Geopolitics

… quick’s the word and sharp’s the action. Jack Aubrey1 Idiosyncratic supply-demand adjustments – some induced by head-spinning reversals of policy (e.g., the U.S. about-face on Iran oil export sanctions) – and uncertainty regarding monetary policy and trade will keep volatility in oil, metals and grains elevated in 2019. We remain overweight energy – particularly oil – expecting OPEC 2.0 to maintain production discipline, and for demand to remain resilient.2 We remain neutral base metals and precious metals, seeing the former relatively balanced, and the latter somewhat buoyant, even as the Fed continues its rates-normalization policy. We remain underweight ags, although weather-induced supply stress has reduced the global inventories some. While we continue to favor being long the energy-heavy S&P GSCI on a strategic basis, tactical positioning will continue to dominate commodity investing in 2019. Highlights Energy: Overweight. OPEC 2.0’s 1.2mm b/d of production cuts goes into effect in January vs. October levels, and should allow inventories to resume drawing. Base Metals: Neutral. Fundamentally, base metals are largely balanced, which is keeping us neutral going into 2019. Precious Metals: Neutral. Gold prices will remain sensitive to Fed policy and policy expectations. Palladium prices have soared as a growing physical deficit noted earlier widens.3 If China cuts sales taxes on autos again, demand could soar. Ags/Softs: Underweight. A strong USD will weigh on ag markets, particularly grains, next year. An agreement on contentious Sino – U.S. trade issues could re-open Chinese markets to U.S. exports. However, the arrest of the CFO of China’s Huawei Technologies in Canada for possible extradition to the U.S. complicates negotiations.   Feature Going into 2019, commodity markets once again are sending conflicting signals. While we continue to favor exposure to commodities as an asset class by being long the energy-heavy S&P GSCI index, which fell 6% this year on the back of the collapse in crude oil prices and flattening of the forward curves in Brent and WTI.  Nonetheless, we believe investors will continue to be rewarded by taking tactical exposure on an opportunistic basis. Volatility remains the watchword, particularly in 1H19, for the primary industrial commodities – oil and base metals. While idiosyncratic supply-demand adjustments will drive prices in each market, Fed policy also will contribute to volatility, as the U.S. central bank likely remains the only systemically important monetary authority following through on rates-normalization. In line with our House view, we expect the Fed to deliver its fourth rate hike of 2018 at its December meeting next week, and four additional hikes next year. On the back of Fed policy, we expect the broad trade-weighted USD to rise another 3-5% in 2019, following a 6% increase in 2018 (Chart of the Week). This will supress demand ex-U.S. for commodities priced in USD, by raising the USD cost of these commodities. Chart of the WeekStronger USD Pressures Commodity Demand Stronger USD Pressures Commodity Demand Stronger USD Pressures Commodity Demand Below, we highlight the key themes we believe will dominate commodities in 2019. Oil Markets Still Re-Calibrating Fundamentals We continue to expect global oil demand to remain strong next year, despite the slight downgrading of global GDP growth earlier this year by the IMF. We expect EM import volumes – one of the key variables we track to proxy EM income levels – to hold up in 1H19, which supports our assessment commodity demand will grow, albeit at a slower rate than this year (Chart 2).4 Chart 2Slowing Trade Volumes Might Pre-sage Softer Commodity Demand Slowing Trade Volumes Might Pre-sage Softer Commodity Demand Slowing Trade Volumes Might Pre-sage Softer Commodity Demand In 2H19, we see the volume of EM imports dipping y/y from higher levels, then recovering toward year-end. This indicates the all-important level of EM income – hence commodity demand – will remain resilient, but the rate of growth in incomes will slow. This is confirmed by the behavior of the Global Leading Economic Indicators we use to cross check our EM income expectation via import volumes (Chart 3). Chart 3Global Leading Economic Indicators Lead EM Import Volume Changes Global Leading Economic Indicators Lead EM Import Volume Changes Global Leading Economic Indicators Lead EM Import Volume Changes There is a chance Sino – U.S. trade relations will thaw, which would remove a large uncertainty over the evolution of demand next year. This would be supportive for EM trade volumes generally, particularly imports. However, this is not a given, and we are not assuming any pick-up in demand in anticipation of such a development. We need to see concrete actions, followed by tangible trade improvement first. On the supply side, oil markets still are in the process of re-adjusting to an extraordinary policy reversal by the Trump administration on its Iranian oil-export sanctions last month – i.e., the last-minute granting of waivers to Iran’s largest oil importers. However, following OPEC 2.0’s decision last week to cut 1.2mm b/d of production to re-balance markets in 1H19, we continue to expect prices to recover. Indeed, going into the OPEC 2.0 meeting last week, we had already lowered our December 2018 production estimates for OPEC 2.0, and also reduced 2019 output estimates by ~ 1mm b/d, so the producer coalition’s action did not come as a surprise (Chart 4).5 Chart 4BCA's Global Oil Balances Anticipated OPEC 2.0 Cuts BCA's Global Oil Balances Anticipated OPEC 2.0 Cuts BCA's Global Oil Balances Anticipated OPEC 2.0 Cuts In addition to the cuts by OPEC 2.0, the Alberta, Canada, government mandated production cuts, which will become effective January 1, 2019, to clear a persistent supply overhang that was decimating producers’ revenues in the province. We estimate there is ~ 200k b/d of trapped Alberta supply – i.e., excess production over takeaway capacity (pipeline and rail) – along with ~ 35mm bbls of accumulated excess production in storage the government intends to draw over the course of 2019 at a rate of ~ 96k b/d. This will lower overall OECD inventories, even if the Canadian barrels are transferred south. Net, in addition to the 1.2mm b/d of cuts from OPEC 2.0, the ~ 300k b/d coming from Canada next year will mean close to 1.5 mm b/d of production, or ~1.4mm b/d of actual supply when accounting for the inventory release, is being cut or curtailed from these two sources. We cannot, at this point, forecast over-compliance with the OPEC 2.0 accord, which was one of the signal features of the deal in 2017 and 1H18. The Trump administration’s waivers for Iran’s eight largest oil importers expire May 2019. We view it as highly unlikely the Trump administration will re-impose export sanctions in full on Iranian exports following the expiration of waivers, and fully expect they will be extended at least for 90 days. This is because oil fundamentals will remain tight next year, despite the massive de-bottlenecking of the Permian Basin in West Texas. While an additional 2mm b/d of new takeaway capacity will be added to the region, it will not be fully operational until 4Q19. We have ~ 300k b/d of additional supply coming out of the Permian after the pipeline expansions are done in 2H19. Even as pipeline capacity is filled, the U.S. still needs to significantly increase its deep-water oil-export capacity to get this crude to market.6 Bottom Line: We expect the oil market to re-balance in 1H19, as production falls by ~ 1.4mm b/d – the combination of OPEC 2.0 and Canadian production cuts – and consumption grows by a similar amount. The USD will continue to appreciate next year, which, at the margin, will temper demand growth and prices. Gold: Remaining Long Equity And Inflation Risks Trump Higher Rates in 2019 As the U.S. economic cycle matures and advances into its final innings, we continue to recommend holding gold in a diversified portfolio. U.S. inflationary pressure will surprise to the upside in 2019, per our House view, which will offset the effects of somewhat less accommodative U.S. monetary policy in the U.S. The October equity correction is a reminder that, when rising UST yields drag stocks down in late-cycle markets, gold works as an effective hedge against equity risks, and can outperform bonds. In fact, both of the corrections we saw in 2018 likely were caused by a sharp increase in bond yields. This convexity on the upside and downside is what makes gold our preferred portfolio hedge. Easy Monetary Policy + Rising Rate = Bullish Gold Prices Despite being negatively correlated with interest rates, gold tends to perform well when the fed funds rate is below r-star – known as the “natural rate of interest” – and is rising (Chart 5, panel 1).7 When this happens, policy rates are below the so-called natural interest rate consistent with a fully employed economy, which, all else equal, is inflationary. In these late-cycle environments, gold’s ability to hedge against inflation and equity risks dominate its price formation, while its correlation with U.S. real rates diminishes. Chart 5Gold Will Stay in Trading Range Gold Will Stay in Trading Range Gold Will Stay in Trading Range In our view, gold will remain in an upward trading range until rates become restrictive enough to depress the inflation outlook (Chart 5, panel 2). Our U.S. strategists estimate the equilibrium fed funds rate is at ~ 3%, and project it will rise to ~ 3⅜% by end-2019. Therefore, despite our House view of four rate hikes next year, we expect the U.S. economy to remain in a below-r-star-and-rising phase for most of the year. Consistent with our House view, we believe U.S. inflation is likely to surprise to the upside next year, which will push gold prices higher (Chart 6, panel 1). The U.S. economy remains strong, particularly on the employment front. This means wage growth will work its way through inflation rates. Chart 6U.S. Inflation Likely to Surprise U.S. Inflation Likely to Surprise U.S. Inflation Likely to Surprise Admittedly, this is not the consensus view. Investors are not worried about significantly higher inflation (Chart 6, panel 2). However, our Bond strategists argue that long-maturity TIPS breakeven inflation is stuck below historical levels because of this abnormally low fear of elevated inflation (i.e. > 2.5%). Once inflation starts drifting higher, there will be an upward shift in investors’ inflation expectations. Any short-term dip in inflation on the back of lower oil prices will be transitory, given our view that oil prices will recover next year. If such a transitory dip, or concerns about a global growth slowdown spilling back into the U.S. causes the Fed to pause, we would add to our precious metal view position, given our assessment that this would raise the probability of an inflation overshoot. Lastly, gold prices recently have been depressed by an abnormally high correlation with the U.S. dollar (Table 1). We put this down to speculative positioning: Net speculative positions are stretched for both the U.S. dollar and gold, Table 1Gold Vs. USD Correlations Running Higher Than Normal 2019 Key Views: Policy-Induced Volatility Will Drive Markets 2019 Key Views: Policy-Induced Volatility Will Drive Markets therefore, any change in expectations likely will be amplified by a reversal in positioning (Chart 7). In the medium-term, we expect the gold-dollar correlation to converge back to its average, which would mute the dollar’s impact on gold. This would, all else equal, raise inflation and equity risks factors. Chart 7Spec Positioning Stretched Spec Positioning Stretched Spec Positioning Stretched Bottom Line: We continue to recommend gold as a portfolio hedge for investors, given its convexity – it outperforms during equity downturns, and participates on the upside (albeit not as much). Given our out-of-consensus House view for inflation, we believe gold also will provide a hedge against this risk. Palladium: China Tax Policy Could Lift Price Palladium soared to dizzying heights this year, on the back of an expanding physical deficit (Chart 8). Were it not for the loss of an automobile-tax break in China, which reduced the rate of growth in sales there to unchanged y/y, this deficit likely would have been considerably wider, inventories would have drawn even harder, and palladium prices would have been higher (Chart 9). Chart 8Palladium's Physical Deficit Expanding Palladium's Physical Deficit Expanding Palladium's Physical Deficit Expanding Chart 9Palladium Inventories Collapse Palladium Inventories Collapse Palladium Inventories Collapse Palladium’s demand is mainly driven by its use in catalytic converters for gasoline-powered cars, which dominate sales in the U.S. and China, the world’s two largest car markets (Chart 10). U.S. sales growth has leveled off this year (Chart 11), as has China’s. However, the China Automobile Dealers Association (CADA) is pressing policymakers to reduce the 10% auto sales tax by half, which could keep palladium demand elevated relative to supply, should it happen.8 Chart 10Auto Catalyst Demand Dominates Palladium 2019 Key Views: Policy-Induced Volatility Will Drive Markets 2019 Key Views: Policy-Induced Volatility Will Drive Markets Chart 11China Car Sales Could Revive With Tax Cut China Car Sales Could Revive With Tax Cut China Car Sales Could Revive With Tax Cut Russian producers, led by Norilsk Nickel, supply ~ 40% of the world’s palladium. Markets have been fearful U.S. sanctions could be imposed on Norilsk and other Russian producers throughout the year by the U.S., most recently in re Russia’s seizure of Ukrainian naval vessels in international waters, and over Russia’s response to the threatened withdraw from the Intermediate-Range Nuclear Forces (INF) Treaty by the U.S., which could be keeping a risk premium firmly embedded in palladium prices.9 With platinum trading below $800/oz, or ~ 65% of palladium’s value, autocatalyst makers could begin to switch out their catalysts (Chart 12). Chart 12Platinum Could Fill Palladium Supply Gap Platinum Could Fill Palladium Supply Gap Platinum Could Fill Palladium Supply Gap Base Metals: Trade Tensions, USD Cloud Outlook Base metals remain inextricably bound up with EM income growth. When EM incomes are growing, commodity demand – particularly for base metals – is growing, and vice versa. This typically shows up in EM GDP and import volume levels, which we use as explanatory variables in our base-metals price modeling (Chart 13). Chart 13Base Metals Demand Tied To EM Income, Trade Volumes Base Metals Demand Tied To EM Income, Trade Volumes Base Metals Demand Tied To EM Income, Trade Volumes There are, in our view, two significant risks to EM income growth over the short and medium terms: Sino – U.S. trade disputes, which erupted earlier this year. They carry the risk of spreading globally and unwinding supply chains that have taken decades to develop between DM and EM economies;10 Fed monetary policy, which is immediately reflected in USD levels. A strong dollar raises the local-currency costs of commodities for consumers ex-U.S., and debt-servicing costs in EM economies. In addition, it lowers the local-currency costs of producing commodities ex-U.S., which incentivizes producers to raise production to capture this arbitrage, since they are paid in USD. The trade-war risk remains, despite the agreement between presidents Trump and Xi at the G20 in Buenos Aires to work on a trade deal. Even so, the actual level of tariffs imposed by both sides is trivial relative to the level of global trade, which is in excess of $20 trillion p.a. – ~$17 trillion for goods, $5 trillion for services, according to the WTO (Chart 14). Chart 14Sino – U.S. Tariffs Remain Trivial Relative to Overall Global Trade 2019 Key Views: Policy-Induced Volatility Will Drive Markets 2019 Key Views: Policy-Induced Volatility Will Drive Markets Fed policy, on the other hand, is a threat of far greater moment to EM income growth, and, through this, import volumes, which we use to proxy that growth. The LMEX index, a gauge of base-metals prices traded on the LME, is extremely sensitive to changes in EM import volumes. This is not unexpected, given the income elasticity of trade for EM economies is greater than 1.0. Our modeling finds a 1% increase in EM import volumes translates to a 1.3% increase in the LMEX, which is consistent with the World Bank’s estimate of EM income elasticity of trade.11 Per our House view, we believe markets are too sanguine regarding the possibility of a Sino – U.S. trade deal. Such an event, should it occur, would immediately affect base metals markets, as China accounts for roughly half of base metals demand globally(Chart 15). Market participants’ default setting appears to be the U.S. and China will resolve their trade differences in short order – i.e., by the March 1, 2019, deadline agreed at the G20 meeting – resulting in a win-win for both countries and the world. We are hopeful this view is correct, but we would not take any positions in base metals in expectation of such an outcome. Instead, we think the substantive technological and strategic differences between the two countries, and underlying distrust, will result in a renewed escalation of tensions. Chart 15China Demand Remains Pivotal Base Metals Demand Could Wobble China Demand Remains Pivotal Base Metals Demand Could Wobble China Demand Remains Pivotal Base Metals Demand Could Wobble Bottom Line: We remain neutral base metals going into 2019. Fundamentally, most of the metals in the LME index are in balance, or can get there in short order. The Fed’s rates-normalization policy continues to represent a larger short-term risk to EM income growth than Sino – U.S. trade tensions, but, longer term, we continue to expect tension between the world’s dominant economies to escalate. Ags: Trade Tensions, USD Cloud Outlook That’s not a typo in the sub-head above; ags – particularly soybeans – are dealing with the same headwinds bedeviling base metals. The agreement to work on a trade agreement reached at the G20 summit between the U.S. and China lifted grain markets, and supported the upward trend in grain and bean prices. All the same, Sino – U.S. trade relations are prone to go off the rails at any time. The Buenos Aries understanding, after all, only holds for 90 days. In addition to the hoped-for agreement to resolve trade-war issues, grain prices received support from the signing of the United States-Mexico-Canada Agreement (USMCA). This helped align supply-demand fundamentals globally with prices. Focusing too much on China can obscure the fact that the USMCA, which replaces the North American Free Trade Agreement (NAFTA), eliminated major uncertainties over the fate of U.S. grain exports to Mexico, the second-largest destination for U.S grains, beans and cotton. In fact, Mexico accounts for 13% of all U.S. ag exports (Chart 16).12 Chart 16Trade Negotiations Hit American Farmers Hard 2019 Key Views: Policy-Induced Volatility Will Drive Markets 2019 Key Views: Policy-Induced Volatility Will Drive Markets All the same, the Sino – U.S. trade war is hitting U.S. ags hard, particularly soybeans. The 25% tariff on China’s imports of U.S. grains created two parallel agriculture markets. In one market, China is scrambling to secure supplies, creating a deficit. In the other, U.S. farmers are struggling to market their produce overseas, suffering from storage shortages and in some cases left with no option but to leave their crops to rot. Close to 60% of U.S. bean exports historically went to China. The U.S. – China trade war caused a soybean shortage in Brazil, as demand from China for its crops soared, while a record 11% of American beans are projected to be left over after accounting for exports and domestic consumption (Chart 17). Chart 17Bean Shortage in Brazil, Supply Glut in the U.S. Bean Shortage in Brazil, Supply Glut in the U.S. Bean Shortage in Brazil, Supply Glut in the U.S. A successful resolution to the U.S. – China trade tensions is unlikely to reverse the over-supply of beans globally (Chart 18). In fact, we expect beans stocks-to-use (STU) ratios to build next year, unlike global corn and wheat stocks (Chart 19). This will set a record for the soybean STU ratios, pushing them above 30%. Chart 18Expect Another Bean Surplus Expect Another Bean Surplus Expect Another Bean Surplus Chart 19Bean STU Ratios Will Grow Bean STU Ratios Will Grow Bean STU Ratios Will Grow As is the case for metals, the USD will weigh on ag markets, which will make U.S. exports more expensive than their foreign competition (Chart 20). As is the case for all of the commodities we cover, a strong dollar will weigh on prices at the margin. Chart 20A Strong USD Will Make U.S. Exports Expensive A Strong USD Will Make U.S. Exports Expensive A Strong USD Will Make U.S. Exports Expensive Bottom Line: A thaw in the Sino – U.S. trade war should realign global grain markets, but will not keep soybeans from setting new global inventory records. A strong USD will be a headwind for ag markets, as it is for other commodity markets we cover.     Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1      This is a fictional character in the movie Master and Commander, based on the novels of Patrick O’Brian. 2      OPEC 2.0 is the name we coined for the OPEC/non-OPEC coalition led by the Kingdom of Saudi Arabia (KSA) and Russia.  It was formed in November 2016 to manage oil production. 3      Please see “Silver, Platinum At Risk As Fed Tightens; Palladium Less So,” published by BCA Research’s Commodity & Energy Strategy February 15, 2018.  It is available at ces.bcaresearch.com. 4      Please see “The Role of Major Emerging Markets in Global Commodity Demand,” published as a Special Focus in the IMF’s Global Economic Prospects in June 2018 for a discussion of income elasticities for oil, base metals and other commodities in large EM economies. 5      In our current forecast for 2019, we expect Brent to average $82/bbl next year, and for WTI to trade $6/bbl below that.  Please see “All Fall Down: Vertigo In the Oil Market … Lowering 2019 Brent Forecast to $82/bbl,” published by BCA Research’s Commodity & Energy Strategy November 15, 2018.  We will be updating our supply-demand balances and price forecast next week. 6      At 11.7mm b/d and growing, the U.S. is the largest crude oil producer in the world, having recently eclipsed Russia’s total crude and liquids production of 11.4mm b/d, and the U.S. EIA’s projected 2019 output of 11.6mm b/d.  U.S. crude oil exports hit 3.2mm b/d for the week ended November 30, 2018, an all-time high, according to EIA data.  It is worthwhile recalling crude oil exports were illegal until December 2015.  U.S. product exports totalled 5.8mm b/d for the week ended November 30, and 6.3mm b/d the week before that.  Total U.S. crude and product exports are running ~ 9mm b/d at present, which placed them just above total imports of crude and products – i.e., the U.S. became a net exporter of crude and products at the end of November. 7      The San Francisco Fed defines r-star as the inflation-adjusted “natural” rate of interest consistent with a fully employed economy, with inflation close to the Fed’s target.  r-star is used to guide interest-rate policy consistent with long-term macro goals set by the Fed.  Please see “R-star, Uncertainty, and Monetary Policy,” by Kevin J. Lansing, published in the FRBSF Economic Letter May 30, 2017. 8      Please see “Exclusive: Reverse gear - China car dealers push for tax cut as auto growth stalls,” published by reuters.com October 11, 2018. 9      Please see “Is Norilsk Nickel too big to sanction?” published by ft.com on April 19, 2018, and “U.S. to Tell Russia It Is Leaving Landmark I.N.F. Treaty,” published by nytimes.com October 19, 2018. 10     We discuss this in “Escalating Trade Disputes Pressuring Base Metals,” published July 12, 2018, in BCA Research’s Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 11     For a discussion of the World Bank’s trade elasticities, please see “Trade Wars, China Credit Policy Will Roil Global Copper Markets” published by BCA Research’s Commodity & Energy Strategy June 21, 2018. It is available at ces.bcaresearch.com. 12     Canada makes up a smaller share of U.S. exports, at ~ 2%. Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table Trade Recommendation Performance In 3Q18 2019 Key Views: Policy-Induced Volatility Will Drive Markets 2019 Key Views: Policy-Induced Volatility Will Drive Markets Trades Closed in 2018 Summary of Trades Closed in 2017 2019 Key Views: Policy-Induced Volatility Will Drive Markets 2019 Key Views: Policy-Induced Volatility Will Drive Markets

Highlights The delay to the U.K. parliamentary vote on the current Brexit deal has edged up our assessed probability of no-deal to 20 percent. Our probability-weighted value of the GBP is still around 5 percent higher than today. Nevertheless, the optimal moment to buy the GBP lies ahead, as the Brexit catharsis cannot properly begin until the U.K. parliament expresses its will. Following the recent 35 percent plunge in the crude oil price, both headline and core inflation rates are very likely to fade in the coming months, but this fading is going to be less pronounced in Europe than in the United States. These relative inflation dynamics should give EUR/USD a leg up in 2019. But given the euro area’s connection with the U.K., await more clarity on Brexit before committing to EUR/USD. Chart of the WeekThe Pound Has Decoupled From British Public Opinion On Brexit The Pound Has Decoupled From British Public Opinion On Brexit The Pound Has Decoupled From British Public Opinion On Brexit Feature Please note this report was written before the outcome of Conservative MPs vote of no confidence in Theresa May held on the evening of December 12. To assess the impact of Brexit on the financial markets, we are going to turn to a fundamental concept in physics – the concept of a ‘phase transition’. In physics, a phase transition is a disruptive tipping point at which a body transforms from one state into another. The classic example is when water transforms into ice. If the temperature drops from 10 degrees (Celsius) to a degree or so lower, you will experience no discernible difference in water. Even if the temperature drops to 2 degrees, the difference is only slight. But if the temperature drops to minus 2 degrees, water transforms into ice – and you will experience a huge difference as roads freeze over, pipes burst, and so on… Beware A Sudden Phase Transition We can draw a powerful analogy for how the various forms of Brexit would impact the British economy and financial markets. If the current membership of the EU equates to water at 10 degrees, a ‘Norway plus’ arrangement – European Economic Area (EEA) plus a customs union – might be a temperature only a degree or so lower, a barely noticeable difference. The Brexit deal negotiated by Theresa May (or an amended version of it) might be a temperature of 2 degrees, so a somewhat discernible change. But crashing out of the EU to WTO trading rules would equate to minus 2 degrees, or lower. This Brexit would be hard (Chart I-2). Its properties would be very different. Chart I-2Goods Still Dominate U.K. Exports Goods Still Dominate U.K. Exports Goods Still Dominate U.K. Exports Also important is the speed of the phase transition. If winter arrives gradually, over the course of several weeks, we can generally prepare, and adapt our behaviour and habits. Thereby, we can even enjoy and thrive in a new climate. But if winter arrives overnight, it causes severe disruption and suffering.1 As Brexit reaches its denouement, the options for the future EU/U.K. relationship – full membership of the EU, a ‘Norway plus’ arrangement, the Brexit deal negotiated by Theresa May, or complete and overnight detachment – are each quite differentiated from the perspective of politics and law. For example, EEA plus a customs union is politically sub-optimal compared with the U.K.’s current full membership of the EU which includes the bonus of precious legal opt-outs. However, from the perspective of an investor in the markets, the first three types of arrangement are not really that different (Chart I-3). Only the last type – complete and overnight detachment from the EU – constitutes a severely disruptive phase transition. Chart I-3For Investors, Brexit Simplifies To A Binary Outcome For Investors, Brexit Simplifies To A Binary Outcome For Investors, Brexit Simplifies To A Binary Outcome For Investors, Brexit Simplifies To A Binary Outcome We can simplify the various Brexit possibilities into a binary investment outcome: The complete and overnight detachment ‘no-deal’ outcome – in which GBP/EUR would collapse to below parity. All other outcomes – in which GBP/EUR would initially rally through 1.20, by liberating the BoE to remove its precautionary monetary policy (Chart I-4 and Chart I-5). Chart I-4U.K. Economic Fundamentals... U.K. Economic Fundamentals... U.K. Economic Fundamentals... Chart I-5...Would Require Higher U.K. Interest Rates Absent The Risk Of A No-Deal Brexit ...Would Require Higher U.K. Interest Rates Absent The Risk Of A No-Deal Brexit ...Would Require Higher U.K. Interest Rates Absent The Risk Of A No-Deal Brexit This makes the key question: what is the probability of no-deal? No-deal is the default outcome if a deal or extension to the Article 50 process is not agreed (by both sides) before March 29 2019. Therefore no-deal can happen either if: The U.K. parliament cannot coalesce a majority around a course of action that is also acceptable to the EU27. Or if: The Prime Minister and government – the executive branch – ignores the will of parliament and runs down the clock to no-deal regardless. Looking at the parliamentary arithmetic, it is conceivable that a majority could exist for either ‘Norway plus’, or a new referendum, or no confidence in the current government leading to a general election. As for the Prime Minister ignoring the will of parliament, this is legally possible though politically improbable. Nevertheless, the Article 50 clock is running down. The delay to the parliamentary vote on the current deal, possibly until January 21, has edged up our assessed probability of no-deal to 20%, slightly reducing our probability-weighted value of GBP/EUR to 1.175.2 On a one year horizon, this still offers respectable upside for the GBP versus the EUR or the USD (Chart of the Week). But the Brexit catharsis cannot properly begin until parliament gets a chance to express its will, meaning that the optimal moment to buy the pound still lies ahead. Explaining Central Banks’ Obsession With 2 Percent Inflation Back in 1979, Daniel Kahneman and Amos Tversky formalized a new branch of behavioural finance called Prospect Theory, which would ultimately win Kahneman the Nobel Prize for Economics. One of the key findings of Prospect Theory is that we are incapable of distinguishing the meaning of very small numbers. In the case of price inflation, we cannot really distinguish inflation rates between 0 percent and 2 percent. Anything within this range is indistinguishably perceived as ‘price stability’. Given that we cannot distinguish inflation rates between 0 percent and 2 percent, it is impossible for monetary policy to fine-tune our inflation expectations to a point-target such as 2 percent. And given that it is impossible to fine-tune our inflation expectations, it is also impossible to fine-tune inflation itself to a point-target such as 2 percent. Prospect Theory says it is much wiser to define price stability in terms of an inflation range such as 0-2 percent, because this is how we actually perceive price stability (Chart I-6). But despite this compelling Nobel Prize winning academic evidence, central banks remain obsessed with an inflation point-target, most commonly 2 percent. Why? Chart I-6Price Stability Means An Inflation Range Of 0-2 Percent, Not A Point-Target Price Stability Means An Inflation Range Of 0-2 Percent, Not A Point-Target Price Stability Means An Inflation Range Of 0-2 Percent, Not A Point-Target The reason is that central banks have created a rod for their own back. Once a central bank has staked its credibility in terms of impossibly precise ‘data-dependency’ – such as an inflation point-target – it becomes extremely difficult to move the goalposts without risking accusations of bias, partiality and exceptionalism. Future generations will judge the inflation point-target as one of the monumental errors of early twenty-first century economic policy. But for the time-being this flawed policy will nonetheless govern central bank behaviour, and as investment strategists we must see it in that light.  Following the recent 35 percent plunge in the crude oil price, both headline and core inflation rates are very likely to fade. But this fading is going to be less pronounced in Europe compared with the United States (Chart I-7 and Chart I-8). The main reason is that tax rates on fuel are much higher in Europe compared with the United States, and this attenuates the proportionate pass-through into European retail fuel prices from lower (or higher) oil prices. Chart I-7The Connection Between Falling Oil Inflation And Falling Core CPI Inflation Is Weak In Europe... The Connection Between Falling Oil Inflation And Falling Core CPI Inflation Is Weak In Europe... The Connection Between Falling Oil Inflation And Falling Core CPI Inflation Is Weak In Europe... Chart I-8...But Strong In The U.S ...But Strong In The U.S ...But Strong In The U.S The ECB has, in any case, committed to keep its policy rates on hold for most of 2019. By contrast, the Fed has been on a one hike per quarter tightening path. Hence, relative to this behaviour, the surprise could be that the Fed indicates an open-ended pause in its tightening. Even if this is discounted to some extent, weak prints on reported inflation in the coming months could still move the rates and currency markets. After a spectacular gain for the EUR in 2017, our stance turned broadly neutral in early 2018 by adding a short position in EUR/JPY to counterbalance a 50:50 long position in EUR/USD and SEK/USD. Overall, this has proved to be a successful strategy (Chart I-9). Chart I-9The Euro Consolidated In 2018. Another Leg-Up Is Likely In 2019 The Euro Consolidated In 2018. Another Leg-Up Is Likely In 2019 The Euro Consolidated In 2018. Another Leg-Up Is Likely In 2019 Looking ahead to the first half of 2019, the aforementioned relative inflation dynamics should give EUR/USD another leg up. But given the euro area’s connection with the U.K., await more clarity on Brexit before committing to EUR/USD. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* This week, we have spotted an excellent tactical opportunity in EUR/NZD which is at a technical level that has signaled several previous tuning points. On this basis, the recommended trade is long EUR/NZD setting a profit target of 2.5% with a symmetrical stop-loss. In other trades, long EM versus DM achieved its profit target while long banks versus healthcare reached the end of its 65 day holding also in profit. Against this, long nickel versus palladium and short Australian telecoms versus insurance both reached their stop-losses. This leaves two open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 Long EUR/NZD Long EUR/NZD The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Footnotes 1 This analogy can also apply to the arrival of spring. If the spring thaw arrives in one day, the consequent severe flooding can also cause terrible disruption and suffering. 2 1.225*0.8 + 0.98*0.2 Fractal Trading Model Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights So What? The tech war will continue to disrupt the trade truce. Why? The U.S. and China have legitimate national security concerns about each other’s tech policies. The 90-day trade talks cannot succeed without some compromises on tech issues. Chinese structural reforms could also reduce U.S. concerns over tech transfer. Feature The fanfare over President Donald Trump’s tariff ceasefire, agreed at the G20 summit on December 1, has already proved short-lived. We know now that on the same day President Trump sat down with Chinese President Xi Jinping to negotiate the truce, Canadian authorities arrested Meng Wanzhou, the chief financial officer of Huawei, under a U.S. warrant. Huawei is the world’s biggest telecoms equipment maker, second-biggest smartphone maker, and one of China’s high-tech champions. So far the controversial arrest – which prompted Beijing to make representations to the U.S. ambassador – has not derailed the trade truce. China’s Commerce Ministry has announced that tariffs will be eased and imports of American goods will increase. The CNY-USD has climbed upwards despite a rocky global backdrop in financial markets (Chart 1). Chart 1Currency Part Of The Trade Truce? Currency Part Of The Trade Truce? Currency Part Of The Trade Truce? Nevertheless, Meng’s arrest calls attention to our chief reason for skepticism about the ability of the U.S. and China to conclude a substantive trade deal. In essence, “trade war” is a misnomer for a broader strategic conflict that is centered on the military-industrial balance rather than the trade balance. Trade War? Tech War! The historian Paul Kennedy, in his bestselling The Rise and Fall of the Great Powers, argued that the history of competition between nations is determined by economic and technologically advanced industrial production.1 Eighteenth-century Britain defeated France; Ulysses S. Grant defeated Robert E. Lee; and the U.S., the allies, and Russia defeated Nazi Germany and Imperial Japan. This thesis helps to explain why China’s recent technological acceleration has provoked a more aggressive reaction from the U.S. than its general economic rise over the past four decades. For example, while China is rapidly catching up to the U.S. in research and development spending, it is only spending about half as much as the U.S. relative to its overall economy (Chart 2). If it comes to match the U.S.’s ratio then it will overwhelm it in real R&D investment, at least in dollar value. And R&D is just one of many factors showing that China is eroding the U.S.’s global dominance. Chart 2The U.S. Has Some Competition The U.S. Has Some Competition The U.S. Has Some Competition In September, an inter-agency U.S. government task force initiated by President Trump’s Executive Order 13806 sought to assess the strength of the U.S. defense industrial base and resilience of its supply chains.2 The conclusion was that the U.S.’s military-industrial base is suffering from a series of macro headwinds that need to be addressed urgently. The report cited key domestic issues, such as the erosion of the U.S. manufacturing sector (Chart 3). It argued that the country is rapidly losing the ability to source its defense needs from home, develop human capital for future needs, and surge capabilities in a national emergency. Chart 3Decline Of The U.S. Manufacturing Base Decline Of The U.S. Manufacturing Base Decline Of The U.S. Manufacturing Base However, foreign competition, specifically “Chinese economic aggression,” also holds a central place in the report. The obvious risk is U.S. overreliance on singular Chinese sources for critical inputs, as highlighted during the 2010 rare earth embargo, when Beijing halted exports of these metals to Japan during a flare-up of their maritime-territorial dispute in the East China Sea (Chart 4). Chart 4China’s Rare Earth Supply Chain Leverage U.S.-China: The Tech War And Reform Agenda U.S.-China: The Tech War And Reform Agenda The authors’ point is not simply that China’s near-monopoly of rare earths remains a threat to the U.S. supply chain, but that Beijing’s willingness to leverage its advantageous position in the supply chain to coerce its neighbors could be used in other areas. After all, Washington’s reliance on China is rapidly extending to industrial goods that are critical for U.S. defense supply chains, such as munitions for missiles. But Washington’s greatest fear is China’s move into higher-end manufacturing and information technology – and hence the flare-up in tensions over ZTE and Huawei this year. Bottom Line: Technological sophistication and economic output determine which nations rise and which fall over the course of history. While the U.S. can accept China’s eventually surpassing it in economic output, it cannot accept China’s technological superiority. This would translate into military and strategic supremacy over time. Semiconductors: The Next Battlefront While the U.S. lacks a national industrial policy, Beijing has made a concerted effort to promote indigenous production and innovation. The obvious example is Beijing’s state-backed ascent to the top of the global solar panel market. More broadly, China’s export growth has been fastest in the categories of goods where the U.S. has the greatest competitive advantage (Chart 5). Again, the U.S. concern is not market share in itself, but China’s ability to compete as an economically advanced “great power.” Chart 5China’s Comparative Advantage Threatens U.S. Global Market Share U.S.-China: The Tech War And Reform Agenda U.S.-China: The Tech War And Reform Agenda Semiconductors are rapidly becoming the next major battleground, as China is trying to build its domestic industry and the U.S. is considering a new slate of export controls that could constrict the flow of computer chips to China.3 Semiconductors are critical as the building blocks of the next generation of technologies. The semiconductor content of the world’s electronic systems is ever rising. Breakthroughs such as artificial intelligence and the Internet of Things (IoT) promise to create a huge boost in demand for chips in the coming decades. China’s predicament is that the U.S. and its allies control 95% of the global semiconductor market (Chart 6), and yet China is the world’s largest importer, making up about a third of all imports, and its largest consumer (Chart 7). This is a dangerous vulnerability that China has been working to mitigate. Back in 2014 Beijing launched a $100-$150 billion semiconductor development program and has more or less stuck with it. The Made in China 2025 program projects that China will produce 70% of its demand for integrated circuits by 2030 (Chart 8). Chart 6China’s Chip Makers Are Still Small Fry U.S.-China: The Tech War And Reform Agenda U.S.-China: The Tech War And Reform Agenda Chart 7China Accounts For 60% Of Global Semiconductor Demand U.S.-China: The Tech War And Reform Agenda U.S.-China: The Tech War And Reform Agenda While China-domiciled chip companies have a long way to go, they are rising rapidly, and China has already become a big player in global semiconductor equipment manufacturing (18% market share to the U.S.’s 11%). Chart 8Made In China 2025 Targets U.S.-China: The Tech War And Reform Agenda U.S.-China: The Tech War And Reform Agenda The problem for the U.S. is that semiconductors are one area where China runs a large trade deficit. Indeed, the U.S.’s share of China’s market is somewhat larger than the U.S. share of the global market, suggesting that the U.S. has not yet gotten shut out of the market (Chart 9). Chart 9U.S. Chips Still Have An Edge In China U.S.-China: The Tech War And Reform Agenda U.S.-China: The Tech War And Reform Agenda Moreover, 60% of U.S. semi imports from China and 70% of exports are with “related parties,” i.e. U.S. corporate subsidiaries operating in China. The U.S.’s highly competitive semiconductor industry is the most exposed to the imposition of tariffs (Chart 10). This may explain why so many exemptions were granted to the U.S. Trade Representative’s third tariff schedule: out of $37 billion in semi-related Chinese imports to face tariffs, $22.9 billion were given waivers.4 Chart 10Tariffs Are Harmful To U.S. Chip Makers U.S.-China: The Tech War And Reform Agenda U.S.-China: The Tech War And Reform Agenda The Barack Obama administration, initially faced with China’s disruptive entrance into this sector, determined that the U.S.’s best response would be to “win the race by running faster.” A council on science and technology warned that the U.S. would have to make extensive investments in STEM education, job retraining, manufacturing upgrades, research and development, international collaboration, and export promotion in order to stay ahead.5 However, these initiatives proved to be either too rhetorical (due to policy priorities and gridlock in Washington) or too slow-in-coming to make a difference in light of China’s rapid state-directed investments under the Xi Jinping administration. The Trump administration has obviously taken a more punitive approach. Trump originally focused on China’s alleged currency manipulation and criticized its large trade surpluses with the United States, but his focus has evolved since taking office. Under the influence of U.S. Trade Representative Robert Lighthizer – who is now heading up the 90-day talks – Trump’s complaints have given way to a Section 301 investigation into forced technology transfers, intellectual property theft, and indigenous innovation. This investigation eventually provided the justification for imposing tariffs on $250 billion worth of Chinese imports. Over this time period, it has become clear that there is considerable consensus across the U.S. government, on both sides of the aisle, to take a more aggressive approach with China that includes tariffs, sanctions, foreign investment reviews, and potentially new export controls. Significantly, the high-tech conflict has escalated separately from the trade war: it operates on a different timeline and according to a different set of interests. For example: The ZTE affair: The Commerce Department’s denial order against telecoms equipment maker ZTE came on April 15, even as the U.S. and China were trying (ultimately failing) to negotiate a trade deal to head off the Section 301 tariffs. CFIUS reforms: The U.S. Congress proceeded throughout the summer on its efforts to modernize the Committee on Foreign Investment in the United States, culminating in the Foreign Investment Risk Review Modernization Act (FIRRMA). The Treasury Department released its implementing rules for the law in October, which will take effect even as trade negotiations get underway. The secretive body’s major actions have always been to block deals with China or related to China (Table 1). Table 1U.S. Foreign Investment Reviews Usually Hit China U.S.-China: The Tech War And Reform Agenda U.S.-China: The Tech War And Reform Agenda Chipmaker sanctions: The U.S. Department of Justice indicted Chinese chipmaker Fujian Jinhua Integrated Circuit despite the November diplomatic “thaw” between the two countries in preparation for the G20 summit.6 This action occurred even as top American and Chinese diplomats and generals engaged in talks intended to simmer down strategic tensions in the South China Sea and elsewhere. New export controls: Despite the 90-day trade talks scheduled through March 1, the U.S. government is currently holding public hearings on whether to expand U.S. export controls to cover a range of emerging technologies. These hearings, to conclude on December 19, are being held pursuant to the Export Control Reform Act signed into law in August along with the CFIUS reform. Most recently, the arrest of Meng Wanzhou, the CFO of Huawei, falls into this trend – casting doubt on the viability of the tariff ceasefire and forthcoming trade talks. The incident highlights how the pace, scale, and momentum of the tech conflict are substantial and will be difficult to reverse. Furthermore, the U.S. is building alliances with like-minded Western countries in order to encourage a unified embargo of Huawei, ZTE, and potentially other Chinese tech companies. In particular the U.S. and its allies are trying to block Chinese companies out of their upcoming 5G networks. The U.S. banned Huawei back in 2012, but it fears that allied countries – particularly those that host U.S. military bases – will have their commercial networks compromised by Huawei.7 5G will enable superfast connections that form the basis of the Internet of Things. If Huawei is embedded in 5G networks, it could theoretically gain unprecedented penetration into Western society and industry. Since China’s Communist Party has prioritized the “fusion” of civilian capabilities with military,8 and since the country’s security forces and cyber regulators are authorized to have access to Chinese companies’ critical infrastructures and data at will, American government departments have been soliciting allied embassies not to adopt Huawei as a supplier despite its competitive pricing and customizability. Australia, New Zealand, and Japan have effectively banned Huawei from 5G for their own reasons; the U.K. and others are considering doing the same. The expansion of this coalition creates a difficult backdrop for negotiating a final trade deal by March 1. And yet the G20 ceasefire clearly improved the odds of such a deal. So what will break first, the tech war or the trade ceasefire? Bottom Line: The tech war is intensifying even as the trade war takes a pause. The large-scale U.S. mobilization of a coalition of states opposed to China’s growing presence is a bad sign for the 90-day talks, though so far they are intact. What A Deal Might Look Like To get a sense of whether the tech war will upend the trade talks, or vice versa, we need to consider what a final trade deal that includes the U.S.’s technological demands would look like. It is significant that on November 20, the eve of the G20 summit, U.S. Trade Representative Lighthizer released a report updating the findings of his Section 301 investigation.9 Lighthizer’s position matters because he is leading the 90-day talks and a critical swing player within the administration.3 Lighthizer’s report is essentially the guideline for the U.S. position in the 90-day talks. It makes the following key claims: China has not altered its abusive and discriminatory trade practices since the Section 301 investigation was concluded. These practices include grave accusations of cyber-theft and industrial espionage. The report also argues that China’s state-driven campaign to acquire tech through mergers and acquisitions is ongoing, despite the drop in Chinese mergers and acquisitions in the United States over 2017-18 (Chart 11). The reason, the USTR alleges, is that China tightened controls on investment in real estate and other non-strategic sectors (essentially capital flight from China), whereas Chinese investment to acquire sensitive technology in Silicon Valley is still intense and is being carried out increasingly through venture capital deals (Chart 12). Chart 11M&A No Longer China’s Best Way To Get Tech... U.S.-China: The Tech War And Reform Agenda U.S.-China: The Tech War And Reform Agenda Chart 12...Now Venture Capital Deals Offer A Better Way U.S.-China: The Tech War And Reform Agenda U.S.-China: The Tech War And Reform Agenda China’s concessions so far are “incremental” and in some cases deceptive. For instance, China’s propaganda outlets have de-emphasized the “Made in China 2025” program even though the government is continuing apace with this program, as well as other state-subsidized industrial programs that utilize stolen tech, such as the “Strategic Emerging Industries” (SEI) policy. Not only has China maintained certain targets for domestic market share in key technologies, but modifications to the program have in some cases increased these targets, such as in the production of “new energy vehicles” (Chart 13). Other concessions, such as on foreign investment equity caps, are similarly unsatisfactory thus far, according to the USTR. For instance, China’s pledge gradually to allow foreigners to operate wholly owned foreign ventures in the auto sector is said to arrive too late to benefit foreign car manufacturers, who have already spent decades building relationships under required joint ventures. Chart 13The Opposite Of U.S.-China Compromise U.S.-China: The Tech War And Reform Agenda U.S.-China: The Tech War And Reform Agenda Trade partners share the U.S.’s concerns and are taking actions to address the same problems. In addition to the aforementioned actions on the 5G, the EU is developing foreign investment review procedures for the first time. Foreign industry groups share the U.S. business lobby’s fear of China’s forced tech transfers. Ultimately, Lighthizer’s report shows both that a trade deal is possible and that it will be extremely difficult to achieve: Possible, because while the report touches on deep structural factors underlying China’s practices, it emphasizes technical issues. Since these issues can often be adjusted by degree, there is ostensibly room to bargain. Difficult, because the main takeaway of the report is that the U.S. is giving China an ultimatum to stop cyber theft and industrial espionage. At minimum, the U.S. will demand assurances that China’s military, intelligence, and cyber agencies will rein in their hacking, spying, and tech acquisition campaigns. Other disputes are more susceptible to tradeoffs, but it will be hard for the U.S. to compromise on a list of grievances that so plainly enumerates national security violations. Can China really compromise on aspects of its Made in China 2025 industrial plan? Possibly. What China cannot compromise on is technological advancement in general, since its future economic sustainability and prosperity depend on it. So China may not accept getting shut out of investment opportunities in Silicon Valley. But if the 2025 plan provokes foreign sanctions, then it interferes with China’s technological advance, and hence can be compromised in order to achieve China’s true end. It makes sense for China and the U.S. to focus on the above tech issues – that is, for the “structural” part of the trade talks – as opposed to any macroeconomic structural demands that are more difficult to pull off at a time when China’s credit cycle is exceedingly weak and the economy is slowing. For instance, on China’s currency, while the U.S. will have to have some kind of agreement, and China has already shown it will allow some appreciation to appease the U.S., China is highly unlikely to agree to a dramatic, Plaza Accord-style currency appreciation. Therefore the negotiators will have to accept a nominal agreement on currency practices, perhaps as an addendum as was done with the U.S.-Korea trade renegotiation. As for other strategic tensions, China is continuing to support the Trump administration’s diplomatic efforts with North Korea. Therefore the U.S. is unlikely to get much traction on its demand that China remove missiles from the South China Sea. But unlike cyber theft and corporate hacking, the South China Sea could conceivably be set aside for the purposes of a short-term trade deal and left for later rounds of negotiations, much as Trump’s border wall with Mexico was set aside during the NAFTA renegotiation. Bottom Line: The U.S. is demanding that China (1) rein in its hacking and spying (2) shift its direct investment to less tech-sensitive sectors (3) adjust its Made in China targets to allow for more foreign competition (4) lower foreign investment equity restrictions. Our sense, from looking at these demands, is that a trade deal is possible. But given the underlying strategic rivalry, and the intensity of the tech conflict, we think it is more likely that the tech war will ultimately derail the trade talks than vice versa. China’s Reform And Opening Up Turns 40 Finally, a word about China’s reforms, which are no longer discussed much by investors, given that many of the ambitious pro-market reforms outlined at the 2013 Third Plenum flopped. This month marks the 40th anniversary of China’s “Reform and Opening Up” policies under Deng Xiaoping. The original Third Plenum, the third meeting of the 11th Central Committee at which Deng launched his sweeping policy changes, occurred on December 18-22, 1978. In the coming days, General Secretary Xi Jinping will commemorate the anniversary with a speech. Various party media outlets have been celebrating reform and opening up over the past few months. We have no interest in adding to the hype. But we do wish to highlight the interesting overlap in the deadline for the trade talks, March 1, with the annual meeting of China’s legislature, when new policy initiatives are rolled out. To conclude a substantive trade deal, China needs to make at least a few structural concessions. And to satisfy the Trump administration, these concessions will have to be implemented, not merely promised, since the administration has argued consistently that past dialogues have gone on forever without tangible results. The surest way to achieve such a compromise would be to strike a trade deal and then begin implementation at the appropriate time in China’s own political calendar, which would be the March NPC session – right after the 90-day negotiation period ends. What kind of structural changes might China make? Of the four points outlined above, the one that is likely to get the most traction is lifting foreign venture equity caps (Table 2). This would be substantive because it would remove an outstanding structural barrier to foreign market access – China’s prohibitive FDI environment – while depriving China of a means of pressuring firms into conducting technology transfers. It would also have the added benefit of attracting investment that could push up the renminbi. Table 2China’s Foreign Investment Equity Caps U.S.-China: The Tech War And Reform Agenda U.S.-China: The Tech War And Reform Agenda In this context, we will watch very carefully both for progress in the 90-day talks and for any new and concrete proposals within President Xi’s upcoming economic statements. This includes the annual Central Economic Work Conference as well as the 40th anniversary of the historic Third Plenum. Bottom Line: The basis for a substantial U.S.-China trade deal would be Chinese structural changes to grant the U.S. (and others) greater market access for investment and a safer operating environment for foreign intellectual property. While we remain pessimistic, the reform agenda is important to watch. Investment Conclusions We continue to believe that a final trade deal between the U.S. and China is not likely forthcoming – at least not in the 90-day timeframe. The difficulty of working out a deal with the tech issues above should support this baseline view. Nevertheless, given that there is a possible path forward, and given that Chinese tech stocks are heavily oversold, is now a good time for investors to buy? Our view is no, on a cyclical 6-12 month horizon. Relative to the MSCI China investable index, tech stocks are not so badly beaten down as they first appear (Chart 14). The incredible earnings performance of this sector over the past five years has rolled over lately, as reflected in trailing earnings-per-share. This is true relative to U.S. tech stocks and the global equity market as well (Chart 15). Chart 14China's Tech Selloff In Line With Market China's Tech Selloff In Line With Market China's Tech Selloff In Line With Market Chart 15Tech Earnings Rolled Over Pre-Tariffs Tech Earnings Rolled Over Pre-Tariffs Tech Earnings Rolled Over Pre-Tariffs Since this is a decline in trailing earnings, it does not stem from the trade war, but rather from internal factors like consumer sentiment and retail sales (given the large weights of consumer-related firms like Alibaba and Tencent in this sector). Relative to global tech stocks, Chinese tech has definitely become less expensive after the recent selloff. But they are still not cheap (Chart 16). Given the headwinds outlined above – the fact that the tech war is more likely to derail the trade talks than the trade talks are likely to resolve the tech war – we think it is too early to bottom-feed. Chart 16Tech Stocks Not All That Cheap Tech Stocks Not All That Cheap Tech Stocks Not All That Cheap In short, U.S.-China tensions are rising when looked at from the perspective of, first, China’s aggressive state-backed industrial programs and technological acquisition and, second, the U.S.’s emerging technological protectionism and alliance formation. Two long-term implications can be drawn: First, many of the United States’ complaints stem not only from China taking advantage of its economic openness, but also from the U.S.’s low-regulation environment and opposition to state-driven industrial policy. The U.S. will not have much luck demanding that China stop pouring billions of dollars of government funds into its nascent industries; it will deprive its own emerging sectors of funds if it prevents Chinese investment into Silicon Valley. In other words, the U.S. will have to become less open and more heavily regulated. The CFIUS reforms and the proposed export controls highlight this trend. In addition, any escalation of tensions will likely result in Chinese reprisals against U.S. companies. The U.S. tech sector is the marginal loser (Table 3). Table 3S&P Tech Companies With Large China Exposure U.S.-China: The Tech War And Reform Agenda U.S.-China: The Tech War And Reform Agenda Second, while it is often believed that China is playing “the long game,” the government’s technological acquisition policies suggest a very short-term modus operandi. The allegations of widespread and flagrant use of tech company employees by intelligence agencies, and gross cyber intrusions, if true, imply that China is making a mad dash for technology even at the risk of alienating its trading partners and driving them into a coalition against it. Since no government can overlook the national security implications of such practices, China will continue to suffer from foreign sanctions and embargoes, until it convinces foreign competitors it has changed its ways. As a result, China’s tech and industrial sectors are the marginal losers. The big picture is that the U.S. is setting up a “firewall” of rules and regulations to protect its knowledge and innovation, and China is frantically “downloading” as much data as possible before the firewall is fully operational. This dynamic will be difficult to reverse given that the overall context is one of rising suspicion and strategic distrust.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1      The Rise and Fall of the Great Powers: Economic Change and Military Conflict from 1500-2000 (Random House, 1988). 2      Please see “Assessing and Strengthening the Manufacturing and Defense Industrial Base and Supply Chain Resiliency of the United States,” Interagency Task Force in Fulfillment of Executive Order 13806, September 2018, available at media.defense.gov. 3      Please see U.S. Bureau of Industry and Security, “Review of Controls for Certain Emerging Technologies,” Department of Commerce, November 19, 2018, available at www.federalregister.gov. 4      Please see Dan Kim, "Semiconductor Supply Chains and International Trade,” SEMI ITPC, November 5, 2018. 5      Please see President’s Council of Advisors on Science and Technology, “Ensuring Long-Term U.S. Leadership In Semiconductors,” Report to the President, January 2017, available at obamawhitehouse.archives.gov. 6      Please see Department of Justice, “PRC State-Owned Company, Taiwan Company, and Three Individuals Charged With Economic Espionage,” Office of Public Affairs, November 1, 2018, available at www.justice.gov. 7      Please see Stu Woo and Kate O’Keeffe, “Washington Asks Allies To Drop Huawei,” Wall Street Journal, November 22, 2018, available at www.wsj.com. 8      Please see Lorand Laskai, “Civil-Military Fusion and the PLA’s Pursuit of Dominance in Emerging Technologies,” China Brief 18:6, April 9, 2018, available at Jamestown.org. 9      Please see Office of the United States Trade Representative, “Update Concerning China’s Acts, Policies, And Practices Related To Technology Transfer, Intellectual Property, And Innovation,” dated November 20, 2018, available at ustr.gov.

Feature An infrastructure bill has been the focus of economists and strategists as the next leg in fiscal easing to sustain the economy. On the face of it, such a thesis appears eminently believable. Despite historically low unemployment, 2018 has seen tremendous fiscal easing (Chart 1), both via the tax cuts at the end of 2017 and through the bipartisan spending agreement in early 2018, implying the current administration fears neither inflation nor deficits in its pursuit of economic growth. Further, after the Republicans’ shellacking in the midterm elections, it is also logical to expect the GOP to double down on their Trump card through the 2020 presidential election cycle. Chart 1An Already-Strong Fiscal Thrust An Already-Strong Fiscal Thrust An Already-Strong Fiscal Thrust As such, much hope has been placed in the passage of an infrastructure bill, which began in late 2016 following the election of the Trump administration and its promise “to invest $550 billion to ensure we can export our goods and move our people faster and safer”. The excitement surrounding infrastructure diminished following the passage of the Tax Cuts and Jobs Act and the implied much lower probability of an infrastructure bill in light of the debt implications of the unfunded tax cut. Further, the White House released their infrastructure plan in February, 2018 which sought only $200 billion in funding, but planned to stimulate $1.5 trillion in new investment via the multiplicative effect of public-private partnerships (PPP). However, the midterm elections have made infrastructure a hot topic once again for our clients. Is passage of an infrastructure bill likely? Would such a bill prolong the business cycle? At first glance, the market’s dimmed hopes of an infrastructure bill seem justified, in the context of the already-powerful fiscal thrust. Still, our sister Geopolitical Strategy service believes the odds of passage are above 50%.   BOX 1 Will Trump And The Democrats Pass An Infrastructure Bill? President Donald Trump, laser focused on reelection in 2020, faces a big decision about how to conduct domestic policy in the wake of the midterm election. Will he negotiate and compromise with the opposition in the House, like President Bill Clinton did after 1994? Or will he become mired in disagreements, like President Barack Obama after 2010? Infrastructure spending is one of the few areas where Trump and the Democrats have a clear basis for passing a major piece of legislation. It is much harder for these two to agree on immigration – given Trump’s demand for funding the border wall – or health care – given Trump’s opposition to Obama’s Affordable Care Act (Obamacare). By contrast, Trump campaigned vociferously on the need for more infrastructure and proposed a $1.5 trillion spending plan ($200 billion in federal funds) in February.1 Democrats are fully in support of infrastructure investment. The likeliest next Speaker of the House, Nancy Pelosi (D-CA), has been saying “build, build, build” both before and after the midterms, and her lieutenant, Representative Steny Hoyer (D-MD), has recently emphasized his eagerness to work with Trump on this issue. There is no doubt whether the public will approve – infrastructure spending always receives high levels of support, and it is one of the few policy areas unaffected by partisanship and polarization (Chart 2). Senate Majority Leader Mitch McConnell (R-KY) and Pelosi have begun negotiations and Democratic Representative Peter DeFazio (D-OR), likely the next head of the House Transportation Committee, has already outlined a plan. Chart 2U.S. Public Wants Infrastructure Spending BCA’s Outlook For Infrastructure Stocks BCA’s Outlook For Infrastructure Stocks The chief constraint is funding, obviously. Republicans want to use a limited amount of federal seed money in order to spur public-private partnerships but Democrats want direct federal funding sourced through indexing the federal fuel tax to inflation and issuing government bonds. There will have to be a new Democratic-authored bill, which may or may not merge with aspects of Trump’s plan.  How much money are we talking about? Trump’s plan called for $1.5 trillion over 10 years, of which $200 billion would be federal. Hence $20 billion in federal spending per year, but with cuts to existing programs. Some analysts have argued that Trump’s plan would actually have seen a net reduction in federal infrastructure spending over the long run due to its cuts to existing federal programs (which happen to be infrastructure-oriented) in order to offset his proposed spending increases. Democrats will insist on no cuts to existing programs, plus funding for new building.2   The mainstream Democrats are proposing $100 billion in new spending per year for 10 years, but this number includes zero cuts to existing programs. Mainstream Democrats are therefore asking for less in actual new spending than meets the eye, but are unlikely to go for less than Trump’s $20 billion. As a reference, President Obama’s last budget proposal was looking at $32 billion in federal infrastructure increases per year.3 An agreement on $20-$40 billion per year in new spending is not insurmountable given that both sides agree that they could raise the $0.18 per gallon tax on gasoline, which has not been raised since 1993 and is not indexed to inflation. Trump has proposed raising it by $0.25 per gallon, and this is more than other proposals (at $0.15 per gallon) or than merely indexing to inflation. This would raise an estimated $375 billion over 10 years.4 In addition, the Democrats are looking to revise aspects of Trump’s tax cuts to fund infrastructure. While Secretary of Treasury Steve Mnuchin says no one in the administration is considering paring back the recent sharp reductions in the corporate rate, Trump has already signaled willingness to negotiate on the corporate rate to provide for a middle-class tax cut. This suggests that modifications to his 2017 Tax Cut and Jobs Act are not out of the question as infrastructure funding. Signature pieces of major legislation help presidents get reelected. The tax cuts were a product of traditional conservative policy, with limited popularity, whereas a populist compromise to the tax cuts in order to fund an infrastructure package (as long as it is still a net tax cut from pre-2017) could produce a signature piece of legislation from Trump “the builder” going into 2020. In other words, Trump can refrain from vetoing a federal gasoline tax hike or an adjustment to his own corporate tax cuts in order to pass a popular infrastructure initiative. The Democratic opposition will have written the bill, so both parties would “share the blame.” And the Democrats in the Senate would only need 15-18 GOP Senators to support a profligate infrastructure plan. Given popular and presidential support, and that the GOP-controlled Senate agreed with the budget spending blowout in early 2018, we think that more than enough Republican Senators can go along with an infrastructure plan. The bill will come at a time when other major legislative options are on ice and when both Trump and the Democrats will need at least one achievement to sell to voters in 2020. Might the Democrats sabotage such a bill in order to deny the president any fiscal help ahead of the 2020 election? Possibly. But they would have to pretend to negotiate before pulling out of the deal. It could backfire mightily. Whereas passing a big infrastructure bill would demonstrate their ability to govern and would help them win over voters in the vital Midwestern battleground states, where collapsing bridges and poisonous water systems have made headlines. Bottom Line: There is a greater than 50% chance that a bill will pass. As a baseline estimate, a bill worth $200-$400 billion over ten years is a reasonable estimate for a bill that could pass in late 2019 or (less likely) early 2020. Needless to say, $200-$400 billion over 10 years is a far cry from headline numbers like $1.5 trillion. It is an even farther cry from the progressive Democrats’ “People’s Infrastructure Plan” which calls for $2 trillion over ten years. Net new spending of $20-$40 billion per year is about 10%-20% of existing annual infrastructure spending and only 0.1%-0.20% of American GDP.   In our examination, we will frequently reference the 2009 American Recovery and Reinvestment Act (ARRA), the most recent major infrastructure bill aimed at stimulating the economy. This bill cost $787 billion, of which $500 billion was cash outlays (the remainder was tax incentives). However, only $105 billion of the ARRA was targeted at infrastructure spending ($20 billion per year). Still using the 2009 ARRA as an analogy, the midpoint of high and low estimates from the CBO’s post-mortem of the ARRA’s efficacy, the ARRA added 1.1% to real GDP in 2009, followed by 2.4% in 2010. If we assume the goal of this bill is truly to prolong the business cycle to align with the election cycle, it stands to reason that time is of the essence. Further, the PPP requirements to achieve the $1.5 trillion in new investment envisaged by the White House raise a host of issues. Buy-in from private partners, the associated incremental planning and an assumed dearth of shovel-ready PPP-appropriate projects lead us to believe that a Q1 passage of a bill would be necessary for it to achieve its goals. Lastly, when the 2009 ARRA became effective, the unemployment rate was 8.3%. It is 3.7% now (Chart 3). We would anticipate an inflation-fearing Fed to deliver a monetary response to this fiscal slack in the form of interest rate hikes that would at least partially offset the stimulus. With two opposing forces pushing on the economy, it is ambiguous to us whether the stimulus would, in fact, stimulate. Chart 3Historically Low Unemployment Historically Low Unemployment Historically Low Unemployment What Drives Domestic Infrastructure Stocks Anyway? As equity strategists, our role is to offer clients insights into the best way to play the anticipated fiscal largesse. Accordingly, we have created an index from a range of industrials and materials GICS3&4 indexes that should see a positive reaction to a spur in infrastructure demand; we present the BCA Infrastructure Basket in Chart 4 with details of its constituents included in an appendix following this report. Chart 4BCA's Infrastructure Basket… BCA's Infrastructure Basket… BCA's Infrastructure Basket… Much like the initial excitement surrounding the prospect of an infrastructure bill following Trump’s election, our infrastructure basket leapt in November 2016. However the diminishing hopes of a bill, especially of the size discussed on the campaign trail, are reflected in the basket’s mostly steady decline from its late 2016 peak. This decline accelerated following the passage of the tax cuts at the end of 2017. A reasonable assumption would be that the price of our basket of equities would track in line, by and large, with most leading economic indicators as they are broadly a reflection of the industrial economy. Testing this hypothesis over the past 30 years is revealing: we found no material correlation between domestic leading indicators, even capital expenditures and planned capital expenditures that should be significant top line drivers (Chart 5). The upshot is that domestic private sector sentiment is unrelated to infrastructure stock performance. Chart 5...Is Not Correlated With Leading Indicators ...Is Not Correlated With Leading Indicators ...Is Not Correlated With Leading Indicators When plotted against the historic budget deficit and government debt levels, a better picture emerges (Chart 6). Our inference is that public spending and the infrastructure basket tend to move together, which is corroborated by the aforementioned recent moves around rising and falling hopes for a Trump infrastructure bill. Still, this analysis is incomplete as the infrastructure basket and fiscal growth were inversely correlated between 2004 and 2009 before reestablishing a positive relationship and even then the relationship is relatively loose. Chart 6Fiscal Expansion And Infrastructure Stocks Mostly In Sync Fiscal Expansion And Infrastructure Stocks Mostly In Sync Fiscal Expansion And Infrastructure Stocks Mostly In Sync Accordingly, we widened our analysis to global indicators excluding the U.S., where we found a significantly tighter correlation (Chart 7), though only post-2001. We ascribe the close post-2001 relationship to China’s joining of the WTO and their resulting ascendency in driving equity returns in the emerging market space. Chart 8 confirms our hypothesis; our infrastructure basket and the EM equity index overlap. Chart 7Global Leading Indicators Are Better Global Leading Indicators Have a Tighter Correlation Global Leading Indicators Have a Tighter Correlation Chart 8EM And Infrastructure Go Hand In Hand EM And Infrastructure Go Hand In Hand EM And Infrastructure Go Hand In Hand Drilling down on China seems appropriate in this context and further corroborates our assertion that China is increasingly the driver of U.S. domestic infrastructure stock performance. Particularly in the post-GFC era, the slowdown in Chinese capex and money supply growth appear to be the principal drivers of these stocks (second and bottom panels, Chart 9). This message is echoed when we compare the infrastructure basket to the Chinese credit growth impulse and the Keqiang index (Chart 10). Chart 9Chinese Growth Drives Domestic Infrastructure Stocks Chinese Growth Drives Domestic Infrastructure Stocks Chinese Growth Drives Domestic Infrastructure Stocks Chart 10Slowing Growth In China Points To A Down Leg bca.uses_sr_2018_12_10_c10 bca.uses_sr_2018_12_10_c10 Bottom Line: Domestic private sector sentiment has little impact on the BCA Infrastructure Basket, though U.S. government spending clearly has a significant impact on the performance of the stocks. Still, it appears that Chinese growth is at least as important as domestic government spending to the relative performance of the infrastructure basket. In light of BCA’s view of flat or slowing growth in China, at least for the year ahead, we would wait for a positive catalyst before adding this basket as a holding.  A Value Trap In The Making Investors may correctly point out that our infrastructure basket has already been beaten up and the stage may be set for a relief rally. In fact, the basket has already notched two months of outperformance, lifting it off its decade low relative to the S&P 500 (Chart 11). However, as shown in the middle panel of Chart 12, this rally has come while forward EPS growth estimates have trailed the broad market, meaning that the rally has been exclusively a valuation rerating rather than a fundamental turning point in earnings (bottom panel, Chart 12). Chart 11Fairly Valued Over Long Term... Fairly Valued Over Long Term... Fairly Valued Over Long Term... Chart 12...And A Value Trap In The Short Term ...And A Value Trap In The Short Term ...And A Value Trap In The Short Term Further, while the bear market for this basket of stocks is set to enter its second year, we would caution that a turning point may be further off in the distance than optimists may hope. Witness the six year period from 1995 to 2001 when the infrastructure basket dramatically underperformed the market (Chart 11). Valuations in the infrastructure basket were only a third of the broad market before a rally occurred, a far cry from where they are now. As well, the relative rally likely had more to do with the souring of the tech sector than a particular affection for infrastructure stocks; it took another five years for the basket to reach its average valuation. We would further note that on a longer-term basis, while still a discount to the broad market, valuations remain roughly in line with their historical average (Chart 11). Bottom Line: History has shown bear markets for infrastructure stocks can be deep and prolonged. Thus while the infrastructure basket is relatively cheap compared to the recent past, looking further back in history tells us that this may not be the case. Accordingly, we think the BCA Infrastructure Basket has all the markings of a value trap. So What Does It All Mean The passage of an infrastructure bill seems likely, though the form it will take remains subject to debate. As well, the timing and efficacy of such a bill may mean that it both undershoots expectations with respect to its size and eventual economic impact. The BCA Infrastructure Basket has tended to trade off of domestic fiscal expansion but EM in general and China in particular appear to have taken over as the core drivers of relative stock performance. While bearishness has reigned in this basket for the past year, we caution that this still looks like the early stages of underperformance. We would wait for a positive catalyst in the EM and/or China before chasing the BCA Infrastructure Basket. Details on the composition of this basket are in an appendix that follows.   Chris Bowes, Associate Editor chrisb@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Appendix BCA’s Outlook For Infrastructure Stocks BCA’s Outlook For Infrastructure Stocks Footnotes 1      Please see the White House, “Legislative Outline for Rebuilding Infrastructure in America,” 2018, available at www.politico.com. 2      Please see Jacob Leibenluft, “Three Key Questions About The Trump Infrastructure Plan,” Center on Budget and Policy Priorities, January 30, 2018, available at www.cbpp.org. 3      Please see Senate Democratic Caucus, “Senate Democrats’ Jobs & Infrastructure Plan For America’s Workers,” March 7, 2018, available at www.democrats.senate.gov. 4      Please see Lauren Gardner, Tanya Snyder, and Brianna Gurciullo, “Trump endorses 25-cent gas tax hike, lawmakers say,” Politico, February 14, 2018, available at www.politico.com.

Highlights Deep-seated economic and political forces will undermine the trade truce between China and the United States. U.S. economic momentum is strong enough to allow the Fed to deliver more rate hikes next year than what the market is discounting. Global growth should stabilize by the middle of next year as China picks up the pace of stimulus and the dollar peaks. Until then, a cautious stance towards global equities and other risk assets is warranted. Global bond yields will fall further in the near term, but will rise by a faster-than-expected pace over a horizon of 6-to-18 months. Feature Trade War Roller Coaster Investors breathed a short-lived sigh of relief following the G20 summit in Buenos Aires this past weekend. During the course of a two-and-a-half hour dinner on the sidelines of the summit, President Donald Trump agreed to postpone raising tariffs from 10% to 25% on $200 billion of Chinese imports by two months to March 1st. For his part, President Xi Jinping pledged to engage in substantive talks to open up the Chinese economy to U.S. imports, while addressing U.S. concerns about forced technology transfers and IP theft. In one of the more ironic moments in history, China also agreed to restrict opioid exports to the West. Unfortunately, the euphoria did not last very long. By Tuesday, President Trump was back to his old self, calling himself “Tariff Man” and ominously warning that “We are going to have a REAL DEAL with China, or no deal at all – at which point we will be charging major Tariffs against Chinese product being shipped into the United States.” News reports indicated that the Chinese were “puzzled and irritated” by Trump’s change in tone. The mood brightened on Wednesday. Trump sounded more conciliatory, perhaps reflecting China’s decision to immediately resume importing soybeans and liquefied natural gas from the United States. By Wednesday night, however, global equities were in turmoil again due to revelations that a high-ranking Chinese tech executive had been arrested in Canada at the behest of the U.S. government on suspicion of violating sanctions against Iran. U.S. stocks recouped some of their losses Thursday afternoon, but the S&P 500 still finished down fractionally for the day. Political Stumbling Blocks To A Trade Deal At times like this, it is crucial to focus on the big picture, which is that major hurdles remain to consummating a trade deal that satisfies both sides. As our geopolitical strategists have argued, the trade war is just as much a tech war.1 China wants access to western technology, but the West, fearful of China’s ascent, is reluctant to provide it. The fact that China has had a history of appropriating western technology without due compensation only makes things worse. It is notable that U.S. Trade Representative Robert Lighthizer issued a hawkish report ahead of the summit concluding that China has not substantively changed any of the trade practices that initiated U.S. tariffs.2 Domestic U.S. politics will also undermine prospects for a lasting trade war ceasefire. Protectionism against China remains popular in the U.S., especially in the Midwestern swing states. If Trump agrees on a permanent deal to end the trade war, who will he blame if the trade deficit continues to widen? This is not just idle speculation. Trump’s trade goals are inconsistent with his fiscal policy. Fiscal stimulus will boost aggregate demand, which will suck in more imports. An overheated economy will prompt the Fed to raise rates more aggressively than it otherwise would, leading to a stronger dollar. The result will be a wider trade deficit. This does not mean that Chinese stocks cannot rally for a few weeks. The MSCI China investable index is in oversold territory, trading at less than 11-times forward earnings, compared to 14-times at the start of the year (Chart 1). Given that China represents nearly one-third of EM stock market capitalization, any sentiment-driven rally that pushes up Chinese stocks is likely to give a solid lift to the aggregate EM equity index (Chart 2). However, for EM equities to put in a durable bottom, two things need to happen: Chinese growth needs to stabilize and the dollar needs to peak. We do not see either happening until the middle of next year. Chart 1Chinese Stocks Have Taken It On The Chin Chinese Stocks Have Taken It On The Chin Chinese Stocks Have Taken It On The Chin Chart 2China Is Large Enough To Give EM A Lift Sorry, But The Trade Truce Won’t Last And The Fed Will Keep Hiking Sorry, But The Trade Truce Won’t Last And The Fed Will Keep Hiking Waiting For A Bottom In Chinese Growth The slowdown in Chinese growth this year has been concentrated in domestic demand rather than in trade. Chinese exports to the U.S. have actually increased by 13% in the first ten months of the year compared to the same period last year. A lull in the trade war, a weaker yuan, and lower energy input costs are all beneficial to Chinese exporters. However, the collapse in the new export order component of the Chinese manufacturing PMI suggests that these positive developments will not be enough to prevent exports from decelerating sharply in the first half of 2019 (Chart 3). Chart 3China: An Ominous Sign For Exports China: An Ominous Sign For Exports China: An Ominous Sign For Exports If Chinese growth is to rebound, domestic demand will need to reaccelerate. While the Chinese government has loosened fiscal and monetary policy at the margin, this has not been sufficient to revive animal spirits. Growth continues to sag, as measured by a variety of activity measures (Chart 4). After a brief rebound, credit growth relapsed in October, pushing the year-over-year change to a multi-year low (Chart 5). Chart 4Still Waiting For Growth To Stabilize Still Waiting For Growth To Stabilize Still Waiting For Growth To Stabilize Chart 5The Chinese Credit Spigot Has Not Been Opened The Chinese Credit Spigot Has Not Been Opened The Chinese Credit Spigot Has Not Been Opened Looking out, there is a risk that undue optimism over the resolution of the trade war will prompt the government to redouble its efforts on its reform agenda. This agenda has been focused on reducing debt-financed investment spending – exactly the sort of expenditure commodity producers and capital goods exporters around the world rely on. Ultimately, China will be forced to pick up the pace of stimulus, as it becomes increasingly clear that the economy needs it. However, this is likely to be a story only for the second or third quarter of 2019, suggesting Chinese growth may continue to disappoint until then. No Help From The Fed The equity sell-off on Tuesday was exacerbated by comments by New York Fed President John Williams who noted that the Fed should continue raising rates “over the next year or so.”3 Williams is regarded as one of the thought-leaders at the Federal Reserve. He is also generally seen as a centrist on monetary policy. As such, his words often echo the views of the majority of FOMC members.  Williams said that the U.S. economy was “on a very strong path with a lot of momentum.” We tend to agree with this assessment. Despite weakness in a few areas such as housing, the economy continues to grow at an above-trend pace. The Atlanta Fed’s GDP tracker is pointing to growth of 2.7% in the fourth quarter. Personal consumption is set to rise by 3.4%, one full percentage point above the average during the recovery. The manufacturing sector remains robust. The ISM manufacturing index rose to 59.3 in November from 57.7 the prior month. The all-important new orders component jumped 4.7 points to a three-month high of 62.1. The non-manufacturing ISM index also surprised on the upside. Strong wage growth, lower gasoline prices, and a declining savings rate will boost consumer spending next year. High levels of capacity utilization, easing lending standards, and rising labor costs will also support business investment. Residential investment should stabilize as well, given the recent decline in bond yields (Chart 6). We see the fed funds rate rising by 125 basis points through to end-2019. This stands in sharp contrast to current market pricing, which foresees only 40 basis points of hikes during this period (Chart 7). Chart 6U.S. Residential Investment Should Stabilize U.S. Residential Investment Should Stabilize U.S. Residential Investment Should Stabilize Chart 7The Market Is Ignoring The Fed Dots Sorry, But The Trade Truce Won’t Last And The Fed Will Keep Hiking Sorry, But The Trade Truce Won’t Last And The Fed Will Keep Hiking Don’t Fear A Flatter Yield Curve… Yet The flattening of the yield curve would seem like a major rebuke to our positive U.S. economic outlook. The 10-year/2-year Treasury spread has declined to 14 basis points. The 5-year/2-year spread has fallen into negative territory, marking the first notable inversion of any part of the Treasury curve.  How worried should we be? Some concern is clearly warranted. Policymakers have been too quick to downplay the signal from the yield curve in the past. In 2006, they blamed the “global savings glut” for dragging down long-term yields. In 2000, they argued that the U.S. federal government’s budget surplus was reducing the supply of long-term bonds. In both cases, the bond market turned out to be seeing something more ominous than they were. Nevertheless, one should keep two points in mind. First, part of the recent decline in long-term bond yields reflects a fall in inflation expectations stemming from lower oil prices (Chart 8). As we discussed last week, lower oil prices should give consumers more spending power without hurting energy capex to the degree that they did in 2015.4 Chart 8Oil Price Decline Is Dragging Down Inflation Expectations Oil Price Decline Is Dragging Down Inflation Expectations Oil Price Decline Is Dragging Down Inflation Expectations Second, the term premium – the extra compensation that investors demand for buying long-term bonds compared to rolling over short-term bills – is currently negative (Chart 9). This partly stems from the fact that investors see long-term Treasurys as a good hedge against recession risk (i.e., bond prices tend to go up when the economy weakens). Chart 9The U.S. Term Premium Is Negative Partly Because Bonds Are A Good Hedge Against A Weaker Economy The U.S. Term Premium Is Negative Partly Because Bonds Are A Good Hedge Against A Weaker Economy The U.S. Term Premium Is Negative Partly Because Bonds Are A Good Hedge Against A Weaker Economy Quantitative easing has also driven down the term premium. While this effect has diminished as the Fed’s balance sheet has shrunk, estimates by the New York Fed indicate that the 10-year yield is still 65 points lower than it would have been in the absence of asset purchases.5 If the term premium were 84 basis points – the average between 2004 and 2007 – the 10-year/3-month slope would be 195 basis points. Empirically, the 10-year/3-month slope is the best recession predictor of any yield curve measure. It still stands at 50 basis points. If long-term yields stay put and the Fed raises rates once per quarter, this part of the yield curve will not invert until the second half of next year. It usually takes about 12-to-18 months for an inversion in the 10-year/3-month slope to culminate in a recession (Chart 10). In the last downturn, the slope fell into negative territory in February 2006, 22 months before the start of the recession. This suggests that the next recession will not occur until late 2020 at the earliest. Chart 10The U.S. Yield Curve: An Admirable Track Record In Forecasting Recessions The U.S. Yield Curve: An Admirable Track Record In Forecasting Recessions The U.S. Yield Curve: An Admirable Track Record In Forecasting Recessions Investment Conclusions The signal for global equities from our tactical MacroQuant model has improved since early October, mainly because the sell-off has gone a long way towards discounting some of the negative macro developments that have occurred. Nevertheless, the model continues to signal downside risks for global stocks stretching into early 2019 (Chart 11). Chart 11The MacroQuant Equity Score Has Improved, But Is Still In Bearish Territory Sorry, But The Trade Truce Won’t Last And The Fed Will Keep Hiking Sorry, But The Trade Truce Won’t Last And The Fed Will Keep Hiking The model utilizes a “what you see is what you get” approach, meaning that it only relies on observable data rather than estimates of unobservable variables like the neutral rate of interest. Right now, global growth is decelerating and financial conditions have tightened, which has caused the model to turn bearish on the near-term outlook for stocks. If we are correct that China will be forced to step up the pace of stimulus; that worries over Italian debt will fade, at least temporarily, with an agreement over next year’s budget; and that U.S. growth will remain buoyant even in the face of higher rates (implying that the neutral rate is higher than widely believed), then global growth should stabilize by the middle of next year. The dollar tends to weaken whenever global growth accelerates, which should provide a further reflationary impulse to the world economy (Chart 12). Chart 12Accelerating Global Growth Tends To Be Bearish For The Dollar Accelerating Global Growth Tends To Be Bearish For The Dollar Accelerating Global Growth Tends To Be Bearish For The Dollar Equity bull markets typically end about six months before the onset of a recession (Table 1). If the next global recession does not occur for at least another two years, this will provide enough time for a blow-off rally in stocks starting in mid-2019. Hence, investors should stay tactically cautious towards global equities over a 3-month horizon, but be prepared to turn cyclically opportunistic over a 6-to-18 month horizon. Table 1Too Soon To Get Out Sorry, But The Trade Truce Won’t Last And The Fed Will Keep Hiking Sorry, But The Trade Truce Won’t Last And The Fed Will Keep Hiking Over the past few months, we have argued that bond yields will temporarily decline due to slower global growth amid widespread bearish bond sentiment. This has indeed happened. Yields are likely to remain under downward pressure into early 2019, but should then begin to stabilize and move higher, ultimately rising much more than expected as global inflation accelerates. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1      Please see Geopolitical Strategy Weekly Report, “Trade Truce: Narrative Vs. Structural Shift?” dated December 3, 2018; and “Trump’s Demands On China,” dated April 4, 2018. 2      Please see Office of the United States Trade Representative, “Update Concerning China’s Acts, Policies, And Practices Related To Technology Transfer, Intellectual Property, And Innovation,” dated November 20, 2018, available at www.ustr.gov. 3      Jonathan Spicer, “Fed's Williams says rate hikes 'over next year or so' still make sense,” Reuters, December 4, 2019. 4      Please see Global Investment Strategy Weekly Report, “Shades Of 2015,” dated November 30, 2018. 5      Please see Brian Bonis, Ihrig, Jane, and Wei, Min, “The Effect of the Federal Reserve’s Securities Holdings on Longer-term Interest Rates,” FEDS Notes, Federal Reserve (April 20, 2017). Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

While the trade-war cease-fire agreed at the G20 summit between the U.S. and China boosted grain markets – particularly as China agreed to begin “substantial” purchases from the U.S. – the future of the trade relationship remains uncertain. The agreement to work out an agreement only holds for 90 days, and there’s a lot to get through. An increase in Chinese purchases of U.S. ag products could realign prices for the grains traded on the Chicago Mercantile Exchange with their global counterparts, by reversing the inefficiencies created by the 25% tariffs announced last summer, particularly re soybean trade flows. However, until concrete steps are announced, this remains nothing more than a hope at present. Then there’s the USD. We expect a stronger dollar in 1H19 to continue to weigh on ag markets, by keeping U.S. exports relatively expensive versus foreign competition. We continue to believe the market underestimates the number of rate hikes the Fed will deliver next year – our House view calling for four policy-rate increases next year is higher than the market consensus – and that positive news on the trade front will be offset by relatively tighter financial conditions in the U.S. Highlights Energy: Overweight. We continue to expect OPEC 2.0 to agree cuts of 1.0mm to 1.4mm b/d at its meeting in Vienna today and tomorrow. Our $82/bbl Brent forecast for 2019 remains in place. Base Metals: Neutral. Zinc treatment charges in Asia hit a three-year high of $170 to $190/MT in November, a one-month gain of $50/MT. Chinese smelters are keeping capacity offline in the wake of lower prices for the metal and holding out for higher treatment charges, according to Metal Bulletin. Precious Metals: Neutral. Gold’s rally to $1,240/oz is consistent with a more dovish read on Fed policy. Nonetheless, we continue to expect a December rate hike, and four more next year. Ags/Softs: Underweight. Grain markets are hopeful for a reprieve following the G20 rapprochement between presidents Trump and Xi. However, a strong USD remains a headwind for U.S. exports. Feature Throughout 2018, ag markets have been in the cross-hairs of Sino – U.S. geopolitical warfare. President Trump’s meeting with his Chinese counterpart Xi Jinping at last week’s G20 summit in Buenos Aires is nothing more than an agreement to begin negotiations. Nevertheless, ags – particularly grains – are poised to benefit from a “substantial” increase in Chinese purchases “immediately.” Although uncertainty regarding the U.S. – China trade relationship will drag on into 2019, we are likely to see at least a thaw in ag markets. Apart from trade, U.S. financial conditions will continue to impact ags. More Fed rate hikes than are currently priced in by markets, which will keep the U.S. dollar well bid relative to the currencies of other ag exporters, will weigh on these markets. Weather will remain a wildcard. The World Meteorological Organization (WMO) assigns an 80% probability to an El Niño event occurring this winter, which, in the past, has led to higher volatility in ag markets due to flooding and droughts. Overall we would not be surprised to see some upside in the short term as Chinese consumers resume purchases of American crops. However, this will be muted when markets begin reassessing Fed policy expectations, and pricing in more hikes than the two currently anticipated over the next 12 months. American Farmers Breathe A Sigh Of Relief … In our most recent assessment of ag markets, we argued that while trade policy had weighed on the ag complex, further downside in these markets was unlikely.1 So far, this narrative has played out. Soybeans, corn, and wheat prices fell 22%, 19%, and 11%, respectively between the end of May and mid-July (Chart of the Week). By Tuesday of this week, they had rebounded, gaining 12%, 13%, and 8%, respectively. Chart of the WeekBetter Days To Come? Better Days To Come? Better Days To Come? Grain prices now are more in line with fundamentals. Moreover, the signing of the United States-Mexico-Canada Agreement (USMCA), which replaces NAFTA and eliminates uncertainty in agricultural trade within the North American market, was a market-positive development. The potential breakdown of North American trade was a significant risk to U.S. agriculture: Mexico is the second-largest destination for U.S agricultural exports, accounting for 13% of all U.S. exports of agricultural bulks (Chart 2). Canada makes up a smaller 2% share. Chart 2Trade Negotiations Hit American Farmers Hard Reprieve For Grain Markets Following G20? Reprieve For Grain Markets Following G20? Away from the USMCA, the agreement to a trade truce between the U.S. and China at the G20 summit is a ray of hope. President Donald Trump agreed to postpone hiking rates from 10% to 25% on the second round of tariffs imposed by the U.S. on Chinese imports until March 1, in exchange for a promise by President Xi Jinping to pursue structural changes to its economy, and that China will raise its imports from the U.S. – specifically of agricultural goods. While the current truce could be an opening salvo to a more favorable trade relationship, BCA Research’s geopolitical strategists warn that this development is inconsistent with their structurally bearish view of the U.S. – China relationship. Given the obstacles still in place, they are skeptical that the truce will endure.2 While China did agree to buy “substantial” agricultural products from U.S. farmers immediately, it is still unclear whether China will remove the tariffs on imports of American grains as part of the truce.3 For now, China’s 25% tariff on its imports of U.S. soybeans, corn, and wheat is still in place. Apart from state-owned enterprises acting in response to government orders to purchase U.S. ags, Chinese traders are unlikely to fulfill this promise on their own unless the tariffs are removed. In any case, there are high odds that this will happen – in order to make room for Chinese traders to purchase the grains, as well as to show of good faith in negotiations with the U.S. … Thank You President T The current global ag landscape mirrors the disputes shadowing the world’s two largest economies. The trade rift – highlighted by the 25% tariff on China’s imports of U.S. grains and other ags – has created two parallel agriculture markets. In one market, China is scrambling to secure supplies, creating a deficit. In the other, U.S. farmers are struggling to market their produce overseas, suffering from storage shortages and in some cases left with no option but to leave their crops to rot. This dichotomy is evident in physical markets. Take soybeans, an especially vulnerable crop, given that almost 60% of U.S. exports have traditionally been consumed in China. While Brazil is facing a shortage amid insatiable Chinese demand, a record 11% of American beans are projected to be left over after accounting for exports and domestic consumption (Chart 3). This comes at a bad time as the global trend over the past few years has been an increase in land devoted to soybeans at the expense of corn. Further evidence of the impact of the tariffs are as follows: Chart 3A Soybean Glut In The U.S., Tight Supplies In Brazil A Soybean Glut In The U.S., Tight Supplies In Brazil A Soybean Glut In The U.S., Tight Supplies In Brazil China’s total soybean imports technically do not qualify as having collapsed. However, the 0.5% y/y decline in volumes so far this year is in stark contrast with the average 10% y/y growth over the past four years (Chart 4). Chart 4China Has Been Shunning American Beans Reprieve For Grain Markets Following G20? Reprieve For Grain Markets Following G20? Chinese consumers are clearly avoiding beans sourced in the U.S. China’s soybean imports from America over the September-to-August 2017/18 crop year are significantly lower than last year’s volumes. There is clear seasonality in China’s sourcing of soybeans, with the U.S. crop gaining a larger share in the fall and winter (Chart 5). Nevertheless, this year is a clear outlier. Previously, in October, ~ 20% of China’s soybean imports were generally from the U.S. This year, the share stands at a mere 1%. Instead, China has been relying on Brazilian-sourced beans. Chart 5Unusual Trade Flows For This Time Of Year Reprieve For Grain Markets Following G20? Reprieve For Grain Markets Following G20? These factors are creating strong demand for beans from Brazil, where crushers are reportedly suffering from a lack of soybean supply and tight margins. The premium paid for Brazilian beans over CBOT prices reached a record high in September (Chart 6). Chart 6Record Premiums For Brazilian Beans In 2018 Record Premiums For Brazilian Beans In 2018 Record Premiums For Brazilian Beans In 2018 While Brazilian farmers are benefiting from the U.S. – China standoff, American farmers are suffering significant losses. U.S. soybean exports to the world are severely behind schedule for this time of the year. This is a clear consequence of weak demand from China, which has completely died down (Chart 7). Even though American farmers are searching for alternative destinations to replace China – and despite exports to countries other than China being double last year’s levels for this time of the year – they are not yet sufficient to compensate for the loss of sales there. Chart 7The Rest Of The World Does Not Compensate For Chinese Bean Purchases Reprieve For Grain Markets Following G20? Reprieve For Grain Markets Following G20? A normalization of agricultural trade between China and the U.S. – if it were to emerge as a consequence of the trade truce – would go a long way toward reversing these trends. However, exogenous factors likely will keep soybean prices, in particular, under pressure: Chinese demand for soybeans – which it uses as feed for its massive pig herds – will likely take a hit due to an outbreak of African Swine Flu. Soybean inventories in China have grown significantly (Chart 8). This is a sign that buyers there had been frontloading imports in anticipation of weaker imports from the U.S. over the winter period, when Brazilian supply dies down. Chart 8Chinese Buyers Well Stocked Ahead Of The Winter Chinese Buyers Well Stocked Ahead Of The Winter Chinese Buyers Well Stocked Ahead Of The Winter In addition, Brazilian farmers have raised their soybean plantings for next year. According to latest USDA estimates, Brazilian production in the 2018/19 will come in at 120.5mm MT, up from 119.8mm MT and 114.6mm MT in the previous two years, respectively. Similarly, exports from Brazil are projected to stand at 77mm MT, up from 76.2 and 63.1mm MT, in the previous two years, respectively. In its November World Agriculture Supply and Demand Estimates – published prior to the trade truce – the USDA projected U.S. exports will come down sharply from 59.0mm MT and 58.0mm MT in 2016/17 and 2017/18, respectively, to 51.7mm MT in the 2018/19. As a result, global ending stocks will swell to a record 112.1mm MT in the next crop year. Thus, even if there is a swift resolution to the trade war, soybean supplies will remain abundant, keeping a lid on prices. Even so, a resolution to the trade war likely would return the spread between Brazilian and American bean prices to their historical mean. In fact, globally the soybean market is projected to remain in a surplus again next year – the volume of which represents 4% of total production (Chart 9). As such, inventories measured in terms of stocks-to-use, are projected to continue rising, setting a new record surpassing 30% (Chart 10). Given that soybean supply is in abundance globally, a resolution in the trade war likely will not be accompanied by a significant rebound in soybean prices. Chart 9Another Global Surplus In Beans... Another Global Surplus In Beans... Another Global Surplus In Beans... Chart 10... Will Push Inventories To New Record High ... Will Push Inventories To New Record High ... Will Push Inventories To New Record High On the other hand, corn and wheat, which are less susceptible to trade disputes with China, are expected to be in deficit next year which will bring down their inventories. However, since global stocks levels are already so elevated, we don’t expect much upside on the back of these deficits. Bottom Line: It is too early to call an end to Sino - U.S. trade tensions just yet. However, an increase in Chinese purchases of U.S. ags will go a long way in reversing the inefficiencies created by the 25% tariffs announced last summer. This will move ags traded on the Chicago Mercantile Exchange more in line with their global counterparts. The Other Factors Driving Ags In addition to the trade war, which has created winners and losers out of Brazilian and American farmers, respectively, currency markets are also more favorable for the former compared with the latter. As such, U.S. financial conditions will remain an important determinant of ag prices. The Fed’s monetary policy decisions impact ags both directly – through changes in real rates – as well as indirectly, through the U.S. dollar. We expect the Fed will make decisions consistent with its mandate to contain inflation. As such, there will likely be more interest rate hikes over the coming twelve months than the market’s current expectation of two. This will affect agricultural markets as follows: Higher real rates increase borrowing costs for farmers, discouraging investment, and research and development. Tighter credit can weigh on growth. This depresses consumption and demand for goods and services in general, and to some extent agricultural commodities as well. In addition to this direct channel of impact of Fed policy on the agricultural markets, U.S. monetary policy decisions vis-à-vis the rest of the world will drive ags through its impact on the U.S. dollar. Moreover, weak global growth in 1H19 will keep a floor under the dollar. When global growth lags U.S. growth, it is usually associated with a strong dollar. These factors suggest upside potential for the dollar over the coming 6 months. This will continue as long as U.S. growth outperforms the rest of the world. Since farmers’ costs are priced in local currencies while commodities – and thus sales -- are priced in U.S. dollars, a stronger dollar vis-à-vis domestic currency raises revenues of non-U.S. farmers. This incentivizes plantings, raising supply, and in turn weighing down on prices (Chart 11). This explains the inverse relationship observed between the U.S. dollar and agricultural prices (Chart 12). Chart 11A Strong Dollar Will Incentivize Planting... A Strong Dollar Will Incentivize Planting... A Strong Dollar Will Incentivize Planting... Chart 12...And Weigh Down On Prices ...And Weigh Down On Prices ...And Weigh Down On Prices As always, weather is the wildcard in agricultural markets and can destroy and damage crops. The Australian Bureau of Agricultural and Resource Economics and Sciences (ABARES) recently lowered its wheat production forecast by 11% on the back of a drought. This will be the smallest crop in a decade. The El Niño event expected this winter will likely prolong the drought into early next year. Thus the risk of an El Niño event is especially relevant. This weather phenomenon occurs when there is an increase in sea surface temperatures in the central tropical Pacific Ocean which increases the chances of heavy rainfall and flooding in South America and drought in Africa and Asia. According to the World Meteorological Organization, there’s a 75-80% chance of a weak El Niño forming this winter. This raises the possibility of damage or destruction to crops, which could bid up agricultural prices. Bottom Line: A stronger dollar, at least into 1H19, will weigh on ags. Thus, ag markets will be hit with headwinds as the market begins to appreciate the possibility of a greater number of rate hikes than is currently priced in. This will mute the impact of positive news on the trade front.   Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com Footnotes 1      Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled “Policy Uncertainty Could Trump Ag Fundamentals,” dated July 26, 2018, available at ces.bcaresearch.com. 2      Please see BCA Research’s Geopolitical Strategy Weekly Report titled “Trade Truce: Narrative Vs. Structural Shift?” dated December 3, 2018, available at gps.bcaresearch.com. 3      The USDA has not changed its plan to provide the second round of its aid package to farmers in attempt to offset losses from the trade war. Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table TRADES CLOSED IN 2018 Reprieve For Grain Markets Following G20? Reprieve For Grain Markets Following G20? Trades Closed in Summary of Trades Closed in 2017 Reprieve For Grain Markets Following G20? Reprieve For Grain Markets Following G20?

Highlights The Reserve Bank of Australia (RBA) may consider a rate hike in 2019 if additional tightening of labor markets leads to higher wage inflation, which would help lift core inflation back to the midpoint of the RBA’s 2-3% target band.  Reflation in China could also embolden the RBA to tighten monetary policy – though the odds of a more aggressive stimulus package will decline as long as China’s overall economy remains stable and the U.S. maintains its tariff ceasefire. The Labor Party is favored to win the federal election, which is most likely to occur in May. This is a low-conviction view, as polls are tight and economic improvement will help the ruling Liberal-National Coalition. Feature 2018 has been a challenging year for global financial markets, as investors have had to deal with greater economic uncertainty, less dovish central banks and more volatile asset prices. One country that has bucked the trend to some degree is Australia. The nation has famously avoided a recession since 1991 and last saw a tightening of monetary policy in 2010. While the recession streak is unlikely to be broken in 2019, there are growing risks that the era of interest rate tranquility will soon end. In this Special Report, jointly published with our colleagues at BCA Geopolitical Strategy, we update our views on Australia for 2019 – a year when the investment backdrop has the potential to become far more interesting, and volatile, due to election year uncertainty and a potential shift to a more hawkish bias for monetary policy. The Bond Outlook: What To Watch To Turn Bearish BCA Global Fixed Income Strategy has maintained an overweight stance on Australian government bonds since the end of 2017. That high-conviction view stemmed from our expectation that the Reserve Bank of Australia (RBA) would keep policy rates on hold for longer due to sluggish economic growth and underwhelming inflation. This recommendation has performed well, with Australian government bonds returning 2.4% (currency-hedged into U.S. dollars) in 2018 year-to-date, beating the Bloomberg Barclays Global Treasury index by 190bps. The benchmark 10-year Australian government is now yielding 36bps below the equivalent 10-year U.S. Treasury yield, the tightest spread since 1980 (Chart 1). Chart 1Australian Bonds Have Outperformed Australian Bonds Have Outperformed Australian Bonds Have Outperformed Looking ahead, we still have a positive opinion on Australian debt relative to its global peers over the next six months. The RBA is unlikely to make any adjustments to the Cash Rate - which remains at a highly-accommodative level of 1.5% - without seeing some signs of accelerating inflation in both the Q4 2018 and Q1 2019 CPI reports. This is especially true given the political uncertainty with another federal election due by May 18,1 which could change the outlook for fiscal policy (as we discuss later in this report) and impact the RBA’s economic projections. In our view, the RBA will only be able to seriously consider an interest rate hike, warranting a downgrade of our recommended overweight stance, if all three of the following conditions occur: Australia’s underemployment rate falls below 8% China’s economy shows convincing evidence of reacceleration, especially in commodity-intensive industries like construction Core CPI inflation rises back to at least the midpoint of the RBA’s 2-3% target band We will now discuss each of these in turn. Underemployment Australia is a fairly open economy with a large export sector, but consumer spending is still the largest share of GDP (60%) so it matters most for growth. On that front, real consumption has grown in a narrow and uninspiring range between 2-3% over the past five years. Anemic wages and disposable incomes have been the problem, with the growth of both (in nominal terms) struggling to grow faster than low realized inflation, which now sits below the RBA’s inflation target range of 2-3% (Chart 2). Households have been forced to deploy a greater share of that modest income growth just to maintain spending, with the savings rate plunging from 8% at the end of 2014 to 1% this year and consumer debt piling up. Chart 2An Income-Fueled Pickup In Consumer Spending An Income-Fueled Pickup In Consumer Spending An Income-Fueled Pickup In Consumer Spending The dynamics may be changing in a more positive direction, however. Growth rates of nominal wage (+2.3%) and disposable income (+3.1%) have accelerated this year to a pace faster than inflation. With real incomes perking up, the year-over-year growth rate of real consumer spending growth accelerated to 3% in Q3/2018, driving real GDP growth to similar levels. A sustained pickup in wage growth is necessary before the RBA would even contemplate a rate hike. For that to occur, there must be decisive evidence of a tightening Australian labor market and increased resource utilization. While the headline unemployment rate of 5.0% is below the OECD’s estimate of the full employment NAIRU for Australia (5.3%), broader measures of labor market slack are still at elevated levels. Specifically, the “underemployment” rate, which includes workers who are working fewer hours than they would like or at jobs below their skill levels, is still at an elevated 8.3% (Chart 3). That is down from the peak of just below 9% seen in early 2017, but well above the 2012 trough near 7% (when wage growth was close to 4%).  Chart 3UNDERemployment Rate Matters More For Australian Wages UNDERemployment Rate Matters More For Australian Wages UNDERemployment Rate Matters More For Australian Wages Australian wage growth tends to correlate more with the underemployment rate than the traditional unemployment rate (middle panel). This suggests that the recent blip higher in wage growth could be the beginning of a new trend, given that it has occurred alongside the recent drop in underemployment. Already, underemployment is back below the levels that prevailed when the RBA did its last interest rate cut back in 2016 (bottom panel).  A further dip lower in the underemployment rate to below the 8% threshold would likely confirm that wage growth has more upside. That outcome would give the RBA greater confidence that consumer spending will gain more strength even with a low savings rate, and that CPI inflation will return back into the target range – both outcomes that would justify some removal of the RBA’s highly stimulative monetary accommodation. China Stimulus The main connection from China’s economy to Australia is through Chinese demand for Australian exports. There is also an indirect, but very important, link between Chinese demand boosting industrial commodity prices. The latter boosts Australian growth through positive terms-of-trade effects and increased capital spending in commodity-related sectors like mining. Iron ore is the most important of those commodities, representing 18% of total Australian goods exports, with 85% of those iron ore exports going to China. Australian export growth has decelerated during 2018 from the very robust 15% year-over-year pace to a still solid 10% rate. This has mirrored the trends seen in many other economies, where exports have slowed alongside diminished demand from China. If Chinese authorities change their current policy trajectory, and embrace more aggressive fiscal and credit stimulus, then they will reaccelerate the country’s flagging demand, which should benefit Australian exporters. If the increase in spending occurs in commodity-intensive parts of China’s economy, like construction, then Australia can also benefit from a terms-of-trade impact if commodity prices rise. However, BCA’s Geopolitical Strategy and China Investment Strategy remain skeptical that China will launch a major economic stimulus package along the lines of what occurred in 2015-16. That surge not only boosted Chinese GDP and import demand but also triggered a boost to global industrial commodity prices that benefitted many commodity exporters, including Australia. In recent months, there has been a pickup in overall Chinese import growth, as well as some acceleration of higher frequency growth indicators like the Li Keqiang index (Chart 4). Australian exports to China have not picked up though, and Chinese iron ore imports are contracting. Part of that is due to the elevated levels of Chinese iron ore inventories. More likely, there is little demand for additional iron ore given China’s reform agenda and the struggles of its construction sector (which accounts for roughly 35% of Chinese steel demand). Chart 4China Stimulus Not Helping Australia...Yet? China Stimulus Not Helping Australia...Yet? China Stimulus Not Helping Australia...Yet? Our colleagues at BCA China Investment Strategy2 have noted that both weakening sales and tighter funding sources for real estate developers point to declining growth in property starts and construction. This will be negative for construction-related commodity markets and construction-related machinery. This is coming at a time when the Chinese government is trying specifically to address over-indebted industries like construction. As for the U.S.-China trade truce, a permanent de-escalation of tensions – which has not yet occurred – could provide a boost to Australian export demand, as with other export-focused countries. But the negative impact of bilateral U.S.-China tariffs on the global economy is much smaller than that of China’s attempt to limit indebtedness. Moreover, a trade truce will remove China’s primary incentive to adopt more aggressive stimulus. Nevertheless, from the RBA’s perspective, any boost to China’s construction-related activity would have a big impact on Australia’s economy and would strengthen the case for a rate hike in 2019.  Core Inflation Australia’s headline CPI inflation has struggled to hit even the bottom end of the RBA’s 2-3% target band since 2015, reaching only 1.9% in Q3 of this year (Chart 5). The story is even worse for inflation excluding food and energy, with core CPI inflation now only at 1.2% after having drifted lower in two consecutive quarters. Both market-based and survey-based measures of inflation expectations are also hovering near 2%. Chart 5Australian Inflation Well Below RBA Target Australian Inflation Well Below RBA Target Australian Inflation Well Below RBA Target When breaking down the CPI into tradeables (i.e. more globally-focused) and non-tradeables (i.e. more domestically-focused), the two types of inflation have not been accelerating at the same time since the 2009-11 period. Since then, faster tradeables inflation has occurred alongside slowing non-tradeables inflation, and vice versa.  While volatility on the tradeables side should be expected given the correlation to swings in commodity prices and the Australian dollar, the weakness in non-tradeables is more directly related to the spare capacity in the domestic economy. Therefore, if wage growth continues to pick up as the labor market tightens, then non-tradeables inflation should follow suit and boost Australian CPI inflation back towards the RBA target range. The implication for the RBA is that a move in core CPI inflation back towards 2.5% (the midpoint of the RBA band), occurring after an acceleration in wage growth as described above, would give the central bank confidence that a higher Cash Rate is required. Bottom Line: The RBA has kept interest rates on hold for over two years, but may consider a rate hike in 2019 if additional tightening of labor markets leads to higher wage inflation, which would help lift core inflation back to the midpoint of the RBA’s 2-3% target band. A more aggressive fiscal and monetary stimulus package in China, while not our base case, would also embolden the RBA to tighten monetary policy. Risks From Australian Banks? Throughout 2018, the Australian financial industry has had to endure the slings and arrows of a government inquiry into its questionable business practices and misconduct. Revelations of bribery, fraud, the charging of fees for no service and from the accounts of deceased people, as well as board-level deception of regulators, have roiled Australia's financial sector since the explosive inquiry began in February. The final report of the Australian Financial Services Royal Commission will be published in February, but the impact is already being felt throughout the industry. Bank CEOs have been publically shamed, while other senior financial sector executives have been forced from their jobs. The chairman of National Australia Bank stated before the inquiry that customers’ trust in lenders had been “pretty well eroded to zero”, and that it could take as long as a decade to successfully overhaul the culture within the banks. The biggest impacts from the Commission will come through hits to banks’ earnings and funding costs, as well as the potential impact on lending standards for new loans. Australian banks will be less profitable because of fines, customer refunds, setting aside provisions for potential misconduct penalties and the government wanting increased competition. If banks also choose to be more conservative with the marking of loans, then higher loan-loss provisions could be an additional drag on bank earnings. Already, Australian bank stocks have severely underperformed the overall domestic market, and there has been some slowing of domestic credit growth (Chart 6). There are also signs of bank funding stresses from contracting bank deposit growth (second panel) and wider offshore funding costs like relatively elevated LIBOR-OIS spreads (bottom panel). Considering how heavily Australian banks rely on offshore funding, any squeeze in those markets could severely influence the availability of credit within the Australian economy. Chart 6Australian Banks Under Some Stress... Australian Banks Under Some Stress... Australian Banks Under Some Stress... Looking ahead, if banks do tighten up their lending standards in response to the criticism and findings of the Commission, that will be from a starting point of very accommodative levels. In other words, getting a loan will likely still be “easy”, rather than “incredibly easy”. The reason is that Australian bank balance sheets remain in excellent condition. Credit crunches begin when banks are undercapitalized and are forced to retrench new loan activity as losses on existing loans pile up. That is not the case in Australia, where the major banks have Tier 1 capital ratios in the 10-12% range and non-performing loans are a tiny share of total lending. In our view, a true credit crunch would likely only occur after the Australian housing bubble bursts and the economy enters a severe downturn. That outcome would most likely be triggered by monetary policy tightening via multiple RBA rate hikes. Importantly, some of the steam has already been taken out of Australian house prices thanks to changes in regulations on new lending (Chart 7), potentially reducing some of the immediate risks to growth from a sharp plunge in home values.  Chart 7...But No Credit Crunch Expected ...But No Credit Crunch Expected ...But No Credit Crunch Expected Bottom Line: In 2019, the Australian government and its key financial regulators will have to work together to enforce responsible lending without triggering a catastrophic property market unwind. RBA policymakers are less likely to hike rates given their desire to maintain financial stability in the aftermath of the Commission – or at least until the inflation story forces their hand, as outlined in this report. The Federal Election: Polling Slightly Favors Labor Scandals in the financial sector are of utmost importance to the other major factor that could make 2019 a year of significant change in Australia: the federal election that looms most likely in the spring. Parliament is balanced on a knife’s edge, with the Australian Liberal Party’s loss of former Prime Minister Malcolm Turnbull’s parliamentary seat in a Sydney by-election on October 20. The ruling Liberal-National Coalition no longer has a majority and must rely on independent MPs to survive any no-confidence vote. This precarious situation suggests that the election could come even sooner than May and that the slightest twist in the campaign could deliver at least a small majority to either of the top two parties. Indeed, at this early stage, a high-conviction view on the election outcome is not warranted. After all, the 2016 election was decided in the Coalition’s favor only after a shift in opinion in the final month! Chart 8Labor Party Narrowly Leads All-Party Opinion Polls A Year Of Change In Australia? A Year Of Change In Australia? Nevertheless, with all due caveats, our baseline case is for a Labor majority in 2019, however slim it may be.3 Labor is slightly ahead of the Coalition in the primary opinion polling, which includes all parties (Chart 8). In two-party preference polling, Labor has gradually widened its general lead since the July 2016 election and now holds a 10% advantage in the federal polls – albeit only a 6% lead when a moving average is taken (Chart 9). Labor is also winning or tied in every major state. Chart 9Labor Has Large Lead In Two-Party Preference Polls A Year Of Change In Australia? A Year Of Change In Australia? The dramatic shift in polling since August is significant because that is when the knives came out and the Coalition ousted Turnbull in favor of the current Prime Minister Scott Morrison. The purpose of this move was to give the party a facelift ahead of the election. It is true that public opinion views Morrison as the preferred prime minister to Labor’s Bill Shorten. Shorten has a negative net approval rating and has never been viewed as an inspiring politician, while Morrison is just barely net positive. This perception works against Labor’s lead in the party polling – which is very competitive anyway – and suggests the election will be close. Critically, the Liberal-National Coalition’s polling as a whole has not benefited from the change in leadership. And in fact the data does not support the two major Australian parties’ abiding belief that a leadership coup will boost their popularity: Australia has seen four of these coups since 2010, two from Labor and two from the Coalition, and the party in question lost an average of 8% of the popular vote and 14 seats in parliament in the succeeding election (Table 1). Table 1Intra-Party Coups Don’t Win Votes A Year Of Change In Australia? A Year Of Change In Australia? Turnbull’s ouster also calls attention to another detrimental factor for the Coalition: the challenge on the right flank from minor and anti-establishment parties. Pauline Hanson’s One Nation has a relatively low support rate both historically and in today’s race, currently at 8%, but anti-establishment feeling may have forced the Coalition into an error. Judging by the party’s weak polling since August, the negative response to Turnbull’s ouster has been more detrimental than the nomination of Morrison, an immigration hardliner and social conservative, has been beneficial. Meanwhile, Labor’s momentum has been corroborated by a string of surprise victories in by-elections and a sweeping win in the Victoria state elections on November 24. In the latter case, the party not only defended its hold on government, as one might expect in this progressive state, but exceeded expectations to win 56 seats out of 88 in the lower House, while the Coalition lost nearly half of its seats, falling from 37 to 21. Still, Labor’s lead is by no means decisive. In the average of the various primary polls its edge over the Coalition is within the margin of error. Moreover, the Coalition holds more “safe” (uncompetitive) seats than Labor.4 The bottom line is that a small swing in either party’s favor can produce a thin majority. The Coalition’s best case is the economy. But as concerns about unemployment and job creation recede, voters will make other demands. The top issues in recent polling are the cost of living, health care, housing affordability, and wages. Some polls also emphasize social mobility and climate change and renewable energy. Will Shorten’s Labor Party be able to capture the median voter? It is highly significant that the party has taken a rightward turn on immigration and taxes even as it holds out a more left-wing agenda on health, education, regulation, and social benefits. Immigration has played a major role in Australian politics and Labor is currently positioned near the political center – in other words, if Morrison hardens his line to guard against populists, he risks over-hardening and moving away from the median voter (Chart 10). Shorten has proposed a large bipartisan task force to determine the proper limits to immigration and how to deal with congestion and infrastructure pressures. Shorten’s platform also calls attention to abuse of temporary visas by foreign workers. Chart 10Labor Is Not Too Soft On Immigration A Year Of Change In Australia? A Year Of Change In Australia? On taxes, Shorten has attempted to separate small and big companies, again in a bid for the political center. When Prime Minister Morrison sought to establish his anti-tax credentials (Chart 11), Shorten met him halfway and proposed relief for middle class families and small and medium-sized enterprises. Yet he doubled down on higher taxes for multinational corporations and high-income earners. Chart 11Liberal-National Coalition Cutting Corporate Tax Rates A Year Of Change In Australia? A Year Of Change In Australia? Critically, the latter redistributive stances are more in line with the median voter than the Liberal Party’s more conservative, supply-side, tax cut agenda. All of Australia’s parties, including the increasingly popular “minority parties,” have a more favorable attitude toward redistribution than the Coalition, which is the outlier (Chart 12). Indeed, the National Party is closer in line with the others than the Liberals, highlighting the divisions within the Coalition that have been jeopardizing votes. As for tax cuts on middle income earners and small businesses, Labor’s acceptance of them speaks to voter concerns about living costs, jobs, and wages. Chart 12The Coalition Is Out Of Synch On Taxes A Year Of Change In Australia? A Year Of Change In Australia? Labor is also closer to the median voter on the aforementioned financial sector scandals. The Coalition stands to suffer because it has developed a reputation for being too cozy with the banks (Chart 13). This is one of the biggest perceived differences between the two major parties – in addition to the negative perception of intra-Coalition betrayal – and it is possibly one of the most salient issues in the election. This presents a serious danger for the Coalition. Chart 13Banks: The Coalition’s Ball And Chain A Year Of Change In Australia? A Year Of Change In Australia? What would a Labor government bring? The market will be jittery about Shorten’s attempts to increase tax revenue, which threatens a non-negligible tightening of fiscal policy. Shorten wants to raise taxes on high income earners; remove or lower deductions and discounts (such as on capital gains); crack down on tax evasion; and tighten control over a range of tax practices specific to Australia (limiting “negative gearing” and cutting cash refunds for “franking credits”). He is also taking a tough position on banks and the energy sector. At the same time, it is clear from Labor’s proposals in 2016 (Chart 14) that there will be a hefty amount of new spending coming down the pike if a Labor government is formed – primarily on education, health, infrastructure and job training. The tax cuts that Shorten does support will go to those with a higher propensity to consume, as well as to SMEs that are responsible for job creation. Chart 14Labor’s Spending Plans Unlikely To Change Much A Year Of Change In Australia? A Year Of Change In Australia? Ultimately, Australia’s recent history, taken in consideration with the global business cycle, does not suggest that the Labor Party is all that much more fiscally profligate than the Coalition – but the current budget balance does suggest that there is substantial room to increase deficits, which is convenient for a government that is predisposed to give voters more services (Chart 15). Hence fiscal easing is the path of least resistance - one that could make the RBA even more comfortable in raising interest rates if the conditions laid out earlier in this report come to pass. Chart 15Australia's Next Government Will Have Room To Spend! Australia's Next Government Will Have Room To Spend! Australia's Next Government Will Have Room To Spend! Bottom Line: The Australian Labor Party is slightly favored to win the next Australian election. This is a low-conviction call given the tight competition in public opinion polling and other mixed indicators. Broadly speaking, Labor’s shift to the political center on immigration and some tax issues makes the party more electable relative to the Coalition; meanwhile its promise of more government services fits with voter demands. We do not accept the narrative that Shorten’s Labor Party will engage in substantial fiscal tightening. The path of least resistance is for tax cuts as well as revenue collection, and for greater government spending. On the other hand, if the Coalition capitalizes on the incumbent advantage and stays in power, larger tax cuts will be in store. Hence we expect Australia to see marginally larger-than-expected budget deficits and fiscal thrust as the one reliable takeaway of next year’s election. Fixed Income Investment Implications We continue to recommend an overweight stance on Australian government bonds in currency-hedged global bond portfolios. While we have laid out the conditions that would make us change that view in this report, it is still too soon to position for such a move. Our RBA Monitor, which measures the cyclical pressures on the central bank to change monetary policy settings, is modestly below the zero line (Chart 16). This indicates a need for easier policy, although the indicator is starting to rise driven by the inflation components in the Monitor (bottom panel). In terms of market pricing, there are only 15bps of rate hikes over the next year discounted in the Australian Overnight Index Swap (OIS) curve, so markets are exposed to any shift to a more hawkish bias by the RBA as 2019 progresses. Chart 16Our RBA Monitor Starting To Turn Less Dovish Our RBA Monitor Starting To Turn Less Dovish Our RBA Monitor Starting To Turn Less Dovish Looking purely at Australian government bond yields, the forward curves are priced for very little change in yields over the next year (Chart 17). This suggests that outright duration trades in Australia look uninteresting from a carry perspective of betting against the forwards. We continue to prefer Australian bonds on a relative basis to global developed market peers until there is more decisive evidence pointing to convergence of Australian growth and inflation to the other major economies (bottom panel). Chart 17Stay Overweight Australian Government Bonds Stay Overweight Australian Government Bonds Stay Overweight Australian Government Bonds Over the past year, Global Fixed Income Strategy has recommended tactical trades in Australian money market futures to fade the pricing of RBA hikes that we did not expect to materialize. Specifically, we entered a long position in December 2018 Australian 90-Day Bank Bill futures on October 17, 2017, then switched to a long October 2019 90-Day Bank Bill futures position on May 29, 2017. The latter contract is now trading at implied interest rate levels just above the RBA’s 1.5% Cash Rate (Chart 18), suggesting that there is no more value in this trade.  Chart 18Taking Profits On Our Long Bank Bill Futures Trade Taking Profits On Our Long Bank Bill Futures Trade Taking Profits On Our Long Bank Bill Futures Trade We therefore take a profit of 21bps on the Bank Bill futures trade, while awaiting evidence from the “RBA Hike Checklist” introduced in this report before considering trades that will benefit from a more hawkish central bank.   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Footnotes 1      Technically the House of Representatives election could occur as late as November 2, while the half Senate election is due May 18, but the norm is to hold the election simultaneously. The 2016 election was a “double dissolution” involving the election of the entire Senate and House of Representatives.  2      Please see BCA China Investment Strategy Special Report, “China’s Property Market: Where Will It Go From Here?” dated September 13, 2018, available at cis.bcareserach.com. 3      We would slightly favor Labor leading a slim majority in the Senate as well as in the House. In the Senate, the half of the seats that are up for grabs are evenly split and the polling at this early stage favors Labor over the Coalition. The poor performance of the Greens, in recent polling and in the Victoria state election, suggests a positive development for Labor on the margin, whereas One Nation, whose polls are improving, poses a threat to the Coalition. 4      Labor is fighting for 15 “marginal” (hotly contested) seats and 28 “fairly safe” seats, while the Coalition is only fighting for 12 marginal seats and 14 fairly safe seats.  

Highlights So What? The U.S.-China tariff ceasefire is a net positive, but a final deal is by no means assured. Why? In the near term there may be a play on global risk assets, but beyond that we remain cautious. Global divergence remains the key theme, and China now has less reason to stimulate. What to watch for a final deal: Trump’s approval rating, China’s structural concessions, and geopolitical tensions. We recommend booking gains on our long DM / short EM trades. Go long EM oil producers on OPEC 2.0 cuts. Feature U.S. President Donald Trump and Chinese President Xi Jinping have agreed to a trade truce at the G20 summit in Buenos Aires. The deal includes: Tariff Ceasefire: A 90-day ceasefire – until March 1 – on hiking the second-round tariffs from 10% to 25% on $200bn of Chinese imports. Substantive Talks: The talks will center on structural changes to the Chinese economy, including forced tech transfer, IP theft, hacking, and non-tariff barriers. Vice-Premier Liu He, Xi Jinping’s key economics and trade advisor, may visit Washington in mid-December. Imports: China has agreed to import more goods to lower the U.S. trade deficit, including agricultural and capital goods. This harkens back to the failed May 20 “beef and Boeings” deal. As with the previous deal, there are no deadlines or quantities promised. Not included in the two-and-a-half-hour dinner between Trump and Xi was a substantive discussion on geopolitical tensions. While Chinese statements following the summit did reaffirm Chinese commitment to the U.S.-North Korean diplomacy, there was no broader agreement on tensions, particularly in the South China Sea. The U.S. has recently demanded that China demilitarize the area. Should investors “play” the summit? Tactically, there is an opportunity to play global risk assets in the near term. Cyclically and structurally, however, both economic fundamentals and the underlying trajectory of U.S.-China relations call for caution over the course of 2019. Will The Truce Hold? There are five reasons to doubt the sustainability of the truce: Trade imbalance: It is highly unlikely that the trade imbalance between China and the U.S. can be substantively altered over the course of 90 days. The U.S. economy is in “rude health,” the USD is strong, unemployment is low and pushing up wages, and the output gap is closed. These are the macroeconomic conditions normally associated with an elevated trade imbalance (Chart 1). Chart 1Trade Deficit To Rise Despite Tariffs Trade Deficit To Rise Despite Tariffs Trade Deficit To Rise Despite Tariffs Domestic politics: The just-concluded midterm election saw no opposition to President Trump on trade. The Democratic Party candidates campaigned against the president on a range of issues throughout the election season, but not on the issue of his aggressive China policy. Polling from the summer also shows that a majority of American voters consider trade with China unfair, unlike trade with other countries (Chart 2). As such, President Trump will have to produce a convincing deal in order to ensure that his base, and many Democrats, support the deal. Chart 2Americans Are Focused On China As Unfair Trade Truce: Narrative Vs. Structural Shift? Trade Truce: Narrative Vs. Structural Shift? Structural tensions: U.S. Trade Representative Robert Lighthizer issued a hawkish report ahead of the G20 summit concluding that China has not substantively changed any of the trade practices that initiated U.S. tariffs.1 The report was an update to the original investigation that launched the Section 301 tariffs against China. Lighthizer’s report therefore provides a road-map for what the U.S. will want to see over the course of 90 days. High-tech transfers: The Department of Commerce announced on November 19 a “Review of Controls for Certain Emerging Technologies.” This review will conclude on December 19 when the public comment period ends. In the report, the federal government lists biotech, AI, genetic computation, microprocessors, data analytics, quantum computing, logistics, 3D printing, robotics, hypersonic propulsion, advanced materials, and advanced surveillance as technologies with potential “dual-use” that may be critical to U.S. national security and thus might merit consideration for export control.2 As such, the U.S. may decide to impose export controls on technologies that China deems critical to accomplishing its “Made in China 2025” goals within the period of the 90 day talks. If those export controls were to include critical items – such as semiconductors, which are critical to China’s export-oriented manufacturing (Chart 3) – negotiations may become more complicated. Geopolitics: The trade truce did not contain any substantive resolution to ongoing strategic tensions between the U.S. and China. These tensions precede President Trump: we have detailed them in these pages since 2012.3 As such, the U.S. defense and intelligence community will have to be on board with any trade deal and that may suggest that Beijing will be asked to make geopolitical concessions over the course of the next 90 days. Chart 3China Accounts For 60% Of Global Semiconductor Demand Trade Truce: Narrative Vs. Structural Shift? Trade Truce: Narrative Vs. Structural Shift? Despite the above, the trade truce is a meaningful and substantive move away from an open trade war. Yes, the U.S. will retain tariffs on $250bn Chinese imports, with China maintaining tariffs on $66bn of U.S. imports (Chart 4). No, the U.S. did not rule out a third round of tariffs covering the remaining $267 billion of Chinese imports, if things go awry. Nevertheless, the 90-day truce implies that the U.S. will not ratchet up the tensions for now. Chart 4U.S.-China Trade Hit By Tariffs Trade Truce: Narrative Vs. Structural Shift? Trade Truce: Narrative Vs. Structural Shift? The truce also allows China to make substantive changes to its domestic economic policies that may satisfy some of the structural concerns cited in the above U.S. Trade Representative report. The soundest basis for a durable deal lies in China recommitting to structural reforms: this would both be positive for China’s productivity and would assuage some of Washington’s underlying anxieties about China’s state-backed industrial policies. Significantly, China’s Ministry of Foreign Affairs now says that it will “gradually resolve the legitimate concerns of the U.S. in the process of advancing a new round of reform and opening up in China.” When would this new round of reform occur? The upcoming Central Economic Work Conference, and the 40th anniversary of Deng Xiaoping’s reforms, should be watched closely for new initiatives. Also, the new March 1 tariff deadline lines up with the calendar for China’s National People’s Congress (NPC). The NPC meets every year and is the occasion when any major new domestic reforms would need to be laid out. Thus, any Chinese compromises on structural issues could be rolled out as part of a more general reform agenda in March. This is important because the U.S. administration is determined to focus on implementation and not to let China delay resolution of differences through endless rounds of dialogue. As such, investors should watch the following issues over the course of the next three months in order to gauge the likelihood of a substantive deal that not only rules out new tariffs but also rolls back the existing ones: Polls: President Trump is focused on his 2020 reelection. As such, he will want to see political gains from the easing of pressure on China, both in the general populace and amongst his GOP base (Chart 5). A slump in the polls, or a threatening turn in the Mueller investigation, may justify a shift in the narrative come March-April and thus end the truce. Chart 5Trump’s Approval Will Affect Trade Talks Trade Truce: Narrative Vs. Structural Shift? Trade Truce: Narrative Vs. Structural Shift? Big ticket announcements: China is going to have to make big-ticket item purchases. A huge order of Boeing airplanes, a massive ramp-up in the purchase of agricultural products, a raft of direct investments in manufacturing in the heartland … these are the type of announcements that President Trump could use to sell a substantive deal to his base. Structural changes to the Chinese economy: China will have to prove that it is addressing the concerns outlined in the U.S. Trade Representative report. We suspect that Lighthizer issued the report ahead of the G20 summit so as to set the benchmark for what the U.S. wants to see from Beijing. It is a high benchmark as it includes: An end to cyber theft, hacking, and corporate espionage; Substantive, rather than merely “incremental,” improvements to U.S. market access, including increased ownership of ventures; Serious changes to state-subsidized industrial programs that utilize stolen technology, particularly the so-called “Strategic Emerging Industries” program and “Made in China 2025”; An end to China’s state-backed investment campaign in Silicon Valley. No new U.S. embargoes: The public comment period for the newly proposed U.S. export controls ends on December 19. That suggests that high-tech restrictions could emerge over the course of the first quarter of 2019. These could exacerbate tensions. No new geopolitical tensions: Geopolitical tensions, such as over human rights in Xinjiang or the militarization of the South China Sea, would obviously make a deal less likely.  Bottom Line: The trade truce could lead to a substantive trade deal between China and the U.S. However, many impediments remain. Investors have to answer three key questions: is the deal politically useful for President Trump ahead of the 2020 election? Does the deal resolve the concerns laid out in the U.S. Trade Representative’s Section 301 report? And will geopolitical and national security tensions ease? Since 2012, we have had a structurally bearish view of the Sino-American relationship. This view is based on long-term structural factors that we do not think can be resolved over the course of 90 days. That said, every structural view can have cyclical deviations. The question we now turn to is how to play such a cyclical deviation in terms of the markets. What Does The Truce Mean For The Markets? In our view, the trade war has been of secondary importance to global markets. Far more relevant to the BCA House View that DM assets will outperform EM has been our conclusion that U.S. and Chinese economies would experience policy divergence. The U.S. economy has been buoyed by pro-cyclical stimulus, whereas Chinese policymakers have created a macro-prudential framework that has impaired the country’s credit channel. This divergence has led to the outperformance of the U.S. economy over the rest of the world, leading to a substantive USD rally (Chart 6). Chart 6U.S. Outperformance Should Be Bullish USD U.S. Outperformance Should Be Bullish USD U.S. Outperformance Should Be Bullish USD While this view has worked out well in 2018, it appears to be fraying as the year comes to the end: Chart 7U.S. Growth Weakening? U.S. Growth Weakening? U.S. Growth Weakening? Fed dovishness: Our recent travels to Asia, the Middle East, Europe, and the Midwest have revealed unease among investors regarding the health of the U.S. economy. Some recent data, such as the woeful core durable goods orders (Chart 7) and weak housing, have prompted calls for a more dovish Fed. On cue, Fed Chair Jay Powell delivered what was perceived as a dovish speech. BCA’s Chief Global Strategist, Peter Berezin, makes a strong case for why investors should fade the enthusiasm.4 Specifically, Peter thinks that investors are focusing too much on the unknown – the neutral rate – and not enough on the known – the budding inflationary pressures (Chart 8). Nonetheless, in the near-term, the narrative of a “Fed pause” may overwhelm the data. Chart 8Does The Fed Like It Hot? Does The Fed Like It Hot? Does The Fed Like It Hot? Chart 9Fiscal Policy Becomes More Proactive Trade Truce: Narrative Vs. Structural Shift? Trade Truce: Narrative Vs. Structural Shift? Chinese stimulus: Evidence of a broad-based, irrigation-style, credit stimulus is scant in China’s data. Nonetheless, many investors we have met on the road are latching on to higher local government bond issuance (Chart 9) and a positive M2 credit impulse (Chart 10). Moreover, Q1 almost always brings a boost in new lending in China. Our colleague Dhaval Joshi, BCA’s Chief European Strategist, has recently pointed out that the global credit impulse has hooked up, suggesting that EM underperformance is over (Chart 11).5 We do not think that China can turn the corner on a slumping economy without a substantive increase in its total social financing, which remains subdued both in growth terms and as a second derivative (Chart 12). However, we concede that the narrative may have shifted sufficiently in the near term to warrant some tactical caution on our cyclical House View. ​​​​​​​Chart 10China's M2 Turned Positive China's M2 Turned Positive China's M2 Turned Positive Chart 11An Up-Oscillation In Global Credit Growth Technically Favours EM An Up-Oscillation In Global Credit Growth Technically Favours EM An Up-Oscillation In Global Credit Growth Technically Favours EM Trade truce: Trade concerns have had a clear impact on the outperformance of U.S. equities relative to the rest of the world (Chart 13). As such, a trade truce may alter the narrative sufficiently in the near term to change the direction. In this report, we cite why we are cautious regarding the truce leading to a substantive deal. However, we are biased by our structural perspective that Sino-American tensions are unavoidable. The vast majority of our clients and global investors does not share this view. In fact, the trade war has caught the investment community by surprise. As such, we would argue that investors are biased towards a “win-win” scenario. Therefore, investors may not be cautious, but may in fact project a much higher probability of a final deal into their market decisions. Chart 12China's Total Credit Is Weak China's Total Credit Is Weak China's Total Credit Is Weak Chart 13U.S. Is Winning The Trade War U.S. Is Winning The Trade War U.S. Is Winning The Trade War Over the course of 2019, we do not think the global risk asset bullishness is sustainable. In fact, a reprieve rally now is going to make global growth resynchronization less likely and continued policy divergence more likely. Why? First, Chinese policymakers will have less of a reason to deploy an irrigation-style credit stimulus if fears of an accelerated trade war abate. Second, the Fed will have less of a reason to back off from its hiking trajectory if both the DXY rally and equity market volatility ease. That said, we are going to close our long DM / short EM trades for the time being. This includes: Our long DM equities / short EM equities, for a gain of 15.70%; Our long U.S. Dollar (DXY) index for a gain of 0.56%; Our long USD / Short EM currency basket for a loss of 0.76%; Our long JPY/GBP call, for a gain of 0.32%. Our hedge of being long China play index ought to outperform on a tactical horizon, so we are leaving it open despite its paltry return so far of 0.32%. Also, we are keeping our long Chinese equities ex. Tech / short EM equities trade, as Chinese assets should rally on the back of the truce. Note that, as outlined above, China’s tech sector is not out of the woods yet. Our decision to close these recommendations is to preserve profits, not change our investment stance. On a cyclical horizon, we remain skeptical that global risk assets will outperform DM, and U.S. assets in particular, over the course of 2019. In the end, we do not believe that a mere narrative shift will be sustainable, especially given the robustness of the U.S. labor market (Chart 14) and the tepidness of Chinese stimulus (Chart 15). Chart 14A Tight Labor Market A Tight Labor Market A Tight Labor Market Chart 15Compare Any Stimulus To Previous Efforts Compare Any Stimulus To Previous Efforts Compare Any Stimulus To Previous Efforts Finally, a word on oil prices. The G20 was crucial for the oil call, as well as the trade war, given that Saudi Arabia and Russia suggested that their OPEC 2.0 union would produce supply cuts at the upcoming Vienna meeting on December 6. This proves that fundamentals were more important than the narrative that Saudi leadership “owed” a favor to President Trump. In particular, the Saudis have fiscal constraints given their budget breakeven oil price is around $80-$85 per barrel. As such, we are reinitiating our long EM energy producers (ex-Russia) / short broad EM (ex-China) equity call. We are excluding Russia from the “long” due to lingering geopolitical concerns – sanctions and Ukraine – and China from the “short,” as we are now tactically bullish on China.   Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1      Please see Office of the United States Trade Representative, “Update Concerning China’s Acts, Policies, And Practices Related To Technology Transfer, Intellectual Property, And Innovation,” dated November 20, 2018, available at www.ustr.gov. 2      Please see The Federal Register, “Review of Controls for Certain Emerging Technologies,” dated November 19, 2018, available at www.federalregister.gov. 3      Please see Geopolitical Strategy Special Report, “Power And Politics In East Asia: Cold War 2.0?,” dated September 25, 2012, Global Investment Strategy Special Report, “Searing Sun: Japan-China Conflict Heating Up,” dated January 25, 2013, “Sino-American Conflict: More Likely Than You Think, Part II,” dated November 6, 2015, and “The South China Sea: Smooth Sailing?,” dated March 28, 2017, available at gps.bcaresearch.com. 4      Please see Global Investment Strategy Weekly Report, “Shades Of 2015,” dated November 30, 2018, available at gis.bcaresearch.com. 5      Please see European Investment Strategy Weekly Report, “DM Versus EM, And Two European Psychodramas,” dated November 22, 2018, available at eis.bcaresearch.com.