Policy

Highlights The recent improvement in China's housing data has been mainly driven by the central bank's direct lending to the real estate sector. This improvement is unlikely to last, as the authorities are scaling down this form of financing. Structural imbalances remain acute in the Chinese real estate market, and the path of least resistance is still down. Diminishing direct financing from the central bank, low affordability, slowing rural-to-urban migration, the promotion of the housing rental market and the government's continuing emphasis on clamping down speculation will all lead to weaker property sales over the next 12 months. Both weakening sales and tightening funding sources for real estate developers point to declining growth of property starts and construction. This will be negative for construction-related commodity markets (steel, cement, copper, aluminum and glass) and construction-related machinery. Stay neutral Chinese versus global stocks and favor low-beta sectors within the Chinese investable universe. Avoid Chinese property developers, though favor large versus small. Feature Chart 1Property Sales And Starts: Will Recent Growth Acceleration Continue? Property Sales And Starts: Will Recent Growth Acceleration Continue? Property Sales And Starts: Will Recent Growth Acceleration Continue? BCA's China Investment Strategy service has argued for the better part of the past year that China's old economy has been in the midst of a benign, controlled slowdown. Since then, our leading indicators have continued to deteriorate, and now China is facing a potentially significant shock to its export sector due to U.S. policy. This has caused many investors to focus on domestic demand, and whether there are any meaningful signs of improvement that could act as a reflationary bridge for the economy to weather the looming external shock. We have argued that housing has stood out as the best potential candidate for a domestic demand upturn and, at first blush, recent data suggests that a material uptrend in activity may be in the cards1 (Chart 1). However, in this report, we argue that the central bank's direct lending to the real estate sector has been the major force behind the recent improvement in the housing data, and will be unwinding. Barring new policy measures, the improvement is unlikely to last. What Has Driven Housing Sales? Chart 2Chinese Housing Monetization Policy: The Main Driver Of Property Market Since 2015 Chinese Housing Monetization Policy: The Main Driver Of Property Market Since 2015 Chinese Housing Monetization Policy: The Main Driver Of Property Market Since 2015 The growth acceleration in both floor space sold and floor space started, shown in Chart 1, warrants scrutiny of the Chinese property market. Will housing sales and starts growth continue to accelerate as it did in 2013 and 2016, or are the most recent gains just a temporary rebound? To answer this question, one needs to understand China's pledged supplementary lending (PSL) scheme, which refers to China's central bank's direct lending to the real estate market. In this report, we also use "housing monetization policy" as an interchangeable term to the "PSL scheme." Our research suggests that the central bank's PSL injections have been the major determinant of sales and prices in the Chinese real estate market over the past three years (Chart 2). The People's Bank of China (PBoC) injected 698 billion RMB in 2015 and 971 billion RMB in 2016 in the form of PSL injections into the real estate market as part of its attempts to revive the property market. The massive fund injection boosted floor space sold from a deep contraction in 2015 to a 30% year-over-year growth rate in 2016. This burst in sales volume drove up already-elevated housing prices even higher. In 2017, the government shrank the PSL amount by 35% and implemented other tightening policies to cool down the domestic property market. As a result, both property price growth and floor space sold growth decelerated significantly. Both floor space started growth and floor space sold growth bottomed last October as PSL injections re-accelerated again in November 2017. The most recent acceleration was also mainly because of the front-loaded PSL injection program, which was ramped back up 4.8% year-on-year in the first five months of 2018. In general, it takes several months for PSL lending to make its way into final purchase of properties. Clearly the PSL program has been responsible for boosting housing sales in the past three years. So, how does the PSL scheme work, and will it continue to boost property sales going forward? PSL = Housing Monetization Chart 3 illustrates how the PSL scheme works. The government designed the policy in 2014 with two objectives in mind: supplying sufficient funds for slum area reconstruction (also called shantytown redevelopment) and de-stocking the housing market. The PSL facility allows the PBoC to lend funds earmarked for slum area reconstruction to the three policy banks (China Development Bank, Agricultural Development Bank of China and Export-Import Bank of China) at very low interest rates. These policy banks in turn lend directly to local governments (mainly in tier-2 and smaller cities). Chart 3How Does Chinese Housing Monetization Scheme work? China's Property Market: Where Will It Go From Here? China's Property Market: Where Will It Go From Here? From there, to buy the land from slum owners, the local government can adopt one of three approaches: Give cash directly to slum owners in exchange for their land, and then the owners can go to real estate developers to buy properties; Use the funds to pay property developers for their existing housing inventories, and then use the purchased properties to exchange the land with slum owners; A combination of 1 and 2. This policy has empowered the PBoC to be able to inject a significant amount of liquidity directly into the Chinese property market. Consequently, the PSL scheme has boosted floor space sold as well as facilitated floor space started by providing more funds to real estate developers. The PSL program has been the main reason why housing inventories have dropped since 2015. Our calculations indicate that about 20% of floor space sold (in volume terms) in 2017 was due to the PSL facility designed for slum area reconstruction (Chart 4). Various reports have also suggested that, for some cities with strong monetization policies, this ratio has reached over 50%. Deposits and advance payments of property sales, which closely correlates with floor space sold, is the major source of funds available for real estate investment (Chart 5). It has contributed 30-40% of total fund growth every year in the past three years. Chart 4Housing Monetization: The Main Driver For Property Sales Since 2015 Housing Monetization: The Main Driver For Property Sales Since 2015 Housing Monetization: The Main Driver For Property Sales Since 2015 Chart 5More Property Sales = More Fund Inflows To Property Developers More Property Sales = More Fund Inflows To Property Developers More Property Sales = More Fund Inflows To Property Developers Last year, in RMB terms, PSL injections were equivalent to 94% of the annual increase in deposits and advance payments. Looking forward, while we do not think the government will completely halt the PSL scheme, we do believe the monetization scale is set to diminish considerably over the next 12 months: First, since this past June, when the central bank signaled it would restrict the scale of monetization, the year-over-year growth of PSL injections has already declined three months in a row with 36% contraction for the period from June-August from a year ago. Chart 6Destocking Is At Late Stage Destocking Is At Late Stage Destocking Is At Late Stage Second, in the government's 2018-2020 slum area reconstruction plan, the authorities aim to reconstruct 15 million units of flats. This year's goal is 5.8 million units, leaving 9.2 million units for the two years of 2019 and 2020 combined. Assuming an equal split of 9.2 million flats over the next two years, this will imply that the number of flats for the slum area reconstruction will decline to 4.6 million units in 2019, a 20% drop from this year's 5.8 million units. Third, the monetization policy has already successfully reduced residential inventories by 42% from their peak, based on the government's measure of property inventories (defined as completed and waiting for sale) (Chart 6). Lastly, if there had been no PSL scheme, the Chinese housing market and economy would have been much weaker. In this aspect, the policy was beneficial. However, it has had unintended consequences: The country's property bubble has become even more inflated. Overall, our view is that the authorities are likely to scale down the scheme. Bottom Line: Recent improvement in the housing data - mainly driven by the government's PSL scheme - is unlikely to last. The scale of housing monetization (i.e., PSL injections) will diminish. Structural Imbalances With diminishing tailwinds from the housing PSL program, will any other drivers emerge to boost floor space sales and started growth? We are quite pessimistic. Structural imbalances remain acute in the Chinese real estate market, suggesting the path of least resistance for the market is still down. The outlook for property sales growth Beyond the prospect of diminishing housing monetization over the next 12 months, structural factors including falling affordability, slowing rural-to-urban migration, demographic changes, the promotion of the rental market and the government's continuing emphasis on clamping down on speculation will all lead to weaker property sales. House prices in China remain extremely high relative to disposable income. Using the NBS 70-city residential average price, our calculation shows that it will take an average two-income household 11 years of disposable income to buy a 90-square-meter (equivalent to 970 square feet) house at current prices, much higher than the same ratio in the U.S. (Chart 7). With respect to the ability to service mortgage payments, on a 90-square-meter house with a 20% down payment, our calculations show that annual interest costs account for nearly half of average household disposable income levels (again, assuming a two-income household) (Table 1). Chart 7Poor Affordability For Chinese Home Buyers Poor Affordability For Chinese Home Buyers Poor Affordability For Chinese Home Buyers Table 1House Price-To-Income Ratios And Affordability China's Property Market: Where Will It Go From Here? China's Property Market: Where Will It Go From Here? A joint report released by the central bank and the finance department shows that the number of delinquent mortgages on housing provident funds2 - loans that are much cheaper than market mortgage loans - rose by 35% year over year last year, validating the extremely poor affordability of Chinese properties. The pace of urbanization is slowing (Chart 8). The number of individuals moving from rural areas to cities as a percentage of the urban population is decreasing. Net migration as a share of the urban population has fallen to 2% today. Overall urban population growth has slowed below 3%. The Chinese population is aging rapidly. The proportion of citizens who are over the age of 65 has risen from 8% of the population in 2007 to 11.4% as of last year, larger than the 10 to 19-year-old age group, which accounts for only 10.5% of the total population. Given Chinese life expectancy is currently at about 76 years, over the next 10 to 15 years the former cohort will leave a large number of houses to the latter cohort, most of whom will get married with high demand for shelter but likely little need to buy due to inheritance. This also indicates the number of second-hand properties available for either rent or sale will rise. The government is currently aiming to develop the domestic rental market. For example, the authorities are encouraging the private sector to convert excess office and commercial buildings and/or use currently empty apartments for housing rentals. President Xi Jinping's mantra that "housing is for living in, not for speculation" - proclaimed in December 2016 - remains the focal point of the government's current policies. Chart 8China: Slowing Pace Of Urbanization China: Slowing Pace Of Urbanization China: Slowing Pace Of Urbanization Chart 9Tightening Funding Sources For Chinese Property Developers Tightening Funding Sources For Chinese Property Developers Tightening Funding Sources For Chinese Property Developers The outlook for property starts growth Falling growth of sold area and the authorities' current de-leveraging focus all point to declining growth of floor space started. Real estate developers need funds to invest in and develop new buildings. Their main source of funds includes deposits and advance payments from property sales, bank loans, foreign investment (i.e., foreign borrowings and foreign direct investment), self-raised (i.e., equity financing), and capital raised through bond issuance. The government's current deleveraging focus has led to a sharp drop in bank loans and foreign investment for domestic real estate developers (Chart 9). In such an environment, developers have been facing increasing difficulty raising funds through issuing bonds - bond issuance both on- and offshore have plunged this year. Diminishing housing monetization will also slow fund growth from property sales. Hence, weakening sales and tightening financing sources available for investment entail floor space starts growth should decelerate. There are several signs suggesting unsustainability of the recent growth acceleration in floor space started. Excluding land purchases, real estate investment has showed contraction across the board - from construction and installation to equipment purchases (Chart 10). Despite the strong growth of floor space started, this may indicate the strength of actual construction activity of recent new starts has actually been weak due to slowing pace of construction because of lack of funds. Otherwise, strong floor space started growth should coincide with robust growth in non-land real estate investment. For projects under construction, completed floor space has also been in deep contraction across the board - from residential to commercial, office and others (Chart 11). This again signals that property developers are slowing the pace of construction. This could also be due to deficient financing. For the first seven months of this year, seven provinces (Jiangsu, Shandong, Hunan, Guizhou, Guangdong, Chongqing, and Fujian), which account for only about 40% of total national floor space started, contributed 80% of floor space started year over year growth. There were still 11 provinces experiencing contraction in floor space started so far this year. This suggests the breadth of the latest improvement in sales has been weak. Chart 10Real Estate Investment Ex. Land: Falling Across Board Real Estate Investment Ex. Land: Falling Across Board Real Estate Investment Ex. Land: Falling Across Board Chart 11Property Completed: Falling Across Board Property Completed: Falling Across Board Property Completed: Falling Across Board Moreover, for all these seven provinces, only this year floor space started growth has surpassed floor space sold growth (Chart 12). Chart 12AProperty Starts Growth Looks Shaky Property Starts Growth Looks Shaky Property Starts Growth Looks Shaky Chart 12BProperty Starts Growth Looks Shaky Property Starts Growth Looks Shaky Property Starts Growth Looks Shaky This raises questions on the sustainability of the recent growth acceleration in floor space started. Our bet is that the lagging relationship between floor space started and floor space sold is still valid. If our projection of weaker demand materializes, floor space started growth will likely soon fall back. Bottom Line: Structural imbalances in the Chinese real estate market point to a downtrend in both floor space sold growth and floor space started growth. Investment Implications From a macro perspective, it is unlikely that housing will act as a significant reflationary offset for the economy without a notable reversal on several policies described above (and then a lag for flow-through to real economy). This suggests that the primary trend for Chinese stock prices and CNY-USD remains captive to the ongoing U.S./China trade war. Stay neutral on Chinese stocks versus global equities and favor low-beta sectors within the Chinese investable universe. In addition, we can also draw the following investment strategy conclusions: Construction-related commodity markets (steel, cement, copper, aluminum and glass) and construction-related machinery may have more downside (Chart 13). As Chinese property developers' stocks are facing rising downside risks, we suggest avoiding Chinese property developers. However, China may have intense consolidation in its real estate market, so some large property developers may outperform. The fundamentals in the U.S. housing market are much better than in China. While rising U.S. interest rates could be a headwind for U.S. homebuilders' share prices, they stand to resume their outperformance versus Chinese property developers (Chart 14). Chart 13Commodities Prices Still Face Downside Risks Commodities Prices Still Face Downside Risks Commodities Prices Still Face Downside Risks Chart 14Chinese Property Developers Equities: More Downside Ahead Chinese Property Developers Equities: More Downside Ahead Chinese Property Developers Equities: More Downside Ahead Ellen JingYuan He, Associate Vice President Emerging Markets Strategy EllenJ@bcaresearch.com 1 Pease see China Investment Strategy Weekly Reports "Is China's Housing Market Stabilizing?", dated February 8, 2018, "China: A Low-Conviction Overweight", dated May 2, 2018, "11 Charts To Watch", dated May 30, 2018, available at cis.bcaresearch.com. 2 The housing provident fund is a long-term housing savings plan made up of compulsory monthly deposits by both employers and employees. It aims to help middle and low-income workers meet their housing needs. Cyclical Investment Stance Equity Sector Recommendations

Highlights Oil markets and U.S. monetary policy are tightening coincidentally. This confluence of events in the past typically presages an equity correction and recession in the U.S. in the following 6 to 18 months (Chart of the Week). EM economies also could weaken as Fed policy collides with the oil-price spike we expect in the wake of a supply shock. In spite of continuing pressure from the Fed's policy-rate normalization policy, we continue to favor gold as a portfolio hedge (see below). Energy: Overweight. Russia's energy minister Alexander Novak expressed his determination to cooperate with OPEC to evolve the current production cut and emphasized his willingness to maintain a stable market, as reported by Platts on Tuesday.1 Base Metals: Neutral. Alcoa workers at Western Australian alumina and bauxite facilities voted to extend a strike initiated on August 8. Precious Metals: Neutral. The odds of sharply higher oil prices colliding with rising U.S. interest rates are increasing as the year winds down. Gold will outperform equities in this environment. Ags/Softs: Underweight. Brazilian farmers are lobbying Chinese consumers and Argentine suppliers to establish a futures contract tailored for delivery of soybeans from Latin America to China.2 Feature Oil markets continue to tighten, as the now fully discounted loss of ~ 2mm b/d of Iranian and Venezuelan exports is compounded by additional supply-side concerns in Iraq and Libya, and razor-thin OPEC spare capacity. Global demand remains robust. Against this backdrop, it is hardly surprising the energy ministers of the Kingdom of Saudi Arabia (KSA) and Russia are huddling with the U.S. Energy Secretary this week to discuss oil markets in separate meetings on opposite sides of the globe.3 The risk an oil-supply shock collides with tightening monetary conditions in the U.S. is rising, as the Fed continues its rates-normalization policy. This potent confluence of risks, which could push Brent prices above $120/bbl, raises the odds of a sharp correction in U.S. equities (Chart of the Week). It also could pull the recession we expect in 2020 into 2019. This is a risk assessment, not our baseline scenario. While the odds of an oil-price spike accompanied by higher interest rates are increasing, we are not changing our view of oil or gold markets: We expect Brent crude to average $70/bbl in 2H18 and $80/bbl in 2019. We also remain long gold as a portfolio hedge against higher inflation this year and next, and expect the Fed to stay the course on its rates-normalization policy.4 Chart of the WeekOil Price Spikes + Rising U.S. Interest Rates Typically Presage S&P 500 Sell-Off Oil-Supply Shock, Rising U.S. Rates Favor Gold As A Portfolio Hedge Oil-Supply Shock, Rising U.S. Rates Favor Gold As A Portfolio Hedge That said, gold will remain one of the best indicators of how markets assess the Fed's willingness to lean into its rates policy: If prices weaken further, it will signal markets are pricing in continued tightness in U.S. monetary policy. Any weakness resulting from this expectation will be an opportunity to get long (or longer) gold as a portfolio hedge, particularly if oil markets tighten as we expect. Energy Ministers Meet As Oil Markets Tighten KSA's minister, Khalid al-Falih, and U.S. Energy Secretary Rick Perry met in Washington this past Monday, and Perry is due to travel to Moscow for a scheduled visit today. The increasing likelihood of 2mm b/d of exports being lost to U.S. sanctions against Iran later this year, and the imminent collapse of Venezuela, provides the context for these meetings. Platts Analytics estimates as much as 1.4mm b/d of Iranian exports could be lost to the market by the time U.S. sanctions against that country kick in in November. In our base case, we expect a loss of 1mm b/d, which keeps the global market in a physical deficit next year (Chart 2). Total OPEC production in August is estimated by Platts at 32.9mm b/d, a 10-month high, with output in Iraq surging to 4.7mm b/d and to 940k b/d in Libya.5 That Iraqi and Libyan production surge is increasingly at risk, however. In addition to the fully discounted Iranian and Venezuelan risk, we expect American, Saudi and Russian ministers also will discuss the growing risk to Iraq's and Libya's production, and its implications for global supply.6 Civil unrest in these states raises the risk of additional unplanned outages over the near term just as output is recovering.7 Concerns over razor-thin OPEC spare capacity - equal to ~ 1.5% to 2.0% of global demand - and continued strong global consumption likely number among their concerns, as well. In our view, these factors strongly suggest the oil market is setting up for a supply shock that could lift prices above $120/bbl (Chart 3). Chart 2Physical Deficits Could Widen Physical Deficits Could Widen Physical Deficits Could Widen Chart 3High-Price Scenarios Becoming More Likely High-Price Scenarios Becoming More Likely High-Price Scenarios Becoming More Likely Fed Policy Could Collide With Oil Price Spike With the U.S. economy at or very near full capacity, unemployment below 4%, and inflation and inflation expectations ticking higher, we believe the Fed will remain focused on its rates-normalization policy. This increases the risk an oil-supply shock collides with tightening monetary conditions in the U.S. is rising. If the Fed looks through the oil-price spike we expect in the next 6 to 12 months - treating it as a transitory event - its rates-normalization policy will become problematic for the U.S. and global economies. Such a reading by the Fed would be a policy error, in our estimation. As shown in the Chart of the Week, an oil-supply shock accompanied by continued Fed tightening raises the risk of a sharp correction in U.S. equity markets, and perhaps could trigger a bear market. In addition, the recession we expect later in 2020 could be pulled into 2019. As shown in Table 1, 10 out of the 11 recessions in the U.S. since 1945 were preceded by spikes in oil prices. Not every rise in oil prices was accompanied by a recession. In other words, recessions in the U.S. are usually preceded by spikes in oil prices, but not all spikes in oil prices are followed by recessions. This is important, as it implies that forecasting a recession based solely on rises in oil prices can sometimes misfire. Table 1History Of Oil Supply Shocks Oil-Supply Shock, Rising U.S. Rates Favor Gold As A Portfolio Hedge Oil-Supply Shock, Rising U.S. Rates Favor Gold As A Portfolio Hedge On the other hand, an oil-price shock combined with a rate-tightening cycle presents a more reliable recession signal. In fact, since 1970, every time the Fed-funds rate rose by more than ~200bps and oil prices rose by more than 50%, the U.S. business cycle peaked in the following 6-18 months.8 EM Growth Threatened, As Well As the Fed proceeds with its policy-rate normalization, the broad trade-weighted USD (USD TWIB) will strengthen. A sharp increase in oil prices accompanied by continued strength in the USD TWIB will redound to the detriment of EM economies, reducing demand for commodities generally, as the local currency costs of all USD-denominated goods increases. The confluence of these factors - should they materialize - would reduce EM income growth - perhaps even cause a contraction - and would produce a medium-term deflationary impulse, along with a rush to U.S. treasuries and other safe-haven assets. This would lower U.S. interest rates, all else equal, forcing the Fed to put its rates-normalization policy on hold, and possibly reverse it.9 Favor Gold, If Oil Spikes And Rates Rise In sum, the U.S. economy is at or very near full capacity, which will keep the Fed focused on its rates-normalization process. This will likely cause the Fed to treat the oil-price spike we expect on the back of a supply-side shock over the next 6 - 12 months as transitory. The Fed won't view it as a true inflationary threat, and will continue with its rates policy, as its core inflation gauge - the U.S. PCEPI ex food and energy - continues to move higher. Over the short run, this would look like U.S. real rates are falling, boosting the appeal of gold. However, the oil-price spike plus a maintained bias by the Fed to continue raising policy rates will lift the USD TWIB, even as oil prices remain high. This will be a double-whammy to EM economies - the absolute price of oil in USD will rise significantly, even as a stronger USD raises the cost of all other dollar-denominated goods and services. This will reduce disposable income and lower aggregate demand in EM economies. Should the Fed misread the oil-price spike in a rising interest-rate environment, we believe holding gold in a diversified portfolio continues to make sense. Gold outperforms in rising inflation environments, and when demand for safe-havens increases. In addition, gold outperforms equities in periods of declining stock markets (Chart 4). This convexity on the upside and downside is one of gold's strongest attributes. Bottom Line: Given the continued pressure on gold from the Fed's rates-normalization policy, the yellow metal will remain an inexpensive portfolio hedge. Gold prices are currently below or close to their long-term average when expressed in terms of the S&P 500 or oil units (Chart 5). Hence, diverting limited amount from equity to gold is recommended on a risk-adjusted basis. Chart 4Gold V. S&P 500 Oil-Supply Shock, Rising U.S. Rates Favor Gold As A Portfolio Hedge Oil-Supply Shock, Rising U.S. Rates Favor Gold As A Portfolio Hedge Chart 5Gold Is Relatively Cheap Gold Is Relatively Cheap Gold Is Relatively Cheap Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see "Russian energy minister Novak sees broader OPEC, Russia, allies cooperation charter 'expedient' from Jan 1, 2019" published by SP Platts Global on September 11, 2018. 2 Please see "Brazil Farmers Vie For Soy Contract During U.S. - China Trade War," published by reuters.com on September 10, 2018. 3 Please see "U.S. and Saudi energy ministers to meet in Washington: DOE," and "Russia's Novak to meet with U.S. counterpart Perry, discuss oil markets," both published by reuters.com on September 10, 2018. 4 Our view is aligned with BCA's U.S. Bond Strategy, which can be found in "The Powell Doctrine Emerges" published September 4, 2018. It is available at usbs.bcaresearch.com. 5 Please see "OPEC crude oil production rises to 32.89 mil b/d in Aug as cuts unwind: Platts survey" published by SP Platts Global September 6, 2018. Noteworthy in the Platts analysis is the KSA increase to 10.5mm b/d. NB: We will be updating our balances next week. See also "U.S. warns Iran it will respond to attacks by Tehran allies in Iraq" published by reuters.com on September 11, 2018. 6 Rising secular tensions in Iraq - particularly vis-à-vis Iran's role in that state - could threaten production and exports there, as we discussed in the Special Report we published last week, in concert with BCA's Geopolitical Strategy. Please see "Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply" published September 5, 2018, and "Iraq Is The Prize In U.S. - Iran Sanctions Conflict" published June 7, 2018. Both are available at ces.bcaresearch.com. 7 Civil order in Libya is collapsing. The Islamic State is increasing the tempo of its operations in and around Libya; forces loyal to the late dictator late Muammar Qaddafi staged a mass escape from a Tripoli prison earlier this month; and local militia are threatening to extend the Libyan unrest into neighboring states. Please see "Libya's Haftar threatens to 'spread war' to Algeria" reported by Arab News September 11, 2018; "Masked gunmen attack Libyan oil corporation HQ in Tripoli," published by The Guardian September 10, 2018; and "Hundreds escape in jailbreak near Libyan capital" published by The National in the UAE September 3, 2018. 8 These effects are not constant or fixed. Each period has its own specificities implying a range around the rate hike and oil-prices spike necessary to disrupt the economy. 9 Please see BCA Commodity & Energy Strategy Weekly Report, "Trade, Dollars, Oil & Metals ... Assessing Downside Risk" published August 23, 2018, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Oil-Supply Shock, Rising U.S. Rates Favor Gold As A Portfolio Hedge Oil-Supply Shock, Rising U.S. Rates Favor Gold As A Portfolio Hedge Trades Closed in 2018 Summary of Trades Closed in 2017 Oil-Supply Shock, Rising U.S. Rates Favor Gold As A Portfolio Hedge Oil-Supply Shock, Rising U.S. Rates Favor Gold As A Portfolio Hedge

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

Highlights The primary trend for both Chinese stock prices and CNY-USD remains captive to negative surprises related to the trade war between the U.S. and China. Considerable uncertainty remains on this front, but our outlook is that the situation is likely to get worse, not better. It remains too early to forecast a durable stabilization in the exchange rate. It is an open question whether the PBOC will be forced to change short-term interest rates in order to guide the currency in their preferred direction. There is some evidence to suggest that China can control both the interest and exchange rate should it choose to do so, but analyzing the issue is significantly complicated by the approach Chinese policymakers are using to manage the impossible trinity. There is room for Chinese short-term interest rates to rise modestly if the worst of the U.S./China trade war does not materialize. This would be consistent with the goal of avoiding significant releveraging of China's private sector. For now, investors should maintain no more than a benchmark allocation towards Chinese investable stocks within a global equity portfolio, and should continue to favor low-beta sectors within the investable universe. Feature We noted in our August 22 Weekly Report that the persistent weakness of the RMB appeared to be one important factor weighing on Chinese stocks, particularly the domestic market.1 We presented some tentative evidence that part of the decline in CNY-USD since mid-June has been policy-driven (despite the PBOC's statements that it had not been depreciating the currency), but also noted that the RMB had now likely fallen outside the comfort zone of policymakers. The PBOC's re-introduction of its "counter-cyclical factor" when fixing the yuan's daily mid-point supports this view, and suggests that monetary authorities are now aiming for a broadly stable exchange rate (or are aiming to limit further downside). Chart 1 highlights that there have been some, albeit modest, signs of success. Whether they succeed will, first and foremost, be largely determined by what appears to be an imminent decision by the Trump administration to levy tariffs on an additional $200 billion in imports from China. Our previous analysis of potential equilibrium levels for CNY-USD suggests that investors have already priced in the imposition of a second round of tariffs, but the key factor for markets will be whether the tariff rate applied is 10% or 25%. In the first case it is possible that the RMB has overshot to the downside; in the latter case, CNY-USD will very likely come under renewed pressure that would be difficult for the PBOC to fully counter. Chart 1Some Modest Signs Of Currency Stability Some Modest Signs Of Currency Stability Some Modest Signs Of Currency Stability Chart 2Interest Rate Differentials And CNY-USD: A Tight Link Interest Rate Differentials And CNY-USD: A Tight Link Interest Rate Differentials And CNY-USD: A Tight Link But an additional question is whether the PBOC will be forced to change short-term interest rates in order to guide the currency in their preferred direction. Both our Global Investment Strategy and Emerging Markets Strategy services have highlighted that USD-CNY has broadly tracked the one-year swap differential between the U.S. and China over the past few years (Chart 2). This suggests that, at a minimum, there is some link between the interbank market and the exchange rate, despite the fact that capital controls are still tight in the Chinese economy. It also seems to imply, ominously, that the PBOC may have to choose between potentially significant releveraging and a significant re-appreciation in the exchange rate. Revisiting The Impossible Trinity "With Chinese Characteristics" The exact nature of this interest/exchange rate link is difficult to analyze, because of how China has chosen to manage the "impossible trinity" following the August 2015 devaluation of the yuan. The upper portion of Chart 3 illustrates the standard view of the impossible trinity, which posits that policymakers must choose one side of the triangle, foregoing the opposite economic attribute. For example, most modern economies have chosen "B", allowing the free flow of capital and independent monetary policy by giving up a fixed exchange rate regime. Hong Kong has chosen "A", meaning that its monetary policy is driven by the Fed in exchange for a pegged exchange rate and an open capital account. Chart 3The Possible Trinity? Moderate Releveraging And Currency Stability: An Impossible Dream? Moderate Releveraging And Currency Stability: An Impossible Dream? China historically has chosen "C", an economy with a closed capital account, a fixed exchange rate, and independent monetary policy. There is no causal link between interest and exchange rates in the world of option C, but following the PBOC's move in 2015 towards a more market-oriented approach for the exchange rate, it was accused by many market participants of trying to pursue all three goals simultaneously. In short, market participants have not been able to clearly discern what option China has chosen following over the past few years. China, in effect, answered these criticisms by arguing that it was not bound by the standard view of the impossible trinity, but rather one "with Chinese characteristics". The lower portion of Chart 3 presents this theory, which posits that policymakers must distribute a 200% adoption rate among three competing choices. The chart depicts a possible scenario where policymakers are relatively tolerant of capital flow, partially adopting two measures in addition to fully independent monetary policy: quasi-floating exchange rates highly subject to the interest rate dynamics shown in Chart 2, and loosely enforced capital controls. The chart also shows what ostensibly occurred in response to significant capital flight in 2014 and 2015, i.e. a crackdown on capital control enforcement and a less market-driven exchange rate. To the extent that this framework still applies, Charts 4 - 7 suggest that this capital flow crackdown has not abated and that the PBOC may be able to prevent significant further weakness in the currency without dramatically raising interest rates: China tightened scrutiny on trade invoicing verifications in 2016 to crack down on "fake" international trades, such as imports from Hong Kong (local firms fabricated import businesses to move money offshore). Based on the recent trend, these restrictions remain in effect (Chart 4). In addition, quarterly net flows of currency and deposits, which turned sharply negative in Q3 2015, have risen back into positive territory (Chart 5). Chart 4Blocking Capital Leakage In Trade... Blocking Capital Leakage In Trade... Blocking Capital Leakage In Trade... Chart 5...And Cash ...And Cash ...And Cash Chart 6 presents Chinese foreign reserves measured in SDRs, and highlights that reserves have been stable for the better part of the past two years. This stability is in sharp contrast to the material decline that occurred in 2015, and is supportive of the view that China can control both the interest and exchange rate, should it choose to do so. Chart 7 highlights that there are a few precedents for a divergence between interbank rates and CNY-USD. One divergence in 2012-2013 is particularly noteworthy: CNY-USD trended higher, but interbank interest rates remained flat for some time. Crucially, this does not appear to have been driven by falling U.S. interest rates, as the 2-year Treasury yield had already fallen close to zero in 2011 and did not begin to rise until mid-2013. Chart 6China Has Stabilized Its ##br##Foreign Reserves China Has Stabilized Its Foreign Reserves China Has Stabilized Its Foreign Reserves Chart 7Short-Term Interest Rates And ##br## CNY-USD Have Diverged Before Short-Term Interest Rates And CNY-USD Have Diverged Before Short-Term Interest Rates And CNY-USD Have Diverged Before Interest Rates And Moderate Releveraging Despite the evidence presented in Charts 4 - 7, the bottom line is that it is not clear whether the PBOC would be forced to raise short-term interest rates (and by how much) if it chooses to stabilize the currency. Would doing so be a death-knell for the Chinese economy? In our view, the answer is no, unless the trade war does indeed metastasize further. We have argued that the magnitude of the decline in the 3-month repo rate has been excessive, and is not currently consistent with a moderately reflationary scenario. We have argued that the repo rate decline is a side-effect of the PBOC's heavy liquidity injections, which were more likely aimed at ensuring financial system stability against the backdrop of struggling small banks. Chart 8Lending Rates Will Decline Substantially ##br## If Repo Rates Don't Rise Lending Rates Will Decline Substantially If Repo Rates Don't Rise Lending Rates Will Decline Substantially If Repo Rates Don't Rise But the current level of liquidity support carries risks to the objective of controlling private-sector leveraging. Chart 8 suggests that unless the PBOC raises the benchmark lending rate (which would be interpreted very hawkishly by the market), the magnitude of the decline in the repo rate will push the weighted average lending back to its 2016 low (when the monetary authority had turned the policy dial to "maximum reflation"). Last week's Special Report explained in detail why this would carry significant risks to China's financial stability.2 We noted that most of the private sector leveraging that has occurred in China since 2010 has occurred on the balance sheet of state-owned enterprises (SOEs) and the household sector. While the household debt-to-GDP ratio is still low, it is rising rapidly and may accelerate even further if lending rates fall significantly. The picture for SOEs is even more dire: leverage is extremely elevated, and a comparison of adjusted return on assets to borrowing costs suggests that the marginal operating gain from debt has become negative. This suggests that further leveraging of SOEs could push them into a debt trap and/or shackle the monetary authority's ability to meaningfully raise interest rates. As such, it is actually our expectation that short-term interest rates will rise modestly following a 10% rate on the second round of tariffs (instead of 25%), or if it becomes clear that there will be no third round. If the trade war escalates, however, short-term interest rates would not be expected to rise at all, and the drive to control leverage could be downshifted yet again. Investment Conclusions Chart 9Stay Neutral Towards Chinese Stocks, ##br##And Favor Low-Beta Sectors Stay Neutral Towards Chinese Stocks, And Favor Low-Beta Sectors Stay Neutral Towards Chinese Stocks, And Favor Low-Beta Sectors What does this all mean for our view on the RMB, and what are the implications for Chinese stocks? For now, we can draw the following conclusions: The primary trend for both stock prices and the exchange rate remains captive to negative surprises related to the trade war between the U.S. and China. We would expect further financial market weakness in response to a 25% rate on the second round of tariffs, and especially if President Trump moves forward with plans to tariff the remaining $250 billion of imports from China (the "third round"). Conversely, a 10% second-round tariff rate, or convincing signs that there will be no third round, could soon put a floor under the RMB and stock prices. On this front, the lead-up to a possible meeting between Presidents Trump and Xi in November will be important to monitor. But for now, given our view that the trade war between the U.S. and China is likely to get worse, not better, it remains too early to forecast a durable stabilization in the exchange rate, and an overweight stance towards Chinese equities in absolute terms remains premature. A-shares are deeply oversold and we are watching closely for signs to time a reversal, relative to investable stocks (at least at first). Higher Chinese short-term interest rates are not necessarily negative for stock prices, as long as the rise is modest and not in the context of a further, material uptick in trade tensions between the U.S. and China. While a moderate releveraging scenario would clearly imply a weaker earnings growth outlook than if credit accelerated strongly, earnings growth is still positive and yet Chinese equities are 20-30% off of their 1-year high in local currency terms. Modestly higher interest rates, in the context of durable RMB stability and an end to the escalation of trade threats, is likely to be equity-positive. As we wait for more clarity on the trade outlook, we reiterate our core equity investment recommendations: Investors should maintain no more than a benchmark allocation towards Chinese investable stocks within a global equity portfolio, and should continue to favor low-beta sectors within the investable universe (Chart 9). As always, we will be monitoring developments related to the timing and magnitude of the upcoming export shock, as well as further policymaker responses continually over the coming weeks and months. Stay tuned! Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Pease see China Investment Strategy Weekly Report "In Limbo", dated August 22, 2018, available at cis.bcaresearch.com. 2 Pease see China Investment Strategy Special Report "Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging", dated August 29, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Monetary Policy: Investors should not place much importance on current estimates of NAIRU or the neutral fed funds rate. The Fed will continue to lift rates at a pace of 25 bps per quarter until the economic recovery is threatened, revising NAIRU and neutral rate estimates as necessary. Duration: The spillover from weak global growth into the U.S. will probably cause the Fed to pause its gradual rate hike cycle at some point next year. But with the market priced for only one rate hike in all of 2019, this risk is already in the price. Maintain below-benchmark portfolio duration on a 6-12 month investment horizon. Inflation: Recent rapid increases in year-over-year core inflation will moderate in the coming months, as base effects provide less of a tailwind. But the economic back-drop remains highly inflationary and we expect inflation's uptrend will continue. Investors should maintain an overweight allocation to TIPS versus nominal Treasuries, targeting a range of 2.3% to 2.5% for both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates. Feature Fed Chairman Jerome Powell used his highly anticipated Jackson Hole address to reinforce the theme that has quickly become the hallmark of his tenure.1 Much like at the June FOMC press conference, the Chairman stressed the importance of incorporating uncertainty into the decision-making process.2 Specifically, the uncertainty surrounding real-time estimates of important macroeconomic variables such as the natural rate of unemployment (NAIRU) and the neutral (or equilibrium) fed funds rate. Chart 1The Fed's "Gradual" Rate Hike Cycle The Fed's "Gradual" Rate Hike Cycle The Fed's "Gradual" Rate Hike Cycle Uncertainty Surrounding NAIRU Considering the uncertainty surrounding NAIRU, the Chairman pointed to two specific time periods. The first being the "Great Inflation" of the 1960s and 1970s. In the late 1960s, real-time NAIRU estimates suggested that the unemployment rate was only slightly below its natural level, meaning that inflationary pressures were thought to be relatively muted (Chart 2). That expectation led policymakers to maintain an accommodative monetary policy that fueled the inflation of the 1970s. In Powell's view, the policy error was placing too much faith in real-time estimates of NAIRU, which with hindsight have been heavily revised (Chart 2, bottom panel). Chart 2Real-Time NAIRU Estimates Are Often A Poor Guidepost For Policymakers Real-Time NAIRU Estimates Are Often A Poor Guidepost For Policymakers Real-Time NAIRU Estimates Are Often A Poor Guidepost For Policymakers The second period Powell discusses is the late 1990s. This period is the opposite of the 1960s in the sense that real-time NAIRU estimates were eventually revised lower (Chart 2). At the time, labor markets were thought to be very tight. But former Fed Chairman Alan Greenspan downplayed real-time NAIRU estimates and kept monetary policy easier for longer than many would have liked. Powell argues that subsequent downward NAIRU revisions vindicated that decision. At present, the unemployment rate of 3.9% is considerably below the Fed's most recent median NAIRU estimate of 4.5% (Chart 3). Complete faith in that NAIRU estimate would suggest that the Fed should be aggressively tightening policy. But as in the 1990s, it is possible that current NAIRU estimates will eventually need to be revised down. Despite seemingly tight labor markets, year-over-year core PCE inflation has still not returned to the Fed's 2% target. This makes future downward NAIRU revisions currently appear more likely than future upward revisions. Chart 3Current Estimates Point To A Very Tight Labor Market Current Estimates Point To A Very Tight Labor Market Current Estimates Point To A Very Tight Labor Market Powell argues that the Fed's "gradual" tightening path - raising the fed funds rate 25 bps per quarter - is a way of splitting the difference. The process of lifting rates acknowledges the current NAIRU estimate, while the relatively slow pace hedges the risk that it turns out to be too high. Uncertainty Surrounding The Neutral Rate Chart 4Growth At Odds With The Yield Curve Growth At Odds With The Yield Curve Growth At Odds With The Yield Curve Other than NAIRU, policymakers must also deal with the concept of the neutral (or equilibrium) fed funds rate. This is the interest rate that will keep the economy growing at its potential, leading to neither inflationary nor deflationary pressures. At the moment, most FOMC participants think the longer-run neutral rate is somewhere between 2.75% and 3% (in nominal terms). If this is correct, it means that the Fed's current 25 bps per quarter rate hike pace will cause the funds rate to reach neutral by the middle of next year. This is illustrated by the shaded grey boxes in Chart 1. If we assume complete confidence in the current estimate of the neutral rate, it is obvious that unless inflation significantly overshoots the 2% target, the Fed should halt its tightening cycle next year when the funds rate hits neutral. In fact, some FOMC members are advocating for at least a pause. Dallas Fed President Robert Kaplan recently said that when the fed funds rate reaches the current estimate of neutral: I would be inclined to step back and assess the outlook for the economy and look at a range of other factors - including the levels and shape of the Treasury yield curve - before deciding what further actions, if any, might be appropriate.3 However, the importance Powell places on uncertainty makes us think that any such pause would be very brief, if it occurs at all. In a recent report we showed that while the slope of the yield curve is consistent with a monetary policy that is already close to neutral, economic indicators do not corroborate this message (Chart 4).4 Bottom Line: Investors should not place much importance on current estimates of NAIRU or the neutral fed funds rate. The Fed will continue to lift rates at a pace of 25 bps per quarter until the economic recovery is threatened, revising NAIRU and neutral rate estimates as necessary. Heading For A Slowdown? The catalyst that could actually derail the Fed's rate hike cycle would be a meaningful slowdown in U.S. economic growth. In this regard, we observed in a recent report that current weakness outside of the U.S. is likely to spill over.5 Since 1993, every time the Global (ex. U.S.) Leading Economic Indicator (LEI) has fallen below zero, the U.S. LEI has eventually followed (Chart 5). Is there any reason to believe that this time might be different? One reason for optimism is that the Eurozone has been the main driver of the year-to-date slowdown in the Global Manufacturing PMI (Chart 6). This is encouraging because while Eurozone growth has certainly slowed, the PMI remains at a high level, well above the 50 boom/bust line. Further, recent data have shown some stabilization. The PMI is falling less rapidly than earlier in the year and broad money growth has picked up (Chart 7, top panel). However, weakness in China and emerging markets could easily swamp any positive impulse out of Europe. Though indicators of current economic activity in China appear in good shape, leading indicators and the imposition of tariffs point to weakness ahead (Chart 7, panel 2). Chinese policymakers have taken some steps to ease monetary conditions (Chart 7, bottom panel), but it remains unclear whether that will be sufficient to maintain current growth rates. Chart 5Global Growth Could Bring Down The U.S. Global Growth Could Bring Down The U.S. Global Growth Could Bring Down The U.S. Chart 6Weakness Due To Eurozone Weakness Due To Eurozone Weakness Due To Eurozone Chart 7The Biggest Risk Is From China The Biggest Risk Is From China The Biggest Risk Is From China Our assessment is that it is highly likely that weak global growth will eventually filter into the States. This will cause the Fed to pause its 25 bps per quarter tightening cycle at some point next year. However, applying Chairman Powell's uncertainty doctrine to our investment strategy, we must weigh this risk against what the market is already discounting. Chart 1 shows that the fed funds futures market is priced for a funds rate of 2.33% by the end of this year and 2.68% by the end of 2019. This means that the market is priced for only a single 25 bps rate hike in 2019, rather than the four we would expect in an environment of no economic hiccups. According to our golden rule of bond investing, we should be reluctant to adopt an above-benchmark portfolio duration stance unless we are confident that Fed rate hikes will come in below expectations over our investment horizon.6 Given that a significant growth slowdown would be required for the Fed to deliver only one hike in 2019, we think below-benchmark portfolio duration is still justified on a 6-12 month horizon. Bottom Line: The spillover from weak global growth into the U.S. will probably cause the Fed to pause its gradual rate hike cycle at some point next year. But with the market priced for only one rate hike in all of 2019, this risk is already in the price. Maintain below-benchmark portfolio duration on a 6-12 month investment horizon. Inflation Update An additional reason why any pause in the Fed's rate hike cycle could prove fleeting is that core inflation is very close to returning to the Fed's 2% target. Trailing 12-month core PCE inflation clocked in at 1.98% in July, while trailing 12-month trimmed mean PCE inflation was 1.99%. Rising inflation is likely the reason that long-dated TIPS breakeven inflation rates have remained stable in recent weeks, even as high-frequency global growth indicators have turned down (Chart 8). Looking ahead, the economic backdrop suggests that monthly inflation prints will continue to be strong. Our Pipeline Inflation Indicator remains elevated, despite the recent decline in commodity prices, and our PCE diffusion index shows that recent price increases have been broadly based (Chart 9). Chart 8Closing In On Target Closing In On Target Closing In On Target Chart 9Macro Environment Is Inflationary Macro Environment Is Inflationary Macro Environment Is Inflationary However, unless month-over-month inflation prints strengthen considerably, we should expect smaller increases in the year-over-year inflation rate going forward, as base effects provide less of a tailwind. To assess how much base effects influence year-over-year inflation rates we created our Core PCE Base Effects Indicator. We constructed the indicator using core PCE growth rates over horizons ranging from 1 to 11 months. We compare each growth rate to the growth rate over the next longest interval and increase the indicator's value by 1 each time a shorter-interval growth rate exceeds a longer-interval growth rate. In other words, we compare the 1-month growth rate in core PCE to the 2-month growth rate. If the 1-month growth rate is above the 2-month growth rate, we add 1 to our indicator. We then compare the 2-month growth rate to the 3-month growth rate, and so on. This gives us an indicator that ranges between 0 and 11. Chart 10 shows that when our Base Effects Indicator is elevated it usually means that year-over-year core PCE inflation will rise during the next six months, and vice-versa. We also observe that the cut-off point between positive and negative base effects is between 5 and 6. That is, when our indicator is at 6 or above, base effects bias the year-over-year core PCE inflation rate higher. Base effects tend to drag year-over-year inflation lower when our Indicator gives a reading of 5 or below. Chart 11 demonstrates the impact of base effects in more detail. The chart presents the median, first quartile and third quartile of 6-month changes in year-over-year core PCE inflation for each possible reading from our indicator. The median inflation change is positive for readings of 6 and above, and negative for readings of 5 and below. Chart 10Base Effects Now Less Of A Tailwind Base Effects Now Less Of A Tailwind Base Effects Now Less Of A Tailwind Chart 11The BCA Base Effects Indicator Tested (1960 - Present) The Powell Doctrine Emerges The Powell Doctrine Emerges In recent months, the reading from our Base Effects Indicator had been at 8, suggesting a very strong tailwind pushing the year-over-year growth rate in core PCE higher. But following last week's July PCE release our indicator fell to 6, suggesting only a mild positive impact from base effects going forward. Bottom Line: Recent rapid increases in year-over-year core inflation will moderate in the coming months, as base effects provide less of a tailwind. But the economic back-drop remains highly inflationary and we expect inflation's uptrend will continue. Investors should maintain an overweight allocation to TIPS versus nominal Treasuries, targeting a range of 2.3% to 2.5% for both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 https://www.federalreserve.gov/newsevents/speech/powell20180824a.htm 2 Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty", dated June 19, 2018, available at usbs.bcaresearch.com 3 https://www.bloomberg.com/news/articles/2018-08-21/fed-s-kaplan-inclined-to-reassess-rates-amid-yield-curve-angst 4 Please see U.S. Bond Strategy Weekly Report, "Tracking The Two-Stage Treasury Bear", dated August 14, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Special Report, "The Golden Rule Of Bond Investing", dated July 24, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights We decompose the fed funds rate cycle into four phases based on the interaction between the level of the fed funds rate and its direction to examine monetary policy's impact on equities. The policy backdrop matters for equity returns. All of the S&P 500's price gains over the last six decades have accrued while policy settings have been accommodative. From a policy perspective, equities have been in an extended sweet spot ever since the Fed began aggressively cutting rates to combat the crisis. We estimate that they will remain there for close to another year. The fed funds rate cycle is only one of the variables we consider when calibrating investment strategy. Its bullish message faces resistance from decelerating growth, full valuations, and trade tensions between China and the U.S. The net impact of the individual crosscurrents is subject to spirited debate within BCA. Feature You really can't fight the Fed. As longtime U.S. Investment Strategy readers know, the fed funds rate cycle has been a consistently robust predictor of the direction and magnitude of equity returns. Over nearly six decades, the S&P 500 has risen at a 10% annualized clip when policy is easy; it's scratched out just a percentage point a year when it's tight. Adjusted for inflation, the easy/tight performance disparity has been even wider. In this Special Report, we update and revise the full-scale analysis we first performed nearly five years ago. In this iteration, we evaluate performance for each phase of the cycle on the basis of chained aggregate returns, rather than in terms of means and medians. That tweak expands our sample size to 685 months from 60 cycle phases, and eliminates the individual phases' sensitivity to short-term outliers. We have also revised the demarcation of the cycle phases to correct for a flaw in our historical effective fed funds rate data feed.1 The Fed Funds Rate Cycle We decompose the fed funds rate cycle into four phases based on the interaction between the level of rates and their direction, as follows: Phase I represents the early stage of the withdrawal of monetary stimulus. This phase begins with the first rate hike of a new tightening cycle and ends when the fed funds rate crosses above our estimate of the equilibrium rate2 (shown as a dashed line in Chart 1 and Chart 2). Chart 1It's Easiest To Be Easy It's Easiest To Be Easy It's Easiest To Be Easy Chart 2The Fed Funds Rate Cycle Revisiting The Fed Funds Rate Cycle Revisiting The Fed Funds Rate Cycle Phase II represents the latter stages of the tightening cycle, when the Fed hikes its target rate above equilibrium in a deliberate effort to cool an overheating economy. Phase III represents the early stage of the easing cycle. It begins with the first rate cut from the peak and lasts until the Fed cuts its target rate below equilibrium. Phase IV represents the late stage of the easing cycle. It encompasses both the period when the fed funds rate breaks below its equilibrium level, and the subsequent adjustment period when the Fed remains on hold at the cycle trough in an effort to kick start an economic recovery. What Is The Equilibrium Fed Funds Rate? The equilibrium fed funds rate is the policy rate that neither encourages nor discourages economic activity. That is a simple enough idea, but we note that the equilibrium rate is just a concept. No one can put a blood pressure cuff around the economy's arm, or stick a thermometer in its mouth, to determine the rate objectively and precisely. Our equilibrium rate, which uses potential GDP growth to adjust a smoothed and filtered long-run series of the actual fed funds rate, is simply the modeled estimate of a concept. Why Bother Pursuing Such Elusive Quarry? 70 years ago, BCA sprang from our founder's insight that investors might be able to intuit a good deal about the future direction of the economy and financial markets by studying the flow of credit through the banking system. The Bank Credit Analyst owes its name and existence to the proposition that money flows matter. Tracking monetary conditions is in our DNA, and the fed funds rate is the foremost input into standard monetary conditions models. The empirical record suggests that the monetary backdrop holds such powerful sway over financial markets that tracking the equilibrium rate's relationship to the actual fed funds rate is worthwhile even if our ability to pin it down in real time is limited. Stocks And The Fed Funds Rate Cycle History convincingly demonstrates that the monetary backdrop matters, and that the level of rates (accommodative or restrictive) exerts far more influence on equity returns than their direction (higher or lower). Table 1 presents annualized price returns for the S&P 500 by fed funds cycle phase for the nearly 60 years covered by our equilibrium fed funds rate estimate. When policy is easy, as in Phases I and IV, the S&P has appreciated at a 10% annual rate; when it's tight, as in Phases II and III, it's barely advanced. Table 2 adjusts the nominal returns for inflation, making the easy/tight policy divide even starker - in real terms, the S&P 500 has lost considerable ground when the fed funds rate has exceeded our estimate of equilibrium. Table 1Tight Policy Is Hazardous To Stocks' Health, ... Revisiting The Fed Funds Rate Cycle Revisiting The Fed Funds Rate Cycle Table 2... Especially In Real Terms, ... Revisiting The Fed Funds Rate Cycle Revisiting The Fed Funds Rate Cycle Estimated Earnings And Forward Multiples Although overall equity returns are a function of the level of rates, their underlying components - earnings growth and the multiple investors are willing to pay for future earnings - are more sensitive to rates' direction. Earnings estimates are directly related to rate moves - they rise more when rates rise than they do when rates fall (Table 3). The direct relationship follows from the countercyclical nature of monetary policy. If the Fed is cutting rates, it must anticipate a softer growth environment in which estimates should be revised lower, whereas if it's hiking them, it must foresee such robust growth that it fears the economy could overheat. Table 3... But Earnings Thrive When The Fed Hikes Revisiting The Fed Funds Rate Cycle Revisiting The Fed Funds Rate Cycle Multiples are inversely related to the direction of rates; they contract in the aggregate when rates rise, and expand when they fall (Table 4). Although multiples are constrained by their mean-reverting properties, their movement around the mean adheres to a tidal pattern: ebbing when the Fed's trying to rein in the economy with rate hikes (and future earnings are subject to an increasing discount factor), and rising when it's trying to give it a boost (and the discount factor is falling). Multiples' action vis-à-vis the rate cycle suggests that they are forward-looking - moving in accordance with the Fed's intentions - while estimates are backward-looking, primarily extrapolating from actual results. In terms of S&P 500 returns, estimates' and multiples' tendency to counter one another when policy is tight has maintained the overall easy/tight dynamic over the four decades covered by forward earnings data (Table 5). Table 4Stocks De-Rate When Rates Rise, ##br##And Re-Rate When They Fall Revisiting The Fed Funds Rate Cycle Revisiting The Fed Funds Rate Cycle Table 5A Rising Tide Lifts All Boats, But Easy Phases Still Lead The Way Revisiting The Fed Funds Rate Cycle Revisiting The Fed Funds Rate Cycle Why Does The Fed Funds Rate Cycle Work? For all of its import, monetary policy is a blunt instrument that works with indeterminate lags. Its shortcomings heavily influence the way the Fed deploys it, and impose a predictable pattern on its economic and market impacts. In this analysis we focus on the Fed's inability to make targeted, precise adjustments; its uncertainty over when its effects will take hold; and its mandate's explicit focus on managing inflation, a lagging indicator. All of these factors come into play when the Fed embarks on a rate-hiking campaign, kicking off a new iteration of the policy rate cycle. New rate cycles begin from the previous cycle's trough level, when the Fed's primary concern is to avoid revisiting the adversity that inspired accommodation. It does not want to induce a double-dip by being too aggressive, especially when inflation readings are tame (Table 6). The Fed does not begin Phase I, or proceed very far with it, until it is all but certain that the economy can withstand higher rates. It therefore predictably embarks upon Phase I with a bias to err on the side of being too easy. Table 6Has The Tail Been Wagging The Dog? Revisiting The Fed Funds Rate Cycle Revisiting The Fed Funds Rate Cycle This bias gives the economy a chance to build up momentum in Phase I, consonant with a cycle peak in earnings growth (Chart 3, third panel). In markets, that momentum helps to feed meaningful excess returns in spread product,3 and sizable outperformance among late-cyclical equity sectors at home and abroad,4 as well as outsized returns in the S&P 500. Left unchecked, the momentum could promote higher inflation. Inflation can move stealthily because of its lagging nature, and the Fed is often compelled to intervene forcefully to counter it. Chart 3Monetary Policy Matters, A Lot Monetary Policy Matters, A Lot Monetary Policy Matters, A Lot Forceful intervention brings about Phase II of the cycle, when economic activity may still be expanding at a good clip, as indicated by double-digit earnings growth. Wielding a blunt instrument that works with a lag, however, the Fed is at risk of going too far, and Phase II hikes often induce a recession. Investors begin to sniff out the looming downturn and de-rate equities. By the time the Fed backs off and initiates a new easing campaign (Phase III), earnings growth has stalled out and measured inflation is peaking (Chart 3, bottom panel). Equities mark time (Chart 3, first and second panels) and spread product generates negative excess returns until, with the recession plainly evident and measured inflation sliding, there is nothing stopping the Fed from full-on accommodation (Phase IV), and it maintains market-friendly settings until the economy begins to look too strong, and the Fed intervenes to hold it back (Phase II). This stylized example focused on the Fed and markets, but monetary policy impacts all aspects of the real economy. Consumer demand for homes and other durable goods that have to be financed, along with businesses' appetite for investment, are keenly sensitive to monetary conditions. There is a powerful self-reinforcing dynamic that joins corporate earnings, business expansion and hiring, and consumption. The links between equity performance and the fed funds rate cycle are real and lasting. Investment Implications In its current setting, the fed funds rate cycle is issuing a risk-friendly signal. Even if it were our only guide to asset allocation and investment strategy, however, we would need to heed a couple of caveats before rushing out to overweight equities and other risk assets. First of all, estimates of the equilibrium fed funds rate are notoriously imprecise - equilibrium is a concept that can only be observed after the fact. Secondly, there is no guarantee that asset returns in this iteration of the fed funds rate cycle will continue to hew closely to the historical record. Following 10-plus years of accommodation, equity valuations are at fairly demanding levels. We continue to have a constructive view of the business, market and policy cycles, but the current environment carries significant risks. Activity is broadly decelerating outside of the U.S., public-market valuations are full nearly everywhere around the world, and the unsettled trade picture has the potential to upend financial markets. BCA is closely monitoring China to see whether or not it will provide monetary or fiscal stimulus that might help mitigate the forces threatening to undermine global trade and the economies that rely upon it. We remain on hold, recommending a benchmark equity allocation, while underweighting bonds and overweighting cash, in line with the house view. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 A bug in our third-party provider's conversion of daily effective fed funds rate data into monthly data slightly skewed our previous phase definitions. 2 Potential GDP growth is the key input to our model estimating the equilibrium policy rate level. 3 Please see the May 27, 2014 U.S. Investment Strategy Special Report, "Bonds and the Fed Funds Rate Cycle." Available at usis.bcaresearch.com. 4 Please see the July 3, 2017 Global ETF Strategy Model Portfolios Review, "Overhauling the U.S. Equity Exposures," and the May 11, 2018 Global Alpha Sector Strategy Special Report, "Global Equity Sectors and the Fed Funds Rate Cycle."Available at getf.bcaresearch.com and gss.bcaresearch.com.

Highlights We remain bullish on the dollar, but no longer think that being long the greenback is the "slam-dunk" trade that it was earlier this year. A reacceleration in growth outside the U.S. and an overly dovish Fed represent the biggest risks to our constructive dollar view. China is likely to stimulate its economy, but concerns about high debt levels and malinvestment will limit the scale of any fiscal/credit stimulus. Letting the RMB slide may prove to be the preferable option. Worries about debt sustainability in Italy and EM contagion to European banks will constrain credit growth in the euro area, thus keeping the ECB in a highly dovish mode. For the time being, we favor developed market stocks over their EM peers. At the sector level, we would overweight defensives relative to deep cyclicals. U.S. stocks will outperform European stocks in dollar terms, although the performance is likely to be much more balanced in local-currency terms. The longer-term path for Treasury yields is to the upside. Nevertheless, a stronger dollar, coupled with safe-haven flows into the Treasury market, could temporarily push the 10-year yield down to 2.5% over the next few months. Feature The Dollar At A Crossroads After surging by 10% between February 1st and August 15th, the broad trade-weighted dollar has fallen by 0.9% over the past two weeks. Despite the latest setback, the greenback is still 23.2% above its 2014 lows and only 2.8% below its December 28, 2016 high (Chart 1). BCA continues to maintain a bullish view on the dollar. However, given recent market action, it is useful to stress-test our thesis in order to explore what could go wrong with it. As we discuss below, a key risk to the dollar is that global growth reaccelerates, with the U.S. once again going from leader to laggard in the global growth horserace. Global Growth And The Dollar The dollar tends to strengthen when global growth is deteriorating. Since the U.S. is a "low-beta" economy dominated by services rather than manufacturing and primary industries, an environment in which the global economy is slowing is usually one where the U.S. is outperforming the rest of the world. Chart 2 shows that there is a strong correlation between the value of the trade-weighted dollar and the difference between The Conference Board's U.S. Leading Economic Indicator (LEI) and the non-U.S. LEI. The gap between the U.S. and the non-U.S. LEI is still quite large. However, it has started to shrink recently, reflecting both a dip in the U.S. LEI as well as a small improvement in the non-U.S. LEI. The implication is that the U.S. economy is outshining the rest of the world, but the magnitude of outperformance has begun to narrow. Looking forward, the fate of the dollar will hinge on whether growth in the rest of the world can catch up with the United States. By definition, this can happen either if U.S. growth falls or non-U.S. growth rises. We examine each possibility in turn. Chart 1Despite Recent Pullback, ##br##The Dollar Is Still Close To Its 2016 High Despite Recent Pullback, The Dollar Is Still Close To Its 2016 High Despite Recent Pullback, The Dollar Is Still Close To Its 2016 High Chart 2The U.S. Economy Is Still Outperforming The Rest Of The World, But The Gap Is Starting To Narrow The U.S. Economy Is Still Outperforming The Rest Of The World, But The Gap Is Starting To Narrow The U.S. Economy Is Still Outperforming The Rest Of The World, But The Gap Is Starting To Narrow U.S. Growth: As Good As It Gets? The second quarter was probably the high watermark for U.S. growth for the rest of this cycle. Real GDP expanded by 4.2%, more than double most estimates of trend growth. The deceleration in payroll growth in July, a string of weak housing data releases, and the drop in the national ISM surveys alongside declines in a number of regional surveys such as the Philly Fed PMI, all point to a somewhat softer third quarter GDP growth reading. How worried should dollar bulls be? We see three reasons to downplay the negative impact on the dollar from the recent string of softer economic data. While the U.S. economy has slowed, it is still quite strong. The Bloomberg consensus forecast suggests that real GDP will increase by 3% in Q3. The Atlanta Fed's GDPNow model predicts 4.1% growth, while the New York Fed's Nowcast anticipates a more modest growth rate of 2%. The underlying drivers of aggregate demand remain supportive. U.S. financial conditions have loosened recently, thanks mainly to narrower credit spreads and higher equity prices (Chart 3). The effects of fiscal stimulus have also yet to make their way fully through the economy, especially with respect to government spending. The consumer is in great shape. The unemployment rate is near a 20-year low and the savings rate stands at a comfortable 6.7%, well above the level that the current ratio of household net worth-to-disposable income would predict (Chart 4). The housing vacancy rate is close to all-time lows, which limits the downside risk both to home prices and construction activity (Chart 5). Chart 3U.S. Financial Conditions Have Eased Recently U.S. Financial Conditions Have Eased Recently U.S. Financial Conditions Have Eased Recently Chart 4The Savings Rate Has Room To Fall The Savings Rate Has Room To Fall The Savings Rate Has Room To Fall Some of the apparent slowdown in U.S. growth appears to be due to intensifying supply-side constraints rather than faltering demand (Chart 6). This is important because slower growth resulting from weaker demand should, in principle, cause the Fed to moderate the pace of rate hikes, whereas slower growth resulting from an overheated economy should prompt the Fed to accelerate the pace of rate hikes. The latter is much better for the dollar than the former. Chart 5Low Housing Inventories Will ##br##Support Home Prices And Construction Low Housing Inventories Will Support Home Prices And Construction Low Housing Inventories Will Support Home Prices And Construction Chart 6U.S. Economy Is Hitting Supply-Side ##br##Constraints U.S. Economy Is Hitting Supply-Side Constraints U.S. Economy Is Hitting Supply-Side Constraints The Fed's Fate Is In The Stars What is true in principle, however, does not always match what happens in practice. In his Jackson Hole address, Jay Powell invoked a Draghi-esque phrase when saying that the FOMC would "do whatever it takes" to keep inflation expectations from becoming unmoored.1 Nevertheless, he also said that "there does not seem to be an elevated risk of overheating" at the moment. This is a curious statement considering the abundant evidence that U.S. firms are struggling to find qualified workers. To his credit, Powell stressed the inherent difficulty of "navigating by the stars," that is, of setting monetary policy based on highly imprecise estimates of the natural rate of unemployment, u*, and the neutral real rate of interest, r*. What he did not say is that the Fed's current estimates of these "stars" stand at record lows, which introduces a dovish bias into monetary policy should these estimates prove to be too low. Our baseline view is that the Federal Reserve will raise rates more than the market is currently discounting. We also doubt the Fed will succumb to President Trump's pressure to keep rates low or to accommodate any effort by the Treasury to intervene in the foreign exchange market with the aim of driving down the value of the dollar. That said, the risk to this view is that the Fed reacts too slowly to rising inflation. This could cause real rates to drift lower, with adverse consequences for the dollar. The China Policy Wildcard The discussion above suggests that the dollar would suffer either if U.S. growth slows significantly or if the Fed falls too far behind the curve in normalizing monetary policy. An additional risk to the dollar is that growth outside the U.S. picks up. This would suck capital away from the U.S. and into the rest of the world, with adverse consequences for the greenback. At present, the biggest question mark around the global growth outlook concerns China. The Chinese economy has struggled of late, with trade tensions adding to the misery (Chart 7). The stock market is down in the dumps. On-shore corporate yields for low-quality borrowers continue to rise. Industrial production, retail sales, and fixed asset investment all disappointed in July, following a further drop in the PMIs. The economic surprise index remains in negative territory. Only the housing market is showing renewed vigour, with both starts and sales rebounding (Chart 8). Chart 7China: Some Signs Of A Struggling Economy... China: Some Signs Of A Struggling Economy… China: Some Signs Of A Struggling Economy… Chart 8...With Housing Being The Main Exception ...With Housing Being The Main Exception ...With Housing Being The Main Exception The central bank has responded by easing liquidity. Interbank rates fell from a peak of 5.9% in late 2017 to 2.9% today. The authorities have also instructed local governments to expedite their spending plans, while ordering state-owned banks to expand lending to the export sector and for infrastructure-related projects. Fiscal/credit stimulus of the sort the authorities engaged in both 2009 and 2015 carries significant risks, however. Debt levels have reached stratospheric levels and concerns about excess capacity and malinvestment abound. We suspect these facts will cause policymakers to be more guarded than they would otherwise be. What's Next For The RMB? Letting the RMB weaken offers an alternative way to stimulate the economy - and one, crucially, that does not require piling on evermore debt. In contrast to more roads and bridges, a cheaper Chinese currency would not be welcome news for the rest of the world. A weaker RMB makes it more difficult for other economies to compete against China. A weaker currency also increases the costs to Chinese firms of importing raw materials, thus putting downward pressure on commodity prices. Despite efforts by emerging markets to diversify their economies, EM earnings remain highly correlated with industrial metals prices (Chart 9). Despite the presence of capital controls, the USD/CNY exchange rate has broadly tracked the one-year swap differential between the U.S. and China over the past few years (Chart 10). The differential has dropped from close to 300 basis points at the beginning of this year to less than 100 basis points today. Given that prospect of further Fed rate hikes, the only way the Chinese authorities will be able to keep the interest rate differential from falling even more is by tightening monetary policy themselves. This could slow credit growth and thus weaken the economy. The failure to raise rates, however, would probably cause the RMB to fall further. Both outcomes would be problematic for the rest of the world. Chart 9EM Earnings Are Correlated ##br##With Industrial Metal Prices EM Earnings Are Correlated With Industrial Metal Prices EM Earnings Are Correlated With Industrial Metal Prices Chart 10USD/CNY Tracks China-U.S. ##br##Interest Rate Differentials USD/CNY Tracks China-U.S. Interest Rate Differentials USD/CNY Tracks China-U.S. Interest Rate Differentials Our bet is that the authorities will ultimately choose to keep domestic monetary conditions fairly easy - leading to a weaker RMB - but will use administrative controls to prevent credit growth from accelerating too rapidly. That said, we would not rule out the possibility that the authorities succeed in stimulating the economy in a way that precludes further currency weakness. If this stimulus coincides with a thawing in trade tensions, it could lead to a burst in optimism about China specifically, and global growth in general. Such an outcome would hurt the dollar. The Euro Area: Keeping The Recovery On Track After putting in a strong performance in 2017, the economy in the euro area has struggled to maintain momentum this year. Growth is still above trend, but the overall tone of the data has been lackluster at best, with the risks to growth increasingly tilted to the downside. Weaker growth in China and other emerging markets certainly has not helped. However, much of the problem lies closer to home. The election of a populist government in Italy renewed concerns about debt sustainability in the euro area's third largest economy. The 10-year yield reached a four-year high of 3.2% this week. It is now 150 basis points above its April 2018 lows (Chart 11). The resulting tightening in Italian financial conditions will continue to weigh on growth in the months ahead. Bank credit remains the lifeblood of the euro area economy. Chart 12 shows that the 12-month credit impulse - defined as the change in credit growth from one 12-month period to the next - tends to move closely with GDP growth. Euro area credit began to moderate this year even before the Italian imbroglio and worries about the exposure of European banks to vulnerable emerging markets came on the scene. It will be difficult for euro area GDP growth to accelerate unless credit growth revives. In the absence of faster credit growth, the ECB will have little choice but to remain firmly in dovish mode. Chart 11Italian Populism Meets The Bond Market Italian Populism Meets The Bond Market Italian Populism Meets The Bond Market Chart 12Euro Area Credit Growth Has Flatlined Euro Area Credit Growth Has Flatlined Euro Area Credit Growth Has Flatlined The best-case scenario for the common currency is that EM stresses subside, and the Italian government reaches a friendly agreement with the European Commission over next year's budget. The thawing in Brexit negotiations would also help. We are skeptical that any of these three things will happen, but if one or a number of them did occur, this would benefit the euro at the expense of the dollar. Investment Conclusions We are not as bullish on the dollar as we were earlier this year. Sentiment towards the greenback has clearly improved (Chart 13). The narrative about a "synchronized global growth recovery" that was all the rage last year has also given way to a more sober appreciation of the problems facing emerging markets. In short, markets have moved a long way towards our view of the world. Still, we are not ready to abandon our strong dollar view. Chinese stimulus or not, the structural challenges facing emerging markets - high debt levels, poor productivity growth - will not go away. The same goes for Europe and its litany of political and economic travails. Even if the dollar did manage to weaken again, this would constitute an unwelcome easing in U.S. financial conditions at a time when the Fed wants to tighten financial conditions in order to keep the economy from overheating. From this perspective, a weaker dollar just means that the Fed would need to hike rates even more than it otherwise would. Since more rate hikes will buttress the dollar, the extent to which the dollar can weaken is self-limiting. In short, interest rate differentials between the U.S. and its trading partners should continue to favor the greenback. Assuming the dollar does strengthen from here, emerging markets will be the main casualties. While EM assets have cheapened considerably, Chart 14 shows that neither EM equities, credit, nor currencies are at levels that have marked past bottoms. Global investors should continue to favor developed market stocks over their EM peers. At the equity sector level, investors should overweight defensives over deep cyclicals. Regionally, this posture implies that U.S. stocks will outperform European stocks in dollar terms, although the performance is likely to be much more balanced in local-currency terms. Chart 13Investors Have Turned More Bullish On The Dollar Investors Have Turned More Bullish On The Dollar Investors Have Turned More Bullish On The Dollar Chart 14EM Assets Are Not Very Cheap EM Assets Are Not Very Cheap EM Assets Are Not Very Cheap As we recently discussed in a two-part Special Report,2 the longer-term path for Treasury yields is to the upside. Nevertheless, a broad-based appreciation in the value of the dollar, coupled with safe-haven flows into the Treasury market, could temporarily push the 10-year yield down to 2.5% over the next few months. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Jerome H. Powell, "Monetary Policy in a Changing Economy," Speech at "Changing Market Structure and Implications for Monetary Policy," a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 24, 2018. 2 Please see Global Investment Strategy Special Reports, "1970s-Style Inflation: Could It Happen Again? (Part 1)," dated August 10, 2018; "1970s-Style Inflation: Could It Happen Again? (Part 2)," dated August 24, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Barring government interference in foreign exchange markets, the path of least resistance for the U.S. dollar is up. The U.S. Treasury has authority to intervene unilaterally in foreign exchange markets. However, conditions for effective interventions to weaken the dollar exist neither within nor outside the U.S. For the time being, central banks in Europe, Japan, and China will not cooperate with the U.S. to depreciate the dollar. The Federal Reserve will effectively team up with the U.S. Treasury to depreciate the greenback only if economic conditions in the U.S. warrant a weaker currency. This is not currently the case. In this context, the dollar will continue to appreciate, but its rally will be accompanied by substantially higher volatility as the U.S. administration aggressively "talks down" the dollar. To capitalize on this theme, traders should consider going long dollar volatility. A firm dollar is consistent with continuous turmoil in EM financial markets. We continue to recommend staying put on EM. Feature Chart I-1U.S. Core Inflation Will Rise Further U.S. Core Inflation Will Rise Further U.S. Core Inflation Will Rise Further Economics and politics are set for a major clash in foreign exchange markets. Economic fundamentals and crosscurrents worldwide herald U.S. dollar appreciation. Yet, U.S. President Donald Trump wholeheartedly opposes any dollar strength. The higher the greenback rises, the more forceful Trump's jawboning about the exchange rate and interest rates will become. If the dollar does not halt its advance and overshoots, the odds are material that at a certain point the U.S. Treasury will initiate currency market interventions itself. It would do so by selling dollars and buying foreign assets. What will be the outcome of this battle between economics and politics in financial markets? The conclusion of this report is that for government-led currency market interventions to be effective in reversing the dollar's uptrend, the U.S. administration will have to convince the Federal Reserve to cease rate hikes and balance sheet contraction. Without the Fed recalibrating policy to be more consistent with a weaker dollar, the U.S. Treasury may not succeed in weakening the greenback on a sustainable basis. Given core consumer price inflation in the U.S. will likely surprise to the upside (Chart I-1), the Fed will not be willing to halt its tightening campaign. Hence, it will take time for the U.S. administration to wrestle and convince the Fed to accommodate currency interventions in efforts to weaken the greenback. In the meantime, the dollar will likely continue its volatile ascent. The Dollar Will Rally If Left To Market Forces Based on economic fundamentals, the path of least resistance for the greenback is up - for now. U.S. growth and inflation warrant higher interest rates, and the Fed is willing to continue moving short rates higher. In contrast, the unfolding EM/China slowdown is not only negative for their own respective currencies but is also harmful for commodities currencies in the advanced economies. Besides, the German and Japanese economies are much more vulnerable to a slowdown in EM/China than the U.S. (Chart I-2). Consistently, Chart I-3 illustrates that outperformance by the equal-weighted U.S. stock index versus its global peers in local currency terms - a measure of relative domestic demand - still points to a stronger U.S. dollar. On the whole, the growth and interest rate differentials between the U.S. and the rest of the world will likely continue to move in favor of the former and extend the dollar rally. Chart I-2Germany and Japan Are Much More Exposed ##br##To EM/China Than To The U.S. Germany and Japan Are Much More Exposed To EM/China Than To The U.S. Germany and Japan Are Much More Exposed To EM/China Than To The U.S. Chart I-3Relative Share Prices Point ##br##To A Firmer Dollar Relative Share Prices Point To A Firmer Dollar Relative Share Prices Point To A Firmer Dollar The dollar is typically a counter-cyclical currency. It depreciates when global trade is improving and appreciates when the global business cycle is slowing (the dollar is shown inverted on this chart) (Chart I-4). Odds are that global trade will continue to decelerate due to the slowdown in EM/China and trade protectionism - even if U.S. domestic demand growth remains robust. Furthermore, U.S. trade protectionism is positive for the dollar. The basis is that exporters to the U.S. could opt for weaker currencies to offset the negative impact of tariffs on their local currency revenues. Financial markets are often self-regulating, and they move to rebalance the global economy and amend economic excesses. A stronger dollar is the right medicine for the global economy for now. A firmer dollar is required to rebalance growth away from the U.S. and towards the rest of the world. In particular, dollar appreciation is needed to cap budding U.S. inflationary pressures. In addition, a stronger greenback will compel unraveling of excesses within the developing economies. While it will cause growth retrenchment and will be painful for EM in the medium term, cheapened currencies and deleveraging (an unwinding of credit excesses) will ultimately create a foundation for stronger and healthier growth in the years ahead. U.S. dollar liquidity is tightening, supporting the greenback (the latter is shown inverted on this chart) (Chart I-5). Continued shrinkage of the Fed's balance sheet entails tighter U.S. dollar liquidity going forward. With respect to currency market technicals, the broad trade-weighted U.S. dollar is not yet overbought, and trader sentiment on the U.S. currency is not extremely bullish (Chart I-6). Hence, conditions for an ultimate cyclical top in the dollar do not yet exist. Chart I-4The Global Business Cycle and The Dollar The Global Business Cycle and The Dollar The Global Business Cycle and The Dollar Chart I-5Upside Risks To The Dollar bca.ems_sr_2018_08_30_s1_c5 bca.ems_sr_2018_08_30_s1_c5 Chart I-6The Dollar: Market Technicals The Dollar: Market Technicals The Dollar: Market Technicals Finally, the U.S. dollar is not expensive. Our favored currency valuation measure - the real effective exchange rate-based on unit labor costs - currently suggests that the greenback is only slightly above its fair value (Chart I-7). This measure is superior to the real effective exchange rate based on consumer and producer prices because it considers both wages and productivity. Ultimately, competitiveness is not a function of wages (or prices) but wages adjusted for productivity.1 Besides, labor costs typically constitute the largest share of business costs. Hence, the unit labor cost-based real effective exchange rate is the best measure of currency competitiveness. This currency valuation yardstick does not corroborate the widely circulating narrative in the investment community that the U.S. currency is very expensive. The greenback is also not expensive according to the real broad trade-weighted dollar index. The latter is only slightly above its historical mean, and well below its previous highs (Chart I-8). Chart I-7AThe Dollar Is Not Expensive The Dollar Is Not Expensive The Dollar Is Not Expensive Chart I-7BThese Currencies Are Expensive These Currencies Are Expensive These Currencies Are Expensive Chart I-8Trade-Weighted Dollar in Real Terms Trade-Weighted Dollar in Real Terms Trade-Weighted Dollar in Real Terms To be sure, we are not implying the dollar is cheap. It is not. Rather, our point is that the greenback is not yet expensive. When valuations are not extreme, they usually do not prevent a rally or selloff. Odds are that the dollar could become more expensive in this cycle before topping out. Bottom Line: Barring government interference in foreign exchange markets, the path of least resistance for the U.S. dollar is up. The Main Risk To The Dollar Is Trump Chart I-9U.S. Monetary Conditions Are ##br##About To Become Tight U.S. Monetary Conditions Are About To Become Tight U.S. Monetary Conditions Are About To Become Tight Will the U.S. administration invoke the "nuclear" option - currency market interventions - to eclipse the dollar's fundamentals and reverse the greenback's rally? President Trump fiercely opposes a stronger dollar. He prefers a structurally weaker currency to bring back manufacturing jobs to the U.S. Besides, from a cyclical perspective, President Trump has been explicit that higher U.S. interest rates and a stronger dollar are negating his economic stimulus. Trump's worry is that tightening monetary conditions, if they persist, will depress growth by late 2019 when the next presidential election season begins in earnest (Chart I-9). President Trump is a genuine economic populist and is ready to cross boundaries that many presidents refused to. This leaves us little doubt that the U.S. administration will escalate its calls both for a weaker currency and a halt in Fed tightening. The U.S. Treasury is in charge of foreign exchange policy, and it can intervene in currency markets. The Fed can, but is not obliged by law, to supplement the Treasury's interventions in foreign exchange markets. In theory, the U.S. Treasury has a special fund (the Exchange Stabilization Fund) and could opt for unilateral currency market interventions even if the Fed does not cooperate. In such a case, a pertinent question is: What are the essential conditions for currency interventions to succeed in reversing the dollar's uptrend? Conditions For Effective Currency Interventions There have been two major interventions conducted by the U.S. authorities to depreciate the dollar: the 1971 Smithsonian Agreement and the 1985 Plaza Accord. BCA's Geopolitical Strategy service has discussed the political and trade backdrops of these interventions in past reports, and we will not detail them here.2 There was also the Louvre Accord in 1987, but it was aimed at propping up the U.S. dollar, not weakening it. All of these interventions were successful and achieved their objective (Chart I-10). We list below the stipulations that secured the success of these interventions and examine whether conditions for effective interventions are present today. Chart I-10The Smithsonian And Plaza Accords Were Successful The Smithsonian And Plaza Accords Were Successful The Smithsonian And Plaza Accords Were Successful Currency interventions accompanied by congruent monetary and fiscal policies tend to be more successful. The previous currency interventions conducted by the U.S. Treasury would not have been successful without the Fed simultaneously adjusting monetary policy. Not only did the Fed join the U.S. Treasury's efforts to depreciate the greenback following the Smithsonian Agreement and the Plaza Accord, but it also altered its monetary policy stance - it pursued a policy of lower-than-otherwise called for real interest rates. Academic literature on this issue is straightforward. Bordo (2010) contends the following about the efficacy of currency interventions: "If intervention were to have anything other than a fleeting, hit-or-miss effect on exchange rates, monetary policy had to support it ... Most of the movements in exchange rates over the Plaza and Louvre period seem attributable to policy changes, not intervention."3 Given current economic conditions in the U.S. economy - a very tight labor market and the prospect of higher inflation - the Fed is unlikely to easily agree to altering its current policy stance to accommodate the Treasury's preferred exchange rate policy. Academic literature finds that sterilized interventions are less effective than non-sterilized ones.4 For the Fed not to sterilize currency interventions aimed at weakening the dollar, it would need to allow commercial banks' reserves to rise. This would conflict with its current explicit objective of reducing commercial banks' reserves and shrinking its balance sheet (Chart I-11). Chart I-11U.S. Banks' Reserves and The Dollar U.S. Banks' Reserves and The Dollar U.S. Banks' Reserves and The Dollar Hence, the bar is presently very high for the Fed to agree to non-sterilized currency interventions to weaken the dollar, as it would go against its current policy objective of tightening and shrinking its balance sheet. Going on the Treasury's leash would substantially damage the Fed's creditability. Bilateral currency interventions are much more effective in achieving the desired objective than unilateral ones. Hence, for interventions to succeed it is critical to involve counterparts in other countries. Back in the 1970s and 1980s, the U.S. used its hegemonic leadership over Europe and Japan as well as tariffs (in 1971) and the threat of tariffs (1980s) to force its allies to agree to bilateral interventions to weaken the dollar. However, it is difficult to envision either Europe or Japan agreeing to allowing their respective currencies to strengthen a lot at this time. First, both Europe and Japan are actively fighting latent deflationary forces at home. Given the high-beta, export-dependent nature of both economies, a strong currency would negatively impact growth. Geopolitically speaking, Europe is not as dependent on the U.S. today as it was at the height of the Cold War. Russia is a "poor man's" Soviet Union, with the combined defense budget of the EU economies dwarfing its own. Besides, in the 1970s and 1980s, the U.S. was "the only market in town." Crossing American policymakers upped the threat of being evicted from the most lucrative global middle class consumer market. This is no longer the case with the rise of emerging markets, China and the common European market. Prominently, Trump's main objective is to depreciate the dollar versus the Chinese RMB. Yet, there is no chance that in the foreseeable future China will agree with the U.S. to engineer considerable yuan appreciation against the dollar. In fact, Beijing has been actively using CNY depreciation to offset the impact of tariffs imposed on its exports by the Trump administration. Chart I-12China: Exchange Rate and Interest Rate##br## Differential Are Correlated China: Exchange Rate and Interest Rate Differential Are Correlated China: Exchange Rate and Interest Rate Differential Are Correlated Notably, this week there was an article published by China's Xinhua news agency referring to the "... Plaza Accord, in which Tokyo agreed to strengthen the currency against the dollar, as cause of the country's economic woes. ... Rapid and steep yen appreciation and Japan's domestic policy mistakes eventually brought about the nation's "lost decade."5 Chinese policymakers have carefully studied and internalized Japan's mistakes in the late 1980s and early 1990s. The mainland will not accept a considerably stronger yuan at times when deleveraging remains an important policy objective - and the latter is bound to weigh on domestic demand. Amid deleveraging, China requires a weaker - not stronger - currency to mitigate deflationary pressures in the economy. For interventions to be effective, foreign counterparts need to also agree to adjust their monetary and fiscal policy stances to be in sync with exchange rate policy. Presently, both the European Central Bank and the Bank of Japan are still conducting QE and expanding their balance sheets. These policies are compatible with weaker - not stronger - currencies. It is highly unlikely these central banks will abruptly reverse their current policies to accommodate President Trump's economic preferences. With time, if the U.S. dollar overshoots on the strong side and the euro and yen plunge substantially, it is probable that the ECB and BoJ will become willing to support the U.S. administration's efforts to depreciate the dollar. However, conditions for bilateral interventions do not exist at the moment. As to China, policymakers are unlikely to push local rates higher to promote a major currency rally. Chart I-12 illustrates the tradeoff between the exchange rate and interest rates in China might be weak but exist - the CNY/USD rate broadly correlates with the China-U.S. interest rate differential. The PBoC may not be able to appreciate the yuan without tolerating higher money market rates. Yet China's corporate debt burden is enormous, and requires low - not high - borrowing costs to smooth the deleveraging process. Bottom Line: Conditions for effective foreign exchange market interventions do not presently exist in the U.S. For the time being, neither the Fed nor central banks in Europe, Japan and China will cooperate with the U.S. Treasury to depreciate the dollar. Can The U.S. Intervene In CNY/USD Market? Chart I-13Trade-Weighted RMB And Dollar Move Together Trade-Weighted RMB And Dollar Move Together Trade-Weighted RMB And Dollar Move Together The U.S. can intervene in the euro, yen and other currency markets, but the focus of President Trump is the dollar's exchange rate with the Chinese yuan. Provided China has capital controls, its government decides which foreign institutions/organizations can buy local currency and assets, and how much. It is highly unlikely the Chinese government will grant permission to the U.S. authorities to freely operate in the RMB market. In short, China will not allow the Fed and other U.S. institutions to act on behalf of the government and push around the exchange rate. The ongoing trade confrontation between the U.S. and China has not produced any agreement. There is, at this time, zero chance that China will agree to appreciate its currency considerably under U.S. pressure. In fact, our geopolitical strategy team still expects the Trump administration to impose tariffs on the announced $200 billion of Chinese imports at some point in September. While the ultimate figure may be smaller than $200 billion, the point remains that the trade war between the U.S. and China continues to heat up, not cool off. The only feasible option for the U.S. authorities is to devalue the dollar against the European and Japanese currencies, triggering a broad-based selloff in the dollar. In this scenario, the RMB might appreciate versus the greenback, but only moderately. The CNY/USD rate is tightly controlled by the PBoC, and the yuan typically depreciates (appreciates) in trade-weighted terms when the greenback weakens (strengthens), respectively (Chart I-13). Consequently, U.S. intervention in currency markets that does not directly embrace the yuan will likely lead to a weaker trade-weighted RMB and make China even more competitive versus other nations. In fact, such an effort would be welcomed by Chinese policymakers, as it would stabilize and even lift the yuan versus the dollar (fostering financial stability in China), but allow the renminbi to depreciate in trade-weighted terms (boosting China's overall trade competitiveness). Bottom Line: There is currently no effective way for the U.S. to intervene and achieve material RMB appreciation in trade-weighted terms. Investment Conclusions Chart I-14Go Long U.S. Dollar Volatility Go Long U.S. Dollar Volatility Go Long U.S. Dollar Volatility The global macro landscape warrants a continued dollar rally. Yet the U.S. administration will use frequent verbal attacks to halt the greenback's ascent. President Trump is likely to continue to publically oppose the Fed and its interest rate policy. At some point, potentially in the near future, his criticism could become a full-on assault. In this context, the U.S. currency will continue to appreciate, but its rally will be accompanied by large dips, i.e., substantially higher volatility. To capitalize on this theme, traders should consider going long dollar volatility (Chart I-14). The trajectory of the U.S. dollar is critical for many financial markets in general and EM in particular. A firm dollar is consistent with continuous turmoil in EM financial markets. We continue to recommend staying put on EM in absolute terms and underweighting EM versus DM for stocks, credit and currencies. BCA's Emerging Markets Strategy continues to recommend shorting a basket of the following EM currencies versus the U.S. dollar: the Brazilian real, the South African rand, the Chilean peso, the Malaysian ringgit and the Indonesian rupiah. Potential dynamics that would persuade the Fed to arrest its tightening campaign include escalating EM turmoil that spills into U.S. financial markets. An intensifying EM selloff is our baseline view, and the dollar will spike materially in this scenario. Only after this occurs will the Fed likely contemplate halting its tightening, and only then will the dollar peter out. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Unit labor cost = (wage per person per hour) / (productivity per person per hour). 2 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, and "The Dollar May Be Our Currency, But It Is Your Problem," dated July 25, 2018, available at gps.bcaresearch.com. 3 Bordo, M. et al (2010), "U.S. Foreign-Exchange-Market Intervention during the Volcker-Greenspan", NBER Working Paper, September 2010 4 Bordo, M., Humpage, O. & Schwartz, A. (2011), "U.S. Monetary-Policy Evolution and U.S. Intervention", Federal Reserve Bank of Cleveland, Working Paper, October 2011 5 South China Morning Post: Chinese state media cites Japan's 'lost decade' when warning of risks of giving in to US demands; https://www.scmp.com/news/china/diplomacy-defence/article/2160196/chinese-state-media-cites-japans-lost-decade-when Equity Recommendations Fixed-Income, Credit And Currency Recommendations

This Special Report examines the impact of a NAFTA cancelation on 21 level-three GICs industries. While the latest news on the NAFTA renegotiation with Mexico is positive as we go to press, there is still a non-negligible risk that the existing trilateral deal will not survive. The U.S.-Mexico bilateral deal is an "agreement in principle" and will take time to ratify. Meanwhile, a framework deal with Canada would leave many thorny issues to be resolved. President Trump can still revert to his tough tactics on Canada ahead of the U.S. mid-term elections. If the President does not gain major concessions that can be presented as "victories" to voters, he is likely to take an aggressive stand in order to fire up his political base. The probability of Trump triggering Article 2205 and threatening to walk away from the suspended U.S.-Canada free trade agreement is still not trivial, despite the deal with Mexico. By itself, the cancelation of NAFTA would not be devastating for any particular U.S. industry because the size of the tariff increases would be fairly small as long as all parties stick with MFN tariff levels. That said, the impact would not be trivial, especially for those industries that have extensive supply lines that run between the three countries involved (especially Autos). We approached the issue from four different perspectives; international supply chains, a model-based approach, and an analysis of foreign revenue exposure and input cost exposure. The broad conclusion is that there are no winners from a NAFTA cancelation for the U.S. manufacturing GICs industries. Pharmaceuticals, Health Care Equipment & Supplies, Personal Products and Construction Materials are lower on the risk scale, but cannot be considered beneficiaries of a NAFTA collapse. The remaining industries are all moderately-to-highly exposed. Considering the four perspectives as a group, the most vulnerable industries are Automobiles, Automobile Components, Metals & Mining, Food Products, Beverages, and Textiles & Apparel. Our U.S. equity sector specialists recommend overweight positions in Defense and Financials; while neither stands to benefit from a NAFTA abrogation, they should at least be relative outperformers. They recommend underweight positions on Auto Components, Steel and Electrical Components & Equipment as relative (and probably absolute) underperformers should NAFTA disappear. While the latest news on the renegotiation of the North American Free Trade Agreement (NAFTA) is positive as we go to press, there is still a non-negligible risk that President Trump could revert to his tough tactics ahead of the U.S. mid-term elections.1 Even if Canada signs on to a framework deal, a lot of thorny details will have to be worked out. A presidential proclamation triggering Article 2205 of the NAFTA agreement (as opposed to tweeting that the U.S. will withdraw) would initiate a six-month "exit" period. Trump could use this deadline, and the threat of canceling the underlying U.S.-Canada FTA, to put pressure on Canada (if not Mexico) to concede to U.S. demands, just as he could revoke his exit announcement anytime within the six-month period. While some market volatility would ensue upon any exit announcement, even a total withdrawal at the end of the six months would have a limited macro-economic impact as long as the U.S. continued to respect its WTO commitments and lifted tariffs only to Most Favored Nation (MFN) levels. Nonetheless, a modest tariff hike is not assured given the Administration's "America First" policy, its looming threat of Section 232 tariffs on auto imports, its warnings against the WTO itself, and the steep tariffs it has already imposed on Canada, including a 20% tariff on softwood lumber and the 300% tariff on Bombardier CSeries jets. Moreover, even a small rise in tariffs to MFN levels would have a significant negative impact on industries that are heavily integrated across borders. Our first report on the evolving U.S. trade situation analyzed the implications of the U.S.-China trade war for the 24 level two U.S. GICs equity sectors. This Special Report examines the impact of a NAFTA cancelation on 21 level three GICs industries (finer detail is required since NAFTA covers mostly goods industries). We find that there are no "winners" among the U.S. equity sectors because the negative impact would outweigh any positive effects. The hardest hit U.S. industries would be Autos, Metals & Mining, Food Products, Beverages, and Textiles and Apparel, but many others are heavily exposed to a failure of the free trade agreement. Out Of Time President Trump is seeking a new NAFTA deal ahead of the U.S. midterms in November. While this timing may yet prove too ambitious, the U.S. has made progress in recent bilateral negotiations with Mexico, raising the potential that Trump will be able to tout a new NAFTA framework deal by November 6. Yet, investors should be prepared for additional volatility. There are technical issues with the bilateral U.S.-Mexico deal that could delay ratification in Congress until mid-2019. The new Mexican Congress must ratify the deal by December 1 if outgoing President Enrique Peña Nieto is to sign off. Otherwise, the incoming Mexican President Andrés Manuel López Obrador may still want to revise any deal he signs, prolonging the process. Meanwhile, it would be surprising if the Canadians signed onto a U.S.-Mexico deal they had no part in negotiating without insisting on any adjustments.2 The important point is that President Trump's economic and legal constraints on withdrawing from NAFTA have fallen even further with the Mexican deal. If Trump does not get major concessions that can be presented as "victories" to voters, he is likely to take an aggressive stand in order to fire up his political base, as a gray area of "continuing talks" will not inspire voters. This could mean imposing the threatened auto tariffs or threatening to cancel the existing trade agreements with Canada. Thus, the risk of Trump triggering Article 2205 is still not trivial. A bilateral Mexican trade deal is not the same as NAFTA. Announcing withdrawal automatically nullifies much of the 1993 NAFTA Implementation Act. Some provisions of NAFTA under this act may continue, but the bulk would cease to have effect, and the White House could refuse to enforce the rest. The potential saving grace for trade with Canada was that the Canada-U.S. Free Trade Agreement (CUSFTA), which took effect in 1989, was incorporated into NAFTA. The U.S. and Canada agreed to suspend CUSFTA's operation when NAFTA was created, but the suspension only lasts as long as NAFTA is in effect. However, Trump may walk away from both CUSFTA and NAFTA in the same proclamation. In that event, WTO rules for preferential trade would require the U.S. and Canada to raise tariffs on trade with each other to Most Favored Nation (MFN) levels. These tariff levels are shown in Charts II-1A and II-1B. The Charts also show the maximum tariff that could potentially be applied under WTO rules. The latter are much higher than the MFN levels, underscoring that the situation could get really ugly if a full trade war scenario somehow still emerged among these three trading partners. Chart II-1AU.S.: MFN Tariff Rates By GICS Industry (2017) September 2018 September 2018 Chart II-1BMexico & Canada: MFN Tariff Rates By GICS Industry (2017) September 2018 September 2018 Current tariffs are set at zero for virtually all of these GICs industries, which means that the MFN levels also indicate how much tariffs will rise at a minimum if NAFTA is cancelled. Tariffs would rise the most for Automobiles, Textiles & Apparel, and Food Products (especially agricultural products), and Beverages. U.S. tariffs under the WTO are not significantly higher than NAFTA's rates; the average MFN tariff in 2016 was 3½%, which compares to 4.1% for the average Canadian MFN tariff. Would MFN Tariffs Be Painful? An increase in tariff rates of 3-4 percentage points may seem like small potatoes. Nonetheless, even this could have an outsized impact on some industries because tariffs are levied on trade flows, not on production. A substantial amount of trade today is in intermediate goods due to well-integrated supply chains. Charts II-2A and II-2B present a measure of integration. Exports and imports are quite large relative to total production in some industries. The most integrated U.S. GICs sectors include Automobiles & Components, Materials, Capital Goods and Electrical & Optical Equipment. Higher tariffs would slam those intermediate goods that cross the border multiple times at different stages of production. For example, studies of particular automobile models have found that "parts and components may cross the NAFTA countries' borders as many as eight times before being installed in a final assembly in one of the three partner countries."3 Tariffs would apply each time these parts cross the border if NAFTA fails. Chart II-2AU.S./Canada Supply Chain Integration September 2018 September 2018 Chart II-2BU.S./Mexico Supply Chain Integration September 2018 September 2018 Appendix Tables II-1 to II-4 show bilateral trade by product between the U.S. and Canada, and the U.S. and Mexico. In 2017, the U.S. imported almost $300b in goods from Canada, and exported $282b to that country, resulting in a small U.S. bilateral trade deficit. The bilateral deficit with Mexico is larger, with $314b in U.S. imports and $243b in exports. The largest trade categories include motor vehicles, machinery, and petroleum products. Telecom equipment and food products also rank highly. As mentioned above, the impact of rising tariffs is outsized to the extent that a substantial portion of trade in North America is in intermediate goods. Box II-1 reviews the five main channels through which rising tariffs can affect U.S. industry. Box II-1 Trade Channels There are at least five channels through which rising tariffs can affect U.S. industry: (1) The Direct Effect: This can be positive or negative. The impact is positive for those industries that do not export much but are provided relief from stiff import competition via higher import tariffs. The impact is negative for those firms facing higher tariffs on their exports, as well as for those firms facing higher costs for imported inputs to their production process. These firms would be forced to absorb some of import tariffs via lower profit margins. Some industries will fall into both positive and negative camps. U.S. washing machines are a good example. Whirlpool's stock price jumped after President Trump announced an import tariff on washing machines, but it subsequently fell back when the Administration imposed an import tariff on steel and aluminum (that are used in the production of washing machines). NAFTA also eliminated many non-tariff barriers, especially in service industries. Cancelling the agreement could thus see a return of these barriers to trade; (2) Indirect Effect: The higher costs for imported goods are passed along the supply chain within an industry and to other industries that are not directly affected by rising tariffs. This will undermine profit margins in these indirectly-affected industries to the extent that they cannot fully pass along the higher input costs. There would also be a loss of economies-of-scale and comparative advantage to the extent that firms are no longer able to use an "optimal" supply network that crosses borders, further raising the cost of doing business; (3) Foreign Direct Investment: Some U.S. imports emanate from U.S. multinationals' subsidiaries outside the U.S., or by foreign OEM suppliers for U.S. firms. NAFTA eliminated many national barriers to FDI, expanded basic protections for companies' FDI in other member nations, and established a dispute-settlement procedure. The Canadian and Mexican authorities could make life more difficult for those U.S. firms that have undertaken significant FDI in retaliation for NAFTA's cancellation; (4) Macro Effect: The end of NAFTA, especially if it were to lead to a trade war that results in tariffs in excess of the MFN levels, would take a toll on North American trade and reduce GDP growth across the three countries. Besides the negative effect of uncertainty on business confidence and, thus, capital spending, rising prices for both consumer and capital goods will reduce the volume of spending in both cases. Moreover, corporate profits have a high beta with respect to economic activity. The macro effect would probably not be large to the extent that tariffs only rise to MFN levels; (5) Currency Effect: To the extent that a trade war pushes up the dollar relative to the Canadian dollar and Mexican peso, it would undermine export-oriented industries and benefit those that import. However, while we are bullish the dollar due to diverging monetary policy, the dollar may not benefit much from trade friction given that tariffs would rise for all three countries. Chart II-3 is a scatter chart of GICs industries that compares the average MFN tariff on U.S. imports to the average MFN tariff on Canadian and Mexican imports from the U.S. A U.S. industry may benefit if it garners significant import protection but does not face a higher tariff on its exports to the other two countries. Unfortunately, there are no industries that fall into the north-west portion of the chart. The opposite corner, signifying low import protection but high tariffs on exports, includes Beverages, Household Durables, Household Products, Personal Products and Machinery. Chart II-3Import And Export Tariffs Faced By U.S. GICS Industries September 2018 September 2018 Model-Based Approach The C.D. Howe Institute has employed a general equilibrium model to estimate the impact of a NAFTA failure at the industrial level.4 The model is able to capture the impact on trade conducted through foreign affiliates. The study captures the direct implications of higher tariffs, but also includes a negative shock to business investment that would stem from heightened uncertainty about the future of market access for cross-border trade. It also takes into consideration non-tariff barriers affecting services. Table II-1Impact Of NAFTA Cancellation By Industry September 2018 September 2018 As with most studies of this type, the Howe report finds that the level of GDP falls by a relatively small amount relative to the baseline in all three countries - i.e. there are no winners if NAFTA goes down. Moreover, the U.S. is not even able to reduce its external deficit. While the trade barriers trim U.S. imports from NAFTA parties by $60b, exports to Canada and Mexico fall by $62b. At the industry level, the model sums the impacts of the NAFTA shock on imports, exports and domestic market share to arrive at the estimated change in total shipments (Table II-1). It is possible that an industry will enjoy a boost to total shipments if a larger domestic market share outweighs the damage to exports. However, the vast majority of U.S. industries would suffer a decline in total shipments according to this study, because the estimated gain in domestic market share is simply not large enough. Beef, Pork & Poultry and Dairy would see a 1-2% drop in total shipments relative to the baseline forecast. Next on the list are textiles & apparel, food products and automotive products. Even some service industries suffer a small decline in business, due to indirect income effects. Foreign-Sourced Revenue And Input Cost Approach Another way to approach this issue is to identify the U.S. industries that garner the largest proportion of total revenues from Mexico and Canada. Unfortunately, few companies provide much country detail on where their foreign revenues are derived. Many simply split U.S. and non-U.S. revenues, or North American and non-North American revenues. Table II-2 presents the proportion of total revenues that is generated from operations outside the U.S. for the top five companies in the industry by market cap (in some cases the proportion that is generated outside of North America was used as a proxy for foreign- sourced revenues). While this approach is not perfect, it does provide a good indication of how exposed a U.S. industry is to Canada and Mexico. This is because any company that has "gone global" will very likely be doing substantial business in these two countries. Table II-2Foreign Revenue Exposure September 2018 September 2018 At the top of the list are the Metals & Mining, Personal Products, and Auto Component industries. Between 62% and 81% of revenues in these three industries is derived from foreign sources. Following that is Household Durables, Leisure Products, Chemicals and Tobacco. Indeed, all of the level three GICs industries we are analyzing are moderately-to-highly globally-oriented, with the sole exception of Construction Materials. Table II-3Import Tariff Exposure September 2018 September 2018 U.S. companies are also exposed to U.S. tariffs that boost the price of imported inputs to the production process. This can occur directly when firm A imports a good from abroad, and indirectly, when firm A then sells its intermediate good to firm B at a higher price, and then on to firm C. In order to capture the entire process, we used the information contained in the Bureau of Economic Analysis' Input/Output tables. We estimated the proportion of each industry's total inputs that would be affected by a rise in tariffs to MFN levels. We then allocated the industries contained in the input/output tables to the 21 GICs level 3 industries we are considering, in order to obtain an import exposure ranking in S&P industry space (Table II-3). All 21 industries are significantly vulnerable to rising input costs, which is not surprising given that we are focusing on the manufacturing-based GICs industries and NAFTA focused on trade in goods. The vast majority of the industries could face a cost increase on 50% or more of their intermediate inputs to the production process. The Automobile industry is at the top of the list, with 72% of its intermediate inputs potentially affected by the shift up in tariffs (Automobile Components is down the list, at 56%). Containers & Packaging, Oil & Gas, Aerospace & Defense, Textiles and Food Products are also highly exposed to tariff increases. The automobile industry is a special case because of the safeguards built into NAFTA regarding rules-of-origin and the associated tracing list. The U.S. is seeking significant changes in both in order to tilt the playing field toward U.S. production, but this could severely undermine the intricate supply chain linking the three countries. Box II-2 provides more details. Box II-2 Automotive Production In NAFTA; Update Required We are focused on two key aspects to the renegotiation of the NAFTA rules that could have far reaching implications for automakers and the auto component maker supply base: the tracing list and country of origin rules. Regarding the first of these, the Trump administration has a legitimate gripe when it comes to automotive production. A tracing list was written in the early-1990's to define automotive components such that the rules of origin (ROO) could be easily met; anything not on the list is deemed originating in North America. As anyone who has driven a vehicle of early-1990's vintage and one of late-2010's vintage can attest, high tech components (largely not included on the tracing list) have grown exponentially as a percentage of the cost of the vehicle and, at least with respect to electronic and display components, are sourced mostly from overseas. Updating the tracing list would force auto makers to source a significantly greater amount of components domestically, almost certainly raising the cost of the vehicle and either hurting margins or hurting competitiveness through higher prices. The current NAFTA ROO require that 62.5% of the content of a vehicle must be sourced in North America, with no distinction between any of the member nations. The result of this legislation has been the creation of a highly integrated supply base that sees components move back and forth across borders through each stage of the manufacturing process. Early proposals from the Trump administration for a NAFTA rework included a country of origin provision for as much as 50% U.S. content. Such a provision would certainly cause a massive disruption in the automotive supply chain with components manufacturers forced to relocate or automakers electing to source overseas and pay the 2.5% MFN tariff on exports within North America. Either scenario presents a headwind to the tightly woven auto components base, underscoring BCA's U.S. Equity Strategy's underweight recommendation on the sector. The recently announced bilateral trade deal with Mexico raises the ROO content requirements to 75% from the 62.5% contemplated under NAFTA but, importantly, no country of origin provisions appear in the new deal. Still, given how quickly this is evolving, a final NAFTA deal could be significantly different. Chart II-4 presents a scatter diagram that compares import tariff exposure (horizontal axis) with foreign revenue exposure (vertical axis). The industries in the north-east corner of the diagram are the most exposed to NAFTA failure. The problem is that there are so many in this region that it is difficult to choose the top two or three, although Metals & Mining stands out from the rest. It is easier to identify the industries that face less risk in relative terms: Pharmaceuticals, Construction Materials, Health Care & Supplies, Leisure Products and, perhaps, Machinery. The rest rank highly in terms of both foreign revenue exposure and import tariff exposure. Chart II-4Foreign Revenue And Import Tariff Exposure September 2018 September 2018 Conclusions: By itself, a total cancelation of NAFTA would not be devastating for any particular U.S. industry because the size of the tariff increases would be fairly small as long as all parties stick with MFN tariff levels. That said, the impact would not be trivial, especially for those industries that have extensive supply lines that run between the three countries involved. The negative impact on GDP growth would likely be worse for Canada (and Mexico if its bilateral somehow fell through), but U.S. exporters would see some loss of business. We approached the issue from four different perspectives; international supply chains, a model-based approach, and an analysis of foreign revenue exposure and import tariff exposure. The broad conclusion is that there are no winners from a NAFTA cancelation for the U.S. manufacturing GICs industries. Pharmaceuticals, Health Care Equipment & Supplies, Personal Products and Construction Materials are lower on the risk scale, but cannot be considered beneficiaries of a NAFTA collapse. The remaining industries are all moderately-to-highly exposed. Considering the four perspectives as a group, the most vulnerable industries are Automobiles, Automobile Components, Metals & Mining, Food Products, Beverages, and Textiles & Apparel. Our U.S. equity sector specialists recommend overweight positions in Defense and Financials; while neither stands to benefit from a NAFTA abrogation, they should at least be relative outperformers. They recommend underweight positions on Auto Components, Steel and Electrical Components & Equipment as relative (and probably absolute) underperformers should NAFTA disappear. As we go to press, rapid developments are taking place in the NAFTA negotiations. The U.S. and Mexico have completed a bilateral agreement in principle and a Canadian team is looking into whether to sign onto the agreement by a U.S.-imposed August 31 deadline. This deadline would enable the current U.S. Congress to proceed to ratification before turning over its seats in January, though it is not a hard deadline. It is possible that the negotiations will conclude this week and the crisis will be averted. But the lack of constraints on President Trump's trade authority gives reason for pause. If Canada demurs, Trump could move to raise the cost through auto tariffs or announcements that he intends to withdraw from existing U.S.-Canada agreements in advance of November 6. While Mexico has now tentatively secured bilaterals with both countries through the new U.S. deal and the Trans-Pacific Partnership (which includes Canada), it still stands to suffer if a trilateral agreement is not in place. Moreover it is technically possible that Canada's refusal to join the U.S.-Mexico bilateral could delay the latter's ratification well into next year. Therefore, we treat Mexico the same as Canada in our analysis, despite the fact that Mexican assets stand to benefit in relative terms from having a floor put under them by the Trump Administration's more constructive posture and this week's framework deal. If Trump does not pursue a hard line with Canada, then it will be an important sign that he is adjusting his trade policy to contain the degree of confrontation with the developed nations and allies and instead focus squarely on China, where we expect trade risks to increase in the coming months. Mark McClellan Senior Vice President The Bank Credit Analyst Matt Gertken Associate Vice President Geopolitical Strategy Chris Bowes Associate Editor U.S. Equity Strategy APPENDIX TABLE II-1 U.S. Imports From Canada (2017) September 2018 September 2018 APPENDIX TABLE II-2 U.S. Exports To Canada (2017) September 2018 September 2018 APPENDIX TABLE II-3 U.S. Imports From Mexico (2017) September 2018 September 2018 APPENDIX TABLE II-4 U.S. Exports To Mexico (2017) September 2018 September 2018 1 Please see BCA Geopolitical Strategy Special Report, "A Mexican Standoff - Markets Vs. AMLO," dated June 28, 2018, and Weekly Report, "Are You 'Sick Of Winning' Yet?" dated June 20, 2018, available at gps.bcaresearch.com 2 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com 3 Working Together: Economic Ties Between the United States and Mexico. Christopher E. Wilson, November 2011. 4 The NAFTA Renegotiation: What if the U.S. Walks Away? The C.D. Howe Institute Working Paper. November 2017.