Policy

Highlights The potential for wrongheaded reform initiatives will be a key policy risk to monitor when judging the likely stability of the Chinese economy over the coming 6-12 months. Brash reform efforts without offsetting fiscal stimulus are unlikely, but this possibility bears monitoring. Chinese export growth will likely moderate over the coming year, but the absence of severe dislocations in the commodity and currency markets, like what occurred in 2015, will be an important factor supporting a stable deceleration in exports. Chinese stocks are outperforming the EM and global benchmarks, even after excluding the high-flying tech sector. Stay overweight. Feature China's 19th Party Congress has concluded, following yesterday's announcement of the new members of the Politburo Standing Committee. We will be providing investors will a full "postmortem" on the Party Congress and what it means for investors next week in a joint Special Report with our Geopolitical Strategy Service, but for now we have a few brief observations. The Congress has confirmed that President Xi has greatly increased his political capital, and that the implementation of his policy directives over the coming years will be greatly aided by this increase in influence. But the principle contradiction highlighted by Xi looms large for investors, as it remains unclear how he plans on managing the dual goal of further increasing living standards and shifting the country's growth model to one that is more environmentally and economically sustainable. Our view remains that brash reform efforts without offsetting fiscal stimulus are unlikely, as they would risk a major policy mistake that could undermine overall stability. But the risk of wrongheaded (and now largely unencumbered) reform initiatives from the President will be a key policy risk to monitor when judging the likely stability of the Chinese economy over the coming 6-12 months. Turning to this week's research topic, today's report is the first of two parts examining the key differences facing China today from what prevailed in mid-2015, when the Chinese economy operated below what investors and market participants considered to be a "stable" pace of growth. In part I we focus on trade, and provide answers to the following questions: What were the root causes of the extremely weak external demand environment that China faced in 2015, and should investors expect these conditions to return? Why has Chinese export growth disappointed over the past several years relative to what BCA's export model would have predicted? Are Chinese exports likely to accelerate or decelerate over the coming year, and does this outlook suggest that China's will experience a gradual or sharp deceleration in economic growth? Revisiting China's External Demand Environment In 2015 Before judging the outlook for China's export sector, it is important to revisit the dynamics of global trade since the global financial crisis. As we will illustrate below, the weak external demand environment faced by China in 2015 was a function of severe dislocations in the commodity and currency markets that are unlikely to occur again over the coming 6-12 months. While Chinese export growth will likely moderate over the coming year, the absence of these shocks is an important factor supporting a stable deceleration. Chart 1 presents the trend in global import volume over the past decade, as well as its emerging market (EM) and developed market (DM) subcomponents. From 2007 until late-2011, the coincident nature of global trade is clearly evident: EM and DM import volume growth rose and fell in lockstep with each other, with the former growing at a consistently higher rate than the latter over the period. Chart 1In 2015, China's Export Sector Suffered From A Synchronized Global Slowdown In 2015, China's Export Sector Suffered From A Synchronized Global Slowdown In 2015, China's Export Sector Suffered From A Synchronized Global Slowdown Starting in 2012, however, regional import volume growth trend began to decouple. DM import volume growth continued to decelerate in 2012 and 2013 following the end of the V-shaped post-recession recovery, largely driven by the negative economic impact of the euro area sovereign debt crisis. While euro area imports were the most affected by the crisis within the DM world, Japanese and U.S. import volume growth also eventually contracted (albeit only modestly in the case of the U.S.). Conversely, EM import volume accelerated materially during this period, boosted by material liquidity easing by Chinese policymakers. The impact of liquidity easing in China appeared very clearly in the total social financing data (excluding equity issuance), which, from mid-2012 to mid-2013, accelerated from 16 to 22%. From a global perspective, the rise in EM import volume growth from 2012 to 2013 successfully offset demand weakness in DM economies, which kept global import volume growth within a low but stable range of 1-3%. Growth in real global imports rose to the high-end of this range by mid-2014, as DM economies recovered from the end of the acute phase of the euro area crisis. The massive collapse in oil prices that began in June 2014 was clearly the trigger for a relapse in global trade from 2014 to early-2016 (which led to very weak export growth for China), but there is a particular aspect of U.S. import volume weakness during this period that is crucial to understand. Using conventional market narratives, a textbook reading of the combined U.S. dollar / oil shock of 2014 would have predicted a rise in real DM imports, which would have at least somewhat offset a decline in EM import demand (a reversal of the dynamics that were at play in 2012/2013). Lower oil prices represent a tax cut for net oil importing nations, and a higher dollar reduces the relative price (and thus increased the attractiveness) of goods imported into the U.S. Instead, however, real U.S. import growth fell in response to the dollar / oil shock, followed, with a lag, by weakness in euro area demand (Chart 2). Underestimating the importance of the oil & gas sector in the U.S. largely accounts for the failure of the textbook prediction: after having risen significantly during the expansion, real U.S. investment in mining exploration, shafts, and wells fell 63% from its peak, which caused an outright contraction in total real U.S. nonresidential fixed investment (Chart 3). The sharpness of the decline in the sector, coupled with the rise in the dollar, led to a broad-based slowdown in U.S. employment growth. Chart 2Lower Oil Prices And A Higher Dollar##br## Did Not Bolster DM Import Demand Lower Oil Prices And A Higher Dollar Did Not Bolster DM Import Demand Lower Oil Prices And A Higher Dollar Did Not Bolster DM Import Demand Chart 3A Collapse In U.S. Oil Productionr##br## Had A Significant Effect On Growth A Collapse In U.S. Oil Production Had A Significant Effect On Growth A Collapse In U.S. Oil Production Had A Significant Effect On Growth But Chart 4 highlights another important contributor to China's export weakness to the U.S. (and more generally) during the dollar/oil shock period: China's exports are not simply a play on consumer demand. The chart shows that U.S. capital goods imports from China have risen materially as a share of total goods imports, highlighting that the days of China exporting predominantly low value consumer goods are behind it. China's growing investment-oriented exports underscore why the sharp decline in oil prices failed to provide a net reflationary effect for the global economy from the dollar/oil shock, even if households and oil-consuming firms did in fact benefit from lower energy costs. Chart 4China's Exports Are Increasingly##br## Investment-Oriented China's Exports Are Increasingly Investment-Oriented China's Exports Are Increasingly Investment-Oriented Looking Forward Chart 5 highlights why China's export outlook over the coming year is unlikely to be buffeted from the sizeable commodity & currency market dislocations that began in 2014. Panel 1 illustrates that the global "oil bill" has fallen modestly below its long-term average from what had been the highest level since the late-1970s, implying that significant further downside for oil prices is likely limited. In fact, our Commodity & Energy Strategy service recently upgraded their oil price forecasts for 2018.1 In addition, the potential for a further sharp move higher in the U.S. dollar would also appear to have low odds, given that it has moved back to its long-term average versus major currencies and is at the high end of its range in broad trade-weighted terms (panel 2). Does this imply that China's export growth is set to stabilize at current levels, or even accelerate? At first blush, our export model would appear to support the latter conclusion, given that the model is currently predicting export growth on the order of 25%. But our model has consistently over-predicted Chinese export growth since mid-2011, and a breakdown of the causes of this gap help explain why a gradual deceleration in export growth is likely over the coming year. Using a method similar to DuPont analysis of Return on Equity, Chart 6 illustrates that China's export growth can be broken down into three component factors: Chart 5The 2015 Shock To China's Export Sector##br## Is Unlikely To Reoccur The 2015 Shock To China's Export Sector Is Unlikely To Reoccur The 2015 Shock To China's Export Sector Is Unlikely To Reoccur Chart 6Lower Global Import Intensity Is A Structural Anchor On China's Exports Lower Global Import Intensity Is A Structural Anchor On China's Exports Lower Global Import Intensity Is A Structural Anchor On China's Exports Global industrial production (IP) The import intensity of global IP, and Imports from China as a share of total global imports The chart shows that the gap between China's export growth and our model's prediction can largely be explained by the reversal of the decade-long rise in global import intensity, and more recently by a modest decline in China's share of global imports. Our measure of global import intensity is clearly impacted by fluctuations in global export prices (which are dominated by changes in commodity prices), but the end of rising global import intensity is also clear when imports are measured in real terms. A detailed examination of the causes of flat real global import intensity are beyond the scope of this report, but over the coming 6-12 months, we do not believe that either of the factors that have structurally depressed Chinese export growth over the past six years are likely to act as a major drag on China's export sector. Barring significant trade action from the Trump administration, real global import intensity in unlikely to change materially, and the recent decline in China's share of global imports appears to have been caused by prior strength in the RMB (Chart 7). The RMB has recently been strong against the dollar, but remains 8-9% below its 2015 peak in trade-weighted terms. As such, our analysis suggests that China's export outlook over the coming year will be largely determined by a single, cyclical factor: the trend in global industrial production, which should accelerate slightly over the coming months (Chart 8). While this would result in a moderation of Chinese export growth from current levels (as exports are currently growing faster than IP), the decline would be relatively modest in size and would not negatively impact Chinese domestic demand (panel 2). Chart 7The RMB-Driven Decline In China's Share ##br##Of Global Imports Is Over The RMB-Driven Decline In China's Share Of Global Imports Is Over The RMB-Driven Decline In China's Share Of Global Imports Is Over Chart 8A Modest Decline In Export Growth Is Likely,##br## But Nowhere Near Like 2015 A Modest Decline In Export Growth Is Likely, But Nowhere Near Like 2015 A Modest Decline In Export Growth Is Likely, But Nowhere Near Like 2015 Investment Conclusions We noted in our October 12 Weekly Report that the economic momentum of China's "mini-cycle" appears to have peaked earlier this year, and presented three possible scenarios for the coming year: 1) a re-acceleration of the economy and a continuation of the V-shaped rebound profile, 2) a benign, controlled deceleration and settling of growth into a stable growth range, and 3) an uncontrolled and sharp deceleration in the economy that threatens a return to the conditions that prevailed in early-2015 (or worse). The key takeaway for investors is that a modest decline in Chinese export growth to the current level of global IP growth is consistent with scenario 2, as it would be a far cry from the outright contraction of exports that occurred in 2015 and 2016. Importantly, a benign, controlled deceleration of Chinese economic growth should continue to support the relative performance of Chinese equities; Chart 9 shows that the MSCI China Free index is now in a relative uptrend vs. both emerging markets and the global benchmark, even after excluding this year's significant outperformance of the Chinese technology sector. As such, we continue to favor an overweight stance towards Chinese stocks relative to the EM benchmark, and within a "Greater China" equity universe.2 Chart 9China Is Outperforming, ##br##Even Excluding The Technology Sector China Is Outperforming, Even Excluding The Technology Sector China Is Outperforming, Even Excluding The Technology Sector Finally, a brief note on scheduling: We highlighted above that next week's report will be a joint Special Report with our Geopolitical Strategy Service, which will provide a summary "postmortem" on the Party Congress and what it means for investors. Part II of our examination of the Chinese economy today vs. mid-2015 will follow on November 9, which will focus on China's monetary policy stance. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report, "Oil Forecast Lifted As Markets Tighten", dated October 19, 2017, available at ces.bcaresearch.com. 2 In last week's joint Special Report with our Geopolitical Strategy Service (GPS), it should be noted that the investment conclusions section related to recommendations that have been made by the GPS team, rather than this publication. Specifically, China Investment Strategy's recommendation on Chinese equities continues to be an overweight stance on the MSCI China Free index vs the emerging markets benchmark, and was not adjusted to include only H-Shares as our GPS team has chosen to do. We apologize for any confusion that this may have caused. Cyclical Investment Stance Equity Sector Recommendations

Highlights China's ascendancy will increase U.S.-China tensions in the medium and long term; "Xi Jinping Thought" is China's rejection of Soviet-style collapse; Xi's new policies face very few domestic political constraints; Xi is playing down GDP targets and playing up centralization; Tax cuts are still coming to the U.S. Feature Global risk assets continue to rally despite an apparent loss of faith in world leaders. In Spain, the showdown between Catalonia and Madrid is escalating as Spanish lawmakers vote to withdraw aspects of self-rule from the wealthy northeastern province. In the U.K., the Brexit negotiations are floundering, causing the Labour Party to raise the alarm against a "no deal" exit from the European Union. In Brazil, the interim president is under legislative scrutiny for corruption; in South Africa, the ruling party is grasping at government employees' pension funds to keep a struggling state airliner afloat. However, policymakers are not always as incompetent as investors (and the financial media) like to think. In China, President Xi Jinping has turned himself into the highest authority since Mao Zedong and Deng Xiaoping. And the country has sprung back from the 2015-16 deflationary spiral so well that financial authorities are tightening financial controls and contemplating interest rate hikes (Chart 1). In Japan, Prime Minister Shinzo Abe has won a two-thirds supermajority in the House of Representatives for the second time, giving him a mandate to continue his "Abenomics" agenda (Chart 2). With unemployment already exceedingly low at 2.8%, Abe could make history. He could rouse the country out of both its deflationary and pacifist slumber in the face of the historic challenges posed by a rising China and multipolar world. Less grandiose, but still highly market-relevant, the U.S. Congress has drawn closer to approving a budget resolution for fiscal 2018 that would pave the way for tax legislation to hit President Donald Trump's desk by the end of the first quarter of next year. This development is in marked contrast to informal surveys of investors around the world, including at BCA's annual New York Conference last month. The market has hardly reacted to the positive news (Chart 3). Chart 1Real Deposit Rate Is Negative Real Deposit Rate Is Negative Real Deposit Rate Is Negative Chart 2Shinzo Abe Does It Again Xi Jinping: Chairman Of Everything Xi Jinping: Chairman Of Everything Chart 3Market Still Doubts Trump Market Still Doubts Trump Market Still Doubts Trump In this report, we focus on China and the United States. Our recent assessments of Spain and Japan are on track - the former is an overstated risk, the latter an opportunity now largely priced in.1 It is the "G2" that poses the biggest risk of negative surprises over the next 12 months. First Take On The Party Congress China's nineteenth National Party Congress will conclude just as we go to press. Our assessment of the line-up of the new Politburo and specific changes to the Communist Party's constitution will have to wait for a Special Report next week. We can still draw some preliminary conclusions, however.2 First, Xi Jinping's induction into the Communist Party's constitution, under the slogan "Xi Jinping Thought on Socialism with Chinese Characteristics for a New Era," makes him second only to Chairman Mao as a philosophical guide in the party. This says as much about the spirit of the age as about Xi's (formidable) power. It is an era of "charismatic authority," in which populations are restless and political elites either adopt populist tactics (like Xi), or are populists themselves.3 The Communist Party wanted a new Mao and Xi obliged them. Why is this the case in China? The Communist Party has based its legitimacy on economic growth since Deng Xiaoping came to power in 1978. But economic growth is slowing as a result of irreversible, secular trends. The party needs a new source of legitimacy, and Xi has offered a "synthesis" of Mao and Deng: he promises to preserve the Communist regime above all, yet also to continue Deng's pragmatic use of the market to strengthen the fundamentally socialist economy. Thesis, antithesis, synthesis. Xi's focus remains on power, namely reinforcing China's ruling institutions and asserting its international influence.4 We will take the latter first, as it is the biggest source of change in the world and a key driver of market-relevant geopolitical risk. Multipolarity Chart 4U.S. Decline Vis-à-Vis China U.S. Decline Vis-à-Vis China U.S. Decline Vis-à-Vis China The most important takeaway from the party congress is that it perfectly captures our long-term investment theme of global multipolarity. This describes a world run by multiple independent powers as American power declines in relative terms.5 The erosion of U.S. global dominance is most striking in relativity to China (Chart 4).6 Xi has declared that it is time for China to take "center stage" in world affairs. He also modified an earlier goal to say that China will become a "leading global power" by 2050. China is unified under a single leader and a single party, its economy has been robust, and it is therefore feeling confident in its ability to take action in the global arena. The implications are disruptive over the long run: Assertive foreign policy will continue: China will continue with the bolder foreign policy it has demonstrated over the past ten years. China's military expenditures, which are widely believed to be larger than official statistics reveal, will continue to drive regional security dynamics (Chart 5).7 Maritime tensions still matter: China's "core interests" in separatist-prone regions like Tibet and Xinjiang have become more secure, whereas its interests in Taiwan and the South China Sea are less secure because of increasing pushback from the U.S. and its allies. The South China Sea is still a potential flashpoint as it governs the vital supply lines of China's major regional rivals and $4 trillion in trade (Diagram 1).8 Diagram 1The South China Sea: Still A Risk Xi Jinping: Chairman Of Everything Xi Jinping: Chairman Of Everything Economic statecraft is the new norm: China is using its economic heft to fill spaces left void by the United States. The U.S. is perceived across the region as relying increasingly on "hard power," ceding ground to China to create "soft power" relationships through trade and investment. Beijing is launching its own system of multilateral trade and finance that could someday operate as a sphere of influence in Asia outside of U.S.-led international norms - such as Xi's "Belt and Road Initiative," which was also enshrined in the Communist Party constitution (Chart 6). Moreover, Beijing is using its growing economic leverage to achieve political goals, having imposed informal sanctions on Japan, both Koreas, Vietnam, Taiwan and others in recent years.9 Chart 5China Raises Asian Security Fears China Raises Asian Security Fears China Raises Asian Security Fears Chart 6China's Belt And Road Club Xi Jinping: Chairman Of Everything Xi Jinping: Chairman Of Everything These trends were all reaffirmed at the party congress, confirming our view that U.S.-China frictions are a serious geopolitical risk. Fortunately, neither Xi nor China is a loose cannon. Most of these trends are developing over the long run. With Xi Jinping overseeing an extensive overhaul of the People's Liberation Army, there is less reason to suppose that the PLA will act aggressively independent of civilian leadership (as was a concern under the previous administration). One would also think that a transition across the armed forces is an inopportune time to instigate conflicts. Notably, the Xi administration has also tactically adopted a milder diplomatic approach since President Trump's coming to power with an arsenal of threats aimed at China. This approach is evident with Japan, India, and Southeast Asian neighbors. Trump's perceived belligerence gives China the ability to play a mediating role and promote trade and investment with other powers looking to hedge against the U.S. Finally, Beijing appears to have domestic unrest in check, at least for now. Public security disturbances have been elevated in the wake of the global financial crisis, but have declined since 2011 (Chart 7). This is a positive sign for markets because China will have greater ability to push domestic reforms - and less reason to be aggressive abroad - if unrest is subdued. Official statistics suggest that China spends about as much on public security as national defense, revealing a key vulnerability to the state (Chart 8). Chart 7Domestic Unrest Down, Though Not Out Domestic Unrest Down, Though Not Out Domestic Unrest Down, Though Not Out Chart 8Domestic Unrest A Risk To The State Xi Jinping: Chairman Of Everything Xi Jinping: Chairman Of Everything Bottom Line: The party congress has highlighted China's rising global influence. This ultimately creates higher geopolitical risk, especially in U.S.-China relations. China also has greater control over domestic factors that could instigate conflicts, at least for the time being. Thus the U.S.'s next moves will be critical. Reform And Opening Up The second major takeaway is that the Xi administration is still officially committed to the reform agenda laid out in the 2012 party congress, the 2013 Third Plenum, and the supply-side structural reforms announced in 2015. Xi's work report calling for "sustained and sound" growth is a nod to the need to reduce capital intensity and systemic risks. He also said that supply-side structural reform would be the "main task" for economic policy for the foreseeable future. His economic reform slogans also made it into the party's constitution. Significantly, there are no more GDP targets beyond 2020. Broadly, we have defined Xi's reform agenda as a combination of centralizing control, improving governance, and streamlining the economy.10 Centralization is not necessarily market-positive, but under the Xi administration it has coincided with efforts to improve governance (fighting corruption, reining in provincial freewheeling, and reducing pollution). This is a sign of growing policy responsiveness to public demands and as such is marginally positive. The clear takeaway from the congress is that the anti-corruption campaign will be institutionalized across the country through new "supervisory commissions." This campaign should improve the legitimacy of the party-state and the implementation of central government policies. We have always been skeptical of progress on structural economic reforms, but the party congress marks a new phase in the political cycle: Xi is in a better position than any Chinese leader since Deng Xiaoping to launch significant reforms. He has increased his political capital massively over the past few years, as illustrated by the dotted line in our "J-Curve of Structural Reform" (Diagram 2). Cyclically, the next opportunity for China to undertake bold reforms may not occur until 2027. Hence it is either now or never for reform. The policy focus is supposed to push along China's economic transition from investment- to consumption-led growth (Chart 9). Importantly, Xi declared that the "principle contradiction" in Chinese society has changed since the 1980s. The principle contradiction used to be that of a poor, economically and technologically "backward" country trying to meet the basic material needs of the population. Now the contradiction is that of an "imbalanced" and under-developed economy trying to provide people with "better lives." These goals can be put into perspective by comparison with South Korea, which reveals both how far China has come and how far it has to go (Chart 10). Xi's statement points to an overall shift in policy toward addressing imbalances and improving quality of life. Diagram 2The J-curve Of Structural Reform Xi Jinping: Chairman Of Everything Xi Jinping: Chairman Of Everything Chart 9Changing The Economic Model Changing The Economic Model Changing The Economic Model Chart 10From Basic Needs To 'Better Lives' From Basic Needs To 'Better Lives' From Basic Needs To 'Better Lives' To put a time frame on many of these reforms, Xi created a new long-term deadline of 2035 to become a fully "modernized" economy, which is smack in the middle of the country's previously declared two "centenary goals" of 2020 (middle income status) and 2050 (global prominence). The interim deadline includes a target for narrowing regional and income disparities. Wealth inequality in China has become extreme and ultimately poses a threat to the regime (Chart 11). Such a goal will require serious redistributionist policies as well as ongoing efforts to build a better social safety net. As expected, Xi reaffirmed China's embrace of globalization, claiming that the door of trade "will only open wider." The financial sector is likely to be at the forefront of any new opening measures - top financial officials claim that a package of reforms is forthcoming. The developed world has begun to doubt China's commitment to financial reform given the closing of the capital account last year and other negative trends, like the persistently low (and falling) share of foreign banks in domestic lending. Only recently have foreign banks begun lending again after withdrawing funds in preceding years (Chart 12). Foreign ownership of domestic equities, which is tightly controlled, has also fallen in importance (Chart 13). Chart 11Inequality: A Liability For The Party Inequality: A Liability For The Party Inequality: A Liability For The Party Chart 12Banks Shying Away From China Banks Shying Away From China Banks Shying Away From China Chart 13Foreign Investors Limited In China Foreign Investors Limited In China Foreign Investors Limited In China The centralization of power should speed up policy implementation, but it also raises risks. The important thing is whether we see hard evidence that Xi's "absolute power" is corrupting absolutely. This would present a new structural risk to the Chinese system, even if markets initially cheered. Why? Because an administrative (as opposed to propagandistic) turn in China in favor of a "cult of personality" as opposed to "collective leadership" would increase the odds of policy mistakes, set off factional struggle in the Communist Party, increase policy uncertainty for the foreseeable future, and jeopardize the smooth transition of power in 2022 ... or whenever "Chairman Xi" outwears his welcome. Therefore, the implementation of policy, the grooming of "heirs apparent," the position of the opposing faction in the party, and the upkeep of rules and norms will be important to monitor - not just after the party congress, but over the next five years. Bottom Line: Xi has reaffirmed formal structural economic goals like consumer-led growth and a commitment to globalization and has signaled that more reforms are in the works. Policy implementation will improve. Stay overweight H-shares within EM equities. However, excessive concentration of power in Xi himself is a serious political risk. It is only a positive in the long term if Xi uses his authority to build institutions rather than personalize them. Principal Contradictions China's declared goals are, of course, riddled with contradictions. As expected, Xi has tried to be everything to everyone. This leaves investors with a number of missing pieces to try to fit together. For example, the slogan indicating Xi's governing philosophy is a revision of Deng Xiaoping's market-oriented slogan, "Socialism with Chinese Characteristics" (Table 1). Xi is announcing that China has entered a "New Era" that will redefine Deng's formulation. Thus, by quoting Deng, he is reaffirming China's need to continue reforming and opening up. But by simultaneously qualifying Deng, he is reasserting the primacy of the state.11 Table 1Xi Jinping Thought Xi Jinping: Chairman Of Everything Xi Jinping: Chairman Of Everything What matters are the concrete policies China actually enacts. Nowhere are the contradictions clearer than in the party's constant assurances that it will both intensify reforms and keep the economy stable. Beijing continues to stress that it will deleverage the financial sector, restructure industry, eliminate overcapacity, and fight smog, all without any negative impact to growth. Given the sharp deceleration in the growth of China's monetary aggregates, we expect a significant slowdown in the coming year.12 "Reform" will in large part consist of demonstrating a higher-than-usual tolerance for slower growth so as to impose market discipline. Authorities will, as always, inject further stimulus if necessary to avoid a hard landing. A key risk to global markets, as discussed last week, is that fiscal spending may not offset a crunch in credit growth next year, should one occur. This is increasingly the case because the composition of fiscal spending in China is shifting as the country focuses more heavily on social stability and economic transition. Education, social security, worker training and relocation, and other public services are simply not as capital intensive as building railroads, urban infrastructure, and houses (Chart 14). Moreover, a critical test of the reform-stimulus trade-off will be Beijing's tolerance for failing companies. Bankruptcies have risen over the past year in China, which suggests that market forces are being given wider scope and that the central government is laying down the legal framework to make bankruptcy more acceptable (Chart 15), a notable reform. This is a clear sign of "short-term pain, long-term gain," but it remains to be seen how far it will go. Chart 14China's Fiscal Spending Is Becoming Less Capital Intensive Xi Jinping: Chairman Of Everything Xi Jinping: Chairman Of Everything Chart 15Creative Destruction At Long Last? Xi Jinping: Chairman Of Everything Xi Jinping: Chairman Of Everything It is also unclear whether failures will be allowed among state-owned enterprises (SOEs), which are the least profitable and most indebted Chinese companies. The future of SOE reform is no clearer than before the congress: Xi promised both to restructure the sector and to enlarge and strengthen it. The principle is in alignment with the Jiang Zemin administration's maxim, "grasp the large, let go of the small," and does not mean that reform is doomed. More than a fourth of SOEs are under water and the government is already committed to cutting the number of centrally administered SOEs in half. There are now several pilot projects for allowing partial privatization, or creating state holding companies, that can be rolled out nationally. And there are a range of perfectly un-strategic sectors (retail, chemicals, real estate, electronics, et al) that have substantial state ownership that could be liquidated. Judging by listed Chinese firms, those that are deemed to be strategic will not likely see their state share diluted much beneath 80% of ownership; yet those that are designated for partial privatization and mixed ownership could see the state share dwindle to less than 10% of ownership (Table 2). This implies that sweeping changes could occur if the government prioritized SOE reform. (This is true despite the fact that the state's hand would still be obtrusive overall.) Table 2Plenty Of Room For Privatization Xi Jinping: Chairman Of Everything Xi Jinping: Chairman Of Everything Bottom Line: Deleveraging and bankruptcies are a key aspect of reform but pose headwinds to growth. The profile of China's fiscal spending is changing to become less capital intensive, which will mean less stimulus for China's aging industries if reforms are pursued. This underscores a real risk to Chinese growth, capex, and imports, and hence to EM. There is no clarity on SOE reform, but it would have far-reaching consequences if prioritized in Xi's second term, given his soaring political capital. Tax Blues In The USA: Are Tax Cuts Really Coming? On the other side of the Pacific, investors remain highly skeptical that tax reform is on the legislative menu (Chart 16). This is after both houses of Congress passed their version of the budget resolution, containing reconciliation instructions for tax reform. Once the House of Representatives passes the Senate version of the budget resolution - which we assume will be swift - the reconciliation process will kick off.13 The Senate version of the budget resolution instructs the Senate Committee on Finance and the House Ways and Means Committee to limit the increase in the budget deficit to no more than $1.5 trillion through 2027.14 The resolution also instructed the Congressional Budget Office (CBO) and Joint Committee on Taxation (JCT) to consider "to the greatest extent practicable... the budgetary effects of changes in economic output, employment, capital stock, and other macroeconomic variables resulting from such major legislation." In plain English, this refers to "dynamic scoring," macroeconomic modeling that takes into account the revenue-raising potential of major tax cuts. BCA's Geopolitical Strategy has harped on "dynamic scoring" since last November. The tool is a favorite of Republican legislators when passing tax legislation. It allows them to cut taxes and then score the impact on the budget deficit holistically, taking into consideration the supposed pro-growth impact of the legislation. Democrats banned this practice when they took back the Senate in the Obama years, but the GOP promptly re-authorized it in January 2015. Fast forward a year later and two core conclusions of our November 2016 forecast on tax policy are now coming true.15 First, the tax bill will not be revenue neutral, except in the imagination of macroeconomic modeling pursued by Republican economists. The bill will be mildly stimulative, to the tune of $100-150 billion per year over the next decade. The numbers are modest, but given that the U.S. is close to full employment and wage pressures are certain to build up (Chart 17), any additional tax relief is bound to be stimulative for the economy. Chart 16High-Tax Firms Not Outperforming (Yet) High-Tax Firms Not Outperforming (Yet) High-Tax Firms Not Outperforming (Yet) Chart 17Inflation Coming Even Without Tax Cuts Inflation Coming Even Without Tax Cuts Inflation Coming Even Without Tax Cuts Second, Republican legislators are not fiscally conservative. The House budget resolution authorizing a $1.5 billion hole in the budget was passed with 18 Republicans dissenting, but 11 of them were from highly-taxed "blue states." Their contention with the bill was not that it would be profligate, but that it would do away with state and local tax deductions in order to pay for the likely $5-$6 trillion price tag. As such, they voted not to make tax cuts less, but rather more, profligate. Going forward, the real threat to the proposed tax bill is in the Senate, where Republicans hold only a slim 52-48 majority. This threat is a surprise, as 12 months ago the question was how a profligate bill would pass the supposedly conservative House. Three risks lurk in the Senate: Alabama: Judge Roy Moore, a highly conservative candidate for the December 12 special election, is holding onto a relatively slim lead against Democrat Doug Jones. A recent Fox News poll shows the two tied in public opinion. Even if the poll is unreliable, other polls suggest that Jones has narrowed the gap to single digits. This is remarkable because Alabama Republicans have defeated their Democrat opponents by an average of 36% in Senate races over the past decade.16 If Moore were to lose, the Republican majority in the Senate would fall to 51. This would leave room for only one defection in passing legislation. The Corker-Flake-McCain Axis: Senators Bob Corker (R - Tennessee), Jeff Flake (R - Arizona), and John McCain (R - Arizona) have all voted in favor of the Senate budget resolution authorizing reconciliation instructions for tax legislation. On that basis, there should be no problem. However, Corker and Flake have announced their retirement, in our view because they plan to challenge President Trump in the 2020 Republican primary. Furthermore, Corker has said in the past that he would not vote for a tax bill that is not revenue neutral. We think that Corker and Flake will ultimately vote for tax cuts, if only because their chances of successfully challenging Trump in 2020 will be higher if they stick to Republican orthodoxy. However, these three Senators are risks to our view as they have the freedom not to care about the 2018 midterms. God: The death of Massachusetts Senator Ted Kennedy on August 25, 2009 greatly changed the fortunes of President Barack Obama, who at the time was enjoying a 60-seat majority in the Senate.17 Democrats failed to move quickly on the Affordable Care Act, assuming that a Democrat would win the special election in staunchly liberal Massachusetts. (If the parallels with Alabama today seem eerie, it is because they are.) But the January 2010 election cost Democrats the 60th seat in a shocking upset. These things can happen again, especially given that the average age of a senator is 103.18 Any one of these factors could reduce the Republican majority in the Senate to 51, forcing President Trump to rely on vociferous critics McCain and Corker. The latter, by the way, is also a likely 2020 primary challenger against Trump. Could a Democrat come to the president's aid? The short answer is yes. The 2001 Economic Growth and Tax Relief Reconciliation Act, the first of two Bush-era tax cuts, passed with 58 votes in favor, including 12 Democrats. Of the 12 that voted with Republicans, only three were from blue states, while the other nine were from red states that President Bush had carried in 2000. The 2003 tax-cut bill, Jobs and Growth Tax Relief Reconciliation Act of 2003, also passed with Democratic support with only 51 votes in favor. Senators Bayh (D - Indiana), Miller (D - Georgia), and Nelson (D - Nebraska), all crossed the aisle. Bayh was facing reelection in 2004, as was Nelson in 2006, in their respective red states, while Zell Miller of Georgia effectively ceased to be a Democrat and endorsed President George W. Bush reelection at the 2004 Republican National Convention. Ominously for today's efforts, John McCain voted against both versions. Given that he is unlikely to campaign again due to terminal cancer, and given his vociferous opposition to President Trump, we have to assume that he will vote against the tax bill as well. Which Democrats could potentially cross the aisle with this year's reconciliation bill? Table 3 lists the 2018 Senate races to watch, particularly the vulnerable Democrats campaigning in red states that President Trump carried in 2016. Particularly vulnerable are Senators Nelson (D - Florida), Donnelly (D - Indiana), McCaskill (D - Missouri), Tester (D - Montana), Heitkamp (D - North Dakota), Brown (D - Ohio), and Baldwin (D - Wisconsin). That makes seven potential votes for the Trump tax cut, plenty of "slack" for the Republicans in Senate to lose one or two votes on the tax bill. Table 32018 Senate Races To Watch Xi Jinping: Chairman Of Everything Xi Jinping: Chairman Of Everything As far as the timing of the bill is concerned, we are sticking with our updated view that the end of Q1 2018 is far more likely for passage of tax legislation than the end of 2017. There are simply too many things on the legislative agenda between now and the end of the year, including a potential government shutdown and an immigration fight. Bottom Line: The market remains unconvinced that Republicans can pass tax legislation through Congress. However, the tax process has played out thus far almost exactly as we expected last year (aside from starting later). Republicans have proposed a profligate tax bill and are using dynamic scoring to get it through Congress. Going forward, we think that GOP can afford to lose one or two votes, as it did in 2003 with the highly controversial Bush tax cuts. This is because there are up to seven Democratic Senators who can pick up the slack. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Is King Dollar Back?" dated October 4, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy, "Strategy Outlook 2015 - Paradigm Shifts," dated January 21, 2015, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 7 Xi is also overhauling the armed forces to imitate modern American joint operations and combatant commands (as opposed to the army-centric Soviet system). 8 Please see BCA Geopolitical Strategy Special Report, "The South China Sea: Smooth Sailing?" March 28, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "Does It Pay To Pivot To China?" July 5, 2017, available at gps.bcaresearch.com. 10 See note 4 above. 11 Whether Xi is mentioned specifically, and described as the founder of a school of "Thought," or a lesser "Theory," or something else, will be a notable watchword. 12 Please see note 2 above, "How To Read Xi Jinping's Party Congress Speech," and BCA Emerging Market Strategy Weekly Report, "China: Deflation Or Inflation?" October 4, 2017, available at ems.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Weekly Report, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," dated May 31, 2017, available at gps.bcaresearch.com. 14 Please see S.Con.Res.25, available at congress.gov. 15 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcareserach.com. 16 Current U.S. Attorney General Jeff Sessions, whose retirement from the Senate has prompted the current special election, ran unopposed in 2014 and garnered 97.25% of the vote! 17 Democrats picked up eight seats in the Senate in the watershed 2008 election, boosting their majority to 57, with two Independents caucusing with the Democrats. Shortly after the election, Pennsylvania Republican Arlen Spector changed parties, giving Democrats the 60-seat, filibuster-proof, majority. 18 It is actually 62, but we wanted to make sure you were still reading. Geopolitical Calendar

Highlights Global "Low-flation" Vs. Oil Reflation: Investors who believe that inflation is dead will be surprised by the breakout of global oil prices in 2018 toward the mid-$60 level anticipated by our commodity strategists. This will help drag both realized and expected inflation higher across the developed world. Fed Tightening Vs. Trump Easing: The trade-off between a full-employment Trump fiscal stimulus and a slowly tightening Federal Reserve next year will first result in higher inflation expectations and a bear-steepening Treasury curve, and eventually lead to more aggressive rate hikes and a bear-flattening curve later in 2018 Strong Growth Vs. Modest Inflation In Europe: The ECB will signal a reduction in the pace of its asset purchases this week, in response to the continued strength of the Euro Area economy. Current moderate rates of inflation will not derail a "taper", but will be enough to push off any ECB interest rate hike until late 2019. Feature The bull market in global risk assets continued last week, with the S&P 500 hitting yet another all-time record and other major bourses in both Developed Markets and Emerging Markets hitting multi-year highs. This is a sensible reflection of the strength and persistence of the current coordinated global economic upturn, which is boosting corporate profit growth worldwide. At the same time, the health of the current expansion has dampened risk-aversion among investors. This is helping to keep market volatility at depressed levels with only modest changes expected for both inflation and monetary policy. Yet there are storms brewing on the horizon that have the potential to shake up this low-volatility, risk-seeking backdrop. Specifically, a potentially less stable outlook for global inflation, amidst uncertainty over the direction of fiscal policy in the U.S. and monetary policy at the Fed and European Central Bank (ECB), could pose a threat to the current Goldilocks environment for risk assets (Chart of the Week). In this Weekly Report, we discuss some macroeconomic "trade-offs" that investors will have to grapple with over the next 6-12 months, and how to position bond portfolios accordingly. Chart of the WeekMarkets Not Worried About The Fed Or ECB Markets Not Worried About The Fed Or ECB Markets Not Worried About The Fed Or ECB Trade-Off #1: "Low-flation" Vs. Rising Oil Prices Chart 2Global Inflation Pressures Are Slowly Building Global Inflation Pressures Are Slowly Building Global Inflation Pressures Are Slowly Building Realized inflation data across the major developed economies is showing no imminent threat of breaching, or even just reaching, central bank targets. This is occurring despite a robust, coordinated global economic expansion that is generating some of the fastest growth rates seen since the Great Recession. With nearly ¾ of the countries in the OECD now with unemployment rates below the estimates of the full employment NAIRU, subdued inflation readings remain a puzzle for both investors and policymakers (Chart 2). The term "low-flation" has been used to describe this backdrop of inflation rates remaining low seemingly regardless of what is happening with growth. Bond investors have reacted to this by keeping market-based inflation expectations at levels below central bank inflation targets, suggesting a potential problem with the credibility of policymakers. Yet a fresh challenge to the low-flation thesis will soon come from the global oil markets. Last week, our colleagues at BCA Commodity & Energy Strategy upgraded their oil price targets for the fourth quarter of 2017 and all of 2018.1 Their estimates for global oil demand were revised upward based on the improving economic momentum, as evidenced by the IMF recently boosting its own forecasts for world GDP growth to 3.6% for all of 2017 and 3.7% for 2018. Combined with continued discipline on output from the so-called "OPEC 2.0" coalition of Russia & Saudi Arabia - currently responsible for 22% of the world's oil production - the global oil market is expected to see demand exceeding supply until late 2018 (Chart 3). The positive demand/supply balance should lead the Brent oil price benchmark to average just over $65/bbl in 2018 (Table 1), which would be a 13% increase from current levels. This is a move that global bond markets are likely to notice, given the strong correlation that still exists between market-based inflation expectations and oil prices in the developed economies. Chart 3A Positive Fundamental Backdrop For Oil A Positive Fundamental Backdrop For Oil A Positive Fundamental Backdrop For Oil Table 1Upgrading The BCA Oil Price Forecasts How To Trade The Trade-Offs How To Trade The Trade-Offs In Charts 4 & 5, we show the market-based pricing on inflation expectations at the 10-year maturity for the U.S. (using TIPS breakevens), the U.K., Germany, Japan, Canada and Australia (using CPI swaps). For each country, we also show the Brent oil price denominated in local currency terms. We add one additional data point to the charts, shown as an asterisk, incorporating the 2018 average Brent oil price expectation converted at current exchange rates versus the U.S. dollar. As can be seen, the higher oil price that our commodity strategists are expecting should act to put upward pressure on the inflation expectations component of government bond yields in the major developed markets. Chart 4Upward Pressure On Inflation Expectations ... Upward Pressure On Inflation Expectations... Upward Pressure On Inflation Expectations... Chart 5... From Higher Oil Prices In 2018 ...From Higher Oil Prices In 2018 ...From Higher Oil Prices In 2018 Of course, the unchanged currency assumption made in Charts 4 & 5 is unrealistic. Yet given the significant increase in oil prices that we are expecting next year (+13%), it is also unrealistic to expect enough currency appreciation in any country to fully offset the inflationary impact from oil. In fact, given the BCA view that the U.S. dollar should enjoy one last cyclical boost next year as the Fed delivers more rate hikes than the market is currently discounting, inflation expectations may actually rise by more than we are showing in our charts in non-U.S. countries (given that oil is priced in U.S. dollars). In Table 2, we show the forecast for the local-currency Brent oil price for 2018 and the date that oil prices were last at that level in each country (all in 2015 after the cyclical peak in oil prices that began in 2014). We also present the data on 10-year government bond yields, the 2-year/10-year slope of yield curves, market-based inflation expectations, and realized headline and core inflation rates for the major developed economies. We show the current levels for all those variables, plus the levels that prevailed the last time oil was at the levels we are forecasting. The major differences that stand out are: Table 2Bond Markets Now Vs. The Last Time Oil Prices Were In The Mid-$60s How To Trade The Trade-Offs How To Trade The Trade-Offs Yield levels are not dramatically different than where they were in 2015 in the U.S., Canada and Australia, but are lower now in the U.K., Euro Area and Japan thanks to central bank asset purchase programs. Yield curves are much flatter now in the U.S., U.K., Canada and Japan, but are steeper in the Euro Area and Australia. Market-based inflation expectations now are very close to the levels that prevailed in 2015, except in Japan where they are much lower. Headline inflation rates are much higher now everywhere except Australia, while core inflation rates are a lot higher in the U.K., a touch higher in the U.S. and Euro Area, and lower everywhere else. The conclusion from Table 2 is that there is potential for bond yields to rise as oil prices head higher in the U.S., U.K. and Euro Area given that inflation expectations are at the same levels as 2015 but realized inflation rates are higher. This would suggest that owning inflation protection in these countries is a sensible way to play the "low-flation vs. oil reflation" trade-off - trades that we already have in place in our Tactical Trade Overlay by being long Euro Area CPI swaps and owning U.S. TIPS versus nominal U.S. Treasuries and (see table on page 16). We are reluctant to add U.K. inflation protection to this list, however, and may even look to go the other way given the likelihood that the currency-fueled surge in U.K. inflation is in the process of peaking out. In sum, bond markets will be unable to ignore a combination of strong global growth (still called for by rising global leading economic indicators), tightening labor markets and rising oil prices in 2018. As investors come to grips with oil trading with a 60-handle for the first time since 2015, inflation expectations should widen out in all developed market countries that are at, or beyond, full employment. This should put upward pressure on nominal bond yields as well, and potentially trigger bear-steepening of yield curves if central banks do not respond to higher oil-driven inflation with a faster tightening of monetary policy. Bottom Line: Investors who believe that inflation is dead will be surprised by the breakout of global oil prices in 2018 toward the mid-$60 level anticipated by our commodity strategists. This will help drag both realized and expected inflation higher across the developed world. Trade-Off #2: Fed Tightening Vs. Trump Easing Last Friday, the U.S. Senate passed President Trump's budget plan by the slimmest of margins (51 to 49), allowing for an increase in federal deficits of up to $1.5 trillion over the next decade. Trump immediately put pressure on the U.S. House of Representatives to also pass the Senate plan, and the initial comments from House Republican leadership was that they would also endorse the Senate budget proposal which included significant tax cuts for corporations and some households. This is unsurprising given that the Republicans need a major, economy-boosting legislative victory to present to voters in next year's U.S. Midterm elections. The U.S. Treasury market responded to this news on Friday in a fashion that we believe to be sensible - the curve bear-steepened, with the 2-year/30-year spread widening 4bps on the day. We have written about the interaction between budget deficits, Fed policy and the slope of the Treasury curve in past Weekly Reports this year, most recently at the beginning of this month.2 Chart 6 is taken from that most recent report, and we feel that it is important to go through our logic once again after last week's events. Chart 6UST Curve: Bear-Steepener First, Bear-Flattener Later UST Curve: Bear-Steepener First, Bear-Flattener Later UST Curve: Bear-Steepener First, Bear-Flattener Later The Treasury curve typically steepens during periods when the U.S. federal budget deficit is widening (top panel). The Treasury curve is typically negatively correlated to the real fed funds rate, steepening when the real rate is falling and vice versa. Budget deficits usually are widening during periods of soft economic growth, when tax receipts are slowing and counter-cyclical fiscal spending is increasing. This is also typically correlated to periods when spare capacity in the U.S. economy is opening up and inflation pressures are diminishing (middle panel), hence giving the Fed cover to lower interest rates and putting steepening pressure on the Treasury curve. The current backdrop is atypical, as a fiscal stimulus is being proposed at a time when the economy is already at full employment with little sign of slowing. At the same time, the Fed is in a tightening cycle - albeit a slow one because of relatively subdued inflation - which usually does not occur during periods of widening budget deficits. This represents another difficult "trade-off" for investors to process. A so-called "full employment" fiscal stimulus should be inflationary at the margin, by definition, if it boosts economic growth to an above-potential pace. That would steepen the Treasury curve as longer-term inflation expectations rise, until the Fed steps in with rate hikes to offset the impact of the fiscal stimulus. If the Fed felt that the greater fiscal deficit was becoming a problem for medium-term inflation stability, then there could be a faster pace of rate hikes that would boost the real funds rate and put flattening pressure on the Treasury curve. A more straightforward way to describe that would be a scenario where the Trump tax cuts end up boosting U.S. real GDP growth to something close to 3% next year, which results in the U.S. unemployment rate falling to a "3-handle". This would likely put upward pressure on U.S. realized inflation and steepen the Treasury curve as the market prices in higher inflation - IF the Fed is slow to respond to that inflation pickup. When inflation rises by enough to threaten the Fed's 2% inflation target, perhaps even rising above that level, then the Fed would step in with more rate hikes. The result: a higher real fed funds rate and a flatter Treasury curve. That scenario is how we envision the next year playing out. Various FOMC members have already noted that they cannot account for any fiscal stimulus in their economic projections until they see the details. Furthermore, many members of the FOMC are expressing concern that the downdraft in inflation was enough of a surprise to raise questions about the Fed's understanding of the underlying inflation process. This suggests that the Fed will want to see inflation, both realized and expected, rise first before increasing the pace of rate hikes beyond current projections. Net-net, we see the Trump fiscal stimulus steepening the Treasury curve in 2018 before the Fed flattens it with tighter monetary policy. One caveat for the latter is the upcoming decision on the next Fed Chair. President Trump, ever the reality game show host, noted last week that the finalists for this season's episode for "The Apprentice: FOMC" are now down to Jerome Powell, John Taylor and current Chair Janet Yellen. Both Powell and, of course, Yellen would represent a continuation of the current cautious FOMC framework, while Taylor would likely be more hawkish given his public comments on Fed policy decisions (and the output of his own Taylor Rule!). If Taylor were to be appointed by Trump as the new Fed Chair, the Treasury curve may not steepen much on the back of fiscal easing if the markets begin to discount a more aggressive Fed. Bottom Line: The trade-off between a full-employment Trump fiscal stimulus and a slowly tightening Federal Reserve next year will first result in higher inflation expectations and a bear-steepening Treasury curve, and eventually lead to more aggressive rate hikes and a bear-flattening curve later in 2018. Trade-Off #3: Strong European Growth Vs. Mild Inflation The ECB meets later this week, and is expected to make a decision on the size and scope of its asset purchase program for next year and beyond. The latest Bloomberg survey of economists is calling for a cut in the monthly pace of asset purchases from €60bn/month to €30bn/month, but with an extension of the program until September 2018.3 The same survey calls for the ECB to deliver a hike in the deposit rate in Q1/2019, with a hike in the benchmark interest rate in Q2/2019. We agree with the former, although we think there will be no rate hikes of any kind until the 4th quarter of 2019, at the earliest. Chart 7Why Would The ECB NOT Taper? Why Would The ECB NOT Taper? Why Would The ECB NOT Taper? The trade-off between robust European growth and still modest rates of core inflation are the reason we expect the ECB to be very late to begin hiking policy rates after the asset purchase program is completed. It is clear from a variety of data, from almost all countries in the Euro Area, that the economy is expanding at a robust, above-potential pace (Chart 7). Headline inflation has increased steadily off the 2015 lows and now sits at 1.5%, still below the ECB's target of "just below 2%". The ECB has played down this pickup in inflation, given that is has largely been driven by the rise in oil prices since the 2015 lows. There is certainly a strong correlation between the annual change of oil prices (denominated in euros) and Euro Area headline inflation (middle panel), and the ECB expects fading oil price momentum to result in Euro Area headline inflation drifting back to 1% in early 2018. Yet the oil price increase that our commodity strategists are calling for next year would boost the year-over-year growth rate to a pace around 40%, which has in the past been consistent with 2% headline inflation outcomes. A rising euro would help mitigate the impact from oil, but as mentioned earlier, we see more potential for some modest depreciation of the euro versus the U.S. dollar after the run-up seen in 2017. Despite the pickup in headline inflation already underway, core inflation in Europe remains benign at 1.1%. Our measure of the "breadth" of the rise in core inflation across 75 individual subsectors - the Euro Area core inflation diffusion index - sits right around the "50 line" suggesting that just as many components of Euro Area core inflation are rising as are falling. Yet with broad Euro Area unemployment approaching 8%, and with some measures of wage inflation starting to awake as a result, the odds are increasing that continued strong growth will result in additional upward momentum in core inflation. The ECB is already forecasting a return of core inflation to 1.9% in 2019, which is why some reduction in the pace of asset purchases will be announced this week. The entire asset purchase program was only put in place in 2015 to fight a deflation threat after oil prices collapsed in 2014, and that has now passed with inflation steadily grinding higher. So the "trade-off" for investors in Europe, between strong growth and moderate inflation, will be resolved by the ECB shifting to a less-accommodative monetary policy stance. In terms of the impact on Euro Area bond yields, however, the change in the pace of bond buying matters even more than the size of the asset purchases. In Chart 8, we show the ECB's monetary base and three scenarios for how it will evolve through asset purchases until the end of 2018: Base Case: The ECB slows the pace of bond buying to €30bn/month starting in January 2018 until September 2018, then cuts that down to €15bn/month for the remainder of 2018 and stops the program completely at year-end. Dovish Scenario: The pace of bond buying is maintained at €60bn/month until the end of 2018, with no commitment to end the program then. Hawkish Scenario: The ECB tapers its purchases by €10bn/month for the first six months of next year, then ends the program in July 2018. In the bottom two panels of Chart 8, we show the year-over-year growth rate of the ECB's balance sheet, with those three scenarios, and compare them to the benchmark 10-year German Bund yield and our estimate of the German term premium. In all three scenarios, even the dovish one where the ECB keeps on buying at the current pace, the growth rate of the monetary base will decelerate in 2018. As can be seen in the chart, that growth rate has been highly correlated to yields and the term premium during the life of the ECB's asset purchase program. The conclusion here is that central bank asset purchase programs need to increase in size versus previous years to maintain the same impact on bond yields over time. Put another way, asset purchases represent a signaling mechanism ("forward guidance") from a central bank to the markets about future changes in interest rates when they are already at the zero bound. Increasing the size of the purchases sends a more powerful message than simply keeping the pace of buying unchanged. This is especially true if the underlying economy is growing and inflation is rising, which would typically cause investors to price in a higher expected path of interest rates into the government bond yield curve. So, unless the ECB takes the highly unlikely step of increasing the size of its asset purchases for next year, then there are no outcomes from this week's ECB meeting that should be expected to be sustainably bullish for longer-dated European government bonds. At the same time, there will be no signals given on future changes in short-term interest rates, as the ECB has maintained for some time that rates will not be touched until "some time" after the asset purchase program has ended (Q4/2019, in our view). Hence, Euro Area yield curves are likely to eventually see some bear-steepening pressure on the back of this week's ECB meeting. The story is similar for Peripheral European government bonds and Euro Area investment grade corporate credit. In Chart 9, we show the same growth rates of the ECB monetary base with our scenario projections versus the 10-year Italy-Germany spread, 10-year Spain-Germany spread, 10-year Portugal-Germany spread and the Barclays Bloomberg Euro Area Investment Grade corporate spread. While the correlations are not as clear as that for German yields, a slower pace of ECB asset purchases would be consistent with some spread widening in Peripheral European and in corporate credit. Chart 8ECB Bond Buying:##BR##Watch The Pace, Not The Level ECB Bond Buying: Watch The Pace, Not The Level ECB Bond Buying: Watch The Pace, Not The Level Chart 9European Credit Spreads##BR##Set To Widen Post-ECB? European Credit Spreads Set To Widen Post-ECB? European Credit Spreads Set To Widen Post-ECB? Bottom Line: The ECB will signal a reduction in the pace of its asset purchases this week, in response to the continued strength of the Euro Area economy. Current moderate rates of inflation will not derail a "taper", but will be enough to push off any ECB interest rate hike until late 2019. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Commodity & Energy Strategy Weekly Report, "Oil Forecast Lifted As Markets Tighten", dated October 19th 2017, available at ces.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "The Case For Steeper Yield Curves", dated October 3rd 2017, available at gfis.bcaresearch.com. 3 https://www.bloomberg.com/news/articles/2017-10-22/draghi-seen-going-for-ecb-bond-buying-limit-in-qe-s-last-hurrah The GFIS Recommended Portfolio Vs. The Custom Benchmark Index How To Trade The Trade-Offs How To Trade The Trade-Offs Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Yield Curve & TIPS: To avoid policy failure the Fed must allow inflation to reach its 2% target before the onset of the next recession. This means it will soon fall behind the inflation curve. Treasury curve steepeners and TIPS breakeven wideners will benefit. Inflation: The current cycle looks very similar to the cycle of the late 1990s. In both cases the unemployment rate fell far below its natural level before inflation started to accelerate. Almost all of the indicators that predicted the 1999 increase in inflation are currently sending strong positive signals. Credit Spreads: Spreads are tight across the entire credit spectrum, but risk-adjusted value is most attractive in the Caa, B and Baa credit tiers. Feature Chart 1Low Inflation + Flat Curve = Policy Mistake Low Inflation + Flat Curve = Policy Mistake Low Inflation + Flat Curve = Policy Mistake In the 12 months leading up to August, headline PCE inflation came in at 1.43% and core PCE inflation was a mere 1.29%. Both readings are well short of the Fed's 2% target. At the same time, the 2/10 Treasury curve is only 79 basis points away from inversion (Chart 1). The combination of low inflation and a flat yield curve suggests that, despite below-target inflation, the market views Fed policy as relatively restrictive. This situation is not sustainable. The Fed must, and will, fall behind the curve. An inverted yield curve represents the market's expectation that the Fed will be forced to cut interest rates in the future. As such, it has an excellent track record as a recession indicator. Now consider a situation where the yield curve inverts with inflation never having re-gained the Fed's target. The Fed would have tightened the yield curve into inversion, and the economy into recession, without having achieved its inflation goal. This is the most striking example of monetary policy failure that we can dream up, and unless we witness a trend change in either inflation or the slope of the curve, it is an outcome we are likely to face. Of course we do not think the above scenario will actually come to pass. In fact, our investment strategy hinges on the premise that the Fed would never abide such an outcome. This means that one of two things will occur in the coming months: Inflation will rebound and the Fed will be able to fall behind the curve while still delivering a pace of rate hikes similar to its median expectation - one more hike this year and three more next year. Inflation will remain low and the Fed will be forced to fall behind the curve by reneging on its forecasted rate hike path. These two possibilities are illustrated by looking at the real fed funds rate (deflated by core PCE inflation) alongside the popular Laubach-Williams estimate of its equilibrium level (Chart 2). In the Fed's policy framework the real interest rate must stay below equilibrium for inflation to rise. Likewise, if the Fed lifts the real interest rate above equilibrium it is because it wants inflation to fall. What is clear from Chart 2 is that one more rate hike with no improvement in inflation will move monetary policy into restrictive territory. Our contention is that the Fed will ensure that monetary policy remains accommodative (i.e. it will remain behind the curve) until inflation returns to the 2% target. Chart 2Too Close To Neutral Too Close To Neutral Too Close To Neutral Investment Implications Chart 3Yield Curve & Breakevens Move Together Yield Curve & Breakevens Move Together Yield Curve & Breakevens Move Together The first corollary of the above proposition is that the Fed will need strong conviction that inflation is poised to move higher before it delivers another rate hike. Chair Yellen is clinging to this notion for now: My best guess is that these soft readings will not persist, and with the ongoing strengthening of labor markets, I expect inflation to move higher next year. Most of my colleagues on the FOMC agree.1 We would also agree that inflation will be strong enough going forward for the Fed to justify a rate increase in December and several more next year (see section titled "Party Like It's 1999?" below). This is the main reason we continue to advocate a below-benchmark duration stance. But while our duration call will suffer if inflation does not rise as we expect, our recommendations to position for a steeper yield curve and wider long-maturity TIPS breakeven rates will pan out as long as the Fed falls behind the curve. If we accept the premise that the Fed must hit its inflation target before inverting the yield curve, then it will keep rates low enough for long enough to achieve that goal. This means that long-dated TIPS breakevens will necessarily return to their target range between 2.4% and 2.5% by the time that core inflation returns to target, and that the yield curve will steepen alongside the widening in breakevens (Chart 3). If the deflationary pressure in the economy turns out to be stronger than we anticipate, then it simply means that a slower pace of rate hikes will be required to get inflation back to target. The way to position for this outcome on a medium-term horizon is via lower real yields (Chart 3, panel 2), not tighter TIPS breakevens or a flatter yield curve. A Fed that is behind the curve is also a key support for our overweight allocation to investment grade and high-yield corporate bonds. Even though valuations have become very expensive (see section titled "Risk-Adjusted Value In Corporate Credit" below), a sustained period of spread widening would likely require a more restrictive monetary policy, one more concerned with dragging inflation lower than with propping it up. Chart 4Tax Cuts Would Steepen The Curve Tax Cuts Would Steepen The Curve Tax Cuts Would Steepen The Curve Political Risk There are two looming political decisions that will impact both our view on how quickly inflation will trend higher and our view on whether the Fed will indeed fall behind the curve. On the inflation front, if President Trump's tax cut plan becomes law, then the resulting fiscal stimulus will almost certainly speed up the return of inflation to target. The market has figured this out and already we observe a correlation between the slope of the yield curve, long-maturity TIPS breakevens and the relative performance of a basket of highly-taxed stocks (Chart 4). Our geopolitical strategists remain optimistic that stimulative tax legislation will be passed early next year, but note that if the Democratic party wins the upcoming Alabama senate election (to be held December 12), then there may not be enough votes in the Senate to push a tax plan through.2 The second important political decision will be the appointment of a new Fed Chair. President Trump will announce his pick within the next two weeks, and the President has suggested that the race has been winnowed down to three candidates - current Fed Chair Janet Yellen, current Fed Governor Jerome Powell and Stanford University economist John Taylor. Ex-Fed Governor Kevin Warsh could also still be in the running, although he was not specifically named by the President last week (Table 1). Table 1Top 4 Fed Chair Candidates The Fed Will Fall Behind The Curve The Fed Will Fall Behind The Curve Of those four candidates, both Yellen and Powell would maintain the status quo at the Fed. Neither would threaten our view that the Fed will fall behind the curve on inflation. Taylor or Warsh, on the other hand, could both push for a faster pace of tightening. As Fed Chairman, Professor Taylor - of Taylor Rule fame - would certainly look to adopt a more rules-based monetary policy. In all likelihood this would involve structuring policy decisions around a chosen policy rule, with the Fed justifying any deviations from that rule. His views on the current speed of Fed tightening are not as well known, but he has been critical of the Fed's zero interest rate policy in the past and has spoken favorably about several policy rules that all suggest higher interest rates than are currently observed. Similarly, Kevin Warsh has suggested that the Fed should target inflation between 1% and 2%, rather than the current symmetric 2% target. Taken at face value, this change in target would suggest a more hawkish reaction function. A John Taylor or Kevin Warsh chairmanship would call into question our key premise that the Fed will fall behind the curve, and would likely cause the Treasury curve to bear-flatten in the immediate aftermath of the appointment. Bottom Line: To avoid policy failure the Fed must allow inflation to reach its 2% target before the onset of the next recession. This means it will soon fall behind the inflation curve. Treasury curve steepeners and TIPS breakeven wideners will benefit. Party Like It's 1999? This year's downtrend in core inflation has caused many to question whether it will ever rise again. Many are questioning whether the Phillips curve relationship between tighter labor markets and rising wage growth still holds, and even Janet Yellen is starting to wonder if the Fed is missing something: [O]ur framework for understanding inflation dynamics could be misspecified in some way. For example, global developments - perhaps technological in nature, such as the tremendous growth of online shopping - could be helping to hold down inflation in a persistent way in many countries.3 We would note, however, that this is not the first time it has taken longer than expected for cyclical inflation pressures to emerge despite a tight labor market. Consider that in the late 1990s the unemployment rate fell below its natural rate in April 1997, but inflation did not move meaningfully higher until mid-1999 (Chart 5). Chart 5The Current Cycle Looks Very Much Like The 1990s The Current Cycle Looks Very Much Like The 1990s The Current Cycle Looks Very Much Like The 1990s A strong dollar and negative import price shock certainly contributed to low inflation in the late 1990s, and this has also been true in the current cycle. The de-synchronized nature of the global recovery caused the dollar to surge in 2014 and 2015, much like in 1997 (Chart 6). In the late 1990s, it was only after the global recovery became more synchronized in 1999 that U.S. inflation started to respond to tight labor markets. In the current cycle, the synchronized global recovery only started in the middle of last year. Chart 6An Import Price Shock Kept Inflation Low In The 1990s And Today An Import Price Shock Kept Inflation Low In The 1990s And Today An Import Price Shock Kept Inflation Low In The 1990s And Today We identified several variables that led inflation higher in 1999. Chart 7 shows these variables from the late 1990s lined up with their readings from the current cycle. The cycles are aligned to when the unemployment rate fell below its natural level, and the vertical line shows when prices started to accelerate in 1999. The variables that led inflation higher in the 1990s were: Chart 7Pipeline Measures Led Inflation In 1999 Pipeline Measures Led Inflation In 1999 Pipeline Measures Led Inflation In 1999 PPI Finished Goods inflation BCA Pipeline Inflation Indicator The New York Fed's Underlying Inflation Gauge4 Corporate Price Deflator With the possible exception of the corporate price deflator, all of these variables are currently sending a strong signal that inflation is poised to rebound. Similar to 1999, we would expect the initial move higher in inflation to be met with wider long-maturity TIPS breakevens and a steeper yield curve. Notice that the 2/10 Treasury slope troughed at -5 bps in 1998, but steepened to +40 bps in early 1999 before starting to flatten again as the Fed ramped up its pace of tightening (Chart 5, panel 3). In the current cycle, we await that final steepening surge before the Fed gets more aggressive and flattens the curve once more. Bottom Line: The current cycle looks very similar to the cycle of the late 1990s. In both cases the unemployment rate fell far below its natural level before inflation started to accelerate. Almost all of the indicators that predicted the 1999 increase in inflation are currently sending strong positive signals. Risk-Adjusted Value In Corporate Credit In a recent report we noted that high-yield bond valuations were approaching all-time expensive levels.5 We concluded that with limited room for spread compression, but equally with no obvious catalyst for sustained spread widening, the high-yield market has essentially become a carry trade. This week we extend that analysis to consider each credit tier in both investment grade and high-yield bonds. Our goal is to see if any credit tiers have room for spread compression, or alternatively, which credit tiers offer the best risk-adjusted value. Unfortunately, the quick answer is that no credit tiers look cheap. In Chart 8 and Chart 9 we show 12-month breakeven spreads for each credit tier, scaled by their percentile rank relative to history. In other words, each chart shows the percentage of time that breakeven spreads for each credit tier have been lower than they are currently. The Aa-rated breakeven spread has been lower than it is today 15% of the time (Chart 8, panel 2), while the Aaa-rated breakeven spread has been lower than it is today only 1% of the time (Chart 8, panel 1). We use the breakeven spread - the spread widening required to earn zero excess return on a 12-month horizon - because it adjusts for the changing average duration of each bond index.6 For example, the average duration of the investment grade corporate bond index has increased during the past fifteen years. This means that a given spread level today looks less attractive than when the duration risk was lower. Chart 8 shows that there is very little room for investment grade spread compression. At the 15th percentile the Aa credit tier looks most attractive, while all other credit tiers rank below the 10th percentile. In Chart 9 we see that valuations get somewhat more compelling as we move down in quality. Ba-rated breakeven spreads have been lower 19% of the time, B-rated spreads have been lower 32% of the time and Caa-rated spreads have been lower 43% of the time. Chart 8Investment Grade Breakeven Spreads Investment Grade Breakeven Spreads Investment Grade Breakeven Spreads Chart 9High-Yield Breakeven Spreads High-Yield Breakeven Spreads High-Yield Breakeven Spreads The results in Table 2 generally confirm that the lowest credit tiers offer the best risk-adjusted value. That table shows a measure we call Days-To-Breakeven. This is a measure of the number of days of average spread widening required for each credit tier to earn zero excess return on a 12-month horizon. It is calculated as the 12-month breakeven spread divided by each sector's historical average daily spread change. It is an attempt to measure each sector's value after adjusting for differences in both duration and spread volatility. According to this measure, Caa-rated and B-rated junk offer the best risk-adjusted value, while Baa-rated corporates offer slightly better value than Ba-rated junk bonds. Table 2 also shows the amount of option-adjusted-spread (OAS) tightening required by each credit tier (at current duration levels) to reach all-time expensive valuations. For example, the Baa-rated index can undergo another 35 bps of OAS tightening before it reaches all-time lows according to its 12-month breakeven spread. We also scale this measure by each sector's historical average daily spread change to calculate a Days-To-Minimum measure, and once again the message is the same. The Caa-rated, B-rated and Baa-rated credit tiers offer the most compelling risk-adjusted value. Table 2Risk-Adjusted Value By Credit Tier The Fed Will Fall Behind The Curve The Fed Will Fall Behind The Curve It is unfortunate, though not surprising, that low quality sectors offer the best risk-adjusted value at this late stage of the credit cycle. Most fund managers have probably already started to scale back credit risk in preparation for the next recession. This is probably a prudent strategy given that even in the lower credit tiers excess returns will not be exceptional. We forecast excess returns between 2% and 5% for the overall High-Yield index. However, we also think that investors are relatively safe taking credit risk until inflationary pressures start to mount and the Fed's reaction function becomes less supportive. If inflation recovers as we expect, then we will likely start scaling back the credit risk in our recommended portfolio sometime next year in preparation for a recession in 2019. Bottom Line: Spreads are tight across the entire credit spectrum, but risk-adjusted value is most attractive in the Caa, B and Baa credit tiers. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Speech by Janet Yellen delivered October 15, 2017. https://www.federalreserve.gov/newsevents/speech/yellen20171015a.htm 2 Please see Geopolitical Strategy Weekly Report, "Why So Serious?", dated October 11, 2017, available at gps.bcaresearch.com 3 Speech by Janet Yellen delivered October 15, 2017. https://www.federalreserve.gov/newsevents/speech/yellen20171015a.htm 4 The Underlying Inflation Gauge captures sustained movements in inflation from information contained in a broad set of price, real activity, and financial data. https://www.newyorkfed.org/research/policy/underlying-inflation-gauge 5 Please see U.S. Bond Strategy Weekly Report, "Living With The Carry Trade", dated October 17, 2017, available at usbs.bcaresearch.com 6 We calculate the breakeven spread as option-adjusted spread divided by duration. For simplicity we ignore the impact of convexity. Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Chinese growth will slow next year, but underlying momentum remains strong. Jerome Powell is the most likely choice for Fed chair. However, no matter who is selected, the general thrust of monetary policy will not change radically next year. The transatlantic interest rate spread is not particularly wide considering that the output gap is larger in the euro area, while the neutral rate and expected inflation are lower. U.S. growth should surprise on the upside over the next few quarters, as already evidenced by the rebound in the economic surprise index. This will give the Fed greater scope to raise rates. We expect EUR/USD to reach $1.15 by the end of the year. Feature China: Let's Get This Party Congress Started China's 19th National Congress of the Communist Party of China kicked off this week. As widely expected, President Xi Jinping lauded the successes that China has enjoyed over the past few years in his opening speech, but cautioned that more must be done to reduce corruption, clean up the environment, and expedite market reforms.1 We expect Chinese growth to slow modestly in 2018 from the current above-trend pace, as the government pares back stimulus efforts. Nevertheless, the underlying trend in growth will remain reasonably solid. Chart 1 shows that real-time measures of economic activity such as electricity production, excavator sales, and railway freight traffic are all growing at a healthy pace. Despite the introduction of some tightening measures this spring, the housing market remains resilient. The share of households planning to buy a new home is close to record high levels, while the amount of land purchased by developers - a good leading indicator for housing starts - has continued to accelerate (Chart 2). Chinese property developer stocks have been on a tear this year, outperforming even the red-hot tech sector. With housing inventory levels at multi-year lows, home prices should stay firm. In the industrial sector, rampant producer price deflation last year has given way to modest inflation this year. This has boosted industrial profits, which should support corporate spending in the months ahead (Chart 3). Chart 1Chinese Economy: No Need To Be Pessimistic Chinese Economy: No Need To Be Pessimistic Chinese Economy: No Need To Be Pessimistic Chart 2Chinese Housing Market Remains Resilient Chinese Housing Market Remains Resilient Chinese Housing Market Remains Resilient Chart 3Boost In Industrial Profits Bodes Well For Corporate Spending Boost In Industrial Profits Bodes Well For Corporate Spending Boost In Industrial Profits Bodes Well For Corporate Spending Both money and credit growth surprised on the upside in September. As we have argued before, copious private-sector savings will forestall a credit crunch and, at least for the foreseeable future, permit the government to run large off-balance sheet budget deficits in an effort to support aggregate demand (Chart 4). Indeed, for all the talk about slowing credit growth, medium- and long-term bank lending to nonfinancial corporations - probably the best single measure of credit flows to the real economy - has continued to accelerate this year (Chart 5). Investors should continue to overweight Chinese stocks relative to the EM aggregate. Chart 4China's Fiscal Deficit Has Been Increasing China, The Fed, And The Transatlantic Interest Rate Spread China, The Fed, And The Transatlantic Interest Rate Spread Chart 5Credit To Real Economy Accelerating Credit To Real Economy Accelerating Credit To Real Economy Accelerating Musical (Fed) Chairs News reports indicate that President Trump has winnowed down the list of candidates for Fed chair to five individuals: Chief economic advisor Gary Cohn, current Fed Governor Jerome Powell, former governor Kevin Warsh, Stanford university economist John Taylor, and current chair Janet Yellen. We suspect that Cohn will not make the cut, given his apparent falling out with Trump following the President's remarks about the Charlottesville protests. Warsh and Taylor are likely to be seen as too hawkish. That just leaves Powell and Yellen. Chair Yellen's relatively dovish views on monetary policy would likely sit well with Trump, but she has two major strikes against her. One, she has generally been in favor of more financial sector regulation, which is anathema to Trump. Two, Trump accused her of abetting Hillary Clinton during the election campaign. Keeping her as Fed Chair (assuming she would actually want the job) might convey the message that he is no longer interested in shaking up the existing institutional order in Washington DC. This just leaves Powell as the default candidate, who reportedly has received the blessing of Treasury Secretary Steven Mnuchin. The prevailing wisdom is that Powell is a moderate who is only slightly more hawkish than Yellen. But the truth is that we don't really know where he stands because he has no academic publication record and has generally steered clear of taking bold views on monetary policy. Such a potentially malleable mind may be exactly what Trump is seeking! Still, the organizational structure of the Fed makes it impossible for the chair to run roughshod over other FOMC members. This suggests that no matter who is selected, the general thrust of monetary policy will not change radically next year. Thoughts On The Transatlantic Yield Spread I have been visiting clients in Europe this week and questions about the relative stance of monetary policy between the U.S. and the euro area have come up in almost every meeting. The gap between U.S. and euro area rate expectations has narrowed since the start of the year, helping to push the euro higher. Nevertheless, most interest rate spreads remain elevated by historic standards. This has led many commentators to speculate that they will continue to shrink, putting further upward pressure on EUR/USD. For example, the U.S. 5-year Overnight Index Swap rate currently stands at 1.82%. This compares to only 0.02% in the euro area. The current level of spreads can be partly explained by the fact that labor market slack is still substantially higher in the euro area than in the U.S. Outside of Germany, labor underutilization is still 6.3 percentage points higher across the euro area than in 2008 (Chart 6). In contrast, our work suggests that the U.S. labor market has returned to full employment.2 Chart 6Euro Area: Labor Market Slack Still High Outside Of Germany Euro Area: Labor Market Slack Still High Outside Of Germany Euro Area: Labor Market Slack Still High Outside Of Germany This is not to say that transatlantic interest rate spreads won't narrow over the coming years. They will. But what matters for investors is how spreads evolve relative to market expectations. The market is already pricing in roughly 50 basis points of spread compression in five-year rates between now and 2022. If one looks further out to 2027, the spread in expected policy rates stands at 94 basis points.3 That may still seem like a lot, but keep in mind that inflation expectations in the euro area are well below those of the U.S. The CPI swap market is predicting that U.S. inflation will exceed euro area inflation by 67 basis points over the next decade. All things equal, lower inflation in the euro area implies that nominal interest rates should be lower there too. Moreover, many euro area government bond markets trade at a discount due to country-specific default/denomination risks. While these risks have faded, they have not gone away. As such, GDP-weighted euro area government bond yields - which are arguably what the ECB cares most about - are generally higher than swap rates of the same maturity. In Search Of Fair Value Chart 7The Neutral Rate Is Lower In The Euro Area The Neutral Rate Is Lower In The Euro Area The Neutral Rate Is Lower In The Euro Area A reasonable estimate is that the market currently sees the real terminal rate in the U.S. as being roughly 40 basis points higher than in the euro area. As it happens, this is almost identical to the gap in the neutral rate between the two regions that Williams, Laubach, and Holston have calculated (Chart 7). Does that mean that the current transatlantic spread is close to fair value? Not quite. One of things that has become apparent over the past eight years is that euro area membership comes at a high price. When countries such as Italy and Spain are hit by adverse economic shocks, they are limited in how they can respond. They cannot devalue their currency because they do not have a currency to devalue; and they cannot loosen fiscal policy for fear of being attacked by the bond vigilantes. All they can do is suffer from grinding deflation in the hopes of regaining competitiveness through weak wage growth. This means that over the long haul, unemployment in the euro area is likely to be above NAIRU more often than in the U.S. This, in turn, implies that euro area policy rates will, on average, be below their neutral value more often than in the U.S. Thus, even if the gap in the real neutral rate between the two regions were 40 basis points, the expected gap in policy rates should be larger than that. Modest Downside For EUR/USD The discussion above suggests that the transatlantic interest rate spread is not especially wide if one looks further out in time. If U.S. growth surprises on the upside over the coming months, while euro area growth flatlines, spreads will widen again. Such an outcome is, in fact, quite likely. U.S. financial conditions have eased significantly relative to those of the euro area since the start of the year (Chart 8). To the extent that changes in financial conditions lead growth by about 6-to-9 months, the U.S. could start outperforming the euro area as we enter 2018. The fact the Goldman's Sachs' U.S. Current Activity Indicator has hooked higher and the economic surprise index has rebounded smartly is early evidence that this process may have already begun (Chart 9). We see EUR/USD falling to 1.15 by the end of the year. Chart 8Diverging Financial Conditions ##br##Favor U.S. Over The Euro Area Diverging Financial Conditions Favor U.S. Over The Euro Area Diverging Financial Conditions Favor U.S. Over The Euro Area Chart 9Early Evidence That U.S. May ##br##Outperform Euro Area Next Year Early Evidence That U.S. May Outperform Euro Area Next Year Early Evidence That U.S. May Outperform Euro Area Next Year Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Geopolitical Strategy / China Investment Strategy Special Report, "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017. 2 Please see Global Investment Strategy Weekly Report, "A Secular Bottom In Inflation," dated July 28, 2017; and "What's the Matter With Wages?" dated August 11, 2017. 3 We estimate the expected policy rates ten years out by looking at one-month, 10-year forward OIS rates (i.e., the market's expectation of where one-month OIS rates will be ten years from today). Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights U.S. credit growth is set to improve as capex has more upside and households benefits from a positive backdrop. The U.S. has substantially more room to increase leverage than the rest of the G10, pointing toward further monetary divergences. The euro is not very cheap and is trading at a significant premium to forward rate differentials. It is thus at risk if U.S. rates can rise vis-à-vis Europe. Chinese underlying inflation is becoming elevated, which could prompt additional tightening by the PBoC. Moreover, Xi Jinping's speech this week suggests a move away from the debt-fueled, investment-led growth model. The AUD is at risk. Feature A general lack of credit growth has been one of the key factors hampering both broader growth and inflation in the U.S. Not only has this muted activity and weak pricing pressure kept the Federal Reserve on the easier side of policy, the absence of lending growth has further depressed real rates as demand for loanable funds remains low. Can credit pick up from here, and what are the implications for the USD? Room For Optimism There are good reasons to lean a bit more on the positive side regarding the U.S. credit growth outlook. As Chart I-1 illustrates, U.S. commercial and industrial loan growth seems to be rebounding. Confirming that this impulse could gain momentum, it follows an easing in lending standards and a pick-up in durable goods orders - two leading indicators of business borrowings. Household debt is also showing some signs of revival. While the annual growth rate of household borrowings from banks has yet to trough, the annualized quarterly growth rate has picked up significantly - a development that tends to precede accelerations in the yearly measure. Moreover, this improvement is broad based among all the key components of household borrowings (Chart I-2). Chart I-1Upside For U.S. C&I Loans... Upside For U.S. C&I Loans… Upside For U.S. C&I Loans… Chart I-2... And For Household Debt As Well ... And For Household Debt As Well ... And For Household Debt As Well This has positive implications for U.S. nonfinancial private credit, which has been in the process of forming a shallow bottom relative to GDP. Moreover, based on the low level of debt servicing costs for both households and businesses, this trend has room to develop (Chart I-3). However, most of the increase in the debt-to-GDP since 1994 has been caused by financial engineering, with firms swapping equity for debt in their capital structure, and has therefore not lifted domestic demand nor created inflationary pressures. However, we posit that this phenomenon is toward its tail end, and that additional debt accretion could have a meaningful impact on growth. Why? On the business front, capex - an essential but volatile component of aggregate demand - is set to accelerate further. Business investment is led by firms' capex intentions, a series that has surged since the summer of 2016 (Chart I-4, top panel). Confirming the message from this indicator, profits from U.S.-listed businesses have also sharply rebounded, a signal that leads capex by a year, as highlighted last Monday by Anastasios Avgeriou, who heads BCA's U.S. Equity Sector Strategy service (Chart I-4, bottom panel).1 Chart I-3The U.S. Has Room To Relever The U.S. Has Room To Relever The U.S. Has Room To Relever Chart I-4Capex Outlook Looks Good Capex Outlook Looks Good Capex Outlook Looks Good On the household front, three factors support our assessment: First, household nominal and real wages and salaries should enjoy further upside as the labor market remains very healthy. This means more consumption and more capacity to accumulate debt, especially as household financial obligations remain near multi-generational lows (Chart I-5). In fact, U.S. real median household income already hit an all-time high in 2016. Chart I-5Supports To Household Consumption Supports To Household Consumption Supports To Household Consumption Second, household confidence is still near record-high levels, a factor which tends to lead credit growth and consumption. Optimistic households are more likely to spend their income gains and buy durable goods like houses or apartments, especially as the household formation rate has regained vigor. Third, U.S. net wealth has hit 430% of disposable income, a record, which will keep supporting consumption. As households see their net worth increase, they can boost consumption and debt as their leverage ratios improve, especially when financial obligation ratios are as low as they are today. These factors point toward a continued increase in the indebtedness of the U.S. private sector, one which this time we anticipate will add to demand through investments, real estate purchases and general consumption. This also means that real rates are likely to experience upside. More debt-fueled aggregate demand implies more demand for loanable funds, and thus higher real rates. In an economy operating near full capacity, it can also lift inflation. Tax cuts and fiscal stimulus would only be a bonus in this environment. This should give the Fed room to increase interest rates in line with its dot plot, or more than the two-and-a-half hikes priced into the OIS curve over the next two years. However, as 2017 has vividly demonstrated, movements in U.S. rates alone are not enough to make a call on the U.S. dollar. One needs to have a sense of how U.S. rates could evolve vis-à-vis the rest of the world. In the context of debt accumulation, we are optimistic that the U.S. could experience a re-leveraging relative to the rest of the G10, putting upward pressures on U.S. real rates relative to the rest of the world. To begin with, U.S. non-financial private credit stands at 150% of GDP, a drop of 20% of GDP since its peak in 2009. The rest of the G10 has not experienced the same extent of post-financial crisis deleveraging, and nonfinancial private credit there still hovers around 175% of GDP (Chart I-6). Today, the indebtedness of the U.S. relative to other advanced economies is near its lowest levels of the past 50 years. Debt levels are obviously not the only consideration; the ability to service that debt also must enter the equation to judge the capacity of an economy to accumulate debt relative to the rest of the world. Currently, according to the BIS, the debt-service ratios of the U.S. nonfinancial private sector still stand well below the GDP-weighted average of the rest of the G10 (Chart I-7). This also highlights that the U.S. has plenty of room to have both higher debt accumulation and higher real rates than the rest of the G10. Chart I-6U.S. Vs. G10: Debt Upside U.S. vs. G10: Debt Upside U.S. vs. G10: Debt Upside Chart I-7Lower Private Sector Debt-Servicing Costs In The U.S. Lower Private Sector Debt-Servicing Costs In The U.S. Lower Private Sector Debt-Servicing Costs In The U.S. This should support the dollar in 2018. As Chart I-8 shows, 10-year bond yield differentials between the U.S. and other large advanced economies lead tops in the dollar by one year. To highlight this relationship, this chart de-trends the DXY by plotting it as a deviation from its 10-year moving average. Not only does the current trend in real rate differentials already point to a higher dollar, but room for more debt accumulation in the U.S. relative to the rest of the G10 supports the notion that the elevated level of spreads could even expand, implying the era of monetary divergence has yet to end. As we highlighted last week, the dollar may not be as expensive as seems at first glance. We have expanded on our 'modelization' exercise this week, using methods employed by the Swiss National Bank to incorporate the Balassa -Samuelsson effect.2, 3 This metric, which incorporates the relative price of manufactured goods in each economy, further confirm our assessment from last week that the dollar is not expensive enough to warrant a sell-signal (Chart I-9). Thus, with competitiveness a non-issue for the dollar for now, the USD is likely to be able to take advantage of potentially supportive real interest rate spreads. Chart I-8Real Rates Point To A Higher Peak For The USD Real Rates Point To A Higher Peak For The USD Real Rates Point To A Higher Peak For The USD Chart I-9U.S. Only Sightly Expensive U.S. Only Sightly Expensive U.S. Only Sightly Expensive On the technical side, our U.S. Dollar Capitulation Index hit very depressed levels earlier this year, but is now rebounding. Crucially, it has moved meaningfully back above its 13-week moving average, an event which normally characterizes uptrends in the dollar (Chart I-10). Chart I-10Dollar: From Bearish To Bullish Mood Dollar: From Bearish To Bullish Mood Dollar: From Bearish To Bullish Mood Bottom Line: The U.S. economy looks set to enjoy an episode of rising debt supporting increasing economic activity and higher rates as capex should grow further and a supportive backdrop continues to emerge for households - whether or not tax cuts happen. Because the U.S. private sector has comparatively healthy balance sheets relative to the rest of the G10, this means that U.S. re-leveraging should outpace the rest of the world. Even if this U.S. re-leveraging is only a cyclical phenomenon and not a resumption of the debt super-cycle, it would imply that monetary policy divergences have yet to reach their apex, and thus the dollar could experience additional upside. Even Against The Euro? We tend to view the euro as the anti-dollar. It is the main vehicle to play both uptrends and downtrends in the dollar and it is also the most liquid instrument, backed with an economy similarly sized as the U.S. Thus, the views expressed above would imply a negative slant on EUR/USD. Such a framework can give an impetus to a EUR/USD view, but is also not enough. Indeed, factors more specific to this pair argue that EUR/USD does have downside. When it comes to valuations, using the SNB's methodology, the EUR/USD is more or less the mirror image of the DXY. This pair is slightly cheap, essentially within the statistical definition of fairly valued (Chart I-11). Thus, valuations alone are fully neutral for the euro. This means EUR/USD remains prisoner to relative interest rate dynamics. On this front, a key driver of this pair paints a risky picture for euro bulls. The 1-year/1-year forward risk-free rate spread between the euro area and the U.S. has been a reliable guide of the EUR/USD's trend for the past 12 years. Yet, the euro's rally has not been matched by a similar move in this spread. As a result, the gap between the currency pair and its rates-implied fair value is at its highest since the summer of 2014 (Chart I-12). Chart I-11Euro: Not That Cheap Euro: Not That Cheap Euro: Not That Cheap Chart I-12Forward Interest Rates Point To Euro Risk Forward Interest Rates Point To Euro Risk Forward Interest Rates Point To Euro Risk But then again, the differential between the European and U.S. 1-year/1-year forward risk-free rate is at its lowest ever over the time frame of this chart. However, it was even lower than current levels in 1999 and 1997. This suggests that if the U.S. can re-leverage relative to the rest of the G10, the spread could grow as negative as it was in these two previous instances. Supporting this assessment, we anticipate U.S. inflation to outperform euro area measures going forward. Last week, we explored the reasons why we see an upcoming uptick in U.S. inflation next year: U.S. financial conditions have eased, American velocity of money has increased, pipeline inflationary pressures are growing and underlying wage growth seems to be improving.4 Meanwhile, European financial conditions have tightened, especially against the U.S., which historically leads to an underperformance of European inflation measures. Very importantly, the euro area core CPI diffusion index has rolled over and is now below 50%, suggesting that euro area core CPI has limited upside (Chart I-13). This means potential downside vis-à-vis the U.S. and room for upside in U.S. rates relative to the euro area, especially as the European Central Bank is likely to craft its message carefully next week when it announces the tapering of its asset purchases, to prevent quick upward movement in interest rate expectations. Additionally, the dollar is still quite under-owned by speculators relative to the euro. Our favorite positioning measure, which sums long bets in the euro with short bets on the DXY - two equivalent wagers - continues to hover near record-high levels, suggesting potential downside in EUR/USD (Chart I-14). This continues to highlight the risks to the euro created by a repricing of the Fed. Chart I-13Euro Area CPI Peaking? Euro Area CPI Peaking? Euro Area CPI Peaking? Chart I-14Excess Bullishness In Euro Intact Excess Bullishness In Euro Intact Excess Bullishness In Euro Intact Bottom Line: The euro is obviously at risk if the dollar gets lifted by rising economic activity and indebtedness in the U.S., even if this cyclical upswing in debt does not represent a resumption of the debt super-cycle. Moreover, 1-year/1-year forward rates differentials point to heightened EUR/USD vulnerability, especially if U.S. inflation bottoms relative to the euro area. Moreover, long euro bets have yet to be washed out, deepening the EUR/USD's vulnerability. A Few Words On China Chart I-15China: Good Reasons For Policy Tightening China: Good Reasons For Policy Tightening China: Good Reasons For Policy Tightening Despite a marginal slowdown in Chinese real GDP growth and slightly disappointing industrial production and fixed asset investment numbers for the third quarter, some key Chinese economic activity metrics have been very robust. Imports are growing at a 19% annual pace, credit growth continues to outperform expectations and electricity production and excavator sales remain robust. Should this make investors bullish on China plays? In our view, two key risks lurk on the horizon. The first is monetary tightening. Pricing pressures in China are growing and are looking increasingly genuine. As Chart I-15 shows, core CPI is clocking in at 2.3%, the highest level since 2010-2011, a level which in the past prompted monetary tightening by the Chinese authorities. Additionally, services inflation - a purely domestic sector and thus one reflective of domestic inflationary pressures - is now above 3% and accelerating. Also, PPI has re-accelerated to 6.9%, pointing to a paucity of deflationary forces in the Chinese economy that could potentially give the People's Bank of China the green light to tighten further. We would expect the rise in the Shibor 7-day rate to continue and monetary conditions, which have been tightening since the end of 2016, to become an even bigger handicap in the future. The second risk lies around the Communist Party Congress underway in Beijing. Xi Jinping's marathon speech highlighted his vision for Chinese socialism in a new era. Xi is very clearly dedicated to the primacy of the Chinese communist party. He did highlight, however, that the new principal problem for the Chinese population is the need for a better life, with less imbalances, less inequalities. This fits with his previously revealed policy preferences. As Matt Gertken, who heads the Asian efforts on our Geopolitical Strategy team, has shown, Xi's administration has massively increased spending to protect the environment and increased financial regulation (Table 1).5 These preferences fit in the optic of addressing China's new principal problems: too much pollution and too much debt. Table 1Fiscal Priorities Of Recent Chinese Presidents All About Credit All About Credit Moreover, the continued fight against corruption also fits into that mold. It is a key tool to maintain the legitimacy of the Communist party, and a popular way to address some of the inequalities and imbalances plaguing China today. What does this mean? China has continued to accumulate debt over the past 10 years, with debt to GDP increasing by nearly 120% between 2008 and 2017 (Chart I-16). If a window is opening to tighten monetary policy because inflationary pressures are growing while there is political will to combat inflation and imbalances, it is likely that investment - which pollutes heavily - and debt - a byproduct of large capex programs - could be curtailed. Moreover, the Chinese government still has the wherewithal to support aggregate economic activity through fiscal stimulus. In addition, in the context of the above, much fiscal stimulus could be deployed to fight pollution and decrease inequalities by supporting households. This means that while Chinese GDP growth is unlikely to weaken substantially, the capex intensity of the economy could decrease. So would imports of raw materials and capital goods. As a result, this could be a very negative environment for metals. Metals prices have rebounded sharply since 2016 as Chinese investment has increased. But now that policy could be tightened further and that Xi's new administration has more freedom to move away from an investment-heavy, deeply polluting growth model, the rally in metals could be at risk. Copper, a bellwether for the metals complex, has surged nearly 70% since 2016, and bullish sentiment on the red metal is now at levels historically associated with imminent corrections (Chart I-17). Chart I-16Is This What Deleveraging Looks Like? All About Credit All About Credit Chart I-17Tighter Policy And A Reform Push Put Metal At Risk Tighter Policy And A Reform Push Put Metal At Risk Tighter Policy And A Reform Push Put Metal At Risk This means that currencies for which metals prices are a key driver of terms of trade are at great risk, specifically the BRL, the CLP and the AUD. Moreover, the latter is expensive, having recently been buoyed by some positive economic numbers, and is now widely owned by very bullish investors. We have a short sell AUD/USD at 0.79 and our short AUD/NZD trade at 1.11 was triggered following the Labor/NZ First/Green coalition announced Thursday in New Zealand. Bottom Line: Chinese authorities are set to tighten monetary conditions further as domestic inflationary pressures are growing. Moreover, while short on details, this week's speech by Xi Jinping at the opening of the 19th Communist Party Congress in Beijing seemed to confirm that addressing imbalances, inequalities, and environmental problems will be a key objective of this administration. This points toward a less debt-/investment-driven economic model - at least until deflationary problems re-emerge. While overall GDP growth could be supported by targeted fiscal support, investment plays linked to Chinese capex and real estate could suffer. The AUD is at risk, and we are entering our proposed short AUD/NZD trade. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see U.S. Equity Strategy Special Report, titled “Top 5 Reasons To Favor Cyclicals Over Defensives” dated October 16, 2017, available at uses.bcaresearch.com 2 The Balassa Samuelson effect is an empirical observation that countries with higher productivity tend to experience an appreciating trend in there real exchange rate. Please see Foreign Exchange Strategy Weekly Report, titled “Is The Dollar Expensive?”, dated October 13, 2017, available at fes.bcaresearch.com 3 Samuel Reynard, “What Drives the Swiss Franc?” Swiss National Bank Working Papers (2008 – 14). 4 Please see Foreign Exchange Strategy Weekly Report, titled “Is The Dollar Expensive?”, dated October 13, 2017, available at fes.bcaresearch.com 5 Please see Geopolitical Strategy Weekly Report, titled “How To Read Xi Jinping’s Party Congress Speech”, dated October 18, 2017, available at gps.bcaresearch.com Currencies U.S. Dollar Chart II-1 USD Technicals 1 USD Technicals 1 Chart II-2 USD Technicals 2 USD Technicals 2 U.S. data was mixed: Last week's CPI releases showed that inflation disappointed in September, with headline CPI increasing by only 2.2%, below the expected 2.3%; and Core CPI coming in at 1.7%, in line with expectations; However, long-term TIC data showed a large inflow of funds of USD 67.2 bn, much larger than the expected USD 14.3 bn. The labor market continues to tighten with initial jobless claims and continuing claims dropping to 222,000 and 1.888 million respectively. The DXY has rebounded this week on this news, and also helped by a somewhat disappointing ZEW survey from the euro area, but pared its gains on Wednesday. Regardless, positive developments in the U.S. fiscal space and disappearing slack will provide a tailwind for the greenback. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day -August 25, 2017 The Euro Chart II-3 EUR Technicals 1 EUR Technicals 1 Chart II-4 EUR Technicals 2 EUR Technicals 2 Data from the euro area has been mixed: Industrial production grew at an annual rate of 3.8% in August; The trade balance contracted to EUR 16.1 bn from EUR 23.2 bn on a non-seasonally-adjusted basis, but improved on a seasonally-adjusted basis. The final estimate for core CPI hit 1.1%, in line with expectations; The ZEW Survey dropped and underperformed expectations; Despite largely weak data, the euro has pared all of last week's losses. Markets may be pricing in Catalan developments as a bullish case. The Spanish government has threatened to enact Article 155 of the constitution if Catalonia does not comply, which will give Spain the authority to take measures to ensure compliance by the rogue region. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 The Yen Chart II-5 JPY Technicals 1 JPY Technicals 1 Chart II-6 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: Bank lending outperformed expectations, growing at a 3% year-on-year pace. Machinery orders yearly growth also outperformed to the upside, coming in at 4.4% However, the annual growth of both imports and exports underperformed expectations and declined significantly from last month, coming in at 12% and 14.1% respectively. The yen has remained relatively flat these past two weeks. Overall, we expect USD/JPY to have additional upside, given that the U.S. OIS curve is not pricing in enough rate hike over the next 2-years. Ultimately, the driver of USD/JPY will simply be U.S. rates as Japanese 10-year rates are capped near 0%. This situation is not likely to change any time soon, as the Japanese economy is still hampered by very low inflation. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day -August 25, 2017 British Pound Chart II-7 GBP Technicals 1 GBP Technicals 1 Chart II-8 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Average hourly earnings outperformed expectations, growing at a 2.2% pace from a year ago. Both headline and core inflation came in line with expectations at 3% and 2.7% respectively. However, both retail sales and retail sales ex-fuel growth underperformed expectations, coming in at 1.2% and 1.6% respectively. Overall, we do not expect much more upside for the pound relative to the U.S. dollar, given that there is already a hike priced for November. At this point, the economic situation does not warrant any more hikes beyond just removing the emergency measures implemented after the Brexit fallout. Furthermore inflation has stopped climbing, and could start to come down in the coming months as the effects of the currency dissipate. Finally, Brexit negotiations have hit a bit of a temporary impass. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Australian Dollar Chart II-9 AUD Technicals 1 AUD Technicals 1 Chart II-10 AUD Technicals 2 AUD Technicals 2 The AUD has not seen much action this week. The RBA minutes highlighted that "slow growth in real wages and high levels of household debt were likely to be constraining influences". This is largely in line with our argument that spare capacity is limiting wage growth and inflation in the economy. Going forward, China remains a risk to our view, with the most recent import figures having provided a welcomed fillip to the AUD. Nevertheless, remarks by RBA Governors will limit the upside in the AUD. Expectations of a rate hike by the RBA depend upon growth numbers, which are unlikely to be achieved given the current trajectory of wages and consumer spending. Furthermore, high underemployment in the economy also remains a drag on spending, dampening the positive effect of a strong job report. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 New Zealand Dollar Chart II-11 NZD Technicals 1 NZD Technicals 1 Chart II-12 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been mixed: Electronic card retail sales year-on-year growth declined form 4.4$ to 2.9%. Business NZ PMI softened from 57.9 to 57.5. However, headline inflation came in at 1.9%, rising from the previous month reading of 1.7% and outperforming expectations. The kiwi sold off by almost 2% yesterday, as Jacinda Ardern was elected as the new prime minister of New Zealand. The market is now pricing the risk that the Labor party, which Ardern leads, could change the mandate of the central bank from just targeting inflation to also seeking full employment. Moreover, Labor and its coalition partner, NZ First, want to curtail immigration, one of the tailwind to New Zealand growth. These development would structurally limit the upside for kiwi rates, acting as a headwinds to the New Zealand dollar. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Canadian Dollar Chart II-13 CAD Technicals 1 CAD Technicals 1 Chart II-14 CAD Technicals 2 CAD Technicals 2 The CAD has been somewhat strong recently due to developments in the oil market. KSA-Russia support for an extension of supply cuts to OPEC 2.0, as well as developments in Iraq, have pointed to an increase in prices. While the path for Canadian interest rates seem fairly priced, oil prices could buoy the CAD. Risks surrounding NAFTA remain, as President Trump stays inflexible with regards to tariffs, although this is likely to have a greater effect on Mexico than on Canada. Furthermore, albeit still in its infancy Morneau's tax plan, which is anticipated to mostly affect the richest of small business, could have an effect on investment intentions. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Swiss Franc Chart II-15 CHF Technicals 1 CHF Technicals 1 Chart II-16 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has surprised to the upside: The unemployment rate decreased from 3.2% and 3.1%, outperforming expectations. Producer and import prices yearly growth came in at 0.8%, also surprising to the upside. Finally, the trade balance also outperformed, coming in at 2.918 billion dollars for September. It seems that the fall in the franc has been very positive to the Swiss economy. Overall, it would be difficult to see much more upside in EUR/CHF, as the euro already reflects euro area positives. That being said, we are reticent to be outright bearish on this cross as the economic data is still too weak for the SNB to change its monetary policy stance. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Norwegian Krone Chart II-17 NOK Technicals 1 NOK Technicals 1 Chart II-18 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been negative: Manufacturing yearly output growth underperformed expectations, contracting at 5.7%. Both core and headline inflation also surprised to the downside, coming in at 1% and 1.6% against expectations of 1.2% and 1.7% respectively. Finally, the Norwegian trade balance declined from 12.4 billion dollars to 9.2 billion dollars USD/NOK has risen 3% since September, even as oil prices have continued their path upward. This was first and foremost reflective of the higher probability of rate hikes in the U.S. in December. Additionally, the recent Norwegian inflation and trade balance numbers are showing that the krone rebounds has tightened monetary conditions in this Scandinavian economy. Overall, we remain bullish on USD/NOK and bearish on EUR/NOK. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swedish Krona Chart II-19 SEK Technicals 1 SEK Technicals 1 Chart II-20 SEK Technicals 2 SEK Technicals 2 The most recent inflation data was slightly weak, with CPI increasing by 0.1% monthly, and 2.1% yearly. Unemployment worsened as the rate rose to 6.2% from 6%. The krona depreciated against the euro on the news, but was flat against the dollar. Despite this temporary setback, PMIs are still perky across the board, and credit is hooking up. China and Europe's recent performance has likely provided a tailwind for growth, which should translate into higher inflation as capacity utilization is extremely tight. Furthermore, the depreciation of the SEK since the beginning of September has eased monetary conditions, making way for the central bank to begin a tightening process in the wake of the ECB's tapering program. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

One of BCA's long-standing clients, Ms. Mea, recently paid us a visit at our Montreal office. Ms. Mea is an experienced and successful investor who has been reading different BCA products for many years. She noted that over the years she has both agreed and disagreed with our market views, but that she appreciates our thematic approach including themes, analysis and views, as they are important to her investment process. Like many of our clients, Ms. Mea has been disappointed by the Emerging Markets Strategy (EMS) team's EM/China call, which has not been correct over the past 18 months. My team and I spent a few hours with Ms. Mea detailing our views and methodology. Despite some tough discussions, she said she found the dialogue valuable. Reflecting on our meeting, I thought it would be beneficial to share the key points with all of EMS clients. This report is a summary of that. Ms. Mea and I agreed to continue the debate as the story plays out, so I will be meeting with her occasionally in Europe when I travel there. Ms. Mea: Clearly your recommended strategy has been wrong for some time. I am aware that your negative view on EM/China and strategy was right and profitable from 2011 until early 2016. Nevertheless, since early last year EM risk assets have rallied considerably, and not participating in this rally has been painful - not to mention being short EM risk assets. For our global equity funds, underweighting EM within the global universe did not hurt performance in 2016. However, this year the EM equity benchmark has considerably outperformed the global averages (Chart I-1). So, what has gone wrong, and why haven't you changed your view already? Chart I-1EMS's Big Picture Asset Allocation Strategy: EM Relative To DM Stock Prices EMS's Big Picture Asset Allocation Strategy: EM Relative To DM Stock Prices EMS's Big Picture Asset Allocation Strategy: EM Relative To DM Stock Prices Answer: My objective today is not to dispute your comments - my view and investment strategy have clearly gone wrong. Rather, I would like to highlight what has gone wrong as well as elaborate on my methodology and thought process. Let me be clear, if I thought in 2016 or early 2017 that the market would rally for more than six months and - in the case of EM equities - by more than 20%, I would have recommended clients to play this rally regardless of my big picture themes and views. The same is true today. My general view has been based on two pillars: Chinese growth and Federal Reserve policy/the U.S. dollar. 1. The first pillar of my argument has been that China's growth improvement would prove unsustainable due to lingering credit imbalances/excesses. In the April 13, 2016 report,1 I laid out the case that China's 2015-16 fiscal stimulus of RMB 850 billion would be offset by a potential slowdown in credit growth from an annual growth rate of 11.5% to 9-9.5%. Chart I-2China: Borrowing Costs Have Been Rising China: Borrowing Costs Have Rising China: Borrowing Costs Have Rising This thesis of credit growth deceleration was based on the natural tendency of credit growth to gravitate toward nominal GDP growth, especially since the credit-to-GDP ratio had massively overshot in the preceding seven years. Besides, since 2013 high-profile policymakers in China had been talking about the need for deleveraging, containing financial excesses, and not repeating the mistakes of 2009-2010, when money and credit was allowed to run at an extremely strong pace. In first half of 2016, I downplayed the recovery in money and credit aggregates arguing that they are temporary and unsustainable. When a country has a lingering credit bubble - which has been the case in China, I am biased to downplay upticks in money and credit growth and easing in monetary policy. At the same time, I put a greater emphasis on both monetary tightening and slowdown in money/credit when the economy suffers from credit excesses. The opposite is also true in cases where there are no excesses/imbalances. Since November 2016, the People Bank of China (PBoC) has been tightening liquidity and pushing money market rates and corporate bond yields higher (Chart I-2). This has been taking place in addition to regulatory tightening on both bank and shadow banking activities. As a result, I have been predicting that regulatory and liquidity tightening amid lingering credit and speculative excesses would weigh on money, credit and capital spending. Importantly, I reckoned that financial markets would be forward-looking and would reverse their rally in anticipation of weaker growth down the road instead of reacting to robust - yet backward looking - growth data. Indeed, money and credit growth have already slowed to all-time lows (Chart I-3). Nevertheless, broad economic growth has not slowed (Chart I-4). This has also been true for China's impact on the rest of the world - the mainland's imports have remained robust (Chart I-5). Chart I-3China: Money And Credit Aggregates China: Money And Credit Aggregates China: Money And Credit Aggregates Chart I-4China: Business Cycle Perspective China: Business Cycle Perspective China: Business Cycle Perspective Chart I-5China: Money Impulses And Imports China: Money Impulses And Imports China: Money Impulses And Imports Not only have I been surprised by the mainland economy's ability to withstand the slowdown in money/credit so far, but I have also been caught off guard by how financial markets have shrugged off the rise in onshore interest rates and the deceleration in money/credit. That said, liquidity tightening works with a time lag. The fact that it has not yet had an impact on the real economy does not mean it won't going forward. 2. The second pillar of my view has been that the Fed's dovish stance would prove transitory. The global market rally began in February 2016 when the Fed sounded dovish in the face of a surging U.S. dollar, collapsing commodities prices, very weak global trade and plunging global risk assets. Remarkably, global growth and corporate profits have recovered very strongly, the U.S. dollar has weakened considerably and commodities and global tradable goods prices have rebounded. As such, I expected that U.S. interest rate expectations would move higher, dampening the carry trade. Unfortunately, markets' reactionary functions does not always follow a symmetrical logic. The decline in U.S. inflation rate amid a weak dollar, rising import prices and robust U.S. growth - especially the tight labor market and some wages pressures (Chart I-6) - has puzzled me. Ms. Mea: Why have you disregarded the clear improvements in EM profits and global trade in 2017? Answer: I have been aware of improving economic data and corporate profits. Yet, these types of data are backward looking and are not a guarantee of future trends. Even though the released economic data and corporate profits have been strong, our forward-looking indicators for both EM and China have been heralding and continue to point to a major downtrend in EM profits (Chart I-7). Chart I-6Subtle Upside Risks To U.S. Inflation Subtle Upside Risks To U.S. Inflation Subtle Upside Risks To U.S. Inflation Chart I-7EM Profits Are At Risk EM Profits Are At Risk EM Profits Are At Risk Importantly, I presume stock prices lead profits. Hence, it is dangerous to turn bullish when forward-looking indicators that lead profits are already flashing red. These are empirical indicators and have a great track record. As such, I have placed substantial weight on them rather than on backward-looking economic and profit data. Since early 2017, I have been facing the following dilemma: Should I change my view based on strong, yet backward-looking, profit data, or remain cautious based on forward-looking growth indicators as well as our big-picture themes. I chose the latter, which in retrospect was wrong. Looking back, the biggest mistake I made was putting little weight on how markets have been trading. EM and global stocks continue to trade as they would in a genuine bull market: they have looked past negative news and rallied a lot in response to positives. Ms. Mea: You mentioned big-picture themes. Can you elaborate on your framework and methodology? Answer: At the core of my analytical framework lies investment themes. I formulate these themes based on a series of in-depth research reports. These themes have multi-year relevance - I expect them to have staying power beyond one year. These themes represent an anchor to my view and strategy. Without anchor themes, I would tend to change my views back and forth based on fluctuations in economic data or swings in financial markets. Having established themes, my team and I monitor cyclical data, market dynamics/signposts and any type of evidence to prove or refute those established themes. Clients have recently been asking why I only show charts/evidence that confirm my view, and rarely entertain the alternative scenario. Indeed, there are always contradictory signals, signposts and data that I identify every week. Yet, I still choose to show those that support my ongoing themes and views. Why? Because I opt to convey a well-argued coherent message to my clients. In this context, I use the limited client-time allocated to reading our reports to highlight the reasons supporting my current themes and high-conviction views. It would also be unhelpful for readers if I demonstrate several charts that herald a bullish stance, and then conclude the opposite. If I were to utilize the alternative approach, i.e., present data and evidence on both sides of the debate, the report would be ambiguous. As a result, readers would gain little conviction and would likely be left confused. Each of these approaches has advantages and disadvantages: when the view plays out, investors see the correct angle and, thereby, develop a strong conviction on the strategy, and hopefully act upon it. Conversely, when the view goes wrong, investors typically wish they had seen the opposite side as well. Chart I-8China: No Deleveraging So Far China: No Deleveraging So Far China: No Deleveraging So Far In short, my goal is to leave clients with a clear and well-argued message when I have high conviction. As to conviction level, like all investors, I am dealing with a black box when gauging the outlook for financial markets. I am never 100% certain; I make investment recommendations only when my conviction level is somewhere around 65-75%. Generally, I do not discuss the areas where my conviction level is less than 60%. Less than 60% means "I do not know". An example of this is whether the current tech rally will persist. Importantly, I try to bring to clients' attention data and evidence that they may not be aware of and analytical points that differ from commonly known market narratives. Investors are aware of overall global financial market dynamics and ongoing narratives. My goal is to add value to their knowledge with the framework of thematic investment research, and to highlight new and potentially market moving charts, data and evidence. My major theme on China in the past several years has been the following: Chinese banks have originated too much money, and the corporate sector has taken on a large amount of leverage. This, in tandem with speculative excesses in the shadow banking and property markets, pose considerable downside risks to capital spending growth in the mainland. This is especially the case given that both liquidity and regulatory tightening of banks and non-banks already begun in late 2016. While financial markets, economic data and corporate profits have gone against this theme, this does not mean credit/money excesses in China have disappeared or do not exist. On the contrary, they have gotten even bigger now (Chart I-8, top panel). The Chinese economy has recovered and benefited commodities prices and the rest of EM due to another round of substantial money/credit injection. Broad money and broad credit have surged by about RMB 45-50 trillion since the middle of 2015 - depending on which measure one uses (Chart I-8, bottom panel). In the context of mushrooming leverage, ongoing policy tightening entails a poor risk-reward profile for bullish bets on mainland growth. This is why I am reluctant to abandon this theme and the bearish view. Ms. Mea: What would it take to change your big picture theme on China? To fundamentally reverse my view on China and commodities on a multi-year time line, I would need to reject my theme that China has meaningful credit excesses and imbalances, or buy into the view that these imbalances are a natural outcome of China's excess savings and will never correct. I have strong conviction in my big picture theme and I have not seen convincing arguments to change it. That said, if I come to the conclusion that EM risk assets and China-related plays will rally for six months or longer, I will change the investment strategy and recommend playing that rally. In this case my market strategy will change even though the big picture theme remains intact. As to the relationship between national and household savings, credit, and money, I have elaborated at great length that money creation and credit excesses do not originate from excess savings.2 Hence, it is simply not natural for a country with excess savings to experience and sustain credit bubbles. Importantly, adjustments in terms of credit excesses/deleveraging in China have not even started (Chart 8, top panel). This does not imply that investors should wait until deleveraging ends before turning positive on mainland growth. Markets are forward looking and will bottom when they see the light at the end of tunnel. But it is very dangerous to be positive when the adjustment has not yet began. It appears China's capital spending in general and construction in particular - the most vulnerable and credit-dependent segments - have in recent years been fluctuating in mini-cycles, similar to what played out in Japan during the 1990s and 2000s. I am not suggesting that China resembles Japan entirely, but comparing their mini cycles is a worthwhile exercise. Chart I-9 shows that the Japanese economy, money, credit and share prices were on a rollercoaster ride in the 1990s and 2000s. Notably, the profile of Chinese H shares fits the profile of Japan's stock market during that period (Chart I-10). On average, the recovery phase of these mini-cycles/equity rallies lasted about 20-24 months. Chart I-9Mini-Cycles In Japan In The 1990-2000s Mini-Cycles In Japan In The 1990-2000s Mini-Cycles In Japan In The 1990-2000s Chart I-10Chinese H-Shares Now And Nikkei In 1990s Chinese H-Shares Now And Nikkei In 1990s Chinese H-Shares Now And Nikkei In 1990s My judgment is that the recovery in the Chinese economy and related financial markets over the past 18 months resembles the mini cycles Japan experienced in the 1990s and 2000s. If so, after the rally in the past 18 months, forward-looking investment strategy should be focused on identifying signposts of a reversal. Consistently, given my bias stemming from our core themes and the fact that financial markets are forward looking and have already rallied a lot, I have been looking for signs of a top in China's business cycle and Asia's trade flows. It is pointless for me to change the view if my bias is that markets will reverse their trend in the next couple of months. Investors who are bullish and long but are somewhat concerned about China's growth sustainability still may want to monitor and be aware when the business cycle and markets will reverse. This is where I believe our research is helpful and relevant to investors with a bullish bias. It is hard to forecast what would be an inflection point to overturn the current financial market trend. It could be an unambiguous message from China's Communist Party Congress in the coming days that containing financial risks - a code word for deleveraging - is a major policy priority, or it could be weak economic data in China, or lower commodities prices and weaker EM currencies, being the flipside of a stronger dollar. Chart I-11China: Beware Of Rising Inflation China: Beware Of Rising Inflation China: Beware Of Rising Inflation Ms. Mea: It seems there is no silver lining in your view. Does this mean Chinese policymakers cannot do much to generate a positive outcome for the economy and financial markets? Answer: Chinese policymakers are in a very tough position. Yet it does not mean there is no silver lining. I assign a 20-25% probability that policymakers can stabilize leverage in the economy and financial system without a meaningful growth slump. If this scenario transpires, my negative view on EM and China-related plays will continue to be wrong. There is a 40-45% probability that growth will slump as the authorities focus on deleveraging and structural reforms (allowing markets to play a greater role in resource/capital allocation), and that policy tightening will begin biting. This heralds a deflationary outcome from a cyclical perspective, but it also represents a necessary adjustment to ensure efficiency gains and productivity-led growth over the long run. In fact, this would make me structurally bullish on China's growth again. There is also a 30-35% probability that policymakers - having no tolerance for any kind of growth slump - will continue to stimulate via money/credit and fiscal deficits. The outcome of this scenario will be an inflation outbreak Notably, as I argued in the October 4th 2017 report,3 underlying inflationary pressures are rising, as shown in Chart I-11. Unless growth decelerates meaningfully, inflation will need to be tackled. If not, capital outflows from residents will escalate again, and the currency will come under depreciation pressure given that the deposit rate is at a very low 1.5%. Rising inflation limits policymakers' maneuvering room: they have to tighten and cannot stimulate rapidly and considerably when growth slows. In short, a silver-lining scenario - which would include the authorities curbing out excesses while preserving overall growth, and especially capital spending growth - is always there and is a well-known narrative in the investment community. I do not write about it because I assign a 20-25% probability of it actually panning out. Why not more? Because the imbalances and excesses are currently so large that it will be difficult to contain them without jeopardizing growth. Finally, my view on China does not spread to the entire economy - our focal point has been and remains capital expenditures in general and construction in particular. These areas are being financed by credit, and consume a lot of raw materials and capital goods. Mainland imports - which are heavy in commodities and capital goods (the two account for 95% of total imports) - are the link between mainland investment expenditures and the rest of the world in general, and EM in particular. The latter will suffer if Chinese imports contract. Ms. Mea: It seems your big-picture themes have considerable influence on your views and strategy. How have your big-picture investment themes evolved over time? Last decade, my overreaching theme was that EM and China were structurally sound and that EM/China/commodities were in a bull market. So, I went from being a staunch bull to a resolute bear. I took over the EMS strategy service in 2005, and was bullish on EM, China and commodities up until 2010 (Chart I-1 on page 1). In 2005, I published an in-depth report arguing that commodities were in secular bull market due to demand from China.4 In April 2006, I pioneered a new theme that in the case of a U.S./DM recession, EM could stimulate and boost domestic demand - an out-of-consensus thesis5 at the time. Having these themes in mind, I recommended upgrading/accumulating Chinese stocks amid the Lehman crisis in the fall of 2008.6 The message was that Chinese policymakers could and would stimulate, and that such stimulus would succeed in lifting Chinese growth, corporate profits, commodities prices and EM risk assets. That was a non-consensus trade at the time, and the exact opposite of my current view. Following the credit boom in EM/China in 2009-10, excesses and imbalances emerged, and I shifted to a negative stance on EM/China in 2010 (Chart I-1 on page 1). Furthermore, in our June 8, 2010 Special Report titled, 'How to Play EM This Decade,' I made a call on a major top and forthcoming bear market in commodities arguing that the 2010-decade leaders in terms of growth and share price performance would be the healthcare and technology sectors. I speculated that during the current decade mania will unfold either in the technology or heath care sectors or some combination of both. Since 2010, the technology and healthcare equity sectors have been the best equity sectors, while commodities have been the worst performing ones within both the global and EM equity space. Consistent with this theme, I have been overweighing EM technology stocks and bourses where tech has a large weight, such as Taiwan, China and Korea. Besides, since 2010 I have maintained a pair strategy recommendation of being long tech and short materials. Ms. Mea: It seems you have been changing the goalposts lately, using new data on Chinese money and credit instead of relying on traditional ones. Our research is an ongoing effort to understand the macro landscape better. Our objective is always to find new variables and indicators that better lead business cycles and corporate profits while continuing to track the existing ones. Thus, it is not about changing goalposts but refining existing indicators or examining alternative ones that have a better track record. The following aspects have led usintroduce new broad money measures in China: Over the past two years, official M2 has been much weaker than various credit and money measures, as illustrated in the top panel of Chart I-8 on page 8. Broad money, and hence new purchasing power, is created when banks originate credit - by lending to or buying claims on non-bank entities. Therefore, properly measuring broad money is vital to assessing the new purchasing power that is created in the economy. In brief, in 2016 and early this year I relied on China's official broad money M2 measure, but it has underestimated the amount of new purchasing power created in the past two years. This was one of the reasons we misjudged the duration and magnitude of this equity rally. In addition, the regulatory clampdown on banks and non-banks may have prompted them to shift credit assets from off balance sheet to on balance sheet, or vice versa. Banks and shadow bank entities can obscure or hide credit by classifying it differently, but the banking system cannot conceal the amount of money in the system. Therefore, by tracing broad money creation, one can trail new purchasing power originated by banks. For these reasons, we have begun calculating new broad money aggregates for China - we produced our measure of M3 (M2 plus some other banks liabilities that are not included in M2) and credit-money (broad money calculated using the asset side of commercial banks' balance sheets). Chart I-3 on page 3 illustrates that all measures of money and credit have slowed in late 2016 and this year. On balance, having examined various measures of money and credit, including official M2, we have concluded that in the past 12 months money/credit creation has been slowing in China, irrespective of which aggregate we focus on (please refer to Chart I-3 on page 3). Ms. Mea: How do you explain strong September money and credit numbers out of China? Money, credit and business activity data for September were indeed strong, but they should be adjusted for working days. In China, the annual Mid-Autumn Festival fell in October this year versus September over the past several years. During this festival, business activity grinds to a halt for several days. I conjecture that money, credit and growth data out of China and Asia in general was strong in September partially due to the increase in the number of business days in September this year versus September a year ago. We need to wait for October data and average the two months to get a better picture of the trajectory of the business cycle in Asia. Chart I-12China: Velocity Of Money Has Been Declining China: Velocity Of Money Has Been Declining China: Velocity Of Money Has Been Declining Ms. Mea: Your view on China, commodities and EM is largely contingent on very weak money growth. Is it possible that the correlation between money and economic growth has diminished or completely broken down in China? The only reason why broad money growth could deviate from nominal GDP growth is due to the rising velocity of money. Let's remind ourselves: Nominal GDP = Money Supply x Velocity of Money. For nominal GDP growth to rise, a considerable decelaration in money supply growth needs to be offset by an even larger acceleration in the velocity of money. It is extremely difficult to forecast velocity of money. I assume money velocity will be steady (constant) and, consequently, nominal GDP growth to be affected primarily by changes in broad money growth. Chart I-12 demonstrates that the velocity of money in China has been declining over the past eight years. So, it would be odd for the velocity of money to suddenly rise going forward, in turn making money growth a less reliable indicator for nominal GDP growth. Overall, while it is always possible that the correlation between money growth and economic activity can break down, it is not something that one can forecast or bet on with high conviction. Chart I-13EM Ex-China, Korea And Taiwan: ##br##Broad Money And Bank Loan Growth Is Weak EM Ex-China, Korea And Taiwan: Broad Money And Bank Loan Growth Is Weak EM Ex-China, Korea And Taiwan: Broad Money And Bank Loan Growth Is Weak Ms. Mea: What about other emerging markets? How dependent are they on China? Where are they in the business cycle? The link from China to other emerging markets is via commodities and EM countries' other exports to the mainland. Even non-commodity countries like Korea and Taiwan sell a lot to China. If Chinese growth decelerates, commodities prices relapse, the U.S. dollar rallies or the RMB comes under selling pressure, the outlook for other EM countries and their risk assets will be dim. I argued that EM currencies, credit, and stocks on aggregate levels are not cheap.7 Segments that appear attractively valued are cheap for a reason, while healthy segments (countries/sectors/companies) are rather expensive. Money and bank loan growth also remain lackluster in the majority of EM, excluding China, Korea and Taiwan (Chart I-13). The reason is that the banking systems in many of these developing countries have not been restructured and remain sick following years of overextended credit and rising non-performing loans. Therefore, even though EM exports to China and the rest of the world have picked up, there has been little recovery in their domestic demand. If external conditions - exports, exchange rates and borrowing costs - deteriorate anew, EM domestic demand recovery will be derailed. Investors often refer to Russia and Brazil when they cite macro adjustments in developing economies. It is true that Russia and Brazil have already gone through a lot of pain and adjustment, including provisioning for NPLs in their respective banking systems. Nevertheless, financial markets in both countries remain dependent on commodities prices and the U.S. dollar outlook. Barring external shocks, both economies will continue to revive. That said, my big-picture view entails a negative shock to EM sentiment due to China and a rally in the greenback so I cannot turn bullish on them yet. In addition, Brazil's public debt is rising in an unsustailable manner, and political risks remain significant, particularly ahead of next year's elections. It will be hard to boost nominal growth and contain the explosion of public debt without meaningful currency depreciation that reflates the economy. That cannot not bode well for foreign investors in Brazilian markets. Credit excesses continue to linger in some other EM economies, and there has been little adjustments in their leverage even when we remove China, Korea and Taiwan from the aggregate (Chart I-14). All in all, while some EM economies have undergone necessary macro adjustments, the largest economy - China - has not. When China begins its own macro adjustments, shockwaves will likely hit Asian economies and commodities producers. There are not many large developing countries outside Asia that are not raw materials exporters. Ms. Mea: What about the technology sector? It alone has been responsible for a substantial portion of price gains in the EM equity benchmark in this rally. Does your view on China's credit cycle also influence your outlook for technology stocks? Indeed, EM tech stocks have exploded in recent years, accounting for a significant portion of EM share price appreciation. Excluding tech stocks, EM equities have not rallied nearly as much (Chart I-15). Chart I-14EM Ex-China, Korea And Taiwan: ##br##Leverage Has Not Diminished EM Ex-China, Korea And Taiwan: Leverage Has Not Diminished EM Ex-China, Korea And Taiwan: Leverage Has Not Diminished Chart I-15EM Equities: Tech Versus Non-Tech EM Equities: Tech Versus Non-Tech EM Equities: Tech Versus Non-Tech Also, Table I-1 reveals that eight out of 11 equity sectors have underperformed the benchmark. Meanwhile, a large share of tech gains has been produced by five or so companies. Table I-1EM Sectors: Only Three Out Of 11 Sectors ##br##Outperformed The Benchmark Ms. Mea Challenges The EMS View Ms. Mea Challenges The EMS View I have no strong view on the technology sector's absolute performance following the exponential price gains of past years. Overweighting the technology sector has been my recommendation since 2010, as we discussed above, and it has panned out quite well. I still maintain this overweight call, but within the technology sector we prefer semis to internet and social-media stocks. On the second part of your question, my negative view on China's credit cycle does not have direct ramifications for technology stocks, including Chinese ones. Critically, the call on internet- and social media-related companies is a bottom-up call. On the macro level, I can only state the following: It is essential to realize that in the past nine years a lot of new purchasing power in China has been created because of explosive money origination by banks. If money/credit growth structurally downshifts in China in the years ahead, nominal income growth for both households and companies will slow and the growth in their spending power will also moderate. That said, I am not in a position to assess and comment on business model viability and equity valuation levels of internet and social media-related companies like Alibaba, Tencent or Baidu. As to the other two tech heavyweights - Samsung Electronics and TSMC - I continue to recommend an overweight position in semis and other tech stocks that stand to benefit from DM growth. However, I am less certain about their absolute performance given their exponential rally. Chart I-16EMS's Fully-Invested Equity Portfolio ##br##Performance Versus The Benchmark EMS's Fully-Invested Equity Portfolio Performance Versus The Benchmark EMS's Fully-Invested Equity Portfolio Performance Versus The Benchmark Finally, regardless of my view on EM absolute performance, we always add value to dedicated EM equity and fixed-income investors by selecting countries to overweight and underweight relative to their respective benchmarks. Our country equity allocation strategy has been very successful. Chart I-16 illustrates our country fully-invested equity portfolio performance versus the EM benchmark. The portfolio is built based on our overweight and underweight recommendations on individual bourses, and is assumed to be fully invested. Our country calls have done quite well in the past nine years, producing 58% outperformance versus the benchmark with extremely low volatility. This translates into 520 basis points of annual compound outperformance for nine years. Our recommended country allocation and other equity positions as well as fixed income and currency recommendations are published at the end of each week's report. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report titled "Revisiting China's Fiscal And Credit Impulses," dated April 13, 2016, link available at ems.bcaresearch.com 2 Please refer to the Emerging Markets Strategy Special Reports from October 26, 2016, November 23, 2016 and January 18, 2017; available on ems.bcaresearch.com 3 Please refer to the Emerging Markets Strategy Weekly Report titled, " China: Deflation Or Inflation?," dated October 4, 2017; link available on page 21. 4 Please refer to the International Bank Credit Analyst Special Report titled, "Commodities: Buy On Dips," dated April 2005. 5 Please refer to the Emerging Markets Strategy Special Report titled, "Global Monetary Tightening And Emerging Markets: Is It Different This Time?"dated April 19, 2006. 6 Please refer to the Emerging Markets Strategy Special Report titled, "Upgrade/Accumulate Chinese Stocks,"dated September 29, 2008. 7 Please see Emerging Markets Strategy Weekly Report titled "Is The Dollar Expensive, And Are EM Currencies Cheap?" dated October 11, 2017, link available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Chinese politics is shifting from a tailwind to a headwind for the economy; Policy implementation should improve in Xi's second five-year term; Tighter financial and environmental controls will continue to bite next year; Key internal and external risks are structural in nature - volatility will rise; Re-initiate our long China volatility and long Big Bank trades; stay overweight Chinese H-shares in EM portfolios Feature Xi Jinping is slated to deliver his "work report" as we go to press, at the opening of China's nineteenth National Party Congress.1 The speech will be filled with communist slogans and jargon and will not give clear "answers" to the questions so heavily debated about China. But it will be the most authoritative distillation of the party's thinking in five years and will bear Xi Jinping's imprimatur as the "core" of the Communist Party. Hence investors will need to read the tea leaves to try to get a sense of the country's policy preferences over the next five years. In this Special Report, we offer a guide to interpreting the work report and the likely changes to the party constitution. Broadly, we think the party congress will herald a period of more effective domestic policy reforms in 2018-19. The nature of these reforms is an open question, but they likely entail that government policy will shift from being a tailwind for Chinese growth, as it has been since 2015, to being a headwind. While the party will aim to maintain stability as always, more effective policy execution will in itself probably increase the risks to stability. At present levels, Chinese political risks are understated by the market (Chart 1). The Stability Imperative Xi's speech is an authoritative party document drafted over the past year. It will be part of the running narrative laid out by his predecessors, particularly former President Hu Jintao's report at the eighteenth party congress in 2012, which Xi himself drafted and which marked the transition of power from Hu to Xi.2 Going back to 1992, the reports tell a story of China's shift from focusing on rapid, market-oriented "catch-up" economic growth to focusing on social stability and consumer-led growth. Analysis of the words most often used in the speeches reveals this critical policy evolution, with terms like "rural" and "security" gaining considerable ground recently (Chart 2). Chart 1Stability Achieved For Party Congress Stability Achieved For Party Congress Stability Achieved For Party Congress Chart 2The Shifting Emphasis In Key Speeches How To Read Xi Jinping's Party Congress Speech How To Read Xi Jinping's Party Congress Speech Broadly, Xi is pre-committed to the following key points about the economy: Primacy of the party and state: The idea of building a "socialist market economy" means maintaining the primacy of the party and the state in the economy. State resources will still be used to prop up economic growth and public ownership will remain dominant in strategic industries. Any debate about reform must occur within this context. Reform and opening up: The period after Chairman Mao is broadly defined as a period of market reform and globalization. China, as a major exporter and growing global investor and consumer, continues to benefit from these forces, as Xi highlighted in his speech at the Davos Forum earlier this year.3 Recently, however, productivity growth has declined, and foreign companies and governments have grown resentful of China's attempts to protect its market while encroaching on their markets and capturing their technology. Foreign direct investment is at the lowest point since the height of the global financial crisis.4 Xi's administration will re-commit to reform and opening up, but the proof will be in the actual policies issued forth in the coming months. Two "Centenary Goals": China has long committed to two overriding "centenary goals" of building a "moderately prosperous society" by 2020 and becoming a "modern socialist" developed country by 2049. The essence of these goals is not only to meet middle-income GDP and income targets by 2020 (Chart 3) but also to avoid getting stuck in the "middle-income trap." The first deadline coincides with the end of the thirteenth Five-Year Plan and is integral to the symbolic hundredth anniversary of the Communist Party in 2021 - another politically sensitive year in which economic stability will be paramount.5 China's global influence: China's global influence is rising along with its economic and military heft. Hu Jintao's 2012 party congress report was the first to emphasize China's emerging status as a "maritime power" and to introduce the concept of a "new type of great power relations."6 The latter would require the U.S. to concede a much greater global leadership role for China in order to avoid conflicts as China carves out a sphere of influence. The 2012 report also focused on building closer economic ties with Asia and the emerging world. Xi is doubling down on these global trends, notably by his assertive foreign policy in the South China Sea and promotion of the Belt and Road Initiative.7 He may make tactical adjustments but the strategic path is set for him. Maintaining stability and balance: China had a tumultuous history under foreign domination and Maoist revolution for most of the past two centuries. Whatever new initiatives its policymakers undertake, they will stress the need to keep the ship of state on an even keel. This applies to the nature of the policies themselves (e.g. rebalancing growth away from investment toward consumption) as well as to the principle of cautious execution. What is the economic implication of these inherited party goals? Looking at the low growth rate in China's various monetary aggregates presents a risk that the country could face a cyclical slowdown next year (Chart 4).8 This risk could be compounded by Xi's tougher policy stance this year (for instance, his imposing curbs on the property market).9 Yet the next politically sensitive deadline is not until 2020-21, implying that Xi still has some wiggle-room to push "reforms," which for us means deleveraging and industrial restructuring. Chart 3Political Deadlines For Xi Jinping Political Deadlines For Xi Jinping Political Deadlines For Xi Jinping Chart 4Money Growth In China Is Slowing bca.gps_sr_2017_10_18_c4 bca.gps_sr_2017_10_18_c4 Over the long term, the "Socialist Put" will remain in place and growth rates will not be allowed to collapse, as long as the party can help it.10 If policy continues tightening in 2018, as we expect, it will become more accommodative as the 2020 political deadline approaches. Bottom Line: Xi's speech will not change the fact that the Communist Party remains committed to regime survival and national stability above all. The Evolution Of The Anti-Corruption Campaign The consensus view of the current party congress is that it marks Xi's consolidation of power. This is true, but it only matters if policymaking becomes more purposeful and effective. If so, then the market is in for some surprises next year, as Xi's policy agenda is ambitious. Chart 5Anti-Corruption Campaign Still Going Anti-Corruption Campaign Still Going Anti-Corruption Campaign Still Going Events over the past year suggest that surprises are coming. First, Xi has continued the sweeping anti-corruption campaign that defined his first five years. This campaign - more so than Xi's accrual of official titles - epitomizes his consolidation of power over the party and military. The latest probes culminated with the sacking of Politburo member Sun Zhengcai, heretofore the likeliest candidate to succeed Premier Li Keqiang in 2022.11 Thus Xi is actively manipulating the post-2022 leadership of China, and this process will continue in the coming years. Regardless of whether Xi overstays his term in office in 2022, he is lining himself up to be the most powerful man in China well into the 2020s. Second, while the anti-corruption campaign appears, on paper, to have passed peak intensity (Chart 5), it is apparently morphing into broader policy enforcement.12 In particular, Xi is using the Central Discipline and Inspection Commission (CDIC), the party's anti-corruption watchdog, to supercharge his policy efforts in financial and environmental regulation. Since last fall, Xi has launched a series of financial tightening and anti-pollution efforts that have proved to be fairly aggressive, especially given the need for overall stability ahead of the party congress. This aggressiveness is partly because of his use of the CDIC, and it looks to be part of the game plan for next year: Anti-corruption officials appointed to top financial regulatory bodies: In late September, the leadership put two leading anti-corruption officials in charge of overseeing anti-corruption efforts within the China Banking Regulatory Commission (CBRC) and the China Insurance Regulatory Commission (CIRC).13 These are two of the three top financial regulating bodies (the other being the China Securities Regulatory Commission). The timing of these appointments, along with other key appointments earlier this year, suggests that the "financial regulatory crackdown" will continue apace in 2018.14 Local government officials to be held accountable for debt: In June and July, Chinese authorities, including Xi, highlighted that local government officials should be held accountable for excessive debt creation - not only in their current office but over the course of their entire lives.15 The implication is that they could get expelled from the party or even imprisoned, rather than simply demoted. Moreover, officials could be punished for accruing illegal debts, and promotions could be tied to fiscal sustainability rather than just economic growth. The implication is that there will be legal ramifications, as well as financial restrictions, for local government officials who add to the country's systemic risks. Tackling systemic financial risk is a clear policy priority. Xi emphasized this at an extraordinary Politburo meeting in April as well as at the National Financial Work Conference in July.16 Not only has China accumulated more debt as a share of its GDP than any other country since the global financial crisis, but also it has done so faster than most other countries (Chart 6 A&B). Regardless of China's high national savings rate, China's top leadership sees leverage as a threat to stability and is taking action. Chart 6AChina Has Added Massive Debt... How To Read Xi Jinping's Party Congress Speech How To Read Xi Jinping's Party Congress Speech Chart 6B... And Done So Faster Than Others How To Read Xi Jinping's Party Congress Speech How To Read Xi Jinping's Party Congress Speech Something similar is taking place in the realm of environmental regulation. This is also a clear priority for the party: Hu Jintao included an "ecological" section in the work report for the first time in 2012; environmental spending grew faster than any other central government category in the beginning of Xi's first five years (Table 1). Table 1Fiscal Priorities Of Recent Chinese Presidents How To Read Xi Jinping's Party Congress Speech How To Read Xi Jinping's Party Congress Speech Here again, the powers that Xi amassed in his anti-corruption campaign are paying off. In August, the anti-pollution teams that fanned out across the country to enforce tougher environmental standards included anti-corruption watchdogs as well. This helps explain why production cuts and factory closures have been so effective in recent months, for instance cutting steel supply (Chart 7). Managers are not only facing environmental fines but also arrest and jail time. Meanwhile, ministerial-level ranking officials accompanied each environmental inspection team, giving them greater clout.17 It is unclear, so far, whether the CDIC or other tools will be brought to bear on the reform of state-owned enterprises (SOEs). SOE reform is one of the major unknowns of Xi's second term. So far, it has moved slowly, with the 2013 broad overview only put into a concrete plan in late 2015, which has since resulted in pilot projects of questionable value and little general implementation. The 2015-16 stimulus gave state companies some breathing space, as they were at last able to build up cash faster than they were borrowing it (Chart 8); but this period has ended and they are still plagued with inefficiencies (Chart 9). Chart 7Cutting Steel Supply, And Iron Demand Cutting Steel Supply, And Iron Demand Cutting Steel Supply, And Iron Demand Chart 8Stimulus Helped Corporate Balance Sheets... Stimulus Helped Corporate Balance Sheets... Stimulus Helped Corporate Balance Sheets... Chart 9...But SOEs Are Still Inefficient ...But SOEs Are Still Inefficient ...But SOEs Are Still Inefficient Chinese authorities have recently been emphasizing that reform is set to "deepen."18 If this effort is to have any teeth, it must include real encouragement to private and foreign capital, as well as real creative destruction - the sale of loss-making assets plus bankruptcies and layoffs (however carefully managed by the state). It will not suffice merely to continue the ongoing process of debt-for-equity swaps, mergers and acquisitions, and the creation of national champions. Anecdotal evidence suggests that bankruptcies are rising, but the proof will be in the pudding.19 What are the macro implications of the above? Assuming that we are right and deleveraging intensifies, the standard policy move in China would be to boost fiscal spending at the National People's Congress in March in order to compensate for the resulting slowdown in credit growth (Chart 10). This is precisely how President Jiang Zemin and Premier Zhu Rongji approached the negative growth effects of supply-side structural reforms after the fifteenth party congress in 1997: more fiscal spending. Xi's recent emphasis on poverty alleviation would seem to call for such spending as part of the broader effort to build a social safety net, reinforce social stability, and boost consumption as a driver of growth (Chart 11). There is a risk, however, as our colleagues at BCA's Emerging Market Strategy have argued, that fiscal spending may not offset a significant drop in credit growth in China. This is not the baseline case of China Investment Strategy, but it is a legitimate concern: it is not clear that any decrease in credit growth will go off seamlessly (Chart 12).20 Chart 10Two Sides Of The Same Coin Two Sides Of The Same Coin Two Sides Of The Same Coin Chart 11High Savings Rate Suppresses Consumer Demand High Savings Rate Suppresses Consumer Demand High Savings Rate Suppresses Consumer Demand Chart 12Credit Growth As Large As Government Spending Credit Growth As Large As Government Spending Credit Growth As Large As Government Spending If Xi seriously addresses China's long-festering financial systemic risks he could create a drag on growth that would be negative for emerging markets and certain commodity prices, like copper and iron ore.21 More broadly, the gradual transition away from China's investment-led growth model toward consumption-led growth is a headwind for the economies that have benefited the most from the status quo over the past two decades. Bottom Line: Xi's anti-corruption campaign is the clearest measure of his consolidation of power, and the party congress puts the capstone on it. Policy implementation will be more effective going forward. If Xi continues to prioritize deleveraging and industrial-environmental restructuring next year, he could create a drag on growth that is negative for the assets of EM exporters and key commodity producers. Xi Jinping Theory... What Does It Mean? Aside from Xi's big speech, the Communist Party will amend its constitution at the party congress. It is not clear what amendments may be made. The current debate is about whether and how Xi Jinping's ideas will be incorporated into the constitution and what this might mean for policy. Currently, the party constitution highlights the thinking of Marx and Lenin as well as China's top leaders since 1949. Each of China's leaders is said to have contributed something essential to the party's guiding philosophy: namely, "Mao Zedong Thought," "Deng Xiaoping Theory," "the important thinking of the Three Represents" (Jiang Zemin's contribution), and "the Scientific Outlook on Development" (Hu Jintao's contribution). These theories are outlined in Table 2. Table 2Xi Jinping Theory How To Read Xi Jinping's Party Congress Speech How To Read Xi Jinping's Party Congress Speech It is hard to draw strict correlations between these theories and economic policy, but the broad trends are well enough known: Mao founded the People's Republic and put a personal stamp on its Marxist-Leninist foundations. Deng Xiaoping brought pragmatism, enabling China to pursue a "socialist market economy," or "socialism with Chinese characteristics," thus opening the door to private and foreign capital, and profit incentives for households and businesses. National and household income surged (Chart 13). Jiang Zemin brought entrepreneurialism, building on Deng's achievement, particularly by phasing out many of the bloated SOEs and "command-style" economic controls and opening the real estate sector for consumers to buy houses (Chart 14). Hu Jintao brought social responsibility into greater focus, emphasizing the need to invest in infrastructure in undeveloped regions, reduce rural and urban disparities, and build out the social safety net (Chart 15). Chart 13Deng Unleashed China's Economic Potential Deng Unleashed China's Economic Potential Deng Unleashed China's Economic Potential Chart 14Jiang Rebooted Growth, Launched Housing Boom Jiang Rebooted Growth, Launched Housing Boom Jiang Rebooted Growth, Launched Housing Boom Chart 15Hu Jintao Sought 'Harmonious Society' Hu Jintao Sought 'Harmonious Society' Hu Jintao Sought 'Harmonious Society' If Xi's ideas are incorporated into this section, it will be notable since that honor usually occurs at the end of a general secretary's term. The precise wording will be heavily studied: e.g. whether Xi is named personally (like Mao and Deng), whether his ideas are referred to as "Thought" or "Theory" (like Mao or Deng respectively), which of his slogans are included, and what they actually mean. The real takeaway for investors is that the party is demanding a return to centralization and Xi is fulfilling this demand.22 Structurally, Xi's anti-corruption campaign has put him at the top of a more disciplined party. He has simultaneously reasserted the party's primacy over the military, which has been extensively reshuffled and reformed, and civil society, which has been muzzled. Re-centralization is also apparent in fiscal and financial management. The previous administration decentralized economic control in order to accelerate growth in the face of the global recession. This specifically meant freeing up the state banks and the provincial governments to borrow, invest, and build to their heart's content. Comparing the trajectory of central and local government spending, it is clear that Xi is overseeing a marginal re-concentration of taxation and spending into the hands of the central government vis-à-vis the provincial governments (Chart 16 A&B). Chart 16ALocal Government Gap Widened Post-Crisis... Local Government Gap Widened Post-Crisis... Local Government Gap Widened Post-Crisis... Chart 16B...But Gap Narrowed Under Xi Jinping ...But Gap Narrowed Under Xi Jinping ...But Gap Narrowed Under Xi Jinping Similarly, he is overseeing a marginal re-concentration of lending back into traditional state-owned bank loans, after nearly a decade of rapid growth in the non-bank, "shadow lending" sub-sector (Chart 17 A&B). Chart 17AShadow Loans Outpaced Bank Loans... Shadow Loans Outpaced Bank Loans... Shadow Loans Outpaced Bank Loans... Chart 17B...But Gap Has Narrowed Under Xi ...But Gap Has Narrowed Under Xi ...But Gap Has Narrowed Under Xi However, re-centralization is not the result of any "coup" by Xi Jinping so much as the Communist Party's strategic response to the fact that the country stands at a historic juncture with serious systemic risks: The "Thucydides Trap": The world has not seen the contest of a fully established world empire (the U.S.) and a newly emergent peer competitor (China) since the Cold War, and strictly speaking since the late 1800s, when Germany emerged as a challenger to the U.K. (Chart 18). The CPC's founding myth is the rejection of a "century of humiliation" at the hands of western powers, so there is no moment more critical than now, when China is emerging as a rival to the greatest western power. Economic reform: China's economic model is slowly evolving, and the outgoing model has left imbalances that are key vulnerabilities to China and could undermine its global emergence. The corporate debt pile is the clearest, but by no means the only, example of this internal threat (Chart 19). Lack of political reform: The country faces an inherent contradiction between its single-party system and the emergent middle class, which is still denied political participation (Chart 20). This is a source of socio-political imbalances that could also undermine China's emergence. Chart 18The 'Thucydides Trap' The 'Thucydides Trap' The 'Thucydides Trap' Chart 19An Outstanding Economic Imbalance An Outstanding Economic Imbalance An Outstanding Economic Imbalance Chart 20Not Your Father's China Not Your Father's China Not Your Father's China True, China has a single authoritative leader (with no alternative) at the head of a unified ruling party (with no alternative). Thus, it faces fewer domestic political constraints, in the strict sense, than any major country in the world. Nevertheless, the challenges themselves are structural and could outstrip any leadership's ability to address them. The policy responses to the crises of 2015-16 - when Beijing committed a series of blunders - do not suggest that Xi is nearly as omnipotent or omniscient as the media will make it sound this week.23 Of crucial importance going forward will be the deteriorating U.S.-China relationship, since the next 12 months will provide at least two major occasions for clashes: North Korea, where diplomacy is balking, and Trump's need to look tough on China ahead of midterm elections.24 Bottom Line: The possible incorporation of Xi's ruling philosophy into the Communist Party's constitution would be a symbolic nod to the concrete executive power that Xi has already achieved. However, only when new structural risks materialize will Xi's capabilities - and the Communist Party's capabilities as a ruling party - truly be put to the test in a way that yields significant information for investors. Investment Conclusions On the brink of the party congress, Xi looks to be continuing his double game of centrally driven internal reforms and external assertiveness. But between these, the key to watch is the extent to which he re-emphasizes internal reforms. Over the next few years, rebooting reforms could help Xi to waylay the Trump administration's threatened punitive measures; to use Trump as a foil to excuse the painful consequences of necessary reforms at home; and to win goodwill among other countries, which would see greater opportunities in a China that is recommitting to opening up to them (and investing more in them). Our "Reform Reboot" checklist, which focuses on deleveraging, is designed for the post-party congress period. As such, most of the points are yet to be determined (see Appendix). We would remind readers to watch for the following: Chart 21Volatility Will Go Up Volatility Will Go Up Volatility Will Go Up The composition of the next Politburo, Politburo Standing Committee, and Central Committee, expected to be revealed on October 25, for a sense of whether reformers will hold key posts and whether Xi's faction will gain the upper hand - we will report on this in subsequent weeks;25 Post-party congress leaks or discussions in state media covering new policy priorities, particularly on financial regulation, the property sector, and SOE reform; Any hints at who will replace Zhou Xiaochuan as governor of the central bank, who will be the first head of the new Financial Stability and Development Committee, and how the National Financial Work Conference's goals are implemented; Outcomes of U.S. President Donald Trump's visit to China and Asia Pacific, November 3-14 - particularly on North Korea and trade frictions; How far the latest property market curbs advance, and whether recently promised "long-term" curbs are implemented, including any nationwide property tax; Whether the financial crackdown spreads further into state-owned and domestic-oriented financial institutions; When and how the tougher scrutiny on local government debt is implemented - and whether local government budget balances rise or fall after the congress; Whether SOE "mixed ownership" and "state capital management" reforms accelerate - and whether asset sales and operational restructuring begin occurring more frequently across multiple provinces; How the party implements its recent proposals to increase the role of entrepreneurs and provide easier access to credit for small and medium-sized enterprises; Priorities for domestic reforms, especially those affecting household registration (hukou) reforms, the urbanization rate, social safety net expansion, and household credit; How foreign investment is attracted, including the implementation of the nationwide foreign investment negative list; When and how capital controls will be lifted; if the government wants "de-risking" reforms in the financial sector, it will have to do that first, before pursuing any capital account reforms. We continue to believe that Xi's second term provides a window of opportunity for rebooting reforms, within the Communist Party's stability constraint, due to his consolidation of power and the currently robust domestic and global economic backdrop. This window will likely close as the term progresses due to political deadlines in 2020 and the likelihood of the external backdrop worsening. Both internal and external risks will rise from here (Chart 21). Xi's initial attack over the next six-to-eight months will determine whether we remain optimistic about incremental progress on reforms. We are re-initiating our long China CBOE volatility ETF trade, and our long Big Five banks relative to smaller banks trade. We also remain overweight Chinese equities versus EM equities. We are adjusting this trade to include Chinese H-shares only. Xi's political recapitalization lessens domestic political constraints, and China's shift to more domestically driven growth will disfavor China-exposed, export-reliant, and commodity-producing EMs. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "China's Nineteenth Party Congress: A Primer," dated September 13, 2017. 2 For this transition, please see BCA Geopolitical Strategy, "China: Two Factions, One Party," dated September 2012, available at gps.bcaresearch.com. 3 Please see Xi Jinping, "Jointly Shoulder Responsibility Of Our Times, Promote Global Growth," dated January 17, 2017, available at america.cgtn.com. 4 Please see BCA Geopolitical Strategy, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 5 Moreover, Xi's term officially ends the following year, in 2022, which will require arrangements for a smooth transition regardless of whether Xi retains power. 6 The term is not used precisely in this way in the report but has been developed in official policy outlets since then. Please see Hu Jintao, "Firmly March On The Path Of Socialism," Report to the 18th National Congress of the Communist Party of China, November 8, 2012, available at www.china.org.cn, and Timothy Heath, "The 18th Party Congress Work Report: Policy Blueprint For The Xi Administration," China Brief 12:23, Jamestown Foundation, November 30, 2012, available at jamestown.org. 7 Please see BCA Frontier Markets Strategy and Geopolitical Strategy Special Report, "China's Belt And Road Initiative: Can It Offset A Mainland Slowdown?" dated September 13, 2017, available at gps.bcaresearch.com. 8 Please see BCA Emerging Markets Strategy Weekly Report, "China: Deflation Or Inflation?" dated October 4, 2017, available at ems.bcaresearch.com. 9 Please see BCA China Investment Strategy Weekly Report, "Chinese Real Estate: Which Way Will The Wind Blow?" dated September 28, 2017, available at cis.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Monthly Report, "The Socialism Put," dated May 11, 2016, available at gps.bcaresearch.com. 11 For our take on factional struggles in anticipation of Sun's fall, please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at gps.bcaresearch.com. 12 There is much speculation about whether anti-corruption chief Wang Qishan will make it onto the next Politburo Standing Committee (to be revealed around October 25) despite having passed the retirement age. This topic is a red herring: age limits have always been arbitrarily enforced, while Xi will maintain a hardline toward corruption even if he replaces Wang. If Xi wishes to stay in power beyond 2022, it will not depend on Wang. 13 Please see Wu Hongyuran, Yang Qiaoling and Leng Cheng, "Two Determined Graft-Busters Put In Senior Posts At Banking, Insurance Watchdogs," Caixin, dated October 11, 2017, available at www.caixinglobal.com. 14 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. 15 Please see Huang Ge, "China's First Lifelong Accountability System To Prevent Local Officials From Accruing Mountainous Debt," Global Times, dated July 24, 2017, available at www.globaltimes.cn. 16 Notably, authorities pledged to give the People's Bank of China greater regulatory powers going forward, coinciding with a generational change at the top of the central bank. Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 17 See Barry Naughton, "The General Secretary's Extended Reach: Xi Jinping Combines Economics And Politics," dated September 11, 2017, available at www.hoover.org. 18 Please see Fran Wang, "China To Take Flexible Approach To SOE Reform," Caixin, September 29, 2017, available at www.caixinglobal.com. 19 See "China bankruptcies rise steadily in 2017 amid 'zombie firm' crackdown," August 3, 2017, available at www.reuters.com. 20 Please see BCA Emerging Markets Strategy Special Report, "Revisiting China's Fiscal And Credit Impulses," dated April 13, 2016, available at ems.bcaresearch.com. 21 Please see BCA Commodity & Energy Strategy Weekly Report, "Slow-Down In China's Reflation Will Temper Steel, Iron Ore In 2018," dated September 7, 2017, available at ces.bcaresearch.com. 22 We have long highlighted this theme as critical to Xi's reforms, along with governance and productivity. Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Monthly Report, "Annus Horribilis," dated January 20, 2016, and "China: Eye Of The Storm," dated September 9, 2015, available at gps.bcaresearch.com. 24 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 25 This will be the subject of our party congress post-mortem pieces in coming weeks. Appendix How To Read Xi Jinping's Party Congress Speech How To Read Xi Jinping's Party Congress Speech

Highlights The economic momentum of China's "mini-cycle" appears to have peaked earlier this year. A benign moderation in growth is the most likely outcome, but this report reviews some factors to watch over the coming year to track the character of the slowdown. This month's Party Congress will hopefully provide investors with some clues whether policymakers have learned from their past mistakes of failing to combine any painful structural reforms with an appropriate amount of fiscal support. Shorter-term measures of money & credit in China are hooking up, and most measures of global growth are still signaling robust export demand. An eventual stabilization in the housing market will be an important signal confirming the benign nature of China's economic slowdown. Investors should remain overweight the MSCI China Free index versus the emerging market benchmark. Feature We reiterated the case for a benign cyclical slowdown of the Chinese economy in last week's report, by highlighting several forces that are working to support stable economic activity.1 Specifically, we noted that: There is presently little risk of aggressive policy tightening on the horizon. There is likely to be reduced downside cyclicality in China's industrial and real estate sectors, owing to the past imposition of "supply side" constraints. External demand will continue to support the Chinese economy, even if global growth momentum moderates. Chart 1 presents a stylized view of the Chinese economy over the past three years, which illustrates our framework of how cyclical growth conditions have evolved over this "mini-cycle". It also highlights three possible outcomes for the coming 6-12 months. Chart 1A Stylized View Of China's Recent 'Mini-Cycle' Tracking The End Of China's Mini-Cycle Tracking The End Of China's Mini-Cycle The chart shows how the Chinese economy began to operate below what investors and market participants considered to be a "stable" pace of growth in early-2015, owing to a "double whammy" of excessively tight monetary conditions and a synchronized global downturn. Policy easing succeeded in sparking a V-shaped rebound in some sectors of the economy (particularly housing), and caused an attendant rally in Chinese relative equity performance (vs EM), emerging market relative performance (vs global), and industrial metals prices. However, based on a number of "hard" growth indicators, the economic momentum of the "mini-cycle" appears to have peaked earlier this year. This raises the question of what is likely to be the character of Chinese economic growth over the coming year, with Chart 1 presenting three distinct scenarios: 1) a re-acceleration of the economy and a continuation of the V-shaped rebound profile, 2) a benign, controlled deceleration and settling of growth into the "stable" growth range, and 3) an uncontrolled and sharp deceleration in the economy that threatens a return to the conditions that prevailed in early-2015 (or worse). Our bet is clearly on scenario 2, but this week's report reviews some factors to watch over the coming year in order to monitor the end of China's mini-cycle and its implications for investment strategy. Policy Risk And The Party Congress China's 19th Party Congress is likely to dominate media headlines about China over the coming two weeks. While it is unlikely that a major, explicit policy announcement will emerge from the Congress, investors are likely to focus on the policy implications of the leadership rotation, as well as any signals from President Xi Jinping's opening speech. Indeed, the next two reports of this publication will be devoted to the Party Congress and our assessment of the economic and financial market impact of the event. Chart 2Bold Action Can Follow ##br##Midterm Congresses Tracking The End Of China's Mini-Cycle Tracking The End Of China's Mini-Cycle We recently published a primer explaining the Party Congress,2 and noted that major new policy initiatives can emerge during the March National People's Congress that follows a "midterm" Party Congress. For instance, Premier Zhu Rongji was appointed to launch the "assault stage" of President Jiang Zemin's reforms of state-owned enterprise at the National People's Congress in March 1998 (Chart 2). Similarly, Hu Jintao's Premier Wen Jiabao launched extensive administrative reforms at the NPC meeting in early 2008. When forecasting the character of Chinese economic growth over the coming year, the relevance of the Party Congress comes into play when assessing whether policymakers have learned from their past mistakes by combining any painful structural reforms with the appropriate amount of fiscal support to manage demand in the economy during the adjustment phase. In the past, policymakers have been preoccupied with the idea that the economy needs painful but eventually rewarding economic reforms, and have viewed short term policy easing as endangering reforms and as a contributor to further structural imbalances. In essence, authorities have in the past cornered themselves into a self-imposed 'either/or' choice between supply-side reforms and demand-side countercyclical policies, rather than pursuing a sensible balance between structural reforms and policy easing to mitigate headwinds. For example, the main pillars of "Likonomics", named after the Chinese premier, were touted as "deleveraging, structural reforms and no stimulus", in stark contrast to the three arrows of Japan's "Abenomics", including fiscal stimulus, monetary easing and structural reforms. For now, our view is that policymakers will provide the fiscal support required for the economy to avoid a potentially sharp downturn were they to aggressively pursue structural reform initiatives, given what occurred in 2015. But this assessment remains a key risk to our view of a benign cyclical slowdown, and we will be watching the Party Congress closely for any indications to the contrary. Domestic Demand Momentum Chart 3Shorter-Term Measures Of ##br##Money & Credit Growth Are Positive Shorter-Term Measures Of Money & Credit Growth Are Positive Shorter-Term Measures Of Money & Credit Growth Are Positive We noted above that China's domestic growth momentum is unlikely to decelerate materially, owing to the lack of aggressive policy tightening and the fact that some of China's industries have not experienced a major cyclical upswing (and thus are less likely to experience a major downswing). Supporting this view, shorter-term measures of money & credit in China are hooking up, suggesting that year-over-year measures may soon stabilize (or even accelerate modestly). Chart 3 presents the growth in M2 and two measures of credit, both on a year-over-year and 3-month annualized basis.3 While the latter measure is highly volatile and dependent on a seasonal-adjustment process that may not perfectly capture the seasonal component of Chinese economic data, it should be noted that all three shorter-term measures are at or above their year-over-year rates of change. Despite this, an outsized slowdown in non-supply constrained industries cannot be ruled out, even if it is far from our base case scenario. At a minimum, the potential for severe data disappointments exists, as Chart 4 highlights that the Chinese economy has already been surprising modestly to the downside over the past three months. Disappointing readings from industrial production, retail sales, and fixed-asset investment were particularly noticeable last month, which is in contrast to the steady uptrend in the surprise index that has prevailed since mid-2015. One recent trend that bears particular attention over the coming months is that of a weakening housing market. Chart 5 shows that house prices are beginning to decelerate on a year-over-year basis, and the pace of appreciation in home sales continues to decline. Worryingly, a 70-city diffusion index of house prices is also falling sharply, and to a level that would tend to imply a significant further deceleration in aggregate prices. A moderation in house price appreciation was all but inevitable given the magnitude of the boom over the past 2 years, and is not concerning in isolation (in fact, it reduces risk of escalating tightening measures). But given that home sales and prices were a key bellwether of the efficacy of policymakers' reflationary efforts over the past two years, and given the sharp decline in a broadly measured diffusion index, an eventual stabilization will be an important signal confirming the benign nature of China's economic slowdown. Chart 4Recently Surprising Modestly To The Downside Recently Surprising Modestly To The Downside Recently Surprising Modestly To The Downside Chart 5A Warning Sign From House Prices A Warning Sign From House Prices A Warning Sign From House Prices Trade, And Global Growth In last week's Foreign Exchange Strategy Weekly Report, our colleague Mathieu Savary explored the potential for "yellow flags" that may herald a slowdown in global growth. A slowdown in global narrow money growth was the most notable of the potential warning signs that he highlighted, which historically has been a leading indicator of global industrial production (Chart 6). It is possible that the deceleration in narrow money growth may correctly forecast a mild slowdown in global trade, which would be negative for Chinese economic growth at the margin. Still, it is very unlikely that a gentle pullback in global growth momentum would be sufficient for China's "mini-cycle" to end in the 3rd scenario highlighted in Chart 1 above (an uncontrolled and sharp deceleration in activity). In addition, narrow money growth is but one global growth indicator among many, several of which are still painting a rosy picture for China's external demand outlook: A GDP-weighted average of our consumer and capital spending indicators for the U.S., U.K., euro area, and Japan are suggesting that global GDP growth will continue to accelerate over the coming year (Chart 7). Barring a decline in global import intensity, this would imply that the acceleration in global export activity is just getting started. Chart 6A 'Yellow Flag' From Narrow Money Growth A 'Yellow Flag' From Narrow Money Growth A 'Yellow Flag' From Narrow Money Growth Chart 7Stronger G4 Growth Will Support China's Export Sector Stronger G4 Growth Will Support China's Export Sector Stronger G4 Growth Will Support China's Export Sector A recent update of our global LEI diffusion index suggests that the LEI itself is unlikely to significantly moderate (Chart 8). This is a notable development, as it somewhat reverses the concerning loss of momentum in the diffusion index that had occurred over the past year. Excluding the U.S., the improvement in the LEI diffusion index is still present, and the uptrend since late-2013 / early-2014 is more clearly defined (panel 2). Finally, both the EM and global PMIs remain in an uptrend, and are either at or near multi-year highs (Chart 9). The resilience of the EM PMI is particularly noteworthy, as much of the improvement in the index reflects the strength of the Caixin China PMI (despite the most recent tick down in the index). In addition, it is an underappreciated point among global investors that the EM PMI correctly forecast the onset of China's "mini-cycle" in 2015, and bottomed several months before the global PMI. The improvement of the EM PMI was sufficient to help catalyze a synchronized global economic recovery, despite having persistently lagged the global PMI in level terms. Chart 8A Positive Sign From Our Global LEIs A Positive Sign From Our Global LEIs A Positive Sign From Our Global LEIs Chart 9Manufacturing PMIs Are Not Heralding ##br##A Sharp Decline In Activity Manufacturing PMIs Are Not Heralding A Sharp Decline In Activity Manufacturing PMIs Are Not Heralding A Sharp Decline In Activity The Investment Strategy Implications Of A Benign Slowdown In China Taken together, the evidence noted above is more consistent with a benign end of China's mini-cycle than an uncontrolled and sharp deceleration in the economy. We will continue to track the pace of moderating economic activity, and will adjust our investment recommendations accordingly if China slows more aggressively than we expect. But for now, we see no reason to alter our constructive view on Chinese equities, suggesting that investors should remain overweight the MSCI China Free index versus the emerging market benchmark. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Pease see China Investment Strategy Special Report "On A Higher Note," dated October 5, 2017, available at cis.bcaresearch.com 2 Pease see China Investment Strategy Special Report "China's Nineteenth Party Congress: A Primer," dated September 14, 2017, available at cis.bcaresearch.com 3 For the latter measure we use a seasonal-adjustment methodology employed by the U.S. Census Bureau to adjust all three series prior to calculating the 3-month annualized rate of change. Cyclical Investment Stance Equity Sector Recommendations