Money/Credit/Debt

Highlights Bond yields have trapped equities, and equities have trapped bond yields. The double-digit investment opportunities are within asset-classes. From a tactical perspective: Banks will outperform the broad market. EM will outperform DM. The Eurostoxx50 will briefly outperform the S&P500. Raw industrial commodities will outperform crude oil. Feature What has been the biggest driver of financial markets this year? Trade wars and the emerging market slowdown? The budget spat between Italy and the EU Commission? The U.S. mid-term elections? Or perhaps, central bank policy normalization? These are all sensible answers, and each one has generated endless output of commentary and analysis. But none of these tells the biggest story of 2018. Chart of the WeekIn 2018, Bond Yields Have Trapped Equities, And Equities Have Trapped Bond Yields In 2018, Bond Yields Have Trapped Equities, And Equities Have Trapped Bond Yields In 2018, Bond Yields Have Trapped Equities, And Equities Have Trapped Bond Yields The Biggest Story Is Not Economics Or Politics... It Is Mathematics This year, the two largest five-day plunges in the global stock market - 6 percent in February and 7 percent in mid-October - resulted directly from the two largest five-day spikes in the global bond yield (Chart I-2 and Chart I-3). This simple observation reveals the biggest story in the financial markets this year: the hypersensitivity of the stock market to rising bond yields, and especially when the global 10-year yield approaches 2 percent - or equivalently 'the rule of 4': when the sum of the 10-year U.S. T-bond, German bund and Japanese government bond approaches 4 percent (Chart of the Week).1 Chart I-2Equities Plunged In February After A Spike In Bond Yields Equities Plunged In February After A Spike In Bond Yields Equities Plunged In February After A Spike In Bond Yields Chart I-3Equities Plunged In October After A Spike In Bond Yields Equities Plunged In October After A Spike In Bond Yields Equities Plunged In October After A Spike In Bond Yields With the global stock market now flat year-to-date, it follows that excluding these two five-day plunges, global equities would be comfortably higher even with the emerging market slowdown, trade war quarrels, and political spats. Meaning that this year's market action is not explained by economics or by politics. It is explained by mathematics, and specifically the great misunderstanding of investment risk. Previous reports have focused on this great misunderstanding, most recently Risk: The Great Misunderstanding Of Finance, to which we refer our readers. Here, we will just summarize:2 An investment's risk depends on the negative asymmetry of its short-term returns. At very low bond yields, bond returns develop the same negative asymmetry as equity returns. This means that equities lose their excess riskiness versus bonds, requiring equity valuations to experience a phase transition sharply higher. But when bond yields normalize, equities regain their excess riskiness versus bonds - and their valuations must suffer a phase transition sharply lower. This phase transition to sharply lower equity valuations is most pronounced when the global 10-year bond yield rises to 2 percent. This dynamic has proved to be the biggest driver of financial markets in 2018, and is likely to be the biggest driver in 2019 too. Essentially, higher bond yields can suddenly and viciously undermine the valuation support of equities, limiting the upside in the stock market (Chart I-4). In turn, a plunge in the stock market and other risk-assets threatens a disinflationary impulse, limiting the sustainable upside in bond yields. Chart I-4Equities Remain Richly Valued Equities Remain Richly Valued Equities Remain Richly Valued In effect, bond yields have trapped equities, and equities have trapped bond yields (Chart I-5). The result is that in 2018 the global asset-classes: equities, bonds, commodities, and cash have all ended up going nowhere. Indeed, the global 30-year bond yield has been trapped since early 2017!3 Chart I-5The Global 30-Year Bond Yield Has Been Trapped For Two Years The Global 30-Year Bond Yield Has Been Trapped For Two Years The Global 30-Year Bond Yield Has Been Trapped For Two Years The Double-Digit Investment Opportunities Are Within Asset-Classes Although the global asset-classes have ended up going nowhere this year (Chart I-6), 2018 has still provided double-digit investment opportunities. But to find these double-digit opportunities, you have to look below the main asset allocation decision to within the asset-classes, in sector, region and country allocation. Chart I-6In 2018, Global Asset-Classes Have Ended Up Going Nowhere In 2018, Global Asset-Classes Have Ended Up Going Nowhere In 2018, Global Asset-Classes Have Ended Up Going Nowhere For example, until very recently: banks had underperformed the broad equity market by 10 percent globally and 25 percent in Europe; emerging market equities had underperformed developed market equities by 15 percent; the Eurostoxx50 had underperformed the S&P500 by 13 percent; and raw industrial commodities had underperformed crude oil by 30 percent. But in the last month or so, these strong trends have exhausted and even started to reverse: banks have started to outperform the market; the Eurostoxx50 has eked ahead of the S&P500; emerging market equities have retraced versus developed market equities; and raw industrial commodities have made up much lost ground on crude oil (Charts I-7 - Chart I-10). One important reason is that the sharp down-oscillation in global credit growth which was responsible for many of this year's intra asset-class trends has now clearly rebounded into an up-oscillation. Chart I-7Banks Have Started To Outperform Banks Have Started To Outperform Banks Have Started To Outperform Chart I-8The Eurostoxx50 Is Starting To Outperform The S&P500 The Eurostoxx50 Is Starting To Outperform The S&P500 The Eurostoxx50 Is Starting To Outperform The S&P500 Chart I-9EM Has Started To Outperform DM EM Has Started To Outperform DM EM Has Started To Outperform DM Chart I-10Industrial Commodities Are Starting To Outperform Crude Oil Industrial Commodities Are Starting To Outperform Crude Oil Industrial Commodities Are Starting To Outperform Crude Oil Hence, we expect these trend reversals to continue in the coming months. From a tactical perspective only, this means: 1. Banks will outperform the broad market. 2. EM will outperform DM. 3. The Eurostoxx50 will briefly outperform the S&P500. 4. Raw industrial commodities will outperform crude oil. Such an inflection point can leave investors scratching their heads in confusion, because sector performances seem to conflict with the economic data releases. But the conflict is easily resolved. Though we are now in mid-November, the economic data releases - for example, German exports - are a lagging indicator, referring to a time in the past, September, when global credit growth might still have been in a down-oscillation. Whereas the financial markets - for example, bank equities' relative performance - are a contemporaneous indicator, sensing credit growth's switch to an up-oscillation in real-time. Always remember that market prices move on the marginal change in information and expectations. To be absolutely clear, we are not referring to the business cycle. We are referring to predictable oscillations in credit growth that occur within the business cycle, but which nevertheless create double-digit investment opportunities - such as bank equities' relative performance. The Importance Of 6-Month Credit Growth Still, several clients have asked about our choice of 6-month credit growth, as it appears to be an arbitrary period plucked out of thin air or, more cynically, 'data-mined'. In fact, our choice of 6-month growth has a rock-solid foundation in economic theory.4 For any item, if supply lags demand by a period t, then economic theory proves that both the quantity of the item and its price will experience oscillations with half-cycle length t. Clearly, bank credit is such an item whose supply does lag demand. For example, a mortgage is only allocated and released after a time-consuming process of checking collateral and creditworthiness. For bank credit in aggregate, the lag between demand and supply, and specifically final spending of the funds, averages six to eight months. Once you accept this fundamental truth, it follows that credit growth must also experience oscillations whose half-cycles last six to eight months. So we end with a very important investment lesson. If you only look at the conventionally examined year-on-year credit growth data, you will not see the predictable oscillations in 6-month credit growth. And if you do not look at 6-month credit growth, you will miss the double-digit investment opportunities that are always on offer (Chart I-11). Chart I-11A Sharp Down-Oscillation In Global Credit Growth Has Rebounded Into An Up-Oscillation A Sharp Down-Oscillation In Global Credit Growth Has Rebounded Into An Up-Oscillation A Sharp Down-Oscillation In Global Credit Growth Has Rebounded Into An Up-Oscillation The choice is yours. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 We use the MSCI All Country World Index in local currency terms to capture the global stock market. 2 Negative asymmetry of returns means the possibility of larger short-term losses than short-term gains. Please see the European Investment Strategy Weekly Report, "Risk: The Great Misunderstanding Of Finance", October 25, 2018 available at eis.bcaresearch.com. 3 Please see the European Investment Strategy Weekly Report, "Trapped: Have Equities Trapped Bonds?", September 13, 2018 available at eis.bcaresearch.com. 4 Please see the European Investment Strategy Special Report, "The Cobweb Theory And Market Cycles", January 11, 2018 available at eis.bcaresearch.com. Fractal Trading Model* Palladium has outperformed nickel by 50% in the past three months, but this strong trend is nearing exhaustion according to its 65-day fractal dimension. Hence, this week's trade recommendation is long nickel/short palladium setting a profit target of 14% with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-12 Long Platinum / Short Nickel Long Platinum / Short Nickel The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights 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 Housing Has Been A Drag On The U.S. Economy This Year Housing 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... No Mystery Why U.S. Housing Has Been Weak... No 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) ...But Fundamentals Are Still In Good Shape (I) ...But Fundamentals Are Still In Good Shape (I) Chart 3B...But Fundamentals Are Still In Good Shape (II) ...But Fundamentals Are Still In Good Shape (II) ...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 Lending Standards Have Been Tight, But Are Starting To Loosen Lending Standards Have Been Tight, But Are Starting To Loosen Chart 5U.S. Banks Are Well Capitalized U.S. Banks Are Well Capitalized U.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 Interest Coverage Looks Relatively High Interest 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 U.S. Corporate Debt Is Not That High By Global Standards U.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 Banks Have Reduced Their Exposure To The Corporate Sector Banks 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 The 2015 Debt Scare Did Not Topple The Economy The 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 U.S. Private Sector Is A Net Saver The 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 Fighting The Last War Fighting The Last War Chart 11Brazil Is Fiscally Challenged Brazil Is Fiscally Challenged Brazil 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 Fighting The Last War Fighting The Last War 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 Recessions And Bear Markets Usually Overlap Recessions 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

Highlights Economic data and policy announcements over the past month reflect the view that policymakers are serious about restraining credit growth, and that they will attempt to combat any weakness in external demand by boosting domestic consumption. A review of historical episodes of "outsized" investment intensity shows that policymakers have good reason to try and shift the composition of China's economy towards consumption, as it suggests that China's current experience probably cannot be sustained. A shift even somewhat away from heavy investment-led growth means that the "strike price" of the China put option has fallen relative to past economic slowdowns, implying that it will take more pain before investors can cash in. It is too soon to move towards an outright long position favoring domestic stocks, even though considerable bad news has been priced in. CNY-USD likely has further downside, and investors allocating among Chinese stocks should only favor domestic over investable equities in currency-hedged terms. Feature September's total social financing data, released earlier this month, provided important evidence supporting our view that Chinese policymakers are not aiming for a significant acceleration in private sector credit growth. Chart 1 highlights that the year-over-year growth rate of adjusted total social financing (TSF) actually ticked modestly lower in September, in clear contrast to the bet of many investors that China is following its "old stimulus rulebook". Chart 1Chinese Policymakers Are Not Pumping The Credit Taps Chinese Policymakers Are Not Pumping The Credit Taps Chinese Policymakers Are Not Pumping The Credit Taps Some market participants have pointed to the fact that adjusted TSF is rising sharply on a 3-month annualized basis after adjusting for seasonality (Chart 2), and have concluded from this fact that a sustained expansion in credit growth is forthcoming. However, Chart 3 illustrates that the pickup shown in Chart 2 is due to a surge in special local government bond issuance, which reflects front-loading of fiscal spending. Financial news outlets have reported that "provincial authorities had by the end of September already raised 92 percent of the 1.35 trillion yuan ($195 billion) worth of special infrastructure bonds that the central government has targeted for the entire year",1 implying that local government bond issuance in Q4 will drop off significantly relative to the past three months. Chart 2A Near-Term Pickup... A Near-Term Pickup... A Near-Term Pickup... Chart 3...Caused By Front-Loaded Fiscal Spending ...Caused By Front-Loaded Fiscal Spending ...Caused By Front-Loaded Fiscal Spending The September credit data aside, we acknowledge that there have been several small-scale stimulus announcements from the Chinese government over the past month. But the bottom line for now is that developments over this period reflect the view that policymakers are serious about restraining credit growth, and that they will attempt to combat any weakness in external demand by boosting domestic consumption.2 Restraining Credit Growth: Wisdom Or Folly? China's unwillingness to resort to a significant acceleration in credit growth to help stabilize its economy has surprised some investors, and raised criticism in some corners that the country is making a policy mistake. A recurring argument in this vein, particularly among perennial China bulls, is that policymakers should not be concerned about China's elevated levels of private sector debt because it is the natural and inevitable result of a high savings rate. According to this view, restraining credit growth and attempting to boost consumption merely dooms China's ability to escape the middle-income trap, because higher per capita income can only be achieved by further growth in the stock of capital. BCA's China Investment Strategy service does not dispute the notion that a high savings rate can lead to a high leverage ratio, particularly among small, fast-growing economies. But in the case of China, the sharp rise in private sector debt that has occurred since 2010 was not natural, and certainly was not inevitable. Instead, our view is that it was the result of an explicit "least-bad" choice made by policymakers to weather the reality of poor external demand following the global financial crisis. Chart 4 presents, in a nutshell, the theoretical support for the "keep investing" view. The chart depicts real per capita GDP for 80 countries in 2014 as a function of the average share of gross capital formation to GDP from 1960 to 2014. The chart clearly shows that richer countries today have tended to invest more on average in the past, which is entirely consistent with textbook economic theory. Chart 4Higher Investment Has Led To Higher Per Capita GDP Growth... Is China Making A Policy Mistake? Is China Making A Policy Mistake? However, there are two reasons why the simple inference from Chart 4 that China should just "keep investing" is deeply flawed. First, while investment as a share of GDP in China has recently declined from its 2011-2014 peak, it remains close to 45%. This is a massive rate of investment, and a historical review points to the conclusion that it probably cannot be sustained: 45% is nearly off the x-axis scale shown in Chart 4, suggesting that China's current rate of investment is not achievable over extended periods of time. In fact, the chart suggests that 30% is the highest realistic rate of investment as a share of GDP that a country can maintain over an extended period. In 2014, based on the definition of the data from the Penn World Table (GDP share of gross capital formation at current purchasing power parity), China had maintained its investment share above 30% for 12 years. At first blush, there appears to be some precedent suggesting that China's outsized investment run can go on for longer: among the 80 countries included in Chart 4, 14 of them have experienced a longer continuous run of investment as a share of GDP. However, Chart 5 shows that most of these experiences occurred in the 1960s and 1970s, when global exports as a share of GDP were rising from a very low base. This implies that historical examples of outsized investment runs have largely reflected export-driven catch-up stories, which bodes poorly for China's ability to continue to invest at its recent massive scale given that global exports to GDP appear to have peaked. Chart 5...But Very High Rates Of Investment Have Driven By Exports ...But Very High Rates Of Investment Have Driven By Exports ...But Very High Rates Of Investment Have Driven By Exports Second, the relationship shown in Chart 4 captures the potential gains of profitable and rational investment, or in other words the accumulation of a "useful" stock of capital. But an unfortunate reality facing savers is that while one can choose to save or invest, one cannot necessarily choose the accompanying rate of return. If China invests heavily at very low or negative rates of return, the idea that investment will lead China out of the middle-income trap is very likely wrong. As we have discussed in previous reports, there is good evidence to suggest that the marginal gains from investment in China have been falling. The private sector debt-to-GDP ratio features prominently in the case against profitable investment in China: despite a massive rise in investment and debt from 2002-2007, the private sector debt-to-GDP ratio barely rose, because this debt was used to accumulate capital that verifiably delivered nominal GDP growth. Yet following 2010 the ratio rose sharply, implying that the returns from the investment that has taken place over the past decade have been (at least so far) considerably lower than those of the prior decade. Also, we noted in our August 29 Special Report that state-owned enterprises (SOEs) have accounted for a sizeable portion of the private sector leveraging that occurred after 2010,3 and that the marginal operating gain from debt for SOEs has become negative (Chart 6). A gap between the cost/return on borrowed funds strongly implies that the investment channeled through SOEs over the past several years does not represent, on balance, the accumulation of useful capital. Chart 6Strong Evidence Against Productive SOE Investment Strong Evidence Against Productive SOE Investment Strong Evidence Against Productive SOE Investment In our view, a cohesive story emerges from the above analysis, one that counters the view that China is making a policy mistake by trying to avoid another significant episode of private sector leveraging. China's enormous catchup in per capita GDP over the past 20 years was initially export-led, but was sustained after 2010 by quasi-fiscal spending in the form of a material leveraging of state-owned enterprises. This shadow government spending was aimed at preventing large-scale job losses, but proved to be considerably less productive than the private, export-driven investment-boom that preceded it. This suggests that China is simply investing too much for an economy that needs to accumulate capital for the purposes of domestic production, and that any further, aggressive leveraging of the private sector will simply raise the odds or the cost of the eventual bailout. While investors who are hoping to profit from China's credit excesses may wish for a different outcome, the bottom line is that Chinese policymakers will act in the best interests of their country, and they have good reason to try and shift China's economy away from extremely high rates of investment towards more consumption. Implications For Investment Strategy As would be the case in any other major country, we have no doubt that Chinese policymakers will eventually move to a maximum reflationary stance (which would imply a significant reacceleration in credit growth) if they feel that the existing slowdown will lead to deep, threatening economic instability. The key point for investors is that a desire of policymakers to shift even somewhat away from heavy investment-led growth means that the "strike price" of the China put option has fallen relative to past economic slowdowns, implying that it will take more pain before investors can cash in. Within the universe of Chinese financial assets, there are three pertinent investment strategy questions that arise from this reality: Even if there is more pain to come, Chinese domestic stocks have fallen 30% in local currency terms, and close to 40% in U.S. dollar terms (Chart 7). Is it time to go outright long? Should investors allocating among Chinese stocks favor domestic or investable equities? What is the outlook for CNY-USD? For now, our answers are as follows: 1) not yet, 2) domestic over investable in currency-hedged terms, and 3) weaker (possibly significantly so). Chart 7The Bear Market In A-Shares Is Advanced... The Bear Market In A-Shares Is Advanced... The Bear Market In A-Shares Is Advanced... We agree that 30% is a reasonable estimate of the likely decline in domestic earnings over the coming year, which normally would suggest that A-shares have fully priced the bad news and that investors should consider buying. However, there are two key reasons why we think this conclusion is premature: We noted in our September 19 Weekly Report that the lesson of 2014/2015 was Chinese stocks needed both policy stimulus and earnings clarity before bottoming.4 For now, China's stimulative response has been measured, and we have yet to see any decline in domestic 12-month forward earnings (Chart 8). While it is not the only factor contributing to the decline, the escalation in the trade war with the U.S. acted as a clear negative catalyst for the Chinese stock market. We have argued that the evolution of the trade positions of both sides suggests that the imposition of a third and final round of import tariffs covering all Chinese exports to the U.S. is likely, which would further reduce Chinese earnings visibility for investors. News reports this week suggested that an announcement to this effect could occur in early-December, if a meeting between Presidents Trump and Xi is called off or fails (as we expect). Chart 8...But Forward EPS Have Yet To Start Falling ...But Forward EPS Have Yet To Start Falling ...But Forward EPS Have Yet To Start Falling Chart 9 presents our framework for forecasting CNY-USD as a function of various U.S. import tariff scenarios, which we used to argue that a break above the psychologically-important level of 7 for USD-CNY appeared likely barring strong action from the PBOC4. The RMB has weakened in line with our view over the past month, and Chart 9 shows that it stands to weaken further, potentially significantly, if the U.S. does move ahead with a 25% import tariff on all imports from China. Chart 9Further Downside In CNY-USD Is Likely Further Downside In CNY-USD Is Likely Further Downside In CNY-USD Is Likely Finally, our negative outlook for the currency informs our view that a relative position favoring domestic over investable stocks should be currency-hedged. Chart 10 shows that an uptrend in relative performance does appear to be forming in local currency terms, but not in U.S. dollar terms (due to the recent renewed weakness in CNY-USD). Chart 10Relative To Investable Stocks, Only Favor A-Shares In Hedged Terms Relative To Investable Stocks, Only Favor A-Shares In Hedged Terms Relative To Investable Stocks, Only Favor A-Shares In Hedged Terms We opened a shadow trade in our July 5 Weekly Report of being long the MSCI China A Onshore index / short MSCI China index,5 which we said we would consider implementing in response to a 5% rally in relative performance. Our intention was to structure this trade in unhedged terms (consistent with most of the trades in our trade book), and our judgement is that it is simply too early to do so despite the fact that a 5% relative rise in U.S. dollar terms has indeed occurred. Signs of a durable bottom in CNY-USD, or an assessment of minimal further downside coupled with strong outperformance of domestic stocks in local currency terms, are likely catalysts for a green light. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 "China Is Struggling To Find Projects To Spend Bond Splurge On", Bloomberg News, October 22, 2018. 2 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. 3 Pease see China Investment Strategy Special Report "Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging", dated August 29, 2018, available at cis.bcaresearch.com. 4 Pease see China Investment Strategy Weekly Report "Investing In The Middle Of A Trade War", dated September 19, 2018, available at cis.bcaresearch.com. 5 Pease see China Investment Strategy Weekly Report "Standing On One Leg", dated July 5, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Policy easing is a necessary but not sufficient condition for a bottom in the business cycle. For monetary easing to become effective, there should be loan demand, banks should be willing to lend, and businesses and consumers should be keen to spend more. In China, risks to both the money multiplier and the velocity of money are to the downside. This will hinder the effectiveness of monetary policy easing in generating economic growth. Eroding business and consumer confidence in China will - for now - negate the budding improvement in its broad money impulse. Emerging markets risk assets and currencies are set to drop further. Stay put. Feature The selloff in EM and Chinese stocks has begun to weigh heavily on DM share prices. The global equity index has broken below its January lows, entailing further downside. Importantly, global cyclical equity sectors such as global industrials, materials and semiconductors are underperforming, and are breaking down in absolute terms. This confirms global trade is in a full downturn swing (Chart I-1). Chart I-1Global Trade Is Decelerating Global Trade Is Decelerating Global Trade Is Decelerating What is required to turn around this global trade slowdown? Our bias is that this growth slump has roots in China/EM and trade tensions are dampening business and investor sentiment on top of that. Consequently, a reversal in the equity selloff is largely contingent on an improvement in China's economy. It is in this context that we devote this week's report to an extensive discussion surrounding the issues of policy stimulus, deleveraging and growth in China. In this report, we answer the questions we think are most pertinent to investors at this moment. Question: Why are financial markets rioting, even though China has announced stimulus? Answer: The market's interpretation is that these stimuli are insufficient to turn around China's business cycle immediately. We agree with this assessment. Policy easing does not always immediately translate into higher share prices and improving growth. For example, amid China's 2015 stock market crash, the Chinese authorities began aggressively stimulating in the middle of 2015, yet Chinese and global markets continued to riot until February 2016 (Chart I-2). Chart I-2China In 2015: Money Growth Preceded Bottom In Markets By Seven Months China In 2015: Money Growth Preceded Bottom In Markets By Seven Months China In 2015: Money Growth Preceded Bottom In Markets By Seven Months Indeed, there was a period of seven months when EM and DM stocks plummeted, despite on-going and very aggressive policy easing in China. In short, these stimulus measures did not preclude a considerable drawdown in global and EM share prices. Outside China, there have been other examples where policy easing did not preclude a full-fledged bear market. For instance, in 2001-'02 and 2007-'08, the Federal Reserve was cutting interest rates aggressively, yet the bear market in U.S. equities did not reverse (Chart I-3). Chart I-3AFed's Easing Did Not Prevent Equity Bear Market Fed's Easing Did Not Prevent Equity Bear Market Fed's Easing Did Not Prevent Equity Bear Market Chart I-3BFed's Easing Did Not Prevent Equity Bear Market Fed's Easing Did Not Prevent Equity Bear Market Fed's Easing Did Not Prevent Equity Bear Market Similarly, the ECB was expanding its balance sheet from the onset of the euro area debt crisis in 2011, yet the region's share prices did not bottom until the middle of 2012, 12 months later (Chart I-4). Chart I-4ECB Balance Sheet Expansion Did Not Prevent Equity Bear Market ECB Balance Sheet Expansion Did Not Prevent Equity Bear Market ECB Balance Sheet Expansion Did Not Prevent Equity Bear Market Question: It is clear there could be a time lag between policymakers stimulating and financial markets and the business cycle turning the corner. What is causing these time lags, and how should one handicap them? Answer: Indeed, monetary and fiscal policies affect the economy with time lags. These lags vary from cycle to cycle. In China, the broad money impulse has improved of late (Chart I-5). Historically, this has led the mainland's business cycle by about nine months on average. Hence, it signifies a tentative bottom early next year. Chart I-5China: Money Impulse Has Bottomed China: Money Impulse Has Bottomed China: Money Impulse Has Bottomed The credit impulse, however, has not improved at all (Chart I-6). The current divergence between credit and money impulses is due to a plunge in shadow (non-bank) credit (Chart I-7). The distinction between broad money and credit is as follows: money is originated by commercial banks when they lend to or acquire an asset from non-banks. Meanwhile, total credit also includes lending and bond purchases by non-banks. Chart I-6China: Credit Impulse Has Not Yet Bottomed China: Credit Impulse Has Not Yet Bottomed China: Credit Impulse Has Not Yet Bottomed Chart I-7Bank And Non-Bank Credit Have Diverged Bank And Non-Bank Credit Has Diverged Bank And Non-Bank Credit Has Diverged Importantly, money/credit fluctuations are not the sole factors that generate swings in economic activity. Companies' and households' willingness to consume and invest matter too. We have written extensively in the past that changes in the velocity of money mirror fluctuations in the marginal propensity to consume and invest.1 Technically speaking, nominal GDP growth is a product of money growth and change in the velocity of money. Nominal GDP = Money Growth x Velocity Of Money When a decline in the velocity of money - stemming from eroding business and consumer confidence - overwhelms an acceleration in money growth, economic growth weakens, despite improvement in the money impulse. Notably, money and credit have led previous business cycles in China by varying time periods. In other words, the velocity of money has not been constant on the mainland. In particular, both the money and credit impulses were early - by about 12 months - in forecasting a growth slowdown in China and global trade at the beginning of 2017. The reason why a growth slowdown did not commence at that time was due to the surge in the velocity of money. The latter is akin to confidence among economic agents. In short, companies and households turned their money balances faster, which offset the impact of weak money/credit impulses on economic activity. Concerning fiscal policy, time lags differ because of implementation delays and varying fiscal multipliers. In China, aggregate fiscal spending, including central, local governments and managed funds, has not yet accelerated (Chart I-8). Chart I-8China: No Rebound In Broad Fiscal Spending China: No Rebound In Broad Fiscal Spending China: No Rebound In Broad Fiscal Spending While special bond issuance by local governments spiked in August and September, overall credit flows in the economy have not yet improved - please refer to Chart I-6. As an aside, there are reports that 42% of the amount raised via special bond issuance will be used to purchase land rather than for infrastructure spending.2 This will not benefit economic growth much. Question: Do you think the time lag between the bottom in China's money/credit impulses and the business cycle will be longer or shorter this time around? Answer: Our bias is that the time lag between the bottom in money/credit impulses and the resultant pickup in growth will be longer than before. Presently, there is some evidence that both business and consumer sentiment in China are beginning to whither at the hands of the trade wars, tanking domestic share prices and budding deflation in real estate prices. Eroding business and consumer confidence in China will - for now - negate the improvement in the broad money impulse. Chart I-9 depicts the velocity of money in China. After rising over the past two years, our bias is that it will drop again. It is critical to realize that forecasting the direction and magnitude of swings in the velocity of money - the marginal propensity to spend - is a dismal science. It reflects business and consumer sentiment, and any assessment on this is very subjective. This is why economic forecasting and investment calls are more of an art. Chart I-9China: The Velocity Of Money China: The Velocity Of Money China: The Velocity Of Money Among many variables we are monitoring to gauge the turn in the mainland's business cycle is the marginal propensity to invest among mainland industrial companies. This indicator is falling, suggesting that monetary policy easing is facing formidable hurdles in re-igniting investment appetite among Chinese companies (Chart I-10). Chart I-10Companies' Marginal Propensity To Spend Companies' Marginal Propensity To Spend Companies' Marginal Propensity To Spend The BCA Emerging Markets Strategy team's assessment is that China-related financial markets are in an air pocket. Investors should not try to catch falling knives. On the contrary, there is still meaningful downside. Question: But the People's Bank of China has been injecting a lot of liquidity into the system via various facilities. Would this liquidity not find its way into financial markets and the real economy? Answer: When a central bank injects liquidity into the banking system, it creates excess reserves. Excess reserves also rise when a central bank cuts the required reserve ratio (RRR). It is essential to differentiate money that households and business use to conduct transactions from reserves of commercial banks at the central bank. Required and excess reserves are not a part of narrow and broad monetary aggregates. Excess reserves are the banking system's liquidity held at the central bank. Importantly, banks do not lend reserves, and do not use reserves to pay for assets they purchase from non-banks. Banks use reserves to settle transactions/payments among themselves. Reserves are "manufactured" solely by central banks. Commercial banks cannot create reserves. They do, however, create the overwhelming majority of money when they lend to or purchase an asset from non-banks. Central banks create broad money - that circulates in the economy - only when they lend to or buy assets from non-banks. Given central banks typically do few transactions with non-banks, central banks originate a very small portion of the broad money supply. For example, as a part of quantitative easing efforts, new money is originated only when a central bank buys bonds from a non-bank (say, an insurance company). In contrast, no money is created when a central bank buys bonds from a bank. In brief, there is no automatic leakage of reserves into the real economy and financial markets. Banks need to be willing to lend to and purchase assets from non-banks for the money supply to expand. Question: But won't expanding excess reserves - banking system liquidity - eventually encourage banks to lend and purchase financial assets? Answer: It will at some point, but it is not imminent. The mainland banking system's excess reserves ratio is depicted in Chart I-11. A few observations are in order: Chart I-11China: Excess Reserves Not Are Growing China: Excess Reserves Not Are Growing China: Excess Reserves Not Are Growing First, the excess reserve ratio - excess reserves (ER) as a share of total deposits - is currently rather low (Chart I-11, top panel). The absolute level of ER is not elevated either (Chart I-11, middle panel). To adjust the absolute level of ER for seasonality, we show the annual change of this measure - it has dropped to zero in September (Chart I-11, bottom panel). This is in contrast to the prevailing market narrative that the PBoC is injecting a lot of liquidity into the system. While they have been injecting liquidity via RRR cuts, at the same time many lending facilities have been maturing without renewal. Does the low level of ER ratio mean the PBoC has been tightening? No, it has not been tightening. Shrinking excess reserves that lead to higher money market rates would qualify as tightening. Provided money market rates are low and are not rising in China, there has been no de-facto tightening, despite the low level of reserves (Chart I-12). Chart I-12China: Excess Reserves And Interest Rates China: Excess Reserves And Interest Rates China: Excess Reserves And Interest Rates Second, any central bank can simultaneously target either quantity of reserves or short-term interest rates, but not both. Before 2014, the PBoC was targeting the level of ER. As a result, short-term interest rates fluctuated a lot to equilibrate demand and supply for ER. Since early 2014, the PBoC has switched to targeting interest rates. Therefore, the level of ER is no longer a policy objective, but rather a tool to navigate interest rates. Chart I-13 illustrates what drives PBoC policy in terms of interest rates and liquidity management. The PBoC sets interest rates based on the strength in the economy - i.e., interest rates rise when loan demand is improving and fall when loan demand is weakening (Chart I-13, top panel). Chart I-13China: What Drives Interest Rates? China: What Drives Interest Rates? China: What Drives Interest Rates? Then, the central bank adjusts the amount of ER to achieve its desired level of short-term interest rates. Hence, the amount of ER is a function of demand for reserves by banks at the current level of interest rates. The current low level of ER is indicative of weak demand for ER by banks. As loan origination has diminished, economic activity has cooled off and the number of transactions by companies and consumers has dwindled, demand for reserves among banks has declined. Third, declining/expanding ER do not always cause a slowdown/acceleration in money/credit growth, as demonstrated on Chart I-14. There is another variable that stands between ER and money/credit: the money multiplier (MM). The latter is defined as how much broad money/credit banks create per one unit of ER. A rising money multiplier reflects banks' willingness and ability to expand their balance sheets aggressively. A falling multiplier signifies growing risk aversion among banks, or their inability to expand their balance sheets. Chart I-14China: Excess Reserves And Money/Credit Impulses China: Excess Reserves And Money/Credit Impulses China: Excess Reserves And Money/Credit Impulses Notably, the credit boom in China since 2009 has been driven not by rapidly expanding ER but primarily by a surging MM. The MM has skyrocketed from 40 in 2008 to 65 presently (Chart I-15). This was the manifestation of excessive risk taking by banks. Chart I-15China: Money Multiplier China: Money Multiplier China: Money Multiplier Why is it sensible to expect the MM in China to decline? With ongoing regulatory tightening, falling asset prices and rising defaults, the odds are non-trivial that mainland banks will be reluctant to expand their balance sheets aggressively. We are not implying they will not boost lending forever, but they may be slower to do so compared to previous downturns. Following the peak in their respective credit bubbles and experiencing deteriorating asset quality, banks in Japan, the U.S., the U.K. and euro area shrunk their balance sheets - even though their respective central banks provided enormous amount of excess reserves, and interest rates were at zero. We do not expect bank credit growth to contract in China like it did in those countries. In fact, bank assets and broad credit are still growing at an annual rate of 7% and 12%, respectively (Chart I-16 and Chart I-7 above). Our point is that deleveraging in China has barely begun, and it still remains a policy priority. Consequently, money and credit growth will languish longer in this downturn than in previous ones. Chart I-16China: Bank Asset Growth To Stay Tame China: Bank Asset Growth To Stay Tame China: Bank Asset Growth To Stay Tame Question: So, how would you summarize the key known unknowns to gauge whether and when monetary policy easing will translate into stronger economic growth? Answer: For monetary policy easing to translate effectively into economic growth, the MM and the velocity of money should rise. Both are driven by sentiment and marginal propensity to lend, borrow and spend. Hence, variations in the MM as well as the velocity of money are contingent on sentiment and behavior among bankers, companies and households. The regulatory clampdown on banks and non-bank financial institutions will hamper their willingness and ability to lend, despite sufficient liquidity and low interest rates. Hence, the MM could surprise on the downside. A combination of the ongoing crackdown on leverage, the starting point of high indebtedness, falling asset prices and trade confrontations, will likely weigh on corporate and consumer sentiment, curb their spending and, thereby, dampen the velocity of money. All in all, risks to both the MM and the velocity of money are to the downside rather than upside at the moment. This will hinder the transmission mechanism from policy easing to economic growth. Question: What is your take on financial markets? Are we close to the bottom in EMs and China-related plays? Answer: EMs and China-plays are in a genuine bear market as we have argued in past.3 BCA's Emerging Markets Strategy service reckons there is still meaningful downside in EM risk assets and currencies. The EM/China bear market will continue. The Fed is not about to come to markets' rescue, because U.S. growth is very robust and inflation is rising. A very important market to watch is the RMB exchange rate. If the RMB depreciates further - which is our baseline scenario - Asian and other EM financial markets will continue plunging. The RMB/USD exchange rate has been closely tracking the interest rate differential between China and the U.S. (Chart I-17). As the Fed continues to raise rates and China maintains rates at their current level or reduces them to stimulate, the RMB will depreciate. Chart I-17RMB/USD And Interest Rate Differentials RMB/USD And Interest Rate Differentials RMB/USD And Interest Rate Differentials Yuan depreciation will lead to a decline in other Asian currencies. In fact, the Korean won is at a critical technical juncture, and a major move is in the cards. Our bias is it will likely break down, consistent with our bearish view on EM risk assets and currencies. As the RMB depreciates, the amount of U.S. dollars that China emits to emerging economies via imports will decline. This will hurt EM exports to China, their currencies and commodities prices. Overall, the U.S. dollar has more upside. The growth disparity between the U.S. and the rest of world warrants a stronger greenback. The latter and a slowdown in EM/China herald a considerable drop in commodities prices. Question: One commodity that has defied the dollar rally and slowdown in China is oil. Will crude continue to float higher? Answer: Oil prices have risen much further and for far longer than we expected.That said, it appears that oil prices are finally beginning to crack, and we see considerable downside.4 China's imports of oil and petroleum products has decelerated substantially (Chart I-18, top panel). This is occurring at a time when Chinese oil strategic and commercial inventories are very elevated (Chart I-18, bottom panel). Chart I-18China's Oil Imports To Weaken Further China's Oil Imports To Weaken Further China's Oil Imports To Weaken Further Oil prices in local currency terms are at record highs in many developing countries. Given oil and fuel subsidies have been removed or reduced in recent years, high oil prices are curbing oil demand in many emerging economies. Global oil production has been outpacing global oil demand since May (Chart I-19, top panel). Typically, this heralds a rollover in oil prices (Chart I-19, bottom panel). Chart I-19A Risk To Oil Prices A Risk To Oil Prices A Risk To Oil Prices Finally, oil output has been surging in the U.S. and strong in Russia (Chart I-20); further, Saudi Arabia could boost its crude output as per its recent pledge. Chart I-20Global Oil Output Has Been Surging Global Oil Output Has Been Surging Global Oil Output Has Been Surging While geopolitics remains a supportive factor for crude prices, it seems a lot of good news is already priced in the oil market and investors are very long. In short, oil prices are probably heading south. This will contribute to the negative investment sentiment toward EM financial markets. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report, "Questions For Emerging Markets," dated November 29, 2017, available at ems.bcaresearch.com. 2https://www.bloomberg.com/news/articles/2018-10-21/china-s-195-billion-debt-splurge-has-less-bang-than-you-think 3 Please see Emerging Markets Strategy Weekly Report, "EMs Are In A Bear Market," dated October 18, 2018; the link is available on page 17. 4 This is BCA's Emerging Markets Strategy team's view and differs from the BCA house view on oil. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Asset allocation: Go long industrial commodities versus equities on a 6-month horizon. If an inflationary impulse is dominating, beaten-down industrial commodities have more upside than richly valued equities; and if a disinflationary impulse is dominating, its main casualty will be equities. Currencies: Take profits on long EUR/CNY. Maintain a broadly neutral stance to EUR, with short EUR/JPY counterbalancing long EUR/USD. Equity sectors: overweight basic materials versus the market. And within the basic materials sector, overweight basic resources versus chemicals. Chart of the WeekChina's 6-Month Credit Impulse Provides A Perfect Explanation For Commodity Inflation China's 6-Month Credit impulse Provides A Perfect Explanation For Commodity Inflation China's 6-Month Credit impulse Provides A Perfect Explanation For Commodity Inflation Feature Equity markets are entering the crossfire between two opposing forces: an inflationary impulse coming from the global economy; and a disinflationary impulse as higher bond yields threaten to deflate the very rich valuations of equities and other risk-assets. As this battle plays out in the coming months a good strategy is to go long commodities versus equities. The logic is simple: if the inflationary impulse from the economy is dominating, then beaten-down industrial commodities have more upside than richly valued equities; and if the disinflationary impulse from higher bond yields is dominating, then commodities have less downside than equities, because commodities have a much weaker valuation link with bond yields. Therefore, going long industrial commodities versus equities on a 6-month horizon should be a good strategy however the battle between inflationary and disinflationary impulses plays out. Inflationary Impulse Battles Disinflationary Impulse Chart I-2 shows the credit impulse oscillations in the euro area, U.S., and China since the start of the millennium, all expressed in dollars to allow a comparison between the three major economies. It is a fascinating chart because the change in the dominant oscillation - the one with the highest amplitude - perfectly illustrates the shift in global economic power and influence from Europe and the U.S. to China. Chart I-2The Shift In Economic Power From Europe And The U.S. To China The Shift In Economic Power From Europe And The U.S. To China The Shift In Economic Power From Europe And The U.S. To China Through 2000-08 the impulses in the euro area and the U.S. dominated. But during the global financial crisis that all changed: the credit stimulus from China dwarfed the responses from the western economies. Then through 2009-12 the impulse oscillations from the three major economies were briefly the same size, before China took on the undisputed mantle of dominant impulse, which it has held consistently since 2013. The world's three major economies are now all in 'up' oscillations according to their credit impulses. This means the global economy will experience an inflationary impulse for the next couple of quarters or so. However, battling the inflationary impulse is a disinflationary impulse. As the inflationary impulse pushes up bond yields, it threatens to deflate the very rich valuations of equities (and other risk-assets). Crucially, this disinflationary force is particularly vicious when bond yields are rising from ultra-low levels. We have described this dynamic exhaustively in previous reports, so we will not go into the detail here. But in a nutshell, both parts of an equity's required return - the risk-free component and the risk premium - go up together when bond yields are rising from ultra-low levels. Meaning that rising yields deflate equity valuations exponentially (Chart I-3).1 Chart I-3At Low Bond Yields The Valuation Of Equities Changes Exponentially Go Long Commodities Versus Equities Go Long Commodities Versus Equities But Which Inflationary Impulse? At our recent investment conference in Toronto, the three speakers on the China panel gave three different conclusions on China: aggressively bullish, moderately bullish, and bearish! The aggressive bull pointed out that the 3-month credit impulse has gone vertical (Chart I-4); the moderate bull pointed out that the 6-month credit impulse appears to be turning up (Chart I-5); while the bearish argument was that the level of the 12-month credit and fiscal impulse remains depressed. Chart I-4The 3-Month Impulse Is Up Sharply... The 3-Month Impulse Is Up Sharply... The 3-Month Impulse Is Up Sharply... Chart I-5But The 6-Month Impulse Is Just Turning But The 6-Month Impulse Is Just Turning But The 6-Month Impulse Is Just Turning So which narrative should we use? The answer is the one that provides the best explanatory power for the cycles that we actually observe in the economic and financial market data. As we described in our Special Report The Cobweb Theory And Market Cycles, the theory and evidence powerfully identifies the 6-month credit impulse as the one with the best explanatory power for the oscillations that we actually observe in the economy and markets - because the 6-month period aligns most closely with the lag between credit demand and credit supply.2 In any case, as we use the 6-month impulse to powerful effect in Europe, consistency demands that we must use the 6-month impulses in U.S. and China too. For the sceptics, the Chart of the Week should finally obliterate any lingering doubts. China's 6-month impulse gives a spookily perfect explanation for the industrial commodity inflation cycle. The important takeaway right now is that if the 6-month impulse is turning up, so will industrial commodity inflation. What Does All Of This Mean For Investors? This brings us to our central message. As we have just seen, an up-oscillation in 6-month impulses, especially in China, will lift industrial commodity inflation. But it will likely have a much smaller influence on developed market equities which, in these circumstances, will be under the strong constraining spell of higher bond yields. On this basis the asset allocation recommendation is to go long industrial commodities versus equities on a 6-month horizon (Chart I-6). Chart I-6Go Long Commodities Vs. Equities Go Long Commodities Vs. Equities Go Long Commodities Vs. Equities Interestingly, technical analysis also supports this recommendation over the next three months or so. Our tried and tested measure of excessive trending and groupthink suggests that the recent underperformance of industrial commodities relative to developed market equities is extreme and at a point which indicates a countertrend move, or at least a trend exhaustion (Chart I-7). Chart I-7The Underperformance Of Industrial Commodities Is Technically Stretched The Underperformance Of Industrial Commodities Is Technically Stretched The Underperformance Of Industrial Commodities Is Technically Stretched For currencies, the foregoing analysis and charts means it is time to take profits in our long position in the euro versus the Chinese yuan. This leaves us with a broadly neutral exposure to the euro, with a short position versus the yen counterbalancing a long position versus the dollar. As for European equities, many years ago they were a pure play on events in Europe. Today, this might still be true for European 'tail-events' such as the euro sovereign debt crisis, or a potential 'no deal' Brexit. However, for the most part, European equity markets are tightly integrated with global equity markets - at least in direction if not level. Given that industrial commodity inflation takes its cue from the 6-month credit impulse - especially in China - it is hardly surprising that the European basic materials sector follows exactly the same cycle, both in absolute terms (Chart I-8) and relative to the broader equity market (Chart I-9). Therefore the equity sector recommendation is to overweight basic materials versus the market. Chart I-8China's 6-Month Credit Impulse Drives Europe's Basic Material Equities In Absolute Terms... China's 6-Month Credit Impulse Drives Europe's Basic Material Equities In Absolute Terms... China's 6-Month Credit Impulse Drives Europe's Basic Material Equities In Absolute Terms... Chart I-9...And In Relative Terms ...And In Relative Terms ...And In Relative Terms Interestingly, there is also a play within the basic materials sector. The basic resources sector which represents the miners and extractors of raw materials should fare better than the chemicals sector which uses these raw materials as an input (Chart I-10). Hence, overweight basic resources versus chemicals. Chart I-10Overweight Basic Resources Vs. Chemicals Overweight Basic Resources Vs. Chemicals Overweight Basic Resources Vs. Chemicals Readers may argue that most of the foregoing charts illustrate the same cycle. But that's precisely the point! Never forget that financial markets follow the Pareto principle: the most important 20 percent of analysis explains 80 percent of the moves across all asset classes across all geographies across all times. The key to successful investing is to find the most important 20 percent of analysis. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Weekly Reports 'Trapped: Have Equities Trapped Bonds?' September 13, 2018 and 'The Rule Of 4 For Equities And Bonds' August 2, 2018 available at eis.bcaresearch.com 2 Please see the European Investment Strategy Special Report 'The Cobweb Theory And Market Cycles' January 11, 2018 available at eis.bcaresearch.com Fractal Trading Model* It was a busy week for our trades. Long basic resources versus chemicals achieved its profit target, but short U.S. telecom versus U.S. autos hit its stop-loss. Meanwhile, short trade-weighted dollar reached the end of its 65 day holding period broadly flat. All three trades are now closed. In line with the main body of the report, this week's trade recommendation is to go long industrial commodities (represented by the CRB industrials index) versus equities (represented by the MSCI World Index in USD). The profit target is 2% with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart 11 Long CRB Industrials Vs. MSCI World Long CRB Industrials Vs. MSCI World The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Set your overall investment strategy with two 'rules of 4' based on 10-year bond yields: If either the Italian BTP or the sum of the U.S. T-bond, German bund and JGB stays above 4 percent, then sell equities and buy bonds. If both the Italian BTP and the sum of the U.S. T-bond, German bund and JGB are in the 3-4 percent range, then remain broadly neutral. If both the Italian BTP and the sum of the U.S. T-bond, German bund and JGB fall below 3 percent, then buy equities and sell bonds. Stay neutral to Italy's MIB and Italian banks for the time being. Among the mainstream European equity markets our top pick remains France's CAC. Feature Many people believe that Italy has one of the world's most indebted economies, but this widely-held belief is wrong. Although Italy's public indebtedness is high, Italy's private indebtedness is one of the lowest in the world (Chart of the Week). This means that Italy's total indebtedness is less than that of France and the U.K., and broadly similar to that of the U.S. (Chart I-2 - Chart 1-5).1 Chart of the WeekItaly's Private Sector Indebtedness Is One Of The Lowest In The World Italy's Private Sector Indebtedness Is One Of The Lowest In The World Italy's Private Sector Indebtedness Is One Of The Lowest In The World Chart I-2Italy: Total Indebtedness = 260% Of GDP Italy: Total Debt Up From 195% To 265% Of GDP Italy: Total Debt Up From 195% To 265% Of GDP Chart I-3France: Total Indebtedness = 305% Of GDP France: Total Debt Up From 190% To 305% Of GDP France: Total Debt Up From 190% To 305% Of GDP Chart I-4U.K.: Total Indebtedness = 280% Of GDP U.K.: Total Indebtedness = 280% Of GDP U.K.: Total Indebtedness = 280% Of GDP Chart I-5U.S.: Total Indebtedness = 250% Of GDP U.S.: Total Indebtedness = 250% Of GDP U.S.: Total Indebtedness = 250% Of GDP The Myth Of Italian Indebtedness An economy's debt sustainability depends on its total indebtedness, and not on its public indebtedness or its private indebtedness in isolation. Debt becomes unsustainable when the marginal extra euro of debt results in misallocation of resources and mal-investment. At this point, the extra debt adds nothing to growth or, worse, it subtracts from growth. Therefore, debt reaches its sustainable limit when the economy has exhausted all productive uses for it. But it does not matter whether these productive uses are funded with private debt or with public debt. For example, successful economies require investment in high-quality healthcare and education. Some economies fund this with private debt, while others fund it with public debt. This means that if productive private indebtedness is low, there is more scope for productive public indebtedness. The crucial point is that Italy has extremely low private indebtedness, which means that it can afford relatively high public indebtedness before reaching the limit of debt sustainability. Right now, this is especially true because the Italian banking system remains dysfunctional, preventing the private sector from borrowing (Chart I-6). Under these circumstances, the Italian government can borrow the private sector's excess savings and debt repayments and put them to highly productive use - which will paradoxically reduce the deficit in the long term. Chart I-6Italy's Private Sector Is Not Borrowing Italy's Private Sector Is Not Borrowing Italy's Private Sector Is Not Borrowing Hence, the M5S/Lega government is following excellent economic policy in proposing a modest increase in the fiscal deficit in 2019. An appropriately sized and targeted fiscal stimulus is exactly what Italy needs right now. But this excellent economic policy will take time to bear fruit and show up in Italy's growth and deficit data. Italy's big problem is that bond vigilantes do not wait, they shoot first and ask questions later. Italy Is Especially Vulnerable To Bond Vigilantes Italy is also a world leader in running primary surpluses (Chart I-7 and Table I-1). In plain English, this means that the Italian government spends considerably less than it receives, if interest payments are excluded. Chart I-7Italy Is A World Leader In Running Primary Surpluses Italy Is A World Leader In Running Primary Surpluses Italy Is A World Leader In Running Primary Surpluses Table I-1Italy Has Consistently Run Primary Surpluses Italy, Bond Vigilantes, And Bubbles Italy, Bond Vigilantes, And Bubbles Put differently, Italy's government deficit results not from its operational spending relative to its income, but from the interest payments on its debt. This makes Italy especially vulnerable to the bond vigilantes. If the bond vigilantes distort Italy's interest rate, they can tip the Italian government into financial distress, even if that distress is not justified by the economic fundamentals. Is this a real risk? Sadly, yes. The euro debt crisis was essentially a liquidity crisis which resulted from bond vigilantes running amok. When irrational markets refuse to lend to sovereigns at a fair interest rate, maturing debt has to be refinanced at a penalising interest rate, causing an undeserved deterioration in the government's finances. Thereby, the irrational fear of insolvency becomes a self-fulfilling prophecy. Italy has an additional problem. When Italian bond prices decline, it erodes the value of the banking system's euro 350 billion portfolio of BTPs and weakens the banks' fragile balance sheets. If a bank's equity capital no longer covers its net non-performing loans (NPLs), investors get nervous. In this regard, the largest Italian banks now have euro 160 billion of equity capital against euro 130 billion of net NPLs, implying a cushion of euro 30 billion (Chart I-8). Chart I-8Italian Banks' Equity Capital Exceeds ##br##Net NPLs By Euro 30 Bn... Italian Banks' Equity Capital Exceeds Net NPLs By €30 Bn... Italian Banks' Equity Capital Exceeds Net NPLs By €30 Bn... So the markets would start to worry about Italian banks' mark-to-market solvency if their bond portfolios sustained a loss of €30 billion. We estimate this equates to the 10-year BTP yield breaching and remaining above 4 percent (Chart I-9).2 Chart I-9...The Excess Would Disappear If The 10-Year BTP Yield Stayed Above 4% ...The Excess Would Disappear If The 10-Year BTP Yield Stayed Above 4% ...The Excess Would Disappear If The 10-Year BTP Yield Stayed Above 4% The ECB solved the euro debt crisis at a stroke by committing to act as lender of last resort to distressed sovereigns at an 'undistorted' interest rate. Indeed, the commitment alone was enough to defeat the bond vigilantes without the ECB spending a single cent from its Outright Monetary Transaction (OMT) program.3 But recall that the ECB only threatened its firepower when the 2-year Spanish Bono yield had breached 6.5 percent and the 10-year yield had breached 7.5 percent. It follows that if the 10-year Italian BTP yield breached 4 percent, the yield would be high enough to hurt the Italian banks, but not nearly high enough for any powerful intervention from the ECB. Hence, the 10-year BTP yield at 4 percent is the level at which we would return to a pro-defensive strategy. Conversely, a level below 3 percent would create some margin of safety providing one precondition for a more pro-cyclical investment stance. In the meantime, the current level at 3.3 percent justifies a neutral cyclical stance to Italy's MIB and Italian banks. Among the mainstream European equity markets our top pick remains France's CAC. The Connection Between Bubbles And Liquidity Crises Bubble formation may seem to have no connection with a liquidity crisis but the two phenomena are closely related. Bubble formation is simply a brewing liquidity crisis resulting from irrational euphoria rather than irrational fear. A bubble forms when value investors stop investing on the basis of a valuation framework. Instead, they get lured into the momentum herd that is participating in a strong rally, and the additional buy orders fuel the euphoria. However, once all of the value investors have joined the momentum herd, and a value investor then suddenly reverts to type and puts in a sell order, the market will suffer a liquidity crisis. There are no buyers left! And finding one might require a substantial reversal in the price to attract an ultra-long-term deep value investor. As regular readers know, fractal analysis measures whether the herding behaviour in any financial instrument is becoming excessive. The analysis suggests that developed market equities are not yet at the tipping point of excessive euphoria that signalled the last two trend exhaustions in May 2017 and January 2018 (Chart I-10). But this does not mean that there are clear blue skies ahead. Chart I-10Developed Market Equities Are Not Yet At A Trend Exhaustion Developed Market Equities Are Not Yet At A Trend Exhaustion Developed Market Equities Are Not Yet At A Trend Exhaustion The danger is not that the rich valuation is irrationally excessive, but that it is hyper-sensitive to bond yields. At low bond yields, bonds offer no price upside but substantial price downside. Confronted with this increased riskiness of bonds, equity returns justifiably collapse to the feeble returns offered by bonds with no additional 'risk premium', giving equity valuations an exponential uplift. But if bond yields normalise, the process goes into vicious reverse - the rich valuation of equities must decline as exponentially as it rose. We have defined the danger point as when the sum of the 10-year yields on the U.S. T-bond, German bund, and JGB breaches and stays above 4 percent. In summary, set your overall investment strategy with two 'rules of 4' based on 10-year bond yields: If either the Italian BTP or the sum of the U.S. T-bond, German bund and JGB stays above 4 percent, then sell equities and buy bonds. If both the Italian BTP and the sum of the U.S. T-bond, German bund and JGB are in the 3-4 percent range, then remain broadly neutral. If both the Italian BTP and the sum of the U.S. T-bond, German bund and JGB fall below 3 percent, then buy equities and sell bonds. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Indebtedness defined as a share of GDP. 2 Assuming that the average maturity of Italian banks' BTPs is around 5 years. 3 The ECB's Outright Monetary Transaction (OMT) program was created in 2012 in response to the euro debt crisis and facilitates the ECB's lender of last resort function to solvent but illiquid sovereign borrowers. Fractal Trading Model* We are pleased to report that our long China/short India trade achieved its 9% profit target and is now closed. This week, we note that the underperformance of the Eurostoxx50 versus the Nikkei225 is technically stretched, with a 65-day fractal dimension approaching the limit which signaled a very recent trend reversal. Hence, this week's recommended trade is long Eurostoxx50 versus Nikkei225. The profit target is 3.5% with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 Long Eurostoxx50 VS. Nikkei 225 Long Eurostoxx50 VS. Nikkei 225 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Fed policy and U.S. interest rates are not irrelevant to EM, but they are of secondary importance. The most vital factors that drive EM financial markets - the direction of global trade, domestic demand, corporate profits, and borrowing costs - do not currently indicate a sustainable bottom. Stay short/underweight EM risk assets. Feature How long and how deep will the selloff in emerging markets (EM) be? There are many factors that investors should be watching to gauge potential for further downside in the EM universe, and to exercise judgement about a bottom. These include the business cycle trajectory, policy actions and shifts, market technicals, liquidity, valuations and other fundamental variables. Not all of preconditions typically need to be satisfied before a major bottom emerges. What's more, not all bottoms are identical and contingent on the same factors. Hence, there is no magical formula for calling a bottom or top in any financial market. Today we revisit some of the variables that, in our opinion, are worth monitoring in terms of gauging a bottom. To begin, we address a currently popular narrative within the investment industry, which contends the following: EM woes are primarily being driven by Federal Reserve tightening. According to this view, when the Fed halts its tightening campaign, the skies will clear for EM risk assets. By and large, we disagree with this narrative. EM And The Fed: Let's Get Things Straight Fed policy and U.S. interest rates are not irrelevant to EM, but they are of secondary importance. The primary drivers of EM economies are domestic fundamentals and the overall global business cycle. Historically, the correlation between EM risk assets and the fed funds rate has been mixed (Chart 1). On this chart, we shaded the periods in which EM stocks rallied, despite a rising fed funds rate. Chart 1EM Equity Prices And Fed Funds Rate: Mixed Correlation 1. EM Equity Prices And Fed Funds Rate: Mixed Correlation 1. EM Equity Prices And Fed Funds Rate: Mixed Correlation There were only two episodes when EMs crashed amid rising U.S. interest rates: the 1982 Latin America debt crisis and the 1994 Mexican Tequila crisis. Yet, it is vital to emphasize that these crises occurred because of poor EM fundamentals: elevated foreign currency debt levels, negative terms-of-trade shocks, large current account deficits, pegged exchange rates, and so on. Importantly, EM stocks and currencies did well during other periods of a rising fed funds rate: in 1983-1984, 1988-1989, 1999-2000 and 2017, as illustrated by the shaded periods in Chart 1. Hence, statistically there is no case that EMs plunge when the Fed is tightening policy. Why did the behavior of EM risk assets during various Fed tightening episodes differ? The key was EM fundamentals at the time: When fundamentals were healthy, EM managed to rally, despite Fed tightening; when fundamentals were flawed, EM markets relapsed regardless of the Fed's policy stance. Dire EM fundamentals also prevailed before the Asian/EM crises of 1997-1998. However, these late-1990s EM crises occurred without much in the way of Fed tightening or rising U.S. bond yields. Notably, U.S. and EU growth were booming and U.S. bond yields were dropping in 1997-'98. Specifically, U.S. and EU import volumes were growing at double-digit rates but this did not preclude EM crises, including in export-dependent Asian economies such as Korea, Malaysia and Thailand (Chart 2). It is critical to emphasize that China was not an economic superpower in the late 1990s. EM economic dependence on the U.S. and European economies was much greater than it is today. Yet neither booming demand in the U.S. and EU nor falling U.S. government bond yields prevented the Asian/EM crises from rolling across the globe in 1997-'98 (Chart 3A). Moreover, the S&P 500 was in a bull market in the second half of 1990s, as it is today (Chart 3B), but it did not help EM either. Chart 2Asian/EM Crises In 1997-98 Occurred Amid Booming Growth In U.S. And EU Asian/EM Crises In 1997-98 Occurred Amid Booming Growth In U.S. And EU Asian/EM Crises In 1997-98 Occurred Amid Booming Growth In U.S. And EU Chart 3AAsian/EM Crises In 1997-98 Took Place Amid Falling U.S. Bond Yields And Rising S&P 500 Asian/EM Crises In 1997-98 Took Place Amid Falling U.S. Bond Yields And Rising S&P 500 Asian/EM Crises In 1997-98 Took Place Amid Falling U.S. Bond Yields And Rising S&P 500 Chart 3BAsian/EM Crises In 1997-98 Took Place Amid Falling U.S. Bond Yields And Rising S&P 500 Asian/EM Crises In 1997-98 Took Place Amid Falling U.S. Bond Yields And Rising S&P 500 Asian/EM Crises In 1997-98 Took Place Amid Falling U.S. Bond Yields And Rising S&P 500 Hence, we can safely conclude that the EM fallout in 1997-'98 was due to EM domestic fundamentals - not developed market dynamics in general and Fed tightening in particular. An essential question is: Why are EM risk assets currently plunging while U.S. stocks and credit markets are holding up just fine? The U.S. economy is much more exposed to rising U.S. borrowing costs than EM. Despite this, the American economy, U.S. share prices and corporate bonds have been performing very well. In our view, this also stipulates that the core root for the current EM bear market is EM fundamentals. As we have repeatedly noted in various reports,1 EM fundamentals have been very frail, and the end of easy Fed monetary policy has not helped. The Fed's tightening can be regarded as the trigger - not the cause - of the EM bear market. The cause is weak EM fundamentals, such as credit excesses, low return on capital, weakening productivity growth and, in some cases, inflation and dependence on external funding. Importantly, the dependence of EM countries on the Chinese economy is presently greater than their dependence on the U.S. as shown in Table 1. Further, mainland growth is decelerating. Adding it all up, it is not surprising to us that EM financial markets are in turmoil. Table 1Many Emerging Economies Sell More##br## To China Than to The U.S. EM: Stay Put EM: Stay Put Our bearish view on EM has not been based on a negative view on U.S./EU growth. On the contrary, we have been bearish on EM/China and positive on domestic demand in the U.S. and the EU. Early this year, we promoted the theme of tectonic macro shifts,2 arguing that China/EM growth would slump and the U.S. economy would accelerate - and that such dynamics would propel the U.S. dollar higher. In turn, a firm dollar would inflict substantial pain on EM. Bottom Line: Rising U.S. interest rates, in and of itself, is neither a necessary nor a sufficient condition for EM to sell off. Consequently, the Fed adopting an easier policy stance or lower U.S. Treasury yields may not, in and of themselves, create sufficient conditions for a reversal in EM financial markets, unless they coincide with a turnaround in other variables that matter for EM. What Matters For EM? As of now, we do not think sufficient conditions exist for a bottom in EM financial markets because of several pertinent factors: The most important factor for EM assets in the medium term is the direction of the business cycle in EM in general, and in China in particular. The EM business cycle is still decelerating, as evidenced by falling manufacturing PMI indexes in EM ex-China and China (Chart 4). Consistently, corporate earnings growth is decelerating for EM non-financial companies and Chinese non-financial A-share corporates (Chart 5). The rationale for our focus on non-financial corporate earnings is that non-performing loans are usually not recognized and provisioned for by banks in a timely way to reflect their true profitability. Typically, banks' earnings cycle lags the real economy. When the real economy is slowing, banks' profits typically deteriorate with a time lag. Chart 4Manufacturing Is Slowing In China And EM Ex-China Manufacturing Is Slowing In China And EM ex-China Manufacturing Is Slowing In China And EM ex-China Chart 5EM/China Corporate Profit Growth Is Decelerating bca.ems_wr_2018_09_06_s1_c5 bca.ems_wr_2018_09_06_s1_c5 Corporate profits in China and in EM have not yet contracted, but our view is that there will be a meaningful profit contraction in this downturn. As and when corporate earnings shrink, share prices will sell off. In brief, we are not out of the woods yet. In China, the industrial part of the economy continues to weaken, as evidenced by the slump in the total freight index and electricity consumption by manufacturing and resource sectors (Chart 6). So far, the cumulative impact of policy easing in China has not been sufficient to reverse its business cycle. As we discussed in our prior report,3 money/credit impulses lead China's industrial sector by nine months or so. Even if the government's recent stimulus initiatives cause money/credit impulses to improve materially today (which we still doubt), the impact on growth will be felt only next year. While financial markets are forward-looking, they are unlikely to bottom a full six months before the bottom in the real economy. Hence, we are currently in the window where China plays in financial markets remain at risk. Global trade is also weakening, as evidenced by falling semiconductor prices (Chart 7) and industrial metals. Similarly, the container freight index at Chinese ports is sluggish, and broader Asian export volumes are slowing (Chart 8). Chart 6Signs Of Industrial Slowdown In China bca.ems_wr_2018_09_06_s1_c6 bca.ems_wr_2018_09_06_s1_c6 Chart 7Semiconductor Prices Are Plunging Semiconductor Prices Are Plunging Semiconductor Prices Are Plunging Chart 8Asian Export To Slow Further Asian Export To Slow Further Asian Export To Slow Further Regarding liquidity, there are various definitions and ways to measure liquidity. One measure of EM liquidity is EM local interest rates. Chart 9A and 9B shows that interbank rates in various EM countries are rising due to the ongoing currency weakness. EM benchmark local currency bond yields are also under upward pressure (Chart 10, top panel). These are all signs of tightening liquidity. The ramifications of higher interest rates will be a slowdown in money and credit, and consequently a slump in domestic demand. Chart 9AEM: Interbank Rates##br## Are Rising EM: Interbank Rates Are Rising EM: Interbank Rates Are Rising Chart 9BEM: Interbank Rates##br## Are Rising EM: Interbank Rates Are Rising EM: Interbank Rates Are Rising Chart 10EM: Local Currency Bonds Yields##br## And Narrow Money Growth EM: Local Currency Bonds Yields And Narrow Money Growth EM: Local Currency Bonds Yields And Narrow Money Growth Chart 10 illustrates that local bond yields negatively correlate with narrow money growth in EM ex-China, Korea, Taiwan and India. These four markets are not included in the EM GBI local bond index; to maintain consistency, we have removed them from the money supply aggregate. EM sovereign and corporate bond yields continue to rise. As we have shown numerous times in previous reports, EM share prices do not bottom until EM corporate and sovereign bond yields roll over on a sustainable basis. Finally, we discussed EM equity and currency valuations in our August 23 report. We maintain that aggregate EM equity and currency valuations are not yet cheap enough to warrant bottom-fishing. Bottom Line: The most vital factors that drive EM financial markets - the direction of global trade, domestic demand, corporate profits, and borrowing costs - do not currently indicate a sustainable bottom. Stay short/underweight EM risk assets. 6 September 2018 The list of our trades and country allocation is always presented at the end of each report (please see page 10-11). Specifically, we continue shorting BRL, CLP, ZAR, IDR and MYR versus the U.S. dollar. Within the equity space, our overweights are Taiwan, Korea, Thailand, Chile, India, Mexico and central Europe; and underweights are Brazil, Peru, Malaysia, Indonesia, and South Africa. Among local currency bonds we are overweight Russia, Korea, Mexico, Thailand, and central Europe and underweight Brazil, South Africa, Turkey, Malaysia, and Indonesia. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see BCA Emerging Markets Strategy Weekly Report, "Understanding The EM/China Cycles," July 19, 2018. 2 Please see BCA Emerging Markets Strategy Weekly Report, "Two Tectonic Macro Shifts," January 31, 2018. 3 Please see BCA Emerging Markets Strategy Weekly Report, "EM: Do Note Catch A Falling Knife," August 23, 2018. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

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 Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging 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 Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging   Chart 3The Private Sector Has Accounted For ##br##Most Of Chinese Leveraging... Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging Chart 4...Due Mostly To State-Owned ##br##Enterprises And Households Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging     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 Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging 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 Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging 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 Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging 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 SOEs Now Appear To Have A Negative Financial Gain From Debt SOEs Now Appear To Have A Negative Financial Gain From Debt Chart 8A Stylized Example Of ##br## Debt Trap Dynamics Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging Chart 9Has SOE Leveraging Caused China's ##br##Natural Rate Of Interest To Fall? Has SOE Leveraging Caused China's Natural Rate Of Interest To Fall? Has SOE Leveraging Caused China's 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 Modest Releveraging Is Ok, As Long As Its Pace Continues To Slow Modest Releveraging Is Ok, As Long As 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 A Rebound, But Weak Relative To History A Rebound, But Weak Relative To History Chart 12Barely Even Registers As An Acceleration In Adjusted TSF Barely Even Registers As An Acceleration In Adjusted TSF Barely 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 No Signs Yet Of A Heavy, Credit-Based Response No 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 Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging 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