counterproductive. Aggressive credit constraint intensifies deflationary pressures, creating a double-whammy on nominal GDP growth through both lower real growth and a falling GDP deflator - which makes it a lot harder to achieve a lower credit-to-GDP ratio. It goes without saying that irresponsible lending and investment behavior should be punished by market forces. However, as shown by "too big to fail" dilemma policymakers in the west had to deal with at the height of the global financial crisis, it is always a delicate balancing act, and it is overly dogmatic to suggest or expect Chinese policymakers to do otherwise. In fact, I have repeatedly argued that the much-touted "Likonomics"2 efforts named after the incumbent Chinese premier a few years ago that appeared to favor harsh "deleveraging" was one of the key reasons behind China's sharp growth slowdown in previous years. Chinese policymakers have since taken a more realistic approach in dealing with the corporate sector debt issue. The government embarked on a new debt-swap program in 2015 to deal with the existing debt load of local government financing vehicles.3 Some provincial "bad bank" asset management companies have been established to absorb regional banks' loan losses - both of which were taken from the early 2000s playbook. Furthermore, policy reflation has significantly eased deflationary pressures and lifted nominal GDP growth, which has narrowed the gap with the pace of credit expansion. In addition, the pace of IPOs in the domestic equity market has quickened notably - i.e. more domestic savings are being channeled into the economy via equity financing as opposed to bank loans. All of these measures in my view are the correct steps to lower the corporate debt-to-GDP ratio, rather than some "short term gain, long term pain" myopic fixes. China's Interbank Rate And The PBoC Liquidity Management Arthur argued in our report that the People's Bank of China (PBoC) in recent years has moved away from controlling money growth (the quantity of money) to targeting interest rates (the price of money), which effectively accommodates commercial banks' credit creation binge by injecting massive amounts of liquidity, as evidenced by the much-lowered volatility in China's interbank market since 2016 - with an explosion of PBoC direct lending to financial institutions (Chart 3). I doubt there is a connection between this point and China's loan growth. The PBoC's direct lending to commercial banks only began to increase in earnest starting in early 2016, while bank loan growth peaked six years before that. If anything, the recent change reflects the PBoC's more flexible and sophisticated management of the country's interbank liquidity compared with previously primitive and blunt measures. It is easy to spot the dramatic volatility in China's interbank rates before 2016 compared with other major economies. Chinese interbank rates routinely had sharp spikes, underscoring dramatic changes in interbank liquidity, which were both extremely rare and potentially damaging in other countries. Hong Kong's interbank rates showed similar spikes during the Asian Crisis in the late 1990s, when its currency peg was under furious speculative attack (Chart 4). U.S. interbank rates spiked amid the "Lehman shock" that marked a dramatic escalation of the global financial crisis. In "normal times" interbank rates closely track the policy interest rates of respective monetary authorities in major economies. Sharp spikes in interbank rates could easily tilt a country's financial institutions into a liquidity crisis, even without any solvency issues, and a central bank should seek all means to avoid such an event as the lender of last resort. Chart 3No Connection Between The PBoC Lending ##br##And Commercial Bank Loan Growth No Connection Between The PBoC Lending And Commercial Bank Loan Growth No Connection Between The PBoC Lending And Commercial Bank Loan Growth Chart 4Interbank Rates: Experiences In Other Countries Interbank Rates: Experiences In Other Countries Interbank Rates: Experiences In Other Countries In other words, the PBoC was effectively playing with fire in the past by allowing extreme swings in interbank liquidity. The impact on the country's banking system was not as dramatic as one would have expected, mainly because Chinese banks are heavily reliant on retail deposits for their loanable funds rather than on wholesale funding through the interbank market, as in other countries. Meanwhile, most Chinese banks are state-owned, which also reduces "perceived" counterparty risks. There were episodes in which some banks failed to honor their liquidity obligations during periods of extreme liquidity crunch, or technically defaulted, which in the west could well have triggered bankruptcies and a massive chain reaction. In China, these features, ironically, have made its banking sector more "resilient" to what effectively are central bank failures. Chart 5RRR Is Still Elevated RRR Is Still Elevated RRR Is Still Elevated The key reason was that the PBoC mainly relied on reserve requirement ratio (RRR) adjustments to manage interbank liquidity, which are by definition blunt and hard to adjust in a timely manner - the very reasons why other central banks have mostly abandoned it. More recently, the PBoC has been utilizing new liquidity tools, such as various lending facilities and open market operations. This is the sole reason behind the apparently steep increase in the PBoC's claims on commercial banks, shown in Chart 3. In fact, rather than providing massive liquidity relief, the PBoC still keeps the RRR at near historically high levels (Chart 5). Therefore, all the items on the PBoC's balance sheet should be cross-checked to assess its liquidity operations, rather than focusing on one item. In my view, what's happening is that PBoC has more recently been learning and experimenting with modern central banking, rather than accommodating/encouraging commercial banks' lending behavior. All in all, the debate on China's debt situation will likely stay, and its evolvement over time will be closely studied by policymakers and academia, which is probably irrelevant to most investors. From investors' point of view, the important point is that the market has been focusing on China's debt and leverage for many years, which means it is likely already priced in. Moreover, from a macro point of view, it is highly unlikely that such a well-known issue will cause a major risk event - black swans, by definition, are unheard of and unpredictable. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Special Report, "The Great Debate: Does China Have Too Much Debt Or Too Much Savings?" dated March 23, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, ""Likonomics": Off To A Rocky Start," dated July 10, 2013, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "A Game Changer?" dated March 11, 2015, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights The latest saber-rattling signals a turn in U.S. policy; New negotiations, with tighter sanctions, will follow; The Iran playbook can work with North Korea ... ... But failure could mean war down the road. Feature The United States's "Pivot to Asia" was not a passing fancy, as the past two weeks of saber-rattling have shown. Over this period, U.S. President Donald Trump took two largely symbolic actions in Syria and Afghanistan. First he launched 59 Tomahawk cruise missiles at a Syrian air base, then he dropped the world's largest non-nuclear bomb on an underground hub of the Islamic State in Afghanistan. Neither action implied an increase in commitment to the region. Instead, the spotlight shifted to North Korea. Trump's multiple conversations with Chinese President Xi Jinping, his orders to move three aircraft carriers to the peninsula, and his standoff with North Korean leader Kim Jong Un over a failed missile launch, all indicated that one of our major geopolitical themes is alive and well: the rotation of risk from the Middle East to Asia Pacific (Chart 1).1 Chart 1The Pivot To Asia Is Not Done Yet The Pivot To Asia Is Not Done Yet The Pivot To Asia Is Not Done Yet The underlying driver of geopolitical risk on the Korean peninsula is Sino-American rivalry. China is an emerging "great power" that threatens the global dominance of the United States and its alliance system. The immediate consequence is rising friction in China's periphery. That is why Taiwan, the South China Sea, and North Korea are all heating up in various ways.2 However, North Korea's regime is highly unpredictable and potentially able to strike the American homeland in a few years. In that sense it is more significant than the other "proxy battles" between the U.S. and China.3 In essence, North Korea is no longer merely an object of satire. A big new round of negotiations over Korea is about to begin - not unlike the Iranian nuclear negotiations over the past decade. Unless diplomacy succeeds in convincing North Korea to freeze its nuclear and missile progress, the potential for a military conflict is high. What Caused The Latest Spike In Tensions? This past week the new U.S. administration, hitherto untested in foreign affairs, has drawn a stark line on how it intends to manage global security. Both President Barack Obama and Presidential Candidate Trump sowed doubts about America's willingness to remain involved in maintaining global order.4 Obama seemed reluctant to reinforce American "red lines" in Syria, Ukraine, and the South China Sea; Trump threatened outright isolationism, rejecting NATO, and notably suggesting that U.S. allies Japan and South Korea might have to fend for themselves. In office, however, Trump is rapidly "normalizing" and abandoning his isolationist rhetoric. Notably, he is maintaining the Obama administration's "pivot" away from the Middle East and toward Asia Pacific. Though he unilaterally withdrew from the Trans-Pacific Partnership trade agreement, he has emphasized the need to renegotiate America's relationship with China, voiced aggressive support for Taiwan, reinforced U.S. freedom of navigation operations in the South China Sea, and sent Secretary of Defense James Mattis, Secretary of State Rex Tillerson, and Vice President Mike Pence on high-profile regional tours. He may visit China himself in May. The current tense standoff with North Korea - which has seen high-flying rhetoric, the aircraft carrier strike groups diverted to the region, extra military exercises with South Korea and Japan, and no less than three conversations with President Xi of China - should remove any doubt that Asia is high on his foreign-policy list. Another major factor contributing to the current flare-up in Korean tensions is Korean peninsula politics. The past year has seen extraordinary South Korean domestic political turmoil and a sharp increase in the frequency of North Korean nuclear and missile tests (Chart 2). These issues are connected. Robust empirical research shows that North Korean foreign policy from 1960-2011 has been more likely to turn hostile in the context of internal difficulties as well as periods of South Korean power transition (Chart 3).5 The past year's events support that conclusion: Chart 2North Korea Run Amok? North Korea: Beyond Satire North Korea: Beyond Satire Chart 3Bull Market For North Korean Threats North Korea: Beyond Satire North Korea: Beyond Satire South Korean turmoil: South Korea's ruling party, the conservative Saenuri Party - hawkish on North Korea - has collapsed in flames under the Park Geun-hye administration. She has been impeached and removed from office and is now under arrest and investigation. It is a sequence of events without comparison since the turmoil that accompanied the country's transition to democracy in the late 1980s. Essentially, the past ten years of conservative rule in the South appear discredited, even as North Korean dictator Kim Jong Un has consolidated power through purges of enemies and family members at home. If there was ever a time for the North to flex its muscles, the past year has been it. Economic weakness: Kim's muscle-flexing at home and abroad have also coincided with internal economic difficulties. China accounts for about 91% of North Korea's trade ex-South Korea, and the North has suffered from the secular slowdown in Chinese growth. Bilateral trade with China collapsed by 10% since its peak in January 2014 (Chart 4). This slowdown has been particularly pronounced in China's northeast, namely Liaoning province, which is key for North Korea. A composite indicator of Chinese and Russian provinces bordering North Korea suggests that internal demand is still contracting (Chart 5). Moreover, the North is mainly an exporter of commodities, such as coal and iron ore, and did not escape the general commodity bust of 2014-16. The Kim regime, already concerned about the pace of pseudo-liberalization of the economy, is using its military advances to distract its populace. Chart 4China Trade Took A Hit Chinese Trade Took A Hit Chinese Trade Took A Hit Chart 5Regional Economic Weakness North Korea: Beyond Satire North Korea: Beyond Satire These factors coalesced late last year - as we argued - to create a situation ripe for a new Korean crisis.6 The collapse of South Korea's conservatives meant that left-leaning candidates became the only real contenders in the presidential election, now scheduled on May 9 (Chart 6). All leading candidates are more likely to try diplomacy and economic engagement with North Korea than to maintain the past ten years of conservative efforts to strengthen military deterrence via stronger alliances with the U.S. and Japan.7 As a result, early this year the U.S. and the flailing Park regime rushed ahead with the deployment of the controversial THAAD missile defense system and ratcheted up pressure tactics on the North via high-intensity regular and irregular military exercises.8 The North responded by testing four short-range missiles at once, threatening to attack Japan and American bases with nuclear weapons, launching another unidentified missile in the face of U.S. warnings, and preparing to conduct another nuclear test and an intercontinental ballistic missile test for the first time. Meanwhile, China imposed sanctions on both Koreas - the former for its missile tests and the latter for THAAD, which China resolutely opposes (Chart 7).9 China sees South Korean weakness as an opportunity to increase its sway in the region, but is sanctioning the North as well because it does not want the latter to provide the U.S. with a pretext to intervene on the Korean Peninsula or take anti-China trade measures. Chart 6Leftward Swing In South Korea North Korea: Beyond Satire North Korea: Beyond Satire Chart 7China Imposes Sanctions On Seoul? China Imposes Sanctions On Seoul? China Imposes Sanctions On Seoul? Bottom Line: The recent spike in Korean tensions (as opposed to some in the past) is driven by real, geopolitical factors - not by media hype alone. The Trump administration is going forward with the "Pivot to Asia" in all but name, and showing a lower threshold than its predecessor for military action globally, while South Korea's power vacuum has emboldened North Korea in its weapons tests and China in its willingness to affect peninsular politics. Is North Korea A Red Herring? Despite the above, this week's spike in Korean tensions failed to generate real panic among global investors, though it did cause a 32% rise in Korean credit-default swaps price and a 2% depreciation of the Korean won from end of March to mid-April (Chart 8). North Korea did not conduct a major provocation on April 15 or thereafter, as it warned it might do.10 The tensions have not fizzled, but seem likely to, once again raising the question of whether North Korea is a red herring for investors. Normally we would say "Yes." Chart 9 explains why. The North has committed a number of acts of aggression over recent decades, killing American as well as South Korean citizens and servicemen. None of these acts has had a pronounced market impact. That is because there is a balance of power on the Korean peninsula and the major players refuse to allow the North to upset that balance through provocations. Chart 8South Korean Risks Rising South Korean Risks Rising South Korean Risks Rising Chart 9North Korean Provocations Rarely Affect Markets For Long North Korean Provocations Rarely Affect Markets For Long North Korean Provocations Rarely Affect Markets For Long Specifically, the North already has a "nuclear option," and it has nothing to do with an atomic bomb. It is approximately 9,000 units of artillery hidden and deeply ensconced in the hills just 35 miles north of the South Korean capital Seoul. This conventional fighting force is ready to attack on a moment's notice and would take days to defeat even granting the vast superiority of American and South Korean forces. In that time it could cause massive casualties in the metropolitan area. In 1994 - when the U.S. chose diplomacy with North Korea for lack of an acceptable military option - a simulation estimated that 1 million people or 9% of the city's population might die - the equivalent of which would be 2.4 million today.11 A conventional attack on Seoul is North Korea's longstanding and well-known trump card. It has prevented the U.S. or South Korea from trying to "solve" the North Korea problem militarily for decades and it remains an active threat. The question, then, is whether this stalemate is changing in a way that breaks the cycle of transgression-and-containment and poses real risks to regional economies and political stability. The answer is "Yes" again. North Korea is no longer a red herring because its nuclear and missile capabilities are improving and it is becoming a bigger problem in U.S.-China relations. Capabilities First, North Korean capabilities are advancing steadily forward, giving the U.S. a smaller window of opportunity to decide whether it can accept a nuclear-armed North Korea. Previous crises with North Korea occurred after the Soviets fell, after 9/11, and after the Great Recession - they were driven exogenously and the U.S. had the luxury of time and distance. That is gradually proving no longer to be the case. To be clear, North Korea has not proved the ability to launch ICBMs reliably. The farthest it has ever shot a missile is around 1,000km, aside from tests of space launch vehicles, which are comparable but as yet inconclusive. Map 1 demonstrates that its missiles are currently a risk to U.S. military bases and allies in Asia Pacific more so than to the continental U.S. Even hitting Guam may be a stretch at the moment. Effective ICBM capabilities are exceedingly rare, as revealed by the fact that only a handful of countries have achieved them (the U.S., U.K., France, Russia, China, India, and arguably North Korea itself). Map 1North Korea's Proven Missile Reach North Korea: Beyond Satire North Korea: Beyond Satire Nevertheless, a number of prominent U.S. defense and intelligence officials have asserted that the U.S. government must be "prudent" and "assume the worst" - i.e. that the North can attach a nuclear warhead to one of its ICBMs (which may function properly) and fire it at the continental U.S.12 The North has surprised the world several times in recent memory with marked advances on everything from nuclear miniaturization to uranium enrichment to the types of long-range missiles in development. While it has not gained the ability to strike the U.S. reliably and accurately, the U.S. wants to stay ahead of the curve. Moreover, nuclear weapons will give the North a much more influential position on the global stage even assuming that it never intends to push the button. (Pyongyang is unlikely to use nukes because to do so would be regime suicide - the response of the U.S. and its allies would be devastating.) As it gains the ability to strike U.S. bases and neighboring Asian countries, it would be able to blackmail the U.S. and its allies more effectively. One result is that the U.S. and South Korea may start to drift apart. As the North gains the ability to strike the U.S. directly, the U.S. loses the willingness to delay military strikes on account of the people of Seoul. Since South Korea knows this, it has an incentive to engage with North Korea and strike a bilateral deal. This is particularly the perception among Koreans born in the 1970s and 1980s, who are gradually assuming power in the country. Though they still support the U.S., like all Koreans, nevertheless they favor it less than other age groups. They also have the highest sympathy for North Korea and China - especially compared to those born after 1988 (Chart 10 A&B). The latter are too young to take charge of policy while the more conservative elderly cohort has been discredited with the fall of Park, at least until the political pendulum swings back again at some point in the future. This suggests a basis for peace overtures. Chart 10AMiddle-Aged Koreans ##br##Sympathetic With China... North Korea: Beyond Satire North Korea: Beyond Satire Chart 10B... And With ##br##North Korea North Korea: Beyond Satire North Korea: Beyond Satire The May 9 election is likely to point in this direction. An inter-Korean thaw may encourage the North to calm down outwardly, but may also encourage its technological efforts inwardly. This occurred during the "Sunshine Policy" of liberal South Korean governments from 1998-2007. The North will expect to face greater diplomatic leniency and economic assistance. Such a thaw will also raise the potential that the U.S. and Japan eventually grow frustrated with South Korean (and Chinese) inaction over the course of talks, especially if the North breaks faith, as it did in the late 1990s and early 2000s.13 This is why a new round of negotiations is crucial to the probability of war. China The second reason North Korea is no longer a red herring for investors is that the U.S.'s approach to China is shifting - it is threatening to slap China with secondary sanctions, trade tariffs, and other measures. The U.S. is demanding that China enforce sanctions and use its economic leverage to convince the North to freeze its nuclear and missile programs. For the first time ever, the U.S. has sanctioned Chinese companies and individuals for their involvement in the North Korean missile program - this is a trend that will continue to evolve.14 Judging by China's stated willingness to ban some coal imports this year (Chart 11), Beijing knows that the U.S. is getting more serious and needs to be pacified. Chart 11Chinese Yet To Punish Pyongyang Chinese Yet To Punish Pyongyang Chinese Yet To Punish Pyongyang But unless "this time is different," China will not impose crippling sanctions on North Korea. The latter is a military and ideological ally, a proxy state that helps keep the U.S. alliance at bay, and a massive liability in the event of collapse (North Korean refugees would flood into northeast China). Investors should remember that the U.S. and China fought a war directly against one another over the Korean peninsula. Time and again, China chooses not to destabilize North Korea, even if that means abetting its nuclear and missile advances.15 In short, North Korea is one more reason - along with trade, China's maritime assertiveness, and Taiwan - that U.S.-China relations will worsen over time, notwithstanding the beginnings of a Trump-Xi détente at Mar-a-Lago in early April. There is some military urgency here as well: Chinese military capabilities are rapidly improving and that further narrows the window for the U.S. to shape the outcome on the peninsula militarily. The longer the U.S. waits, the greater China's ability to deter U.S. action against the North. Hence the U.S.'s simmering conflict with the North could easily feed into a larger U.S.-China confrontation. Moreover, if we are wrong and China imposes crippling sanctions on the North, the investment-relevance of North Korea still goes up. The latter will become unstable in that case, given its vast overreliance on China. Eventually the regime could fragment and impact China's economy and internal stability, or lash out at its other neighbors and instigate tit-for-tat conflicts. Bottom Line - The current saber-rattling is carefully orchestrated. But North Korea can no longer be consigned to the realm of satire. The very fact that the U.S. administration is adopting greater pressure tactics makes this year a heightened risk period. Investors should be especially wary of any missile tests that reveal North Korean long-range capabilities to be substantially better than is known to be the case today. Table 1 provides a checklist for investors to determine if the current tensions get out of hand. Table 1Will The U.S. Attack North Korea? North Korea: Beyond Satire North Korea: Beyond Satire Investors should also be wary of U.S. sanctions on China, or broader U.S.-China tensions, which are structurally driven and have not substantially subsided despite the Trump-Xi talks. In lieu of war, a deterioration in Sino-American relations is the key investment risk from North Korea. What Is The End Game? The U.S. has three paths it can take: Do nothing: The U.S. has allowed murderous tyrants to develop deliverable nuclear weapons before: see Stalin and Mao. It is possible that the U.S. could do the same for North Korea, essentially "setting in stone" the current status quo for lack of willingness to fight a second Korean war. Such an arrangement would put "rational actor theory" to the test - and so far that has been the case, with no second Korean war occurring. Attack, attack, attack! The North holds the South hostage, but Washington might decide someday to "shoot the hostage." For instance, if its own security needs outweigh its loyalty to its ally. Negotiate a solution: China's tentative cooperation on sanctions this year suggests that a major multilateral initiative is getting under way, comparable to the Iranian negotiations that concluded with the nuclear-monitoring and sanctions-lifting deal of 2015. The solution would likely consist of North Korea retaining its nuclear capability but admitting some inspections and refraining from developing long-range missile capabilities. It would seek a peace treaty to replace the 1953 armistice as well as sanctions relief and economic aid. Chart 12The Great East Asian Powder Keg The Great East Asian Powder Keg The Great East Asian Powder Keg What is wrong with these options? First, the U.S. has not yet accepted the North as a nuclear-armed state. Trump's naval buildup this month was evidence of a policy change designed to increase pressure tactics, with the aim of getting a better (non-nuclear-armed) result. It is still believed that the North will use its nuclear deterrent as a cover to expand its campaign of military intimidation and coercion against sovereign states: it has a record of attacks on civilians, attempted assassinations, and acts of war, including but not limited to the Chonan sinking and Yeonpyeong Island shelling in 2010. As the North gains the ability to strike the U.S., any hostilities will become harder for the U.S. public and defense establishment to ignore. Moreover, doing nothing allows a nuclear-armed Korea to kick off a nuclear arms race in a region that is already developing into a powder keg (Chart 12). More generally, it reduces America's ability to shape outcomes regarding China. A preemptive strike, on the other hand, would devastate Seoul and deliver a shock to the global economy. It would destabilize the peninsula and call all alliances and relationships into question. This option is extremely unlikely unless the U.S. is attacked, believes it is about to be attacked, or sees one of its allies suffer a serious attack. Diplomacy is the only real option. And in fact it is already taking shape. The theatrics of the past few weeks mark the opening gestures. And theatrics are a crucial part of any foreign policy. The international context is looking remarkably similar to the lead-up to the new round of Iranian negotiations in 2012. The United States pounded the war drums and built up the potential for war before coordinating a large, multilateral sanctions-regime and then engaging in talks with real willingness to compromise (Chart 13). Chart 13Tensions Ramp Up As Nuclear Negotiations Begin North Korea: Beyond Satire North Korea: Beyond Satire Today the U.S. is similarly showing off its capabilities and willingness to use force to the North, thus establishing a "credible threat."16 The other actors are playing their parts. China is offering to assist with tougher sanctions than usual; South Korea is heading for a policy shift; Japan is raising alarms and demonstrating its lock-step with the U.S.; Russia is calling for calm and a return to talks. However, over time, diplomacy could be unsatisfactory if it merely approximates the first option of "doing nothing." This is likely North Korea's last chance to prove that it can be pragmatic. Bottom Line: Therefore we are at the critical phase - within say one-to-four years - in which the U.S. must decide whether to attack. Given the current heightened tensions, the danger zone consists of (1) the near-term, in which the U.S. is applying more pressure, tensions are spiking, and talks have not yet taken shape (2) the long term, when talks could fail. Conclusion The Korean peninsula is the site of a proxy battle between China and the U.S. However, China sees the dangers of a nuclear-armed North Korea and recognizes that its patronage has a strategic downside by provoking U.S. military intervention. Like Russia in the Iranian negotiations, it can be brought to the table if the U.S. is convincing in warning that it may take matters into its own hands. China's apparent decision to enforce sanctions on coal imports, combined with the U.S. aversion to preemptive strikes and South Korean political leftward tilt, make this new round of talks especially likely to occur. Japan also prefers North Korea to be a threat, but a contained threat, as it looks to normalize its defense posture yet avoid an economic destabilization. The threat in North Korea will be a convenient excuse for Prime Minister Abe to pursue his re-militarization agenda. Thus, over the next four years, the North might be persuaded to freeze its programs to create an uneasy modus vivendi, as with Iran. This would require a non-aggression nod from the U.S. and a lifting of sanctions. It could also bring economic engagement with all parties into focus, even though North Korea does not have as much economic resources to offer as Iran. It is looking to trade national security for national security. All of this has a limit, however. China will not cripple the North Korean economy or force out the regime. Remember that in the case of Iran it was only willing to go so far, and received a waiver for the Iranian oil sanctions - yet North Korea is even closer to its immediate security. Therefore the North's willingness to change its behavior - to demonstrate that it is a rational player if brought in from the cold - is critical to the effectiveness of negotiations. Trump's reelection prospects may also be critical. A lame duck Trump in 2020, in the face of another failed North Korea policy, could attempt a decisive action, especially if the North is belligerent. By contrast, there is very little risk that Japan will "go rogue" and attack North Korea - even less so than there was with Israel in the Iran talks. It is Trump who is playing the role of the unpredictable negotiator who might "go it alone." The U.S. will continue to make the military option credible in spite of Seoul's vulnerability to retaliation. Therefore any failure of negotiations will induce a real crisis in which the U.S. contemplates unilateral action. The final question of whether the U.S. will attack may hinge on the fact that the U.S. has a potent form of nationalism in the country that could be directed against North Korea under certain circumstances, as has happened against other regimes like Vietnam and Iraq. A North Korean act of war, or even a suspected imminent act of war in certain scenarios, could prompt a wave of reaction. Matt Gertken, Associate Editor Geopolitical Strategy mattg@bcaresearch.com Oleg Babanov, Editor/Strategist EM Equity Sector Strategy obabanov@bcaresearch.co.uk 1 Please see BCA Geopolitical Strategy Monthly Report, "The Great Risk Rotation," dated December 11, 2013, and Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy and EM Equity Sector Strategy Joint Report, "The South China Sea: Smooth Sailing?" dated March 28, 2017, Geopolitical Strategy Weekly Report, "Donald Trump Is Who We Thought He Was," dated March 8, 2017, Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2016: Multipolarity & Markets," dated December 9, 2015, and "North Korea: A Red Herring No More?" in Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Monthly Report, "The Socialism Put," dated May 11, 2016, available at gps.bcaresearch.com. 5 Please see Robert Daniel Wallace, "The Determinants Of Conflict: North Korea's Foreign Policy Choices, 1960-2011," doctoral dissertation, Kansas State University (2014), available at krex.k-state.edu. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Joint Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 7 Most notably, the South Korean foreign policy shift will likely put an end to the unified U.S.-Japan-Korea stonewalling of North Korea that has prevailed since 2008. If Moon Jae-In wins, in particular, it will call the U.S. THAAD missile system emplacement into question. It will also call into question the progress in Korea-Japan relations, which includes a Japanese attempt to settle the "comfort women" controversy and a notable military-cooperation and intelligence-sharing agreement. 8 Including letting it be known that they would simulate special-forces operations to strike at the leadership in Pyongyang and decapitate the regime. 9 China opposes THAAD because its radar will be able to penetrate deep into China's territory. More broadly, it opposes U.S. efforts to upgrade its military capabilities in the region or otherwise shift the regional balance of power. 10 Kim Il Sung Day, or the "Day of the Sun," is, like several regime holidays, a possible occasion for missile tests or other provocative actions or revelations. However, Pyongyang is rarely predictable. Faced with a notable display of force by the U.S., the North conducted a small missile test, which failed. Notably, it steered clear of testing another nuclear device, as predicted. More may be to come. 11 Please see W. J. Hennigan and Barbara Demick, "Trump administration faces few good military options in North Korea," April 14, 2017, available at www.latimes.com. 12 Please see Admiral Bill Gortney's comments: "Our assessment is that they have the ability to put a nuclear weapon on a KN-08 [ICBM] and shoot it at the homeland ... That is the way we think, and that's our assessment of the process," in Aaron Mehta, "US: N. Korean Nuclear ICBM Achievable," April 8, 2015, available at www.defensenews.com. In 2013, Chairman of the Joint Chiefs of Staff General Martin Dempsey said that "in the absence of concrete evidence to the contrary, we have to assume the worst case, and that's ... why we're postured as we are today," quoted in "Hagel: North Korea Near 'Red Line,'" UPI, April 10, 2013, available at www.upi.com. See also Mark Landler, "North Korea Nuclear Threat Cited by James Clapper, Intelligence Chief," New York Times, February 9, 2016; Siegfried S. Hecker, "The U.S. Must Talk To North Korea," New York Times, January 12, 2017, available at www.nytimes.com; Jeff Seldin, "N. Korea Capable of Nuclear Strike at US, Military Leader Says," Voice of America, April 7, 2015, available at www.voanews.com. 13 Japan is especially likely to diverge from South Korea as a left-leaning government in Seoul will likely see relations decline far faster with Japan than with the U.S. Increasingly, Japan is concerned about North Korea's risk and is boosting its Self-Defense Forces and attempting to win popular support for controversial constitutional revisions that would ultimately have a bearing on national security posture. North Korea is both a real and a convenient threat at this time. 14 Please see "US sanctions Chinese company for alleged support of North Korea," The Guardian, September 26, 2016, available at www.theguardian.com; see also the Department of Commerce, "Secretary of Commerce Wilbur L. Ross, Jr. Announces $1.19 Billion Penalty For Chinese Company's Export Violations To Iran And North Korea," dated March 7, 2017, available at www.commerce.gov. 15 And Chinese state-owned companies are implicated in significant and recent military advances, such as the provision of Transporter-Erector-Launchers (TELs) for North Korea's mobile-launched ICBM prototypes. Please see Melissa Hanham, "North Korea's Procurement Network Strikes Again: Examining How Chinese Missile Hardware Ended Up In Pyongyang," Nuclear Threat Initiative, July 31, 2012, available at www.nti.org. 16 Please see BCA Geopolitical Strategy Special Report, "Trump Re-Establishes America's 'Credible Threat,'" dated April 7, 2017, available at gps.bcaresearch.com.

Highlights The sequential improvement in global trade is less pronounced than the annual growth rates in the Asian trade data imply. China has been instrumental to the recovery in global trade but mainland's credit and fiscal spending impulse has rolled over decisively pointing to a relapse its growth in general and imports in particular. This will hurt meaningfully countries and sectors selling to China. Commodities prices are set to tumble. In Turkey, reinstate the short TRY versus U.S. dollar and short bank stocks trades. Feature Economic data from China and Asian trade data have been strong of late. However, when one looks ahead, China's growth and imports are set to roll over decisively in the second half of the year, based on the credit and fiscal spending impulse (Chart I-1). This will hurt countries and industries that sell to China. This is why we believe commodities prices are in a broad topping-out phase. Commodities producers and Asian economies will again suffer materially. Any possible strength in U.S. and European growth will not offset the drag on EM growth emanating from China and lower commodities prices. As a result, having priced in a lot of good news, EM risk assets are at major risk of a selloff in absolute terms and are poised to underperform their DM counterparts over the next six months. Beware Of The Low Base Effect Asian trade data have been strong, but the magnitude of recovery has not been as large as implied by annual growth rates: Annual growth rates of export values in U.S. dollar terms have surged everywhere - in Korea, Taiwan, Japan and China (Chart I-2A). Chart I-1China's Growth To Decelerate Again China's Growth To Decelerate Again China's Growth To Decelerate Again Chart I-2AHigh Annual Growth Rates Are Due To... High Annual Growth Rates Are Due To... High Annual Growth Rates Are Due To... Chart I-2B...Low Base In Early 2016 ...Low Base In Early 2016 ...Low Base In Early 2016 Chart I-2B depicts the level of export values in U.S. dollar terms. It is clear that dollar values of shipments remain well below their peak of several years ago. Looking at the annual rate of change is reasonable since it removes seasonality from the series. However, investors should be aware of the low base effect of late 2015 and early 2016 that has made these annual growth rates extraordinarily elevated in recent months. As for export volumes, Chart I-3 illustrates that volumes held up better than U.S. dollar values in late 2015, which is why they are now expanding at a moderate rate (i.e. they are not surging). In short, in the past 12 months there has been a major discrepancy between dollar values and volumes of Asian exports. Indeed, the V-shaped profile of Asian export growth rates has been partially due to price swings in tradable goods. Prices for steel and other metals as well as for petrochemical products and semiconductors dropped substantially in late 2015 and early 2016, and have rebounded materially from that low base since. Correspondingly, Asian export prices have rebounded considerably in percentage terms (Chart I-4). Chart I-3Export Volume Recovery Has Been Moderate Export Volume Recovery Has Been Moderate Export Volume Recovery Has Been Moderate Chart I-4Export Values Are Inflated By Rising Prices Export Values Are Inflated By Rising Prices Export Values Are Inflated By Rising Prices In the U.S., the low base effect from a year ago is also present in manufacturing and railroad shipments. Both intermodal (container) and carload shipment volumes excluding petroleum and coal plunged in early 2016 and recovered considerably on an annual rate-of-change basis, from a low base (Chart I-5). Chart I-5U.S. Railroad Shipments ##br##Also Had Low Base In Early 2016 U.S. Railroad Shipments Also Had Low Base In Early 2016 U.S. Railroad Shipments Also Had Low Base In Early 2016 All told, the skyrocketing annual rate of change of Asian export values and other global trade series is exaggerated by the fact that global trade volume was sluggish and various tradable goods/commodities prices fell precipitously in the last quarter of 2015 and first quarter of 2016, thereby creating a base effect. We are not implying that there has been no genuine recovery in global trade. Indeed, there has been reasonable sequential recovery in global demand and trade. The point is that the sequential improvement in global trade is less pronounced than the annual growth rates in the trade data imply. Importantly, China has been instrumental to the recovery in global trade and the rebound in commodities prices. Hence, the outlook for China holds the key. Looking Ahead Looking forward, there are few reasons to worry about U.S. growth. Consumer spending is robust and core capital goods orders are recovering following a multi-year slump (Chart I-6). Nevertheless, BCA's Emerging Markets Strategy team's view is that global trade growth will decelerate again because China's one-off stimulus-driven recovery will soon reverse, causing the rest of EM to also suffer: In particular, the credit and fiscal spending impulse has rolled over decisively; the indicator typically leads nominal GDP growth and mainland imports by six months, as exhibited in Chart I-1 on page 1. As Chinese import volume relapses again, economies and sectors selling to China will suffer. Chart I-7 demonstrates China's credit and fiscal spending impulses separately. Chart I-6U.S. Final Demand: No Major Risk U.S. Final Demand: No Major Risk U.S. Final Demand: No Major Risk Chart I-7China: Fiscal And Credit Impulses China: Fiscal And Credit Impulses China: Fiscal And Credit Impulses The credit impulse is the second derivative of outstanding corporate and household credit.1 It does not take much of a slowdown in credit growth for the second derivative, credit impulse, to roll over and then turn negative. Remarkably, narrow (M1) and broad (M2) money as well as banks' RMB loan growth have all slowed in recent months (Chart I-8). Non-bank (shadow banking) credit growth remains stable (Chart I-8, bottom panel). Yet given that the PBoC's recent tightening has targeted shadow banking activities, it is a matter of time before shadow banking credit also decelerates meaningfully. To assess real-time strength in China's economic activity, we monitor prices of various commodities trading in China. Chart I-9 demonstrates that these commodities prices have lately plunged. Chart I-8China: Money/Credit Growth Is Slowing China: Money/Credit Growth Is Slowing China: Money/Credit Growth Is Slowing Chart I-9Plunging Commodities Prices Plunging Commodities Prices Plunging Commodities Prices To be sure, commodities prices are influenced not only by final demand but also by other factors such as supply, inventory swings and investor/trader positioning. We use these data as one among many inputs in our analysis. Bottom Line: Money/credit growth has rolled over and will continue to downshift, causing the current recovery underway in China to falter. This will hurt meaningfully countries and sectors selling to China. Commodities prices are set to tumble. Market-Based Indicators Financial asset prices often lead economic data. Therefore, one cannot rely on economic data releases to time turning points in financial markets. We watch and bring to investors' attention price signals from various segments of financial markets to corroborate our investment themes and economic analysis. Presently, there are several indicators flashing warning signals for EM risk assets: The plunge in iron ore prices warrants attention as it has historically correlated with EM equities and industrial metals prices (the LMEX index) (Chart I-10). The commodities currencies index - an equal-weighted average of CAD, AUD and NZD - also points to an end of the rally in EM share prices (Chart I-11). Chart I-10Is Iron Ore A Canary In A Coal Mine? Is Iron Ore A Canary In A Coal Mine? Is Iron Ore A Canary In A Coal Mine? Chart I-11EM Stocks Have Defied ##br##Rollover In Commodities Currencies EM Stocks Have Defied Rollover In Commodities Currencies EM Stocks Have Defied Rollover In Commodities Currencies It appears these long-term correlations have broken down in the past several weeks. We suspect this is due to hefty fund flows into EM. In the short term, the flows could overwhelm fundamentals and prompt financial variables that have historically been correlated to temporarily diverge. However, flows can refute fundamentals for a time, but not forever. It is impossible to time a reversal or magnitude of flows as there is no comprehensive set of data on global investor positioning across various financial markets. The message of a potential relapse in Chinese imports is being reinforced by commodities currencies that lead global export volume growth, and are pointing to weakness in global trade in the second half of this year (Chart I-12). The latest erosion in the commodities currencies has occurred even though the U.S. dollar has been soft and U.S. TIPS yields have not risen at all. This makes this price signal even more important. Oil prices have recovered to their recent highs, but share prices of global oil companies have not confirmed the rebound (Chart I-13). When such a divergence occurs between spot commodities prices and respective equity sectors, the spot prices typically converge toward the equity market. This leads us to argue that oil prices will head south pretty soon. Chart I-12Commodities Currencies ##br##Lead Global Trade Cycles Commodities Currencies Lead Global Trade Cycles Commodities Currencies Lead Global Trade Cycles Chart I-13Oil Stocks Have Not Confirmed ##br##The Latest Rebound In Oil Prices Oil Stocks Have Not Confirmed The Latest Rebound In Oil Prices Oil Stocks Have Not Confirmed The Latest Rebound In Oil Prices The average stock (an equally-weighted equity index) is underperforming the market cap-weighted index in both the EM universe and the U.S. equity market (Chart I-14). Chart I-14Narrowing Breadth Of Equity Rally Narrowing Breadth Of Equity Rally Narrowing Breadth Of Equity Rally This usually occurs in two instances: (1) the rally is losing steam and narrowing to large market-cap stocks; and/or (2) the rally is being fueled by flows into ETFs that must allocate money based on market cap. Narrowing breadth of the rally is a warning signal of a top, albeit the precise timing is tricky. Bottom Line: There are several market-based indicators that herald an imminent top in EM share prices, commodities prices and other risk assets. Stay put. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Turkey: Deceitful Stability Turkey held a constitutional referendum that dramatically expands the powers of the presidency on April 16. The proposed 18 amendments passed with a 51.41% majority and a high turnout of 85%. As with all recent Turkish referenda and elections, the results reveal a sharply divided country between the Aegean coastal regions and the Anatolian heartland, the latter being a stronghold of President Recep Tayyip Erdogan. Is Turkey Now A Dictatorship? First, some facts. Turkey has not become a dictatorship, as some Western press alleged. Yes, presidential powers have expanded. In particular, we note that: The president is now both a head of state and government and has the power to appoint government ministers; The president can issue decrees, however, the parliament has the ability to abrogate them through the legislative process; The president can call for new elections, however, they need three-fifths of the parliament to agree to the new election; The president has wide powers to appoint judges. What the media is not reporting is that the parliament can remove or modify any state of emergency enacted by the president. In addition, removing a presidential veto appears to be exceedingly easy, with only an absolute majority (not a super-majority) of votes needed. As such, our review of the constitutional changes is that Turkey is most definitely not a dictatorship. Yes, President Erdogan has bestowed upon the presidency much wider powers than the current ceremonial position possesses. However, the amendments also create a trap for future presidents. If the president should face a parliament ruled by an opposition party, they would lose much of their ability to govern. The changes therefore approximate the current French constitution, which is a semi-presidential system. Under the French system, the president has to cohabitate with the parliament. This appears to be the case with the Turkish constitution as well. Bottom Line: Turkish constitutional referendum has expanded the powers of the presidency, but considerable checks remain. If the ruling Justice and Development Party (AKP) were ever to lose parliamentary control, President Erdogan would become entrapped by the very constitution he just passed. Is Turkey Now Stable? The market reacted to the results of the referendum with a muted cheer. First, we disagree with the market consensus that President Erdogan will feel empowered and confident following the constitutional referendum. This is for several reasons. For one, the referendum passed with a slim majority. Even if we assume (generously) that it was a clean win for the government, the fact remains that the AKP has struggled to win over 50% of the vote in any election it has contested since coming to power in 2002 (Chart II-1). Turkey is a deeply divided country and a narrow win in a constitutional referendum is not going to change this. Chart II-1AKP Versus Other Parties In Turkish Elections EM: The Beginning Of The End EM: The Beginning Of The End Second, Erdogan is making a strategic mistake by giving himself more power. It will also focus the criticism of the public on the presidency and himself if the economy and geopolitical situation surrounding Turkey gets worse. If the buck now stops with Erdogan, it also means that all the blame will go to him as well. We therefore do not expect Erdogan to push away from populist economic and monetary policies. In fact, we could see him double down on unorthodox fiscal and monetary policies as protests mount against his rule. While he has expanded control over the army, judiciary, and police, he has not won over support of the major cities on the Aegean coast, which not only voted against his constitutional referendum but also consistently vote against AKP rule. That said, opposition to AKP remains in disarray. As such, there is no political avenue for opposition to Erdogan. The problem is that such an arrangement raises the probability that the opposition takes the form of a social movement and protest. We would therefore caution investors that a repeat of the Gezi Park protests from 2013 could be likely, especially if the economy takes a stumble. Bottom Line: The referendum has not changed the facts on the ground. Turkey remains a deeply divided country. Erdogan will continue to feel threatened by the general sentiment on the ground and thus continue to avoid taking any painful structural reforms. We believe that economic populism will remain the name of the game. What To Watch? We would first and foremost watch for any sign of protest over the next several weeks. Gezi Park style unrest would hurt Erdogan's credibility. Given his penchant to equate any dissent with terrorism, President Erdogan is very likely to overreact to any sign of a social movement rising in Turkey to oppose him. It is not our baseline case that the constitutional referendum will motivate protests, but it is a risk investors should be concerned with. Next election is set for November 2019 and the constitutional changes will only become effective at that point (save for provisions on the judiciary). Investors should watch for any sign that Erdogan or AKP's popularity is waning in the interim. A failure to secure a majority in parliament could entrap Erdogan in an institutional fight with the legislature that creates a constitutional crisis. Chart II-2Turkey Depends On Europe Turkey ##br##Is Very Reliant On Europe Economically Turkey Depends On Europe Turkey Is Very Reliant On Europe Economically Turkey Depends On Europe Turkey Is Very Reliant On Europe Economically Relations with the EU remain an issue as well. Erdogan will likely further deepen divisions in the country if he goes ahead and makes a formal break with the EU, either by reinstituting the death penalty or holding a referendum on EU accession process. Erdogan's hostile position towards the EU should be seen from the perspective of his own insecurity as a leader: he needs an external enemy in order to rally support around his leadership. We would recommend that clients ignore the rhetoric. Turkey depends on Europe far more than any other trade or investment partner (Chart II-2). If Turkey were to lash out at the EU by encouraging migration into Europe, for example, the subsequent economic sanctions would devastate the Turkish economy and collapse its currency. Nonetheless, Ankara's brinkmanship and anti-EU rhetoric will likely continue. It is further evidence of the regime's insecurity at home. Bottom Line: The more that Erdogan captures power within the institutions he controls, the greater his insecurities will become. This is for two reasons. First, he will increase the risk of a return of social movement protests like the Gezi Park event in 2013. Second, he will become solely responsible for everything that happens in Turkey, closing off the possibility to "pass the buck" to the parliament or the opposition when the economy slows down or a geopolitical crisis emerges. As such, we see no opening for genuine structural reform or orthodox policymaking. Turkey will continue to be run along a populist paradigm. Investment Strategy On January 25th 2017, we recommended that clients take profits on the short positions in Turkish financial assets. Today, we recommend re-instating these short positions, specifically going short TRY versus the U.S. dollar and shorting Turkish bank stocks. The central bank's net liquidity injections into the banking system have recently been expanded again (Chart II-3). As we have argued in past,2 this is a form of quantitative easing and warrants a weaker currency. To be more specific, even though the overnight liquidity injections have tumbled, the use of the late liquidity money market window has gone vertical. This is largely attributed to the fact that the late liquidity window is the only money market facility that has not been capped by the authorities in their attempt to tighten liquidity when the lira was collapsing in January. The fact remains that Turkish commercial banks are requiring continuous liquidity and the Central Bank of Turkey (CBT) is supplying it. Commercial banks demand liquidity because they continue growing their loan books rapidly. Bank loan and money growth remains very strong at 18-20% (Chart II-4). Such extremely strong loan growth means that credit excesses continue to be built. Chart II-3Turkey: Central Bank ##br##Renewed Liquidity Injections Turkey: Central Bank Renewed Liquidity Injections Turkey: Central Bank Renewed Liquidity Injections Chart II-4Turkey: Money/Credit ##br##Growth Is Too Strong Turkey: Money/Credit Growth Is Too Strong Turkey: Money/Credit Growth Is Too Strong Besides, wages are growing briskly - wages in manufacturing and service sector are rising at 18-20% from a year ago (Chart II-5, top panel). Meanwhile, productivity growth has been very muted. This entails that unit labor costs are mushrooming and inflationary pressures are more entrenched than suggested by headline and core consumer price inflation. It seems Turkey is suffering from outright stagflation: rampant inflationary pressures with a skyrocketing unemployment rate (Chart II-5, bottom panel) The upshot of strong credit/money and wage growth as well as higher inflationary pressures is currency depreciation. Excessive credit and income/wage growth are supporting import demand at a time when the current account deficit is already wide. This will maintain downward pressure on the exchange rate. The currency has been mostly flat year-to-date despite the CBT intervening in the market to support the lira by selling U.S. dollars (Chart II-6). Without this support from the CBT, the lira would be much weaker than it currently is. Chart II-5Turkey: Stagflation? TURKEY: UNEMPLOYMENT RATE Turkey: Stagflation? TURKEY: UNEMPLOYMENT RATE Turkey: Stagflation? Chart II-6Turkey: Central Bank's Net FX ##br##Reserves Are Being Depleted Turkey: Central Bank's Net FX Reserves Are Being Depleted Turkey: Central Bank's Net FX Reserves Are Being Depleted That said, the CBT's net foreign exchange rates (excluding commercial banks' foreign currency deposits at the CBT) are very low - they stand at US$ 12 billion and are equal to 1 month of imports. Therefore, the central bank has little capacity to defend the lira by selling its own U.S. dollar. Chart II-7Short Turkish Bank Stocks Short Turkish Bank Stocks Short Turkish Bank Stocks We also believe there is an opportunity to short Turkish banks outright. The currency depreciation will force interbank rates higher (Chart II-7, top panel). Historically, this has always been negative for banks' stock prices as net interest margins will shrink (Chart II-7, bottom panel). Surprisingly, bank share prices in local currency terms have lately rallied despite the headwinds from higher interbank rates and the rollover in net interest rate margin. This creates an attractive opportunity to go short again. Bottom Line: Re-instate a short position in the currency. In addition, short Turkish bank stocks. Dedicated EM equity as well as fixed-income and credit portfolios should continue underweighting Turkish assets within their respective EM universes. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Report titled, "Gauging EM/China Credit Impulses", dated August 30, 2016, link available on page 19. 2 Please refer to the Emerging Markets Strategy Special Report titled, "Turkey's Monetary Demagoguery", dated June 1, 2016, link available on page 19. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The Trump-Xi summit offers hopeful signs that the two sides are mending once-severely tested bilateral relations. The risk of escalation in trade tensions has declined. President Trump and President Xi have different time horizons in setting policy priorities. Trump needs immediate success on trade and job creation to show to his working-class electorates, while Xi's primary objective is to avoid the "Thucydides trap". This offers space for compromises. Unless the Trump administration addresses America's "savings shortage," the country's external deficit will not change materially. Any serious negotiations on bilateral trade imbalances between China and the U.S. must deal with the root causes. Feature The summit between President Donald Trump and President Xi Jinping in Mar-a-Lago last week was hailed by both sides as an "ice breaking" success. Even though no substantive details have been offered, the two countries have formulated a new mechanism for senior-level dialogue, and established a 100-day process for addressing bilateral trade frictions. The risk still exists that Trump could unilaterally impose punitive measures against Chinese goods with his administrative powers, and it is overly simplistic to draw too much information from one particular event. However, the Trump-Xi summit confirms a developing trend: that some of President Trump's highly controversial remarks on his campaign trail are being quickly rolled back. The risk of escalating trade tensions between the world's two largest economies has on margin abated. Trump Goes Mainstream? America's China policy under recent administrations can best be described as "congagement" - an ambiguous mixture of containment and engagement by varying degrees. Trump's remarks on the campaign trail and in his early days in office suggested he was mainly interested in confrontation. But the Trump-Xi summit, along with some recent developments, implies that Trump's China policy is coming back to the middle ground, at least for now. After setting off a fierce firestorm on the Taiwan issue late last year, Trump reaffirmed the "One China" policy in a February phone call with President Xi, re-stating long-standing U.S. policy and easing a key source of diplomatic tensions. Taiwan is still re-emerging as a source of risk.1 But it is unquestionably positive in the short-term that Trump backed away from his initial, highly provocative approach. Treasury Secretary Steven Mnuchin stated in February that the Trump administration will stick to the existing statutory process in judging whether China manipulates its currency, a marked departure from Trump's repeated campaign pledges. It is almost certain that China will not be named a currency manipulator in the U.S. Treasury's upcoming semi-annual assessment due later this week.2 In his visit to Beijing last month, Secretary of State Rex Tillerson used Chinese verbiage to characterize the U.S.-China relationship. This verbiage was not repeated by other officials during Xi's visit to Florida, so it is unclear whether it signals the Trump administration's adoption of China's idea of a "new model of great power relations." Nonetheless, it is a drastic change from Tillerson's aggressive remarks at his congressional confirmation hearings, when he suggested blockading Chinese-built islands in the South China Sea. Separately, Secretary of Defense James Mattis, on his first trip abroad to Japan and South Korea, said he did not anticipate any "dramatic military moves" in the South China Sea. More recently, Steve Bannon, White House Chief Strategist, was removed from the National Security Council. It is futile to try to understand all the internal power struggles within the new administration. Nevertheless, Bannon's departure from the NSC is probably a positive development, viewed through the Chinese lens. Bannon not long ago openly identified China as a major threat to the U.S. and predicted a war in the South China Sea as inevitable. In short, President Trump's summit with President Xi marked continued "mainstreaming" of his China policy. Some strong anti-China rhetoric from him and his inner circle has apparently been sanded off, setting the stage for constructive negotiations with Beijing. Can China Accommodate? The restructuring of the Sino-U.S. comprehensive dialogue and the declaration of a 100-day process for addressing economic frictions are probably the most tangible outcomes from the discussions between the two leaders during the summit. Further detail deserve close attention in order to map out how relations between the world's two largest economies will evolve in the near future. In our view, China is likely to make concessions and avoid confrontations. First, trade appears to be front and center in President Trump's grand dealings with China, an important change compared with previous U.S. administrations that also focused heavily on values and ideological issues, such as democracy, freedom of speech and human rights. From China's perspective, the government has a lot more flexibility in making concessions on trade and economic fronts than in dealing with ideological differences. In the past, China has almost always yielded to U.S. pressure on trade-related issues. For instance, China depegged the RMB from the dollar in 2005 and allowed the RMB to continue to appreciate after the global economic recovery began, all under American political pressure. Chinese senior officials routinely led massive commercial delegations touring the U.S. with big procurement orders for everything from aircraft to agricultural goods in order to address American complaints. Both the U.S. and China understand that bilateral trade imbalances favor the U.S. in the event of an all-out trade war, which China will try its best to avoid. Strategically, President Trump and President Xi have different time horizons in setting policy priorities. Trump needs immediate success on trade and job creation to deliver on promises to his working-class electorate, while Xi is more interested in establishing a cooperative and productive strategic standing with the world's sole superpower. Xi's primary objective is to avoid the "Thucydides trap" - the likelihood of conflict between a rising power and a currently dominant one - by convincing the U.S. to grant China greater global sway. In this vein, Trump's withdrawal from the Trans Pacific Partnership (TPP) has been viewed as an important positive development from Xi's perspective, and it is likely that Beijing will offer incentives to further discourage President Trump to "pivot to Asia". It is already rumored that Beijing has drafted investment plans in the U.S. that could create 700,000 jobs, as well as further opening up agricultural goods imports and financial market access. We suspect these deals will be announced during the 100-day negotiation period, which should give Trump a much-needed boost in his approval ratings. Economically, Trump's resentment of China's trade practices is based on the old growth model that the country no longer adheres to. Trump's version of Chinese manufacturers - "sweat shops" operating in "pollution heaven" heavily dependent on state subsidies and a cheap currency - is increasingly out of touch with today's reality, as discussed in detail in a previous report.3 In a nutshell, Chinese manufacturers have quickly climbed up the value-add ladder due to rapidly rising labor costs, and pollution control has become an urgent social issue. Meanwhile, the RMB has been under constant downward pressure in recent years, and the Chinese authorities may welcome coordinated efforts to weaken the dollar and support the yuan. In short, China will not find it too painful to accept Trump's terms and conditions, as the "sick parts" of the Chinese economy will inevitably be cleansed regardless of pressure from the U.S. The risk to this view is that Trump finds China's progress too slow and grows impatient. Previous American presidents have come to accept China's gradualism and have demurred from punitive measures. Trump, with his populist base and promises, may at some point find it politically expedient to exact a price on China for failing to deliver the desired results on his electoral timeline. Across the board tariffs on Chinese imports are unlikely, but highly symbolic sanctions and anti-dumping measures remain distinct possibility. The End Game Of Sino-U.S. Trade Imbalances However, any immediate concessions from China on trade will do little to fundamentally change the U.S.'s external imbalances. It is well known that a country's current account balance is the residual of its national savings and domestic capital spending. Therefore, it is unrealistic to expect a meaningful reduction in the country's current account deficit without lifting America's domestic savings rate. Chart 1 shows the chronic nature of America's external deficit. It is worth noting that the "Nixon shock" in 1971 - the policy package of closing the gold window and imposing across-the-board tariffs on imports - was triggered when the U.S. was on track to have its first annual trade deficit since the 19th century. Fast forward 46 years later, various attempts by American administrations have failed to rescue the deteriorating trend. Many countries over the years such as Germany, Japan and newly-industrialized economies in Asia were all singled out as conducting unfair trade practices with the U.S., but none of the bilateral and multi-lateral efforts were effective with lasting impact. A fundamental change in global trade over the past four decades has been the rapid industrialization of China. In essence, China has become the final point of an increasingly integrated global assembly line, and therefore America's chronic deficit has been transferred from other countries to China. Chart 2 shows China's surplus with the U.S. has ballooned, while other countries' surpluses have dwindled. This has put China squarely under the spotlight, replacing previous scapegoats. Chart 1America's Secular Deficit... America's Secular Deficit... America's Secular Deficit... Chart 2... From Changing Sources ... From Changing Sources ... From Changing Sources From China's perspective, the country will continue to run a surplus with the U.S. so long as it remains in the most manufacturing-intensive phase of its development curve, though the product mix will continue to shift from lower-value-added goods to higher-value-added ones. Meanwhile, the Chinese corporate sector will shift production capacity to even lower cost countries, similar to what Japan, Hong Kong and Taiwan have done in relation to China since the early 1980s when China began to open up. Already, China's direct investment to Vietnam has surged in recent years, which partially explains the sharp increase in Vietnam's trade surpluses with the U.S. (Chart 3). In fact, Vietnamese trade surplus with the U.S. account for 15% of the country's GDP, even though its overall trade balance is barely positive. This means that America's demand for cheap consumer goods is the main driving forces for its deficit, rather than any particular country's unfair trade practices. The fact is that the U.S. has moved beyond industrialization and become a post-industrial society, where the service sector generates more wealth than the manufacturing sector. China's shrinking share of imports from the U.S. is the mirror image of America's shrinking share of the manufacturing sector in the overall economy (Chart 4). Furthermore, the self-imposed restrictions on some high-tech goods exports to China further limits American firms growth potential, as this is the most competitive segment of America's manufacturing sector in the global market. Without removing these restrictions, it is unrealistic to expect a material increase in sales to China. Chart 3The "China Factor" In Vietnam's##br## Growing Trade Surpluses The "China Factor" In Vietnam's Growing Trade Surpluses The "China Factor" In Vietnam's Growing Trade Surpluses Chart 4America's Deindustrialization And ##br##Shrinking Market Share In China America's Deindustrialization And Shrinking Market Share In China America's Deindustrialization And Shrinking Market Share In China For now, the Trump-Xi summit offers hopeful signs that the two sides are mending severely tested bilateral relations and that the risk of escalation in trade tensions has declined. Trump may adopt a "good cop / bad cop" strategy that creates greater volatility. Longer term, unless the Trump administration addresses America's "savings shortage," the country's external deficit will not change materially. Imposing tariffs on Chinese imports only pushes Chinese surpluses to other less-competitive countries; it does not bring jobs back to the U.S. Any serious negotiations on bilateral trade imbalances between China and the U.S. must deal with the root causes. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "The RMB: Back In The Spotlight," dated March 16, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report, "Dealing With The Trump Wildcard," dated January 26, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Global political risks are understated in 2018; U.S. policy will favor the USD, as will global macro trends; Trump's trade protectionism will re-emerge; China will slow, and may intensify structural reforms; Italian elections will reignite Euro Area breakup risk. Feature In our last report, we detailed why political risks are overstated in 2017.1 First, markets are underestimating President Trump's political capital when it comes to passing his growth agenda. Second, risks of populist revolt remain overstated in Europe. Third, political risks associated with Brexit probably peaked earlier this year. Next year, however, the geopolitical calendar is beset with potential systemic risks. First, we fear that President Trump will elevate trade to the top of his list of priorities, putting fears of protectionism and trade wars back onto the front burner. In turn, this could precipitate a serious crisis in the U.S.-China relationship and potentially inspire Chinese policymakers to redouble their economic reforms - so as not to "let a good crisis go to waste." That, in turn, would create short-term deflationary effects. Meanwhile, we fear that investors will have been lulled to sleep by the pro-market outcomes in Europe this year. The series of elections that go against populists may number seven by January 2018 (two Spanish elections, the Austrian presidential election, the Dutch general election, the French presidential and legislative elections, and the German general election in September). However, the Italian election looms as a risk in early 2018 and investors should not ignore it. Investors should remain overweight risk assets for the next 12 months. Our conviction level, however, declines in 2018 due to mounting geopolitical risks. Mercantilism Makes A Comeback Fears of a trade war appear distant and alarmist following the conclusion of the Mar-a-Lago summit between U.S. President Donald Trump and his Chinese counterpart Xi Jinping. We do not expect the reset in relations to last beyond this year. Trump has issued a "shot across the bow" and now the two sides are settling down to business - but investors should avoid a false sense of complacency.2 Investors should remember that candidate Trump's rhetoric on China and globalization was why he stood out from the crowd of bland, establishment Republican candidates. Despite the establishment's tenacious support for globalization, Americans no longer believe in the benefits of free trade, at least not as defined by the neoliberal "Washington Consensus" of the past two decades (Chart 1). We take Trump's views on trade seriously. They certainly helped him outperform expectations in the manufacturing-heavy Midwest states of Michigan, Pennsylvania, and Wisconsin (Chart 2). And yet, Trump's combined margin of victory in the three states was just 77,744 votes -- less than 0.5% of the electorate of the three states! That should be enough to keep him focused on fulfilling his campaign promises to Midwest voters, at least if he wants to win in 2020.3 Chart 1America Belongs To The Anti-Globalization Bloc Political Risks Are Understated In 2018 Political Risks Are Understated In 2018 Chart 2Protectionism Boosted Trump In The Rust Belt Protectionism Boosted Trump In The Rust Belt Protectionism Boosted Trump In The Rust Belt In 2017, Trump's domestic agenda has taken precedent over international trade. The president is dealing with several key pieces of legislation, including the repeal and replacement of the Affordable Care Act, comprehensive tax reform, the repeal of Obama-era regulations, and infrastructure spending. However, there is considerable evidence that trade will eventually come back up: President Trump's appointments have favored proponents of protectionism (Table 1) whose statements have included some true mercantilist gems (Table 2). Table 1Government Appointments Certifying That Trump Is A Protectionist Political Risks Are Understated In 2018 Political Risks Are Understated In 2018 Table 2Protectionist Statements From The Trump Administration Political Risks Are Understated In 2018 Political Risks Are Understated In 2018 Secretary of Treasury Steven Mnuchin, who is not known as a vociferous proponent of protectionism, prevented the G20 communique from reaffirming a commitment to free trade at the March meeting of finance officials in Baden-Baden, Germany.4 Such statements were staples of the summits over the past decade. The Commerce Department - under notable trade hawk Wilbur Ross - looks to be playing a much more active role in setting the trade agenda under President Trump. Ross has already imposed a penalty on Chinese chemical companies in a toughly worded ruling that declares, "this is not the last that bad actors in global trade will hear from us - the games are over." He is overseeing a three-month review of the causes of U.S. deficits, planning to add "national security" considerations to trade and investment assessments, proposing a new means of collecting duties in disputes, and encouraging U.S. firms to bring cases against unfair competition. Ross is likely to be joined by a tougher U.S. Trade Representative (who has historically been the most important driver of trade policy in the executive branch). In addition, we believe that Trump's success on the domestic policy front, in combination with the global macro environment, will lead to higher risk of protectionism in 2018. There are three overarching reasons: Domestic Policy Is Bullish USD: We do not know what path the White House and Congress will take on tax reform. We think tax reform is on the way, but the path of least resistance may be to leave reform for later and focus entirely on tax cuts in 2017. Whatever the outcome, we are almost certain that it will involve greater budget deficits than the current budget law augurs (Chart 3). Even a modest boost to government spending will motivate the Fed to accelerate its tightening cycle at a time when the output gap is nearly closed and unemployment is plumbing decade lows (Chart 4). This will perpetuate the dollar bull market. Chart 3Come What May, Trump Will Increase The Budget Deficit Come What May, Trump Will Increase The Budget Deficit Come What May, Trump Will Increase The Budget Deficit Chart 4A Fiscal Boost Will Accelerate Inflation A Fiscal Boost Will Accelerate Inflation A Fiscal Boost Will Accelerate Inflation Chinese Growth Scare Is Bullish USD: At some point later this year, Chinese data is likely to decelerate and induce a growth scare. Our colleague Yan Wang of BCA's China Investment Strategy believes that the Chinese economy is on much better footing than in early 2016, but that the year-on-year macro indicators will begin to moderate.5 This could rekindle investors' fears of another China-led global slowdown. Meanwhile, Chinese policymakers have gone forward with property market curbs and begun to tighten liquidity marginally on the interbank system. The seven-day repo rate, a key benchmark for Chinese lending terms, has surged to its highest level in two years, according to BCA's Foreign Exchange Strategy. It could surge again, dissuading small and medium-sized banks from bond issuance (Chart 5). Falling commodity demand and fear of another slowdown in China will weigh on EM assets and boost the USD. European Political Risks Are Bullish USD: Finally, any rerun of political risks in Europe in 2018 will force the ECB to be a lot more dovish than the market expects. With Italian elections to be held some time in Q1 or Q2 2018 - more on that risk below - we think the market is getting way ahead of itself with expectations of tighter monetary policy in Europe. The expected number of months till an ECB rate hike has collapsed from nearly 60 months in July 2016 to just 20 months in March, before recovering to 28 months as various ECB policymakers sought to dampen expectations of rate hikes (Chart 6).6 In addition, our colleague Mathieu Savary of BCA's Foreign Exchange Strategy has noted that a relationship exists between EM growth and European monetary policy (Chart 7), which suggests that any Chinese growth scares would similarly be euro-bearish and USD-bullish.7 Chart 5Interbank Volatility Will ##br##Dampen Chinese Credit Growth Interbank Volatility Will Dampen Chinese Credit Growth Interbank Volatility Will Dampen Chinese Credit Growth Chart 6Market Is Way Ahead Of ##br## Itself On ECB Hawkishness Market Is Way Ahead Of Itself On ECB Hawkishness Market Is Way Ahead Of Itself On ECB Hawkishness Chart 7EM Spreads, ECB Months-To-Hike: ##br##Same Battle EM Spreads, ECB Months-To-Hike: Same Battle EM Spreads, ECB Months-To-Hike: Same Battle The combination of Trump's domestic policy agenda and these global macro-economic factors will drive the dollar up. At some point in 2018, we assume that USD strength will begin to irk Donald Trump and his cabinet, particularly as it prevents them from delivering on their promise of shrinking trade deficits. We suspect that President Trump will eventually reach for the "currency manipulation" playbook of the 1970s-80s. There are two parallels that investors should be aware of: 1971 Smithsonian Agreement - President Richard Nixon famously closed the gold window on August 15, 1971 in what came to be known as the "Nixon shock."8 Less understood, but also part of the "shock," was a 10% surcharge on all imported goods, the purpose of which was to force U.S. trade partners to appreciate their currencies against the USD. Much like Trump, Nixon had campaigned on a mercantilist platform in 1968, promising southern voters that he would limit imports of Japanese textiles. As president, he staffed his cabinet with trade hawks, including Treasury Secretary John Connally who was in favor of threatening a reduced U.S. military presence in Europe and Japan to force Berlin and Tokyo to the negotiating table.9 Economists in the cabinet opposed the surcharge, fearing retaliation from trade partners, but policymakers favored brinkmanship.10 The eventual surcharge was said to be "temporary," but there was no explicit end date. The U.S. ultimately got other currencies to appreciate, mostly the deutschmark and yen, but not as much as it wanted. Critics in the administration - particularly the powerful National Security Advisor Henry Kissinger - feared that brinkmanship would hurt Trans-Atlantic relations and thus impede Cold War coordination between allies. As such, the U.S. removed the surcharge by December without meeting most of its other objectives, including increasing allied defense-spending and reducing trade barriers to U.S. exports. Even the exchange-rate outcomes of the deal dissipated within two years. 1985 Plaza Accord - The U.S. reached for the mercantilist playbook again in the early 1980s as the USD rallied on the back of Volcker's dramatic interest rate hikes. The subsequent dollar bull market hurt U.S. exports and widened the current account deficit (Chart 8). U.S. negotiators benefited from the 1971 Nixon surcharge because European and Japanese policymakers knew that Americans were serious about tariffs. The result was coordinated currency manipulation to drive down the dollar and self-imposed export limits by Japan, both of which had an almost instantaneous effect on the Japanese share of American imports (Chart 9). Chart 8Dollar Bull Market And ##br## Current Account Balance Dollar Bull Market And Current Account Balance Dollar Bull Market And Current Account Balance Chart 9The U.S. Got What It ##br##Wanted From Plaza Accord The U.S. Got What It Wanted From Plaza Accord The U.S. Got What It Wanted From Plaza Accord The Smithsonian and Plaza examples are important for two reasons. First, they show that Trump's mercantilism is neither novel nor somehow "un-American." It especially is not anti-Republican, with both Nixon and Reagan having used overt protectionism as a negotiating tool in recent history. In fact, Trump's Trade Representative, the yet-to-be-confirmed Robert Lighthizer, is a veteran of the latter agreement, having negotiated it for President Ronald Reagan.11 Second, the experience of both negotiations in bringing about a shift in the U.S. trade imbalance will motivate the Trump administration to reach for the same "coordinated currency manipulation" playbook. The problem is that 2018 is neither 1971 nor 1985. The Trump administration will face three constraints to using currency devaluation to reduce the U.S. trade imbalance: Chart 10Globalization Has Reached Its Apex Globalization Has Reached Its Apex Globalization Has Reached Its Apex Chart 11Global Protectionism Has Bottomed Global Protectionism Has Bottomed Global Protectionism Has Bottomed Economy: Europe and Japan were booming economies in the early 1970s and mid-1980s and had the luxury of appreciating their currencies at the U.S.'s behest. Today, it is difficult to see how either Europe or China can afford significant monetary policy tightening that engineers structural bull markets in the euro and RMB respectively. For Europe, the risk is that peripheral economies may not survive a back-up in yields. For China, monetary policy tightness would imperil the debt-servicing of its enormous corporate debt horde. Apex of Globalization: U.S. policymakers could negotiate the 1971 and 1985 currency agreements in part because the promise of increased trade remained intact. Europe and Japan agreed to a tactical retreat to get a strategic victory: ongoing trade liberalization. In 2017, however, this promise has been muted. Global trade has peaked as a percent of GDP (Chart 10), average tariffs appear to have bottomed (Chart 11), and the number of preferential trade agreements signed each year has collapsed (Chart 12). Temporary trade barriers have ticked up since 2008 (Chart 13). To be clear, these signs are not necessarily proof that globalization is reversing, but merely that it has reached its apex. Nonetheless, America's trade partners will be far less willing to agree to coordinated currency manipulation in an era where the global trade pie is no longer growing. Geopolitics: During the Cold War, the U.S. had far greater leverage over Europe and Japan than it does today over Europe and China. While the U.S. is still involved in European defense, its geopolitical relationship with China is hostile. What happens when the Smithsonian/Plaza playbook fails? We would expect the Trump administration to switch tactics. Two alternatives come to mind: Protectionism: As the Nixon surcharge demonstrates, the U.S. president has few legal, constitutional constraints to using tariffs against trade partners.12 As the Trump White House grows frustrated in 2018 with the widening trade imbalance, it may reach for the tariff playbook. The risk here is that retaliation from Europe and China would be swift, hurting U.S. exporters in the process. Dovishness: There is a much simpler alternative to a global trade war: inflation. Our theory that the USD will rally amidst domestic fiscal stimulus is predicated on the Fed hiking rates faster as inflation and growth pick up. But what if the Fed decides to respond to higher nominal GDP growth by hiking rates more slowly? This could be the strategy pursued by the next Fed chair, to be in place by February 3, 2018. We do not buy the conventional wisdom that "President Trump will pick hawks because his economic advisors are hawks" for two reasons. First, we do not know that Trump's economic advisors will carry the day. Second, we suspect that President Trump will be far more focused on winning the 2020 election than putting a hawk in charge of the Fed. Chart 12Low-Hanging Fruit Of Globalization Already Picked Political Risks Are Understated In 2018 Political Risks Are Understated In 2018 Chart 13Temporary Trade Barriers Ticking Up Political Risks Are Understated In 2018 Political Risks Are Understated In 2018 Bottom Line: Putting it all together, we expect that U.S. trade imbalances will come to the forefront of the political agenda in 2018. This will especially be the case if the USD continues to rally into next year, contributing to the widening of the trade deficit. We expect any attempt to reenact the Smithsonian/Plaza agreements to flame out quickly. America's trade partners are constrained and unable to appreciate their currencies against the USD. This could rattle the markets in 2018 as investors become aware that Trump's mercantilism is real and that chances of a trade war are high. On the other hand, Trump may take a different tack altogether and instead focus on talking down the USD. This will necessitate a compliant Fed, which will mean higher inflation and a weaker USD. Such a strategy could prolong the reflation trade through 2018 and into 2019, but only if the subsequent bloodbath in the bond market is contained. China Decides To Reform Presidents Trump and Xi launched a new negotiation framework on April 6 that they will personally oversee, as well as a "100 Day Plan" on trade that we expect will result in a flurry of activity over the next three months. One potential outcome of the meeting is a rumored plan for massive Chinese investment into the U.S. that could add a headline 700,000 jobs, complemented with further opening of China's agricultural, automotive, and financial sectors to U.S. investment and exports. Investors may be fêted with more good news, especially with President Trump slated to visit China before long. President Trump, a prominent China-basher, may decide that the deals he brings home from China will be enough to convince the Midwest electorate that he has gotten the U.S. a "better deal" as promised. This would enable him to stabilize China relations in order to focus on other issues, as all presidents since Reagan have done. However, we doubt that the Sino-American relationship can be resolved through short-term trade initiatives alone. There is too much distrust, as we have elucidated before.13 The 100-day plan is a good start but it carries an implicit threat of tariffs from the Trump administration if China fails to follow through; and China is not likely to give Trump everything he wants. Moreover, strategic and security issues are far from settled, despite some positive gestures. As such, we expect both economic and geopolitical tensions to resurface in 2018. Meanwhile Chinese policymakers may decide to use tensions with the U.S. as an opportunity to redouble efforts towards structural reforms at home. Since the Xi Jinping administration pledged sweeping pro-market reforms in 2013, the country has shied away from dealing with its massive corporate debt hoard (Chart 14) and has only trimmed the overcapacity in sectors like steel and coal (Chart 15). It fears incurring short-term pain, albeit for long-term gain. However, if Beijing can blame any reform-induced slowdown on the U.S. and its nationalist administration, it will make it easier to manage the political blowback at home, providing a means of rallying the public around the flag. Chart 14China's Corporate Debt Pile Still A Problem... China's Corporate Debt Pile Still A Problem... China's Corporate Debt Pile Still A Problem... Chart 15...And So Is Industrial Overcapacity ...And So Is Industrial Overcapacity ...And So Is Industrial Overcapacity China has, of course, undertaken significant domestic reforms under the current administration. It has re-centralized power in the hands of the Communist Party and made steps to improve quality of life by fighting pollution, expanding health-care access, and loosening the One Child policy. These measures have long-term significance for investors because they imply that the Chinese state is responsive to the secular rise in social unrest over the past decade. The political system is still vulnerable in the event of a major economic crisis, but the party's legitimacy has been reinforced. Nevertheless, what long-term investors fear is China’s simultaneous backsliding on key components of economic liberalization. Since the global financial crisis, the government has adopted a series of laws that impose burdens on firms, especially foreign and private firms, relating to security, intellectual property, technology, legal (and political) compliance, and market access. Moreover, since the market turmoil in 2015-16, the government has moved to micromanage the country’s stock market, capital account, banking and corporate sectors, and Internet and media. The general darkening of the business environment is a major reason why investors have not celebrated notable reform moves like liberalizing deposit interest rates or standardizing the business-service tax. These steps require further reforms to build on them (i.e. to remove lending preferences for SOEs, or to provide local governments with revenues to replace the business tax). But all reforms are now in limbo as the Communist Party approaches its “midterm” party congress this fall. Most importantly for investors, the government has still not shown it can "get off the train" of rapid credit growth that has underpinned China's transition away from foreign demand (Chart 16). The country's relatively robust consumer-oriented and service-sector growth remains to be tested by tighter financial conditions. And the property sector poses an additional, perpetual financial risk, which policymakers have avoided tackling with reforms like the proposed property tax (a key reform item to watch for next year).14 The PBoC's recent tightening efforts come after a period of dramatic liquidity assistance to the banks (Chart 17), and even though interbank rates remain well below their brief double-digit levels during the "Shibor Crisis" in 2013 (see Chart 5 above, page 6), any tightening serves to revive fears that financial instability could re-emerge and translate to the broader economy. Chart 16China's Savings Fueling Debt Buildup China's Savings Fueling Debt Buildup China's Savings Fueling Debt Buildup Chart 17PBoC Lends A Helping Hand PBoC Lends A Helping Hand PBoC Lends A Helping Hand What signposts should investors watch to see whether China re-initiates structural reforms? Already, personnel changes at the finance and commerce ministries, as well as the National Development and Reform Commission and China Banking Regulatory Commission, suggest that the Xi administration may be headed in this direction. Table 3 focuses on the steps that we think would be most important, beginning with the party congress this fall. Given current levels of overcapacity and corporate leverage, we suspect that genuine structural reform will begin with a move toward deleveraging, and involve a mix of bank recapitalization and capacity destruction, as it did in the 1990s and early 2000s. These reforms included the formation of new central financial authorities, like policy banks, regulatory bodies, and asset management companies, to oversee the cleaning up of bank balance sheets and the removal of numerous inefficient players from the financial sector.15 They eventually entailed transfers of funds from the PBoC, from foreign exchange reserves, and from public offerings as major banks were partially privatized. On the corporate side, the reforms witnessed the elimination of a range of SOEs and layoffs numbering around 40% of SOE employees, or 4% of the economically active workforce at the time. Table 3Will China Launch Painful Economic Restructuring Next Year? Political Risks Are Understated In 2018 Political Risks Are Understated In 2018 Chinese President Jiang Zemin launched these reforms after the party congress of 1997, just as his successor, Hu Jintao, attempted to launch similar reforms following the party congress of 2007. The latter got cut short by the Great Recession. The question now for Xi Jinping's administration is whether he will use his own midterm party congress to launch the reforms that he has emphasized: namely, deep overcapacity cuts and financial and property market stabilization through measures to mitigate systemic risks.16 Bottom Line: China may decide to use American antagonism as an "excuse" to launch a serious structural reform push following this fall's National Party Congress. Short-term pain, which is normal under a reform scenario in any country, could then be blamed on an antagonistic U.S. trade and geopolitical policy. While reforms in China are a positive in the long term, we fear that a slowdown in China would export deflation to still fragile EM economies. And given Europe's high-beta economy, it could also be negative for European assets and the euro. Europe's Divine Comedy Investors remain focused on European elections this year. The first round of the French election is just 11 days away and polls are tightening (Chart 18). Although Marine Le Pen is set to lose the second round in a dramatic fashion against the pro-market, centrist Emmanuel Macron (Chart 19), she could be a lot more competitive if either center-right François Fillon or left-wing Jean-Luc Mélenchon squeaks by Macron to get into the second round.17 Chart 18Melenchon's Rise: Comrades Unite! Melenchon's Rise: Comrades Unite! Melenchon's Rise: Comrades Unite! Chart 19Le Pen Cruisin' For A Bruisin' Le Pen Cruisin' For A Bruisin' Le Pen Cruisin' For A Bruisin' The risk of someone-other-than-Macron getting into the second round is indeed rising. However, Mélenchon's rise thus far appears to be the mirror image of Socialist Party candidate Benoît Hamon's demise. At some point, this move will reach its natural limits: not all Hamon voters are willing to switch to Mélenchon. At that point, the Communist Party-backed Mélenchon will have to start taking voters away from Le Pen. This is definitely possible, but would also create a scenario in which it is Mélenchon, not Le Pen, that faces off against a centrist candidate in the second round. As such, we see Mélenchon's rise primarily as a threat to Le Pen, not Macron.18 While we remain focused on the French election, we think that any market relief from that election - and the subsequent German one - will be temporary. By early next year, investors will have to deal with Italian elections. Unfortunately, there is absolutely no clarity in terms of who will win the Italian election. If elections were held today, the Euroskeptic Five Star Movement (M5S) would gain a narrow victory (Chart 20). However, it is not clear what electoral law will apply in the next election. The current law on the books, which the Democratic Party-led (PD) government is attempting to reform by next February, would give a party reaching 40% of the vote a majority-bonus. As Chart 20 illustrates, however, no party is near that threshold. As such, the next election may produce a hung parliament with no clarity, but with a Euroskeptic plurality. Meanwhile, the ruling center-left Democratic Party is crumbling. Primaries are set for April 30 and will pit former PM Matteo Renzi against left-wing factions that have coalesced into a single alliance called the Progressive and Democratic Movement (DP). For now, DP supports the government of caretaker PM Paolo Gentiloni, but its members have recently embarrassed the government by voting with the opposition in a key April 6 vote in the Senate. If Renzi wins the leadership of the Democratic Party again, DP members could formally split and contest the 2018 election as a separate party. The real problem for investors with Italy is not the next election, whose results are almost certain to be uncertain, but rather the Euroskeptic turn in Italian politics. First, aggregating all Euroskeptic and Europhile parties produces a worrying trend (Chart 21). And we are being generous to the pro-European camp by including the increasingly Euroskeptic Forza Italia of former PM Silvio Berlusconi in its camp. Chart 20Five Star Movement Set For Plurality Win Five Star Movement Set For Plurality Win Five Star Movement Set For Plurality Win Chart 21Euroskeptics Take The Lead Euroskeptics Take The Lead Euroskeptics Take The Lead Unlike its Mediterranean peers Spain and Portugal, Italian support for the euro is still plumbing decade lows -- no doubt a reflection of the country's non-existent economic recovery (Chart 22). It is difficult to see how Italians can regain confidence in European integration given that they are unwilling to pursue painful structural reforms. Chart 22Italian Economic Woes Hurt Euro Support Italian Economic Woes Hurt Euro Support Italian Economic Woes Hurt Euro Support The question is not whether Italy will face a Euroskeptic crisis, but rather when. It may avoid one in 2018 as the pro-euro centrists cobble together a weak government or somehow entice the center-right into forming a grand coalition. But even in that rosy scenario, such a government is not going to have a mandate for painful structural reforms that would be required to pull Italy out of its low-growth doldrums. As such, it is unlikely that the next Italian government will last its full five-year term. Bottom Line: Investors should prepare for a re-run of Europe's sovereign debt crisis, with Italy as the main event. We expect this risk to be delayed until after the Italian election in 2018, maybe later. However, it is likely to have global repercussions, given Italy's status as the third-largest sovereign debt market. Will Italy exit the euro? Our view is that Italy needs a crisis in order to stay in the Euro Area, as only the market can bring forward the costs of euro exit for Italian voters by punishing the economy through the bond market. The market, economy, and politics have a dynamic relationship and Italian voters will be able to assess the costs of an exit first hand, as yields approach their highs in 2011 and Italian banks face a potential liquidity crisis. Given that support for the euro remains above 50% today, we would expect that Italians would back off from the abyss after such a shock, but our conviction level is low.19 Housekeeping This week, we are taking profits on our long MXN/RMB trade. We initiated the trade on January 25, 2017 and it has returned 14.2% since then. The trade was a play on our view that Trump's protectionism would hit China harder than Mexico. Given the favorable conclusion to the Mar-a-Lago summit - and the likely easing of risks of a China-U.S. trade war in the near term - it is time to book profits on this trade. We still see short-term upside to MXN and investors may want to pair it by shorting the Turkish lira. We expect more downside to TRY given domestic political instability, which we expect to continue beyond the April 15 constitutional referendum. We see both the yes and no outcomes of the referendum as market negative. In addition, we are closing our short Chinese RMB (via 12-month non-deliverable forwards) trade for a profit of 5.89% and our long USD/SEK trade for a gain of 1.27%. Our short U.K. REITs trade has been stopped out for a loss of 5%. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Matt Gertken, Associate Editor Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com. 2 For this negotiating sequence, please see BCA Geopolitical Strategy and The Bank Credit Analyst Special Report, "A Q&A On Political Dynamics In Washington," dated November 24, 2016, available at bca.bcaresearch.com, and Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 3 Trump loves to win. 4 Please see Federal Ministry of Finance, Germany, "Communique - G20 Finance Ministers and Central Bank Governors Meeting," dated March 18, 2017, available at www.bundesfinanzministerium.de. 5 Please see BCA China Investment Strategy Weekly Report, "Chinese Growth: Testing Time Ahead," dated April 6, 2017, available at cis.bcaresearch.com. 6 The head of the Lithuanian central bank, Vitas Vasiliauskas, was quoted by the Wall Street Journal in early April stating that "it is too early to discuss an exit because still we have a lot of significant uncertainties." This was followed by the executive board member Peter Praet dampening expectations of even a reduction in the bank's bond-buying program and President Mario Draghi stating that the current monetary policy stance remained appropriate. 7 Please see BCA Foreign Exchange Strategy Weekly Report, "ECB: All About China?" dated April 7, 2017, available at fes.bcaresearch.com. 8 Please see Douglas A. Irwin, "The Nixon shock after forty years: the import surcharge revisited," World Trade Review 12:01 (January 2013), pp. 29-56, available at www.nber.org, and Barry Eichengreen, "Before the Plaza: The Exchange Rate Stabilization Attempts of 1925, 1933, 1936 and 1971," Behl Working Paper Series 11 (2015). 9 Treasury Secretary John Connally was particularly protectionist, with two infamous mercantilist quips to his name: "foreigners are out to screw us, our job is to screw them first," and "the dollar may be our currency, but it is your problem." 10 Paul Volcker, then Undersecretary of the Treasury, provided some color on this divide: "As I remember it, the discussion largely was a matter of the economists against the politicians, and the outcome wasn't really close." 11 We highly recommend that our clients peruse Lighthizer's testimony to the U.S.-China Economic and Security Review Commission. Beginning at p. 29, he recommends three key measures: using the 1971 surcharge as a model (p. 31); going beyond "WTO-consistent" policies (p. 33); and imposing tariffs against China explicitly (p. 35). Please see Robert E. Lighthizer, "Testimony Before the U.S.-China Economic and Security Review Commission: Evaluating China's Role in the World Trade Organization Over the Past Decade," dated June 9, 2010, available at www.uscc.gov. 12 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, and Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Reports, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, and "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. See also the recent Geopolitical Strategy and Emerging Market Equity Sector Strategy Special Report, "The South China Sea: Smooth Sailing?" dated March 28, 2017, available at gps.bcaresearch.com. 14 Please see BCA's Commodity & Energy Strategy Special Report, "Chinese Property Market: A Structural Downtrend Just Started," dated June 4, 2015, available at ces.bcaresearch.com. 15 Please see BCA Geopolitical Strategy, "China: Is Beijing About To Blink?" in Monthly Report, "What Geopolitical Risks Keep Our Clients Awake?" dated March 9, 2016, available at gps.bcaresearch.com. 16 At a meeting of the Central Leading Group on Financial and Economic Affairs, which Xi chairs, the decision was made to make some progress on these structural issues this year, but only within the overriding framework of ensuring "stability." The question is whether Xi will grow bolder in 2018. Please see "Xi stresses stability, progress in China's economic work," Xinhua, February 28, 2017, available at news.xinhuanet.com. 17 That said, the most recent poll - conducted between April 9-10 - shows that Mélenchon may be even more likely to defeat Le Pen than Macron. He had a 61% to 39% lead in the second round versus Le Pen. 18 In the second round, Macron is expected to defeat Mélenchon by 55% to 45%, according to the latest poll, conducted April 9-10. 19 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com.

Highlights Chinese capex and EM domestic demand will falter again in the second half of this year. This is not contingent on a growth slowdown in the advanced economies, but due to a further slowdown in bank lending in EM and lower commodities prices. The direction of EM share prices in absolute terms and relative to the S&P 500 is determined by EPS trajectory, not equity valuations. We expect EM EPS to drop in absolute terms and to underperform U.S. EPS. India's deleveraging cycle is well advanced, especially when compared with other EM economies. Maintain an overweight position in Indian equities within the EM universe. Continue betting on yield curve steepening. Stay long the Czech koruna versus the euro. Feature EM/China growth will relapse in the second half of this year. Share prices, presuming they are forward-looking, will roll over beforehand. Chinese interest rates have risen, which typically heralds a downtrend in the mainland's credit impulse and business cycle (Chart I-1). Chinese interest rates are shown as an annual percentage change, inverted and advanced. This is a typical relationship between interest rates and credit cycles, and there is currently no reason why it will play out any differently in China. Given the mainland has a lingering credit bubble, rising borrowing costs and regulatory tightening of banks and the shadow banking system are guaranteed to lead to a relapse in credit origination, and in turn economic growth. China's yield curve has been flattening in recent months. This often precedes a selloff in both EM share prices and industrial metals (Chart I-2). Chart I-1China: Interest Rates ##br##And Credit/Business Cycles China: Interest Rates And Credit/Business Cycles China: Interest Rates And Credit/Business Cycles Chart I-2A Flattening Yield Curve In China Is ##br##A Bad Omen For EM And Commodities A Flattening Yield Curve In China Is A Bad Omen For EM And Commodities A Flattening Yield Curve In China Is A Bad Omen For EM And Commodities The Chinese yield curve has been experiencing bear flattening - front-end rates have risen more than long-term rates. Bear flattening in yield curves typically occurs before a major top in growth, when current conditions are still robust but the fixed-income market begins to question growth sustainability going forward. A flattening yield curve is consistent with our assessment: a lack of follow-through from last year's stimulus combined with the recent policy tightening will cause growth to downshift materially very soon. EM narrow (M1) money growth has rolled over decisively, and historically it has been a good leading indicator for EM earnings per share (EPS) (Chart I-3). The former has historically led the latter by about nine months. Chart I-3EM EPS To Roll Over In the Second Half 2017 EM EPS To Roll Over In the Second Half 2017 EM EPS To Roll Over In the Second Half 2017 The same is true in the case of China - the M1 impulse (the second derivative of M1) leads industrial profits by about six months and heralds an imminent reversal (Chart I-4). Chart I-4China's Industrial Profit Growth Recovery Is At A Risk China's Industrial Profit Growth Recovery Is At A Risk China's Industrial Profit Growth Recovery Is At A Risk The commodities currency index (an equally weighted average of AUD, NZD and CAD) has relapsed against the greenback. This index points to global growth deceleration in the second half of this year (Chart I-5). Similarly, these commodities currencies also lead commodities prices, and presently signal a top in the commodities complex (Chart I-6). Chart I-5Commodities Currencies Signify Weakness In Global Trade Commodities Currencies Signify Weakness In Global Trade Commodities Currencies Signify Weakness In Global Trade Chart I-6Commodities Currencies Point To Relapse In Commodities Prices Commodities Currencies Point To Relapse In Commodities Prices Commodities Currencies Point To Relapse In Commodities Prices In EM ex-China, Korea and Taiwan, bank loan growth has still been decelerating despite the global growth recovery of the past 12 months (Chart I-7, top panel). Besides, retail sales volume growth in EM ex-China, Korea and Taiwan has not ameliorated yet (Chart I-7, bottom panel). All of these economic aggregates are equity market cap-weighted. Similarly, auto sales in EM ex-China, Korea and Taiwan have been stabilizing at very low levels but have not recovered at all (Chart I-8). Hence, we infer that domestic demand in EM ex-China has stabilized, but it has not recovered. For example, manufacturing production in Brazil, Russia, South Africa and Indonesia has been rather subdued (Chart I-9). Chart I-7EM Ex-China, Korea And Taiwan: ##br##Domestic Demand Has Not Recovered EM Ex-China, Korea And Taiwan: Domestic Demand Has Not Recovered EM Ex-China, Korea And Taiwan: Domestic Demand Has Not Recovered Chart I-8EM Ex-China, Korea And Taiwan: ##br##Auto Sales Are Stabilizing At Low levels EM Ex-China, Korea And Taiwan: Auto Sales Are Stabilizing At Low levels EM Ex-China, Korea And Taiwan: Auto Sales Are Stabilizing At Low levels Chart I-9Synchronized Global Recovery? Synchronized Global Recovery? Synchronized Global Recovery? As EM ex-China credit growth decelerates further due to the lingering credit excesses and poor banking system health, their domestic demand will disappoint. This is a major risk to the EM profit outlook. Bottom Line: Chinese and EM domestic demand and by extension corporate earnings will falter again in the second half of this year. This view is not contingent on a growth slowdown in the advanced economies but will be the outcome of further slowdown in bank lending in EM and lower commodities prices. A reversal in Chinese imports from other EM is the link that explains how a relapse in the mainland's growth in the second half this year will hurt the rest of the world in general, and EM in particular. Profits Hold The Key Chart I-10Profits, Not Valuations, Hold The Key Profits, Not Valuations, Hold The Key Profits, Not Valuations, Hold The Key Emerging markets' relative performance versus the S&P 500 has historically been driven by EPS (Chart I-10). In the past 12 months, EM EPS has improved modestly but has not outperformed U.S. EPS in U.S. dollar terms. Consistently, EM stocks have failed to outperform the S&P 500 in common currency terms; they have been flat at low levels in the past 12 months. An important message from this chart is that equity valuations are not critical to EM versus U.S. relative equity performance. It is all about corporate profit cycles. The widely held view within the investment community is that EM stocks are cheaper than those in the U.S., and therefore will outperform based on more attractive valuations. The fact that EM stocks are indeed cheaper versus the S&P 500 only reflects the fact that U.S. equity valuations are expensive and EM equity valuations are neutral in absolute terms. Equity valuations may affect the degree of out- and underperformance, but they do not determine the direction of relative performance as vividly illustrated by Chart I-10. The same can be said about EM stocks' absolute performance. Equity valuations do not determine the direction of share prices; the latter rise when profits expand, and fall when EPS contracts. However, valuations affect the magnitude of the move in equity prices: cheap valuations and growing EPS will produce a larger rally compared to neutral equity valuations and identical growth in EPS. We discussed EM equity valuations at great length in our Weekly Report published two weeks ago.1 In absolute terms, EM equity valuations are presently neutral. Therefore, they have no bearing on the direction of share prices. If EM EPS expands, stocks will continue to rally. If EPS growth stalls or turns negative, EM stocks will stumble. As Charts I-3 and I-4 on page 3 illustrate, EM EPS will soon relapse. In addition, U.S. return on equity (RoE) remains well above EM's RoE (Chart I-11), reflecting better equity capital utilization in the U.S. versus the EM. Looking forward, one variable that has had a reasonably good track record in gauging relative performance of EM versus U.S. share prices is the ratio of industrial metals to U.S. lumber prices (Chart I-12). Industrial metals prices are a proxy for economic growth in China/EM, while U.S. lumber prices are indicative of America's business cycle. Industrial metals prices (the LMEX index) have lately underperformed U.S. lumber prices, pointing to renewed EM underperformance versus the S&P 500. Chart I-11EM RoE Is Below U.S. RoE EM RoE Is Below U.S. RoE EM RoE Is Below U.S. RoE Chart I-12EM Stocks To Underperform The S&P 500 EM Stocks To Underperform The S&P 500 EM Stocks To Underperform The S&P 500 Our view is that EM EPS growth will contract again within a cyclical investment horizon (over the next 12 months). While not all sectors' earnings are set to shrink, our view is that banks' profits will decline driven by credit growth deceleration and a rise in non-performing loans in a number of countries. Besides, commodities producers' EPS will drop anew if, as we expect, commodities prices head south again. Table I-1 illustrates the weights of each EM equity sector within total EM-listed companies' profits. Financials account for 24%, while energy and materials comprise 7.5% each of the aggregate EM equity market cap, respectively. In aggregate, these sectors make up 50% of EM EPS and 40% of the stock index. Table I-1EM Sectors: Equity Market Caps ##br##And EPS's Share Of Total EPS Signs Of An EM/China Growth Reversal Signs Of An EM/China Growth Reversal We remain positive on the technology/internet sector's growth outlook. While this sector's weight in terms of both market cap and EPS is very large, it is not yet sufficient to lift the overall EM equity index if other large sectors falter. In fact, technology/internet stocks have already rallied dramatically and are presently overbought. They will likely correct along with the rest of the universe. Nevertheless, we continue to recommend an overweight stance in technology stocks within the EM benchmark. Bottom Line: The direction of EM share prices in absolute terms and relative to the S&P 500 is determined by EPS trajectory, not equity valuations. We expect EM EPS to drop in absolute terms and to underperform U.S. EPS. Consistently, we maintain our long-standing strategy of being short EM / long the S&P 500. Taking Profits On Short Korean Auto Stocks Initiated on July 3, 2013, this recommendation has generated a 35% gain (Chart I-13, top panel). Notably, Korean auto stocks have failed to rally in the past 12 months. Furthermore, Korean auto stocks have underperformed the overall EM equity index by a whopping 22% since our recommendation (Chart I-13, bottom panel). For dedicated investors, we recommend lifting the allocation to this sector from underweight to neutral. In regard to allocation to the KOSPI overall, we maintain our overweight stance within an EM equity portfolio for now. Geopolitical volatility could create near-term disturbance but the primary trend in Korea's relative performance against the EM benchmark is up (Chart I-14). Within the KOSPI, we continue to overweight technology stocks, companies with exposure to DM growth and domestic industries. Meanwhile, companies with exposure to China's capital spending should be avoided. Chart I-13Take Profits On Short ##br##Korean Stocks Recommendation Take Profits On Short Korean Stocks Recommendation Take Profits On Short Korean Stocks Recommendation Chart I-14Korean Equities ##br##Relative To EM Overall Korean Equities Relative To EM Overall Korean Equities Relative To EM Overall Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report, titled "EM Equity Valuations Revisited", dated March 29, 2017, link available on page 21. India: Beyond De-Monetization The growth-dampening effects from India's de-monetization program are beginning to dissipate. Both services and manufacturing PMIs are recovering (Chart II-1). As more cash is injected back into the system, consumer sector growth will improve. Beyond the recovery in consumption, however, capital spending - the key driver of productivity and non-inflationary growth - is still anemic because of structural reasons that began well before de-monetization was announced (Chart II-2). Chart II-1PMIs Are Recovering PMIs Are Recovering PMIs Are Recovering Chart II-2Capital Spending Is Depressed Capital Spending Is Depressed Capital Spending Is Depressed Public Banks: Is Deleveraging Advanced? The Indian authorities appear serious about restructuring their public banks, and the banking downturn cycle is likely approaching its final stages (Chart II-3). As and when India's public banks find themselves on more solid footing, industrial credit growth will pick up meaningfully and capital expenditures will follow. The previous credit boom that occurred in the infrastructure, mining, and materials sectors left a large number of failed and stalled projects. Chart II-4 shows the number of stalled projects remains stubbornly high and is not yet declining. These mal-investments have ended up as non-performing loans primarily on public banks' balance sheets: Non-performing loans (NPLs) currently amount to 11.8% and distressed assets (DRA) stand at around 4% of total loans on Indian public banks' balance sheets. This has forced public banks to curtail credit growth to the industrial sector (Chart II-5). Chart II-3Bank Credit Growth Is At All Time Low Bank Credit Growth Is At All Time Low Bank Credit Growth Is At All Time Low Chart II-4Plenty Of Projects Stalled Plenty Of Projects Stalled Plenty Of Projects Stalled Chart II-5Bank Credit Growth To Industries Is Contracting Bank Credit Growth To Industries Is Contracting Bank Credit Growth To Industries Is Contracting Public banks' NPLs and DRAs have spiked because the Reserve Bank of India (RBI) is forcing commercial banks to acknowledge and provision for these bad loans via the central bank's Asset Quality Review (AQR) program. This is eroding public banks' capital and constraining their ability to grow their loan book. However, the program is bullish for India's economy in the long run and stands in stark contrast to other EM countries where authorities are turning a blind eye on banks attempting to window dress their NPLs. India's government and the RBI are currently working with commercial banks and proposing measures to recover loans from defaulters. The government is also injecting capital into public banks. It has announced 100 billion INR in capital injections for this fiscal year and will inject more if needed. It is also forcing banks to raise more capital by ridding their books of non-core businesses. We have performed a scenario analysis on public banks (presented in Table II-1) to gauge their stock valuations. In all scenarios, we assume that DRAs will be constant at 5% of total loans, and also assume a 70% recovery rate on DRAs. We examine various scenarios for NPLs - the latter vary from 12-15% of total loans (the current actual NPL rate is 11.8%). Equity valuations are very sensitive to the recovery rate on NPLs. We stress test for recovery rates of 30%, 40%, 50% and 60%. If one assumes a 12% NPL ratio and a recovery rate of 60%, public bank stocks would be 30% cheap - their adjusted (post provisions, capital impairment, and recapitalization) price-to-book value (PBV) ratio will be 0.7, which is 30% less than its historical mean PBV ratio for public banks of 1.0. By contrast, assuming a 15% NPL ratio and a 30% recovery rate, banks' equity valuations would be 50% expensive - their adjusted (post provisions, capital impairment, and recapitalization) PBV ratio would be 1.5. Table II-1Under/Overvaluation (In %) Of Public Banks Stocks For A Given NPL Ratio And Recovery Ratio* Signs Of An EM/China Growth Reversal Signs Of An EM/China Growth Reversal Our bias is to believe that the NPL ratio is somewhere between 14-15% and the recovery rate near 40%. In such a case, public bank stocks would presently be 10-20% expensive. This does not offer a great buying opportunity at current levels, but suggests the downside is probably smaller than in other EM bank stocks. Overall, India is much more advanced in terms of recognizing and provisioning for NPLs as well as re-capitalization of its banking system than many other EM countries. Therefore, we believe India's deleveraging cycle is well advanced, especially when compared with other EM economies. Due to this and the fact that this economy is not exposed to China/commodities prices, we still recommend an overweight position in Indian equities within the EM universe. Inflation And Fixed-Income Strategy While headline inflation is easing due to temporarily lower food prices, core inflation remains sticky. The central government's overall and current expenditures - which often drive inflation - are rising rapidly (Chart II-6). Likewise, state governments' current expenditures are also booming and state development loans - borrowing by state governments - are growing at an extremely fast pace. In addition, in June 2016, the Indian central government announced it will raise salaries, allowances and pensions of government employees by 23%. The central government also raised the minimum wage for non-agriculture laborers by 42% in August 2016, and the Ministry of Labor followed by doubling the minimum wage of agricultural workers in March 2017. All of this will entail accumulating inflationary pressures, even if oil and food prices remain tame. The central bank hiked the reverse repo rate last week to absorb excess liquidity from the banking system. Even though it cited service sector inflation as a concern, we believe it will lag behind accumulating inflationary pressures. This warrants a steeper yield curve. Investors should continue to bet on yield curve steepening by paying 10-year swaps / receiving 1-year swap rates (Chart II-7). Chart II-6Government Expenditures Are Rising Government Expenditures Are Rising Government Expenditures Are Rising Chart II-7Bet On A Yield Curve Steepening Bet On A Yield Curve Steepening Bet On A Yield Curve Steepening Rising inflationary pressures and higher bond yields could weigh on Indian stocks in absolute terms, but will likely not preclude them outperforming the EM equity benchmark. Ayman Kawtharani, Associate Editor aymank@bcaresearch.com Stay Long Czech Koruna Versus Euro On September 28th 2016, we recommended going long CZK / short EUR on the back of expectations that the Czech National Bank (CNB) would abandon its currency peg. Last week, the CNB has floated the koruna. We expect this currency to appreciate versus the euro further and suggest keeping this position. Inflationary pressures in the Czech economy are genuine and heightening. The 1.5% appreciation in the koruna versus the euro since last week will not tighten monetary conditions enough to cap inflation. As such, we expect the CNB to eventually start raising interest rates, leading to further koruna appreciation versus the euro (Chart III-1). The output gap is turning positive, which historically has led to a rise in core inflation (Chart III-2). Chart III-1The Czech Koruna Has More Catch-Up To Do The Czech Koruna Has More Catch-Up To Do The Czech Koruna Has More Catch-Up To Do Chart III-2Output Gap And Inflation Output Gap And Inflation Output Gap And Inflation The labor market is tight - the Czech unemployment rate is the lowest in Europe. Both wages and until labor costs growth are robust and trimmed-mean consumer price inflation is accelerating (Chart III-3). The CNB's foreign exchange reserve accumulation has generated an overflow of liquidity in the Czech financial/banking system (Chart III-4). Chart III-3Inflationary Pressures Are Broad-Based Inflationary Pressures Are Broad-Based Inflationary Pressures Are Broad-Based Chart III-4Money And Credit Growth Are Very Strong Money And Credit Growth Are Very Strong Money And Credit Growth Are Very Strong The rapid expansion of liquidity has led to strong credit growth (Chart III-4, bottom panel), and a rapid appreciation in real estate prices. This warrants higher interest rates to prevent the formation of a bubble. Furthermore, the Czech economy has been benefiting from the recovery in European economic growth in general and manufacturing in particular. Tourist arrivals have also been robust. Notably, the nation's current account surplus stands at 1% of GDP. Chart III-5The Koruna Is Mildly Cheap The Koruna Is Mildly Cheap The Koruna Is Mildly Cheap With regards to currency valuations, the koruna is silently cheap and as such has further room to appreciate (Chart III-5). Either the koruna will gradually appreciate over the next few months, tightening monetary conditions to an extent where the CNB does not need to hike interest rates, or the CNB is eventually forced to hike rates considerably. The latter will push up the value of the Czech currency. We suspect that the CNB is still intervening in the forex market in order to prevent a dramatic appreciation in the koruna. The central bank has stated in its last press conference that it stands ready to intervene to mitigate exchange rate fluctuations if needed. However, in an economy with open capital account, the central bank cannot target the exchange rate and interest rates simultaneously. If the CNB desires to cap inflation, it has to hike interest rates or allow the currency to appreciate considerably. If it chooses the former, the koruna will still rally dramatically. Bottom Line: Stay long the Czech koruna versus the euro. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Feature Game theory teaches us that "credible threats" are an important part of creating stable equilibria. To enforce a credible threat, a geopolitical actor must have the capability and willingness to act on a standing threat. For example, if a country A states that action X will produce a response a, it must follow through decisively with a if X occurs. Otherwise, the lack of action will incite other actors to shirk compliance and conduct action X with little threat of retaliation. The lack of enforcement raises the probability of action X occurring in the future. President Donald Trump has re-established American credibility when it comes to the long-standing opposition to the use of chemical weapons. According to various news reports, approximately 50 BGM-109 Tomahawk cruise missiles were launched from two U.S. Navy destroyers - USS Porter and USS Ross - in the Eastern Mediterranean. The air strike targeted Syrian government-controlled Shayrat Air Base 30km southeast of Homs. The air base was allegedly used by Syrian forces earlier in the week to launch the chemical attack that left at least 86 people, including 28 children, dead. The following are facts that we know surrounding the attack: Russian angle: Russian military has had a presence at the Shayrat air base since December 2015, which has included a contingent of attack helicopters since April 2016.1 This information is public knowledge and therefore was known to American officials ahead of the strike. According to news reports, U.S. officials informed their Russian counterparts of the strike earlier in the day, but President Trump did not speak to President Vladimir Putin ahead of the attack. Limited target: Cruise missiles focused on the parts of the airbase critical to launching further air strikes: runway, aircraft hangars, and fuel depots. However, given the American warning to Russia of the incoming attack, it is highly likely Syrian forces had advance warning as well. Therefore, the attack is likely to have had no discernable military effect. Justification: President Trump justified the attack in broad terms in his statement following the attacks, citing "vital national security interest... to prevent and deter the spread and use of deadly chemical weapons." He also cited Syria's obligations under the Chemical Weapons Convention and U.N. Security Council rulings. There is no evidence that the U.S. is preparing a more comprehensive intervention in Syria. While such an action cannot be ruled out, given that Trump has been overseeing a comprehensive policy review, the nature of the strike suggests that it was designed to re-establish America's credible threat against the use of chemical and biological weapons. What does America's commitment to use of military force mean in broader geopolitical sense? We think that the timing and the optics of the attack are relevant in five ways: Re-establishing "red lines": The alleged chemical attack - if indeed perpetrated by the armed forces of the Syrian government and not by rebel forces or the Islamic State to draw the U.S. into conflict - has little or no military utility. As such, it appears to have been conducted precisely to test President Trump's credibility and commitment to enforcing American "red lines," which were put into question in Syria in particular by the previous administration. We speculate, but the attack may have been encouraged by Assad's allies Iran and Russia to create a low-cost crisis - where both could claim plausible deniability - that tests Trump's resolve to retaliate militarily. Objectively speaking, President Trump has passed the test. Signaling: The quick reaction from Washington signals to potential foes like Iran and North Korea that President Trump has a lower threshold for using military force than his predecessor. Most notably, President Trump did not seek authorization of U.S. Congress for the attack, instead justifying the use of force via international law and longstanding U.S. commitment to defending allies.2 Timing: The attack occurred while President Trump and China's President Xi Jinping were dining at the Mar-a-Lago Florida resort. President Trump notably stated ahead of Xi's visit that "if China is not going to solve North Korea, we will." His administration has also said that time was running out on North Korea and all options were on the table. Words like these carry greater weight in light of Trump's actions today. On the other hand, the attack against Syria does allow Trump to scale-down rhetoric on North Korea and South China Sea - having now proven his military mettle - where conducting a military show-of-force would have been much more difficult for the U.S. Capabilities: The attack reminds the world that U.S. military capabilities and its global reach are unrivaled. Much has been made of Russian power-projection capabilities since their successful intervention in Syria. However, the U.S. was able to deliver a payload of 50-60 cruise missiles without tipping its hand and with little fanfare.3 Russian and Chinese capabilities to project power within their spheres of influence have increased dramatically over the past ten years. However, the U.S. remains the only actor capable of acting globally. Doctrine: President Trump's quick decision to use force suggests that he will not follow an extreme isolationist foreign policy. As we wrote in a February note, a truly isolationist America would produce paradigm shifting outcomes, including the eventual loss of U.S. dollar reserve currency status.4 However, Trump's decision to cite international law and American responsibility to allies as justifications for the Syrian air strikes suggest that the Trump White House has abandoned the isolationist rhetoric of the campaign. It also reveals the preferences of the U.S. defense and intelligence establishment, which has re-established its influence in the Trump White House. Incidentally, the air strike coincides with the removal of ultra-isolationist Steve Bannon - campaign chief and White House Chief Strategist - from the National Security Council. Investment Implications We believe that the air strikes are a limited attack whose main purpose is messaging. If the U.S. planned to accomplish broader goals, we would have expected to see multiple strikes against Syrian air force, air defense installations, and command and control capabilities. A risk to this view would be any follow-up rhetoric from the White House on establishing "no-fly zones" above Syrian air space. We suspect that the attack against Shayrat air base will instead be eventually followed by closer coordination with Russia and other regional players to find a diplomatic solution to the Syrian civil war. As such, any negative market reaction, bid-up in oil prices, or safe-haven flows should be temporary (Chart 1). In fact, the attack is bullish for risk assets for three reasons: Political recapitalization: We suspect that President Trump will see a bump in approval rating due to the limited, but resolute, air strikes. Currently, Trump is plumbing unseen lows in overall popularity and even his support among Republican voters appears to be slipping (Chart 2).The strikes will be a shot-in-the-arm, at least among GOP voters. This will further aid President Trump in his ongoing squabbles with the fiscally conservative Freedom Caucus and thus increase the probability of tax legislation being passed by Congress later this year.5 Chart I-1Market Reaction ##br##Should Be Temporary Trump Re-Establishes America's "Credible Threat" Trump Re-Establishes America's "Credible Threat" Chart 2Can A Resolute Strike ##br##Rescue Trump's Popularity? Trump Re-Establishes America's "Credible Threat" Trump Re-Establishes America's "Credible Threat" Establishment strikes back: The air strikes are a highly orthodox reaction to a foreign policy crisis, suggesting that the extreme isolationist rhetoric of the Trump's presidential campaign has been abandoned. It also suggests that the U.S. establishment has wrestled control of foreign policy from unpredictable novices like Steve Bannon. Escalation is limited: We don't see the probability of air strikes against North Korea as having risen. As we will show in a forthcoming military assessment of the risks on the Korean peninsula, North Korea retains considerable retaliatory capacity. It can still inflict massive civilian casualties on Seoul via a conventional artillery barrage. We suspect that the market will quickly realize the objective superiority of a foreign policy that enforces credible threats. As such, the probability of future use of force declines, now that the U.S. has reestablished its commitment to military retaliation when its "red lines" are crossed. The two risks to our view are that: Russia decides it must respond to the U.S. attack for either strategic or domestic political reasons; President Trump is emboldened by the political recapitalization that follows the attack to expand operations in Syria or to attempt a similar strike in North Korea. We doubt that either will happen, but it may take time for the market to be convinced. First, Russia will likely oppose U.S. involvement rhetorically, given the close proximity of its forces to the attack. This is despite the fact that the U.S. informed Russia, showing the courtesy of a geopolitical peer. Indeed, Russian officials are already threatening to scuttle the agreement with the U.S. that keeps the two militaries informed of each other movement in Syria. Second, we doubt that the U.S. defense establishment will advise President Trump to attack North Korea, as it has understood Pyongyang's retaliatory capability for decades. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com 1 The airport was used by the Russian forces as an "advance airfield," which means that it was mainly used for quick refueling and rearming of frontline aviation. There was no permanent presence of Russian troops. 2 In his statement following the attacks, President Trump stated that destabilization of the region and ongoing refugee crisis threatened the U.S. and its allies. 3 As a side note, the number of cruise missiles involved in the strike appears to be complete overkill given the limited nature of the attack. The number appears to have been selected for maximum PR effect, showing again that the attack was meant to serve a signaling purpose. 4 Please see BCA Geopolitical Strategy Weekly Report, "The Trump Doctrine," dated February 1, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com.

Highlights The European economy has outperformed that of the U.S. recently, prompting investors to bring forward their estimates of the first ECB rate hike. To make this judgement, one really needs to be positive on EM economies in general, and China in particular. This sphere is the source of the growth delta between Europe and the U.S. The recent tightening in Chinese monetary conditions points to risks for European growth bulls. In fact, we would expect emerging markets growth to begin disappointing in the coming months, which will limit the capacity of the ECB to hike by 2019. Cyclically, stay short the euro and commodity currencies. While cyclical headwinds against the yen are plentiful, the tightening in Chinese monetary conditions could provide a further temporary fillip for the JPY. Feature Chart I-1The Reason Behind The Euro's Resilience The Reason Behind The Euro's Resilience The Reason Behind The Euro's Resilience 2016 witnessed an astounding phenomenon: Euro area growth outperformed that of the U.S. This performance is even more impressive as Europe's trend GDP growth is around one percentage point lower than that of the U.S. As investors internalized this development, their perception of the ECB changed: from the first hike being expected 59 months in the future in July 2016, the ECB is now expected to hike in 2019 (Chart I-1). Obviously, with this kind of a move, the euro was able to remain resilient, even as 2-year real rates differentials moved in favor of the USD. Are markets correct to extrapolate the recent European economic strength into the future, or is there more at play? We believe that in fact, Europe's growth outperformance has mostly reflected something else: EM and Chinese resilience. This means that if our Emerging Market Strategy team is correct and EM economic conditions begin to soften anew, the days of economic outperformance in Europe are marked. Other FX crosses will feel the blow. Betting On Faster European Rate Hikes = Betting On A Further EM Rally Core inflation in Europe remains muted and in fact, slowed substantially last month (Chart I-2). Meanwhile, U.S. core CPI and PCE inflation are still clocking in at 2.2% and 1.8%, respectively, and remain perky when compared to the euro area. Going forward, for the path of the ECB policy to be upgraded relative to the Fed, thus, prompting a durable rally in the euro, economic slack in Europe needs to continue to dissipate faster than in the U.S. The recent economic data still points toward future growth improvement in Europe and in the global manufacturing cycle. Not only have euro area PMIs been very strong, Sweden's have also shot to the moon (Chart I-3). The small, open nature of Sweden's economy suggests that some real improvement is brewing behind the scenes. Hence, it would suggest that this European inflation underperformance should soon pass. Chart I-2No Domestic Inflationary Pressures No Domestic Inflationary Pressures No Domestic Inflationary Pressures Chart I-3European Growth Indicators Are On Fire European Growth Indicators Are On Fire European Growth Indicators Are On Fire However, this misses one key point: the source of the economic outperformance of Europe. It is true that Europe continues to create a fair amount of jobs as the unemployment rate has fallen to 9.5%, but the U.S. too is generating healthy job gains, averaging 210,000 jobs over the past nine months. Labor market dynamics are unlikely to be the source of the European economic outperformance, especially as European wages continue to underperform U.S. ones (Chart I-4). Instead, it would seem that some of the positive growth delta that has lifted European economic activity above U.S. activity comes from outside Europe. Indeed, euro area PMIs and industrial production have outperformed that of the U.S. on the back of improving monetary conditions in China. As Chart I-5 illustrates, since 2008, easing Chinese MCI has led to stronger European PMI and IP. Even more interesting is the relationship exhibited in Chart I-6. The difference in economic activity between Europe and the U.S. is even more tightly correlated with the gap between Chinese M2 and Chinese M1. When M2 underperforms M1, the growth rate of time deposits slows. This is akin to saying that the marginal propensity to save in China is slowing. This boosts European economic activity. Meanwhile, when M2 outperforms M1, Chinese time deposits accelerate relative to checking deposits, Chinese savings intentions grow, and the European economy underperforms. Chart I-4U.S. Domestic Demand##br## Is Better Supported U.S. Domestic Demand Is Better Supported U.S. Domestic Demand Is Better Supported Chart I-5Euro/U.S. Growth Differentials ##br##And Chinese Liquidity (I) Euro/U.S. Growth Differentials And Chinese Liquidity (I) Euro/U.S. Growth Differentials And Chinese Liquidity (I) Chart I-6Euro/U.S. Growth Differentials ##br##And Chinese Liquidity (II) Euro/U.S. Growth Differentials And Chinese Liquidity (II) Euro/U.S. Growth Differentials And Chinese Liquidity (II) The dynamics between Europe's relative performance vis-à-vis the Chinese MCI and vis-à-vis time deposits are congruent. It highlights that China's economy does respond to tightening monetary conditions by raising its savings, which subtracts from domestic economic activity. These increased savings tend to be deflationary (as demand falls relative to supply), and also tend to limit the growth rate of imports. This is a shock for countries exporting to China. Here lies the key link explaining why Europe is more sensitive to Chinese dynamics: Europe trades more with China and EM than the U.S. does. The euro area's growth is therefore more sensitive to EM economic conditions than the U.S., a proposition supported by the IMF's work, which shows that a 1% growth shock in EM economies affect European growth by nearly 40 basis points, versus affecting U.S. growth by around 10 basis points (Chart I-7). So what does this mean going forward? We continue to be worried by dynamics in Chinese monetary conditions, even if the timing of their repercussion on economic activity is uncertain. Chinese monetary conditions have already begun to tighten, suggesting savings should rise and that growth in the industrial sector should deteriorate. Buttressing this tightening, nominal rates in China keep rising with the 7-day interbank repo rate in a clear uptrend (Chart I-8, top panel). Chart I-7Europe Is More Sensitive To EM ECB: All About China? ECB: All About China? Chart I-8Higher Chinese Rates Have Consequences Higher Chinese Rates Have Consequences Higher Chinese Rates Have Consequences This rise in interest rates could have a material impact on Chinese credit growth. As the bottom panel of Chart I-8 illustrates, bond issuance by small and medium banks has already fallen substantially. In this cycle, this variable has been a reliable leading indicator of the Chinese credit impulse. This makes sense: much of the recent Chinese credit growth has happened in the "shadow banking system", outside of the traditional channels. Research by the Kansas City Fed has shown that securitized credit tends to be very sensitive to short-term rates, thus, this slowing in bond issuance by small Chinese lenders is very likely to genuinely affect broader credit growth.1 Moreover, the risk of a vicious circle emerging is real. At the peak of the hard lending fears in China, real rates were at 10.5%, mostly reflecting deep producer prices deflation of 6%. This meant that for many highly indebted borrowers, debt servicing was a herculean effort that cut funding available for investments and economically accretive activities. As Chart I-9 shows, tightening Chinese monetary conditions have led to slowing PPI inflation. As the current tightening in China's MCI progresses, Chinese PPI inflation is likely to weaken, putting upward pressure on real rates and further hurting monetary conditions. These dynamics are dangerous, even if a repeat of the 2015 hecatomb is unlikely. Preventing as negative an outcome as occurred in 2015 are a few key factors: some of the excess capacity in the steel and material sector has been removed; the authorities have now better control of the capital account; and while PPI has downside, it is unlikely to plunge as deeply as it did in 2015 - oil prices are now better anchored, as consequential amounts of oil supply have been cut globally. This means that deep commodity deflation like in 2015 is unlikely to repeat itself and annihilate PPI inflation in China in the process (Chart I-10). Chart I-9Chinese PPI Will Roll Over Soon Chinese PPI Will Roll Over Soon Chinese PPI Will Roll Over Soon Chart I-10Commodity Prices: Friend And Foe Commodity Prices: Friend And Foe Commodity Prices: Friend And Foe Thus, as the Chinese monetary tightening progresses without spiraling out of control, it is likely that the window of opportunity for the ECB to increase interest rates will dissipate. When this reality dawns on the markets, we would expect the bear market in the euro to resume. Additionally, the global inflation surprise index has spiked massively. Historically, a surge in positive inflation surprises tends to prompt global tightening cycles (Chart I-11). In other words, because inflation surprises have been so strong, it is likely that global liquidity conditions tighten exactly as Chinese monetary and fiscal conditions do. In addition, the fiscal thrust in other EM economies deteriorate.2 This represents a potential headwind for growth in the EM space, which could temporarily limit the upswing in global inflation. These dynamics also reinforce the risks highlighted by Arthur Budaghyan, BCA's head of EM research, that EM spreads have little downside from here and may in fact be selling off in the coming quarters. As Chart I-12 shows, this would also imply that the ECB's perceived months-to-hike metric has more upside from here than potential downside. This is a cyclical handicap for the euro. Chart I-11Global Tightening On Its Way? Global Tightening On Its Way? Global Tightening On Its Way? Chart I-12EM Spreads, ECB Month-To-Hike: Same Battle EM Spreads, ECB Month-To-Hike: Same Battle EM Spreads, ECB Month-To-Hike: Same Battle These forces may also have implications for EUR/JPY. In the long-term, the yen is likely to be the main victim of the dollar strength as the Bank of Japan is currently the G7 central bank with the strongest dovish bias. But the short-term dynamics resulting from the tightening in Chinese monetary conditions could nonetheless prompt a fall in EUR/JPY over the next six months. To begin with, since 2014, the spread between German and Japanese inflation expectations has been linked to Chinese monetary conditions (Chart I-13). German 5-year / 5-year forward inflation expectations are already melting. An underperformance relative to Japan would suggest that the perception by investors of the increasing proximity of an ECB rate hike is likely to be disappointed. Chart I-13China Tightens, Germany Feels It More China Tightens, Germany Feels It More China Tightens, Germany Feels It More Moreover, the yen continues to display stronger "funding currency" attributes than the euro. Japan has a positive net international investment position of 170% of GDP versus -8% for the euro area. This suggests that the potential for repatriations when global market turbulence emerges is greater in Japan than in the euro area. Additionally, the market currently expects the ECB to begin hiking one year before the Bank of Japan. This would also mean that there is more room in the European fixed-income markets to further push away the first rate hike than there is in Japanese markets in the event of an EM deflationary shock. Does the reasoning described above have any implications for the dollar? On a 12-to-18-months basis, these dynamics support being more bullish the USD than the euro. The U.S. economy is less exposed to EM growth than that of Europe. This implies that on over such a horizon, the Fed will be less constrained than the ECB by EM economies, especially as the domestic side of the ledger is more promising in the U.S. Additionally, our Geopolitical Strategy team continues to argues that tax cuts are far from dead in the U.S., and that some significant fiscal stimulus will emerge over the course of the next 12 months in the U.S. In Europe, while no fiscal drag is tabulated, the potential for a similarly-sized fiscal boost is more limited. These same dynamics are also unambiguously bearish commodity and EM currencies versus the USD as commodity currencies are a direct play on EM activity (Chart I-14). The Australian dollar is the most poorly placed currency in the G10. It is 11% overvalued on our productivity-adjusted metrics and investors are now very long the AUD. Most crucially, Australian's terms of trade are especially vulnerable to a slowdown in the Chinese sectors most exposed to the tightening in Chinese monetary conditions (Chart I-15). These risks are further compounded by the fact that China has accumulated large inventories of some of the natural resources most important for the Australian terms of trade. Chart I-14Problems In EM Equals Problems ##br##For Commodity Currencies Problems In EM Equals Problems For Commodity Currencies Problems In EM Equals Problems For Commodity Currencies Chart I-15AUD Is Most Exposed To ##br##The Chinese Tightening AUD Is Most Exposed To The Chinese Tightening AUD Is Most Exposed To The Chinese Tightening Tactically, the picture is more nuanced. Since 2015, the euro has benefited from some risk-off attributes, managing to rise against the USD when market sell-offs are at their most acute point. Again, while EUR does not display these "funding currency" attributes as strongly as the yen, it nonetheless does more so than the USD. Also, April is traditionally a month of seasonal weakness for the greenback. A homegrown shock could also give the euro a further fillip: the French election. Le Pen's probability of winning is low but not 0%. In a report co-published nine weeks ago, we and our Geopolitical Strategy team argued that a Le Pen victory was very unlikely.3 Hence, we expect that her bookies' odds of winning, which stands between 20% and 30%, will dissipate to 0% after the second round of the election, supporting the euro independently of relative monetary dynamics. Practically, in the short run, the euro could remain well bid until this summer. We prefer to express our positive tactical stance on the euro against the AUD instead of the USD. We are also more tactically positive on the yen than any other currency and thus hold short USD/JPY and short NZD/JPY positions. Cyclically, we are looking for either a market correction to unfold or a clear upswing in U.S. wages before moving outright short EUR and JPY against the USD. Our tactical and cyclical views on commodity currencies are lined up: we are shorting them. Bottom Line: The source of the delta in European growth seems to be emanating out of EM and China in particular. This means that if one wants to bet on the ECB being able to increase rates sooner than what is currently priced in - a key precondition to bet on a cyclical rebound in the euro - one needs to remain bullish EM. Currently, our Emerging Markets Strategy sister publication remains negative on the medium-term outlook for EM, this represents a big problem for cyclical euro bulls. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Tobias Adrian and Hyun Shong Shin, "Financial Intermediaries, Financial Stability and Monetary Policy," Federal Reserve Bank of New York, Staff Report No. 346, September 2008. 2 Please see Foreign Exchange Strategy Weekly Report, "Et Tu, Janet?" dated March 3, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy and Geopolitical Strategy Special Report, "The French Revolution," dated February 3, 2017, available at fes.bcaresearch.com and gps.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The March FOMC minutes reveal that members discussed the possibility of a normalization of the bank's balance sheet in the near future, through phasing out or ceasing reinvestments of both Treasuries and mortgage-backed securities. This is quite a hawkish comment, as the Fed acknowledges a strengthening economy: ADP employment change recorded a 263,000 new jobs, above the 187,000 consensus; Initial jobless claims decreased to 234,000; ISM Manufacturing PMI came in at 57.2; ISM Prices Paid was at 70.5. Despite this data, some members also stated that stock prices were "quite high", which prompted weakness in the S&P, Treasury yields, and the dollar, as markets revised their growth outlook. Although this is most likely a misinterpretation, as the data quite accurately depicts the economy's fundamentals, the dollar will likely display a neutral bias this month due to seasonality effects. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 Healthcare Or Not, Risks Remain - March 24, 2017 USD, Oil Divergences Will Continue As Storage Draws - March 17, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 The euro is likely to see some temporary strength on the back of improving economic conditions: Producer prices picked up to 4.5%, beating the 4.4% consensus; Retail sales remain strong at 1.8%; German manufacturing PMI remained unchanged at 58.3, while composite increased to 57.1. Nevertheless, PMIs were weak for many of the smaller, peripheral economies, which will cause downside for the euro in the longer-term. Adding confirmation to Praet's comments last week, Vitas Vasiliauskas, governor of Bank of Lithuania, stated that "the recovery of inflation is still fragile" and that they will first "have to end purchases and only then we can discuss other actions", further corroborating a weaker euro in the longer-term. In other news, the CNB seems to be softening its peg with the EUR as the bank progressively reverts to conducting an independent monetary policy. EUR/CZK depreciated more than 1.5%. Report Links: Healthcare Or Not, Risks Remain - March 24, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent Japanese data has been mixed: The unemployment rate outperformed expectations, falling down to 2.8%. However, household spending contracted further, falling by 3.8%, underperforming expectations. Furthermore, the Nikkei manufacturing PMI, also underperformed expectations, falling to 52.4 This deterioration in Japanese economic data is most likely a byproduct of the appreciation that the yen this year. Indeed, inflationary pressures and economic activity in Japan have been closely linked to the yen. This relationship will embolden the BoJ to keep its aggressive monetary stance in place, as the rate-setting committee understands that a weakening yen is a key lever to kick star Japan's tepid economy. Thus, while we are bullish on the yen on a 3-month horizon, we remain yen bears on a cyclical basis. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 JPY: Climbing To The Springboard Before The Dive - February 24, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Data in the U.K. has been disappointing as of late: GDP grew at 1.9% in Q4, against expectations of 2% growth. Construction and manufacturing PMI also underperformed, coming in at 52.2 and 54.2 respectively. Both measures also decreased from the previous month. Amid disappointing data, one bright spot for the pound was the massive reduction in their current account deficit. At 12 Billion pounds, the British current account deficit now stands at the lowest level since 2013. This is positive for the U.K. economy, as it provides a buffer against any slowdown in financial inflows that could materialize from the separation with the European Union. Thus, we continue to be bullish on the pound, particularly against the euro, as we believe that Brexit-related fears are overstated. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits -December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The latest dwelling figures indicate the fastest increase since May 2010, with Sydney and Melbourne witnessing 19% and 17% increases, respectively. They are up 8.3% nationally. What really highlights risks for Australia is that interest-only loans account for 40% of the country's housing finance, which prompted the APRA to put forward a limitation to interest-only lending to 30% of new mortgages, as a part of numerous other restrictive macro-prudential measures put in place to curb euphoria. Low rates, while sustaining robust housing activity in the past years, have been a primary factor in this exuberance. Worryingly, these low rates have not been enough to support wages, leading to increasing debt-to-income ratios. The RBA will find it hard to lift rates in the face of high household debt and the large share of interest-only loans, limiting the AUD's upside. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 Et Tu, Janet? - March 3, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Although the NZD has been slightly weak this week against the U.S. dollar, it has appreciated against the Aussie. This might have something to do with the recent uptick in dairy prices, stopping a correction in prices that started in late 2016. Furthermore, the weakness in this cross seems to be sending an ominous signal, as AUD/NZD tends to lead relative activity dynamics between the manufacturing and non-manufacturing sectors in China. There is a reason behind this relationship, as the staple commodities of Australia and New Zealand (iron and dairy prices) cater to the industrial sector and the consumer sector, respectively. We believe that the outperformance by the Chinese industrial sector might be on its last legs, thus AUD/NZD is an attractive short. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 As highlighted numerously, the Canadian economy is haunted by the same underlying risk as the Australian economy. With the average price for a detached home in Toronto now at CAD 1.2 million, risks are coming into sharper focus. News media now highlights that the housing market is in a shortage, with multiple buyers in competition to purchase a single home, with buyers even skipping home inspections. In better news, the RBC Manufacturing PMI read at 55.5 in March, more than a 3-year high, with its output, new orders and employment components also at multi-year highs. Furthermore, the Business Outlook Survey highlights business intentions to expand and hire continue to be buoyant, which should augur well for the economy in the near future. Report Links: AUD And CAD: Risky Business - March 10, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 EUR/CHF has rebounded after coming close to hitting the SNB implied floor of 1.065 on Tuesday. It seems that this strategy is paying off for the SNB, as recent data shows an improving Swiss economy: Real retail sales outperformed expectations, as they exited contractionary territory. They are now growing at 0.6%. SVME PMI also outperformed, coming in at 58.6. This measure now stands at its highest level since 2011. Moreover Swiss headline inflation month-on-month grow came in above expectations at 0.6%, while the annual inflation rate came in at 0.2%. This batch of strong data will certainly reassure the SNB that its intervention in the currency market is helping kick start the Swiss economy. However, for the time being the peg will remain as the economy is not yet strong enough to handle a change in this policy. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits -December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 USD/NOK appreciated by almost 1.5%, even on the face of a nearly 5% rally in oil. This is not an isolated case: since the beginning of the year USD/NOK has become much less sensitive to oil and more sensitive to the changes in the dollar. The poor state of the Norwegian economy explains this phenomenon as core and headline inflation continue to plummet and the credit impulse still stands in negative territory. One could point to unemployment as a bright spot, as it now stands at 2.9%. However this reduction in unemployment is accompanied by a contraction in employment, which suggests that people are just leaving the labor market. These factors will continue to solidify the Norges Bank's dovish bias, causing NOK to underperform terms-of-trade dynamics. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits -December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 As momentum retreats from oversold levels, the krona is displaying some strength on the back of buoyant economic data: Manufacturing PMI hit 65.2 for March; Industrial production in February increased at a 4.1% annual pace; New orders were up 12% in February. This data augurs well for Sweden's export sector, the economy's most key area. The Riksbank's Business Survey highlights these developments, with their proprietary economic activity indicators pointing to good growth. An interesting development in pricing pressures is that negotiated prices are no longer being reduced as often as before, which is "regarded as an incipient sign of demand, which in turn creates expectations of future price rises". The effects of rising commodity prices and a weaker krona are also now kicking in. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights WTI and Brent forward curves remain more or less backwardated beginning in 2018. On its face, this indicates hedgers and speculators are trading and positioning as if the OPEC - non-OPEC production deal negotiated by the Kingdom of Saudi Arabia (KSA) and Russia in late 2016 will succeed in drawing inventories, leaving the market in a physical deficit this year. Over the short-term, this induced supply shock benefits producers generally. Longer term, KSA and Russia will have to continue to manage supplies if they are to exert any influence on oil prices. This is a three-level game, which now involves U.S. shale-oil producers as a permanent feature of the market. It will be difficult to manage. But the stakes are sufficiently high for KSA and Russia that we believe it has to be played. Energy: Overweight. We closed the first quarter on an up note, with our trade recommendations still open and closed in 2017Q1 up 420.75% on average. Base Metals: Neutral. Striking miners at Freeport McMoRan's Cerro Verde facility in Peru are back on the job, as are workers at BHP's Escondido mine in Chile. Export licensing difficulties at Freeport's Grasberg facility in Indonesia are close to being resolved.1 Precious Metals: Neutral. Our long volatility play in gold is down -32.8%, which, from a macro perspective, indicates markets are not fearful of a Fed-related surprise over the next couple of months. Ags/Softs: Underweight. U.S. farmers' corn planting intentions came in 1mm acres less than expected at 90mm; beans came in at 89.5mm acres, or 1.4mm over expectations; and wheat was up 100k acres at 46.1mm. Stocks remain high, and we remain bearish. Feature KSA, Russia and their allies - OPEC 2.0 - are trying to regain control of oil fundamentals produced by one of the most unlikely combinations of events ever seen in the history of the oil market. This week, we review how we arrived at the market conditions we now confront, and consider a possible strategy evolving out of the production-cutting Agreement (the "Agreement" for short) that may allow them to do so. Current markets conditions were spawned by a surge in EM oil demand in the early part of the 21st century, which met an almost perfectly inelastic supply curve. This took prices from $55/bbl in 2005 to more than $140/bbl by the end of 2008H1 (Chart of the Week). Along the way, some 5mm b/d of DM oil demand had to be destroyed by higher prices to make room for the EM growth depicted in Chart 2, which is taken from an analysis by Hamilton (2009).2 Chart of the WeekEM Consumption Surge, Flat Production ##br##Drove Prices Past $140/bbl Pre-GFC EM Consumption Surge, Flat Production Drove Prices Past $140/bbl Pre-GFC EM Consumption Surge, Flat Production Drove Prices Past $140/bbl Pre-GFC Chart 2High Prices Were Required##br## To Balance Markets Pre-GFC The Game's Afoot In Oil, But Which One? The Game's Afoot In Oil, But Which One? These high prices combined with the post-Global Financial Crisis (GFC) low-interest rate regime into a perfect storm, which allowed the supply side to evolve the shale technology in the U.S. Steadily rising light-tight-oil (LTO) production has profoundly altered the market, forcing OPEC and non-OPEC petro-states to devise a strategy to contain this surge. Whether they can do so is yet to be determined. In this article we consider one strategy that might allow OPEC 2.0 to regain some control over pricing and the rate of growth in shale production, but it is highly dependent on them maintaining production discipline and finding a way to coordinate their production. First, though, a quick review. How Did We Get Here? The GFC dragged all markets lower, leaving oil prices just above $40/bbl by the end of 2008. In the wake of the GFC, central banks led by the Fed pursued massively accommodative monetary policies, which took interest rates to the zero lower bound. OPEC, led by KSA, drastically cut supplies to remove a huge unintended inventory accumulation that developed as demand collapsed (Chart 3). While DM oil demand remained depressed in the wake of the GFC, EM governments, led by China, massively stimulated their economies, which lifted global oil consumption more than 4% by 2010 (Chart 4). Chart 3OPEC Cut Production To Defend Prices, ##br##Make Room For Shale To End-2014H1 OPEC Cut Production To Defend Prices, Make Room For Shale To End-2014H1 OPEC Cut Production To Defend Prices, Make Room For Shale To End-2014H1 Chart 4EM Lifted Global Demand Post-GFC EM Lifted Global Demand Post-GFC EM Lifted Global Demand Post-GFC Growth in global supplies post-GFC, meanwhile, was more measured. OPEC total liquids production from 2009 to 2014 averaged just below 0.05% growth yoy. Part of this meager growth in OPEC production no doubt was explained by lower production from the Cartel resulting from civil war in Libya and nuclear-related sanctions against Iran, which reduced overall output. It also is possible the fall-out from the GFC and the euro-area crisis of 2009 - 2011 kept OPEC producers from committing to higher production as well. Be that as it may, EM demand growth, along with OPEC's lower output, allowed prices to again trade above $100/bbl by 2011 and stay there till mid-2014 (Chart 5). The years-long combination of near-zero interest rates and high oil prices allowed U.S. shale-oil production to advance in leaps and bounds, such that by 2014, yoy light-tight oil (LTO) production from the shales was growing at more than 1mm b/d (Chart 6). Chart 5EM Surge, OPEC Production Moderation##br## Keep Prices Above $100/bbl To 2014H1 EM Surge, OPEC Production Moderation Keep Prices Above $100/bbl To 2014H1 EM Surge, OPEC Production Moderation Keep Prices Above $100/bbl To 2014H1 Chart 6High Prices, Low Interest Rates Propel Shale ##br##Production To 1mm b/d+ Growth By 2014 High Prices, Low Interest Rates Propel Shale Production To 1mm b/d+ Growth By 2014 High Prices, Low Interest Rates Propel Shale Production To 1mm b/d+ Growth By 2014 Now What? OPEC underestimated the magnitude of the shale-oil revolution, as did most observers. However, KSA, the leader of the Cartel, was pre-occupied with geopolitical considerations, chiefly its ongoing proxy wars throughout the Middle East with Iran and its allies. High prices allowed it to build its reserves and fund these proxy wars. This ended when Iran and western powers began negotiating an end to sanctions, which, if successful, would once again allow Iran to access foreign capital and technology to develop its economy.3 As the negotiations to remove sanctions on Iran progressed, KSA led OPEC into a market-share war at the end of 2014, presumably to take back customers lost to shale, particularly in the U.S. We do not believe OPEC's primary aim in declaring a market-share war was to crush U.S. shale output. Indeed, we have consistently maintained the market-share war was more an extension of KSA's and Iran's proxy wars throughout the Middle East, and that KSA was using the pump-at-will strategy to limit revenues that would flow to Iran in the post-sanctions environment. The secondary target of the market-share war was U.S. shale production, but, even then we maintained shale-oil production was needed to keep prices from revisiting $140/bbl-plus levels.4 The market-share war tanked prices, as OPEC increased the quantity of oil it would supply at lower prices. In particular, Saudi Arabia surged production from November 2014, into the collapse of oil prices. Over time, the market-share strategy destroyed high-cost supply worldwide. U.S. shale production fell ~ 15% from a high of ~ 5.3mm b/d in March 2015 in the four largest LTO basins to a low of ~ 4.5mm b/d, by our reckoning, in 2017Q1. At the same time, non-Gulf OPEC production fell dramatically as well, close to 8% in 2016 yoy to an average of 7.7mm b/d. Gulf Arab producers in OPEC and Russia, however, saw production increase 6.5% and 2% yoy, respectively, to close to 25mm b/d and 11.2mm b/d in 2016. In the aftermath of the price collapse, U.S. shale producers retreated to their "core" producing properties - those areas with the lowest-cost, most accessible shale reserves - and dramatically improved their productivity (Chart 7). A collapse in services costs allowed LTO producers to maintain core operations and continue to advance shale-oil technology. At the end of the day, this made the global supply curve more elastic, in that LTO production now allowed higher demand to be met by smaller price increases than had been the case in the lead-up to the GFC. The increased elasticity of supply from U.S. shales, and the increased quantity supply by OPEC is depicted in Chart 8, which picks up from Hamilton's (2009) analysis shown in Chart 2. Chart 7U.S. Shale Productivity Surged ##br##During OPEC's Market-Share War U.S Shale Productivity Surged During OPEC's Market-Share War U.S Shale Productivity Surged During OPEC's Market-Share War Chart 8Global Oil Supply##br## Transformed By 2014H1 The Game's Afoot In Oil, But Which One? The Game's Afoot In Oil, But Which One? OPEC's Market-Share War Failed We contend the KSA - Russia production Agreement negotiated at the end of last year represents an abandonment of OPEC's market-share strategy. If, as recent research suggests, this strategy was an attempt to "squeeze" higher-cost shale production from the market by increasing OPEC crude supplies, it was a failure: The market-share strategy imperiled the finances of OPEC and non-OPEC states heavily dependent on oil revenues to sustain themselves, and left U.S. shale production more resilient than it was prior to the market-share war being declared.5 The surge in shale supplies and in OPEC's quantity supplied to the market during its market-share war, coupled with slower growth following the dramatic increase in EM demand in 2010 - 2012, led to unintended inventory accumulation worldwide, which has kept global storage at record levels. This is the central issue being addressed by the OPEC - non-OPEC production Agreement to remove up to 1.8mm b/d of production from the market. In effect, the KSA - Russia deal is inducing a supply shock to shift the global supply curve back to the left, after it was pushed down and to the right from 2014H2 to 2015H2, as depicted in Chart 9. In and of itself, this should lift and stabilize prices by the end of this year. We expect this induced supply shock will begin to force more visible inventories - e.g., in the U.S. and OECD generally - to draw rapidly. We continue to expect OECD stocks to reach 5-year average levels by year-end 2017, and for prices to reach $60/bbl by year end (Chart 10). We do not believe an extension in OPEC 2.0's production Agreement is needed to achieve this. Chart 9KSA - Russia Deal Is An Induced Supply Shock##br## Intended To Shift The Curve Back To The Left The Game's Afoot In Oil, But Which One? The Game's Afoot In Oil, But Which One? Chart 10Oil Stocks Will Fall To 5-Year ##br##Averages By End-2017 Oil Stocks Will Fall To 5-Year Averages By End-2017 Oil Stocks Will Fall To 5-Year Averages By End-2017 It goes without saying, the parties to OPEC 2.0's production-management deal must maintain production discipline for this strategy to be able to evolve to the next level, where they attempt to restore a measure of price inelasticity to the global supply curve. If they are successful, then they will be able to exercise a degree of control over prices using spare capacity, storage and forward guidance to achieve and defend specific targets. If not, the market will do the hard work of destroying high-cost supply with lower prices. The End Game For KSA - Russia For the KSA - Russia Agreement to affect U.S. shale output over the medium to longer term, they have to coordinate production in a way that keeps WTI prices from rising to the point where shale-oil producers are able to step outside their "core" production areas. We believe over the short term, this price is between $55/bbl and $60/bbl. Our colleague Matt Conlan, of the BCA Energy Sector Strategy, has illustrated that the "true" breakeven for shale producers is much closer to $50/bbl, than the $30/bbl figure oft cited in the media.6 However, above $60/bbl, more costly reserves can be developed and still produce acceptable returns for LTO drillers. Therefore, if prices can be kept below $60/bbl, and the induced supply shock engineered by KSA and Russia causes oil inventories to draw as we expect this year, we believe the resulting backwardation in WTI will limit the rate at which rigs return to the field. In our modeling, we find shale rig counts to be sensitive to the shape of the forward curve for WTI. A backwardated curve translates into fewer rigs returning to the field than a flat or contango curve. In one model we estimated, we found a 10% backwardation from mid-2017 to end-2018 resulted in a rig count that was close to 18% below the rig count that could be expected from a relatively flat forward curve. The only way we see for KSA and Russia to affect the shape of the WTI forward curve over the short term - to end 2018 - is to use their own spare capacity and storage to keep the front of the curve below $60/bbl, and to provide forward guidance that they are able to adjust supply markets over the short- to medium-term in a manner that keeps the forward curve backwardated. This will require short-term production coordination among the states comprising OPEC 2.0, so that refinery demand is met out of current production plus inventories, and that unforeseen outages are remedied quickly. This is a short-term fix. It likely can be implemented this year and carried into next year. However, beyond that, it is difficult to see how KSA and Russia, and their respective allies, will coordinate production, storage operations and forward guidance having never attempted such an effort in the past. However, we are reasonably sure members of OPEC 2.0 are discussing how to implement such coordination. Keeping the front of the curve at a price that dissuades shale producers from expanding beyond their "core" production also will limit the amount of investment that can be made in non-Gulf OPEC production, which already is in decline, and other higher-cost conventional production like deep water.7 This, coupled with the $1-trillion-plus cuts to global capex for projects that would have been producing between 2015 - 2020 resulting from the 2015 - 16 price collapse could produce a supply deficit by 2019 that only can be remedied by significantly higher prices that not only encourage new higher-cost production but destroys demand in the meantime while that production is being developed. Bottom Line: We expect the KSA - Russia Agreement to produce a physical deficit this year that draws OECD oil inventories down by ~ 300mm barrels by year end. We also expect to see deeper coordination among the petro-states that are party to this Agreement - OPEC 2.0 - this year and next, which will keep the WTI forward curve backwardated into 2018. While we expect WTI prices to average $55/bbl to 2020 - and to trade between $45 and $65/bbl most of the time - our level of conviction in that forecast is low beyond 2018. It is not clear OPEC 2.0 can endure beyond the short term (into 2018). We will be watching the response of U.S. shale producers to increasing demand, and increasing decline-curve losses outside the U.S. shales, the Gulf OPEC producers and Russia, where we expect production declines to accelerate. As we have noted often in the past, the loss of more than $1 trillion of capex will place an enormous burden on U.S. shales, Gulf Arab producers in OPEC and Russia. If any one of these cannot deliver higher volumes when called upon, prices could move sharply above $65/bbl after 2018 going forward. Likewise, we will be watching to see if OPEC 2.0 is capable of setting and meeting production and inventory goals. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Assistant hugob@bcaresearch.com 1 Please see "Workers to end strike at Peru's top copper mine Cerro Verde," published March 30, 2017, by miningweekly.com. 2 Please see "Causes and Consequences of the Oil Shock of 2007-08," by James D. Hamilton, in the Brookings Papers on Economic Activity, Spring 2009, particularly pp. 228 - 234. 3 Please see "P5+1 and Iran agree on nuclear negotiation framework in Vienna," published February 20, 2014, by cnn.com. The sanctions were lifted in early 2016; see "Iran nuclear deal: Five effects of lifting sanctions," published January 18, 2016, by bbc.com. 4 For an in-depth analysis of OPEC's market-share war, please see the Special Report entitled "End Of An Era For Oil And The Middle East," published jointly by BCA Research's Commodity & Energy Strategy and Geopolitical Strategy groups on April 9, 2015, available at ces.bcaresearch.com. 5 Please see "Ignore The KSA - Russia Production Pact, Focus Instead On Their Need For Cash," published September 8, 2016, and our "2017 Commodity Outlook: Energy," published December 8, 2016, in which we discuss the toll lower oil prices were taking on oil-dependent states including KSA and Russia. See also "The Dynamics of the Revenue Maximization - Market Share Trade-Off: Saudi Arabia's Oil Policy in the 2014 - 2015 Price Fall," by Bassam Fattouh, Rahmatallah Poudineh and Anupama Sen, published by The Oxford Institute For Energy Studies in October 2015, and "An analysis of OPEC's strategic actions, US shale growth and the 2014 oil price crash," by Alberto Behar and Robert A. Ritz, published by the IMF July 2016. Both papers consider OPEC's market-share war vis-à-vis U.S. shale-oil production, the strategy of squeezing shale producers from the market by increasing supply and lowering prices, and the likelihood for success. 6 Please see BCA Energy Sector Strategy Weekly Report, "Breakeven Analysis: Shale Companies Need ~$50 Oil To Be Self-Sufficient," dated March 15, 2017, available at nrg.bcaresearch.com. 7 Please see "The Other Guys In The Oil Market" in this week's Energy Sector Strategy, which takes an in-depth look at the stagnant-to-declining production in conventional oil-producing provinces outside the U.S. onshore, Middle East OPEC and Russia, available at nrg.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table The Game's Afoot In Oil, But Which One? The Game's Afoot In Oil, But Which One? Summary of Trades Closed In 2016