Government

Special Report

Highlights So what? Egyptian assets will benefit from improving fundamentals. Why?   March credit data confirm China’s stimulus, supporting the commodity/EM complex. Oil price risks are also to the upside. In Egypt, investors will welcome constitutional changes that reinforce the regime and overall stability. Egypt is beginning to reap the rewards of painful IMF reforms enacted in late 2016. A large, under-invested labor market is a key structural risk that will weigh on Egypt’s long-term investment potential. We recommend an overweight stance in Egyptian sovereign (USD) bonds relative to EM. Feature Egypt is the world’s most populous Arab country and a geopolitical fulcrum at the critical juncture between Africa, Europe, and Asia. Its stability is particularly important at a time of rapid geopolitical change. The U.S. is deleveraging from the Middle East and regional powers are scrambling to fill the void. Popular discontent is toppling rigid authoritarian leaders, most recently in Algeria and Sudan. Displaced peoples have spilled into Europe in the recent past and could do so again if more regimes fail (Chart 1). In this week’s Special Report we take a close look at Egypt and show how its continued stabilization is a rare positive trend for the region and one that presents an investment opportunity in its own right. China’s March Credit data confirm that stimulus is surprising to the upside this year. Before proceeding, however, we make note of some key developments on the global front, especially our oil view: China’s Stimulus: China’s March credit data confirm that stimulus is surprising to the upside this year (Chart 2). The data will help galvanize expectations of firming global growth, supporting commodity prices and EM risk assets. We are long Chinese equities, Indonesian and Thai equities, and EM energy producer equities relative to the EM benchmark.    Chart 1Asylum Seekers May Rise Amid Mideast Instability Chart 2Chinese Credit Supports Economic Outlook Iranian Sanctions: The Trump administration is increasing the pressure on Iran again and threatening to enforce sanctions strictly on oil exports. Exports have recovered somewhat since Trump issued waivers for key importers last fall and this means that 1.3mm bpd are still at risk if enforcement intensifies (Chart 3). Libyan War: Libyan National Army leader, General Khalifa Haftar, has made a move for Tripoli after sweeping across the country’s south, jeopardizing the roughly 300,000 barrels per day exported from Zawiya, west of Tripoli. Egypt is one of Haftar’s geopolitical backers, along with the UAE, so Egypt’s improving domestic situation, discussed below, is a factor supporting Haftar’s ability to extend his control across western Libya, which poses a risk of unplanned oil outages this year. The combination of these factors will put upward pressure on oil prices in an environment where supplies are already limited. As a result, Bob Ryan, the head of BCA’s Commodity & Energy Strategy, believes that OPEC 2.0 will eventually follow Russia’s preferred path at this juncture and increase production. Russia and Saudi Arabia are comfortable with Brent crude above $70 per barrel, but will get nervous once prices rise above $80 and threaten to kill demand in emerging markets. An alteration of slated production cuts has not yet been agreed and prices remain well supported in the meantime, with Brent on track to average $75 per barrel in 2019 and $80 in 2020.1  We do not expect President Trump to impose “maximum pressure” on Iran in this context. We have long assumed the worst of Venezuelan production, i.e. that it will at least be cut in half to 500,000 bpd by end of year, and possibly fall to zero. Libyan outages could theoretically rise to the full 900,000 bpd, though the likely cap is 300,000 bpd. The removal of 1.3mm bpd of Iranian barrels would bring the combined production losses close to OPEC 2.0’s spare capacity of around 2.1mm bpd. Moreover, the Iranians have the ability to retaliate, which jeopardizes other output across the Middle East. The United States has a valuable tool in the Strategic Petroleum Reserve.2 But President Trump would still be taking an enormous risk with the economy in advance of an election year to enforce the maximum sanctions on Iran. So we maintain that he will largely keep the waivers in place on May 2. The real danger, from our point of view, comes if Trump is re-elected, as then he will be less constrained both politically (no chance of reelection) and economically (U.S. production going up) in pursuing his hawkish foreign policy against Iran. But that is a story for 2021. With that, we turn to Egypt.  A Dream Deferred Earlier this year, the Egyptian parliament voted in favor of a series of proposed constitutional amendments that will further consolidate President Abdel Fattah al-Sisi’s power. Among the changes are the extension of the president’s term, allowing him in principle to rule for another 15 years. The proposed amendments will also expand the role of the military, enshrining a political role for it, thus solidifying its already preeminent position in Egyptian politics.3 These proposed changes bring the de facto Egyptian political environment close to its pre-2011 state – that is, the state of affairs before an estimated two million Egyptians rose in protest at Tahrir Square and removed President Hosni Mubarak from power, setting in motion a tumultuous decade. Sisi supporters argue that these changes will guarantee much needed stability and policy continuity to the Egyptian economy, allowing it to regain its footing. With GDP growth expected to near 6% by the middle of next year – the strongest since the 2011 revolution – it is no surprise that the aspirations of Egypt’s revolutionaries have become a dream deferred. Chart 4Improving Fundamentals Bode Well For Egyptian Equities Instead, policymakers and ordinary citizens alike have focused on making ends meet – both in terms of the fiscal purse and the household bank account. Policy continuity is what is required for Egypt at this point in time: It is finally beginning to reap the rewards of the painful reforms enacted in late 2016 as part of the IMF program. Sisi’s own position is reinforced by the fact that he oversaw this process and has come out on the other side. While the proposed constitutional amendments will pass, and will be characterized as a step back into authoritarian rule, the stability will be favorable for investors, as it will support a more predictable near-term trajectory for the Egyptian economy. Egyptian assets have already started to reflect this reality, signaling that Egypt is transitioning into a new era that portends a more attractive investment climate. As such, Egyptian equities have picked up and have outperformed the broader EM index since December (Chart 4). Bottom Line: “Stability” is the catch-phrase of the Sisi regime. Constitutional amendments allowing the Egyptian president and military to amass far-reaching powers are likely to pass. While they mark a return to Egypt’s traditional authoritarian system, this will be welcomed by foreign investors who were otherwise hesitant to re-enter the Egyptian market during the turbulent aftermath of 2011 Egypt’s 2016-2019 Policy Mantra: No Pain, No Gain Since the 2011 revolution, the Egyptian economy has been defined by years of turmoil. The popular uprising and ensuing loss of security drove away tourists and foreign investors – key sources of hard currency – causing the central bank to chew through its foreign exchange reserves as it scrambled to stabilize confidence and the currency. High rates of poverty, unemployment, and inequality amid a growing public sector wage bill, over reliance on food imports and an overvalued currency were a recipe for an economic disaster. Public debt ballooned while the black market for foreign exchange thrived. Thus, the structural reforms (Box 1) that accompanied the November 2016 $12bn IMF loan – while painful – were necessary to transition the economy onto a more sustainable trajectory.   Box 1 Structural Reforms Implemented Since 2016 The reforms that accompanied the IMF program are designed to improve fiscal consolidation, liberalize the foreign exchange market, and create a more business friendly investment climate. They include the following measures: The floating of the currency in November 2016 which resulted in the Egyptian pound losing half its value relative to the dollar. Given that Egyptians rely on imports for a large chunk of their consumption, the impact on household budgets and consumer prices have been massive (Chart 5). However, the inflation rate has since slowed to 14.4%, with the Central Bank of Egypt (CBE) targeting single-digit inflation by the end of next year. Similarly, it has stabilized the EGP/USD.4 Reductions to fuel subsidies have weighed on consumer expenditures. The target is full-cost recovery by the end of 2018-19 for almost all fuel products (except LPG and fuel oil used in bakeries and electricity generation). The introduction of a value-added tax (VAT) of 13% in 2016, which subsequently rose to 14%. The VAT will help generate revenue, by replacing the distortionary sales tax and broadening the tax base. Basic goods and services are exempt from the VAT in order to shield the poor from rising living costs. A reduction in utility subsidies to reduce state spending and instead channel funds to more productive uses. Authorities target the full elimination of electricity subsidies by 2020-21. Similarly, water and sewage subsidies have been cut. As of December 2018, Egypt ended a discounted customs exchange rate for non-essential imports. The monthly fixed customs exchange rate was introduced in 2017, following the 2016 currency devaluation, offering a favorable exchange rate to importers. In the second half of last year, the customs exchange rate was set at 16 EGP/USD while the market rate was EGP/USD 17.82-17.96. The non-essential imports include tobacco products, alcohol, pet food, and cosmetics. Other goods that will also be subject to the market rate include mobile phones, computers, furniture, shoes, cars, and motorbikes. The elimination of the repatriation mechanism for new inflows. The repatriation mechanism guaranteed the availability of foreign exchange for capital repatriation to portfolio investors that chose to sell foreign exchange to the central bank. Its elimination means that cash inflows and outflows by foreign portfolio investors will now impact the supply and demand of foreign currencies in the market. A new investment law was enacted in July 2017, which aims to promote domestic foreign investments by offering incentives and reducing bureaucracy. A new bankruptcy law was enacted in January 2018. Egypt ranks 101 out of 168 in the “Resolving Insolvency Index” of the Doing Business report. The law simplifies post-bankruptcy procedures and aims to reduce the need for companies to resort to courts in the case of bankruptcy. It also removes investment risk by abolishing imprisonment in bankruptcy cases. Chart 5FX Reform Was Inflationary     To mitigate the impact of these changes, especially on the lower and lower-middle income brackets, social programs have been expanded and improved, including: Takaful and Karama: An expansion of the cash transfer program, which now targets more than 10 million people, or ~10% of the population. Forsa: A program that helps create job opportunities for underprivileged youth by focusing on employment training. Mastoura: A program that lifts living standards and provides economic empowerment for Egyptian women by supplying microloans to fund projects. Sakan Karim: A program that aims to improve housing conditions of the poor by promoting access to clean drinking water and sanitation. Together, the structural reforms and targeted social programs will support the Egyptian economy by strengthening the business climate, attracting investment, and increasing employment. Since the beginning of the program, the country’s fiscal arithmetic has improved, inflation has been contained, and foreign exchange is no longer scarce. As a result, investor confidence has picked up. With the final $2bn tranche of the loan expected to be dispersed in the middle of 2019, the onus now lies on Egyptian policymakers to keep up the momentum. Bottom Line: With the IMF program now winding down, the continuity of reform implementation is squarely on the back of policymakers. With further structural policies in the pipeline, we expect policymakers to build on the macroeconomic gains of the past few years. Reaping The Rewards The most evident improvement following the reforms is seen in the fiscal purse. For the first time in over a decade, the primary balance is in surplus (Chart 6). The improvement reflects lower government spending commitments on the back of fiscal consolidation (Chart 7). Nevertheless, revenues remain weak, despite the implementation of the VAT, implying a need to improve tax collection and boost aggregate demand to raise taxable revenues. Chart 6Improving In Fiscal Arithmetic... Chart 7...On Back Of Fiscal Consolidation As policymakers continue reforming budgetary allocations, we expect the primary surplus to remain intact. This will alleviate some of the pressure on the overall budget, which, while still in deficit, has improved substantially. With the final $2bn tranche of the loan expected to be dispersed in the middle of 2019, the onus now lies on Egyptian policymakers to keep up the momentum. Nevertheless, the stock of public debt – whilst declining – remains elevated and will continue weighing on the overall budget (Chart 8). This is especially problematic for fiscal arithmetic since domestic interest rates are in the double digits and interest payments will tie down roughly half of government revenues. A combination of improving potential GDP, falling domestic interest rates, and continued prudence on debt is needed to stabilize Egypt’s debt dynamics. In fact, with the decline in both headline and core inflation, the Central Bank of Egypt has already embarked on a monetary easing cycle, cutting rates by 300 basis points since the beginning of last year (Chart 9). Although interest rates remain extremely high, lower borrowing costs will not only improve debt dynamics on the margin, but also encourage private sector credit, thus raising aggregate output and revitalizing domestic investment. Chart 8Debt Remains A Burden Chart 9Continued Easing Will Boost Outlook While inflation may accelerate in the coming months – on the back of a seasonal uptick in food prices during the month of Ramadan and the further removal of subsidies – we expect further cuts by the CBE in 2H2019 and 2020. Falling real wages due to fiscal consolidation also point to lower inflationary pressures (Chart 10). Unless Egypt manages to stabilize its debt dynamics, it will once again be forced to resort to debt monetization, which bodes ill for the currency as well as for inflation. The evidence to date points to an improvement (Chart 11). Chart 10Inflationary Pressures Are Contained Along with the improvement in the fiscal account, Egypt’s external deficit has also narrowed on the back of the improvement in the macroeconomic climate (Chart 12). The contraction in the current account deficit has been bolstered by an expansion in exports, which grew more than 10% in 2018. Chart 11Authorities Resisting Urge To Monetize Debt Chart 12External Deficit Contracting Chart 13Natural Gas Exports Will be Supportive   Notably, the energy trade balance has benefitted from an increase in Egypt’s natural gas potential (Chart 13). The giant Zohr field – the largest gas discovery ever made in the Mediterranean – came on stream in December 2017, and will support Egypt’s self-sufficiency in gas after falling domestic production forced Egypt to cut most LNG exports in 2014. The location of the gas field also presents opportunities for Egypt to become a natural gas export hub in the region. The Zohr field is close to other major fields in Israel and Cyprus, which means economies of scale can be utilized in developing regional export infrastructure. Egypt’s LNG export plants in Damietta and Idku have a capacity of 19 billion cubic meters (bcm) per year, which have been mostly idle in recent years. Already, an agreement between Egypt and Cyprus this past December committed to the construction of a pipeline connecting the Aphrodite gas field to Egypt’s LNG facilities. Similarly, a rebound in revenues from tourism to near-pre-crisis levels has helped improve the external account (Chart 14). Going forward, we expect the decline in terrorism to support the rebound of foreign inflows from tourism (Chart 15). This will be a non-negligible source of cash as tourism now accounts for roughly half of all service receipts, up from less than a quarter just three years ago. However, given that the security situation is unpredictable, this sector remains vulnerable to downside risks. Chart 14Rebound In Tourism... Another supportive source of inflows has been remittances from Egyptians living abroad. These continue to grow at a double-digit rate (Chart 16). Chart 16Recovery In Remittance Inflows Chart 17Foreign Investment Will Be Supported...   However, the financial account has taken a hit recently as inflows from portfolio investments have come down quite sharply on the back of investor aversion to emerging markets last year (Chart 17). Given the Fed’s pause, China’s stimulus, and other factors, we expect a pickup in portfolio investment. What’s more, Egyptian authorities have been working on improving the business environment, reflected in Egypt’s rising rank in the ease of doing business and global competitiveness surveys (Chart 18). This should improve foreign direct investment, which remains relatively weak so far. Chart 19Build Up In Central Bank Reserves Of course, despite these improvements, Egypt still ranks relatively low on these measures. Thus continued efforts to improve the business environment will be necessary to make Egypt an attractive destination for businesses. Yet Egypt’s foreign reserves have picked up considerably, and more importantly its net reserves – which exclude the CBE’s foreign borrowings – have once again turned positive (Chart 19). Bottom Line: The rewards from Egypt’s structural reforms are evident in the improvements to its twin deficits. While continued policy prudence is necessary to maintain the momentum of these policies, we expect the EGP/USD to remain flattish for the remainder of the year. We expect continued policy easing as the CBE cuts rates at least one more time in the second half of the year on the back of slowing inflation. Ghosts Of Futures Past Political stability and an improvement in macroeconomic indicators will no doubt be supportive of the Egyptian economy and assets in the near term. However, several structural risks remain, and could derail its performance down the road. For one, Egypt remains heavily reliant on its external environment. This environment has been largely cooperative throughout Sisi’s term in office, but a global or EM downturn could cause investment to collapse. Meanwhile the cyclical rise in oil prices will weigh on the import bill and raise headline inflation. Improvements in the business environment should attract foreign directinvestment. Second, a rising dependency ratio will pose a burden on Egypt in the coming years (Chart 20). Furthermore, elevated female and youth unemployment keep the output gap wide. True, the current improvement in the overall labor market will help the country weather the demographic headwind. However, another chronic problem is the quality of the Egyptian labor market. The latest data from the World Bank shows that government spending on education is significantly lower than it is among EM peers (Chart 21). Similarly, health expenditure per capita has not picked up much in recent years and has actually fallen as a share of GDP. Chart 20Demographic Challenges Remain   This has manifested in relatively low labor productivity and highlights the need for investment in human capital to improve potential GDP and the necessity for funds to be channeled to these sectors. Fortunately, the reforms have freed up badly needed fiscal space for now. Another key concern is the bloated economic role of the state and military. This is a double whammy to the Egyptian economy as it reduces fiscal funds available for other uses, such as healthcare and education while constraining the private sector. The crowding out of the private sector is evident from the recipients of bank credit: loans to the government – beyond purchases of government securities – are growing at by nearly 50% y/y, while lending to other sectors is expanding at less than 15% y/y (Chart 22). Once again, however, there is evidence of improvement: bank investments in government securities have come down from their peak and now represent roughly a third of total bank assets (Chart 23). Accordingly, credit to the private sector has likely bottomed. Chart 22Private Sector Crowding Out Remains... Chart 23...But Signs Of Improvement One structural concern that is here to stay is the fact that the Egyptian military occupies an oversized share of the economy. Given that all companies of the Egyptian armed forces are exempt from taxes, they have an unfair advantage over the private sector. The military has an especially large presence in Egypt’s recent infrastructure mega-projects. These include $8.2 billion invested in an expansion of the Suez Canal as well as the construction of a new administrative capital, 45 km to the east of Cairo. The military budget is secret and connected industries are not subject to auditing. Preferential treatment in assigning government contracts and the ability to offer services at a cheaper rate have further expanded the military’s role in the economy. Bottom Line: Risks to our optimistic outlook on Egypt mostly come from any deterioration in the external environment. The Egyptian economy is also weakened by structural weaknesses such as a large, under-invested labor market. These structural risks are considerable and will weigh on the long term investment potential of Egypt. In the short term, however, Egypt appears to be a lucrative trade opportunity. Investment Implications Egyptian sovereign spreads will likely contract going forward on the back of an improvement in the economic outlook (Chart 24). Thus, we recommend an overweight stance in Egyptian sovereign bonds within the EM space. Chart 24Improved Fundamentals A Positive For Sovereign Bonds Chart 25Equities Still Attractive   In the equities space, Egypt’s valuations look attractive relative to their Emerging Market and Frontier Market peers (Chart 25), despite the recent rally in recognition of the stability we outline here.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Marko Papic Consulting Editor marko@bcaresearch.com Footnotes 1      Please see BCA Commodity & Energy Strategy Weekly Report, “Sussing Out OPEC 2.0’s Production Cuts, U.S. Waivers On Iran Sanctions,” April 11, 2019, available at www.bcaresearch.com. 2      The U.S. Strategic Petroleum Reserve (SPR) was created in 1975, in the wake of the Arab oil embargo, to protect the U.S. from supply disruptions. Faced with a “severe energy supply interruption” the U.S. president can authorize a maximum drawdown of 30 million barrels within a 60-day period, beginning 13 days after the decision. Notably, the SPR was tapped for 21 million barrels in 1990-91, during the Iraqi invasion of Kuwait, and for 30 million barrels in 2011, when Libyan production fell to zero amid the revolution. The current inventory is 649 million barrels of sweet and sour crude, which could last the U.S. 114 days of crude imports. As U.S. net oil imports decrease, the length of time that the SPR could substitute for net imports rises. 3      The Egyptian parliament voted in favor of the proposed changes on April 16. The changes will be put to a public referendum – as early as next week – before taking effect. The amendments seek to (1) extend presidential terms from four to six years, (2) permit President Sisi to run again after his current term ends in 2022 – as an exceptional case, (3) allow the president to select the heads of judicial bodies and to oversee a new council responsible for judicial affairs, and (4) enshrine in the constitution a political role for the army to preserve the constitution, democracy and – ironically – the civilian nature of the country. 4      The most recent appreciation this year raised fears that the CBE is once again intervening in the currency market through state-owned banks.  

Highlights We remain constructive on the U.S. economy, …: It was another uneven week, but conditions remain broadly favorable for the U.S., and the expansion is intact. … and things seem to be perking up in the rest of the world, in line with BCA’s house view, …: China’s PMI data gave global markets a boost and European PMIs hinted at the potential for green shoots on the continent. … but money managers get paid to worry for their clients, and we get paid to worry for the managers, …: We would be remiss if we didn’t explore alternative scenarios, especially around an unobservable variable like the equilibrium fed funds rate. … so we’re always looking for the ways that we could be getting it wrong: This week’s report explores how the landscape would look from the perspective of consumption, investment, and government spending if a recession were at hand. Feature Chart 1Selloff, What Selloff?   Last week’s data were mixed, but there is no doubt, as we’ve acknowledged throughout 2019, that the U.S. economy is decelerating. The deceleration has fanned recession fears, and the yield curve’s fleeting inversion two weeks ago added fuel to the fire.1 The sell-off in financial markets in the fourth quarter seemed largely to have been animated by concerns that the Fed was pushing the fed funds rate into restrictive territory. The sharp decline in equities, and the sharp rise in corporate bond yields, amounted to a material tightening in financial conditions that threatened to become a self-fulfilling prophecy. What a difference a quarter makes. The potent first-quarter rally has reversed much of the fourth quarter’s tightening of financial conditions (Chart 1), while the FOMC’s March meeting indicated that the Fed has pivoted from defending against inflation overshoots to trying to correct its extended post-crisis undershoot. The threat that the Fed would follow the typical path of tightening into a recession has now receded, at least for the rest of 2019. As long as inflation doesn’t suddenly flare up, the expansion should remain intact, provided that the Fed hasn’t already lifted short rates into restrictive territory. We have contended that it hasn’t, as the fed funds rate is comfortably below our current estimate of the equilibrium rate, and is even further below our year-end equilibrium projection. We are well aware that the equilibrium rate cannot be directly observed, and that our estimate may be off the mark. We therefore devote this week’s report to considering what the building blocks of GDP might look like if a recession were about to begin. We particularly focus on consumption, which accounts for the lion’s share of U.S. activity, and indirectly affects both investment and government spending.2 Is Consumption On A Recession Path? Retail sales contracted month-over-month in February, though upward revisions to the January data made the release something of a wash. Year to date, though, retail sales growth has not been strong enough to erase the disappointment from December’s lousy print. From a longer-term perspective, real retail sales don’t suggest anything definitive about the business cycle: although they’re in a mini downtrend, previous pre-recession slides have been steeper and/or longer (Chart 2, top panel). Growth in real personal consumption expenditures (PCE), the consumption input to GDP, has been trendless for the last three years, but is not in the extended slide that preceded other recessions, nor has it yet become stretched in this cycle (Chart 2, bottom panel). Chart 2Neither Here Nor There   Chart 3Steady As She Goes We find that consumption fundamentals are sending a clearer message than the retail sales or PCE series themselves. We segment the fundamentals into three components: ongoing demand for workers, the prospects for wage increases, and households’ capacity to borrow to support spending. The labor market is currently quite strong and net payroll growth has been remarkably steady for the last four years (Chart 3). Our payrolls model, which incorporates initial unemployment claims, temporary workers and NFIB small business hiring plans, projects no more than modest slowing (Chart 4). Chart 4No More Than Mild Deceleration Ahead     Prices rise when demand outpaces supply, and the excess of job openings over unemployed workers (Chart 5) bodes well for wage growth. The elevated rate of employees quitting their jobs is also a positive sign (Chart 6). A worker doesn’t quit one job unless s/he has a higher-paying one lined up. We therefore read the elevated quits rate as an indication that the competition to attract employees is fierce, and that workers have regained some measure of bargaining power. Chart 5More Jobs Than Candidates ... Chart 6... Makes For A Johnny Paycheck Labor Market ...   The combination of rising household income and a light debt-servicing burden augurs well for consumption. A negative unemployment gap (an unemployment rate below the estimated natural rate of unemployment) also tends to be good for compensation growth. Over the last 30 years, annualized average hourly earnings (AHE) have grown one-and-a-half times faster when the unemployment gap is negative than when it is positive, and the earnings growth rates have been remarkably consistent (Chart 7). Household income will have a solid tailwind behind it if AHE gains can catch up to the nearly 4% level consistent with negative gaps in the late ‘80s, late ‘90s and mid-aughts. Chart 7... Where Employers Have To Keep Employees Happy Employment and wage gains suggest that rising household incomes will support spending, but the support would be undermined if households chose to use the income gains to pay down debt. Households have been shoring up their balance sheets ever since the crisis, more than tripling the savings rate from its summer 2005 low (Chart 8, top panel), and have now unwound nearly all of the debt (as a share of GDP) they took on in the ’01-’07 expansion (Chart 8, second panel). They may not yet be done, but the pace at which they’ve been deleveraging has slowed considerably over the last few years. With today’s still-low interest rates, servicing households’ debt burden is easier than it has been at any time in the last 40 years (Chart 8, bottom panel). Households are positioned to take on more debt if they so choose. Chart 8Low Rates Make For A Light Burden Bottom Line: Prospects for continued payroll expansion and wage gains are good, and households have the capacity to borrow to augment spending. We therefore expect that consumption is not on a recessionary path. The fundamentals underlying the U.S. economy’s largest pillar are solid. Could Investment Tip The Economy Into A Recession? Consumption is clearly the 800-pound gorilla of the U.S. economy. It accounted for close to 70% of GDP in the fourth quarter, and when it sneezes, the overall economy catches a cold. It has been a relatively stable series over time, however, and its infrequent contractions tend to be pretty modest. The story is quite different for private domestic investment, which routinely makes wild swings, and tends to seize up during recessions (Chart 9). Even though investment and government spending each account for just a quarter of consumption’s weight, it’s statistically easiest for investment to negate 2% growth in the rest of the economy (Table 1). Chart 9Consumption May Be Larger, But Investment Punches Harder Table 1The Road To Recession We have previously demonstrated that consumption leads capex. It turns out that fixed investment is the opposite of the if-you-build-it-they-will-come “Field of Dreams” mantra; corporations will only build if the customers have already come (Chart 10). Consumption is gently slowing right now, which suggests that corporate investment is not about to boom. To induce a recession, though, fixed private investment would have to crater, and nothing in consumption’s current trend, the employment outlook, the compensation outlook, or households’ borrowing capacity suggests that consumption is at risk of plunging. Chart 10Consumption Drives Capex Surveys asking corporations about their investment plans have been decent coincident indicators of corporate fixed investment. The dip in capital spending plans from the NFIB survey suggests that demand for non-defense capital goods is headed lower (Chart 11, top panel), as does the decline in capex plans in the regional Fed surveys (Chart 11, bottom panel). Neither implies the sharp decline that would be required to offset trend growth in the rest of the economy, however. The corporate tax cut does not appear to have inflated 2018 capex, so 2019 investment should not be at risk of suddenly unwinding. Chart 11Capex May Soften, But It's Not About To Melt Residential investment accounts for around a fifth of private domestic investment. We have written about housing at length over the last several months and will not rehash the discussion here, other than to note that permits and starts remain in a broad uptrend (Chart 12, top panel), as do new and existing home sales (Chart 12, middle panel). Affordability has revived with the decline in mortgage rates, and is once again above its pre-crisis peaks. The inventory of homes for sale is also at multi-year lows (Chart 12, bottom panel). With the Fed sidelined for an extended period, housing demand appears as if it will hold up, and there’s nothing to worry about from a supply perspective. Chart 12The Housing Market Is Fine Bottom Line: The investment component of GDP does not appear as if it is about to contract in a significant way. It is unlikely to be the source of a cyclical inflection. Government Spending By virtue of its modest size and muted volatility relative to consumption and investment, government spending is the least likely component of GDP to extinguish the expansion. The prospects for a negative-two-standard-deviation event that could trigger a recession look especially slim. With employment and household incomes rising, and home values still appreciating, state and local tax receipts should be well supported. Pro-cyclical federal fiscal policy is an anomaly (Chart 13), but we see no signs that the current administration will reverse course with a presidential election on the horizon. Although defense has accounted for a shrinking share of federal spending ever since the end of the Cold War, it still accounts for 60% of federal spending (Chart 14, bottom panel), and a quarter of aggregate government spending. Consistent with CBO projections, we expect defense spending will continue to expand through 2020, as it remains a Republican priority. Federal entitlements were a sacred cow in the 2016 Trump campaign and will remain so in the 2020 campaign, given their importance to the administration’s aging rural base. Chart 13Fiscal Policy Has Turned Pro-Cyclical   State and local spending account for the majority of aggregate government spending (Chart 14, top panel). Healthcare and education are the biggest line items in state budgets, and healthcare reforms have the potential to alter budget composition, but aggregate spending moves in lockstep with aggregate revenues, as many states are constitutionally mandated to maintain balanced budgets. The main sources of state revenues are income taxes and sales taxes. Municipalities rely heavily on property taxes. Chart 14State Spending Matters ... State income tax receipts are clearly a function of employment, though the link has come and gone this cycle as the expansion has matured (Chart 15, top panel). Sales tax receipts move with employment as well, because consumption is tied to income (Chart 15, second panel). Property taxes are a function of appraised property values, for which home prices are a solid proxy (Chart 15, third panel). If demand for labor remains robust, wages face upward pressure, and home prices don’t contract, state and local government spending is unlikely to dry up anytime soon. Chart 15... And It's Tied To Income, Consumption, And Property Prices   As long as the expansion remains intact (and valuations don’t get silly), risk-friendly positioning remains appropriate. Bottom Line: Nothing points to a sudden decline in government expenditures on the order of the negative-two-standard-deviation move which would be required to induce a recession. Weakness in employment and wage growth would hurt state tax revenues, reinforcing a slowdown in consumption, but that is not our base-case scenario for 2019. Investment Implications Investors should stay the course and remain overweight equities, given that a recession is not imminent. Although we think the Fed’s largesse will ultimately be reversed in potentially heavy-handed fashion, its implicit pledge to remain on the sidelines into the second half of this year extends the runway for risk asset outperformance. We are not in love with the S&P 500 at current levels, and will be surprised if it continues to appreciate at its current pace, but the policy climate – monetary and fiscal – is conducive to outperforming cash and high-quality fixed income. We would hold some capital in reserve to deploy in the event of a pullback, but continue to advocate a risk-friendly portfolio tilt.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Jennifer Lacombe Senior Analyst, Global ETF Strategy jenniferl@bcaresearch.com Footnotes 1 With the yield curve clawing its way back to positive territory by March 29’s close, it actually has yet to invert on a monthly basis. We have heard its downbeat growth message loud and clear, however, and are on alert for further potential weakness. 2 We leave net exports out of our analysis, as they’re not consequential to the comparatively closed U.S. economy.

Highlights Odds are that the recent improvement in Chinese manufacturing PMIs could be due to inventory re-stocking rather than a decisive turnaround in final demand. “Hard” data have not shown meaningful improvements in China’s final demand. Weighing the pros and cons, we are instituting a stop-buy on our EM strategy: We will turn tactically positive on EM risk assets if the MSCI EM equity index breaks above 1125, which is 4% above its current level. Keep Malaysia on an upgrade watch list. Downgrade Brazil to underweight. Feature The strong Chinese PMI prints released this week have challenged our negative view on EM assets and China plays. This week we take a deeper look at the underlying reasons behind the recent improvement in China’s PMI data. In addition, we elaborate on what it would take for us to alter our current strategy on EM risk assets. A Manufacturing Upturn The upturn in China’s manufacturing PMIs in March has been validated by improvement in Taiwanese PMI’s export orders (Chart I-1, top panel). The latter’s amelioration has been broad-based across all sectors: electronics and optical, electrical machinery and equipment, basic materials, and chemical/biological/medical (Chart I-1, bottom panel). China accounts for 30% of Taiwanese exports, making Taiwan’s manufacturing sector heavily exposed to China’s business cycle. Does this improvement in manufacturing PMIs reflect a final demand revival in China? Looking For Final Demand Revival China’s domestic and overseas orders remain weak, as exhibited in Chart I-2. These indicators give us the primary trajectory of the Chinese business cycle, while the PMI indexes exhibit considerable short-term volatility. Chart I-1One-Month Surge In China's And Taiwan's PMIs Chart I-2Noise And Business Cycle Trajectory   The domestic demand and overseas orders reflect quarterly data from 5,000 enterprises. The latest datapoints are from Q1 2019 and were released on March 22. To be sure, we are not suggesting an absence of bright spots, but at the moment “hard” data do not corroborate broad-based improvement in final demand. Consumer spending: There has been no improvement in households’ propensity to spend. Our proxy for households’ marginal propensity to spend has not turned up (Chart I-3). Consistently, China’s smartphone sales and passenger car sales are contracting at double-digit rates, while the growth rate in online sales of services has not improved (Chart I-4, top three panels). Chart I-3Chinese Consumers' Propensity To Spend Chart I-4China: No Improvement In "Hard" Data   The bottom panel of Chart I-4 demonstrates the retail sales of consumer goods during the Chinese New Year compared with the previous year’s spring festival. It is evident that as of mid-February, when this year’s spring festival took place, there was no improvement in Chinese consumer demand. Business spending / investment: Our proxy for enterprises’ propensity to spend continues to decline (Chart I-5). Companies’ propensity to spend has historically led the cyclical trajectory in industrial metals prices. Crucially, this has not corroborated the rebound in base metals prices over the past three months. Besides, China’s imports of capital goods, its total imports from Korea and its machinery and machine tool imports from Japan are all still contracting at a double-digit rate (Chart I-6). Chart I-5China: Enterprises' Propensity To Spend And Metals Chart I-6Contracting At A Double Digit Rate   China’s fixed asset investment in infrastructure has picked up of late and will continue to improve. However, this may not be sufficient to revive the mainland’s economy. China’s growth decelerated in 2014-2015 and industrial commodities prices dwindled, despite robust growth in infrastructure investment at the time (Chart I-7). The culprit was the decline in property construction in 2014-2015. As to the property market, the People’s Bank of China’s (PBoC) Pledged Supplementary Lending (PSL) financing points to further weakness in property demand in the coming months (Chart I-8). Chart I-7China's Infrastructure Investment And Base Metals Prices Chart I-8China: The Outlook For Residential Property Demand   Moreover, property starts have been surging, yet their completions have been tumbling. This suggests a ballooning amount of work-in-progress on real estate developers’ balance sheets. To be sure, we are not suggesting an absence of bright spots, but at the moment “hard” data do not corroborate broad-based improvement in final demand. It may well be that property developers do not have financing to complete work or that they are reluctant to bring new units to the market amid tame demand. Whatever the case, the mediocre pace of construction activity is negative for suppliers to the construction industry. Government spending: Aggregate government spending in China – including central and local government as well as government-managed funds (GMF) – has been very robust in the past year (Chart I-9). Hence, government spending has not been the reason behind the economic slowdown. Chart I-9China's Aggregate Fiscal Spending For 2019, overall government spending is projected to expand by 11% in nominal terms from a year ago, down from 17% in 2018. The key fiscal risk is shrinking land sales, which account for 86% of GMF revenues. The latter have substantially increased in size and now makeup 27% of aggregate fiscal spending. Local and central government expenditures account for 62% and 11% of aggregate fiscal spending, respectively. If land revenues undershoot, GMF and local governments will not be able to meet their expenditure targets without Beijing altering the former’s borrowing quotas. In brief, fiscal policy may be involuntarily tightened due to a shortfall in land sales revenues before the central government permits local governments to borrow more. Exports: Chinese shipments to the U.S. will recover as China and the U.S. finalize their trade deal. The media is extremely focused on the trade negotiations, and markets have been trading off the headlines. Nevertheless, it is essential to realize that China’s exports to the U.S. make up only 3.6% of the country’s total GDP (Chart I-10). This contrasts with capital spending that accounts for 42% of the mainland’s GDP.  Consequently, we believe the credit cycle that drives construction and capital spending is more important to China’s growth than its shipments to the U.S. Global ex-China Demand: The areas of global final demand that weighed on global growth last year remain depressed. Global semiconductors and auto sales have been shrinking at a rapid pace and have so far not experienced a reversal (Chart I-11). Chart I-10China Is Not Reliant On Exports To The U.S. Chart I-11Global "Hard" Data Are Still Bad   Bottom Line: There is a lack of pertinent “hard” business cycle data in China that have improved. What Does It All Mean Having reviewed final demand conditions in China, it is reasonable to argue that the improvement in the Chinese and Taiwanese manufacturing PMIs could be due to inventory re-stocking. Unfortunately, in China, there is limited reliable data that quantifies inventory levels well in various industries. Having reviewed final demand conditions in China, it is reasonable to argue that the improvement in the Chinese and Taiwanese manufacturing PMIs could be due to inventory re-stocking. The consensus view in the investment community is that China’s credit stimulus has boosted the economy since the beginning of this year. Business conditions have certainly improved. The rally in Chinese stocks has in turn mirrored this improvement. Yet it is not clear that this revival in the business cycle is due to the credit stimulus. Chart I-12 plots the credit impulse, including local government general and special bonds issuance, with the three typical business cycle variables: manufacturing PMI and nominal manufacturing production growth. Chart I-12China: Credit Impulse Leads "Hard" Data As can be seen from the chart, the manufacturing PMI is very volatile. In the short term, there is little correlation between it and the credit impulse (Chart I-12, top panel). Meanwhile, the credit impulse leads nominal manufacturing output growth by nine months (Chart I-12, bottom panel). Based on the past time lag relationships, the mainland’s business cycle should not have bottomed until the third quarter of this year. Hence, the bottom in the manufacturing PMIs in January does not fit the historical pattern of the relationship between the credit impulse and the mainland’s business cycle. Bottom Line: Presently, it is hard to make a definite conclusion on the reasons behind the pick-up in Chinese manufacturing. That said, business cycles do not always evolve in a common-sense manner that can be both rationalized and forecast by indicators. Therefore, it is essential for investors, to have confirmation signals from financial markets on the direction of the business cycle. Financial Markets As A Litmus Test We continuously monitor numerous financial markets that are sensitive to both the global and Chinese business cycles. These financial market-based indicators are often coincident with EM asset prices. Hence, they can be used to confirm or refute EM market direction. Our Risk-On-to-Safe-Haven (ROSH) currency ratio has recently softened, flashing a warning signal for EM share prices (Chart I-13). Chart I-13Currency Markets Are Flashing Amber For EM Stocks The ROSH ratio is the relative total return (including carry) of six commodities currencies (AUD, NZD, CAD, CLP, BRL and ZAR) versus two safe-haven currencies: the yen and Swiss franc. Hence, this currency ratio is agnostic to U.S. dollar trends, making its signals especially valuable. Our Reflation Confirming Indicator has retreated, also signaling a pullback in the EM equity index (Chart I-14). This indicator is composed of an equal-weighted average of industrial metals prices (a play on Chinese growth), platinum prices (a play on global reflation) and U.S. lumber prices (a proxy play on U.S. growth). Chart I-14Commodities Markets Are Flashing Amber For EM Stocks Within EM credit markets, corporate investment-grade spreads have begun narrowing versus high-yield spreads (Chart I-15). This typically coincides with lower EM share prices. Finally, EM share prices have been underperforming DM since late December. Relative performance of EM ex-China stocks against the global equity index has been even more underwhelming. In short, these markets are at a critical juncture. A decisive breakout will entail a lasting rally, while a failure to break out will signal imminent downside risk. Bottom Line: These financial market signals are not consistent with a durable China-led recovery in the global business cycle. Investment Strategy A number of financial markets are currently at a critical juncture. These markets will either break out or break down, with subsequently significant moves. The broad U.S. trade-weighted dollar has been flattish in the past nine months despite falling interest rate expectations in the U.S. and the risk-on market environment. We read this as a sign of underlying strength. The trade-weighted dollar is presently sitting on its 200-day moving average (Chart I-16). Consistent with a flattish trend in the greenback, the U.S. dollar volatility has dropped to very low levels. Exchange rates usually do not trade sideways much longer than that. Hence, the dollar is about to break out or break down and any move will be lasting and large. Chart I-15A Message From EM Corporate Credit Market Chart I-16The U.S. Dollar Is About To Make A Big Move   The Korean won has been forming a tapering wedge pattern from both short-term and long-term perspectives (Chart I-17, top and middle panels). Its volatility has also plunged to a record low (Chart I-17, bottom panel). Chart I-17The Korean Won Is At Crossroads Chart I-18A Stop-Buy On EM Stocks Finally, emerging Asian equities’ relative performance to global stocks is facing an important technical resistance as are copper and oil prices. In short, these markets are at a critical juncture. A decisive breakout will entail a lasting rally, while a failure to break out will signal imminent downside risk. Consistently, China’s “soft” data that has improved markedly yet there is no “hard” data confirmation. Moreover, there is some evidence to suggest that the pickup in the soft data may simply reflect inventory building.   Weighing the pros and cons, we are instituting a stop-buy on our EM strategy: We will turn tactically positive on EM risk assets if the MSCI EM equity index in U.S. dollar terms breaks above 1125, which is 4% above its current level (Chart I-18). Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Malaysia: Keep On Upgrade Watch List Malaysian equities have been underperforming their EM counterparts since 2013 and are now resting around their 2017 lows (Chart II-1). The odds are high that this market’s underperformance is late. Chart II-1Malaysian Stocks Relative to EM Investors should keep Malaysian equities on an upgrade watch list. We upgraded the Malaysian bourse from underweight to neutral in December 2018. In a Special Report published at that time, we argued that the structural outlook for Malaysia had improved, yet the cyclical downturn would persist. The latter did not warrant moving the bourse to overweight. This view is still at play. Economic Slowdown Is Advanced The Malaysian economy has been digesting credit and property market excesses. Property sector: Property sales have declined by 37% since 2010, and prices for some property segments are beginning to deflate (Chart II-2). Similarly, housing construction approvals have slumped severely since 2012. Consumers: Passenger vehicle sales have been falling since 2012 along with households' declining marginal propensity to consume, and retail trade has been very weak (Chart II-3). Chart II-2Property Sector Is Depressed Chart II-3Consumer Sector Is Weak   An ongoing purge of excesses by companies entails lower wage growth and weaker employment, resulting in subdued household income growth. The latter could extend the consumer slump. Business sector: Capital spending growth in real terms has decelerated and may contract. Both profit margins and return-on-equity (ROE) for non-financial publicly listed companies have slumped and are currently resting below their 2008 levels (Chart II-4). This warrants cost-cutting and reduced corporate spending/capital expenditures for now. Chart II-4Corporate Restructuring On The Way? Reduced employment and weak wage growth are negative dynamics for households but positive for companies’ profit margins. Commercial Banks: Malaysian banks remain unhealthy. At 1.5%, their NPLs remain low relative to the credit boom that occurred over the past decade. Moreover, Malaysian banks have been lowering their provisions levels to boost profits. This is an unsustainable strategy. Provided economic growth will remain weak, both NPLs and provisions will rise, hurting banks’ profits and share prices. Banks hold a very large market-cap weighting in this bourse, and the negative outlook for banks’ profits deters us from upgrading this equity market. Purging Excesses: Implications For The Exchange Rate Purging of economic excesses is painful in the short- and medium-term, as it instills deflation. A currency often depreciates during this phase to mitigate the deflationary forces in the economy. However, purging excesses, deleveraging and corporate restructuring are ultimately structurally bullish for a currency. First, corporate restructuring and improved capital allocation lift productivity growth in the long run. The Malaysian economy has been digesting credit and property market excesses. Second, low inflation or outright deflation allow the currency to depreciate in real terms. The Malaysian ringgit is already cheap based on the real effective exchange rate (Chart II-5). Finally, amid deflation and in the absence of widespread bailout of debtors funded by bank loans or excessive government borrowing, cash becomes “king”. Hence, deleveraging is ultimately currency positive. In contrast, pervasive bailouts funded by money creation – i.e., mushrooming money growth – usually undermine residents’ and foreigners’ willingness to hold the currency. A capital flight ensues and the currency plunges. Malaysia in 2015 was the latter case, with the ringgit plummeting as residents converted their ringgits to U.S. dollars (Chart II-6, top panel). Chart II-5The Ringgit Is Cheap Chart II-6Malaysia: 2015 Vs. Now   Presently, the opposite dynamics are at play. The central bank is reducing commercial banks’ excess reserves, domestic private credit growth is weak and residents are not fleeing the ringgit (Chart II-6). In addition, the structural reorientation of the economy from commodities to semiconductors/technology is beginning to bear fruit. As a result, overall trade balance has significantly improved, despite weak commodities prices. This is also positive for the currency. Finally, a more stable (i.e., modestly weaker) exchange rate amid both a global and domestic downturn will allow Malaysia’s central bank to reduce interest rates and smooth the growth slump. This is in contrast to 2015 when capital outflows and the plunging currency did not allow the central bank to reduce borrowing costs. Investment Conclusions We recommend keeping Malaysian stocks on an upgrade watch list for now. We recommend upgrading Malaysian sovereign credit and local currency government bonds from underweight to neutral relative to their respective EM benchmarks A relatively stable ringgit will benefit Malaysia’s local and U.S. dollar bonds. Furthermore, foreign ownership of local bonds has fallen meaningfully, diminishing the risk of future outflows. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Downgrading Brazil: The Honeymoon Is Over In our October 9 report, we upgraded Brazil following the outcome of the first round of presidential elections. We, like the market, gave a benefit of the doubt to the new president. However, the honeymoon is over for President Bolsonaro. The markets are becoming increasingly pessimistic because of the lack of progress on the social security reforms front. It is no secret that Brazil needs bold pension reform to make its public debt sustainable. As things stand now, the public debt dynamic in Brazil is precarious. Two prerequisites for public debt sustainability are (1) for interest rates to be below nominal GDP growth or (2) continuous robust primary fiscal surpluses. Hence, a government can stabilize its debt-to-GDP ratio by either having nominal GDP above its borrowing costs, or by running persistent and sizable primary fiscal surpluses. Neither of these two stipulations are presently satisfied in Brazil. The gap between government local currency bond yields and nominal GDP growth is still very wide (Chart III-1). Meanwhile, the primary fiscal deficit is 1.5% of GDP (Chart III-2). Chart III-1Brazil: An Unsustainable Gap Chart III-2Brazil: Public Debt Dynamics Are Precarious     In the early 2000s, the government stabilized its public debt dynamics by running persistent primary surpluses of about 4% of GDP (Chart III-2, top panel). Will Brazil achieve primary fiscal surpluses in the coming years assuming some form of the pension reform is adopted? It is doubtful. According to the government’s own forecasts, the submitted draft of social security reforms, including the one for the army, will save only BRL190 billion in next four years or 0.7% of GDP per year. The current primary deficit is 1.5% of GDP (Chart III-2). Unless nominal GDP growth and government revenue growth shoot up, the primary deficit will not be eliminated or the primary surplus will be very small. Overall, it seems unlikely that the government’s proposed pension reforms will be sufficient to turn around Brazil’s public debt dynamics in the next several years - barring very strong economic growth that will fill in government coffers. Bottom Line: We are downgrading Brazil from overweight to underweight within EM equity, local currency bonds and sovereign credit benchmarks. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Footnotes Equity Recommendations Fixed-Income, Credit And Currency Recommendations

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, 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. The logical investment conclusion from infrastructure stimulus would be to position overweight in infrastructure stocks. We created a basket of such equities to test this hypothesis. When compared to the historic U.S. federal budget deficit (top panel), we found that, while a correlation exists, there are prolonged periods where fiscal largesse has not translated into infrastructure stock outperformance. Drilling down, we found that EM stock performance (second panel) in general and capital spending in China (bottom panel)in particular have taken over as the principal drivers of these stocks. Please see this week’s Special Report for our deep dive into infrastructure stock performance and drivers as well as our sister Geopolitical Strategy Service’s take on why they believe an infrastructure bill worth $200-$400 billion over ten years has a greater than 50% chance of passing.

Highlights Investors are worrying too much about the things that caused the global financial crisis, and not enough about those that could cause the next downturn. Despite the recent patch of soft data, the U.S. housing market is in good shape. Go long homebuilders relative to the S&P 500. Imbalances in the corporate debt market have increased, but are not severe enough to generate systemic economic distress. U.S. rates will need to rise quite a bit more than the market anticipates before the economy slows by enough to force the Fed to back off. The combination of a stronger dollar and inadequate Chinese stimulus will continue to pressure emerging markets. Even Brazil's pro-capitalist new president may not be able to reverse the country's bleak fiscal dynamics. Our MacroQuant model, which predicted the correction, points to further near-term downside risk for global equities. The cyclical (12-to-18 month) outlook looks much better, however. Feature The Market's Maginot Line One of the most reliable ways to make money as an investor is to figure out the market's collective biases and trade against them. Behavioral economists have long noted that people tend to assign too much weight to recent experience in taking decisions. As a result, in finance, as in military strategy, there is a constant temptation to fight the last war. The last war policymakers waged was against the scourge of deflation that followed the housing bust and financial crisis. For much of the past decade, investors have held a magnifying glass over anything that could possibly resemble the conditions that led up to the Global Financial Crisis. While such behavior is understandable, it is misplaced. History suggests that both lenders and borrowers tend to act prudently for years, if not decades, following major financial crises. Mistakes are still made, but they are different mistakes. People overcompensate. They obsess about the past rather than focusing on the future. U.S. Housing Is Okay There is no denying that the U.S. housing market has softened this year (Chart 1). Housing starts, building permits, and home sales have all fallen. Residential investment has subtracted from GDP growth over three consecutive quarters. Chart 1Housing Has Been A Drag On The U.S. Economy This Year There is little mystery as to why the housing market has been on the back foot. The Trump tax bill capped the deduction on state and local property taxes, while reducing the amount of mortgage debt on which homeowners can deduct interest payments from $1 million to $750,000. This had a negative effect on housing activity, especially in high-tax Democrat-leaning states with elevated real estate prices. More importantly, mortgage rates have risen by over 100 basis points since last August. Chart 2 shows that home sales and construction almost always decline after mortgage rates rise. In this respect, the weakness in housing activity is reminiscent of the period following the taper tantrum, when housing activity also slowed sharply. Chart 2No Mystery Why U.S. Housing Has Been Weak... We do not expect mortgage rates to fall from current levels. But they are not going to rise at the same pace as they have over the past year. Thus, while the headwinds from higher financing costs will not disappear, they will abate to some extent. Fundamentally, the housing market is on solid ground (Chart 3). Mortgage rates are still well below their historic average. Home prices have risen considerably, but do not appear excessively stretched compared to rents or incomes. Unlike in 2006, the home vacancy rate is near its historic lows. Residential investment stands at only 3.9% of GDP, compared with a peak of 6.7% of GDP in the second half of 2005. The average age of the residential capital stock has risen by nearly five years since 2006, the largest increase since the Great Depression. With household formation rebounding briskly from its post-recession lows, homebuilders are still arguably not churning out enough new homes. Chart 3A...But Fundamentals Are Still In Good Shape (I) Chart 3B...But Fundamentals Are Still In Good Shape (II) Mortgage lenders have learned from past mistakes (Chart 4). While lending standards have eased modestly over the past 4 years, underwriting standards have remained high. The average FICO score for new borrowers is more than 40 points above pre-recession levels. The Urban Institute Housing Credit Availability index, which measures the percentage of home purchase loans that are likely to default over the next 90 days, is at reassuringly low levels. This is particularly the case for private-label mortgages, whose default risk has hovered at just over 2% during the past few years, down from a peak of 22% in 2006. Moreover, banks today hold much more high-quality capital than in the past, which gives them additional space to absorb losses (Chart 5). Chart 4Lending Standards Have Been Tight, But Are Starting To Loosen Chart 5U.S. Banks Are Well Capitalized With all this in mind, we are initiating a new strategic trade to go long U.S. homebuilders relative to the S&P 500.1 Corporate Debt: How Big Are The Risks? Unlike household debt, U.S. corporate debt has risen over the past decade and now stands at a record high level as a share of GDP. The quality of the lending has also been less than pristine, as evidenced by the proliferation of "covenant lite" loans. The interest coverage ratio for the economy as a whole - defined as the volume of profits corporations generate for every dollar of interest paid - is still above its historic average (Chart 6). However, this number is skewed by a few mega-cap tech companies that hold a lot of cash and have little debt. Chart 6Interest Coverage Looks Relatively High My colleague Mark McClellan, who writes our monthly Bank Credit Analyst publication, has shown that the interest coverage ratio for companies comprising the Bloomberg Barclays index would drop close to the lows of the Great Recession if interest rates were to rise by a mere 100 basis points across the corporate curve. The damage would be far worse if profits also fell by 25% in this scenario.2 While the corporate debt market has become increasingly frothy, it does not pose an imminent danger to the economy. There are several reasons for this. First, while U.S. corporate debt is high in relation to the past, it is still quite low in comparison with many other economies (Chart 7). The ratio of corporate debt-to-GDP, for example, is 30 percentage points higher in the euro area. This suggests that U.S. businesses still have the "carrying capacity" to take on additional debt. Chart 7U.S. Corporate Debt Is Not That High By Global Standards Second, the average maturity of U.S. corporate debt has risen over the past decade, with an increasing share of companies opting for fixed over floating-rate borrowings. This implies that it will take a while for the effect of higher rates to make their way through the system. Third, and perhaps most importantly, corporate bonds are generally held by non-leveraged investors such as pension funds, insurance companies, and ETFs. Bank loans account for only 18% of nonfinancial corporate-sector debt, down from 40% in 1980 (Chart 8). The share of leveraged loans held by banks has declined from about 25% a decade ago to less than 10% today. Chart 8Banks Have Reduced Their Exposure To The Corporate Sector Tellingly, we already had a dress rehearsal for what a corporate debt scare might look like. Credit spreads spiked in 2015. Default rates rose, but the knock-on effects to the financial system were minimal (Chart 9). This suggests that corporate America could withstand quite a bit of monetary tightening without buckling under the pressure. Chart 9The 2015 Debt Scare Did Not Topple The Economy Government Debt: No Worries... Yet If the risks posed by both the housing market and corporate debt market are contained, what about the risks posed by soaring government debt? The long-term fiscal outlook is certainly bleak, but the near-term risks are low.3 President Trump's tweets aside, the U.S. has an independent central bank which has been able to keep inflation expectations well anchored. The U.S. private sector is also running a financial surplus at the moment, meaning that it earns more than it spends (Chart 10). Not only does this make the economy more resilient, it also provides the government with additional savings with which to finance its fiscal deficit. Chart 10The U.S. Private Sector Is A Net Saver The private sector's financial balance will deteriorate over the next two years as household savings decline and corporate investment rises. This will put upward pressure on Treasury yields. However, if rising yields are reflective of stronger aggregate demand, this is unlikely to derail the economy. When Things Break Recessions are usually caused when the Fed raises rates by enough to undermine spending on interest rate-sensitive purchases such as housing, or when higher rates prick an asset bubble just waiting to burst. Given the lack of clear imbalances either in the real economy or financial markets, the Fed may have to raise rates significantly more than the market is currently anticipating. In fact, far from having to press the pause button midway through next year, our baseline expectation is that the Fed will expedite the pace of rate hikes in late 2019 as inflation finally starts to accelerate. Aggressive Fed rate hikes combined with an incrementally less expansionary fiscal policy will sow the seeds of a recession in late 2020 or 2021. Before the next U.S. downturn arrives, the dollar will have strengthened further. A resurgent greenback will cast a long shadow over emerging markets and commodity producers. As we discussed last week, China is unlikely to save the day by launching a massive stimulus program of the sort that it orchestrated in both 2009 and 2015.4 True, not all emerging markets are equal. Emerging Asia is more resilient now than it was two decades ago. Thailand, for example, was patient zero for the Asian crisis in 1997. Today, it sports a current account surplus of over 10% of GDP and low levels of external debt. This resilience will not prevent Asian economies from experiencing slower growth on the back of weaker Chinese demand, but it will prevent a full-blown balance of payments crisis from spiraling out of control. In contrast to Emerging Asia, Latin America looks more vulnerable (Table 1). BCA's chief emerging market strategist, Arthur Budaghyan, wisely upgraded Brazilian assets on a tactical basis on October 9th ahead of the presidential elections. Nevertheless, Arthur still worries that Brazil's daunting fiscal challenges - the budget deficit currently stands at 7.8% of GDP and the IMF expects government debt to rise to nearly 100% of GDP over the next five years (Chart 11) - are so grave that even South America's answer to Donald Trump may not be able to save the Brazilian economy. Table 1Vulnerability Heat Map For Key EM Markets Chart 11Brazil Is Fiscally Challenged A Correction, Not A Bear Market The current market environment bears some similarities to the late 1990s. The Fed is tightening monetary policy in order to keep the domestic economy from overheating. The U.S. economy is responding to higher rates to some extent, but the main effects are being felt overseas. The Asian Crisis did not end the bull market in U.S. stocks, but it did generate a few nasty selloffs, the most notable being the 22% peak-to-trough decline in the S&P 500 between July 20 and October 8, 1998. We witnessed such a selloff this October. The bad news is that our MacroQuant model is pointing to additional equity weakness over the coming weeks (Chart 12). The model tends to downgrade stocks whenever growth is slipping, financial conditions are tightening, and sentiment is deteriorating from bullish levels. All three of these things are currently occurring. Chart 12MacroQuant* Model Suggests Caution Is Warranted The good news is that none of our recession indicators are flashing red. Since recessions and bear markets typically overlap (Chart 13), the odds are high that the current stock market correction will be just that, a correction. Chart 13Recessions And Bear Markets Usually Overlap Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 The corresponding ETFs are long ITB/short SPY. 2 Please see The Bank Credit Analyst Special Report, "The Long Shadow Of The Financial Crisis," dated October 25, 2018. 3 It is actually not even clear that a loss of confidence in America's fiscal management would cause a recession. The Fed largely determines borrowing costs at the short-to-medium end of the yield curve, which is where the government finances most of its debt. If people lose confidence in the dollar, they will either need to run down their cash balances by purchasing more goods and services or try to move their wealth abroad. The former will directly increase aggregate demand, while the latter will indirectly increase it through a weaker currency. To be clear, we are not suggesting that such an outcome would be beneficial to the economy; it would, among other things, greatly slow potential GDP growth by discouraging investment. But the near-term effect would likely be economic overheating and rising inflation rather than a recession. 4 Please see Global Investment Strategy Weekly Report, "Chinese Stimulus: Not So Stimulating," dated October 26, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Special Report

Highlights The presidential race between Haddad and Bolsorano will be very tight. At present, we put slightly higher odds on Haddad winning by a small margin in the second round. A Haddad victory would lead to a continuation of stress in financial markets. The prospects of Lula's release and populist policies will lead to further downside in Brazilian assets Bolsorano's victory in the second round will likely lead to a tradeable rally in Brazil's financial markets. For now continue underweighting Brazilian equities and credit and continue shorting the BRL. We will consider whether to upgrade Brazil after the outcome of the elections becomes clearer. Feature Chart 1Potential Roadmaps For Equities Relative Performance Brazil's upcoming general elections will be among the closest in recent history. Current polls show a tight race between right-wing candidate Jair Bolsonaro and left-wing candidate Fernando Haddad. A victory by Bolsonaro may spark a short-term rally in Brazilian assets on the expectation of structural reforms. On the other hand, a Haddad victory and return of the Worker's Party to power would be quite negative for financial markets. The upside of this election, regardless of outcome, is that a new government with a new mandate will be formed, restoring a semblance of legitimacy for the first time since the impeachment of President Dilma Rousseff in 2016. The downside is that this mandate will be weak, the odds of a "pro-market" government are uncertain, and Congress will be fragmented. Much-needed yet painful social security reforms will face an uphill battle, with potentially another market riot needed to motivate policymakers and legislators to enact social security reforms. On the macroeconomic front, Brazil does not have a lot of room and time for maneuver. Without drastic measures to cut the budget deficit or boost nominal GDP, public debt will most likely spiral out of control. Due to the current state of polarization, we cannot have a high conviction view on the election outcome until after the congressional elections on October 7. That said, the macro forces remain negative for EM overall and Brazil in particular. Barring Bolsorano's victory in the second round, there is little reason for Brazilian risk assets to rally (Chart 1). An Anti-Establishment Victory? Media attention has centered on Bolsonaro of the Social Liberal Party. He is the frontrunner in the first round of the race, despite his controversial rhetoric and overt sympathies with Brazil's military dictatorship of the past. In polling for the second round, his considerable lead has shrunk, as he is now neck and neck with the other contenders (Chart 2). Bolsonaro is a serious candidate not because of any overarching, international "Trumpian" narrative, but because Brazil itself is ripe for an anti-establishment electoral outcome: With Lula out of the race, the combined "right-wing" and "left-wing" vote is close in the first round (Chart 3). Chart 2Second-Round Polls Very Tight Chart 3A Tight Race The country is still in the throes of a political crisis and a historic recession (Chart 4). The major political parties have been discredited. Years of slow economic growth have resulted in extremely low levels of public trust in government (Chart 5). Chart 4Brazil In The Wake Of A Historic Recession Chart 5Low Growth Countries Suffer From Lack Of Trust In Their Government This is prompting voters to seek a "change in direction" and/or a "protest vote," from which Bolsonaro is apparently benefiting. There is even a sizable audience for Bolsonaro's authoritarianism and nostalgia for military rule. Brazilians are disillusioned with democracy - with 67% of respondents in a Pew Research poll saying they are "not satisfied" with democracy, compared to a global median of 52%.1 Almost a third of educated Brazilians favor military rule, and that number is as high as 45% among the uneducated (Chart 6).2 Bolsonaro's net approval is less negative than other candidates. In fact, only former Presidents Lula and Rousseff have higher net approval (Chart 7). This is a serious risk to Bolsonaro's likeliest rivals, Fernando Haddad of the Worker's Party and Ciro Gomes of the Democratic Labor Party. Bolsonaro's stabbing at a rally on September 6 has not taken him out of the race. His social media support has become an important tool to reach out to his fan base. Chart 6Brazilian Voters Harbor Some Authoritarian Tendencies Chart 7Net Approvals Advantage Bolsonaro However, there are two key reasons why Bolsonaro is not the favorite to win the election: First, Brazil's two-round electoral system works against Bolsonaro because it enables left-leaning voters to vote strategically in favor of the "least bad option," i.e. the available left-of-center candidate, in the second round. Thus while polling shows Bolsonaro very close to each of his potential opponents in the second round, his final opponent will receive a boost that will not be fully accounted for until after the first round eliminates other left-wing contenders. Recent polls suggest that Haddad stands to benefit much more than Bolsonaro from the "migration" of votes after the first round, as left-wing supporters team up against Bolsonaro in the second round (Table 1). Second, with Lula disqualified from the race, Lula supporters are now in the process of switching to support Haddad. Lula has carried a high approval rating of around 35%-40% for over a year, well above all other candidates. In our "poll of polls" (average of various polls) Haddad has risen rapidly in the one month since Lula's disqualification became clear, so that he is now at equal odds with Bolsonaro (see Chart 2 above). A few polls even suggest Haddad is ahead of Bolsonaro in the second round (Chart 8).3 Table 1Second Round Migration##br## Polls Advantage Haddad Chart 8Haddad Is Ahead##br## In These Polls To elaborate on this last point: First, about 59% of Lula's supporters say they will shift to Haddad (Chart 9), which should be enough to position him as one of the top two contenders in the first round of voting. Only 4% of Lula supporters will shift to right-of-center candidate Alckmin- a share that is overpowered by the 71% of the Lula vote that will go to left-leaning candidates. Second, the number of undecided and "blank" Lula voters is high at 18%. These voters - if they vote - will mostly go to Haddad, and then Gomes. From the above we can conclude that Haddad will face Bolsonaro in the second round runoff. Because of strategic voting, Haddad will be favored to win the Presidency. A major risk to the left-wing candidate in the second round is that as many as 18% of Lula voters may stay home and not vote. This would mean that Haddad could lose the final vote due to low turnout.4 Overall voter turnout has been falling slightly since 2006 (from 83.3% to 80.7% in 2014) and the disillusionment of voters could result in still lower turnout in 2018. This would favor Bolsonaro, whose supporters are the most likely to vote, whereas Haddad's are the least likely, according to surveys. The profile of the most likely voters favors Bolsonaro (Table 2).5 Chart 9Lula's Migration Vote Table 2Voter Profile Of Each Candidate As a consequence, we give Bolsonaro 40%-50% odds of winning the presidency, with the possibility of downgrading his probability to a flat 40% if the rise in Haddad's polling continues at the current pace. Strategic voting imposes a handicap on Bolsonaro, making it hard for him to increase his odds above 50%. The lower net approval for Haddad and Gomes, and the risk that Lula voters will fail to transfer in full force to Haddad, suggests that Bolsonaro has a fair chance of winning the second round. Elections are a Bayesian process and we will update our probabilities as more information comes in. In particular, it is important to see if Haddad exceeds expectations in the October 7 first round. Bottom Line: Given strategic voting in the second round and the momentum behind Haddad, the odds of a left-wing victory in the Brazilian election are 50%-60%. However, this is a low-conviction view. Bolsonaro's odds of winning are closer to 40%-50%, particularly if Lula voters stay home. The New Government's Mandate Will Be Weak No matter who wins, there will be at least one positive takeaway for Brazilian risk assets: a new government will be elected with a fresh mandate to lead the country. The Brazilian state has suffered from a crisis of legitimacy over the past few years. A countrywide anti-corruption campaign and economic depression has led to a general loss of confidence. The latter was further exacerbated by the impeachment of President Rousseff and paralysis of the interim government of Michel Temer. Hence this election will clear the air and give a new government the chance to tackle the country's economic and political problems. However, this clearly positive factor will be overwhelmed by negative factors as the election unfolds and in the aftermath: No first round winner: As outlined above, none of the candidates are likely to win a simple majority of the vote in the first round on October 7. This has been the norm in recent elections, but it precludes the possibility that the current crisis will be matched by a leader with a strong personal mandate, like Cardoso in the 1990s. A close election may lead to contested results: The current second-round polling suggests the outcome will be close. The losing side may challenge the results, a controversy that could cause significant political uncertainty for weeks or months. Bolsonaro has already suggested that he can only lose if the Worker's Party rigs the election. Congress will be fractured: Brazil's Congress is always fractious; with numerous parties and coalitions cobbled together by presidents whose own party has a relatively small share of seats (Chart 10). The upcoming president may even have a weaker congressional base than usual. The erstwhile dominant parties, the PDMB and the PSDB, are less popular than they once were and have put forward lackluster presidential candidates, suggesting they will not win large numbers of seats. The Worker's Party, with a large support base in recent decades, was at the epicenter of the impeachment crisis and suffered huge losses in the municipal elections of 2016, also suggesting it will not win as many seats.6 Meanwhile Bolsonaro's Social Liberal Party is starting from a low base (it currently has only eight out of 513 seats in the lower house and none in the senate). Hence, no party is in a position to sweep Congress, or even come close to a majority, ensuring high diffusion of power, horse-trading, and unstable, ad hoc coalitions. Such coalitions have been a hallmark of Brazilian politics and may even be more unstable this time around. Chart 10ABrazil's Parliament Is Fractious Chart 10BBrazil's Parliament Is Fractious No more pork: Given the focus on fiscal austerity and corruption, the next president of Brazil will struggle to command as much "pork-barrel spending" - politically-motivated fiscal handouts to individual congress members - to grease the wheels of politics. President Lula and President Cardoso both relied on pork to ensure passage of key legislation in the 1990s and early 2000s. Polarization: Polarization will remain high as a result of the economic crisis. If Haddad wins, we expect that he will pardon President Lula, despite his assertions to the contrary, and create ill-will among the roughly 52% of the population that views Lula as corrupt. If Bolsonaro manages a victory, he will face intense opposition and resistance from civil society and possibly a left-of-center Congress. Historically, a governing coalition with a majority of seats eventually emerges from Brazil's fragmented Congress. However, periods of political crisis - and transitions from one leading party to the next - often require more time to form such coalitions. It took Lula two years, from 2002-04, to form a majority coalition during his first term in office, according to research by Taeko Hiroi of the University of Texas at El Paso (Chart 11). Chart 11Historical Profile Of Governing Coalitions Bottom Line: The formation of a new government with a new mandate is positive but it will not bestow as much political capital as the market expects: in all likelihood the new president's mandate will be weak and Congress will, at least initially, be divided. Will Reforms Be Reactive Or Proactive? What are the likely market reactions from the different election scenarios? And will policymakers be proactive or reactive in their pursuit of any structural reforms? While we cannot rule out a knee-jerk rally if Bolsonaro wins, the length and breadth of the market reaction will depend on the government's political capital (e.g. popular margin of victory and strength in Congress) and willingness to be proactive about structural reforms. On the left, both Haddad and Gomes are "populist," left-leaning, candidates whose victory would exacerbate the selloff. Haddad's vice-presidential candidate and coalition partner is Manuela D'Avila, from the Brazilian Communist Party (PCdoB). Their platform states that the solution to low economic growth is expansionary fiscal and monetary policies, such as a removal of the cap on government spending and a reduction in interest rates. Meanwhile the Gomes campaign has denied that Brazil has a pension deficit.7 Neither Haddad nor Gomes faces the IMF-imposed constraints that Lula faced when he took power in 2002. The market pressure surrounding his election in 2002 and the IMF proposals at that time essentially forced Lula to continue his predecessor Cardoso's reforms. Compared to 2002-03, today's profile of Brazilian share prices suggests that more downside is warranted (see Chart 1, page 1). Hence, we believe more market turmoil would be necessary to force Haddad or Gomes to adopt any difficult and unpopular fiscal reforms. We believe that both could be capable of executing reforms if pressed by the market, but a market riot is needed first. On the other hand, a Bolsonaro victory would likely trigger a meaningful rally on the expectation of pro-market reforms. Bolsonaro's economic advisor Paulo Guedes, a University of Chicago economics PhD holder, is a supply-side reformer who has proposed to privatize state-owned assets, enact tax and pension reforms, and scale back the bureaucracy. Crucially, Bolsonaro's camp wants to use the proceeds from privatization to repurchase public debt and buy time before reforming the pension system. Hence, in the eyes of many investors, Bolsonaro represents a market-friendly candidate despite his tough talk and anti-establishment tendencies. The problem is that Guedes has spent far more time giving interviews to the financial press than campaigning on draconian structural reforms. As such, it is not clear that Bolsonaro's economic team's promises jive with the desires of the median voter in the country. Bolsonaro, meanwhile, will likely be limited in forming a coalition in the Chamber of Deputies.8 The ability to form and maintain alliances in the Chamber of Deputies is a key constraint for any Brazilian president, especially from a smaller party. Obstructionism is common.9 Even large parties with strong alliances have fallen into gridlock, most obviously in attempting structural reforms. In late 1998, for instance, President Cardoso's own PSDB party deprived him of the votes needed to seal a painstakingly negotiated deal with the IMF, which led to a loss of confidence among creditors and a sharp devaluation of the real in January 1999. In short, it will be difficult for the new president to implement reforms at the beginning of his term even though, as noted above, Brazilian presidents tend to cobble together a coalition over time. It should be noted that Bolsonaro's authoritarian tendencies and desire to rewrite the 1988 constitution - a partisan Pandora's Box - could result in a further deterioration of Brazilian governance (Chart 12). This would push up the risk premium on assets over the long run, though in the short run Bolsonaro may be positively received by financial markets. Bottom Line: Bolsonaro would likely want to be a proactive structural reformer, but he would also be constrained at first due to his small party base in Congress and need to form a coalition. In addition, the days of liberally soothing partisan battles with pork-barrel spending are over. Brazil is both fiscally constrained and increasingly sensitive to corruption. Moreover, fiscal austerity would come with a negative hit to growth in the short term. It is not clear whether Bolsonaro will be able to form a Congressional coalition that can push through the painful part of the "J-Curve" of structural reform (Diagram 1). Chart 12Brazilian Governance Set To Fall Further Diagram 1The J-Curve Of Structural Reform On the other hand, neither Haddad's nor Gomes's platforms are market-friendly. Neither is likely to attempt structural reforms proactively. The market would have to sell off further, as in 2002, to pressure them into such policies. At that point, however, they might ultimately have a better ability to push legislation through Congress than Bolsonaro due to their ability to form larger coalitions amongst leftist parties. Either way Brazilian risk assets have further downside from where they stand today. A market riot is likely necessary to galvanize the population's support for painful structural reforms. That support currently does not exist. What Is At Stake? Chart 13The Achilles Heel Of The Brazilian Economy Brazil's public debt is out of control. Weak nominal GDP growth and high borrowing costs are increasing the public debt burden. This debt stems in large part from a sizable social security deficit that will continue expanding without the above-mentioned reforms (Chart 13). Thus, the next president will face a dilemma: implement austerity to satisfy creditors or increase spending to satisfy voters. A close look at voter preferences suggests that top priorities are improving health services and raising the minimum wage, while pension reform is at the bottom of the list (Chart 14). This reinforces our view that the left-of-center candidates are likely to be the closest to the median voter, and that fiscal austerity is not forthcoming. However, voters are also demanding that inflation be controlled, taxes be cut, and jobs be created - all of which could result in support for right-of-center candidates. Two possibilities to stabilize or reduce the debt load are: (1) restoring a primary budget surplus by enacting social security cuts and/or (2) privatizing state assets to raise fiscal revenues. In Europe throughout the early 2000s, peripheral countries with large public debt imbalances ran large primary budget deficits, just as Brazil has been running (Chart 15, top panel). Portugal, Ireland, Italy, Greece, and Spain stabilized their debt-to-GDP ratios by cutting social spending and capping fiscal expenditures (Chart 15, bottom panel). This will prove challenging as Brazil's pension system is one of the most generous in the world, with retirement ages of 54 and 52 for men and women, respectively, and a much lower contribution period relative to other countries. Furthermore, replacement rates for both men and women are 61%, or 10 percentage points above the OECD average and over 15 percentage points above other countries' reformed pension systems.10 Finally, the dependency ratio will continue to increase, as rising life expectancy and a declining working-age population remain structural headwinds for years to come.11 In our conversations with clients, the reality of Brazil's aging demographics usually comes as a complete surprise. Chart 14Brazil's Population Is ##br##Not Open To Fiscal Austerity Chart 15Eurozone Debt Crisis Resulted ##br##In Lower Spending And Stable Debt Therefore, social security reforms require outright cuts in spending, rather than soft caps on the budget balance. The present soft cap on government expenditures is not adequate to stabilize or reduce government debt levels. Could privatization help stabilize public debt dynamics? The privatization program during the 1990s under the Collor, Franco, and Cardoso governments led to the sale of $91 billion (around R$ 100 billion or 9% of GDP) worth of assets from 107 state-owned enterprises over the course of a decade. Presently, in order to re-balance the primary deficits of R$93 and R$79 billion for 2018 and 2019 respectively, the government would be required to frontload the sale of large state-owned entities, such as Petrobras or Banco do Brasil. This will prove challenging, since the sale of state-owned enterprises requires legislative approval. In fact, over the past two years, under interim President Temer, the government has struggled to sell its assets such as Electrobras. Even assuming that a Brazilian government under Bolsonaro conducts large-scale asset sales, previous privatization programs have failed to yield targeted sums and have required a longer time to implement than originally expected. Overall, privatization is not a feasible option to reduce high debt levels in Brazil in the short run. Bottom Line: Stabilizing or reducing the public debt as a share of GDP will be challenging under the current set of preferences set by voters. Moreover, demographic headwinds and structural constraints embodied in Brazil's two-tier legislative system will slow down the process of privatization and pension reform. The market is forward-looking and will cheer attempts to enact supply-side reforms in the short run, should they emerge, despite long-term uncertainties. The key questions are (1) whether the election produces a proactive Bolsonaro regime or a reactive left-wing regime (2) whether coalition formation - in Bolsonaro's case - or exogenous market pressure - in Haddad's case - are sufficient to initiate reforms in a timely manner in 2019. Amidst a broad EM selloff driven by external factors as well as Brazil's and other EM's internal fundamentals, we expect the markets to be largely disappointed in 2019. The evolution of the political context throughout the year will then determine when and if a buying opportunity emerges. Investment Implications In the late 1990s, faced with high foreign debt levels, a large current account deficit, and weak nominal growth, the Brazilian central bank devalued the real by 66% in January 1999 (Chart 16). This led to a rebound in nominal growth which helped the country relieve itself from built up excesses. In today's context, a weaker currency and lower interest rates are required to boost nominal GDP and contain Brazil's public debt as a share of GDP. There are already signs that the central bank is easing liquidity amid currency depreciation - which stands in contrast of the recent past (Chart 17). More liquidity provisioning by the central bank will cause the real to depreciate further. In light of this, we recommend that investors continue shorting the currency versus the U.S. dollar. Furthermore, due to our expectation of further deceleration in global growth stemming from China and a strong dollar, investors should expect more downside in broader EM and Brazilian share prices in U.S. dollar terms. With respect to the outcome of the elections, investors should continue underweighting Brazilian equities and credit in their respective portfolios for now (Chart 18). Chart 16Brazil Needs A Weaker Currency To##br## Boost Nominal Growth Chart 17A New##br## Paradigm Shift? Chart 18Sovereign Credit Spreads Will##br## Continue Widening We will consider whether an upgrade of Brazil is warranted after electoral outcomes become known. Particularly, the balance of the parties in Congress and the new president's coalition formation options will dictate the relative performance of Brazilian equities and credit over the next 6-12 months. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see, Wike, R. et al., "Globally, Broad Support for Representative and Direct Democracy", October 16th, 2017, available at http://www.pewglobal.org/2017/10/16/many-unhappy-with-current-political-system/ 2 In addition to the Pew Research data cited in Chart 5, please see Dora Saclarides, "Do Brazilians Believe In Democracy?" InoVozes, The Wilson Center, November 21, 2017, available at www.wilsoncenter.org. 3 Please see "Brazil: Vox Populi Poll Gives Haddad Lead In Presidential Race," Telesur, September 13, 2018, available at www.telesurtv.net, & Data Poder 360 poll from September 21st, available at: https://www.poder360.com.br/datapoder360/datapoder360-bolsonaro-tem-26-e-haddad-22-os-2-empatam-no-2o-turno/ 4 Please see, BTG Pactual September 15-16 poll, page 18. The Polls states that 57% of Lula voters would "not vote at all" while 41% would vote for Haddad. While turnout will improve for the second round, this is a risk to Haddad. 5 A poll by Empiricus Research and Parana Pesquisas p56 shows that 89.5% intend to vote (which is unrealistic), and that 95.7% of Bolsonaro voters intend to vote while 91.6% of Haddad voters intend to vote. 6 "The PT lost four of the five state capitals it had run, including Sao Paulo, the country's economic powerhouse where the leftist party was born. The PT lost two-thirds of the municipalities it won in 2012, dropping to 10th place from third in the number of mayors controlled by each party." Please see Anthony Broadle, "Brazil parties linked to corruption punished in local elections," Reuters, October 2, 2016, available at www.reuters.com. 7 Gomes has, however, admitted the need for some adjustments to the retirement age and public sector worker privileges, which suggests that he could be brought to pursue structural reforms under the right circumstances. https://todoscomciro.com/en_us/pnd/ciro-gomes-previdencia-social/ 8 Bolsonaro's legislative experience is also surprisingly thin. As a congressional representative for 27 years, he has only passed two laws, after presenting a total of 171 bills and one amendment to the constitution. Only three of these bills presented were of economic nature. It is unclear whether he has what it takes to galvanize the legislature in pursuit of tricky reforms. 9 Please see BCA Geopolitical Strategy Special Report, "Separating The Signal From The Noise," dated September 10, 2014, available at gps.bcaresearch.com. 10 A replacement rate is the percentage of a worker's pre-retirement income that is paid out by a pension program upon retirement. 11 Ratio measuring number of dependent zero to 14 and over the age of 65 to total working age population

Special Report

Highlights Since 2010, China's private sector has accounted for the majority of the country's increase in the debt-to-GDP ratio, most of which has been on the balance sheets of state-owned enterprises (SOEs) and the household sector. While policymakers achieved their goal of maintaining aggregate demand in the decade following the global financial crisis, the financial condition of SOEs has been greatly sacrificed as a result. An analysis of SOE return on equity highlights a sharp decline in return on assets, which has occurred due to both declining profit margins and a falling asset turnover ratio. Even worse, a comparison of adjusted SOE ROA to borrowing costs suggests that the marginal operating gain from debt has become negative. This has profound implications for policymakers, as it suggests that further leveraging of SOEs could push them into a debt trap and/or shackle the monetary authority's ability to meaningfully raise interest rates. We can envision a modest releveraging scenario over the coming 12-18 months, but even that scenario is not consistent with a surge in investment-driven economic activity. Policymakers face a clear choice between growth and leveraging, and our bet is that they will choose just enough of the latter to prevent the former from decelerating significantly. This implies that the typical beneficiaries of Chinese reflation are not likely to outperform global risk assets, and that China's contribution to global growth is not set to rise sharply. However, over the coming 6-12 months, we acknowledge that domestic stocks are significantly oversold, and we are watching closely for an opportunity to time a reversal. Feature Global investors have paid considerable attention to China over the past month, focusing on the likely stimulative response of policymakers to an upcoming, tariff-induced export shock. We recently presented our view of the likely character and magnitude of upcoming Chinese stimulus in a two-part joint special report with our geopolitical team,1 and concluded that an acceleration in fiscal spending was far more likely than a sharp pickup in credit growth. In this report, we further examine the constraints facing Chinese policymakers and again conclude that they are likely to remain committed to preventing a significant releveraging of the economy. The financial condition of Chinese state-owned enterprises features prominently in our argument, and we highlight how the damage caused by China's post-2008 "business model" is a serious roadblock to further credit excesses. Whereas most modern central banks characterize their monetary policy decisions within the context of a trade-off between growth and inflation, Chinese policymakers now appear to understand that they face a trade-off between growth and leveraging. While we agree that economic stability will always remain the paramount objective of policymakers and a major policy mistake is not likely in the cards, reflationary efforts are likely to be carefully calibrated to avoid a dramatic overshoot of credit growth. This means that there is both limited downside and upside to Chinese economic activity, implying that expectations of a material, credit-driven reacceleration in growth are not likely to be met. A Brief Review Of Chinese Private Sector Debt Chart 1A Now Familiar Concern After several years of intense concern about China's elevated debt, Chart 1 should be familiar to most investors. It highlights the significant rise in Chinese credit to the non-financial sector (i.e. total credit to governments, households, and non-financial corporations) based on data from the Bank for International Settlements (BIS), most of which has occurred in the private sector (non-financial firms and households). But Charts 2-4 presents a different breakdown of credit to the non-financial sector, based on IMF data, that includes a separation of corporate debt into private and state-owned enterprises (SOEs). The data shown in Charts 2-4 covers the 2010-2016 period; for reference, private non-financial sector debt continued to rise relative to GDP in 2017, in large part due to households (see Table A1 in Appendix 1 for the most recent IMF estimate of China's non-financial sector debt, absent the breakdown in corporate debt by ownership that the fund previously provided). Chart 2 presents the IMF's version of the rise in total non-financial debt (akin to Chart 1 from the BIS), and Charts 3 and 4 attribute the rise in debt to different sectors. Chart 3 shows that the increase in private sector debt accounts for 70% of the increase in leverage since 2010, and Chart 4 shows that the rise in SOE debt has accounted for nearly half of the rise in private sector debt. Within the private sector, household leverage has also risen substantially, accounting for roughly 40% of the rise from 2010-2016. Non-SOE corporates accounted for only 12% of the total rise in private leverage, the smallest of all sectors. Chart 2Another Perspective On Chinese Leveraging, With A Breakdown Of Corporate Debt By Ownership   Chart 3The Private Sector Has Accounted For ##br##Most Of Chinese Leveraging... Chart 4...Due Mostly To State-Owned ##br##Enterprises And Households     When considering the potential economic impact of a sharp rise in leverage, BCA's view is that the focus should usually be on the increase in private sector debt rather than government debt. Public sector deleveraging is fundamentally a political choice in countries that have control over their own monetary policy, and simply will not occur in China over the coming year given the headwinds facing the economy. Given this, Chart 4 suggests that to understand any constraints facing policymakers from excessive leverage, investors should primarily devote their attention towards China's SOEs. China's State-Owned Enterprises: The Sacrifice Of Profitability For Stability Chart 5Within SOEs, Industrial And Construction Firms ##br##Account For Half Of The Increase In Debt When assessing the risk of a potential private sector debt crisis in China, many investors have a sanguine view. The common refrain is that Chinese corporations, particularly state-owned enterprises, will be bailed out by the government if debt problems arise. Ultimately, we agree with this view, although we would note that the market pressure required to force the government to act could be quite severe. Still, there is a more pressing concern for investors: an analysis of the financial condition of China's state-owned enterprises suggests that the country may have reached the limit of how much SOEs can be further leveraged by policymakers in an attempt to rescue the economy, without significantly increasing the ultimate cost to the public. Our sense is that the campaign to control debt growth over the past two years reflects this economic reality, suggesting that the motivation behind the campaign will not be easily abandoned. Chart 2 showed that non-financial SOE debt-to-GDP rose by 20 percentage points from 2010-2016, a change in the stock of debt of roughly RMB33 trillion. Chart 5 shows that roughly half of this amount can be accounted for by the change in liabilities of state-owned industrial and construction enterprises over the same period. To the extent that they broadly reflect the condition of all non-financial SOEs, the availability of income statement and balance sheet data for these two industries allows us to make some inferences about the debt sustainability of China's state-owned firms.   Table 1 presents a breakdown of return on equity (ROE) for state-owned/state-holding companies in these industries, using the DuPont approach. Several points are noteworthy: Industrial & construction SOEs are highly leveraged entities, with an assets to equity ratio of 2.7. This explains the substantial difference between return on equity, which has been decently high, and a low single-digit return on assets (ROA). From 2010-2016, the ROE for industrial & construction SOEs fell from 14% to 8%, entirely because of a substantial decline in ROA. The decline in ROA occurred because of a roughly equal combination of declining profit margins and a falling asset turnover ratio. Based on the DuPont approach to expressing leverage,2 SOEs in the industrial and construction industries increased their leverage only very modestly during the period. But when leverage is expressed as liabilities relative to net income, a considerably more relevant measure when considering the potential to service debt, leverage nearly doubled. Table 1A Meaningful Decline In SOE Efficiency And Profitability We presented Chart 6 in our last weekly report of 2017,3 and used it to represent a stylized timeline of China's economic history over the past 15 years. The chart describes how China's extremely rapid growth phase from 2002-2008 was followed by the global financial crisis and a normal, counter-cyclical rise in the debt-to-GDP ratio from 2008 to 2010. Chart 6A Stylized Timeline Of China's Recent Economic History However, amidst the Great Recession, it became clear that China's export-enabled catchup growth phase was durably over, and policymakers were faced with a hard choice. They could either replace exports with debt-fueled domestic demand as a growth driver in order to buy time to transition to a services-led economy (the "reflate" path), or allow the labor market to suffer the consequences of a sharp slowdown in export growth while preserving fiscal and state-owned firepower for some uncertain future opportunity (the "stagnate" path). The picture that emerges from the combination of this narrative and our analysis of the evolution of SOE financial health is straightforward, but sobering. State-owned enterprises, already highly indebted at the onset of the global economic recovery, were levered even further in order to pursue the "reflate" path described above. While policymakers achieved their goal of maintaining aggregate demand, the consequence of their choice is that both the profitability and efficiency of SOEs have declined significantly. Avoiding An SOE Debt Trap A significant deterioration in SOE efficiency against the backdrop of a sharp rise in leverage speaks to the existence of capital misallocation, i.e. investment that has been funded by debt but cannot produce sufficient income to repay the debt. This suggests that SOEs are likely to have a bad debt problem at some point that will need to be resolved with government support. But in our view, the decline in profitability is a more immediate problem for policymakers, because it does not appear that SOEs can be leveraged any further without pushing them dangerously towards a self-reinforcing debt trap. Chart 7 illustrates why. The chart shows SOE ROA adjusted for interest expenses (a proxy for EBIT/Assets) versus a market-based proxy for SOE borrowing rates.4 Adjusted ROA fell below borrowing rates in 2013, suggesting that some of the observed decline in SOE profitability has occurred because the marginal operating gain from debt for Chinese state-owned enterprises has become negative. If so, this has profound implications for Chinese policymakers. Chart 8 illustrates how the process of perpetually leveraging an entity with a negative marginal operating gain from new borrowing eventually leads to a debt trap. An initial increase in debt causes interest costs to rise and profits to fall, as the return on new assets fails to exceed the interest rate on the debt used to acquire the assets. The process repeats itself as the entity is directed to leverage further, although management may choose to raise the entity's debt in this situation regardless of policy objectives (e.g. to cover a working capital deficit) if they mistakenly believe that the decline in ROA below debt costs is temporary. In addition, the existence of a negative marginal gain from new borrowing for a significant portion of the private sector would imply that China's natural rate of interest may have fallen. Chart 9 shows some evidence in support of this notion: the rise in the weighted average lending rate since late-2016 was relatively minor compared with levels that have prevailed over the past decade, and yet it is clear that it succeeded in materially slowing the investment-driven sectors of China's economy. This suggests that further leveraging of SOEs could tighten the shackles on the PBOC in terms of its ability to meaningfully raise interest rates, potentially fueling credit excesses in other sectors of the economy Chart 7SOEs Now Appear To Have A Negative ##br##Financial Gain From Debt Chart 8A Stylized Example Of ##br## Debt Trap Dynamics Chart 9Has SOE Leveraging Caused China's ##br##Natural Rate Of Interest To Fall?         In short, the financial condition of China's state-owned enterprises appears to represent a proximate constraint preventing policymakers from responding to economic weakness with a significant acceleration in credit growth. It is not just that SOEs are highly levered and there is "a lot of debt in the system"; material further leveraging of these entities risks deteriorating what is already very poor profitability, which may push SOEs into an outright debt trap. That would precipitate a crisis and necessitate a bailout from the government, the cost of which will increase directly in line with the amount of additional debt taken. We agree that economic stability will always remain the paramount objective of policymakers, and we fully expect a policy response to address the upcoming export shock from the U.S. But whereas most modern central banks characterize their monetary policy decisions within the context of a trade-off between growth and inflation, our analysis of China's state-owned enterprises suggests that Chinese policymakers now seem to understand that they face a trade-off between growth and leveraging. This implies that current reflationary efforts from policymakers are likely to be carefully calibrated to avoid a dramatic overshoot of credit growth. Envisioning Modest Releveraging Chart 10Modest Releveraging Is Ok, As Long As ##br##Its Pace Continues To Slow What is a carefully calibrated credit response likely to look like, and what does it mean for private sector debt growth? As noted above, my colleague Matt Gertken addressed this question by presenting three scenarios in part 1 of the recent joint special report with our geopolitical team.5 His base-case view, to which he assigned 70% odds, implied that there would be a very modest reacceleration in total social financing (on the order of 1% or so). In this report we take a second approach to estimating the potential magnitude of a modest reacceleration scenario using the BIS private sector credit data, primarily to incorporate different growth rates for the corporate and household sectors. Using the BIS data, Chart 10 shows the growth rate in Chinese total private sector debt, nominal GDP, and the difference between the two. The significant leveraging period from 2010-2016 is evidenced by the persistently positive gap between credit and GDP growth (it was only briefly negative in 2011).   But the chart also shows that there has been a downtrend in the gap since 2013, with 2017 representing a major overshoot (to the downside). Given that the trend shown in Chart 10 points downward and reflects policy efforts to control debt growth, we could envision Chinese policymakers tolerating some acceleration in credit growth relative to GDP, as long as it does not materially overshoot the trendline to the upside. Using this framework as a guide, we can calculate what modest releveraging might mean for corporate sector debt, assuming the following: Chinese policymakers, through a combination of fiscal spending and modest releveraging, succeed in stabilizing nominal GDP growth at current levels. Policymakers tolerate total non-financial private sector credit growth that is 4% in excess of nominal GDP growth. Household credit growth remains well in excess of GDP growth, in-line with its average of the past 5 years. Given the significant leveraging of the household sector and the recent uptick in home sales, this appears to be a reasonable assumption barring a major crackdown on the property market by Chinese officials. Chart 11 presents the result of these assumptions, which shows non-financial corporation credit growth accelerating to roughly 12% by the end of 2019. At first blush, the chart appears to show a meaningful acceleration, as the annual change in year-over-year credit growth based on this measure would meet or exceed that of the past two credit cycles. But there are two important caveats for investors: Even as depicted in Chart 11, non-financial corporate credit growth would still be extremely weak relative to its recent history. At the end of 2019, the chart shows that corporate credit growth would be almost two percentage points lower than its weakest point in 2015. Chart 11 illustrates a scenario where the level of credit to the total private non-financial sector grows by RMB36 trillion by the end of 2019. Chart 12 shows that when compared to our estimate of the stock of adjusted total social financing, this rise barely even registers as an acceleration. Chart 11A Rebound, But Weak Relative To History Chart 12Barely Even Registers As An Acceleration In Adjusted TSF In short, while the degree of acceleration in credit growth as implied in our scenario varies depending on the definition of credit employed, the bottom line for investors is that a modest releveraging scenario is not consistent with a surge in investment-driven economic activity. Policymakers face a clear choice between growth and leveraging, and our bet is that they will choose just enough of the latter to prevent the former from decelerating significantly. This cautious, contingent attitude towards an acceleration in private sector credit growth would be in marked contrast to previous episodes of reflation, suggesting that investors who are following China's "old stimulus rulebook" are likely to be disappointed. Implications For Investment Strategy Chart 13No Signs Yet Of A Heavy, Credit-Based Response There are two clear implications of our analysis for investment strategy. First, in ironic reference to Reinhart & Rogoff's book that coined the term, "this time" is likely to be different for China because policymakers seem resolute in their intention to prevent a financial crisis (as opposed to the term having been used in the past by those who have ended up contributing to one). Our analysis shows that the debt burden for state-owned enterprises is already extreme, and that further, material, forced leveraging of the sector risks a possible debt trap. This implies that the typical beneficiaries of Chinese reflation are not likely to outperform global risk assets, and that China's contribution to global growth is not set to rise sharply. For now, our BCA China Play Index and the relative performance of infrastructure stocks seem to support our conclusion (Chart 13). Second, if this time is not different, i.e. if policymakers allow a significant further releveraging of the private sector, either intentionally or by accident, investors should recognize that the longer-term outlook for China may darken considerably if the country is not capable of quickly shifting away from its old growth model over the next few years. Unfortunately for officials in China, the reality of economics is that positive NPV projects for SOEs to invest in cannot simply be willed into existence. The significant decline in profitability and asset turnover that we have observed in state-owned enterprises since 2010 speaks to the poor use of credit, and policymaker reliance on the traditional methods of stimulus is likely to achieve the country's short-term goals at the expense of making the already large debt problem (and the cost of the eventual bailout by the public sector) much worse. This would raise both the political and economic risks facing the country, at a time when a U.S. and/or global recession appears likely within the next 2-3 years. As a final point, despite our caution against over-optimism concerning China's stimulative response, we acknowledge that policymakers are likely to succeed in preventing a significant deceleration in their economy over the coming 6-12 months. Given how materially Chinese stock prices have declined, it remains a debate whether a mere stabilization of economic activity at a modest pace will be enough for domestic or investable equities to meaningfully rally in absolute or relative terms. For now, we have highlighted that the relative selloff in domestic stocks appears to be quite late, particularly in common currency terms, and we are watching closely for an opportunity to time a reversal.   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com   Appendix 1 Appendix A-1Chinese Non-Financial Sector Debt 1 Pease see China Investment Strategy Special Reports "China: How Stimulating Is The Stimulus?", dated August 8, 2018, and "China: How Stimulating Is The Stimulus? Part Two", dated August 15, 2018 available at cis.bcaresearch.com 2 The DuPont approach breaks down return on equity into the product of profit margins (profits / revenue), asset turnover (revenue / assets), and financial leverage (assets / equity). 3 Pease see China Investment Strategy Weekly Report "Legacies Of 2017", dated December 21, 2017, available at cis.bcaresearch.com 4 We use the yield-to-maturity of the ChinaBond Corporate Bond Index as our proxy for the interest rate paid by state-owned firms, given that the index includes bonds issued by central and local government SOEs. Importantly, our proxy is closely aligned with the weighted average bank loan borrowing rate paid by SOEs from 2014-2016, as per a 2017 report from the China Academy of Fiscal Science ("Cost reduction: 2017 survey and analysis", August 28, 2017). 5 Pease see China Investment Strategy Special Reports "China: How Stimulating Is The Stimulus?", dated August 8, 2018, and "China: How Stimulating Is The Stimulus? Part Two", dated August 15, 2018 available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Special Report

Highlights The Philippines is seeing a genuine inflation outbreak. The Duterte administration's policies favor "growth at all costs." "Charter change," or constitutional revision, will stoke political polarization, erode governance, and feed inflation. We are neutral on Philippine stocks and bonds within EM benchmarks for now but are placing the country on downgrade watch. Feature Chart 1Markets Sold On Duterte Election It has been nearly two years since Rodrigo "Roddy" Duterte - the Philippines' populist and anti-establishment president - was elected. On May 11, 2016, two days after the vote, BCA's Geopolitical Strategy and Emerging Markets Strategy published a joint report arguing that Duterte would "take the shine off" the economic structural reforms that had taken place under the outgoing administration of President Benigno Aquino.1 We downgraded the bourse from overweight to neutral within the EM universe. Financial markets have largely vindicated this view. Philippine stocks peaked against EM stocks three days before Duterte's inauguration and have continued to underperform since then. The Philippine peso has also suffered, both in real effective terms and relative to the weakening U.S. dollar (Chart 1). Is it time to buy then? No. Duterte's policies will continue to erode the country's governance and macro fundamentals, overheating the economy and subtracting from investment returns. Of course, the country is well insulated from any China or commodity shock, and this is an important advantage over other EMs in the medium term. Also, equity and currency valuations have improved relative to other EMs. Hence we recommend clients remain neutral Philippine stocks, currency, and credit versus the EM benchmark for now, and use any meaningful outperformance to downgrade the country to underweight within aggregate EM portfolios. An Inflation Outbreak One of the most reliable definitions of a populist leader is one who pursues nominal, as opposed to real, GDP growth. While policymakers can stimulate nominal growth through various policies, real growth over the long run depends on productivity and labor force growth, which are much harder to control. The only way policymakers can affect real growth is by undertaking structural reforms - which are often painful and unpopular in the short run. By contrast, faster nominal growth as a result of higher inflation can create the "money illusion" among the populace and bring political rewards, at least for a time.2 Higher nominal growth might initially please the public, but when inflation escalates it will reduce living standards. Moreover, an inflation outbreak will eventually necessitate major policy tightening and a growth downturn to reverse inflation. A comparison of a range of populist political leaders with orthodox (non-populist) leaders across Latin America, Central Europe, and Central Asia demonstrates that populists really do tend to achieve higher nominal growth relative to non-populists in the first two years of their rule (Chart 2). This finding has served BCA's Geopolitical Strategy well in predicting that U.S. President Donald Trump would blow out the federal budget through tax cuts and government spending in pursuit of faster growth.3 With stimulus taking effect while the output gap is closed, inflationary pressures are likely to rise higher than they otherwise would have done over the next 12-to-24 months.4 Chart 2Populists Pursue Nominal GDP Growth President Duterte of the Philippines also appears to fit this rubric. Like Donald Trump, he combines foul-mouthed eccentricity and personal risk-taking with a policy agenda of tax cuts, fiscal spending, and deregulation (Table 1).5 Yet unlike Trump, his infrastructure program - which is desperately needed in the Philippines, a laggard in this respect - is up and running, producing a large increase in capital expenditures and imports. The gap between nominal and real GDP growth - i.e. the inflation rate - looks likely to rise further. Table 1Duterte's Agenda Consists Of Drug War, Tax Cuts, And Big Spending Signs of an inflation outbreak are already evident. Chart 3 shows that both core and headline inflation measures are now rising sharply and have crossed the Bangko Sentral ng Pilipinas's (BSP) 3% inflation target by a wide margin, even rising above the 2%-4% target band. Further, local currency yields are rapidly ascending while the currency has been plunging against the weak U.S. dollar. These indicators suggest that the inflation outbreak that BCA's Emerging Markets Strategy warned investors about in October has now come to pass.6 The official explanation for the inflation spike this year is Duterte's tax reform bill, which took effect January 1 (and is the first of several such bills). The bill cuts taxes for households and raises excise taxes on a range of goods - from electricity, petroleum products, coal, and mining to sugary drinks and tobacco.7 The central bank has cited this law and its ramifications (including transportation costs and wage demands) as reasons for the inflation overshoot to be temporary. Yet Duterte's growth agenda and the BSP's simulative policies have created an environment ripe for inflationary pressures to build, namely by encouraging banks to expand their balance sheets and money supply (Chart 4). This has led to excessive strength in domestic demand. Chart 3An Inflation Outbreak Chart 4Stimulative Policies Further signs of a genuine inflation outbreak include: Twin deficits: both the current account and fiscal balances are negative in the Philippines, a significant development over the past two years (Chart 5). Further, the trade balance now stands at a nearly two-decade low of 9.5% of GDP (Chart 6). Worryingly, the current account has fallen into deficit despite the fact that remittances from Filipinos living abroad, which account for 9% of GDP, have been robust (Chart 6, bottom panel). Oil prices are surprising to the upside as global inventories drain and the geopolitical risk premium rises. This puts additional pressure on the current account balance and adds to inflationary pressures. Chart 5The Philippines Now Has Twin Deficits Chart 6Trade Deficit Worsens; Remittances The Saving Grace The Philippines' import bill is growing briskly, especially that of consumer goods (Chart 7, top panel). Meanwhile, overall export volumes and revenues of non-electronic/manufacturing exports are contracting (Chart 7, second panel). This is a sign that the Philippine economy is losing competiveness. Indeed, the third panel of Chart 7 shows that the country's global export market share is deteriorating. Wages are rising across many sectors (Chart 8). The imposition of excise taxes on electricity and fuel has prompted a wave of demands for higher wages from labor groups and provincial wage boards. Duterte is also said to be preparing a nationwide minimum wage law (to increase regional wages vis-à-vis the capital Manila) and an end to temporary employment contracts, which cover about 25% of the nation's workers and pay wages that are 33% lower on average. As wage growth outpaces productivity gains, unit labor costs are rising, eating into listed non-financial companies' profit margins (Chart 9). Chart 7Domestic Demand Surges While Competitiveness Falls Chart 8Wage Growth Is Strong On the fiscal front, the Duterte administration is pushing badly needed spending increases in infrastructure, health, and education. The investments amount to $42 billion over six years, or roughly 2% of GDP per year in new fiscal spending.8 While these investments will be beneficial in the long run as they augment both the hard and soft infrastructure of the nation, their size and timing needs to be modulated in real time to prevent them from creating excessive inflationary pressures in the short and medium run. This is difficult and the administration is likely to err on the side of higher spending that feeds inflation. Further, the administration's tax reform plan is unlikely to raise enough revenue to cover all the new spending. The first tax reform bill to pass through Congress cuts household tax rates for most brackets (with rates to fall further in 2023) and raises the threshold to qualify for income tax, thereby narrowing the tax base to 17% of the population. The value added tax (VAT) will also have its threshold increased. Corporate taxes will be cut next. Revenue shortfalls will add to the budget deficit. Loosening fiscal policy will foster higher inflation and will continue weighing on the currency. Despite the upside inflation surprise, the central bank has kept the policy rate at the record low level of 3% where it has been since 2014. It also cut reserve requirements in March, injecting liquidity into the system. Deputy Governor Diwa Guinigundo says that an inflation reading within the target band at the May 10 monetary policy meeting will increase the likelihood that no rate hikes will occur this year.9 The central bank explicitly views this year's high inflation as a passing phenomenon tied to the excise taxes. It may also have stayed its hand due to signs of waning momentum in certain segments of the economy such as autos and property construction, which are weakening (Chart 10). Chart 9Higher Labor Costs Eat Firm Margins Chart 10Central Bank Not Worried About Overheating But in light of the fiscal and credit trends outlined above, and given that the Philippine economy is domestically driven and insulated from the slowdown in global growth, we do not expect domestic growth to fall very far. Overall, the central bank has maintained accommodative monetary policy for too long and tolerated an inflation outbreak. At this stage, central bank independence thus becomes a critical question. The current governor, Nestor Espenilla, is a tough enforcer against financial crimes who may be willing to do what it takes to rein in inflation: his comments have been a mixture of hawkish and dovish. But he is also a Duterte appointee, and thus perhaps unwilling to counter a popular, and forceful, president. It is too soon to say that the BSP will fail in its duties, but it does have a reputation for dovishness that it has reinforced this year.10 This analysis points to a policy of "growth at all costs." Odds are that growth will remain fast, that the inflation outbreak will continue, and that the BSP has fallen behind the curve. Bottom Line: The Philippines is witnessing an inflation outbreak that is likely to continue. Credit growth is booming, fiscal policy is loose, and the central bank is behind the curve. This policy setup is negative for the currency and for stock prices and local bonds in the absolute. Cha-Cha: What Does It Mean? In the long run, Duterte's authoritarian leanings will weigh on the country's performance. Governance has declined since he took office, primarily because of his rampant war against drugs. The Drug War has officially led to the deaths of 6,542 people since July 1, 2016, according to the Philippine Drug Enforcement Agency.11 Human rights groups believe the actual tally is twice as high. Yet even if we exclude "political stability and absence of violence" from the Philippines' governance indicators, the country's score has declined under Duterte and is worse than that of its neighbors (Chart 11). And this score does not yet account for the fact that Duterte has imposed martial law on the southern island of Mindanao and is using his popularity (56% net approval, Chart 12) and supermajority in Congress (89% of seats in the House and 74% in the Senate) to push a constitutional rewrite that would give him even more extensive powers.12 Chart 11Even Excluding The Drug War, Philippine Governance Is Bad And Getting Worse Chart 12Duterte Is Popular (But Not That Popular) Like previous administrations, the Duterte administration wants to revise the 1987 Philippine constitution. There are three current proposals, each of which would change the government from a "unitary" to a "federal" system.13 Manila would remain the capital but the provinces would be incorporated into states or regions that would have their own governments and greater autonomy. The proposals differ in detail, but if and when congressmen and senators reconstitute themselves into a Constituent Assembly to rewrite the charter, they will have complete freedom, i.e. will not be limited to the specifics of these proposals. A popular referendum will be necessary to approve the results and could occur as early as May 13, 2019, when Senate elections will be held, or the summer afterwards.14 "Charter change" or Cha-cha is a perennial preoccupation in the country with three main drivers (Table 2). First, successive Philippine presidents try to revise the constitution so that they can stay in power longer than the single, six-year term limit. Second, provincial political forces seek to change the constitution to decentralize power. Third, economic reformers and business interests seek to remove protectionist articles embedded in the constitution, particularly limitations on private and foreign investment. Table 2History Of Cha-Cha In The Philippines In general, Manila is seen as a distant and unresponsive capital ruling over an extremely diverse and disparate archipelago. The centralized system is prone to corruption due to the pyramid-like patronage structure descending from a handful of elite, Manila-based, families at the top. Meanwhile the provinces lack autonomy and economic development. While the capital region only contains 13% of the population, it accounts for 38% of GDP. The central government has trouble raising resources - as indicated by a low tax revenue share of GDP compared to neighbors (Chart 13). It is at times incapable of providing essential services like security and infrastructure, particularly in far-flung provinces like Mindanao or parts of the Visayas where poverty, under-development, natural disasters, and militancy reign. The chief goal of those who want a federal system is to decentralize power in order to strengthen the provinces. They argue that reversing the role of central and regional fiscal powers will improve government effectiveness overall by bringing the government closer to the people it governs. Today, the central government controls about 93.7% of the revenues and 82.7% of the spending while local governments control about 6.3% and 17.3% respectively (Chart 14). Chart 13The Philippine Government Is Underfunded And Weak Chart 14The Philippine Government Is Heavily Centralized Under a federal system these roles would reverse. Local governments would gain greater powers to tax and spend within their jurisdictions, while also improving tax collection. This would enable them to improve public services while still providing the federal government with resources to pursue national goals. Better funded and more autonomous local governments would presumably be more responsive to public demands within their jurisdictions. This is especially the case given the country's population and geography, with 101 million people spread out over more than 7,000 islands. The result - say the proponents - would be better governance all around, including greater economic development across the regions. From this point of view, over the long run, Cha-cha appears to be a pro-market outcome. In particular, the proposed changes will probably include greater openness to foreign direct investment (FDI), easing restrictions on land ownership, utilization, and resource exploitation that have long been difficult to remove because of their constitutional status (a vestige of anti-colonial sentiment). The Philippines falls markedly behind its peers in attracting FDI (Chart 15). This change would likely have a positive impact on FDI and productivity, as the Philippines has long suffered from its closed, protectionist, and heavily regulated model.15 Chart 15The Problem With Constitutional Restrictions On Foreign Investment However, Cha-cha's opponents argue that the net effect will be negative for the business community and financial markets because of the drastic shift in the status quo. They argue that the 1987 constitution provides ample authority for decentralization but that Congress has refused to pass implementing legislation due to vested interests. As opposed to reforming the Local Government Code and other laws on the books, a total change of the government system would be controversial, expensive, and prone to expanding bureaucracy (as it would replicate the current national government institutions for each state/region in the new federal system). It would also be self-interested. Cha-cha would give Duterte additional powers to oversee the chaotic transition, and likely give him new powers in the aftermath as a result of the provisions themselves.16 Weighing both sides, we expect that charter change will require a massive political struggle and a long transition period in which economic uncertainty will spike. It will also give Duterte more arbitrary power and weaken central institutions and legal frameworks designed to keep him in check. While he insists that he will step down in 2022 according to existing term limits, Cha-cha could remove the constitutional limit on his time in office or allow him to resume as prime minister indefinitely. He would also have extensive powers of appointment and dismissal affecting the judiciary and other checks and balances. Is creeping authoritarianism market-negative? Not necessarily. Authoritarian governments in some cases have greater ability to make difficult, unpopular decisions that benefit national interests in the long run - including on macroeconomic policy. Singapore, Taiwan, and China are famous regional examples. Nevertheless, the Philippines is not Singapore or China - it is not a weak or non-existent democracy with a strong central government, but rather a strong democracy with a weak central government. It will not be easy for Duterte to seize ever-greater control if he should attempt to. He will eventually meet resistance from "people power" - mass protests from civil society such as those that overthrew dictator Ferdinand Marcos in 1986 and President Joseph Estrada in 2001. Such a movement may not develop in the short run, given his popularity, but the distance from here to there will involve political instability and a deterioration of monetary and fiscal management. To illustrate this process, consider the Philippines' record in the "Polity IV" dataset, which is a political science tool that provides a standardized measure of the quality of democracy in different regimes across the world.17 A time series of the Philippines' Polity scores illustrates the drastic collapse of governance under Marcos (Chart 16), who imposed martial law from 1972-81 and plunged the country into a morass of oppression, dysfunction, and corruption. This ended with the first People Power Revolution in 1986 and the promulgation of the 1987 constitution. Since then, Polity scores have improved markedly. Today the Philippines scores an eight, within the range of western democracies. The democratic era has been a boon for investors who have seen the Philippines improve its macroeconomic and business environment over this period. But Duterte is a Marcos-like figure who could reverse this process even if he does not drag the country all the way down into the worst conditions of the 1970s-80s. Could Duterte succeed in charter change where his post-Marcos predecessors have failed? Yes. He has a lot of political capital and is well situated to push for dramatic change. He is an anti-establishment political outsider - the first Philippine president from the deep south - elected amidst a wave of disenchantment over persistent, endemic problems like poverty, corruption, lawlessness, and lack of development. He has high public approval ratings and a supermajority in Congress (Chart 17). It is too early in the game to give firm probabilities on whether the constitutional changes will pass the necessary popular referendum in spring or summer 2019, but it is perfectly possible for Duterte to succeed judging by his standing today. Chart 16The Marcos Dictatorship Was Inflationary Chart 17Duterte's Legislative Supermajority What will be the economic effects? Aside from policy uncertainty, decentralization will be good for growth and inflation. Local leaders will have more tax money to spend and less central discipline. Pent-up demand for development in the provinces will be unleashed, with local political leaders likely to encourage credit expansion. In the context outlined above this change means higher inflation. Inflation rates in the provinces should start to climb toward those of the capital region, while those of the capital region would have no reason to fall amid the flurry of new activity. Hence investors interested in the Philippines must monitor the long and rocky road of charter change. They should look to see if the Congress and Senate do indeed merge into a Constituent Assembly (the quickest yet most controversial way of revising the constitution because it is the least constrained); what proposals look to be codified in the drafting of the constitution and assembly debates; if Duterte retains his popularity throughout the constitutional process; and whether the public is supportive of the proposals.18 Our rule of thumb is that a constitutional process focused on decentralization and removal of protectionist provisions would be market-positive in principle. However, if authoritarian provisions creep into the final text, they may reveal the market-negative priorities and a lack of constraints on policymakers in Manila. Bottom Line: Philippine governance will continue to decay under the Duterte administration. Revisions to the constitution will have pro-market aspects, and net FDI will probably continue to rise. But these positive aspects will be overweighed by the politically polarizing and destabilizing process of charter change itself. Moreover, decentralization will feed into the current credit boom and inflationary backdrop and could produce excesses. The U.S.-China Crossfire The Philippines is a strategically located island chain that frames the South China Sea (Diagram 1). It has been caught in great power struggles for centuries. The rising U.S. colonial power displaced the remnants of the established Spanish colonial power there in 1898; the rising Japanese empire displaced the established U.S. in 1941, only to be defeated by the U.S. and its allies in 1944. Diagram 1The South China Sea: Still A Risk Now China is the rising power in Asia and is applying pressure on America's visiting forces. The Philippines is again caught in the middle. It relies on the U.S. more than China economically and strategically, but China is rapidly catching up, as is clear in trade data (Chart 18). And China's newfound naval assertiveness must be taken seriously. Indeed, Duterte claims that Chinese President Xi Jinping threatened him with war if his country crossed China's red line in the South China Sea.19 Chart 18China Rivals U.S. In The Philippines Geopolitical risk has fallen since Duterte's election as a result of his pledge to improve relations with China and distance his country from the United States. This was a sharp reversal of Philippine policy. From 2010-16, the Aquino administration engaged in aggressive strategic balancing against China. The country was threatened by China's militarization of the Spratly Islands in the South China Sea and encroachment into Philippine maritime space and territory. The pro-American direction of Aquino's policy culminated in the signing of the Enhanced Defense Cooperation Agreement (EDCA), which granted the American military the right, for ten years, to rotate back into Philippine bases. In July 2016, the Permanent Court of Arbitration ruled in favor of the Philippines, against China, in a landmark case of international law. It held that the South China Sea "islands" were not islands at all and that China could not base territorial or maritime claims off them.20 This strategic balancing brought tensions with China to a near boiling point. However, the pot was taken off the fire when the Philippine public elected the outspokenly anti-American, pro-Chinese, and communist-sympathizing Duterte. Duterte immediately set about courting Chinese investment, calling for bilateral China-Philippine solutions in the South China Sea (such as joint energy development), and denouncing President Barack Obama, the West, and various international legal bodies.21 As a result, China has largely dropped its pressure tactics against the Philippines. It has been investing more in the country over time (Chart 19) and has recently proposed a range of new projects worth a headline value of $26 billion. In the short run, Duterte's policy is positive because it enables the country to extract economic and security benefits from both the U.S. and China. China has reduced its coercive tactics, while the U.S. under President Trump has taken an easy-going attitude both toward Duterte's human rights violations and his pro-China (and pro-Russia) leanings. Duterte, for his part, has not tried to nullify the 2014 military pact with the U.S., but rather reversed his claim that he would sever ties with the U.S. by asking for American counter-insurgency support during the 2017 Siege of Marawi. Eventually, however, the emerging U.S.-China "Cold War" could force Duterte to make unpopular choices that violate economic relations with China or security protections from the U.S. The Philippine public is largely pro-American and suspicious of China.22 Thus, if Duterte pushes his foreign policy too far, he will provoke a backlash. This could take the form of a revolt against Chinese investments in the economy - as Chinese companies will be eager to take advantage of greater FDI access, especially under constitutional reform. Or it could take the form of a revolt against Chinese encroachments in the South China Sea, which are bound to recur.23 Alternatively, if the Philippines takes China's side, the U.S. could threaten to cut off market access, remittances, or (less likely) military support. A rupture in U.S. or China relations could spark or feed into domestic opposition to Duterte over political or constitutional issues or trigger a tense U.S.-China diplomatic standoff with economic ramifications. This is something to monitor in case a conflict emerges such as that which occurred in 2012-14 at the height of Philippine-China tensions, or in South Korea in 2015-16. In both cases, China imposed discrete economic sanctions against American allies as a result of foreign policy moves they took in stride with the United States (Chart 20). Chart 19Chinese Investment Will Rise Under Duterte Chart 20China Imposes Sanctions In Geopolitical Spats Bottom Line: Geopolitical risks have abated over the past two years and should remain contained for the next few years, as China wishes to reward Duterte and his foreign policy. However, relations between the U.S. and China are getting worse, which puts the Philippines in the middle of the crossfire. The South China Sea remains a fundamental, not superficial, source of tension. Investment Conclusions Chart 21Stocks And Bonds Will Underperform This scenario is negative for financial markets and will cause stocks to fall and local bonds yields to rise in absolute terms (Chart 21). Philippine equities remain very expensive. At this point only policy tightening by the BSP can control inflation, but that, even if it were to occur (unlikely in our opinion), will be negative for growth and financial markets in the short-to-medium term. Relative to other EMs, Philippine financial markets have underperformed considerably for the past few years, and thus might experience a relative rebound. If so, it will not be due to Philippine fundamentals but to the fact that in other EMs, fundamentals are deteriorating and financial markets selling off. These markets have had a good run in the past two years and are vulnerable to the downside. In this context, it matters that the Philippines is not a major commodity exporter and not highly vulnerable to a Chinese growth slowdown. Oversold conditions relative to EM peers and lower commodity prices could allow the Philippine bourse and currency to outperform those peers for a time. We thus maintain neutral allocation on Philippine stocks and bonds within EM benchmarks for now but are placing it on downgrade watch. On the political side, President Duterte is making investments in the country that will improve the supply side, but his policies will feed inflation in the short term and erode governance in the long term. His push to reshape the political and governmental system will increase political risk at a rare moment when geopolitical risks have somewhat abated. The latter are significant, but latent, and could flare up significantly in the long run due to U.S.-China conflicts. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Ayman Kawtharani, Associate Editor Emerging Markets Strategy ayman@bcaresearch.com 1 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 2The "money illusion" is a concept in macroeconomics coined by economist Irving Fisher, who wrote a book of the same title in 1928, to describe the failure of economic actors to perceive fluctuations in the value of any unit of money. In other words, people tend to pay more attention to nominal than to real changes in money or prices. The concept is valid today, albeit subject to academic debate over its precise workings. 3 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, and Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 4 Please see BCA Emerging Markets Strategy Weekly Report, "EM: Perched On An Icy Cliff," dated March 29, 2018, and "Two Tectonic Macro Shifts," dated January 31, 2018, available at ems.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Monthly Report, "Transformative Vs. Transactional Leadership," dated September 14, 2016, available at gps.bcaresearch.com. 6 Please see "The Philippines: An Overheating Economy Requires Policy Tightening" in BCA Emerging Markets Strategy Weekly Report, "Is The Dollar Expensive, And Are EM Currencies Cheap?" dated October 11, 2017, available at ems.bcaresearch.com. 7 Please see Office of the Presidential Spokesperson, "A Guide To T.R.A.I.N. Tax Reform for Acceleration and Inclusion (Republic Act No. 10963," dated January 2018, available at www.pcoo.gov.ph, and Department of Finance, "The Tax Reform For Acceleration And Inclusion (TRAIN) Act," dated December 27, 2017, available at www.dof.gov.ph. 8 Please see the Philippine Department of Finance, "The Comprehensive Tax Reform Program: Package One: Tax Reform For Acceleration And Inclusion (TRAIN)," January 2018, available at www.dof.gov.ph. 9 At its March policy meeting the BSP decided to keep interest rates on hold despite a March inflation reading of 4.3%, above the top of the target range of 4%. For Guinigundo's comments about the May 10 meeting, please see "Philippines c. bank says monetary policy still data-driven, may hold rates," April 20, 2018, available at www.reuters.com. 10 The BSP has reportedly only surprised markets four times out of 84 scheduled monetary policy meetings over the past ten years. Please see Siegfrid Alegado, "Life Is Getting Harder For Philippine Central Bank Watchers," dated March 21, 2018, available at www.bloomberg.com. 11 Please see Rambo Talabong, "Duterte gov't tally: At least 4,000 suspects killed in drug war," dated April 5, 2018, available at www.rappler.com. 12 Duterte's personal popularity is overstated. He was elected in a landslide, but only received 39% of the popular vote. The Pulse Asia quarterly polls suggest his popularity and "trust" ratings have ranged from 78%-86% since his inauguration (currently 80%), but this falls to 60% if undecided voters and disapproving voters are netted out. The Social Weather Station polls, which we cite, show a 56% net approval rating, which is mostly in line with Duterte's predecessor President Aquino at this stage in his term. 13 There are currently three draft proposals. The first is Senate Resolution No. 10, filed by Senator Nene Pimentel; the second is House Resolution No. 08, filed by Representatives Aurelio Gonzales and Eugene Michael de Vera; the third is the ruling PDP Laban Party's proposal, from Jonathan E. Malaya at the party's Federalism Institute. 14 The funding to hold a referendum in 2018 does not exist nor are legislators ready. A "special budget" will coincide with the plebiscite, no doubt strictly to pay for the polling and not to grease the wheels of the "yes" vote! Please see Bea Cupin, "Charter Change timetable: Plebiscite in 2018 or May 2019, says Pimentel," I, February 2, 2018, available at www.rappler.com. 15 Please see Gary B. Olivar, "Update On Constitutional Reforms Towards Economic Liberalization And Federalism," American Chamber of Commerce Legislative Committee, dated September 27, 2017, available at www.investphilippines.info. 16 Please see Neri Javier Colmenares, "Legal Memorandum on Charter Change under the Duterte Administration: Resolution of Both Houses No. 8 Proposed Federal Constitution," December 4, 2017, available at www.cbcplaiko.org. 17 Please see the Center for Systemic Peace and Monty G. Marshall, Ted Robert Gurr, and Keith Jaggers, "Polity IV Project: Political Regime Characteristics and Transitions, 1800-2016," July 25, 2017, available at www.systemicpeace.org. 18 Local elections in May 2018 may also provide some indications of popular support, as well as the Senate elections in May 2019 (if the referendum is not simultaneous). 19 Please see Richard Javad Heydarian, "Did China threaten war against the Philippines?" Asia Times, dated May 23, 2017, available at www.atimes.com. 20 Please see BCA Geopolitical Strategy Special Report, "South China Sea: Smooth Sailing?" dated March 28, 2017, available at gps.bcaresearch.com. 21 He has since said the Philippines will leave the International Criminal Court, which it joined in 2014, and arrest any prosecutor of the court who comes to the Philippines to investigate the government and police handling of the drug war. Please see Rosalie O. Abatayo, "Arresting ICC prosecutor could get Duterte in more legal trouble, says lawyer," The Philippine Daily Inquirer, April 22, 2018, available at globalnation.inquirer.net. 22 Please see Jacob Poushter and Caldwell Bishop, "People In The Philippines Still Favor U.S. Over China, But Gap Is Narrowing," Pew Research Center, September 21, 2017, available at www.pewglobal.org. 23 At present the Association of Southeast Asian Nations is negotiating a long-awaited, albeit non-binding, "code of conduct" with China in the South China Sea that could be concluded as early as this or next year. However, South China Sea tensions could heat up again at any point due to Chinese encroachments, U.S. pushback, or other regional actions. Also, with oil prices set to increase rapidly, non-U.S./OPEC/Russia international offshore oil rigs could begin to increase again, renewing an additional source of tension in the sea.

Highlights Overstated geopolitical risks in 2017 are giving way to understated risks in 2018; The reshuffle of China's government raises policy headwinds for global growth and EM assets; U.S. politics will be roiled by a leftward turn and Trump's protectionism and foreign policy; Italian politics, more than German, is the chief threat to European risk assets; Volatility and the USD will rise; shift to neutral on European risk assets; close tactical long on Chinese Big Banks. Feature BCA's Geopolitical Strategy has operated this year on a high conviction view that geopolitical risks would be overstated, thus generating considerable upside for risk assets. Our analysis focused on three particular "red herrings": European populism, U.S. politics, and Brexit.1 Meanwhile we identified North Korea as a genuine geopolitical risk, though not one that would cause us to change our "risk on" outlook. We therefore take issue - and perhaps offense - with the contemporary narrative that "geopolitics did not matter" in a year when the S&P 500 rose by 15% and VIX plumbed historic lows (Chart 1). Stocks rose and the VIX stayed muted precisely because geopolitical risks were overstated earlier in the year. Investors who correctly assessed the balance of geopolitical risks and opportunities would have known to "buy in May and enjoy your day."2 At the same time that we encouraged investors to load up on risk this year, we cautioned that 2018 would be a challenging year.3 Three themes are now coming into focus as 2017 draws to a close: Politics has become a headwind to growth in China as Beijing intensifies deleveraging and structural reforms; U.S. fiscal and monetary policy favor the USD, which will reignite trade protectionism from Washington D.C.; Italian elections may reignite Euro Area breakup risk. In this report, we update our view on these three risks. Data out of China are particularly concerning: broad money (M3) growth has decelerated sharply with negative implications for the economy (Chart 2).4 M3 is at last ticking up but the consequences of its steep drop have not yet translated to the economy. Our message to clients since 2016 has been that the nineteenth Party Congress would mark a turning point in President Xi Jinping's tenure, that he would see his political capital replenished, and that Beijing's pain threshold would therefore rise appreciably in 2018. Hence we do not expect any new stimulus to be quick in coming or very large. Chart 1Buy In May And Enjoy Your Day Chart 2China's Money Impulse Spells Slowdown What happens in China will not stay in China. Signs of cracks are emerging in the buoyant global growth narrative (Chart 3), with potentially serious consequences for emerging markets (EM) (Chart 4).5 Chart 3Signs Of Cracks Forming Chart 4EM Manufacturing: Rolling Over China: Ramping Up For The New Year Crackdown The aftermath of the Communist Party's nineteenth National Party Congress is unfolding largely as we expected: with a reboot of President Xi Jinping's reform agenda. Chinese economic data are starting to reflect the consequences of tighter policy since late last year (Chart 5), and BCA's China Investment Strategy has shown consumer-oriented sectors outperforming industrials and materials since the party congress, as the reform drive would have one expect.6 China's policymakers have already allowed the monetary impulse - the rate of growth in the supply of money - to slow to the lowest levels in recent memory. This bodes ill for Chinese imports and base metal prices (Chart 6), as BCA's Emerging Market Strategy has emphasized.7 Chart 5Expect More Disappointments From China Chart 6Chinese Imports And Base Metals At Risk It is true that policymakers will re-stimulate the economy when they reach their pain threshold, but with Xi Jinping's political capital replenished and the party and state unified under him, we expect that threshold to have moved higher than financial markets expect. Yes, the government will try to prevent its policies from being highly disruptive and destabilizing - as with the People's Bank of China injecting liquidity to ease rapidly rising bond yields (Chart 7) - but the bottom line is that it is pressing forward with tightening. How can we be so sure that this policy trajectory is set? The initiatives in the early stages of implementation after the congress confirm our view that the central government is hardening the line on several key economic-political fronts: Financial regulatory overhaul: People's Bank Governor Zhou Xiaochuan has made a series of dire comments about China's financial risks and the danger that it is reaching a "Minsky Moment," or accumulation of risks that will end in a catastrophe.8 Zhou's likeliest replacements are both financial reformers, and one of them, Guo Shuqing, is the hawkish regulator who has led the crackdown on shadow lending this year (Chart 8). Moreover, whoever heads the central bank will have the benefit of new financial oversight capabilities. The Financial Stability and Development Commission (FSDC), a new entity charged with coordinating the country's various financial regulatory agencies, has just held its first meeting. Its inaugural chairman, Vice-Premier Ma Kai, is likely to retire soon, but rumors are swirling that his replacement will be Liu He, President Xi's top economic thinker and a reformist, who wrote an ominous article about excessive leverage in the People's Daily in May 2016 and has now made it onto the Politburo. If Liu He takes charge, given his very close relationship with Xi, the FSDC will be irresistible. If not, the FSDC will still be effective, judging by the fact that Ma Kai's replacement will likely be someone, like Ma, who sits on both the Politburo and State Council. Chart 7China's Bond Yields Rising Sharply Chart 8Shadow Banking Has Peaked Local government crackdown: Local government officials in two cities in Inner Mongolia have canceled urban metro projects due to excessive debt, reportedly under orders from the central government. Other cities in other provinces have suggested that approvals for such projects are being delayed.9 In other words, the central government is no longer endlessly accommodating debt-financed local government projects, even projects that support priority goals like urbanization and interior development. This news, so soon after the party congress, is likely to be the tip of the iceberg, which suggests that local government spending cannot be assumed to shake off its weakening trend anytime soon (Chart 9). Top officials pointed out local government leverage as a systemic risk, along with shadow banking, at the National Financial Work Conference in July, and both the outgoing finance minister and the outgoing central bank chief have called for reining in local governments. The latter's comments were formally endorsed by being included in the Communist Party's official "party congress study guide," suggesting that they are more than just the parting advice of a soon-to-be retiree. Property tightening: China's real estate sector, which provides 22% of investment in the country, is feeling the squeeze from financial tightening and targeted measures to drive out speculation since October 2016 (Chart 10). More, not less, of a squeeze is expected in both the short and long term. In the short term, inspections of commercial housing for corruption and speculative excesses could exert an additional dampening effect. In the medium and long term, the Xi administration plans to roll out a nationwide property tax, according to Huang Qifan, an economic policymaker tied to the legislature, "in the near future, not ... 10-20 years. It could happen in the next several years."10 The tax was delayed in 2016 amid economic turmoil. A national property tax would be an important fiscal reform that would tamp down on the asset bubble, rebalance the growth model, and enable the government to redistribute wealth from multiple homeowners to lower income groups. Chart 9Local Government Spending Is Weak Chart 10Property Tightening Continues Industrial restructuring: Environmental curbs on outdated and excess industrial capacity are continuing. Although China aggressively cut overcapacity in coal, steel and other sub-sectors over the past twelve months, it continues to face larger overcapacity than other economies (Chart 11), particularly in glass, cement, chemical fertilizers, electricity generation and home construction. It is also possible that SOE restructuring will become more aggressive. Currently, SOEs listed on the Shanghai exchange are rallying relative to the A-share market, as they have tended to do when the Communist Party reaffirms its backing of the state sector (Chart 12). However, announcements of SOE reforms in this administration have also triggered phases of under-performance. SOEs targeted for reforms face greater scrutiny of their finances and operations.11 Moreover, any SOE is vulnerable to the new wave of the anti-corruption campaign.12 National Supervision Commission: The new anti-corruption czar, Zhao Leji, will be a very influential figure if he is even to hold a candle to his predecessor, Wang Qishan. Zhao is to oversee the creation of a nationwide anti-corruption system that targets not only the Communist Party, as before, but every public official. The new commission will have branches at each level of administration (city, province, central government) and will combine the various existing anti-corruption agencies under one head. The purpose is not merely to root out political enemies (as administration critics, with some justice, would argue) but also to improve the effectiveness of policy implementation and address public grievances that threaten to undermine the regime. The latest environmental curbs have shown that employing anti-corruption teams to help enforce broader economic policy can be highly effective. Xi and Zhao Leji look set to extend this practice to state ministries, including financial regulators.13 It is not clear whether they will succeed in rebuilding the regime's legitimacy in public eyes, but in the short term an initiative like this should send a chilling effect throughout the state bureaucracy, similar to that which occurred among local government party chiefs in 2014 after the initial anti-corruption campaign was launched.14 Chart 11Overcapacity Still A Problem For China Chart 12SOEs Preserved, But Face Reforms In short, preparations are under way for Xi's second five-year term in office. (Perhaps not his last term, as the party congress also made clear.)15 New agencies and personnel suggest that the administration is embarking on an intensification of policy tightening. Tougher policy is viewed as necessary, not optional: top leadership has repeatedly stated that a lack of action on systemic threats will lead to regime-threatening crises down the road.16 Chart 13China's Impact On Global Growth How will this agenda impact the rest of the world? Our colleagues at China Investment Strategy hold that China may step up reforms but will not do so in a way that will negatively impact China's imports or key assets like base metal prices.17 However, from a political perspective, we view the combination of Xi's political capital with the new financial and anti-corruption commissions as likely to increase policy effectiveness to an extent that causes banks to lend less eagerly and local governments and SOEs to err on the side of less borrowing and spending. This will reduce demand for imports and commodities and will also raise the tail-risk of excessive tightening. China's contribution to global growth had fallen over the years, but has recently rebounded on the back of stimulus in 2015-16 (Chart 13). As such, it will not take much of a drag on import growth in 2018 to have a global impact. The most exposed commodity exporters to China (outside of oil) are Brazil, Chile and Peru (with Indonesia and South Africa also at risk), while the most exposed exporters of capital goods are Taiwan and South Korea, followed by Southeast Asia (the Philippines, Malaysia, Vietnam and Thailand). Looking at the China-exposed countries whose stocks rallied the most while China stimulated in 2016, the prime candidates for a negative impact in 2018 will be Brazil and Peru, and less so Hungary and Thailand. Bottom Line: The Xi administration is rebooting its reform agenda and has a higher tolerance for pain than the market yet realizes. Centralization, deleveraging and industrial restructuring have been deemed necessary to secure the long-term stability of the regime. China's policy risks are understated and the next wave of stimulus will not be as rapidly forthcoming as financial markets expect. U.S.: Trouble In (GOP) Paradise Markets have rallied throughout the year despite a lack of policy initiatives from the U.S. Congress. Judging by the performance of highly taxed S&P 500 equities, the rally this year has not been about the prospects of tax reform (Chart 14).18 Rather, markets have responded to strong earnings data and a lack of policy initiatives. Wait, what? Yes, markets have rallied because nothing has been accomplished. Investors just want President Trump and the Republican-held Congress to maintain a pro-business regulatory stance (Chart 15) and not do anything anti-corporate. Doing nothing is just fine. Chart 14Market Has Doubted Tax Reform Chart 15Market Has Cheered De-Regulation Here Come The Socialists Dems The Democratic Party leads the 2018 generic Congressional vote polling by 10.8%, up from 5.9% in May (Chart 16). The generic ballot polling is notoriously unreliable as most U.S. electoral districts are politically designed to be safe seats - "gerrymandered" - and as such are unlikely to respond to nation-wide polling (Chart 17). However, Republican support has fallen and Democratic candidates have performed extremely well this year. Chart 16U.S. Public Leans Democratic Chart 17Electoral System Reduces Competition First, candidates for governor in Virginia and New Jersey have outperformed their polling in November elections. Second, in the four special elections this summer, Democrats narrowed Republican leads by 18%. If the electoral results from Table 1 are replicated in 2018, Republicans could face a massacre in the House of Representatives. In addition, Republicans are suddenly vulnerable in Alabama, where the anti-establishment Senate candidate, and Breitbart-endorsee, Roy Moore is struggling with accusations of pedophilia (Chart 18). Table 12017 Special Elections Are Ominous For The GOP Chart 18Republican Senate Majority May Lose A Seat Why should investors fear a Democratic takeover of the House of Representatives? Yes, the odds of impeachment proceedings against President Trump would rise, but we are on record saying that investors should fade any impeachment risk to assets.19 The greater risk is that the Democratic Party has turned firmly to the left with its new manifesto, "A Better Deal." A strong performance by unusually left-of-center Democratic candidates could spook financial markets that have been lulled into complacency by the lack of genuine populism from the (thus far) pluto-populist president. Protectionism While most investors are focused on the ongoing NAFTA negotiations - which we addressed in last week's Special Report20 - we would draw attention again to the shift towards protectionism by the Republicans in the Senate. Normally a bastion of pro-business free-traders, the Senate has turned to the left on free trade. Senator John Cornyn (R, Texas) has introduced a bill to make significant reforms to the process by which the United States reviews foreign investments for national security, led by the Committee on Foreign Investment in the United States (CFIUS). Two further bills, one in the House and another in the Senate, would also significantly tighten access to the U.S. by foreign investors. China is foremost in their sights. In early 2018, investors will also be greeted by two significant decisions. First, on tariffs: Trump will have to decide on January 12 and February 3 whether to impose tariffs on solar panels and washing machines, respectively, under Section 201 of the U.S. Trade Act of 1974. The International Trade Commission has already determined that imports of these goods can cause material injury to U.S. industries, so Trump merely has to decide whether to impose tariffs (likely from 35% to 50%), import quotas (which have never received limits from courts), or bilaterally negotiated export limitations from trade partners.21 The consequences would go beyond the current, country-specific tariffs on these items, setting a precedent that would expose a wide range of similar imports to punitive action, and more broadly would signal to the world that the U.S.'s protectionist turn under Trump is real.22 Second, the White House has allegedly completed a comprehensive review of China policy under way since June.23 The review is said to focus on economic rather than strategic matters and to call for the use of punitive measures to insist that China alter tactics long complained about by the United States, including intellectual property theft, export subsidies, and forced tech transfer from joint ventures in China. Already the U.S. is investigating China for intellectual property theft under Section 301 of the 1974 Trade Act, with results that could prompt tariffs no later than August 2018.24 As if on cue, Wang Yang, a new inductee on China's Politburo Standing Committee and a prominent reformer, wrote an editorial in the People's Daily declaring that China should protect intellectual property, not require tech transfers, and give foreign firms equal treatment under the "Made in China 2025" plan.25 China has made similar promises and the U.S. has made similar threats many times before, so decisions in the coming months will be telling. Ultimately we fear that President Trump may feel compelled to ratchet up protectionism in 2018 for two reasons. First, Americans within his populist base will grow restless as they do the math on the tax legislation and realize that their champion is not quite the populist they voted for. Trump will need to re-convince them of his protectionist credentials and independence from Washington elites and the policy status quo. Second, if our view on Chinese slowdown and American fiscal thrust is correct, the USD bull market should restart in 2018. This would hurt U.S. export competitiveness, expand the trade deficit, and motivate U.S. companies to invest abroad, a paradox of President Trump's tax and fiscal policy. The White House may, therefore, be compelled to reach for mercantilist solutions to an FX problem. Foreign Policy The final reason to worry is a "Lame Duck" presidency. Far more predictable presidents sought relevancy abroad late in their mandate. For example, President George H. W. Bush committed troops to Somalia on his way out of the White House. President Bill Clinton bombed Yugoslavia. Given Trump's dismal approval polling and a potentially historic "wave" election for the Democrats in November, President Trump could similarly shift focus to geopolitics. If that shift includes confronting regional powers like China (and/or North Korea), or Iran, risk premiums may rise. In the meantime, we expect tax cuts to pass. The going is getting tougher in the Senate. The decision to include the repeal of the Obamacare individual mandate - designed to cut another $300 billion in government spending over the next ten years - will make it more difficult to secure 51 Senate votes. We maintain our view that the final legislation may need until Q1 to pass. Between now and then, legislators may need a failure or two in order to realize that the clock is ticking toward the midterms. Bottom Line: Markets have cheered lack of action from the Congress. However, the going will get tougher in 2018 as investors fret about protectionism, President Trump's itch to remain relevant, and a potential takeover of the House by the most left-of-center Democratic Party in a generation. Europe: Germany Is A Passing Risk, Focus On Italy The collapse of coalition talks in Germany is not a structural concern for Europe. The breakdown in the negotiations occurred because of the immigration debate, in which the right-of-center Christian Social Union (CSU) and the Free Democratic Party (FDP) struck out a different position from the ruling Christian Democratic Union (CDU) and the liberal Green Party. Of course, the disagreement is not about immigration today, given that inflows of asylum seekers this year has been well below past flows (Chart 19A). Rather, the fundamental disagreement is over how the CDU and its leader Angela Merkel handled the 2015 migration crisis and how it will be handled in the future. Chart 19ANo Immigration Crisis Today Chart 19BGermans Love Europe For investors, what matters is that there is no substantive disagreement over the EU, European integration, or Germany's role in it. The mildly euroskeptic FDP did not draw any red lines. The reason is obvious: the German euroskeptic constituency is small, shrinking, and largely already captured by the Alternative for Germany (AfD) anti-establishment party (Chart 19B). Germans are objectively the most europhile people in Europe. Going forward, a new election would cause further political uncertainty. On the margin, it could cause business confidence to stall. However, Germany runs a 14 billion euro budget surplus and is not expected to launch any structural reforms or fundamental economic changes. As such, if the formation of a government is delayed by three-to-six months, the economic implications will be fleeting. In fact, the result of a new election could be a Grand Coalition between the CDU and Socialists, which would be positive for European integration. However, as we have argued before, hopes for a significant restart of integration have probably run ahead of reality.26 For us, Italy is the immediate concern. Italy passed a new electoral law in late October, setting the stage for the election due by May 2018. The consensus in the news media is that the president will call elections in January, with the vote taking place sometime in March.27 The consensus is that the new law will make it more difficult for the populist Five Star Movement (M5S) to win a majority of seats in the Italian Parliament. In addition, it will give a lift to the parties with strong regional ties - such as the governing Democratic Party (PD) and Lega Nord. Chart 20Italy Set For A Hung Parliament The nuances of the new law are largely irrelevant, however, given the close polling of the three electoral blocs. The most likely outcome will be a hung parliament (Chart 20). Nonetheless, we can still learn something from the law: the Italian establishment parties are cooperating to subvert the electoral chances of M5S. The ruling PD and the center-right Forza Italia of former Prime Minister Silvio Berlusconi are working together to design an electoral system that favors the pre-election norm of coalition-building and parties with strong regional representation. Neither of these factors fits M5S's profile. This suggests that the two centrist blocs will be able to put together an establishment coalition following the election. On one hand, this will give stability to the Euro Area for at least the duration of that government. On the other hand, the underlying data continues to point to structural euroskepticism in Italy. Unlike their European peers, Italians seem to be flirting with overt euroskepticism. When it comes to support for the common currency, Italians are clear outliers, with support levels around 55% (Chart 21). Similarly, over 40% of Italians appears to be confident in the country's future outside the EU (Chart 22). These are ominous signs for the future. Still, both M5S and the mildly euroskeptic Lega Nord have tempered their demands for an exit from the common currency union. The official stance of the M5S is that the exit from the Euro Area is only "option B," that is, an option if the bloc is not reformed. Meanwhile, Lega Nord is on record opposing a referendum on membership in the currency union because it is illegal.28 Chart 21Italians Stand Out For Distrust Of Euro Chart 22Italians Not Enthusiastic About EU The stance of Italy's euroskeptics will change as soon as it is convenient. The country's establishment is likely making a mistake by contemplating a grand coalition alliance. Unless such a government develops a serious plan for painful structural reforms - it will not - it will likely waste its mandate and fall at the first sign of recession or crisis. At that point, the only alternative will be the M5S, which will stand alone in opposition to such an ineffective government. Investors can therefore breathe a sigh of relief in the medium term. Italy will likely not be a source of risk-off in 2018 or even 2019, although it is still the main risk in Europe for next year and bears monitoring. However, in the long term, we maintain that Italy will be a catalyst for a serious global risk-off episode within the next five years. We remain optimistic that such a crisis will ultimately strengthen Italy's commitment to the Euro Area, as we outlined in a recent Special Report.29 But that is a low conviction view that will require constant monitoring. Could there be another scenario? Several clients have asked us if an Emmanuel Macron could emerge in Italy? Our answer is that there already was an Emmanuel Macron: Matteo Renzi, the former prime minister and current PD leader, was Macron before Macron. And yet he failed to enact significant structural and constitutional reforms. Yet two potential candidates may be ready to swoop in from the "radical center" position that Renzi and Macron characterize. The first is ECB President Mario Draghi. He is widely respected in Italy and is seen as someone who not only allayed the Euro Area sovereign debt crisis, but also stood up to German monetarist demands in doing so. The second is Fiat-Chrysler CEO Sergio Marchionne, one of the world's most recognizable business leaders and a media star inside and outside Italy. If the centrist coalition begins to fray by the end of 2019, both of these individuals may be available to launch a star-studded campaign to "save Italy." Bottom Line: We remain cautiously optimistic about the upcoming Italian elections. While our baseline case is that Italian elections will produce a weak and ineffective government, though crucially not a euroskeptic one, nevertheless risks abound and require monitoring. Investment Implications There are a lot of unknowns heading into 2018. What will become of U.S. tax cuts? How deep will the policy-induced slowdown become in China? What will President Trump do if he becomes the earliest "Lame Duck" president in recent U.S. history? Will he embark on military or protectionist adventures abroad? Asset implications are unclear, but we offer several broad takeaways. First, the VIX will not stay low in 2018. Second, the USD should rally. Both should happen because investors are far too complacent about the Fed's pace of hikes and because of potential global growth disappointments as Beijing tinkers with the financial and industrial sectors. Chart 23AEuro Area Versus U.S. Growth: Don't Ignore China (I) Chart 23BEuro Area Versus U.S. Growth: Don't Ignore China (II) Third, it is time to close our recommendation to be overweight European risk assets. European equities have a higher beta to global growth due to the continent's link to Chinese demand. As our colleague Mathieu Savary has pointed out, when Chinese investment slows, Europe feels it more acutely than the U.S. (Chart 23). Chart 24U.S. Dollar Rebound = EM Pullback We are also closing our tactical long position on China's big banks versus its small-to-medium-sized banks. This position has been stopped out at a loss of 5%, despite the riskier profile of the latter banks and the fact that their non-performing loans are rising. Faced with these challenges, Beijing decided to open the door to foreign investment and too ease regulations on these banks so that they can lend to small cap companies as part of the reform drive. These actions inspired a rally relative to the Big Banks that worked against our trade. As financial tightening will continue, however, we expect this rally to be short-lived, and for big banks to benefit from state backing. Our highest conviction view is that it is time to short emerging markets. Our two core views - that politics will become a tailwind to growth in the U.S. and a headwind to growth in China - should create a policy mix that will act as a headwind to EM (Chart 24). The year 2017 may therefore turn out to have been an anomaly. Emerging markets outperformed as China aggressively stimulated in 2016 and as both the U.S. dollar and bond yields declined. This mix of global fiscal and liquidity conditions proved to be a boon for EM, giving it a liquidity-driven year to remember. That year is now coming to an end. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day," dated April 26, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 4 China's official broad money (M2) measure has also sharply decelerated, as have all measures of China's money. We prefer BCA's Emerging Market Strategy's broader M3 measure. The official M2 has underestimated the amount of new money in China because banks and shadow banks have done extensive off balance sheet lending. The M3 measure includes bank liabilities excluded from M2, it is calculated by taking the total of non-financial institution and household deposits, plus other financial corporation deposits, and other liabilities. Please see BCA Emerging Market Strategy, "Ms. Mea Challenges The EMS View," dated October 19, 2017, available at ems.bcaresearch.com. 5 Please see BCA Foreign Exchange Strategy Weekly Report, "Temporary Short-Term Risks," dated November 10, 2017, available at fes.bcaresearch.com and BCA Emerging Markets Strategy Weekly Report, "EM: Cracks Are Appearing," dated November 15, 2017, available at ems.bcaresearch.com. 6 Please see BCA China Investment Strategy Weekly Report, "Messages From The Market, Post-Party Congress," dated November 16, 2017, available at cis.bcaresearch.com. 7 Please see BCA Emerging Markets Strategy Special Report, "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017, available at ems.bcaresearch.com. 8 Zhou's comments should not be interpreted merely as a farewell speech of a retiring central bank governor, since they echo the general policy shift in the administration since December 2016's Central Economic Work Conference, and April 2016's Politburo meeting, toward tackling financial risk. For Zhou's comments, please see "China's central bank chief lays out plans to avert future financial crisis," South China Morning Post, November 4, 2017, available at www.scmp.com. 9 Xianyang in Shaanxi, and Wuhan in Hubei. Please see Wu Hongyuran and Han Wei, "Another City Halts Subway Projects Amid Financing Concerns," Caixin, November 13, 2017, available at www.caixinglobal.com. 10 Please see Kevin Yao, "China central bank adviser expects less forceful deleveraging in 2018," Reuters, November 15, 2017, available at www.reuters.com. 11 The latest official announcement claims that an additional 31 SOEs will be listed for restructuring. Please see "More SOEs to be included in reform plan," People's Daily, November 16, 2017, available at en.people.cn. 12 We fully expect SOEs to be subjected to rigorous treatment from the National Supervision Commission. Note that the crackdown on overseas investment earlier this year merely touches the tip of the iceberg in terms of the SOE corruption that could be revealed by probes. See, for example, the following report on the National Audit Office's public notice on SOE fraud and irregularities, "20 Central Enterprises Overseas Investment Audit Revealed A Lot Of Problems," Pengpai News (Shanghai), June 26, 2017, available at news.163.com. 13 Please see BCA Geopolitical Strategy Special Report, "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017, available at gps.bcaresearch.com. 14 Please see BCA China Investment Strategy Weekly Report, "Policy Mistakes And Silver Linings," dated October 7, 2015, and "Legacies Of 2014," dated December 17, 2014, available at cis.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 16 Xi Jinping has called financial security an important part of national security and declared that "safeguarding financial security is a strategic and fundamental task in the economic and social development of our country." Please see Wang Yanfei, "Leaders aim to fend off financial risks," China Daily, April 26, 2017, available at www.chinadailyasia.com. For Zhao Leji's post-congress comments on this topic in the People's Daily, please see "China faces historic corruption battle, new graft buster says," The Guardian, November 11, 2017, available at www.theguardian.com. 17 See footnote 6. 18 More anecdotally, a clear majority of our clients disagrees with our bullish prospects of tax cuts. 19 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 21 Please see Chad P. Bown, "Donald Trump Now Has The Excuse He Needs To Open The Floodgates Of Protectionism," Peterson Institute of International Economics, October 9, 2017, available at piie.com. 22 Other measures could follow thereafter. For instance, the Commerce Department will issue its final report on steel and aluminum in January and Trump could decide to take punitive actions on these goods under Section 232 of the 1962 Trade Expansion Act. Please see Ana Swanson, "Democrats Pressure Trump to Fulfill Promise to Impose Steel Tariffs," New York Times, October 26, 2017, available at www.nytimes.com. 23 The review itself began in June, around the time when Trump's and Xi's initial "100-day plan" to improve trade relations expired. The report that the review is completed is from Lingling Wei et al, "Beyond Trump-Xi Bond, White House Looks to Toughen China Policy," Fox Business News, November 19, 2017, available at www.foxbusiness.com. See also Adam Behsudi et al, "White House conducting wide-ranging review of China policy," Politico, September 28, 2017, available at www.politico.com. 24 The U.S. Trade Representative Robert Lighthizer is supposed to finish his investigation into intellectual property under Section 301 of the 1974 Trade Act within a year of August 18, 2017. Please see Gary M. Hnath and Jing Zhang, "Trump Administration Initiates Section 301 Investigation of China's Acts, Policies and Practices Related to Technology Transfer, Intellectual Property and Innovation," dated August 25, 2017, available at www.lexology.com. 25 Please see "Chinese vice premier pledges fair treatment of foreign firms as China opens up," Reuters, November 10, 2017, available at www.reuters.com. 26 Please see BCA Geopolitical Strategy Weekly Report, "Stick To The Macro(n) Picture," dated May 10, 2017, available at gps.bcaresearch.com. 27 Just in time to get a new government in place ahead of the World Cup! Oh wait... Too soon? 28 Which is an odd position to take given their supposed anti-establishment orientation. For example, the U.K. referendum on EU membership was non-binding, and yet it took place and had relatively binding political consequences. 29 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com.