Policy

Highlights So What? Global divergence will persist beyond the near term. Why? China’s stimulus will be disappointing unless things get much worse. U.S.-China trade war will reignite and strategic tensions will continue. European risks are limited short-term, but will surge without reform. U.S. assets will outperform; oil and the yen will rise; the pound is a long-term play; EM pain will continue. Feature The year 2019 will be one of considerable geopolitical uncertainty. Three issues dominate our Outlook, with low-conviction views on all three questions: Question 1: How much will China stimulate? Question 2: Will the trade war abate? Question 3: Is Europe a Black Swan or a Red Herring? U.S. Outperformance Should Be Bullish USD U.S. Outperformance Should Be Bullish USD The main story in 2018 was policy divergence. American policymakers ramped up stimulus – both through the profligate tax cuts and fiscal spending – at the same time that Chinese policymakers stuck to their guns on de-levering the economy. The consequence of this policy mix was that the synchronized global recovery of late 2016 and 2017 evolved into a massive outperformance by the U.S. economy (Chart 1). The Fed responded to the bullish domestic conditions with little regard for the global economy, causing the DXY to rally from a 2018 low of 88.59 in February to 97.04 today. Fiscal Conservatism Melts Away Fiscal Conservatism Melts Away Republicans Change Their Minds When In Power Republicans Change Their Minds When In Power While the policy divergence narrative appears to be macroeconomic in nature, it is purely political. There is nothing cyclical about the ‘U.S.’ economic outperformance in 2018. President Donald Trump campaigned on an economic populist agenda and then proceeded to deliver on it throughout 2017 and 2018. He faced little opposition from fiscal conservatives, mainly because fiscal conservativism melts away from the public discourse when budget deficits are low (Chart 2) and when the president is a Republican (Chart 3). Meanwhile, Chinese policymakers have decided to tolerate greater economic pain in an effort to escape the Middle Income Trap (Chart 4). They believe this trap will envelop them if they cannot grow the economy without expanding the already-massive build-up of leverage (Chart 5). 2019 Key Views: Balanced On A Knife’s Edge 2019 Key Views: Balanced On A Knife’s Edge Debt Still Rising Debt Still Rising Geopolitics is not just about “things blowing up somewhere in the desert.” In today’s world, emblematized by paradigm shifts, politicians are more than ever in the driver’s seat. While technocrats respond to macroeconomic factors, politicians respond to political and geopolitical constraints. Few investment narratives last much longer than a year and policy divergence is coming to a close. Will the Fed pause given the turn in global growth? Will China respond with effective stimulus in 2019? If the answer to both questions is yes, global risk assets could light up in the next quarter and potentially beyond. Already EM has outperformed DM assets for a month and some canaries in the coal mine for global growth – like the performance of Swedish economic indicators – signal that the outperformance is real. Global Economic Divergence Will Continue Global Economic Divergence Will Continue 2019 Key Views: Balanced On A Knife’s Edge 2019 Key Views: Balanced On A Knife’s Edge We are skeptical that the move is sustainable beyond a quarter or two (Chart 6). As our colleague Peter Berezin has highlighted, the market is pricing less than one hike in 2019 (Chart 7). Regardless, the impact on the U.S. dollar, remains muted, with the DXY at 97.04. This suggests that the backing off that the Fed may or may not have already done is still not enough from the perspective of weakening global growth (Chart 8). Global risk assets need more from the Fed than what the market is already pricing. And with U.S. inflationary pressures building (Chart 9), the BCA House View expects to see multiple Fed hikes in 2019, disappointing investors bullish on EM and global risk assets. Global Growth Leading Indicators Global Growth Leading Indicators Does The Fed Like It Hot? Does The Fed Like It Hot? With our Fed view set by the House View, we therefore turn to where we can add value. To this end, the most important question of 2018 largely remains the same in 2019: How much will China stimulate? Question 1: How Much Will China Stimulate In 2019? bca.gps_sr_2018_12_14_c10 bca.gps_sr_2018_12_14_c10 China is undoubtedly already stimulating, with a surge in local government bond issuance earlier this year and a bottoming in the broad money impulse (Chart 10). M2 is in positive territory. However, the effort can best be characterized as tepid, with a late-year collapse in bond issuance (Chart 11) and a still-negative total social financing (TSF) impulse (Chart 12). TSF is the broadest measure of private credit in China’s economy.   2019 Key Views: Balanced On A Knife’s Edge 2019 Key Views: Balanced On A Knife’s Edge China's Total Credit Is Weak China's Total Credit Is Weak We expect a surge in TSF in Q1, but this is a normal seasonal effect. A typical Q1 credit surge will not be enough to set global risk assets alight for very long, particularly if the market has already priced in as much of a “pause” from the Fed as we are going to get. Investors should specifically focus on new local government bond issuance and whether the “shadow financing” component of TSF gets a bid, since the primary reason for the weakness in TSF over the past year is the government’s crackdown on shadow lending. As Chart 13A & B shows, it was new local government bonds that led the way for stimulus efforts in 2015, followed by a surge in both bank lending and shadow lending in 2016. Don't Focus Just On TSF... Don't Focus Just On TSF... ...But Shadow Financing In Particular ...But Shadow Financing In Particular We would also expect further monetary policy easing, with extra RRR cuts or even a benchmark policy rate cut. However, monetary policy has been easy all year and yet the impact on credit growth has remained muted. This begs two important questions: Is the credit channel impaired? A slew of macroprudential reforms – which we have dubbed China’s “Preemptive Dodd-Frank” – may have impaired the flow of credit in the system. The official policy of “opening the front door, closing the back door” has seen bank loans pick up modestly but shadow lending has been curtailed (Chart 14A & B). This way of controlling the rise of leverage has its costs. For private enterprises – with poor access to the official banking sector – the shadow financial system was an important source of funding over the past several years. Opening The Front Door... Opening The Front Door... ...Closing The Back Door ...Closing The Back Door Is policy pushing on a string? An even more dire scenario would be if China’s credit channel is not technically, but rather psychologically, impaired. Multiple reasons may be to blame: a negative net return on the assets of state-owned enterprises (Chart 15); widespread trade war worries; mixed signals from policymakers; or a general lack of confidence in the political direction of the country. The rising M2/M1 ratio suggests that the overall economy’s “propensity to save” is rising (Chart 16). Old China Is A Zombie China Old China Is A Zombie China Propensity To Save Propensity To Save Why would Chinese policymakers keep their cool despite a slow pickup in credit growth? Are they not concerned about unemployment, social unrest, and instability? Of course, they are. But Chinese policymakers are not myopic. They also want to improve potential GDP over the long run. Table 1China: The Trend In Domestic Demand, And The Outlook For Trade, Is Negative 2019 Key Views: Balanced On A Knife’s Edge 2019 Key Views: Balanced On A Knife’s Edge So far, the economy has weathered the storm relatively well. First, eight out of ten of our China Investment Strategy’s housing price indicators (Table 1) are flat-to-up – although it is true that the October deterioration in floor space started and especially floor space sold (Chart 17) is cause for concern. If and when the housing market weakens further, stimulus will be used to offset it, despite the fact that the government is attempting to prevent a sharp increase in prices at the same time. With so much of China’s middle-class savings invested in the housing market, the key pillar of socio-economic stability is therefore real estate. A Possible Clue For China Stimulusr A Possible Clue For China Stimulusr Second, credit has fueled China’s “old economy,” but policymakers want to buoy “new China” (Chart 18). This means that measures to boost consumption and the service sector economy will be emphasized in new rounds of stimulus, as has occurred thus far (tax cuts, tariff cuts, deregulation, etc). This kind of stimulus is not great news for global risk assets leveraged to “old China,” such as EM and industrial metals. Rebalancing Of The Chinese Economy Rebalancing Of The Chinese Economy Third, policymakers are not exclusively focused on day-to-day stability but are also focused on the decades-long perseverance of China’s political model. And that means moving away from leverage and credit as the sole fuel for the economy. This is not just about the Middle Income Trap, it is also about national security and ultimately sovereignty. Relying on corporate re-levering for stimulus simply doubles-down on the current economic model, which is still export-oriented given that most investment is geared toward the export sector. But this also means that China will be held hostage to foreign demand and thus geopolitical pressures, a fact that has been revealed this year through the protectionism of the White House. As such, moving away from the investment-led growth model and towards a more endogenous, consumer-led model is not just good macro policy, it makes sense geopolitically as well. Will the trade war – or the current period of trade truce – change Chinese policymakers’ decision-making? We do not see why it would. First, if the trade truce evolves into a trade deal, the expected export shock will not happen (Chart 19) and thus major stimulative measures would be less necessary. Second, if we understand correctly why policymakers have cited leverage as an “ill” in the first place, then we would assume that they would use the trade war as an excuse for the pain that they themselves have instigated. In other words, the trade war with the U.S. gives President Xi Jinping the perfect excuse for the slowdown, one that draws attention from the real culprit: domestic rebalancing. Trump's Initial Tariffs Soon To Be Felt Trump's Initial Tariffs Soon To Be Felt Bottom Line: Since mid-2018, we have been asking clients to focus on our “Stimulus Overshoot” checklist (Table 2). We give the first item – “broad money and/or total credit growth spike” – a premier spot on the list. If a surge in total credit occurs, we will know that policymakers are throwing in the towel and stimulating in a major way. It will be time to turn super-positive on global risk assets, beyond a mere tactical trade, as a cyclical view at that point. Note that if one had gone long EM in early February 2016, when January data revealed a truly epic TSF splurge, one would not have been late to the rally. Table 2Will China’s Stimulus Overshoot In 2019? 2019 Key Views: Balanced On A Knife’s Edge 2019 Key Views: Balanced On A Knife’s Edge Our low-conviction view, at the moment, is that the increase in credit growth that we will see in Q1 will be seasonal – the usual frontloading of lending at the beginning of the year – rather than an extraordinary surge that would signal a policy change. A modest increase in credit growth will not be enough to spark a sustainable – year-long – rally in global risk assets. The Fed has already backed off as far as the market is concerned. As such, a pickup in Chinese credit could temporarily excite investors. But global stabilization may only embolden the Fed to refocus on tightening after a Q1 pause. Question 2: Will The Trade War Abate? The first question for investors when it comes to the trade war is “Why should we care?” Sure, trade policy uncertainty appears to have correlated with the underperformance of global equity indices relative to the U.S. (Chart 20). However, such market action was as much caused by our policy divergence story – being as it is deeply negative for EM assets – as by a trade war whose impact on the real economy has not yet been felt. U.S. Is 'Winning' The Trade War U.S. Is 'Winning' The Trade War Nonetheless, we do believe that getting the trade war “right” is a big call for 2019. First, while the impact of the U.S.-China trade war has been minimal thus far, it is only because China front-loaded its exports ahead of the expected tariffs, cut interbank rates and RRRs, accelerated local government spending, and allowed CNY/USD to depreciate by 10%. A restart of trade tensions that leads to further tariffs will make frontloading untenable over time, whereas further currency depreciation would be severely debilitating for EMs. We doubt the sustainability of the trade truce for three reasons: U.S. domestic politics: The just-concluded midterm election saw no opposition to President Trump on trade. The Democratic Party candidates campaigned against the president on a range of issues, but not on his aggressive China policy. Polling from the summer also shows that a majority of American voters consider trade with China unfair (Chart 21). In addition, President Trump will walk into the 2020 election with a wider trade deficit, due to his own stimulative economic policy (Chart 22). He will need to explain why he is “losing” on the one measure of national power that he campaigned on in 2016. Structural trade tensions: Ahead of the G20 truce, the U.S. Trade Representative Robert Lighthizer issued a hawkish report that concluded that China has not substantively changed any of the trade practices that initiated U.S. tariffs. Lighthizer has been put in charge of the current trade negotiations, which is a step-up in intensity from Treasury Secretary Steven Mnuchin, who was in charge of the failed May 2018 round. Geopolitical tensions: The G20 truce did not contain any substantive resolution to the ongoing strategic tensions between the U.S. and China, such as in the South China Sea. Beyond traditional geopolitics, tensions are increasingly involving high-tech trade and investment between the two countries and American allegations of cyber theft and spying by China. The recent arrest of Huawei’s CFO in Canada, on an American warrant, will likely deepen this high-tech conflict in the short term. 2019 Key Views: Balanced On A Knife’s Edge 2019 Key Views: Balanced On A Knife’s Edge Trade Deficit To Rise Despite Tariffs Trade Deficit To Rise Despite Tariffs Since the G20 truce with Xi, President Trump has seen no significant pickup in approval ratings (Chart 23). Given that the median American voter has embraced protectionism – against China at least – we would not expect any. Meanwhile, U.S. equities have sold off, contrary to what President Trump, or his pro-trade advisors, likely expected in making the G20 decision to delay tariffs. Appeasing China Doesn't Pay Appeasing China Doesn't Pay At some point, President Trump will realize that he risks considerable political capital on a trade deal with China that very few voters actually want or that the U.S. intelligence and defense community supports. Democrats did not oppose his aggressive China policy in the midterm election because they know that the median voter does not want it. As such, it is guaranteed that Trump’s 2020 Democratic Party opponent will accuse him of “surrender,” or at least “weakness.” If, over the next quarter, the economic and market returns on his gambit are paltry, we would expect President Trump to end the truce. Furthermore, we believe that a substantive, and long-lasting, trade deal is unlikely given the mounting tensions between China and the U.S. These tensions are not a product of President Trump, but are rather a long-run, structural feature of the twenty-first century that we have been tracking since 2012.1 Tensions are likely to rise in parallel to the trade talks on the technology front. We expect 2019 to be the year when investors price in what we have called Bifurcated Capitalism: the segmentation of capital, labor, and trade flows into geopolitically adversarial – and yet capitalist in nature – economic blocs. Entire countries and sectors may become off-limits to Western investors and vice-versa for their Chinese counterparts. Countries will fall into either the Tencent and Huawei bloc or the Apple and Ericsson bloc. This development is different from the Cold War. Note our emphasis on capitalism in the term Bifurcated Capitalism. The Soviet Union was obviously not capitalist, and clients of BCA did not have interests in its assets in the 1970s and 1980s. Trade between Cold War economic blocs was also limited, particularly outside of commodities. The closest comparison to the world we now inhabit is that of the nineteenth century. Almost all global powers were quite capitalist at the time, but they engaged in imperialism in order to expand their economic spheres of influence and thus economies of scale. In the twenty-first century, Africa and Asia – the targets of nineteenth century imperialism – may be replaced with market share wars in novel technologies and the Internet. This will put a ceiling on how much expansion tech and telecommunication companies can expect in the competing parts of Bifurcated Capitalism. The investment consequences of this concept are still unclear. But what is clear is that American policymakers are already planning for some version of the world we are describing. The orchestrated effort by the U.S. intelligence community to encourage its geopolitical allies to ban the use of Huawei equipment in their 5G mobile networks suggests that there are limits to the current truce ever becoming a sustainable deal. So does the repeated use of economic sanctions originally designed for Iran and Russia against Chinese companies. President Trump sets short- and medium-term policies given that he is the president. However, the intelligence and defense communities have “pivoted to Asia” gradually since 2012. This shift has occurred because the U.S. increasingly sees China as a peer competitor, for the time being confined in East Asia but with intentions of projecting power globally. To what extent could President Trump produce a trade deal with Xi that also encompasses a change in the U.S. perception of China as an adversary? We assign a low probability to it. As such, President Xi has little reason to give in to U.S. pressure on trade, as he knows that the geopolitical and technology pressure will continue. In fact, President Xi may have all the reason to double-down on his transformative reforms, which would mean more pain for high-beta global plays. Bottom Line: What may have appeared as merely a trade conflict has evolved into a broad geopolitical confrontation. President Trump has little reason to conclude a deal with China by March. Domestic political pressures are not pushing in the direction of the deal, while America’s “Deep State” is eager for a confrontation with China. Furthermore, with President Trump “blinking” on Iranian sanctions, his administration has implicitly acknowledged the constraints discouraging a deeper involvement in the Middle East. This puts the geopolitical focus squarely on China. Question 3: Is Europe a Black Swan or a Red Herring? The last two years have been a dud in Europe. Since the Brexit referendum in mid-2016, European politics have not been a catalyst for global markets, save for an Italy-induced sell-off or two. This could substantively change in 2019. And, as with the first two questions, the results could be binary. On one hand, there is the positive scenario where the stalled and scaled-back reforms on the banking union and Euro Area budget get a shot in the arm in the middle of the year. On the other hand, the negative scenario would see European-wide reforms stall, leaving the continent particularly vulnerable as the next global recession inevitably nears. At the heart of the binary distribution is the broader question of whether populism in Europe is trending higher. Most commentators and our clients would say yes, especially after the protests and rioting in Paris over the course of November. But the answer is more complicated than that. While populists have found considerable success in the ballot box (Chart 24), they have not managed to turn sentiment in Europe against the currency union (Chart 25). Even in Italy, which has a populist coalition government in power, the support for currency union is at 61%, the highest since 2012. This number has apparently risen since populists took over. Anti-Establishment Parties Are Rising... Anti-Establishment Parties Are Rising... ...But Euroskepticism Is A Failed Strategy ...But Euroskepticism Is A Failed Strategy What explains this divergence? Effectively, Europe’s establishment parties are being blamed for a lot of alleged ills, liberal immigration policy first amongst them. However, European integration remains favored across the ideological spectrum. Few parties that solely focus on Euroskepticism have any chance of winning power, something that both Lega and Five Star Movement found out in Italy. Italy’s Deputy Prime Minister Matteo Salvini confirmed his conversion away from Euroskepticism by stating that he wants to “reform the EU from the inside” and that it was time to give the “Rome-Berlin axis” another go.2 Salvini is making a bet – correct in our view – that by moderating Lega’s populism on Europe, he can capture the center ground and win the majority in the next Italian election, which could happen as soon as 2019. As such, we don’t think that the “rise of populism” in Europe is either dramatic or market-relevant. In fact, mainstream parties are quickly adopting parts of the anti-establishment agenda, particularly on immigration, in a bid to recoup lost voters. A much bigger risk for Europe than populism is stagnation on the reform front, a perpetual Eurosclerosis that leaves the bloc vulnerable in the next recession. What Europe needs is the completion of a backstop to prevent contagion. Such a backstop necessitates greatly enhancing the just-passed banking union reforms. The watered-down reforms did not include a common backstop to the EU’s single resolution fund nor a deposit union. A working group will report on both by June 2019, with a potential legislative act set for some time in 2024. What could be a sign that the EU is close to a grand package of reforms in 2019? We see three main avenues. First, a political shift in Germany. Investors almost had one, with conservative Friedrich Merz coming close to defeating Merkel’s hand-picked successor Annegret Kramp-Karrenbauer (also known as AKK) for the leadership of the ruling Christian Democratic Union (CDU). Merz combined a right-leaning anti-immigrant stance with staunch pro-European integration outlook. It is unclear whether AKK will be willing to make the same type of “grand bargain” with the more conservative factions of the CDU electorate. However, AKK may not have a choice, with both Alternative for Germany (AfD) and the Green Party nibbling at the heels of the right-of-center CDU and left-of-center Social-Democratic Party (SPD) (Chart 26). The rise of the Green party is particularly extraordinary, suggesting that a larger portion of the German electorate is radically Europhile rather than Euroskeptic. AKK may have to adopt Merz’s platform and then push for EU reforms. Challengers To The Established Parties Challengers To The Established Parties Second, French President Emmanuel Macron may have to look abroad for relevance. With his reform agenda stalled and political capital drained, it would make sense for Macron to spend 2019 and beyond on European reforms. Third, a resolution of the Brexit debacle. The longer the saga with the U.K. drags on, the less focus there will be in Europe on integration of the Euro Area. If the U.K. decides to extend the current negotiating period, it may even have to hold elections for the European Parliament. As such, we are not focusing on the budget crisis in Italy – our view that Rome is “bluffing” is coming to fruition –or a potential early election in Spain. And we are definitely not focusing on the EU Parliamentary election in May. These will largely be red herrings. The real question is whether European policymakers will finally have a window of opportunity for strategic reforms. And that will require Merkel, AKK, and Macron to expend whatever little political capital they have left and invest it in restructuring European institutions. Finally, a word on Europe’s role in the global trade war. While Europe is a natural ally for the U.S. against China – given its institutional connections, existing alliance, and trade surplus with the latter and deficit with the former (Chart 27) – we believe that the odds are rising of a unilateral tariff action by the U.S. on car imports. EU Surplus With U.S. Pays For Deficit With China EU Surplus With U.S. Pays For Deficit With China This is because the just-concluded NAFTA deal likely raised the cost of vehicle production in the trade bloc, necessitating import tariffs in order for the deal to make sense from President Trump’s set of political priorities. The Trump administration may not have the stomach for a long-term trade war with Europe, but it can shake up the markets with actions in that direction. Bottom Line: In the near term, there are no existential political risks in Europe in 2019. As such, investors who are bullish on European assets should not let geopolitics stand in the way of executing on their sentiment. We remain cautious for macroeconomic reasons, namely that Europe is a high-beta DM play that needs global growth to outperform in order to catch a bid. However, 2019 is a make-or-break year on key structural reforms in Europe. Without more work on the banking union – and without greater burden sharing, broadly defined – the Euro Area will remain woefully unprepared for the next global recession. Question 4: Will Brexit Happen? Given the volume of market-relevant geopolitical issues, we have decided to pose (and attempt to answer) five additional questions for 2019. We start with Brexit. Prime Minister Theresa May has asked for a delay to the vote in the House of Commons on the Withdrawal Treaty, which she would have inevitably lost. The defeat of the subsequent leadership challenge is not confidence-inspiring as the vote was close and a third of Tory MPs voted against her. May likely has until sometime in January to pass the EU Withdrawal Agreement setting out the terms of Brexit, given that all other EU member states have to get it through their parliaments before the Brexit date on March 29. The real question is whether any deal can get through Westminster. The numbers are there for the softest of soft Brexits, the so-called Norway+ option where the U.K. effectively gets the same deal as Norway, if May convinces the Labour Party to break ranks. Such a deal would entail Common Market access, but at the cost of having to pay essentially for full EU membership with no ability to influence the regulatory policies that London would have to abide by. The alternative is to call for a new election – which may usher the even less pro-Brexit Labour Party into power – or to delay Brexit for a more substantive period of time, or simply to buckle under the pressure and call for a second referendum. We disagree that the delay signals that the “no deal Brexit,” or the “Brexit cliff,” is nigh. Such an outcome is in nobody’s interest and both May and the EU can offer delays to ensure that it does not happen. Whatever happens, one thing is clear: the median voter is turning forcefully towards Bremain (Chart 28). It will soon become untenable to delay the second referendum. And even if the House of Commons passes the softest of Soft Brexit deals, we expect that the Norway+ option will prove to be unacceptable when Westminster has to vote on it again in two or three year’s time. Bremain Surging Structurally Bremain Surging Structurally Is it time to buy the pound, particularly cable, which is cheap on a long-term basis (Chart 29)? It is a tough call. On one hand, our confidence that the U.K. ultimately has to remain in the EU is rising. However, to get there, the U.K. may need one last major dose of volatility, either in the form of a slow-burn crisis caused by Tory indecision or in the form of a far-left Labour government that tries its own hand at Brexit while pursuing a 1970s style left-wing economic agenda. Can any investor withstand this kind of volatility in the short and potentially long-ish term? Only the longest of the long-term investors can.  Start Buying The Pound Start Buying The Pound Question 5: Will Oil Prices Rally Substantively In 2019? Several risks to oil supply remain for 2019. First, there is little basis for stabilization in Venezuelan oil production, and further deterioration is likely (Chart 30). Second, sectarian tensions in Iraq remain unresolved. Third, supply risks in other geopolitical hot spots – like Nigeria and Libya – could surprise in 2019. Venezuela: On A Downward Spiral Venezuela: On A Downward Spiral The most pressing geopolitical issue, however, is a decision on the Iranian sanction waivers. President Trump induced considerable market-volatility in 2019 by signaling that he would use “maximum pressure” against Iran. As a result, the risk premium contribution to the oil price – illustrated in Chart 31 by the red bar – rose throughout 2018, only to collapse as the White House offered six-month sanction waivers. Not only did the risk premium dissipate, but Saudi Arabia then scrambled to reverse the production surge it had instituted to offset the Iran sanctions. 2019 Key Views: Balanced On A Knife’s Edge 2019 Key Views: Balanced On A Knife’s Edge We agree with BCA’s Commodity & Energy Strategy that oil market fundamentals are tight and numerous supply risks loom. We also struggle to see why President Trump will seek to pick a fight with Iran in the summer of 2019. Our suspicion is that if President Trump was afraid of a gasoline-price spike right after the midterm election, why would he not “blink” at the end of the spring? Not only will the U.S. summer driving season be in full swing – a time of peak U.S. gasoline demand – but the 2020 election primaries will only be six months away. Furthermore, it is highly unlikely that OPEC and Russia will do the U.S. president’s bidding by turning on the taps to offset any unforeseen supply losses in 2019. They did not do so even when President Trump asked, very nicely, ahead of the just-concluded Vienna meeting. Once Trump prioritized domestic politics over Saudi geopolitical interests – by backing away from his maximum pressure tactic against Iran – he illustrated to Riyadh that his administration is about as reliable of an ally as the Obama White House. Meanwhile, his ardent defense of Riyadh in the Khashoggi affair, at a cost of domestic political capital, means that he lost the very leverage that he could have used to pressure Saudi Arabia. We therefore remain cautiously bullish on oil prices in 2019, but with the caveat that a big-bang surge in prices due to a U.S.-Iran confrontation – our main risk for 2019 just a few months ago – is now less likely. Question 6: Will Impeachment Become A Risk In 2019? While we have no way to forecast the Mueller investigation, it is undoubtedly clear that risks are rising on the U.S. domestic front. President Trump’s popularity among GOP voters is elevated and far from levels needed to convince enough senators to remove him from power (Chart 32). However, a substantive finding by Mueller may leave the moderate Democrats in the House with no choice but to pursue impeachment. 2019 Key Views: Balanced On A Knife’s Edge 2019 Key Views: Balanced On A Knife’s Edge This may rattle the market for both headline and fundamental reasons. The headline reasons are obvious. The fundamental reasons have to do with the looming stimulus cliff in 2020. A pitched battle between the House Democrats and the White House would make cooperation on another substantive stimulus effort less likely and thus a recession in 2020 more likely. The market may start pricing in such an outcome at some point in 2019. Furthermore, sentiment could be significantly impacted by a protracted domestic battle that impairs Trump’s domestic agenda. President Bill Clinton sought relevance abroad amidst his impeachment proceedings by initiating an air war against Yugoslavia. President Trump may do something similar. There is also an unclear relationship between domestic tensions and trade war. On one hand, President Trump may want a clear win and so hasten a deal. On the other hand, he may want to extend the trade war to encourage citizens to “rally around the flag” and show his geopolitical mettle amidst a distracting “witch hunt.” While we have faded these domestic risks in 2017 and 2018, we think that it may be difficult to do so in 2019. We stick by our view that previous impeachment bouts in the U.S. have had a temporary effect on the markets. But if market sentiment is already weakened by global growth and end of cycle concerns, a political crisis may become a bearish catalyst.  Question 7: What About Japan? Japan faces higher policy uncertainty in 2019, after a period of calm following the 2015-16 global turmoil. We expect to see “peak Shinzo Abe” – in the sense that after this year, his political capital will be spent and all that will remain will be for him to preside over the 2020 Tokyo Olympics. The primary challenge for Abe is getting his proposed constitutional revisions passed despite economic headwinds. Assuming he goes forward, he must get a two-thirds vote in both houses of parliament plus a majority vote in a popular referendum. The referendum is unscheduled but could coincide with the July upper house elections. This will be a knife’s edge vote according to polling. If he holds the referendum and it passes, he will have achieved the historic goal of making Japan a more “normal” country, i.e. capable of revising its own constitution and maintaining armed forces. He will never outdo this. If he fails, he will become a lame duck – if he does not retire immediately like David Cameron or Matteo Renzi. And if he delays the revisions, he could miss his window of opportunity.   This uncertain domestic political context will combine with China/EM and trade issues that entail significant risks for Japan and upward pressure on the yen. Hence government policy will resume its decidedly reflationary tilt in 2019. It makes little sense for Abe, looking to his legacy, to abandon his constitutional dream while agreeing to raise the consumption tax from 8% to 10% as expected in October. We would take the opposite side of the bet: he is more likely to delay the tax hike than he is to abandon constitutional revision. If Abe becomes a lame duck, whether through a failed referendum, a disappointing election, or a consumption tax hike amid a slowdown, it is important for investors to remember that “Abenomics” will smell just as sweet by any other name. Japan experienced a paradigm shift after a series of “earthquakes” from 2008-12. No leader is likely to raise taxes or cut spending aggressively, and monetary policy will remain ultra-easy for quite some time. The global backdrop is negative for Japan but its policy framework will act as a salve. Question 8: Are There Any Winners In EM? We think that EM and global risk assets could have a window of outperformance in early 2019. However, given the persistence of the policy divergence narrative, it will be difficult to see EM substantively outperforming DM over the course of 2019. Mexico Over Brazil That said, we do like a few EM plays in 2019. In particular, we believe that investors are overly bullish on Brazil and overly bearish on Mexico. In both countries, we think that voters turned to anti-establishment candidates due to concerns over violence and corruption. However, Brazilian President-elect Jair Bolsonaro has a high hurdle to clear. He must convince a traditionally fractured Congress to pass a complex and painful pension reform. In other words, Bolsonaro must show that he can do something in order to justify a rally that has already happened in Brazilian assets. In Mexico, on the other hand, Mexican President Andrés Manuel López Obrador (AMLO) remains constrained by the constitution (which he will be unable to change), the National Supreme Court of Justice, and political convention that Mexico is right-of-center on economic policy (an outwardly left-wing president has not won an election since 1924). In other words, AMLO has to show that he can get out of his constraints in order to justify a selloff that has already happened. To be clear, we are not saying that AMLO is a positive, in the absolute, for Mexico. The decision to scrap the Mexico City airport plans, to sideline the finance ministry from key economic decisions, and to threaten a return to an old-school PRI-era statism is deeply concerning. At the same time, we are not of the view that Bolsonaro is, in the absolute, a negative for Brazil. Rather, we are pointing out that the relative investor sentiment is overly bullish Bolsonaro versus AMLO. Especially given that both presidents remain constrained by domestic political intricacies and largely campaigned on the same set of issues that have little to do with their perceived economic preferences. They also face respective median voters that are diametrically opposed to their economic agendas – Bolsonaro, we think, is facing a left-leaning median voter, whereas the Mexican median voter is center-right. The macroeconomic perspective also supports our relative call. If our view on China and the Fed is correct, high-beta plays like Brazil will suffer, while an economy that is tied-to-the-hip of the U.S., like Mexico, ought to outperform EM peers. Mexico Finally Has Some Positive Carry Mexico Finally Has Some Positive Carry As such, we are putting a long MXN/BRL trade on, to capture this sentiment gap between the two EM markets. Investors will be receiving positive carry on Mexico relative to Brazil for the first time in a long time (Chart 33). The relative change in the current account balance also favors Mexico (Chart 34). Finally, the technicals of the trade look good as well (Chart 35). Mexico Looks Good On Current Account Mexico Looks Good On Current Account Technicals Look Good Too Technicals Look Good Too South Korea Over Taiwan  Diplomacy remains on track on the Korean peninsula, despite U.S.-China tensions in other areas. Ultimately China believes that peace on the peninsula will remove the raison d’être of American troops stationed there. Moreover, Beijing has witnessed the U.S.’s resolve in deterring North Korean nuclear and missile tests and belligerent rhetoric. It will want to trade North Korean cooperation for a trade truce. By contrast, if Trump’s signature foreign policy effort fails, he may well lash out. We view deeply discounted South Korean equities as a long-term buy relative to other EMs. Taiwan, by contrast, is a similar EM economy but faces even greater short-term risks than South Korea. In the next 13-month period, the Tsai Ing-wen administration, along with the Trump administration, could try to seize a rare chance to upgrade diplomatic and military relations. This could heighten cross-strait tensions and lead to a geopolitical incident or crisis. More broadly, U.S.-China trade and tech tensions create a negative investment outlook for Taiwan. Thailand Over India Five state elections this fall have turned out very badly for Prime Minister Narendra Modi and his National Democratic Alliance (NDA). These local elections have a negative impact, albeit a limited one, on Modi’s and the NDA’s reelection chances in the federal election due in April (or May). Nevertheless, it is entirely possible to lose Chhattisgarh, Madhya Pradesh, and Rajasthan while still winning a majority in the Lok Sabha – this is what happened to the Indian National Congress in 2004 and 2009. So far federal election opinion polling suggests anything from a hung parliament to a smaller, but still substantial, BJP majority. Modi was never likely to maintain control of 20 out of 29 states for very long, nor to repeat his party’s sweeping 2014 victory. He was also never likely to continue his reform push uninhibited in the lead up to the general election. Nevertheless, the resignation of Reserve Bank of India Governor Urjit Patel on December 10 is a very worrisome sign. Given that Indian stocks are richly valued, and that we expect oil prices to drift upwards, we remain negative on India until the opportunity emerges to upgrade in accordance with our long-term bullish outlook. By contrast, we see the return to civilian rule in Thailand as a market-positive event in the context of favorable macro fundamentals. Thai elections always favor the rural populist “red” movement of the Shinawatra family, but presumably the military junta would not hold elections if it thought it had not sufficiently adjusted the electoral system in favor of itself and its political proxies. Either way, the cycle of polarization and social unrest will only reemerge gradually, so next year Thailand will largely maintain policy continuity and its risk assets will hold up better than most other EMs.   Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim, Editor Strategist roukayai@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com   Footnotes 1      Please see Geopolitical Strategy Special Report, “Power And Politics In East Asia: Cold War 2.0?” dated September 25, 2012, Global Investment Strategy Special Report, “Searing Sun: Japan-China Conflict Heating Up,” dated January 25, 2013, “Sino-American Conflict: More Likely Than You Think, Part II,” dated November 6, 2015, and “The South China Sea: Smooth Sailing?” dated March 28, 2017, available at gps.bcaresearch.com. 2      Yes. He literally said that.   Geopolitical Calendar

Highlights So What? Global divergence will persist beyond the near term. Why? China’s stimulus will be disappointing unless things get much worse. U.S.-China trade war will reignite and strategic tensions will continue. European risks are limited short-term, but will surge without reform. U.S. assets will outperform; oil and the yen will rise; the pound is a long-term play; EM pain will continue. Feature The year 2019 will be one of considerable geopolitical uncertainty. Three issues dominate our Outlook, with low-conviction views on all three questions: Question 1: How much will China stimulate? Question 2: Will the trade war abate? Question 3: Is Europe a Black Swan or a Red Herring? Chart 1U.S. Outperformance Should Be Bullish USD U.S. Outperformance Should Be Bullish USD U.S. Outperformance Should Be Bullish USD The main story in 2018 was policy divergence. American policymakers ramped up stimulus – both through the profligate tax cuts and fiscal spending – at the same time that Chinese policymakers stuck to their guns on de-levering the economy. The consequence of this policy mix was that the synchronized global recovery of late 2016 and 2017 evolved into a massive outperformance by the U.S. economy (Chart 1). The Fed responded to the bullish domestic conditions with little regard for the global economy, causing the DXY to rally from a 2018 low of 88.59 in February to 97.04 today. Chart 2Fiscal Conservatism Melts Away Fiscal Conservatism Melts Away Fiscal Conservatism Melts Away Chart 3Republicans Change Their Minds When In Power Republicans Change Their Minds When In Power Republicans Change Their Minds When In Power While the policy divergence narrative appears to be macroeconomic in nature, it is purely political. There is nothing cyclical about the ‘U.S.’ economic outperformance in 2018. President Donald Trump campaigned on an economic populist agenda and then proceeded to deliver on it throughout 2017 and 2018. He faced little opposition from fiscal conservatives, mainly because fiscal conservativism melts away from the public discourse when budget deficits are low (Chart 2) and when the president is a Republican (Chart 3). Meanwhile, Chinese policymakers have decided to tolerate greater economic pain in an effort to escape the Middle Income Trap (Chart 4). They believe this trap will envelop them if they cannot grow the economy without expanding the already-massive build-up of leverage (Chart 5). Chart 4Policymakers Fear The Middle Income Trap 2019 Key Views: Balanced On A Knife’s Edge 2019 Key Views: Balanced On A Knife’s Edge Chart 5Debt Still Rising Debt Still Rising Debt Still Rising Geopolitics is not just about “things blowing up somewhere in the desert.” In today’s world, emblematized by paradigm shifts, politicians are more than ever in the driver’s seat. While technocrats respond to macroeconomic factors, politicians respond to political and geopolitical constraints. Few investment narratives last much longer than a year and policy divergence is coming to a close. Will the Fed pause given the turn in global growth? Will China respond with effective stimulus in 2019? If the answer to both questions is yes, global risk assets could light up in the next quarter and potentially beyond. Already EM has outperformed DM assets for a month and some canaries in the coal mine for global growth – like the performance of Swedish economic indicators – signal that the outperformance is real. Chart 6Global Economic Divergence Will Continue Global Economic Divergence Will Continue Global Economic Divergence Will Continue Chart 7The Market Has Already Priced-In A Fed Pause 2019 Key Views: Balanced On A Knife’s Edge 2019 Key Views: Balanced On A Knife’s Edge We are skeptical that the move is sustainable beyond a quarter or two (Chart 6). As our colleague Peter Berezin has highlighted, the market is pricing less than one hike in 2019 (Chart 7). Regardless, the impact on the U.S. dollar, remains muted, with the DXY at 97.04. This suggests that the backing off that the Fed may or may not have already done is still not enough from the perspective of weakening global growth (Chart 8). Global risk assets need more from the Fed than what the market is already pricing. And with U.S. inflationary pressures building (Chart 9), the BCA House View expects to see multiple Fed hikes in 2019, disappointing investors bullish on EM and global risk assets. Chart 8Global Growth Leading Indicators Global Growth Leading Indicators Global Growth Leading Indicators Chart 9Does The Fed Like It Hot? Does The Fed Like It Hot? Does The Fed Like It Hot? With our Fed view set by the House View, we therefore turn to where we can add value. To this end, the most important question of 2018 largely remains the same in 2019: How much will China stimulate? Question 1: How Much Will China Stimulate In 2019? Chart 10A Ray Of Hope From Broad Money bca.gps_sr_2018_12_14_c10 bca.gps_sr_2018_12_14_c10 China is undoubtedly already stimulating, with a surge in local government bond issuance earlier this year and a bottoming in the broad money impulse (Chart 10). M2 is in positive territory. However, the effort can best be characterized as tepid, with a late-year collapse in bond issuance (Chart 11) and a still-negative total social financing (TSF) impulse (Chart 12). TSF is the broadest measure of private credit in China’s economy.   Chart 11Fiscal Policy Becomes More Proactive? 2019 Key Views: Balanced On A Knife’s Edge 2019 Key Views: Balanced On A Knife’s Edge Chart 12China's Total Credit Is Weak China's Total Credit Is Weak China's Total Credit Is Weak We expect a surge in TSF in Q1, but this is a normal seasonal effect. A typical Q1 credit surge will not be enough to set global risk assets alight for very long, particularly if the market has already priced in as much of a “pause” from the Fed as we are going to get. Investors should specifically focus on new local government bond issuance and whether the “shadow financing” component of TSF gets a bid, since the primary reason for the weakness in TSF over the past year is the government’s crackdown on shadow lending. As Chart 13A & B shows, it was new local government bonds that led the way for stimulus efforts in 2015, followed by a surge in both bank lending and shadow lending in 2016. Chart 13ADon't Focus Just On TSF... Don't Focus Just On TSF... Don't Focus Just On TSF... Chart 13B...But Shadow Financing In Particular ...But Shadow Financing In Particular ...But Shadow Financing In Particular We would also expect further monetary policy easing, with extra RRR cuts or even a benchmark policy rate cut. However, monetary policy has been easy all year and yet the impact on credit growth has remained muted. This begs two important questions: Is the credit channel impaired? A slew of macroprudential reforms – which we have dubbed China’s “Preemptive Dodd-Frank” – may have impaired the flow of credit in the system. The official policy of “opening the front door, closing the back door” has seen bank loans pick up modestly but shadow lending has been curtailed (Chart 14A & B). This way of controlling the rise of leverage has its costs. For private enterprises – with poor access to the official banking sector – the shadow financial system was an important source of funding over the past several years. Chart 14AOpening The Front Door... Opening The Front Door... Opening The Front Door... Chart 14B...Closing The Back Door ...Closing The Back Door ...Closing The Back Door Is policy pushing on a string? An even more dire scenario would be if China’s credit channel is not technically, but rather psychologically, impaired. Multiple reasons may be to blame: a negative net return on the assets of state-owned enterprises (Chart 15); widespread trade war worries; mixed signals from policymakers; or a general lack of confidence in the political direction of the country. The rising M2/M1 ratio suggests that the overall economy’s “propensity to save” is rising (Chart 16). Chart 15Old China Is A Zombie China Old China Is A Zombie China Old China Is A Zombie China Chart 16Propensity To Save Propensity To Save Propensity To Save Why would Chinese policymakers keep their cool despite a slow pickup in credit growth? Are they not concerned about unemployment, social unrest, and instability? Of course, they are. But Chinese policymakers are not myopic. They also want to improve potential GDP over the long run. Table 1China: The Trend In Domestic Demand, And The Outlook For Trade, Is Negative 2019 Key Views: Balanced On A Knife’s Edge 2019 Key Views: Balanced On A Knife’s Edge So far, the economy has weathered the storm relatively well. First, eight out of ten of our China Investment Strategy’s housing price indicators (Table 1) are flat-to-up – although it is true that the October deterioration in floor space started and especially floor space sold (Chart 17) is cause for concern. If and when the housing market weakens further, stimulus will be used to offset it, despite the fact that the government is attempting to prevent a sharp increase in prices at the same time. With so much of China’s middle-class savings invested in the housing market, the key pillar of socio-economic stability is therefore real estate. Chart 17A Possible Clue For China Stimulusr A Possible Clue For China Stimulusr A Possible Clue For China Stimulusr Second, credit has fueled China’s “old economy,” but policymakers want to buoy “new China” (Chart 18). This means that measures to boost consumption and the service sector economy will be emphasized in new rounds of stimulus, as has occurred thus far (tax cuts, tariff cuts, deregulation, etc). This kind of stimulus is not great news for global risk assets leveraged to “old China,” such as EM and industrial metals. Chart 18Rebalancing Of The Chinese Economy Rebalancing Of The Chinese Economy Rebalancing Of The Chinese Economy Third, policymakers are not exclusively focused on day-to-day stability but are also focused on the decades-long perseverance of China’s political model. And that means moving away from leverage and credit as the sole fuel for the economy. This is not just about the Middle Income Trap, it is also about national security and ultimately sovereignty. Relying on corporate re-levering for stimulus simply doubles-down on the current economic model, which is still export-oriented given that most investment is geared toward the export sector. But this also means that China will be held hostage to foreign demand and thus geopolitical pressures, a fact that has been revealed this year through the protectionism of the White House. As such, moving away from the investment-led growth model and towards a more endogenous, consumer-led model is not just good macro policy, it makes sense geopolitically as well. Will the trade war – or the current period of trade truce – change Chinese policymakers’ decision-making? We do not see why it would. First, if the trade truce evolves into a trade deal, the expected export shock will not happen (Chart 19) and thus major stimulative measures would be less necessary. Second, if we understand correctly why policymakers have cited leverage as an “ill” in the first place, then we would assume that they would use the trade war as an excuse for the pain that they themselves have instigated. In other words, the trade war with the U.S. gives President Xi Jinping the perfect excuse for the slowdown, one that draws attention from the real culprit: domestic rebalancing. Chart 19Trump's Initial Tariffs Soon To Be Felt Trump's Initial Tariffs Soon To Be Felt Trump's Initial Tariffs Soon To Be Felt Bottom Line: Since mid-2018, we have been asking clients to focus on our “Stimulus Overshoot” checklist (Table 2). We give the first item – “broad money and/or total credit growth spike” – a premier spot on the list. If a surge in total credit occurs, we will know that policymakers are throwing in the towel and stimulating in a major way. It will be time to turn super-positive on global risk assets, beyond a mere tactical trade, as a cyclical view at that point. Note that if one had gone long EM in early February 2016, when January data revealed a truly epic TSF splurge, one would not have been late to the rally. Table 2Will China’s Stimulus Overshoot In 2019? 2019 Key Views: Balanced On A Knife’s Edge 2019 Key Views: Balanced On A Knife’s Edge Our low-conviction view, at the moment, is that the increase in credit growth that we will see in Q1 will be seasonal – the usual frontloading of lending at the beginning of the year – rather than an extraordinary surge that would signal a policy change. A modest increase in credit growth will not be enough to spark a sustainable – year-long – rally in global risk assets. The Fed has already backed off as far as the market is concerned. As such, a pickup in Chinese credit could temporarily excite investors. But global stabilization may only embolden the Fed to refocus on tightening after a Q1 pause. Question 2: Will The Trade War Abate? The first question for investors when it comes to the trade war is “Why should we care?” Sure, trade policy uncertainty appears to have correlated with the underperformance of global equity indices relative to the U.S. (Chart 20). However, such market action was as much caused by our policy divergence story – being as it is deeply negative for EM assets – as by a trade war whose impact on the real economy has not yet been felt. Chart 20U.S. Is 'Winning' The Trade War U.S. Is 'Winning' The Trade War U.S. Is 'Winning' The Trade War Nonetheless, we do believe that getting the trade war “right” is a big call for 2019. First, while the impact of the U.S.-China trade war has been minimal thus far, it is only because China front-loaded its exports ahead of the expected tariffs, cut interbank rates and RRRs, accelerated local government spending, and allowed CNY/USD to depreciate by 10%. A restart of trade tensions that leads to further tariffs will make frontloading untenable over time, whereas further currency depreciation would be severely debilitating for EMs. We doubt the sustainability of the trade truce for three reasons: U.S. domestic politics: The just-concluded midterm election saw no opposition to President Trump on trade. The Democratic Party candidates campaigned against the president on a range of issues, but not on his aggressive China policy. Polling from the summer also shows that a majority of American voters consider trade with China unfair (Chart 21). In addition, President Trump will walk into the 2020 election with a wider trade deficit, due to his own stimulative economic policy (Chart 22). He will need to explain why he is “losing” on the one measure of national power that he campaigned on in 2016. Structural trade tensions: Ahead of the G20 truce, the U.S. Trade Representative Robert Lighthizer issued a hawkish report that concluded that China has not substantively changed any of the trade practices that initiated U.S. tariffs. Lighthizer has been put in charge of the current trade negotiations, which is a step-up in intensity from Treasury Secretary Steven Mnuchin, who was in charge of the failed May 2018 round. Geopolitical tensions: The G20 truce did not contain any substantive resolution to the ongoing strategic tensions between the U.S. and China, such as in the South China Sea. Beyond traditional geopolitics, tensions are increasingly involving high-tech trade and investment between the two countries and American allegations of cyber theft and spying by China. The recent arrest of Huawei’s CFO in Canada, on an American warrant, will likely deepen this high-tech conflict in the short term. Chart 21Americans Are Focused On China As Unfair 2019 Key Views: Balanced On A Knife’s Edge 2019 Key Views: Balanced On A Knife’s Edge Chart 22Trade Deficit To Rise Despite Tariffs Trade Deficit To Rise Despite Tariffs Trade Deficit To Rise Despite Tariffs Since the G20 truce with Xi, President Trump has seen no significant pickup in approval ratings (Chart 23). Given that the median American voter has embraced protectionism – against China at least – we would not expect any. Meanwhile, U.S. equities have sold off, contrary to what President Trump, or his pro-trade advisors, likely expected in making the G20 decision to delay tariffs. Chart 23Appeasing China Doesn't Pay Appeasing China Doesn't Pay Appeasing China Doesn't Pay At some point, President Trump will realize that he risks considerable political capital on a trade deal with China that very few voters actually want or that the U.S. intelligence and defense community supports. Democrats did not oppose his aggressive China policy in the midterm election because they know that the median voter does not want it. As such, it is guaranteed that Trump’s 2020 Democratic Party opponent will accuse him of “surrender,” or at least “weakness.” If, over the next quarter, the economic and market returns on his gambit are paltry, we would expect President Trump to end the truce. Furthermore, we believe that a substantive, and long-lasting, trade deal is unlikely given the mounting tensions between China and the U.S. These tensions are not a product of President Trump, but are rather a long-run, structural feature of the twenty-first century that we have been tracking since 2012.1 Tensions are likely to rise in parallel to the trade talks on the technology front. We expect 2019 to be the year when investors price in what we have called Bifurcated Capitalism: the segmentation of capital, labor, and trade flows into geopolitically adversarial – and yet capitalist in nature – economic blocs. Entire countries and sectors may become off-limits to Western investors and vice-versa for their Chinese counterparts. Countries will fall into either the Tencent and Huawei bloc or the Apple and Ericsson bloc. This development is different from the Cold War. Note our emphasis on capitalism in the term Bifurcated Capitalism. The Soviet Union was obviously not capitalist, and clients of BCA did not have interests in its assets in the 1970s and 1980s. Trade between Cold War economic blocs was also limited, particularly outside of commodities. The closest comparison to the world we now inhabit is that of the nineteenth century. Almost all global powers were quite capitalist at the time, but they engaged in imperialism in order to expand their economic spheres of influence and thus economies of scale. In the twenty-first century, Africa and Asia – the targets of nineteenth century imperialism – may be replaced with market share wars in novel technologies and the Internet. This will put a ceiling on how much expansion tech and telecommunication companies can expect in the competing parts of Bifurcated Capitalism. The investment consequences of this concept are still unclear. But what is clear is that American policymakers are already planning for some version of the world we are describing. The orchestrated effort by the U.S. intelligence community to encourage its geopolitical allies to ban the use of Huawei equipment in their 5G mobile networks suggests that there are limits to the current truce ever becoming a sustainable deal. So does the repeated use of economic sanctions originally designed for Iran and Russia against Chinese companies. President Trump sets short- and medium-term policies given that he is the president. However, the intelligence and defense communities have “pivoted to Asia” gradually since 2012. This shift has occurred because the U.S. increasingly sees China as a peer competitor, for the time being confined in East Asia but with intentions of projecting power globally. To what extent could President Trump produce a trade deal with Xi that also encompasses a change in the U.S. perception of China as an adversary? We assign a low probability to it. As such, President Xi has little reason to give in to U.S. pressure on trade, as he knows that the geopolitical and technology pressure will continue. In fact, President Xi may have all the reason to double-down on his transformative reforms, which would mean more pain for high-beta global plays. Bottom Line: What may have appeared as merely a trade conflict has evolved into a broad geopolitical confrontation. President Trump has little reason to conclude a deal with China by March. Domestic political pressures are not pushing in the direction of the deal, while America’s “Deep State” is eager for a confrontation with China. Furthermore, with President Trump “blinking” on Iranian sanctions, his administration has implicitly acknowledged the constraints discouraging a deeper involvement in the Middle East. This puts the geopolitical focus squarely on China. Question 3: Is Europe a Black Swan or a Red Herring? The last two years have been a dud in Europe. Since the Brexit referendum in mid-2016, European politics have not been a catalyst for global markets, save for an Italy-induced sell-off or two. This could substantively change in 2019. And, as with the first two questions, the results could be binary. On one hand, there is the positive scenario where the stalled and scaled-back reforms on the banking union and Euro Area budget get a shot in the arm in the middle of the year. On the other hand, the negative scenario would see European-wide reforms stall, leaving the continent particularly vulnerable as the next global recession inevitably nears. At the heart of the binary distribution is the broader question of whether populism in Europe is trending higher. Most commentators and our clients would say yes, especially after the protests and rioting in Paris over the course of November. But the answer is more complicated than that. While populists have found considerable success in the ballot box (Chart 24), they have not managed to turn sentiment in Europe against the currency union (Chart 25). Even in Italy, which has a populist coalition government in power, the support for currency union is at 61%, the highest since 2012. This number has apparently risen since populists took over. Chart 24Anti-Establishment Parties Are Rising... Anti-Establishment Parties Are Rising... Anti-Establishment Parties Are Rising... Chart 25...But Euroskepticism Is A Failed Strategy ...But Euroskepticism Is A Failed Strategy ...But Euroskepticism Is A Failed Strategy What explains this divergence? Effectively, Europe’s establishment parties are being blamed for a lot of alleged ills, liberal immigration policy first amongst them. However, European integration remains favored across the ideological spectrum. Few parties that solely focus on Euroskepticism have any chance of winning power, something that both Lega and Five Star Movement found out in Italy. Italy’s Deputy Prime Minister Matteo Salvini confirmed his conversion away from Euroskepticism by stating that he wants to “reform the EU from the inside” and that it was time to give the “Rome-Berlin axis” another go.2 Salvini is making a bet – correct in our view – that by moderating Lega’s populism on Europe, he can capture the center ground and win the majority in the next Italian election, which could happen as soon as 2019. As such, we don’t think that the “rise of populism” in Europe is either dramatic or market-relevant. In fact, mainstream parties are quickly adopting parts of the anti-establishment agenda, particularly on immigration, in a bid to recoup lost voters. A much bigger risk for Europe than populism is stagnation on the reform front, a perpetual Eurosclerosis that leaves the bloc vulnerable in the next recession. What Europe needs is the completion of a backstop to prevent contagion. Such a backstop necessitates greatly enhancing the just-passed banking union reforms. The watered-down reforms did not include a common backstop to the EU’s single resolution fund nor a deposit union. A working group will report on both by June 2019, with a potential legislative act set for some time in 2024. What could be a sign that the EU is close to a grand package of reforms in 2019? We see three main avenues. First, a political shift in Germany. Investors almost had one, with conservative Friedrich Merz coming close to defeating Merkel’s hand-picked successor Annegret Kramp-Karrenbauer (also known as AKK) for the leadership of the ruling Christian Democratic Union (CDU). Merz combined a right-leaning anti-immigrant stance with staunch pro-European integration outlook. It is unclear whether AKK will be willing to make the same type of “grand bargain” with the more conservative factions of the CDU electorate. However, AKK may not have a choice, with both Alternative for Germany (AfD) and the Green Party nibbling at the heels of the right-of-center CDU and left-of-center Social-Democratic Party (SPD) (Chart 26). The rise of the Green party is particularly extraordinary, suggesting that a larger portion of the German electorate is radically Europhile rather than Euroskeptic. AKK may have to adopt Merz’s platform and then push for EU reforms. Chart 26Challengers To The Established Parties Challengers To The Established Parties Challengers To The Established Parties Second, French President Emmanuel Macron may have to look abroad for relevance. With his reform agenda stalled and political capital drained, it would make sense for Macron to spend 2019 and beyond on European reforms. Third, a resolution of the Brexit debacle. The longer the saga with the U.K. drags on, the less focus there will be in Europe on integration of the Euro Area. If the U.K. decides to extend the current negotiating period, it may even have to hold elections for the European Parliament. As such, we are not focusing on the budget crisis in Italy – our view that Rome is “bluffing” is coming to fruition –or a potential early election in Spain. And we are definitely not focusing on the EU Parliamentary election in May. These will largely be red herrings. The real question is whether European policymakers will finally have a window of opportunity for strategic reforms. And that will require Merkel, AKK, and Macron to expend whatever little political capital they have left and invest it in restructuring European institutions. Finally, a word on Europe’s role in the global trade war. While Europe is a natural ally for the U.S. against China – given its institutional connections, existing alliance, and trade surplus with the latter and deficit with the former (Chart 27) – we believe that the odds are rising of a unilateral tariff action by the U.S. on car imports. Chart 27EU Surplus With U.S. Pays For Deficit With China EU Surplus With U.S. Pays For Deficit With China EU Surplus With U.S. Pays For Deficit With China This is because the just-concluded NAFTA deal likely raised the cost of vehicle production in the trade bloc, necessitating import tariffs in order for the deal to make sense from President Trump’s set of political priorities. The Trump administration may not have the stomach for a long-term trade war with Europe, but it can shake up the markets with actions in that direction. Bottom Line: In the near term, there are no existential political risks in Europe in 2019. As such, investors who are bullish on European assets should not let geopolitics stand in the way of executing on their sentiment. We remain cautious for macroeconomic reasons, namely that Europe is a high-beta DM play that needs global growth to outperform in order to catch a bid. However, 2019 is a make-or-break year on key structural reforms in Europe. Without more work on the banking union – and without greater burden sharing, broadly defined – the Euro Area will remain woefully unprepared for the next global recession. Question 4: Will Brexit Happen? Given the volume of market-relevant geopolitical issues, we have decided to pose (and attempt to answer) five additional questions for 2019. We start with Brexit. Prime Minister Theresa May has asked for a delay to the vote in the House of Commons on the Withdrawal Treaty, which she would have inevitably lost. The defeat of the subsequent leadership challenge is not confidence-inspiring as the vote was close and a third of Tory MPs voted against her. May likely has until sometime in January to pass the EU Withdrawal Agreement setting out the terms of Brexit, given that all other EU member states have to get it through their parliaments before the Brexit date on March 29. The real question is whether any deal can get through Westminster. The numbers are there for the softest of soft Brexits, the so-called Norway+ option where the U.K. effectively gets the same deal as Norway, if May convinces the Labour Party to break ranks. Such a deal would entail Common Market access, but at the cost of having to pay essentially for full EU membership with no ability to influence the regulatory policies that London would have to abide by. The alternative is to call for a new election – which may usher the even less pro-Brexit Labour Party into power – or to delay Brexit for a more substantive period of time, or simply to buckle under the pressure and call for a second referendum. We disagree that the delay signals that the “no deal Brexit,” or the “Brexit cliff,” is nigh. Such an outcome is in nobody’s interest and both May and the EU can offer delays to ensure that it does not happen. Whatever happens, one thing is clear: the median voter is turning forcefully towards Bremain (Chart 28). It will soon become untenable to delay the second referendum. And even if the House of Commons passes the softest of Soft Brexit deals, we expect that the Norway+ option will prove to be unacceptable when Westminster has to vote on it again in two or three year’s time. Chart 28Bremain Surging Structurally Bremain Surging Structurally Bremain Surging Structurally Is it time to buy the pound, particularly cable, which is cheap on a long-term basis (Chart 29)? It is a tough call. On one hand, our confidence that the U.K. ultimately has to remain in the EU is rising. However, to get there, the U.K. may need one last major dose of volatility, either in the form of a slow-burn crisis caused by Tory indecision or in the form of a far-left Labour government that tries its own hand at Brexit while pursuing a 1970s style left-wing economic agenda. Can any investor withstand this kind of volatility in the short and potentially long-ish term? Only the longest of the long-term investors can.  Chart 29Start Buying The Pound Start Buying The Pound Start Buying The Pound Question 5: Will Oil Prices Rally Substantively In 2019? Several risks to oil supply remain for 2019. First, there is little basis for stabilization in Venezuelan oil production, and further deterioration is likely (Chart 30). Second, sectarian tensions in Iraq remain unresolved. Third, supply risks in other geopolitical hot spots – like Nigeria and Libya – could surprise in 2019. Chart 30Venezuela: On A Downward Spiral Venezuela: On A Downward Spiral Venezuela: On A Downward Spiral The most pressing geopolitical issue, however, is a decision on the Iranian sanction waivers. President Trump induced considerable market-volatility in 2019 by signaling that he would use “maximum pressure” against Iran. As a result, the risk premium contribution to the oil price – illustrated in Chart 31 by the red bar – rose throughout 2018, only to collapse as the White House offered six-month sanction waivers. Not only did the risk premium dissipate, but Saudi Arabia then scrambled to reverse the production surge it had instituted to offset the Iran sanctions. Chart 31Trump Sanctions Boosted Risk Premium 2019 Key Views: Balanced On A Knife’s Edge 2019 Key Views: Balanced On A Knife’s Edge We agree with BCA’s Commodity & Energy Strategy that oil market fundamentals are tight and numerous supply risks loom. We also struggle to see why President Trump will seek to pick a fight with Iran in the summer of 2019. Our suspicion is that if President Trump was afraid of a gasoline-price spike right after the midterm election, why would he not “blink” at the end of the spring? Not only will the U.S. summer driving season be in full swing – a time of peak U.S. gasoline demand – but the 2020 election primaries will only be six months away. Furthermore, it is highly unlikely that OPEC and Russia will do the U.S. president’s bidding by turning on the taps to offset any unforeseen supply losses in 2019. They did not do so even when President Trump asked, very nicely, ahead of the just-concluded Vienna meeting. Once Trump prioritized domestic politics over Saudi geopolitical interests – by backing away from his maximum pressure tactic against Iran – he illustrated to Riyadh that his administration is about as reliable of an ally as the Obama White House. Meanwhile, his ardent defense of Riyadh in the Khashoggi affair, at a cost of domestic political capital, means that he lost the very leverage that he could have used to pressure Saudi Arabia. We therefore remain cautiously bullish on oil prices in 2019, but with the caveat that a big-bang surge in prices due to a U.S.-Iran confrontation – our main risk for 2019 just a few months ago – is now less likely. Question 6: Will Impeachment Become A Risk In 2019? While we have no way to forecast the Mueller investigation, it is undoubtedly clear that risks are rising on the U.S. domestic front. President Trump’s popularity among GOP voters is elevated and far from levels needed to convince enough senators to remove him from power (Chart 32). However, a substantive finding by Mueller may leave the moderate Democrats in the House with no choice but to pursue impeachment. Chart 32Barometer Of Trump’s Survival 2019 Key Views: Balanced On A Knife’s Edge 2019 Key Views: Balanced On A Knife’s Edge This may rattle the market for both headline and fundamental reasons. The headline reasons are obvious. The fundamental reasons have to do with the looming stimulus cliff in 2020. A pitched battle between the House Democrats and the White House would make cooperation on another substantive stimulus effort less likely and thus a recession in 2020 more likely. The market may start pricing in such an outcome at some point in 2019. Furthermore, sentiment could be significantly impacted by a protracted domestic battle that impairs Trump’s domestic agenda. President Bill Clinton sought relevance abroad amidst his impeachment proceedings by initiating an air war against Yugoslavia. President Trump may do something similar. There is also an unclear relationship between domestic tensions and trade war. On one hand, President Trump may want a clear win and so hasten a deal. On the other hand, he may want to extend the trade war to encourage citizens to “rally around the flag” and show his geopolitical mettle amidst a distracting “witch hunt.” While we have faded these domestic risks in 2017 and 2018, we think that it may be difficult to do so in 2019. We stick by our view that previous impeachment bouts in the U.S. have had a temporary effect on the markets. But if market sentiment is already weakened by global growth and end of cycle concerns, a political crisis may become a bearish catalyst.  Question 7: What About Japan? Japan faces higher policy uncertainty in 2019, after a period of calm following the 2015-16 global turmoil. We expect to see “peak Shinzo Abe” – in the sense that after this year, his political capital will be spent and all that will remain will be for him to preside over the 2020 Tokyo Olympics. The primary challenge for Abe is getting his proposed constitutional revisions passed despite economic headwinds. Assuming he goes forward, he must get a two-thirds vote in both houses of parliament plus a majority vote in a popular referendum. The referendum is unscheduled but could coincide with the July upper house elections. This will be a knife’s edge vote according to polling. If he holds the referendum and it passes, he will have achieved the historic goal of making Japan a more “normal” country, i.e. capable of revising its own constitution and maintaining armed forces. He will never outdo this. If he fails, he will become a lame duck – if he does not retire immediately like David Cameron or Matteo Renzi. And if he delays the revisions, he could miss his window of opportunity.   This uncertain domestic political context will combine with China/EM and trade issues that entail significant risks for Japan and upward pressure on the yen. Hence government policy will resume its decidedly reflationary tilt in 2019. It makes little sense for Abe, looking to his legacy, to abandon his constitutional dream while agreeing to raise the consumption tax from 8% to 10% as expected in October. We would take the opposite side of the bet: he is more likely to delay the tax hike than he is to abandon constitutional revision. If Abe becomes a lame duck, whether through a failed referendum, a disappointing election, or a consumption tax hike amid a slowdown, it is important for investors to remember that “Abenomics” will smell just as sweet by any other name. Japan experienced a paradigm shift after a series of “earthquakes” from 2008-12. No leader is likely to raise taxes or cut spending aggressively, and monetary policy will remain ultra-easy for quite some time. The global backdrop is negative for Japan but its policy framework will act as a salve. Question 8: Are There Any Winners In EM? We think that EM and global risk assets could have a window of outperformance in early 2019. However, given the persistence of the policy divergence narrative, it will be difficult to see EM substantively outperforming DM over the course of 2019. Mexico Over Brazil That said, we do like a few EM plays in 2019. In particular, we believe that investors are overly bullish on Brazil and overly bearish on Mexico. In both countries, we think that voters turned to anti-establishment candidates due to concerns over violence and corruption. However, Brazilian President-elect Jair Bolsonaro has a high hurdle to clear. He must convince a traditionally fractured Congress to pass a complex and painful pension reform. In other words, Bolsonaro must show that he can do something in order to justify a rally that has already happened in Brazilian assets. In Mexico, on the other hand, Mexican President Andrés Manuel López Obrador (AMLO) remains constrained by the constitution (which he will be unable to change), the National Supreme Court of Justice, and political convention that Mexico is right-of-center on economic policy (an outwardly left-wing president has not won an election since 1924). In other words, AMLO has to show that he can get out of his constraints in order to justify a selloff that has already happened. To be clear, we are not saying that AMLO is a positive, in the absolute, for Mexico. The decision to scrap the Mexico City airport plans, to sideline the finance ministry from key economic decisions, and to threaten a return to an old-school PRI-era statism is deeply concerning. At the same time, we are not of the view that Bolsonaro is, in the absolute, a negative for Brazil. Rather, we are pointing out that the relative investor sentiment is overly bullish Bolsonaro versus AMLO. Especially given that both presidents remain constrained by domestic political intricacies and largely campaigned on the same set of issues that have little to do with their perceived economic preferences. They also face respective median voters that are diametrically opposed to their economic agendas – Bolsonaro, we think, is facing a left-leaning median voter, whereas the Mexican median voter is center-right. The macroeconomic perspective also supports our relative call. If our view on China and the Fed is correct, high-beta plays like Brazil will suffer, while an economy that is tied-to-the-hip of the U.S., like Mexico, ought to outperform EM peers. Chart 33Mexico Finally Has Some Positive Carry Mexico Finally Has Some Positive Carry Mexico Finally Has Some Positive Carry As such, we are putting a long MXN/BRL trade on, to capture this sentiment gap between the two EM markets. Investors will be receiving positive carry on Mexico relative to Brazil for the first time in a long time (Chart 33). The relative change in the current account balance also favors Mexico (Chart 34). Finally, the technicals of the trade look good as well (Chart 35). Chart 34Mexico Looks Good On Current Account Mexico Looks Good On Current Account Mexico Looks Good On Current Account Chart 35Technicals Look Good Too Technicals Look Good Too Technicals Look Good Too South Korea Over Taiwan  Diplomacy remains on track on the Korean peninsula, despite U.S.-China tensions in other areas. Ultimately China believes that peace on the peninsula will remove the raison d’être of American troops stationed there. Moreover, Beijing has witnessed the U.S.’s resolve in deterring North Korean nuclear and missile tests and belligerent rhetoric. It will want to trade North Korean cooperation for a trade truce. By contrast, if Trump’s signature foreign policy effort fails, he may well lash out. We view deeply discounted South Korean equities as a long-term buy relative to other EMs. Taiwan, by contrast, is a similar EM economy but faces even greater short-term risks than South Korea. In the next 13-month period, the Tsai Ing-wen administration, along with the Trump administration, could try to seize a rare chance to upgrade diplomatic and military relations. This could heighten cross-strait tensions and lead to a geopolitical incident or crisis. More broadly, U.S.-China trade and tech tensions create a negative investment outlook for Taiwan. Thailand Over India Five state elections this fall have turned out very badly for Prime Minister Narendra Modi and his National Democratic Alliance (NDA). These local elections have a negative impact, albeit a limited one, on Modi’s and the NDA’s reelection chances in the federal election due in April (or May). Nevertheless, it is entirely possible to lose Chhattisgarh, Madhya Pradesh, and Rajasthan while still winning a majority in the Lok Sabha – this is what happened to the Indian National Congress in 2004 and 2009. So far federal election opinion polling suggests anything from a hung parliament to a smaller, but still substantial, BJP majority. Modi was never likely to maintain control of 20 out of 29 states for very long, nor to repeat his party’s sweeping 2014 victory. He was also never likely to continue his reform push uninhibited in the lead up to the general election. Nevertheless, the resignation of Reserve Bank of India Governor Urjit Patel on December 10 is a very worrisome sign. Given that Indian stocks are richly valued, and that we expect oil prices to drift upwards, we remain negative on India until the opportunity emerges to upgrade in accordance with our long-term bullish outlook. By contrast, we see the return to civilian rule in Thailand as a market-positive event in the context of favorable macro fundamentals. Thai elections always favor the rural populist “red” movement of the Shinawatra family, but presumably the military junta would not hold elections if it thought it had not sufficiently adjusted the electoral system in favor of itself and its political proxies. Either way, the cycle of polarization and social unrest will only reemerge gradually, so next year Thailand will largely maintain policy continuity and its risk assets will hold up better than most other EMs.   Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim, Editor Strategist roukayai@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com   Footnotes 1      Please see Geopolitical Strategy Special Report, “Power And Politics In East Asia: Cold War 2.0?” dated September 25, 2012, Global Investment Strategy Special Report, “Searing Sun: Japan-China Conflict Heating Up,” dated January 25, 2013, “Sino-American Conflict: More Likely Than You Think, Part II,” dated November 6, 2015, and “The South China Sea: Smooth Sailing?” dated March 28, 2017, available at gps.bcaresearch.com. 2      Yes. He literally said that.   Geopolitical Calendar

Highlights On the bright side, Malaysia’s structural backdrop is improving notably, especially in the semiconductors segment. Yet the cyclical growth outlook remains downbeat. While we are maintaining a market-weight allocation to Malaysian equities within an EM equity portfolio, we are putting this bourse on our upgrade watch list. As a play on the ameliorating structural outlook, we recommend an overweight position in Malaysian small-cap stocks relative to the EM universe – both the small-cap and overall equity benchmarks. Feature Malaysian stocks have performed quite poorly in recent years: the equity index, in U.S. dollars, is close to its 2016 lows in absolute terms, and relative to the emerging markets (EM) benchmark, it is not far from the lows of last decade (Chart I-1). Chart I-1Malaysian Stocks & Commodities Prices: Tight Relationship Malaysian Stocks & Commodities Prices: Tight Relationship Malaysian Stocks & Commodities Prices: Tight Relationship Odds are that a structural bottom in this bourse’s relative performance versus the EM index may have been reached. Hence, we are putting Malaysian equities on our upgrade watch list while maintaining a market-weight allocation due to tactical considerations. On the negative side, the past credit excesses have not been recognized and provisioned for by Malaysian commercial banks. The latter account for a notable 34% of the MSCI Malaysia index, and they will be a drag on this bourse's performance. Absolute performance also still hinges on global growth, commodities prices and the overall direction of Asian/EM markets. We are still negative on these parameters. Critically, there are various signs indicating an ameliorating structural backdrop in Malaysia. The country is undergoing notable improvements in the semiconductor sector, thereby reducing its dependence on commodities and increasing its exposure to a high-value industry. To capitalize on this theme of an improving structural backdrop, we are recommending an overweight position in Malaysian small-cap stocks relative to the EM universe – both the small-cap and overall equity benchmarks. Shifting Away From Commodities And Toward Electronics Parting Ways With Commodities Malaysia and its financial markets have been very exposed to commodities prices over the past 15 years or so (Chart I-1, top panel). Nevertheless, the country seems to be shifting away from its considerable reliance on the resource sector and moving into other value-added segments: in particular, semiconductors and technology. Such a structural shift – if successful – would be an extremely positive development as it would lead to rising productivity gains and higher per capita income growth. In short, the country would be able to achieve higher rates of sustainable non-inflationary growth, feeding into a sustainable bull market in Malaysian equities. Several points are noteworthy in this regard: The real output of crude and petroleum products as well as palm oil are declining sharply relative to the economy’s real total output (Chart I-2). Chart I-2Malaysia's Commodities Output Is Falling In Importance Malaysia's Commodities Output Is Falling In Importance Malaysia's Commodities Output Is Falling In Importance Exports volumes of palm oil, crude oil and natural gas have all been falling relative to Malaysia’s total overseas shipment volumes (Chart I-3). Chart I-3Commodities Export Volumes Are Declining In Relative Terms Commodities Export Volumes Are Declining In Relative Terms Commodities Export Volumes Are Declining In Relative Terms Crude oil, gas, and palm oil now account for 4%, 5%, and 7% of total exports in value terms, respectively. Crucially, not only is the importance of commodities in the overall Malaysian economy diminishing in volume terms, it is also falling in nominal terms due to low resource prices. For instance, net export revenues from fuel (i.e. crude oil, petroleum and natural gas) have fallen from US$18 billion in 2013 to US$5 billion today (Chart I-4, top panel). Chart I-4Commodities' Net Export Revenues Are Also Diminishing Commodities' Net Export Revenues Are Also Diminishing Commodities' Net Export Revenues Are Also Diminishing Meanwhile, net exports of palm oil (and other plant-based fats) have dropped from US$20 billion to US$10 billion (Chart I-4, bottom panel). Improvement In High-Value-Added Manufacturing There are also some positive structural signs taking place in the Malaysian economy that are signaling an improvement in productivity and competitiveness: Malaysian export volumes of machinery and transport equipment are expanding in absolute terms as well as relative to overall export volumes (Chart I-5, top and middle panels). Chart I-5Malaysia's Machinery Exports Are Rocking Malaysia's Machinery Exports Are Rocking Malaysia's Machinery Exports Are Rocking Remarkably, Malaysian aggregate export volumes are quickly regaining lost global market share (Chart I-5, bottom panel). Further, the ratio of exports to imports has hit a structural bottom and is slowly picking up in volume terms (Chart I-6). Chart I-6Malaysian Overall Exports Are Regaining Lost Market Share Malaysian Overall Exports Are Regaining Lost Market Share Malaysian Overall Exports Are Regaining Lost Market Share This suggests some improvements in the competitiveness of domestic industries is slowly underway. Meanwhile, Malaysian high-skill and technology intensive exports as a share of global high-tech exports seem to have made a major bottom in U.S. dollar terms and will begin to rise (Chart I-7). Chart I-7Bottom In Malaysia's High-Tech Global Share? Bottom In Malaysia's High-Tech Global Share? Bottom In Malaysia's High-Tech Global Share? Advanced education enrollment is high and improving – and is only outpaced by Korea and China in emerging Asia (Chart I-8). Importantly, Malaysia has among the best demographics of mainstream developing countries. The working age population as a share of the total population will continue to be high all the way to 2040. Chart I-8Malaysians Like Going To School Malaysians Like Going To School Malaysians Like Going To School Malaysian expenditures on R&D have also been on the rise, outpacing a lot of other countries in the region (Chart I-9, top panel). R&D expenditures in Malaysia could also be catching up to Singapore’s (Chart I-9, bottom panel). Chart I-9Malaysia's Expenditure On R&D Is Rising Malaysia's Expenditure On R&D Is Rising Malaysia's Expenditure On R&D Is Rising In line with these positives, net FDIs into Malaysia have been rising briskly (Chart I-10). Importantly, these investments have been driven by European companies, meaning the latter are transferring valuable technological know-how to Malaysia. Chart I-10Net FDIs Are Rising Net FDIs Are Rising Net FDIs Are Rising The Malaysian ringgit is cheap (Chart I-11) and has reached almost two-decade lows against many Asian currencies. This makes Malaysia increasingly more competitive. Chart I-11The Ringgit Is Cheap The Ringgit Is Cheap The Ringgit Is Cheap Finally, our colleagues from the Geopolitical Strategy team believe that the recently elected Pakatan Harapan government will improve governance and transparency, which had significantly deteriorated under Najib Razak’s rule. A Marriage To Electronics Malaysia is attempting to reestablish itself as a major semiconductor hub in the region. Remarkably, after declining for 15 years, semiconductor exports are finally rising as a share of GDP (Chart I-12) and Malaysian semiconductor exports are outperforming those of its neighbors. Chart I-12Malaysian Semiconductor Exports Are Booming Malaysian Semiconductor Exports Are Booming Malaysian Semiconductor Exports Are Booming The Malaysian government since 2010, has identified the semiconductor sector as a key area for development and prosperity. In turn, it has been introducing programs and setting up institutions to support the industry. The 2019 budget reinforces the government’s priority to develop the sector. Several anecdotal observations confirm that Malaysia is moving up the value chain in the semiconductor industry, and is going beyond simple testing and assembly: Growing the semiconductor cluster: The Malaysian Institute of Microelectronic Systems (MIMOS) has established a shared services platform for advanced analytical services in the semiconductor industry to provide support to Malaysian semiconductor companies. The Economic Industrial Design Centre (EIDC) is also providing support to SMEs in order to enhance their efficiency. Similarly, the Semiconductor Fabrication Association of Malaysia (SFAM) has been partnering with local universities to enhance their engineering programs and offer training, internships and research opportunities for students. Developing home-grown semiconductors: In 2015, Malaysian public institutions in partnership with private companies developed the Green Motion Controller (GMS), an integrated circuit that reduces energy consumption. This semiconductor is an energy efficient controller that carries applications in hybrid cars and air conditioners, among other things. Nanotechnology: NanoMalaysia – a nanotechnology commercialization agency – is providing services to SMEs and start-ups to help increase their competitiveness by enabling them to upgrade to more efficient production methods. Light-emitting Diode (LED) manufacturing: Malaysia is becoming a hub for the manufacturing of energy efficient LED chips. This is the result of OSRAM’s – a German light manufacturer – large investment in a high-tech production facility. There are early signs already that the above developments are beginning to bear results. Chart I-13 shows that the difference between exports and imports of semiconductors (in U.S. dollars) have been surging. This shows Malaysia is able to add greater value to the semiconductors it imports and then re-exports. Chart I-13Malaysia Adds Value To The Semis It Imports Malaysia Adds Value To The Semis It Imports Malaysia Adds Value To The Semis It Imports Bottom Line: Commodities are declining in importance to the Malaysian economy. Meanwhile, Malaysia’s structural backdrop is improving as the semiconductor and hardware technology segments are rising in prominence. Cyclical Weakness Despite the positive structural backdrop, Malaysia’s cyclical outlook remains challenging. Our view on commodities and global trade continues to be negative. Not only are commodities prices deflating but semiconductor prices are also falling, and their global shipments are weakening (Chart I-14). Chart I-14Cyclical Weakness In Global Semiconductor Cycle Cyclical Weakness In Global Semiconductor Cycle Cyclical Weakness In Global Semiconductor Cycle The epicenter of the global trade slowdown, however, will be in Chinese construction activity. Consequently, industrial resources prices are more vulnerable than electronics in this global growth downturn. The above deflationary forces would negatively shock Asia’s growth outlook, and consequently Malaysian growth as well: The top panel of Chart I-15 shows that Malaysian narrow money growth has already rolled over decisively and is foreshadowing weaker bank loan growth. Chart I-15Malaysian Domestic Growth Set To Weaken Malaysian Domestic Growth Set To Weaken Malaysian Domestic Growth Set To Weaken Slower bank loan growth will weaken purchasing power and impact domestic consumption. The middle panel of Chart I-15 shows that car sales – having surged this summer because of the abolishment of the GST – are weakening anew. Malaysian companies and banks have among the largest foreign currency debt loads (Table I-1). We expect more currency depreciation in Malaysia, as we do in EM overall. This will make foreign currency debt more expensive to service, and consequently dampen companies’ and banks’ appetites for expansion. Table I-1Malaysia's External Debt Breakdown Malaysia: Structural Improvements Despite Cyclical Weaknesses Malaysia: Structural Improvements Despite Cyclical Weaknesses Finally, the real estate sector remains depressed. Property volume sales are contracting and have dropped to 2008 levels, and housing construction approvals are slumping (Chart I-16). Chart I-16Malaysia's Property Sector Is Depressed Malaysia's Property Sector Is Depressed Malaysia's Property Sector Is Depressed While this means that cleansing has been taking place in the property sector, the banking sector has not recognized NPLs and remains the weakest link in the Malaysian economy. Specifically, the top panel of Chart I-17 illustrates that the NPLs in the banking system still stand at a mere 1.5%. This is in spite of the fact that since 2009, non-financial private sector credit to GDP has risen significantly. Therefore, the true level of NPLs is probably considerably higher. Chart I-17Malaysian Banks Are Under-Provisioned Malaysian Banks Are Under-Provisioned Malaysian Banks Are Under-Provisioned Further, Malaysian banks have been lowering provisions to boost profits (Chart I-17, bottom panel). This is unsustainable. As growth weakens, Malaysian banks will see their NPLs rise and will need to raise provisions. Chart I-18 demonstrates that if provisions rise by 20%, bank operating earnings will contract and bank share prices would fall. Chart I-18Malaysian Banks' Share Prices Will Fall Malaysian Banks' Share Prices Will Fall Malaysian Banks' Share Prices Will Fall Bottom Line: Malaysia’s cyclical growth outlook is still feeble, with the banking system being the weakest link. Banks’ large weight in the equity index makes this bourse still vulnerable in the coming months. Optimal Macro Policy Mix Fiscal Consolidation… Fiscal policy is set to be tighter as per the Malaysian government budget announced on November 2 and its preference to pursue fiscal consolidation to reduce the deficit. The budget projects only a slight increase in expenditures in 2019, which means it will likely slowdown from 8% currently (Chart I-19). Chart I-19Government Expenditure Growth Will Soften Government Expenditure Growth Will Soften Government Expenditure Growth Will Soften The government will also recognize public-sector liabilities not presently shown on its balance sheet and strengthen both transparency and administrative efficiency. Critically, the budget also includes strategies to support the entrepreneurial part of the economy. Overall, this budget bodes very well for the structural outlook. Yet it will not support growth cyclically. …To Be Offset By Easy Monetary Policy Despite continued currency weakness, the Malaysian monetary authorities will not be in a hurry to raise interest rates to defend the ringgit. This is in contrast with other central banks in the region like Indonesia and the Philippines. This is presently an optimal policy mix for Malaysia and is positive for the stock market’s relative performance versus its counterparts in many other EMs. Malaysia’s structural inflation is low: core inflation hovers around zero. Therefore, the central bank will neither raise interest rates nor sell its foreign exchange reserves to defend the currency. Both currency depreciation and low interest rates are needed to mitigate the downturn in exports as well as offset fiscal consolidation. In the meantime, the ringgit is unlikely to depreciate in a sudden and vicious manner but rather will likely fall gradually. First, the current account will remain in surplus, even as global trade contracts. The basis is that if Malaysian exports fall, imports will simultaneously follow. The country imports a lot of intermediate goods to then process and re-export. Second, Malaysia is unlikely to witness pronounced capital flight as occurred in 2015. The new government has increased confidence in the economy among both locals and foreigners. In addition, net portfolio investments have been negative for a while. This means that a large amount of foreign capital has exited already, reducing the risk of further outflows. What’s more, foreign ownership of local currency bonds has fallen from 33% in June 2016 to 24% today. Moreover, at 28% of market cap, foreign ownership of equities is among the lowest in EM. These also limit potential foreign selling. Bottom Line: Policymakers are adopting a wise policy mix for the economy at the current juncture: tight fiscal and easy monetary policies. This is structurally positive, even if it does not preclude cyclical weakness. Investment Conclusions Weighing structural positives versus the cyclical growth weakness and the unhealthy banking system, we are maintaining a market-weight allocation to Malaysian stocks within the EM universe, but are placing this bourse on our upgrade watch list. We need to see a selloff in bank stocks before we upgrade it to overweight. Within Malaysian equities, we recommend shorting/underweighting banks and going long/overweighting small cap stocks. To capitalize on Malaysia’s improving structural growth outlook, we recommend buying Malaysian small caps, but hedging positions by shorting the EM aggregate or small-cap indexes. The ringgit is poised to depreciate further versus the U.S. dollar along with other EM/Asian currencies. We continue to short the ringgit versus the greenback. With respect to sovereign credit and local government bonds, dedicated portfolios should currently have a market-weight allocation. The negative cyclical growth outlook is offset by the right macro policy mix and improving growth potential.   Ayman Kawtharani, Associate Editor ayman@bcaresearch.com​​​​​​​ Equity Recommendations Fixed-Income, Credit And Currency Recommendations

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

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

Highlights Late-cycle pressures will keep pushing bond yields higher. Global growth will remain above trend in 2019, keeping unemployment rates low and preventing central banks from turning dovish. The unwind of crisis-era global monetary policies will continue. Slowing central bank asset purchases will worsen the supply/demand balance for government bonds, resulting in gentle upward pressure on yields via higher term premia. It is too early to worry about inverted yield curves. The time to be concerned about the recessionary implications of an inverted U.S. Treasury curve will come after the Fed has lifted real interest rates to above neutral (R*), which should occur in the latter half of 2019. Expect poor corporate bond returns from an aging credit cycle. While default risk is likely to stay benign through 2019, the greater risk for corporates could come from concerns over future credit downgrades, as well as diminished inflows in a “post-QE” world. Feature BCA’s annual Outlook report, outlining the main investment themes that will drive global asset markets in 2019, was sent to all clients in late November.1 In this Weekly Report, we discuss the four broad implications of those themes for global fixed income. In a follow-up report to be published next week, we will translate those themes into strategic investment recommendations and allocations within our model bond portfolio framework. Key View #1: Late-Cycle Inflation Pressures Will Keep Pushing Bond Yield Higher The main theme from last year’s BCA Outlook was that markets and policy would collide in 2018. This year’s Outlook concluded that those same frictions would persist in 2019, and for similar reasons. The global economy is likely to see another year of above trend growth, after the current deceleration phase bottoms out in the first half of the year. Tight labor markets will continue to force developed market central banks, who still strongly believe in the Phillips Curve relationship as the best way to forecast inflation, to move toward less dovish monetary policies, putting steady upward pressure on global bond yields. Our own Central Bank Monitors signal a need for tighter monetary policy (Chart of the Week), most notably in the U.S. That may sound strange given the recent softening of global growth momentum and plunge in oil prices. Yet economic survey data (like the global ZEW index) show a huge divergence between actual and expected growth, with real bond yields responding more to the former than the latter (Chart 2). Chart of the WeekStill A Bearish Bond Backdrop Still A Bearish Bond Backdrop Still A Bearish Bond Backdrop   Chart 2Global Yields Will Remain Resilient In 2019 Global Yields Will Remain Resilient In 2019 Global Yields Will Remain Resilient In 2019 The fear of a global economic downturn appears greater than the current reality - a trend likely magnified by the ongoing U.S.-China trade tensions and the sharp fall in oil prices which some are interpreting to be a sign of weaker demand. BCA’s commodity strategists view the oil decline as purely supply driven, and expect that a tighter demand/supply balance will result in oil prices recovering recent losses and rising smartly in 2019. This should lead to a rebound in the inflation expectations component of global bond yields later next year (bottom panel). As was argued in the 2019 BCA Outlook, the conditions for a deep pullback in global growth are not yet in place, especially in the U.S. where consumer fundamentals remain solid (strong income growth, booming net worth and a low debt service ratio). China, where growth is currently slowing, remains the biggest wild card for the world economy, especially given the degree to which emerging market economies are levered to Chinese growth. Yet the most likely outcome is that Chinese authorities will make enough policy adjustments to stabilize the economy in the first half of 2019, which will help put a floor under global growth. With over 80% of OECD economies now with an unemployment rate below estimates of “full employment”, the backdrop today is more conducive to sustained higher inflation than at any point since the 2008 Global Financial Crisis (Chart 3). This means that actual inflation readings are likely to be stickier to the upside, especially for domestically focused measures like wages and services which are accelerating in many countries. Chart 3Tight Labor Markets Will Prevent A Sharp Drop In Inflation Tight Labor Markets Will Prevent A Sharp Drop In Inflation Tight Labor Markets Will Prevent A Sharp Drop In Inflation From the point of view of global central bankers, this means that as long as global growth does not slow sustainably below trend, then unemployment rates are unlikely to begin to rise. For policymakers who slavishly follow the Phillips Curve when forecasting inflation, that will make it difficult to shift to a more dovish policy bias, even if inflation remains below target for a time thanks to the recent pullback in oil prices (Chart 4). Chart 4Central Banks Who Believe In The Phillips Curve Can’t Turn Dovish 2019 Key Views: Normalization Is The "New Normal" 2019 Key Views: Normalization Is The "New Normal" The degree of policy bias in 2019 will not be uniform, though, which was also the case in 2018. Central banks in countries with core inflation rates closer to policymaker targets (the U.S., Canada, the U.K. if the Brexit uncertainty fades, Sweden) will be more likely to raise rates than those where inflation is still well below target (Japan, the euro area, Australia). Relative government bond market performance over the course of 2019 should reflect those trends. U.S. Treasury yields will still most likely to see the largest increase from current levels as the Fed will lift rates over the full 2019 calendar by more than markets are currently discounting (only 33bps are currently priced in the U.S. Overnight Index Swap curve – a low hurdle to beat). Key View #2: The Unwind Of Crisis-Era Global Monetary Policies Will Continue Quantitative easing (QE) – central banks buying huge amounts of bonds to help keep yields low enough to sustain economic growth amid weak inflation expectations – has been a dominant feature of global bond markets since the 2009 recession. Policymakers have been forced to engage in such unusual activities to try and boost weak inflation expectations even after policy interest rates have been cut to 0% (and even lower in some cases). Now, a decade later, inflation expectations are more stable and much closer to central bank targets in most countries (except, as always, Japan). That means government bond returns are no longer negatively correlated to equity returns (Chart 5), reducing the value of bonds as a hedge to stocks. Chart 5Bonds Are A Less-Effective Hedge For Equities With More Stable Inflation Bonds Are A Less-Effective Hedge For Equities With More Stable Inflation Bonds Are A Less-Effective Hedge For Equities With More Stable Inflation In the 2019 BCA Outlook, several other reasons were given as to why that correlation has been weakening, including a shift towards more consumption and less savings from aging populations entering their retirement years. The biggest change, however, has been the move from QE to “QT” (quantitative tightening) as central banks buy fewer bonds or, in the case of the U.S. Fed, actually letting bonds run of its massive balance sheet. The new year will bring an end to the net new buying phase of the European Central Bank (ECB) Asset Purchase Program. That represents a loss of €180 billion of liquidity into European bond markets compared to 2018 (twelve months at €15bn per month), both for government debt and investment grade corporates which are also part of the ECB’s program. This will come on top of reduced purchases from the Bank of Japan (BoJ), who will likely buy at a reduced ¥30 trillion pace in 2019 (down from around ¥40 trillion in 2018), and from the Fed who will let $600bn of maturing bonds run off its balance sheet ($360bn of which will be Treasuries). That slowing pace of central bank asset accumulation means that private investors must absorb an even greater supply of government bonds next year. The BCA Outlook estimated that the change in the supply of government bonds available to private investors would equal $1.2 trillion in 2019, a huge increase from the $400bn seen in 2018 (Chart 6). This will come at a time when new government bond issuance is set to increase once again thanks to wider U.S. budget deficits, further worsening the global supply/demand balance for government debt from the major developed economies. Chart 6Private Sector To Absorb More Bonds Private Sector To Absorb More Bonds Private Sector To Absorb More Bonds The reduction in the pace of central bank bond buying will continue to put gentle upward pressure on government bond yields, as has been the case since the pace of ECB purchases peaked in 2016 (Chart 7). More importantly, the diminished central bank liquidity expansion means there will be less money going into risky assets via the portfolio balance channel (i.e. private investors taking the funds earned from selling bonds to central banks and placing that in equity and credit markets). Chart 7Upward Pressure On Yields & Vol From 'QT' Upward Pressure On Yields & Vol From 'QT' Upward Pressure On Yields & Vol From 'QT' This creates a backdrop where volatility spikes will be more frequent, as has been the case in 2018 (bottom panel). Risky asset valuations will also be impacted from reduced inflows from yield-seeking investors who have sold government bonds to central banks. This suggests wider credit spreads and lower equity price/earnings multiples, all else equal (Chart 8). Chart 8Risk Asset Valuations Will Continue To Suffer From QT In 2019 Risk Asset Valuations Will Continue To Suffer From QT In 2019 Risk Asset Valuations Will Continue To Suffer From QT In 2019 Of course, all is not equal. A rebound in global growth could trigger a new wave of inflows into global equity and credit markets with valuations having cheapened in recent months. The important point is that, without central bank liquidity propping up asset prices, global risk assets will trade more off fundamentals in 2019 than has been the case during the past couple of years. Key View #3: Too Soon To Worry About Inverted Yield Curves “Yield curve inversions lead to recessions” is a well-known (if not well understood) relationship that has gained almost mythical status among investors. As the widely-watched spread between 2-year and 10-year U.S. Treasury yields (the 2/10 curve) has melted away during the course of 2018 – now sitting at a mere 13bps – the prognosticating power of the curve has many worried that a U.S. recession could be just around the corner. Especially after the Fed has raised the fed funds rate by 200 basis points over the past three years. Those fears are misguided, for several reasons: 1. The Treasury curve segment with the most successful track record in heralding U.S. recessions is the spread between the 10-year U.S. Treasury bond yield and the 3-month U.S. Treasury bill rate (Chart 9). That spread is still a firmly positive 42bps. We showed in a Special Report published last July that, on average, the length of time between the inversion of the 3-month/10-year Treasury curve and the beginning of a recession is seventeen months.2 Chart 9UST Curve Not Close To A True Recessionary Inversion Signal UST Curve Not Close To A True Recessionary Inversion Signal UST Curve Not Close To A True Recessionary Inversion Signal 2. The slope of the Treasury curve is unusually flat given the level of the fed funds rate measured in real (inflation-adjusted) terms. The previous three episodes where the 2-year/10-year Treasury curve has inverted over the past thirty years have occurred when the real fed funds rate was between 300-400bps (Chart 10). The current level of the real funds rate (deflated by headline CPI inflation) is near zero which, in the past, has occurred alongside a 2-year/10-year Treasury curve that had a positive slope between 150-200bps. Chart 10Global Yield Curves Look Too Flat Vs Real Policy Rates... Global Yield Curves Look Too Flat Vs Real Policy Rates... Global Yield Curves Look Too Flat Vs Real Policy Rates... 3. The depressed level of bond term premia is weighing on longer-dated Treasury yields and dampening the slope of the curve. This is happening not only in the U.S., but also in other major bond markets in Germany, the U.K. and Japan (Chart 11). The impact of global QE programs is the most likely common factor. Chart 11...With Global Term Premia Depressed ...With Global Term Premia Depressed ...With Global Term Premia Depressed 4. The 2-year/10-year U.S. Treasury curve has never been inverted without the real fed funds rate being above the neutral real rate, also known as R-star (Chart 12). Chart 12No 2/10 UST Inversion Before Real Rates Exceed R* No 2/10 UST Inversion Before Real Rates Exceed R* No 2/10 UST Inversion Before Real Rates Exceed R* The implication for fixed income investing for 2019 is that it is too soon in the Fed’s monetary tightening cycle to expect an inverted yield curve driven by an overly tight monetary policy. That outcome is more likely by late 2019 after inflation expectations pick up and the Fed delivers at least another 75bps over the course of the year, pushing the funds rate into restrictive territory. Key View #4: Poor Corporate Returns From The Aging Credit Cycle The other major fixed income implication of the 2019 BCA Outlook is that global corporate bond markets are likely to see another year of poor returns (both in absolute terms and relative to government bonds). Spreads remain near historically tight levels across most spread product sectors, suggesting that credit risk premia will need to be repriced higher as the endgame of the multi-year credit cycle draws nearer (Chart 13). Both investors and policymakers have grown increasingly worried about the risks to the U.S. corporate bond market from high corporate leverage. However, as was discussed in the Outlook, U.S. corporate interest coverage remains well above levels that have preceded the end of previous credit cycles and BCA’s models suggest U.S. corporate profit growth will remain solid (albeit much slower than the rapid +20% growth seen in 2018). Chart 13Fading Support For Corporate Bonds From Growth & Policy Fading Support For Corporate Bonds From Growth & Policy Fading Support For Corporate Bonds From Growth & Policy That does not mean that corporate bonds are without risk. With 50% of global investment grade bond indices now rated BBB (one notch above junk), the greater threat to corporates may come from downgrades. While those are less likely in a growing economy, investors in lower-rated investment grade bonds may require higher yields and spreads to compensate for the future risk of losses as those bonds could become “fallen angel” high-yield debt in the next economic downturn. This impact would be magnified as how many large fixed income managers have mandates that forbid investment in bonds rated below investment grade, thus creating forced selling in the event of downgrades. More fundamentally, the outlook for global corporate bonds, with spreads still much closer to historical tights than long-run averages, remains reliant on strong economic growth momentum and supportive monetary policy. On the former, we do not anticipate a move to sub-trend global growth, as discussed earlier, and corporate bond returns could stabilize once the current downtrend in the world economy subsides (Chart 14). This would likely represent a final period of calm, however. Tightening global monetary policies – both Fed hikes and diminished asset purchases – will create a more bearish backdrop for credit in the latter half of 2019 as markets begin to discount slower economic growth in 2020. Chart 14Fading Support For Corporate Bonds From Growth & Policy Fading Support For Corporate Bonds From Growth & Policy Fading Support For Corporate Bonds From Growth & Policy   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Footnotes 1 Please see the December 2018 edition of The Bank Credit Analyst, “Outlook 2019 – Late Cycle Turbulence”, available at bca.bcaresearch.com and gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Special Report, “Three Frequently Asked Questions About Global Yield Curves”, dated July 31st 2018, available at gfis.bcaresearch.com.   Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index 2019 Key Views: Normalization Is The "New Normal" 2019 Key Views: Normalization Is The "New Normal" Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

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

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