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Special Report

Highlights Globalization, technological progress, weak trade unions, high debt levels, and population aging are often cited as reasons for why inflation will remain dormant. None of these reasons are inherently deflationary, and in some contexts, they may actually turn out to be quite inflationary. The combination of a stronger dollar and rising EM stress means that U.S. Treasury yields are more likely to fall than rise during the coming months. Over the long haul, however, bond yields are going higher - potentially much higher - as inflation surprises on the upside. Long-term bond investors should maintain below-benchmark exposure to duration risk in their portfolios. Gold offers some protection against rising inflation. That said, the yellow metal is still quite expensive in real terms, which limits its appeal. Investors would be better off simply buying inflation-protected securities such as TIPS. Historically, stocks have not performed well in inflationary environments. A neutral allocation to global equities is appropriate at this juncture. Feature Will Structural Forces Limit Inflation? In Part 1 of this report, we argued that inflation could surprise materially on the upside over the coming years due to the growing conviction among policymakers that: The neutral real rate of interest is extremely low; The natural rate of unemployment has fallen significantly over time; There is an exploitable trade-off between higher inflation and lower unemployment; The presence of the zero lower-bound on nominal short-term interest rates implies that it is better to be too late than too early in tightening monetary policy. A common refrain in response to these arguments is that the structural features of today's economy are so deflationary that policymakers simply would be not able to lift inflation even if they wanted to. Four features are often cited: 1) globalization; 2) modern technologies such as automation and e-commerce; 3) the declining influence of trade unions; and 4) population aging, high debt levels, and other contributors to "secular stagnation." In this week's report, we discuss all four features in turn. In every case, we conclude that the purported deflationary forces are not nearly as strong as most observers believe. Inflation And Globalization Imagine two closed economies, identical in every way other than the fact the one economy is larger than the other. Would one expect inflation to be structurally higher in the smaller economy? Most people would probably say no. After all, if one economy has more workers and capital than another economy, it will be able to generate more output. But all those additional workers will also want to spend more, so it is not immediately obvious why inflation should differ in the two regions. Now let us change the terminology a bit. Suppose the larger economy refers to the world as a whole. What would happen to the balance between aggregate demand and supply if we were to shift from a setting where countries do not trade with one another to a globalized world where they do? As the initial example suggests, to a first approximation, the answer is nothing. Since one country's exports are another's imports, globally, net exports will always be zero. Thus, it stands to reason that simply moving from autarky to free trade will not, in itself, boost global aggregate demand. Could a move towards free trade increase aggregate supply? Yes. Global production will rise if countries can specialize in the production of goods in which they have a comparative advantage. Productivity will also benefit from the fact that a large global market will allow companies to better exploit economies of scale by spreading their fixed costs over a greater quantity of output. But here's the catch: More production also means more income, and more income means more spending. Thus, if globalization increases aggregate supply, it will also increase aggregate demand. And if both aggregate demand and aggregate supply increase by the same amount, there is no reason to think that inflation will change. Granted, it is possible that desired demand will rise more slowly than supply in response to increasing globalization, putting downward pressure on inflation and interest rates in the process. This could be the case, for example, if globalization increases the share of income going towards rich people. As Chart 1 shows, rich people tend to save more than poor people. Chart 1Savings Heavily Skewed Towards Top Earners If globalization has increased income inequality, it is possible that this has had a deflationary effect. However, for this effect to persist, the world has to become even more globalized. This does not seem to be happening. Global trade has been flat as a share of GDP for over a decade (Chart 2). The share of U.S. national income flowing to workers has also been rising in recent years as the labor market has tightened (Chart 3). Chart 2Global Trade Has Peaked Chart 3Rising Labor Share Of Income Occurring ##br##Alongside Labor Market Tightening Globalization As An Inflationary Safety Valve The discussion above suggests that the often-heard argument that globalization is deflationary because it leads to an overabundance of production is not as straightforward as it seems. What about the argument that globalization is deflationary because it limits the ability of companies to raise prices? While this is a seemingly compelling argument, it runs square into the problem that profit margins are near record-high levels in many economies. Far from making companies more price-conscious, globalization has often created oligopolistic market structures. Granted, free trade can still provide a safety valve for countries suffering from excess demand. To see this, return to our earlier example of the large country versus the small country. Suppose that because of its well-diversified economy, the large country often encounters situations where one region is booming, while another is down in the dumps. When this happens, workers and capital will tend to flow to the thriving region, alleviating any capacity pressures there. The same adjustments often occur among countries. If desired spending exceeds a country's productive capacity, it can run a trade deficit with the rest of the world. Rather than the prices of goods and services needing to rise, excess demand can be satiated with more imports. However, for that realignment in demand to occur, exchange rates must adjust. In today's context, this means that the dollar may need to strengthen further. Notice that this dynamic only works if there is slack abroad. This is presently the case, but there is no assurance that this will always be so. The implication is that inflation could rise meaningfully as global spare capacity is absorbed. Technology And Inflation If the price of electronic goods is any guide, it would seem undeniable that technological innovation is a deflationary force. However, this belief involves a fallacy of composition. Above-average productivity gains in one sector of the economy will cause prices in that sector to decline relative to other prices. But falling prices will also boost real incomes, leading to more spending. It is possible that prices elsewhere in the economy will rise by enough to offset the decline in prices in the sector experiencing above-average productivity gains, so that the overall price level remains unchanged. Ultimately, whether inflation rises or falls in response to faster productivity growth depends on what policymakers do. Over the long haul, productivity growth will lead to higher real wages. However, real wages can go up either because the price level declines or because nominal wages rise. The extent to which one or the other happens depends on the stance of monetary policy. In any case, just as in our discussion of globalization, the whole narrative about how faster productivity growth is deflationary seems rather antiquated considering that productivity growth has been quite weak in most of the world for over a decade (Chart 4). Consistent with this, the price deflator for electronic goods has been falling a lot less rapidly in recent years than it has in the past (Chart 5). Chart 4Globally, Productivity Growth Has Been ##br##Falling For Over A Decade Chart 5Steadier Prices For Computer Hardware ##br##And Software In Recent Years Admittedly, it is possible to imagine a scenario where the pace of productivity growth slows but the nature of that growth changes in a more deflationary direction. However, evidence that this has happened is fairly thin. Take the so-called Amazon effect, which purports to show sizable deflationary consequences from the spread of e-commerce. As my colleague Mark McClellan has shown, outside of department stores, profit margins in the retail sector are well above their historic average (Chart 6).1 This calls into doubt claims that online shopping has undermined corporate pricing power. Recent productivity growth in the U.S. distribution sector has actually been slower than in the 1990s, a decade which produced large productivity gains stemming from the displacement of "mom and pop" stores with "big box" retailers such as Walmart and Costco. The Waning Power Of Unions The declining influence of trade unions is also often cited as a reason for why inflation will remain subdued. There are a number of empirical and conceptual problems with this argument. Empirically, unionization rates in the U.S. peaked in the mid-1950s, more than a decade before inflation began to accelerate. While the unionization rate continued to decline in the U.S. during the 1980s and 1990s, it remained elevated in Canada. Yet, this did not prevent Canadian inflation from falling as rapidly as it did in the United States (Chart 7). The widespread use of inflation-linked wage contracts in the 1970s appears mainly to have been a consequence of rising inflation rather than the cause of it (Chart 8). Chart 6Retail Sector Profit Margins Are Strong Chart 7Inflation Fell In Canada, Despite A ##br##High Unionization Rate Chart 8Higher Inflation Led To More Inflation-Indexed ##br##Wage Contracts, Not The Other Way Around Conceptually, the argument that strong unions tend to instigate price-wage spirals is highly suspect. Yes, firms may be forced to raise wages in response to union pressures, which could prompt them to increase prices, leading to demands for even higher wages, etc. However, the price level cannot increase on a sustained basis independent of other things such as the level of the money supply. Central banks must still play a decisive role. One can imagine a scenario where the presence of powerful trade unions creates a dual labor market, one with well-paid unionized workers and another with poorly-paid non-unionized workers. Governments may be tempted to run the economy hot to prop up the wages of non-unionized workers. On the flipside, one could also imagine a scenario where the absence of strong unions exacerbates income inequality, causing governments to pursue more demand-boosting macroeconomic policies. In either case, however, the ultimate cause of rising inflation would still be macroeconomic policy. Inflation And The Neutral Rate As the discussion so far illustrates, inflation is unlikely to rise unless policymakers let it happen. But what if the neutral rate of interest is so low that policymakers lose traction over monetary policy? In that case, central banks may not be able to bring inflation up even if they wanted to. This is not just an academic question. Japan has had near-zero interest rates for over two decades and this has not been enough to spur inflation. Chart 9Long-Term Inflation Expectations In The Euro Area ##br##Are Still Much Higher Than In Japan We do not disagree with the notion that the neutral rate of interest is lower today than it was in the past. However, magnitudes are important here. In thinking about the secular stagnation thesis, which underpins the rationale for why the neutral rate has fallen, one should distinguish between the "weak" form and the "strong" form versions of the thesis. The weak form says that the neutral nominal rate of interest is low but positive, whereas the strong form says that the neutral nominal rate is negative.2 While this may seem like a minor distinction, it has important policy and market implications. Under the strong form version of the thesis, central banks really do lose control of their most effective policy tool: the ability to change interest rates to keep the economy on an even keel. By definition, if the neutral nominal rate is deeply negative, then even a policy rate of zero would mean that monetary policy is too tight. Under such circumstances, an economy could easily succumb to a vicious circle where insufficient demand causes inflation to fall, leading to higher real rates and even less spending. Such a vicious circle is less probable when the weak form version of the secular stagnation thesis dominates. As long as the neutral nominal rate is positive, central banks can always choose a policy rate that is low enough to allow the economy to grow at an above-trend pace. If they keep the policy rate below neutral for an extended period of time, the economy will eventually overheat, generating higher inflation. The fact that the U.S. unemployment rate has managed to fall during the past few years, even as the Fed has been raising rates, strongly suggests that the weak form of the secular stagnation thesis is applicable to the United States. The euro area is a much tougher call, given the region's poor demographics and high debt levels. Nevertheless, at least so far, the euro area has one thing on its side: Long-term inflation expectations are still much higher than they are in Japan (Chart 9). Whereas a neutral real rate of zero implies a nominal rate of 1.8% in the euro area, it implies a much lower nominal rate of 0.5% in Japan. The Neutral Rate Will Likely Move Higher As we argued a few weeks ago, cyclically, the neutral real rate of interest has risen in the U.S., and to a lesser extent, the rest of the world.3 This has happened because deleveraging headwinds have abated, fiscal policy has turned more stimulative, asset values have risen, and faster wage growth has put more money into workers' pockets. Structurally, the neutral rate may also begin to creep higher as some of the very same long-term forces that have depressed the neutral rate in the past begin to push it up in the future. Demographics is a good example. For several decades, slower population growth has reduced the incentive for firms to expand capacity. Diminished investment spending has suppressed aggregate demand, leading to lower inflation. Population aging also pushed more people into their prime saving years - ages 30 to 50. By definition, more savings mean less spending. However, now that baby boomers are starting to retire en masse, they are moving from being savers to dissavers. Chart 10 shows that the "world support ratio" - effectively, the ratio of workers-to-consumers - has begun to fall for the first time in 40 years. As more people stop working, aggregate global savings will decline. The shortage of savings will put upward pressure on the neutral rate. Japan has been on the leading edge of this demographic transformation. The unemployment rate has fallen to a mere 2.4%, while the ratio of job openings-to-applicants has reached a 45-year high (Chart 11). The shackles that have kept Japan immersed in deflation for over two decades may be starting to break. Chart 10The Ratio Of Workers-To-Consumers Is Now Falling Chart 11Japan: Labor Market Tightening May Spur Inflation Debt Deflation Or Debt Inflation? The distinction between the weak form of secular stagnation and the strong form is critical for thinking about debt issues. Rising debt tends to boost spending, but when debt reaches very high levels, spending normally suffers as borrowers concentrate on paying back loans. As such, high indebtedness generally implies a lower neutral real rate of interest. There is an important caveat, however. The presence of a lot of debt in the financial system also creates an incentive for policymakers to boost inflation in order to erode the real value of that debt. This is particularly the case when governments are the main borrowers. When the strong form version of secular stagnation prevails, generating inflation is difficult, if not impossible. In such a setting, debt deflation becomes the main concern. In contrast, when the weak form version of secular stagnation prevails, higher inflation is achievable. Debt inflation becomes an increasingly likely outcome. If we are in a period where countries such as Japan are transitioning from a strong form of secular stagnation to a weak form, inflation could begin to move rapidly higher. We are positioned for this by being short 20-year versus 5-years JGBs. Inflation As A Political Choice There is a school of thought that argues that high inflation in the 1970s and early 80s was an aberration; that the natural state of capitalism is deflation rather than inflation. We reject this view. The natural state of capitalism is ever-increasing output. Whether prices happen to rise or fall along the way depends on the choice of monetary regime. This is a political decision, not an economic one. Regimes based on the gold standard tend to have a deflationary bias, whereas regimes based on fiat money tend to have an inflationary one. The introduction of universal suffrage in the first few decades of the twentieth century made inflation politically more palatable than deflation (Chart 12). There is little mystery as to why that was the case. In every society, wealth is unevenly distributed. Creditors tend to be rich while debtors tend to be poor. Unexpected inflation hurts the former, but benefits the latter. Chart 12Universal Suffrage Made Inflation Politically ##br##More Palatable Than Deflation Once universal suffrage was introduced, a poor farmer did not need to worry quite as much about losing his land to the bank, since he could now vote for someone who would ensure that crop prices increased rather than decreased. In William Jennings Bryan's colorful words, the rich and powerful "shall no longer crucify mankind on a cross of gold." Today, populism is on the rise. Trumpist Republicans have clobbered mainstream Republicans in one primary election after another. The democrats are also shifting to the left, as the ousting of ten-term incumbent Joe Crowley by the firebrand socialist candidate Alexandria Ocasio-Cortez in June illustrates. And the U.S. is not alone. Italy now has an avowedly populist government. Other European nations may not be far behind. Meanwhile, a growing chorus of prominent economists have argued in favor of raising inflation targets on the grounds that a higher level of inflation would allow central banks to push real interest rates deeper into negative territory in the event of a severe economic downturn. We doubt that any central bank would proactively raise its inflation target in the current environment. However, one could imagine a situation where inflation begins to gallop higher because central banks find themselves behind the curve in normalizing monetary policy. Confronted with the choice between engineering a painful recession and letting inflation stay elevated, it would not be too surprising in the current political context if some central banks chose the latter option. Investment Conclusions As we discussed last week, the combination of a stronger dollar and rising EM stress means that U.S. Treasury yields are more likely to fall than rise during the coming months.4 Over the long haul, however, bond yields are going higher - potentially much higher - as inflation surprises on the upside. Long-term bond investors should maintain below-benchmark exposure to duration risk in their portfolios. Gold offers some protection against inflation risk. However, the yellow metal is still quite expensive in real terms, which limits its appeal (Chart 13). Investors would be better off simply buying inflation-protected securities such as TIPS. Chart 13Gold Is Not Cheap Historically, equities have not performed well in inflationary environments. U.S. stocks are quite expensive these days (Chart 14). Analyst expectations are also far too rosy (Chart 15). Non-U.S. stocks are more attractively priced, but face a slew of near-term headwinds. A neutral allocation to global equities is appropriate at this juncture. Chart 14U.S. Stocks Are Expensive Chart 15Analysts Are Far Too Optimistic Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Did Amazon Kill The Phillips Curve?" dated September 1, 2017. 2 To keep things simple, we are assuming that nominal interest rates cannot be negative. In practice, as we have seen over the past few years, the zero lower-bound constraint is rather fuzzy. Nevertheless, it is doubtful that interest rates can fall too far into negative territory before people begin to shift negative-yielding bank deposits into physical currency. 3 Please see Global Investment Strategy Weekly Report, "U.S. Housing Will Drive The Global Business Cycle... Again," dated July 6, 2018. 4 Please see Global Investment Strategy Weekly Report, "Hot Dollar, Cold Turkey," dated August 17, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

  Neutral U.S retailers have been surging recently as customers have been piling in faster than they have in a long time. Walmart reported results last week showing a 4.5% increase in same-store sales and a 40% increase in online sales; the stock responded by rising more than 9%. Target too reported exceptional results with the CEO commenting that the consumer environment was the strongest he had seen in his career. Overall, things are looking up for retailers as the consumer has been spending at an expanding pace for several years. Considering the savings rate remains elevated (second panel), the consumer probably has significant dry powder to maintain the trend. However, we remain nervous about margins; transportation costs are clearly rising and an economy at full capacity means increasing employment costs, which tend to hurt retailers earlier than most other sectors. This likely underlies why S&P hypermarkets EPS has fallen further behind the broad market (bottom panel). Tack on much higher volatility in Walmart's share price as investors whipsaw the stock based on the online sales performance and we see strong rationale to remain on the sidelines; stay neutral. The ticker symbols for the stocks in this index are: BLBG: S5HYPC - WMT, COST.    

Special Report

There is growing evidence that Trump and the U.S.A. are winning not only the war of words, but also the actual trade war, even though it is still early days. Chart 1 clearly depicts that the S&P 500 is having a stellar year compared with the rest of the world's bourses, leaving in the dust the MSCI All Country World Index. As trade policy uncertainty has skyrocketed to two-decade highs (only the 1993/4 Clinton era trade spat hit a higher mark),1 U.S. stocks have been primary beneficiaries. Even in absolute terms, the SPX is also enjoying a healthy and positive return year. Chart 1U.S. Is Winning The Trade War... Similarly, the U.S. dollar, boosted by rising interest rate differentials, has greatly benefited from increased trade rhetoric as the rest of the world bears the brunt of American trade protectionism (Chart 2). Granted, the U.S. profit backdrop remains upbeat, easily surpassing the rest of the world courtesy of the tax fillip for the current calendar year. But, even 10% EPS growth slated both for next year and 2020, at this later stage in the cycle is nothing less than rock-solid. Thus, relative EPS euphoria is a key pillar of the U.S. equity market's global dominance as, at the margin, global capital has flowed to the growth delta of the U.S. (Chart 3). Chart 2... And So Is The U.S. Dollar Chart 3EPS Also Explains The U.S. Outperformance In more detail, Chart 4 breaks down the MSCI ACWI performance in its major components and makes abundantly clear that the U.S. comes out on top, whereas both its DM and EM peers trail far behind. Keep in mind that the U.S. remains a mostly closed economy (70% PCE driven, top panel, Chart 5) and the ultimate consumer of the world, while Europe and Japan are open economies sporting trade surpluses and levered to net exports (bottom panel, Chart 5). This backdrop is also reflected in country equity composition with the U.S. being the most defensive index compared with its European and Japanese peers that are more cyclically exposed. Chart 4Rest Of The World Bears Brunt Of Trade War Chart 5U.S. Is A Closed Economy Nevertheless, U.S. stocks are not 100% insulated from the Administration's trade policy. Chart 6 shows a bifurcated deep cyclical equity market. Materials and industrials stocks have underperformed the SPX year-to-date as the appreciating greenback has dealt a blow both to the CRB raw industrials and base metals indexes. An exception is energy, which has ground higher as crude oil has up to now escaped the greenback's wrath, but may not do so indefinitely. Chart 6Bifurcated Deep Cyclical Market Tech has been the shining star, but it is also a risk that can bring the SPX down given its hefty 25% plus market capitalization weighting and the highest export exposure among GICS1 sectors at 60% of sales. The purpose of this Special Report is to delve deeper into the current Administration's increasing trade protectionism rhetoric and document if the equity market cares, using empirical evidence. A Unique Entry Into The U.S. National Archives Much hay has been made over Donald Trump's use of Twitter in the White House. Parsing 280 characters that are as likely to reveal a consequential new trade policy or fire a key staffer as they are to complain about news coverage has become sport for pundits and an endless source of fodder for the media. However, at BCA, we are focused on the wealth preservation of our clients. As such, it is incumbent upon us to perform an analysis of the market implications of these tweets in order to determine whether @realDonaldTrump is a source of investable strategies or merely noise. For the purposes of our analysis, we are examining only tweets relating to trade over the past six months (including those subsequently deleted). These should have the broadest stock market impact. They are plentiful, as summarized in Table 1. The Broad Market Does Not Care... Our analysis begins with the S&P 500's performance on the dates noted in Table 1. The result of the analysis (Table 2) is that there is no statistical correlation between the S&P 500's performance on those dates as the market both rose and fell relatively indiscriminately. In other words, the market does not appear to care what Donald Trump is tweeting with respect to trade. The absence of a confirming result is logical; somewhat less than 40% of the S&P 500's revenues are generated overseas, implying limited negative market repercussions from trade rhetoric. Further, the S&P 500 is far more international than the broad U.S. corporate sector. We thus glean two lessons from the analysis: trade rhetoric does not materially impact the stock market and has even less bearing on the health of corporate America. Table 1Trump Tweets About Trade Table 2S&P 500 Reaction To Trade Tweets ...Nor Do Sectors... Still, we presume there must be some market impact from trade rhetoric. Accordingly, we deepened our analysis to the relative performance of the 11 GICS1 sectors vis-à-vis the S&P 500 on the dates noted in Table 1. The results are presented in Table 3. Table 3GICS1 Reaction To Trade Tweets As with the broad market, there appears to be little correlation between internationally-geared indexes and negative trade tweets. S&P technology, the most international of the GICS1 sectors, underperformed in 75% of the iterations but only by an average of 0.1%, hardly significant enough to make a claim that the market was focused on the president's Twitter account. Further, S&P health care, a mostly trade-insulated index, underperformed the same number of times as S&P technology and by a greater amount. We therefore conclude that sectors do not materially react to trade tweets. ...But The International Champions Do Our last effort to find a correlation between Donald Trump's use of Twitter and the stock market's performance met with greater success. We assumed that the trade bellwether stocks would likely have a greater reaction function to negative trade tweets. We accordingly built an equal-weighted index of Apple, Boeing, Caterpillar, General Electric and 3M that we coined "The Internationals". The relative performance of this index is shown in Table 4. Table 4International Stocks Reaction To Trade Tweets The Internationals underperformed the S&P 500 in every iteration we tested. Most notable was on March 22, 2018 when the S&P 500 fell 2.5%, the Internationals underperformed even that low mark by 1.8%. The inference is that market implications of negative trade tweets are largely confined to these few international stocks. Considering their heft (these five stocks comprise 6.5% of the S&P 500's weight), they are largely responsible for weighing on the S&P 500 around trade rhetoric iterations. Conclusions: Rhetoric Matters Less Than Reality Chart 7U.S. Has The Upper Hand The upshot of our analysis is that, aside from a few notable international trade bellwethers, Donald Trump's trade rhetoric does not have material broad market implications. However, negative trade tweets pose a threat to a few of BCA's U.S. Equity Strategy portfolio recommendations, as we maintain high-conviction overweight ratings on the S&P 500 technology hardware, storage & peripherals and S&P 500 construction machinery & heavy trucks indexes. Apple and Caterpillar each represent more than 60% of the weight of these respective indexes. Nevertheless, we think the rhetoric is mostly noise and any impact will likely be transitory. Of much greater importance are the real world impact of tariffs and the potential earnings impact of a decline in global trade and especially a continuation in the U.S. dollar rally. The U.S. dollar appreciation remains the key risk to U.S. Equity Strategy's cyclically-oriented portfolio positioning. Meanwhile, we recently highlighted the U.S. equity sector implications of a mounting U.S./China trade war in a Special Report. In it, we identified service-oriented industries and defense stocks as relative winners should the dispute escalate - both BCA's Geopolitical Strategy and U.S. Equity Strategy are already bullish defense stocks2 - though few stocks would likely be absolute positive performers. Recent news of a new round of U.S. and China talks is a step in the right direction, but as likely to disappoint as to mark the peak of a protectionist cycle. Bottom Line: Empirical evidence suggests that Trump's trade rhetoric has yet to short-circuit the broad U.S. equity market, despite affecting a select few internationally exposed bellwether stocks. The rest of the world has borne the brunt of hawkish trade comments from the U.S. administration Chart 7 that has helped to put a solid bid under the U.S. dollar. We continue to expect an earnings led advance in the S&P 500 in the coming 9-12 months, but are closely monitoring the U.S. currency given the heightened EPS sensitivity. BCA Geopolitical Strategy Housekeeping On a separate housekeeping note, BCA's Geopolitical Strategy is closing its South Korean curve steepener trade for a gain of 0.2%. Instead, to play our constructive view on the Korean peninsula, BCA's Geopolitical Strategy will go long Korean equities relative to Emerging Markets. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Chris Bowes, Associate Editor U.S. Equity Strategy chrisb@bcaresearch.com 1 In a similar effort to address the trade deficit with Japan, President Clinton threatened a combination of tariffs, quotas and sanctions on Japanese autos. The culmination was a broad agreement on automotive trade. 2 Please see BCA Geopolitical Strategy Special Report, "Brothers In Arms," dated January 11, 2017, available at gps.bcaresearch.com.

Highlights Portfolio Strategy Looming inflation, the synchronized global capex upcycle and rising real Treasury yields all argue for preferring oil-related to gold-exposed equities. Recent Changes Initiate a long S&P oil & gas exploration & production / short global gold miners pair trade today. Table 1 Feature Chart 1No Contagion Yet Stocks recovered smartly from the Turkey induced pullback last week, and continue to flirt with all-time highs. While the risk of contagion remains acute, three key high-frequency financial market metrics suggest that the SPX will likely escape unscathed. The second panel of Chart 1 shows that both the Japanese yen and the Swiss franc, the two ultimate safe havens, have barely budged vis-a-vis the U.S. dollar and also the junk bond market remains extremely calm (third panel, Chart 1). We will continue to closely monitor these indicators to gauge the risk of contagion in U.S. equities. The greatest risk, however, is China's economic footing, particularly its foreign exchange policy (bottom panel, Chart 1). Any further steep devaluation in the renminbi will prove destabilizing and bring back memories of August 2015 when Chinese policy easing caused the dollar to spike and short-circuited SPX EPS growth. Relatedly, there is also a risk that China moves forward more aggressively on capital account liberalization, likely leading to a renminbi devaluation at least initially. Re-reading this Bank For International Settlements paper (starting on page 35 penned by Mitsuhiro Fukao, an ex-Director of Economic Research at the Bank of Japan) and taking a cue from Japan's experience was insightful.1 But, it remains difficult to predict what China's ultimate reaction function to Trump's trade rhetoric will be (Mathieu Savary, BCA's foreign exchange strategist, will be addressing this in one of his upcoming reports). While a tactical 5-10% pullback cannot be ruled out as the seasonally weak month of September is nearing, from a cyclical perspective our strategy would be to "buy the dip" if one were to materialize. Importantly, this bulletproof equity market that refuses to go down has two stealthy allies on its side: pension plans that are forced into equities and corporate treasurers that execute buybacks. Granted, EPS have delivered and suggest that upbeat fundamentals remain the key market support pillars. As a result, the S&P 500 is on track to register a tenth consecutive positive total return year, which is unprecedented in previous expansions. The only other time that the (reconstructed) SPX rose every year for 10 years in a row was in the late 1940s, however, two recessions occurred during that equity market run (Chart 2). While we are undoubtedly in the later stages of the bull market and the business cycle, there is a big difference between "late-cycle" and "end-of-cycle". Keep in mind that the current backdrop is unusual. A large fiscal package has hit late in the game likely extending the cycle. Thus, gauging where we are in the cycle is important. Chart 3 shows a stylized liquidity cycle and our sense is that we are in the early innings of the inflation stage. The handoff from reflation to inflation has happened and during this stage excesses take root eventually morphing, more often than not, into a mania. Chart 2Impressive Streak Continues Chart 3Liquidity Cycle From a macro perspective inflation is slated to rear its ugly head. Nominal GDP is far exceeding the 10-year Treasury yield, and this yield curve type steepening is bullish for SPX top line growth (Chart 4). As a reminder, in Q2 the GDP deflator jumped to 3.35% pushing nominal GDP growth to 7.41%. Money velocity2 is also enjoying a slingshot recovery. Nominal GDP growth is outpacing M2 money supply growth by roughly 150bps. The U.S. money multiplier (M2 over the monetary base, not shown) is also at a 5-year high. This is an inflationary backdrop (bottom panel, Chart 5) and should also boost SPX revenues and thus continue to underpin the broad equity market. Similarly, the NY Fed's Underlying Inflation Gauge (UIG) is firing on all cylinders and is a harbinger of a further pickup in core inflation in the coming months. As a result, SPX sales growth remains on a solid foundation (Chart 6). Chart 4SPX Sales Rest On Solid Foundations Chart 5A Little Bit Of Inflation... Chart 6...Is A Boon For The SPX This week we are initiating a market and asset class neutral pair trade to benefit from the inflationary backdrop. Initiate A Long Oil & Gas E&P / Short Gold Miners Pair Trade One way to benefit from this onset of the inflation stage/mania phase is to go long oil & gas exploration & production/short global gold miners. On the underlying commodity front, the handoff from reflation to inflation has historically been a boon to the oil/gold ratio (OGR). Importantly, the prices paid subcomponent of the ISM manufacturing survey has gone parabolic compared with the new order sub index, roughly doubling since the 2016 nadir. This depicts an inflationary backdrop and is signaling that the OGR will play catch up in the coming months (Chart 7). Chart 7CHART 7 Reflation To Inflation Handoff Similarly, another surging inflation indicator also suggests that the OGR has ample room to run. The GDP deflator has recently eclipsed the 3% mark and since exiting deflation following the end of the recent global manufacturing recession it is up over 370bps. Chart 8 shows that if this multi-decade positive correlation were to hold then the OGR could double from current levels. Chart 8GDP Deflator On The Rise Finally, the NY Fed's UIG is also closely correlated with OGR momentum, corroborates the other firming inflation signals and hints that more gains are in store for the OGR (bottom panel, Chart 9). Global macro tailwinds are also clearly in favor of oil at the expense of gold. BCA's global industrial production gauge of 40 DM and EM countries continues to expand at a healthy clip. Oil is a global growth barometer, whereas gold represents one of the few true safe havens in times of duress. Taken together, the implication is that a catch up phase looms for the OGR (middle panel, Chart 9). The relative commodity backdrop is the most important determinant of relative share prices as it dictates the direction of relative profitability (middle panel, Chart 10). Therefore, as the OGR goes so do relative share prices. Chart 9Enticing Global Macro Backdrop Chart 10Buy Oil & Gas E&P... Beyond this enticing relative commodity complex outlook, the synchronized global capex upcycle, one of BCA's key themes for the year, is underpinning the relative share price ratio. U.S. capex in particular is outpacing GDP growth and oil & gas investment is the key driver. The V-shaped recovery in the Baker Hughes oil & gas rig count data (bottom panel, Chart 10) confirms this upbeat energy capital outlay backdrop. Moreover, capex intentions from the Dallas Fed survey point to more upside in relative share prices (bottom panel, Chart 11). Meanwhile, keep in mind that the U.S. has been at full employment for 18 months now (in other words the unemployment gap closed in February of 2017) and the economy is firing on all cylinders. Real rates have also shot the lights out recently. In fact the 5-year real Treasury yield is perched near 1%, a multi-year high. Given that gold does not yield any income, it suffers when real yields rise and vice versa (for additional details on the relationship between gold and interest rates, please refer to the early-May piece penned by our sister publication U.S. Bond Strategy titled "A Signal From Gold?").3 Similarly, relative share prices thrive when real yields advance and retreat when the TIPS yield sinks (top panel, Chart 12). Chart 11...At The Expense Of Gold Miners Chart 12Bullion TIPS Over Unsurprisingly, the Fed has been tightening monetary policy since December 2015. Nevertheless, the "Fed Spread" (2-year Treasury yield compared with the fed funds rate) is steepening and continues to point to additional gains in the share price ratio (bottom panel, Chart 12). Given that both the ECB and the BoJ have remained ultra-accommodative, a hawkish Fed has boosted the U.S. dollar. However, most commodities are priced in greenbacks, thus the currency effect is a washout and is neither closely correlated to the OGR nor to the share price ratio. Two risks to this high octane, high momentum pair trade are: an EM accident induced risk off phase and a global recession likely due to a flare up in the global trade war (policy uncertainty shown inverted, top panel, Chart 9). In either of these scenarios, investors will likely seek the refuge of bullion's perceived safety as the bond market will almost immediately start pricing in easier monetary policy with investors flocking into the ultimate safe haven asset, U.S. Treasurys. Netting it all out, an enticing macro backdrop with the onset of the inflation stage, the synchronized global capex upcycle and rising real Treasury yields all argue for preferring oil-related to gold-exposed equities. Bottom Line: Initiate a market- and currency-neutral long S&P oil & gas exploration & production/short global gold miners pair trade today. The ETF ticker symbols the S&P oil & gas exploration & production and the global gold mining index are: XOP and GDX, respectively. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 BIS Papers No 15 "China's capital account liberalisation: international perspectives", Monetary and Economic Department, April 2003. 2 "The velocity of money is the frequency at which one unit of currency is used to purchase domestically- produced goods and services within a given time period. In other words, it is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy". Source: Federal Reserve Bank of St. Louis. 3 Please see BCA U.S. Bond Strategy Weekly Report, "A Signal From Gold?" dated May 1, 2018, available at usbs.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Underweight This week we have been highlighting winners & losers in a global trade war. With the vast majority of revenues coming from overseas and a high estimated import tariff exposure (please refer to Chart II-5 of the Special Report we published on Monday) semiconductor companies are a stand-out sector to avoid. The drubbing that EM currencies have taken this weak on fear of contagion from Turkey highlights this risk. Global semi sales have historically tracked EM currencies and a leg down for semiconductor sales seems to be the path of least resistance (second panel). The timing is unfortunate; global semiconductor inventories have been growing strongly for the past year and a decline in sales may force a costly inventory clear out. Tack on headline risk from security flaws in index heavyweight Intel's chips and the decision to avoid this early cyclical tech sub-index looks easy; stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5SECO - INTC, QCOM, TXN, AVGO, NVDA, ADI, MU, SWKS, MCHP, XLNX, QRVO.

Overweight Consumer discretionary giant Home Depot has put together a string of solid earnings reports and outlook improvements that have served to keep the S&P home improvement retail index at its lofty levels for the past several years. We think more is to come. Lumber prices, though off the stratospheric levels they reached earlier this year, remain exceptionally high (second panel). Further, pricing power of household appliances continues to expand, thanks to more expensive imports resulting from tariffs put in place earlier this year (third panel). As home improvement retailers earn a spread on these key products, both sales and earnings should continue to expand; Home Depot's Q2 same store sales growth of 8% certainly underscores this point. While home improvement retail sales growth is likely to trail industry retail sales, we think as long as the six year run of earnings growth beating the S&P 500 continues (as we expect it will, bottom panel) investors should stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5HOMI - HD, LOW.

Overweight On Monday of this week, President Trump signed the John S. McCain National Defense Authorization Act into law. Most significantly, the bill authorizes $717 billion in defense funding for FY2019, a small increase from the $696 billion in FY2018, which was a significant increase from the FY2016 $580 billion budget. The administration's commitment to returning military funding to wartime levels (regardless of budget constraints or geopolitical threat) are confirmed by defense spending surging at the fastest rate in nearly a decade (second panel). This is further reflected in the recovery in defense investment (bottom panel). We highlighted earlier this week that defense stocks should be winners in a trade war, particularly if such a war increases the threat of a more conventional one. Tack on above-normal earnings growth from exceptional government funding and defense stocks look even more appealing; stay overweight. The ticker symbols for the stocks in the BCA Defense index are: LMT, GD, RTN, NOC, LLL.

Special Report

Highlights China's policy headwinds have begun to recede, but Beijing is not riding to the rescue for emerging markets; While monetary policy has eased substantively, credit growth will be hampered by the government's financial crackdown; Potential changes to China's Macro-Prudential Assessment framework could be significant, but the impact on credit growth is overestimated at present; The recognition of non-performing loans (NPLs) and cleansing of China's banking system is still in early innings and will weigh on banks' risk appetite; The anti-corruption campaign is another reason to be cautious on EM. Geopolitical Strategy recommends clients stay overweight China (ex-tech) relative to EM. Feature In the first part of this two-part Special Report, we concluded that policy headwinds to China's economic growth have begun to recede, but recent easing measures will likely disappoint the markets.1 Chart 1Money Growth Bottomed, Credit Still Weak In essence, China is girding for a trade war with the United States, which favors stimulus. But it is still attempting to reduce systemic financial risk. As a result, fiscal stimulus may surprise to the upside, but credit growth will be lackluster. The problem for investors - especially for emerging market (EM) assets and the commodity complex - is that Chinese fiscal stimulus typically operates with a six-to-ten month lag, as opposed to credit stimulus which only takes about three months to kick in.2 July statistics confirm our suspicion that credit stimulus will be hampered by the government's crackdown on shadow banking. Total credit growth remains weak, although broad money (M2) does appear to be bottoming (Chart 1). Thus far, BCA's China Investment Strategy has been correct in characterizing the latest developments as "taking the foot off the brake" rather than "pressing down on the accelerator."3 In this report we take a deeper dive into the policy factors that cause us to limit our "stimulus overshoot" scenario to a 10% subjective probability. The three chief reasons are: overstated easing of macro-prudential controls; the continuing process of cleansing the banking sector of non-performing loans; and the anti-corruption campaign in the financial sector. A Preemptive Dodd-Frank Since the Xi administration redoubled its efforts to tackle systemic financial risk last year, we have urged investors to be cautious about Chinese growth.4 The creation of new institutions and new regulatory requirements set in motion processes that would be hard to reverse quickly. While these institutions are now making several compromises for the sake of stability, their operations will continue to weigh on credit growth. In July 2017, China's government held the National Financial Work Conference to address the major issues facing the country's financial system. This conference takes place once every five years and has often occasioned significant shakeups in financial regulation. In 1997, it initiated a sweeping purge of the banking system, and in 2002, it saw the creation of three financial watchdogs that would become critical institutional players throughout the 2000s.5 Chart 2Crackdown On Informal Credit Continues One of the skeletons in the closet from 2002 was the debate over whether financial regulation should be heavily centralized or divided among different, specialized, state agencies. Former Premier Wen Jiabao won the argument with the creation of the three watchdogs covering banking, securities, and insurance. After a series of controversies and conflicts, the Xi administration decided that these agencies had failed in their primary purpose of curbing systemic risk and ordered a reorganization with greater centralization. At the 2017 financial conference, Xi announced the creation of the Financial Stability and Development Committee (FSDC) to act as a centralized watchdog over the entire financial system. The FSDC would coordinate with the central bank, oversee macro-prudential regulation, and prevent systemic risk. Liu He, Xi's right-hand man on the economy and a policymaker with a hawkish reputation, was soon promoted to the Politburo and given the top job at the FSDC.6 As a second step, the Xi administration announced that it would combine the banking and insurance regulators into a single entity - the China Banking and Insurance Regulatory Commission (CBIRC). The CBIRC, to be headed by Xi ally, and notable hawk, Guo Shuqing, would continue and escalate the crackdown on shadow lending that Guo had begun at the helm of the bank watchdog in 2017 (Chart 2). The merging of the agencies would also close the regulatory gap that had seen the insurance regulator increase its dominion and rent-seeking by encouraging "excessive" financial innovation and risky pseudo-insurance products.7 The FSDC was expected, rightly, to bring a more hawkish tilt to Chinese macro-prudential regulation. In reference to the U.S.'s Financial Stability Oversight Council, we dubbed these moves a "Preemptive Dodd-Frank."8 We also argued, however, that the purpose was to bring unified command and control to financial regulation and that China would continue to prize stability above all. Therefore the degree of tightening or loosening should vary in accordance this goal.9 After a series of announcements in July and August, it is clear that China's government has shifted to a more accommodative posture (Chart 3). As usual, there are rumors of high-level political intrigue to go along with the policy shift: some argue that Premier Li Keqiang is making a comeback while Xi's golden boy, Liu He, has been sidelined due to his failure to forestall tariffs during his trade talks with Donald Trump this spring.10 Such rumors are valuable only in revealing the intensity of the policy debate in Beijing. Chart 3Monetary Policy Has Eased Substantively What is certain, however, is that the FSDC, with Liu He as chairman, only met for the first time as a fully assembled group in early July, just before the major easing measures were taken. This implies that any initial conclusions were pragmatic (i.e. not excessively hawkish). Moreover, Guo Shuqing is not only the CBIRC head but also the party secretary of the PBOC, meaning that central bank chief Yi Gang cannot have adopted easing measures without Guo's at least condoning it. Chinese policymakers see the recent easing measures as "fine-tuning" even as they continue the rollout of new regulatory institutions and systems. It is thus too soon to claim that Xi Jinping or any of these government bodies have thrown in the towel on their attempts to contain excessive leverage. Both the Politburo and the State Council - the highest party and state decision-makers - have made clear that they do not intend to endorse a massive stimulus on the magnitude of 2008-09 or 2015-16.11 They have also insisted that the "Tough Battle" against systemic financial risk, and the campaign to "deleverage" the corporate sector, will continue. What does this mean in practical terms? While new regulations will be compromised, they will also continue to be implemented. For example, authorities have watered down new regulations governing the $15 trillion asset management industry, yet the regulations are still expected to go into force by 2020. These rules will weigh on shadow banking activity (e.g. wealth management products) as banks prepare to meet the requirements.12 Two other examples are critical and will be discussed below: first, the potential easing of rules under the Macro Prudential Assessment (MPA) framework for stress-testing banks; second, this year's changes to rules governing non-performing loans (NPLs). In the former case, the degree of financial easing is potentially significant but at present overestimated by investors; in the latter case, the degree of tightening is already significant and widely underestimated. Bottom Line: New financial regulatory institutions will inherently suppress credit growth, especially by dragging on informal or non-bank credit growth. Macro-Prudential Assessments: Less Easing Than Meets The Eye A key factor in determining China's credit growth going forward will be banks' responses to any softening of the Macro Prudential Assessment (MPA) requirements. News reports have suggested that a relaxation of these rules may occur, but authorities have not finalized such a move. Furthermore, the impact on credit growth may be far less than the astronomical sums being floated around the investment community. The MPA framework began in 2016. It is an evaluative system of "stress-testing" China's banks each quarter. As such it is part of the upgrade of macro-prudential systems across the world in the aftermath of the global financial crisis, comparable to the American Financial Stability Oversight Committee or the European Systemic Risk Board.13 It is managed by the PBOC and the FSDC. The MPA divides banks into systemically important financial institutions and common institutions, and subdivides the former into those of national and regional importance. The evaluation method contains seven major criteria for assessing bank stability: Capital adequacy and leverage ratios; Bank assets and liabilities; Liquidity conditions; Pricing behavior for interest rates; Quality of assets; Cross-border financing; Execution of credit policy. The first and fourth of these criteria (capital adequacy and leverage ratios, and pricing behavior for interest rates) are in bold font because they result in a "veto" over the entire assessment: if a bank fails to maintain a sufficient capital buffer, or deviates too far from policy interest rates, it can fail the entire stress-test. Otherwise, failure of any two of the other five categories results in overall failure. A system of rewards and punishments awaits banks depending on how they perform (Diagram 1). Diagram 1China's Macro Prudential Assessment Framework Explained On July 20, the PBOC published a document saying that "in order to better regulate assets of financial institutions, during Macro Prudential Assessment (MPA), relevant parameters can be reasonably adjusted." Subsequently Reuters reported that the PBOC would reduce the "structural parameter" and the "pro-cyclical contribution parameter" of the capital adequacy ratio (CAR) requirements, thereby easing rules on one of the veto items. The structural parameter would fall from 1.0 to 0.5. Rumors suggest that the pro-cyclical parameter could fall from 0.4-0.8 to 0.3. No such changes have been finalized - only a few banks actually claim to have received notification of a change and there are regional differences. Clearly a general change of the rule would reduce regulatory constraints on bank credit. But how big would the impact be? Under the MPA, banks' CARs are not allowed to fall too far below the "neutral CAR," or C*, a variable that is calculated using the formula outlined in Diagram 2. Most of the variables in this formula will not change often: for instance, the minimum legal CAR will be slow to change, as will the capital reserve buffer and the bonus buffer for systemically important institutions. The one factor that can change frequently is the "discretionary counter-cyclical buffer," as it responds to the country's current place in the business cycle. Diagram 2China's Macro-Prudential Assessment Framework: Capital Adequacy Ratios The key input to this factor is broad credit growth. Thus, if authorities should reduce the CAR's cyclical parameter from a simple average of 0.6 to 0.3, broad credit growth could go higher without creating an excessive increase in the pro-cyclical buffer. In other words, at present about 60% of bank credit expansion in excess of nominal GDP growth counts toward a counter-cyclical capital buffer, which is added to other capital buffers. A tweak to this parameter could decrease that proportion to 30%, meaning that bank lending could go twice as high with the same impact on the counter-cyclical buffer. More significantly, if authorities should reduce the CAR's structural parameter from 1.0 to 0.5, any increase in credit growth would have a less dramatic impact on C*. Hence banks would be able to lend more while still keeping their neutral CAR within the appropriate range relative to their actual CAR. Banks could theoretically lend twice as much with the same impact on the assessment.14 On paper these changes could result in unleashing as much as 41.4 trillion RMB in new lending in 2018, or 28 trillion (33% of GDP) on top of what could have been expected without any adjustment to the macro-prudential rules. This is because broad credit growth would theoretically be allowed to grow as fast as 30% instead of 17%.15 But in reality this growth rate is extremely unlikely. Why? Because it assumes that banks will grow their lending books as rapidly as they are allowed. In fact, banks are currently increasing broad credit at a rate of about 10%, which is considerably lower than either today's or tomorrow's permitted rate of growth under the MPA framework (Chart 4). If tweaks to the MPA increase this speed limit to 30%, it does not mean that banks will drive any faster than they are already driving. They are lending at the current pace for self-interested reasons (and there is fear of excessive debt, default, or insolvency due to the government's ongoing regulatory and anti-corruption crackdown).16 Chart 4Banks Are Not Lending To The Regulatory Maximum Still, if the MPA rules are tweaked, then it will send a signal that macro-prudential scrutiny is abating and banks can lend more aggressively - this would have some positive effect on credit growth, at least for major banks that are secure in meeting their CARs. Moreover, there will be a practical consequence in that fewer banks will be punished for having insufficient CARs. At present, only rarely do banks fail the evaluations. But a strict CAR requirement during an economic downturn could change that. The proposed MPA adjustment would show that banks are graded on a sliding rule: the authorities would slide the grading scale downward to enable more banks to pass the test. This means fewer failures, which means fewer punitive measures that could upset liquidity or stability in the banking system. Ultimately, in order for the new system to have any credibility at all, punishment will have to be meted out to banks that fail the stress tests. A key punishment within the MPA system is exclusion from medium-term lending facility (MLF) loans from the PBOC. This is a regulatory action with teeth, as this is one of the PBOC's major means of injecting liquidity (Chart 5). A misbehaving bank could face short-term liquidity shortage or even insolvency. Therefore the authorities are opting to soften the rules so that the new regulatory system is preserved yet the harshest implications are avoided (for now). Chart 5Regulators Can Deprive Banks Of MLF Access This would be short-term gain for long-term pain, the opposite of what China needs from the standpoint of an investor looking for improvements to productivity and potential GDP growth. But it would not necessarily be a great boon for global risk assets in the near term. While it could help stabilize expectations for China's domestic growth, it is not clear that it would unleash a mass wave of new bank loans that would reaccelerate China's economy and put wings beneath EM assets and commodity prices. Bottom Line: Tweaking the MPA parameters is a clear example of policy easing. Yet the MPA system itself is a fairly rigorous means of stress-testing banks that is part of a much larger expansion of financial sector regulation. The results of the easier rules - if implemented - will not be as reflationary as might be expected from the headline 41 trillion RMB in new loans that could legally be created. Banks are already expanding loans more slowly than they are allowed to do, so increasing the speed limit will have little effect. The real purpose of the macro-prudential tweaks is to make it more difficult for banks to fail their stress tests in a downturn. As such, any tweaks would actually reveal that Chinese policymakers are expecting a more painful downturn, not that they are asking for a credit splurge. NPL Recognition Will Weigh On Credit Growth Another factor that we have highlighted that separates today's easing measures from outright stimulus: the growing recognition of non-performing loans (NPLs) in China's banks and the financial cleansing process. The government's reform push has already led to two trends that are relatively rare and notable in the Chinese context: rising corporate defaults (Chart 6) and rising bankruptcies (Chart 7). While the impact may be small relative to China's economic size, the direction of change is significant in a country that has been extremely averse to recognizing losses. Chart 6Defaults Are Rising Chart 7Creative Destruction In China These changes reflect the tightening of financial conditions and restructurings of various industries and as such are evidence of Xi's attempt to make progress on reforms while maintaining stability. They also reflect a general environment that is conducive to the realization of bad loans. Two recent policy decisions are affecting banks' accounting of bad loans. First, the CBIRC issued new guidance that eases NPL provision requirements for "responsible" banks (banks with good credit quality) while maintaining the existing requirements for "irresponsible" banks.17 Since the major state-controlled banks will largely meet the standards, they will be able to lend somewhat more (we estimate around 600 billion RMB or 0.7% of GDP). This would support the recent trend in which traditional bank lending rises as a share of total credit growth. Second, however, the CBIRC is requiring banks to reclassify all loans that are 90-or-more-days delinquent as NPLs, resulting in upward revisions of bank NPL ratios. This will send the official rate on an upward march toward 5%, from current extremely low 1.9% (Chart 8). It is the direction of change that matters, as NPL recognition can take on a life of its own. While many state banks may already have recognized the 90-day delinquent loans, many small and regional banks probably have not. Anecdotally, a number of small banks are reporting large NPL ratios as a result of the regulatory clampdown and definition change. Rural commercial banks, in particular, are in trouble with several showing NPLs in double digits (Chart 9). These small and regional banks will have until an unspecified date in 2019 to reclassify these loans and raise provisions against them. The result will hamper credit growth. Chart 8Bad Loan Ratios Set To Rise Chart 9City And Rural Commercial Banks Most At Risk Of Rising Bad Loans To get a more detailed picture of the NPL recognition process, we have updated our survey of 16 commercial banks listed on the A-share market.18 This research reveals that banks have continued to increase the amount of bad loans they have written off. While the NPL ratio has remained roughly the same, cumulative loan-loss write-offs combined with NPLs have reached 7% of total loans and are still rising (Chart 10). This shows that a cleansing process is well underway. It is concerning that write-offs have reached nearly 50% of pre-tax profits. And even as losses mount, the proportion of each year's losses to the previous year's NPLs has fallen, implying that the previous year's NPLs had grown bigger (Chart 11). Chart 10The Bank Cleansing Process Continues Chart 11Write-Offs Almost 50% Of Bank Profits Furthermore, while loan losses grow, the surveyed banks' profit growth has been reduced to virtually zero (Chart 12). Our updated "stress test" for Chinese banks, which is based on the same sample of 16 commercial banks, suggests that if total NPLs rise to a pessimistic, but still quite realistic, ratio of 13% (a weighted average of NPL ratio assumptions per sector, ranging from 10%-30%), then total losses could amount to 10.4 trillion RMB, or 12% of GDP (Table 1). Chart 12Write-Offs Weigh On##br## Bank Profit Growth Table 1Pessimistic Scenario Analysis ##br##For Commercial Bank NPLs In this scenario, banks' net equity would be impacted by 38% as this amount surpasses the buffer of net profits (1.75 trillion RMB) and NPL provisions (3 trillion). China's banks are well provisioned, but they would be less so after a hit of this nature. A similar stress-test by BCA's Emerging Markets Strategy found that equity impairment could range from 33%-49%, implying that Chinese banks were roughly 29% overvalued on a fair price-to-book-value basis.19 Looking at different economic sectors, it is apparent that domestic trade, manufacturing, and mining have seen the highest incidence of loans going sour (Table 2). In all three cases, it is reasonable to conjecture that the NPL ratio can continue to expand - and not only because of the definitional change. First, wholesale and retail (4.7%) consists largely of SMEs, and the government is publicly concerned about their ability to get credit. Second, manufacturing (3.9%) has been hit by changing trade patterns and rising labor costs and has not yet suffered the impact from recently imposed U.S. trade tariffs. Third, mining (3.6%) has felt the first wave of the impact from the government's cuts to overcapacity in recent years, but has seen very extensive restructuring and the fallout may continue. Table 2China: Troubled Sectors Can Produce More Bad Loans More realistic NPL recognition is an important and positive development for China over the long run. Over the short run, banks' efforts to write-off NPL losses will weigh on their willingness to lend and could pose a risk to overall economic activity. Bottom Line: The government's reform and restructuring efforts are initiating a process of creative destruction in the Chinese economy. This is most notable in the government's willingness to recognize NPLs, which will continue to weigh on credit growth. The government is trying to control the pace and intensity of this process, but we expect credit stimulus to be disappointing relative to fiscal stimulus as long as the financial regulatory crackdown is at least half-heartedly implemented. Anti-Corruption Campaign Is Market-Negative Another reason to expect total credit growth to remain subdued comes from the anti-corruption campaign and its probes into local government finances and the financial sector. Chart 13Anti-Corruption Campaign Trudges Onward One of the new institutions created in China's 2017-18 leadership reshuffle was the National Supervisory Commission (NSC). This is a powerful new commission that is capable of overseeing the highest state authority (the National People's Congress). It is also ranked above the formal legal system, the Supreme Court and the public prosecutor's office. It is charged with formalizing the anti-corruption campaign and extending it from the Communist Party into the state bureaucracy, including state-owned enterprises.20 Having operated for less than a year, it is not possible to draw firm conclusions about the doings of the NSC, let alone any macro impact. Tentatively, the commission has focused on financial and economic crimes that have the potential to create a "chilling effect" among government officials and bank executives.21 Notably, the NSC has investigated Lai Xiaomin, former chief executive of Huarong, the largest of the big four Asset Management Corporations (AMCs), i.e. China's "bad banks." There is more than one reason for Huarong to attract the attention of investigators, but it is notable that it had extensive investments in areas outside its official duty of acquiring and disposing of NPLs. The implication could be that the government wants the AMCs to focus on their core competency: cleaning up the coming deluge of NPLs. The anti-corruption is also targeting local government officials for misappropriating state funds. These investigations involve punishment of provincial officials for false accounting as well as embezzlement and other crimes. We have noted before that the provinces that revised down their GDP growth targets most aggressively this year were also some of the hardest hit with anti-corruption probes into falsifying data and misallocating capital.22 On several occasions it has appeared as if the anti-corruption campaign was losing steam, but the broadest tally of cases under investigation suggest that it is still going strong despite hitting a peak at the beginning of the year (Chart 13). The campaign remains a potential source of disruption among the very officials whose risk appetite will determine whether central government policy easing actually results in additional bank lending and local government borrowing. Bottom Line: While difficult to quantify, the anti-corruption campaign will dampen animal spirits within local governments and the financial sector as long as the new NSC is seeking to establish itself and the Xi administration remains committed to prosecuting the campaign aggressively. Investment Conclusions We would be surprised if credit growth did not perk up at least somewhat as a result of the past month's easing measures. But as outlined above, these measures may disappoint the markets as a result of the ongoing financial regulatory drive, the baggage of NPL recognition, and any negative impact on risk appetite due to the anti-corruption campaign. And this is not even to mention the dampening effects of ongoing property sector and pollution curbs.23 In lieu of a credit surge, Beijing is likely to rely more on fiscal spending to stabilize growth. Fiscal spending also faces complications, of course. In recent years, China's local governments have built up a potentially massive pool of off-balance-sheet debt due to structural factors limiting local government revenue generation (Table 3). Beijing is now attempting to force this debt into the light. The local government debt maturity schedule suggests a persistent headwind in coming years as hidden debt is brought onto the balance sheet and governments scramble to meet payment deadlines (Chart 14). In addition, the local government debt swap program launched in 2014-15 will wrap up this month. Table 3Estimates Of Hidden Local Government Debt Chart 14Local Governments Face Rising Debt Payments Nevertheless Beijing has introduced a new class of "refinancing bonds" in 2018 to help stabilize the fiscal situation. These bonds are separate from brand new bonds that have the potential to increase significantly over the second half of this year. China's Finance Ministry has also reportedly asked local governments to issue 80 percent of net new special purpose bonds by the end of September. Since only about a quarter of the year's 1.35 trillion RMB quota was issued in H1, this order would mean that about half of the quota (675 billion RMB out of 1.35 trillion RMB) would be issued in August and September alone - implying a significant surge to Chinese demand, albeit with a lag of six months or so.24 The latest data releases from July suggest that Beijing is trying to do two things at once: ease liquidity conditions while cracking down on excess leverage. Until we see a spike in credit growth, we will continue to expect the policy turn to be only moderately reflationary, with the ability to offset existing headwinds but not spark a broad-based reacceleration of the economy. Going forward, data for the month of August will be very important to monitor, as many of the easing measures were not announced until late July. For all the reasons outlined in this two-part Special Report, we would view a sharp increase in total credit as a game-changer that would point toward a "stimulus overshoot" (Table 4). Such an overshoot is less likely if the government relies more heavily on fiscal spending this time around, which is what we expect. Table 4Will China Over-Stimulate This Time Around? Meanwhile, turmoil in emerging markets - which we fully anticipated based on China's policy headwinds this year and our dollar bullish view - will only be exacerbated by China's unwillingness to stimulate massively.25 Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Qingyun Xu, Senior Analyst qingyun@bcaresearch.com Yushu Ma, Contributing Editor yushum@bcaresearch.com 1 Please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "China: How Stimulating Is The Stimulus?" dated August 8, 2018, available at gps.bcaresearch.com. 2 Please see BCA China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle," dated November 30, 2017, available at cis.bcaresearch.com. 3 Please see BCA China Investment Strategy Weekly Report, "China Is Easing Up On The Brake, Not Pressing The Accelerator," dated July 26, 2018, available at cis.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Politics Are Stimulative, Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 9 Please see footnote 8 above. 10 Please see BCA Geopolitical Strategy Weekly Report, "Italy, Spain, Trade Wars... Oh My!" dated May 30, 2018, available at gps.bcaresearch.com. 11 Please see Part I of this series in footnote 1 above. 12 Please see BCA China Investment Strategy Weekly Report, "Now What?" dated June 27, 2018, available at cis.bcaresearch.com. Note that according to the new asset management rules, financial institutions will be required to have a risk reserve worth 10% of their fee income, or corresponding risk capital provisions. When the risk reserve balance reaches 1% of the product balance, no further risk provision will be required. We estimate that setting aside these funds will be a form of financial tightening worth about 1.2% of GDP. 13 Please see Liansheng Zheng, "The Macro Prudential Assessment Framework of China: Background, Evaluation and Current and Future Policy," Center for International Governance Innovation, CIGI Papers No. 164 (March 2018), available at www.cigionline.com. 14 Recall that the second category of the MPA consists of bank assets and liabilities. This category also has a rule for broad credit growth, which is that it should not exceed broad money (M2) plus 20%-25%. Therefore passing this part of the exam already requires banks to meet a 28%-33% speed limit on new credit. Assuming that that the pro-cyclical parameter of the CAR category remains at its current minimum of 0.4, then the structural parameter cannot be effectively pushed any lower than 0.6-0.8. The bottom line is that pushing the CAR structural parameter lower is not going to yield a significant increase in the allowable rate of credit growth. 15 To reach this estimate, we began with the fact that the outstanding level of broad credit growth was around 207 trillion RMB by the end of 2017 (that is, loans plus bonds plus equities plus wealth management products and other off-balance-sheet assets). The 2017 growth rate was about 10% and is assumed to be the same in 2018. Therefore broad credit should reach 227.7 trillion by the end of the year. Then, if we assume that all banks lend at the maximum weighted growth rate allowed by adjusting the structural parameter in the MPA CAR requirement (which is 30%), outstanding broad credit would reach 269.1 trillion by the end of the year. Hence an extra 41.4 trillion RMB in broad credit growth would be released. For comparison, please see CITIC Bond Investment, "Deep Analysis: Impact of Parameter Adjustments in the MPA Framework," July 30, 2018, available at www.sohu.com. 16 Based on actual CARs in 2017, the limit to broad credit growth was 17%-22% for large state-owned banks, 10%-20% for joint-equity banks, and 15%-20% for city or rural commercial banks. However, the actual broad credit growth for most banks was a lot lower than that. For example, for all five state-owned banks (nationally systemically important financial institutions), it was below 10%, well beneath the 17%-22% determined by their actual CARs and C*. 17 Under current regulations, the loan provision ratio is 2.5% while the NPL provision coverage ratio is 150%. The higher of the two is the regulatory standard for commercial banks. On February 28, 2018, the China Banking Regulatory Commission issued a notice declaring that the coverage requirement would change to a range of 120%-150%, while the loan provision requirement would change to a range of 1.5%-2.5%. Banks would qualify for the easier requirements according to how accurately they classified their loans, whether they disposed of their bad loans, and whether they maintained appropriate capital adequacy ratios. This could result in a release of about 800 billion RMB worth of provisions that can be kept as core tier-1 capital or support new lending. 18 Please see BCA China Investment Strategy Special Report, "Stress-Testing Chinese Banks," dated July 27, 2016, available at cis.bcaresearch.com. 19 Please see BCA Emerging Markets Strategy Weekly Report, "Mind The Breakdowns," dated July 5, 2018, and Special Report, "Long Indian / Short Chinese Banks," dated January 17, 2018, available at ems.bcaresearch.com. 20 Please see Jamie P. Horsley, "What's So Controversial About China's New Anti-Corruption Body?" The Diplomat, May 30, 2018, available at thediplomat.com. 21 The NSC is operationally very close to the Central Discipline Inspection Commission (CDIC), which is the Communist Party corruption watchdog formerly headed by heavyweight Wang Qishan. It received only a 10% increase in manpower over the CDIC in order to expand its target range by 200% (covering all state agencies and state-linked organizations). It has allegedly meted out 240,000 punishments in the first half of 2018, up from 210,000 during the same period last year and 163,000 in H1 2016. About 28 of these cases were provincial-level cases or higher. The controversy over the "rights of the detained" has been highlighted by the beating of a local government official's limousine driver in one of the organization's first publicly reported actions. The NSC has also arrested local government officials tied to "corruption kingpin" Zhou Yongkang and known for misappropriating budgetary funds, and has secured the repatriation of fugitives who fled abroad and recovered the assets that they stole or embezzled. 22 The provinces include Tianjin, Chongqing, Liaoning, Inner Mongolia, etc. Please see BCA Geopolitical Strategy "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. There is empirical evidence that anti-corruption probes are correlated with debt defaults. Please see Haoyu Gao, Hong Ru and Dragon Yongjun Tang, "Subnational Debt of China: The Politics-Finance Nexus," dated September 12, 2017, available at gcfp.mit.edu. 23 Please see BCA Emerging Markets Strategy Special Report, "China Real Estate: A Never-Bursting Bubble?" dated April 6, 2018, available at ems.bcaresearch.com, and Commodity & Energy Strategy Weekly Report, "Blue Skies Drive China's Steel Policy," dated August 9, 2018, available at ces.bcaresearch.com. 24 Please see "As economy cools, China sets deadline for local government special bond sales," Reuters, dated August 14, 2018, available at www.reuters.com. For more on local government bond issuance, see Part I of this series in footnote 1 above. Note also rumors in Chinese media suggesting that a new local government debt swap program could be launched with the responsibility of tackling off-balance-sheet debts that are guaranteed by local governments. The program has thus far only swapped debts that local governments were obligated to pay. It is not clear what would happen to a third class of local debt, that which is neither an obligation upon local governments nor guaranteed by them but that nevertheless is deemed to serve a public interest. 25 Please see BCA Geopolitical Strategy Weekly Report, "The EM Bloodbath Has Nothing To Do With Trump," dated August 14, 2018, available at gps.bcaresearch.com.

Special Report

Dear Client, This week we are sending you a Special Report written by Mark McClellan, Chief Strategist, The Bank Credit Analyst, Marko Papic, Chief Strategist, Geopolitical Strategy and our very own Chris Bowes, Associate Editor, U.S. Equity Strategy. This report deals with the implications of the U.S./Sino trade war for U.S. equity sectors. It identifies the next products to be targeted with higher tariffs on both sides of the dispute. A higher U.S. tariff wall will shield some industries from competition, but rising input costs will be widely felt because of extensive supply chains between and within industries. There is only a small handful of industries that will be winners in absolute terms. I trust you will find his report insightful. Kind regards, Anastasios Avgeriou, Vice President U.S. Equity Strategy In this Special Report, we shed light on the implications of the U.S./Sino trade war for U.S. equity sectors. The threat that trade action poses to the U.S. equity market is greater than in past confrontations. Perhaps most importantly, supply chains are much more extensive, globally and between China and the U.S. Automobile Components, Electrical Equipment, Materials, Capital Goods and Consumer Durables have the most extensive supply chain networks. The USTR claims that it is being strategic in the Chinese goods it is targeting, focusing on companies that will benefit from the "Made In China 2025" initiative. The list of Chinese goods targeted in both the first and second rounds covers virtually all of the broad import categories. The only major items left for the U.S. to hit are apparel, footwear, toys and cellphones. Beijing is clearly targeting U.S. products based on politics in order to exert as much pressure on the President's party as possible. Based on a list of products that comprise the top-10 most exported goods of Red and Swing States, China will likely lift tariffs in the next rounds on civilian aircraft, computer electronics, healthcare equipment, car engines, chemicals, wood pulp, telecommunication and integrated circuits. Supply chains within and between industries and firms mean that the impact of tariffs is much broader than the direct impact on exporters and importers. We measure the relative exposure of 24 GICs equity sectors to the trade war based on their proportion of foreign-sourced revenues and the proportion of each industry's total inputs that are affected by U.S. tariffs. The Semiconductors & Semiconductor Equipment sector stands out, but the Technology & Hardware Equipment, Capital Goods, Materials, Consumer Durables & Apparel and Motor Vehicle sectors are also highly exposed to anti-trade policy action. Energy, Software, Banks and all other service sectors are much less exposed. China may also attempt to disrupt supply chains via non-tariff barriers, placing even more pressure on U.S. firms that have invested heavily in China. Wholesale Trade, Chemicals, Transportation Equipment, Computers & Electronic Parts and Finance & Insurance are most exposed. U.S. technology companies are particularly vulnerable to an escalating trade war. Virtually all U.S. manufacturing industries will be negatively affected by an ongoing trade war, even defensive sectors such as Consumer Staples. The one exception is defense manufacturers, where we recommend overweight positions. Our analysis highlights that the best shelter from a trade war can be found in services, particularly services that are insulated from trade. Financial Services appears a logical choice, and the S&P Financial Exchanges & Data subsector is one of our favorites. The trade skirmish is transitioning to a full-on trade war. The U.S. has imposed a 25% tariff on $50 billion worth of Chinese goods, and has proposed a 10% levy on an additional $200 billion of imports by August 31. China retaliated with tariffs on $50 billion of imports from the U.S., but Trump has threatened tariffs on another $300 billion if China refuses to back down. That would add up to over $500 billion in Chinese goods and services that could be subject to tariffs, only slightly less than the total amount that China exported to the U.S. last year. BCA's Geopolitical Strategy has emphasized that President Trump is unconstrained on trade policy, giving him leeway to be tougher than the market expects.1 This is especially the case with respect to China. There will be strong pushback from Congress and the U.S. business lobby if the Administration tries to cancel NAFTA. In contrast, Congress is also demanding that the Administration be tough on China because it plays well with voters. Trump is a prisoner of his own tough pre-election campaign rhetoric against China. The U.S. primary economic goal is not to equalize tariffs but to open market access.2 The strategic goal is much larger. The U.S. wants to see China's rate of technological development slow down. Washington will expect robust guarantees to protect intellectual property and proprietary technology before it dials down the pressure on Beijing. The threat that the trade war poses to the U.S. equity market is greater than in past confrontations, such as that between Japan and the U.S. in the late 1980s. First, stocks are more expensive today. Second, interest rates are much lower, limiting how much central banks can react to adverse shocks. Third, and perhaps most importantly, supply chains are much more extensive, globally and between China and the U.S. Nearly every major S&P 500 multinational corporation is in some way exposed to these supply chains. Chart II-1 shows that Automobile Components, Electrical Equipment, Materials, Capital Goods and Consumer Durables have the most extensive supply chain networks. The Global Value Chain Participation rate, constructed by the OECD, is a measure of cross-border value-added linkages.3 In this Special Report, we shed light on the implications of the trade war for U.S. equity sectors. Complex industrial interactions make it difficult to be precise in identifying the winners and losers of a trade war. Nonetheless, we can identify the industries most and least exposed to a further rise in tariff walls or non-tariff barriers to trade. We focus on the U.S./Sino trade dispute in this Special Report, leaving the implications of a potential trade war with Europe and the possible failure of NAFTA negotiations for future research. Chart II-1Measuring Global Supply Chains Trade Channels There are at least five channels through which rising tariffs can affect U.S. industry: The Direct Effect: This can be positive or negative. The impact is positive for those industries that do not export much but are provided relief from stiff import competition via higher import tariffs. The impact is negative for those firms facing higher tariffs on their exports, as well as for those firms facing higher costs for imported inputs to their production process. These firms would be forced to absorb some of the tariff via lower profit margins. Some industries will fall into both positive and negative camps. U.S. washing machines are a good example. Whirlpool's stock price jumped after President Trump announced an import tariff on washing machines, but it subsequently fell back when the Administration imposed an import tariff on steel and aluminum (that are used in the production of washing machines); Indirect Effect: The higher costs for imported goods are passed along the supply chain within an industry and to other industries that are not directly affected by rising tariffs. This will undermine profit margins in these indirectly-affected industries to the extent that they cannot fully pass along the higher input costs; Foreign Direct Investment: Some Chinese exports emanate from U.S. multinationals' subsidiaries in China, or by Chinese or foreign OEM suppliers for U.S. firms. Even though it would undermine China's economy to some extent, the Chinese authorities could make life more difficult for these firms in retaliation for U.S. tariffs on Chinese goods. Macro Effect: A trade war would take a toll on global trade and reduce GDP growth globally. Besides the negative effect of uncertainty on business confidence and, thus, capital spending, rising prices for both consumer and capital goods will reduce the volume of spending in both cases. Moreover, corporate profits have a high beta with respect to economic activity. We would not rule out a U.S. recession in a worst-case scenario. Obviously, a recession or economic slowdown would inflict the most pain on the cyclical parts of the S&P 500 relative to the non-cyclicals, in typical fashion. Currency Effect: To the extent that a trade war pushes up the dollar relative to the other currencies, it would undermine export-oriented industries and benefit those that import. However, while we are bullish the dollar due to diverging monetary policy, the dollar may not benefit much from trade friction given retaliatory tariff increases by other countries. Some of the direct and indirect impact can be mitigated to the extent that importers facing higher prices for Chinese goods shift to similarly-priced foreign producers outside of China. Nonetheless, this adjustment will not be costless as there may be insufficient supply capacity outside of China, leading to upward pressure on prices globally. Targeted Sectors: (I) U.S. Tariffs On Chinese Goods As noted above, the U.S. has already imposed tariffs on $50 billion of Chinese imports and has published a list of another $200 billion of goods that are being considered for a 10% tariff in the second round of the trade war. The first round focused on intermediate and capital goods, while the second round includes consumer final demand categories such as furniture, air conditioners and refrigerators. The latter will show up as higher prices at retailers such as Wal Mart, having a direct and visible impact on U.S. households. Appendix Table II-A1 lists the goods that are on the first and second round lists, grouped according to the U.S. equity sectors in the S&P 500. The U.S. Trade Representative (USTR) claims that the Chinese items are being targeted strategically. It is focusing on companies that will benefit from China's structural policies, such as the "Made In China 2025" initiative that is designed to make the country a world leader in high-tech areas (see below). Table II-1 reveals the relative size of the broad categories of U.S. imports from China, based on trade categories. The top of the table is dominated by Motor Vehicles, Machinery, Telecommunication Equipment, Computers, Apparel & Footwear and other manufactured goods. The list of Chinese goods targeted in both the first and second rounds covers virtually all of the broad categories in Table II-1. The only major items left for the U.S. to hit are Apparel and Footwear, as well as two subcategories; Toys and Cellphones. These are all consumer demand categories. Table II-1U.S. Imports From China (January-May 2018) (II) Chinese Tariffs On U.S. Goods Total U.S. exports to China were less than $53 billion in the first five months of 2018, limiting the amount of direct retaliation that China can undertake (Table II-2). The list of individual U.S. products that China has targeted so far is long, but we have condensed it into the broad categories shown in Table II-3. The U.S. equity sectors that the new tariffs affect so far include Food, Beverage & Tobacco, Automobiles & Components, Materials and Energy. China has concentrated mainly on final goods in a politically strategic manner, such as Trump-supported rural areas and Harley Davidson bikes whose operations are based in Paul Ryan's home district in Wisconsin. Table II-2U.S. Exports To China (January-May 2018) Table II-3China Tariffs On U.S. Goods What will China target next? Chart II-2 shows exports to China as percent of total state exports, and Chart II-3 presents the value of products already tariffed by China as a percent of state exports. Other than Washington, the four states most targeted by Beijing are conservative: Alaska, Alabama, Louisiana and South Carolina. Chart II-2U.S. Exports To China By State Chart II-3Value Of U.S. Products Tariffed By China (By State) Beijing is clearly targeting products based on politics in order to exert as much pressure on the President's party as possible. To identify the next items to be targeted, we constructed a list of products that comprise the top-10 most exported goods of Red States (solidly conservative) and Swing States (competitive states that can go either to Republican or Democratic politicians). Appendix Tables II-A2 and II-A3 show this list of products, with those that have already been flagged by China for tariffs crossed out. Table II-4 shows the top-10 list of products that are not yet tariffed by China, but are distributed in a large proportion of Red and Swing states. What strikes us immediately is how important aircraft exports are to a large number of Swing and Red States. In total, 27 U.S. states export civilian aircraft, engines and parts to China. This is an obvious target of Beijing's retaliation. In addition, we believe that computer electronics, healthcare equipment, car engines, chemicals, wood pulp, telecommunication and integrated circuits are next. Table II-4Number Of U.S. States Exporting To China By Category Market Reaction Chart II-4 highlights how U.S. equity sectors performed during seven separate days when the S&P 500 suffered notable losses due to heightened fears of protectionism. Cyclical sectors such as Industrials and Materials fared worse during days of rising protectionist angst. Financials also generally underperformed, largely because such days saw a flattening of the yield curve. Tech, Health Care, Energy and Telecom performed broadly in line with the S&P 500. Consumer Staples outperformed the market, but still declined in absolute terms. Utilities and Real Estate were the only two sectors that saw absolute price gains. The market reaction seems sensible based on the industries caught in the cross-hairs of the trade action so far. At least some of the potential damage is already discounted in equity prices. Nonetheless, it is useful to take a closer look at the underlying factors that should determine the ultimate winners and losers from additional salvos in the trade war. Chart II-4S&P 500: Impact Of Trade-Related Events Determining The Winners And Losers The U.S. sectors that garner the largest proportion of total revenues from outside the U.S. are obviously the most exposed to a trade war. For the 24 level 2 GICS sectors in the S&P 500, Table II-5 presents the proportion of total revenues that is generated from operations outside the U.S. for the top five companies in the sector by market cap. Company reporting makes it difficult in some cases to identify the exact revenue amount coming from outside the U.S., as some companies regard "domestic" earnings as anything generated in North America. Nonetheless, we believe the data in Table II-5 provide a reasonably accurate picture. Table II-5Foreign Revenue Exposure (2017) Semiconductors, Tech Equipment, Materials, Food & Beverage, Software and Capital Goods are at the top of the list in terms of foreign-sourced revenues. Not surprisingly, service industries like Real Estate, Banking, Utilities and Telecommunications Services are at the bottom of the exposure list. U.S. companies are also exposed to U.S. tariffs that lift the price of imported inputs to the production process. This can occur directly when firm A imports a good from abroad, and indirectly, when firm A sells its intermediate good to firm B at a higher price, and then on to firm C. In order to capture the entire process, we used the information contained in the Bureau of Economic Analysis' Input/Output tables. We estimated the proportion of each industry's total inputs that are affected by already-implemented U.S. tariffs and those that are on the list for the next round of tariffs. These estimates, shown in Appendix Table II-A4 at a detailed industrial level, include both the direct and indirect effects of higher import costs. At the top of the list is Motor Vehicles and Parts, where Trump tariffs could affect more than 70% of the cost of all material inputs to the production process. Electrical Equipment, Machinery and other materials industries are also high on the list, together with Furniture, Computers & Electronic Parts and Construction. Unsurprisingly, service industries and Utilities are in the bottom half of the table.4 We then allocated all the industries in Appendix Table II-A4 to the 24 GICs level 2 sectors in the S&P 500, in order to obtain an import exposure ranking in S&P sector space (Table II-6). Table II-6U.S. Import Tariff Exposure Chart II-5 presents a scatter diagram that compares import tariff exposure (horizontal axis) with foreign revenue exposure (vertical axis). The industries clustered in the top-right of the diagram are the most exposed to a trade war. Chart II-5U.S. Industrial Exposure To A Trade War With China The Semiconductors & Semiconductor Equipment sector stands out by this metric, but the Technology & Hardware Equipment, Capital Goods, Materials, Consumer Durables & Apparel and Motor Vehicle sectors are also highly exposed to anti-trade policy action. Energy, Software, Banks and all other service sectors are much less exposed. Food, Beverage & Tobacco lies between the two extremes. Joint Ventures And FDI Table II-7Stock Of U.S. Direct ##br##Investment In China (2017) As mentioned above, most U.S. production taking place in China involves a joint venture. The Chinese authorities could attempt to disrupt the supply chain of a U.S. company by hindering production at companies that have ties to U.S. firms. Data on U.S. foreign direct investment (FDI) in China will be indicative of the industries that are most exposed to this form of retaliation. The stock of U.S. FDI in China totaled more than $107 billion last year (Table II-7). At the top of the table are Wholesale Trade, Chemicals, Transportation Equipment, Computers & Electronic Parts and Finance & Insurance. Apple is a good example of a U.S. company that is exposed to non-tariff retaliation, as the iPhone is assembled in China by Foxconn for shipment globally with mostly foreign sourced parts. Our Technology sector strategists argue that U.S. technology companies are particularly vulnerable to an escalating trade war (See Box II-1).5 BOX II-1 The Tech Sector The U.S. has applied tariffs on the raw materials of technology products rather than finished goods so far. At a minimum, this will penalize smaller U.S. tech firms which manufacture in the U.S. and provide an incentive to move production elsewhere. Worst case, the U.S. tariffs might lead to component shortages which could have a disproportionately negative impact, especially on smaller firms. Although it has not been proposed, U.S. tariffs on finished goods would be devastating to large tech companies such as Apple, which outsources its manufacturing to China. China appears determined to have a vibrant high technology sector. The "Made In China 2025" program, for example, combines ambitious goals in supercomputers, robotics, medical devices and smart cars, while setting domestic localization targets that would favor Chinese companies over foreigners. The ZTE sanctions and the potential for enhanced export controls have had a traumatic impact on China's understanding of its relatively weak position with respect to technology. As a result, because most high-tech products are available from non-U.S. sources, Chinese engineers will likely be encouraged to design with non-U.S. components; for example, selecting a Samsung instead of a Qualcomm processor for a smartphone. Similarly, China is a major buyer of semiconductor capital equipment as it follows through with plans to scale up its semiconductor industry. Most such equipment is also available from non-U.S. vendors, and it would be understandable if these suppliers are selected given the risk which would now be associated with selecting a U.S. supplier. The U.S. is targeting Chinese made resistors, capacitors, crystals, batteries, Light Emitting Diodes (LEDs) and semiconductors with a 25% tariff. For the most part these are simple, low cost devices, which are used by the billions in high-tech devices. Nonetheless, China could limit the export of these products to deliver maximum pain, leading to a potential shortage of qualified parts. A component shortage can have a devastating impact on production since the manufacturer may not have the ability to substitute a new part or qualify a new vendor. Since the product typically won't work unless all the right parts are installed, want of a dollar's worth of capacitors may delay shipping a $1,000 product. Thus, the economic and profit impact of a parts shortage in the U.S. could be quite severe. Conclusions: When it comes to absolute winners in case of a trade war, we believe there are three conditions that need to be met: Relatively high domestic input costs. Relatively high domestic consumption/sales; the true beneficiaries of a tariff are those industries who are allowed to either raise prices or displace foreign competitors, with the consumer typically bearing the cost. Relatively low direct exposure to global trade - international trade flows will certainly slow in a trade war. There are very few manufacturing industries that meet all of these criteria. Within manufacturing, one would typically expect the Consumer Staples and Discretionary sectors to be the best performers. However, roughly a third of the weight of Staples is in three stocks (PG, KO and PEP) that are massively dependent on foreign sales. Moreover, a similar weight of Discretionary is in two retailers (AMZN and HD) that are dependent on imports. As such, consumer indexes do not appear a safe harbor in a trade war. Nevertheless, if the trade war morphs into a recession then consumer staples (and other defensive safe-havens) will outperform, although they will still decrease in absolute terms. Transports are an industry that has relatively high domestic labor costs and an output that is consumed virtually entirely within domestic borders. However, their reliance on global trade flows - intermodal shipping is now more than half of all rail traffic - means they almost certainly lose from a prolonged trade dispute. There is one manufacturing industry that could be at least a relative winner and perhaps an absolute winner: defense. Defense manufacturers certainly satisfy the first two criteria above, though they do have reasonably heavy foreign exposure. However, we believe high switching costs and the lack of true global competitors mean that U.S. defense company foreign sales will be resilient. After all, a NATO nation does not simply switch out of F-35 jets for the Russian or Chinese equivalent. Further, if trade friction leads to rising military tension, defense stocks should outperform. Finally, the ongoing global arms race, space race and growing cybersecurity requirements all signal that these stocks are a secular growth story, as BCA has argued in the recent past.6 Still, as highlighted by the data presented above, the best shelter from a trade war can be found in services, particularly services that are insulated from trade. Financial Services appears a logical choice, especially the S&P Financial Exchanges & Data subsector (BLBG: S5FEXD - CME, SPGI, ICE, MCO, MSCI, CBOE, NDAQ). Another appealing - and defensive - sector is Health Care Services. With effectively no foreign exposure and a low beta, these stocks would outperform in the worst-case trade war-induced recession. Mark McClellan Senior Vice President The Bank Credit Analyst Marko Papic Senior Vice President Geopolitical Strategy Chris Bowes Associate Editor U.S. Equity Strategy 1 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 3 For more information, please see: "Global Value Chains (GVSs): United States." May 2013. OECD website. 4 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. 5 Please see BCA Technology Sector Strategy Special Report "Trade Wars And Technology," dated July 10, 2018, available at tech.bcaresearch.com 6 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. Appendix Table II-1 Allocating U.S. Import Tariffs To U.S. GICS Sectors Appendix Table II-2 Exports By U.S. Red States Appendix Table II-3 Exports By U.S. Swing States Appendix Table II-4 Exposure Of U.S. Industries To U.S. Import Tariffs

Highlights Seasonal capacity restrictions in China during the winter heating months - when pollution from steel mills is particularly high - and continued efforts to limit particulate emissions in major cities will drive steel prices higher. The steel rebar market in China is backwardated, indicating physical markets are tight; inventories have been falling since mid-March. We expect prices to remain elevated going into the winter months, when capacity restrictions kick in. Ongoing capacity reductions in steelmaking will favor higher-grade iron ores, which will widen price differentials versus lower-grade ores. We are recommending a long China rebar futures on the SHFE in 1Q19 vs short 62% Fe iron ore futures on the Dalian DCE in 1Q19 at tonight's close, based on our research. Energy: Overweight. Loadings of Iranian crude are expected to be curtailed beginning this month, as the November 4 deadline for the imposition of U.S. secondary sanctions kick in. Our base case calls for the loss of 500k b/d of exports from Iran; our ensemble forecast includes an estimate of 1mm b/d. Base Metals: Neutral. BHP asked the Chilean government to intervene in the strike called by unions at its Escondida mine. Union officials delayed strike action while talks are being held. Negotiators have until August 14 to reach an agreement. Reuters reported Chile's copper production was up 12.3% y/y in 1H18 to 2.83mm MT.1 Precious Metals: Neutral. U.S. sanctions on trading gold and precious metals with Iran went into effect earlier this week. Ags/Softs: Underweight. Chinese imports of U.S. soybeans could fall 10mm MT over the next year, if pig and chicken farmers switch to lower-protein feed and substitutes like sunflower seeds, and boost local production of the legume, state-run news service Xinhua reported.2 The USDA expects U.S. exports of 55.52mm MT of soybeans in the 2018 - 19 crop year, down 1.22mm MT from last year. Feature Steel prices have performed exceptionally since the beginning of 2Q18, seemingly oblivious to Sino - U.S. trade tensions, a stronger USD, and risks to China's economy roiling other metal markets (Chart of the Week). The MySteel Composite Index we use to track steel prices is up 7% since the beginning of April. With demand growth leveling off, steel's price dynamics highlight the continued relevance of the market's supply-side developments. Most notably, Beijing's battle for blue skies: Winter capacity curbs, and, to a lesser extent, ongoing efforts to retire older, highly polluting capacity will keep prices elevated over the next 9 months. Winter Curbs: China's New Normal As we highlighted in our April 12 weekly, despite the much-ballyhooed reductions in China's steel capacity over the 2017 - 18 winter months, markets in China and globally remained relatively well supplied over the winter.3 However, several key changes this year suggest the impact of these measures will intensify this time around, keeping producers constrained in their ability to ramp up production of the metal. For one, the data suggest strong production levels amid the anti-pollution curbs last winter were a result of an increase in output from regions unaffected by the capacity restrictions (Chart 2). This went a long way in muting the impact of the restrictions in the heavily industrialized Beijing-Tianjin-Hebei region of northern China. Chart of the WeekSteel Oblivious To Pessimism Chart 22017/18 Winter Cuts: A Net Non-Event This year's curbs will broaden the regions targeted by anti-pollution restrictions. The campaign will encompass 83 cities, up from last year's 28, thereby reducing the potential production ramp up from regions not covered by these measures (Chart 3). This coming winter's closures will cover regions where producers traditionally account for 68% of China's steel output (Chart 4). Chart 3Second Annual Winter Capacity ##br##Restrictions Will Broaden Coverage... Chart 4...And##br## Impact The anti-pollution campaign is one of the three battles prioritized in Xi Jinping's plan for the coming years. These curbs will be implemented during the October 1, 2018 to March 31, 2019 heating season, extending the duration from last year's mid-November to Mid-March period. Because the minimal effect observed per last year's closures was due to specifying too narrow a range of plants and regions, not to non-compliance, we expect the measures announced for this coming winter to be fully implemented. These measures come amid already-tight market conditions. The steel rebar market in China is in backwardation - meaning a physical shortage is pushing up prompt prices relative to those further out the curve. Inventories have been falling since mid-March, reflecting supply-demand dynamics in other steel product markets. Thus, we expect prices to remain elevated going into the winter months. Capacity Impacts Are Difficult To Gauge Opaqueness and discretionary authority in the new rules clouds the outlook on how anti-pollution reforms will impact the steel market. This makes it difficult to estimate their impact with precision. This time around, China's State Council announced that curbs will be implemented in a more scientific and targeted approach, ensuring maximum efficiency to attain the targets. This means the constraints this year will depend on emissions in each region, which will be set at the discretion of local authorities.4 For example, steel mills in six key cities including Tianjin, Shijiazhuang, Tangshan, Handan, Xingtai and Anyang will be asked to keep capacity below 50% this winter, while producers in the rest of the Beijing-Tianjin-Hebei region will keep production running at less than 70% of capacity. Furthermore, a draft plan by the city of Changzhou - which planned to implement the curbs beginning August 3 - suggests production curbs may vary by company, depending on operational situations and emission levels.5 These restrictions are applied to capacity, rather than production. Without up-to-date and accurate information on crude steel-making capacity across the different regions, it is extremely difficult to accurately quantify the impact. Specifics of the plans are up to the discretion of local authorities. Thus, these restrictions can be applied to different stages in the steel-making process (Diagram 1), impacting furnaces, pig iron or sintering plants. In some cases, the output curbs are not only restricted to the winter heating months. Several regions have been implementing curbs throughout the year on an as-needed basis. The cities of Tangshan and Changzhou are two such examples, implementing restrictions during the summer months as well. Furthermore, all industrial plants in the city of Xuzhou remain shut. High profit margins at steel mills may incentivize the shuttered illegal furnaces to restart. The industry ministry acknowledges this threat, and claims it will carry out checks on these producers to ensure they do not come back online. Diagram 1Steelmaking Production Process: Restrictions Can Be Applied To Different Stages Without full knowledge of these details, quantifying the impact of these restrictions is a challenge. Morgan Stanley estimates the impact of these curbs on steel output to be 78mm MT during the winter period by assuming capacity utilization is restricted to 50% in the key cities, while the rest of the areas cut capacity by 30%. The estimated production loss from these restrictions accounts for 9% of China's 2017 crude steel output.6 China's Ongoing Capacity-Reduction Reforms Most of the planned permanent capacity shutdowns have already taken place. Of the targeted 150mm MT of cuts between 2016 and 2020, 115mm MT have already taken place over the past two years. Furthermore, 1H17 witnessed the closure of all illegal induction furnaces producing sub-par quality steel, estimated to account for 140mm MT of crude steel capacity (Table 1).7 Table 1De-Capacity Reforms Still Ongoing We expect the magnitude of cutbacks to slow considerably. Even though the industry ministry issued a statement in February that it plans to meet steel capacity reduction targets this year - two years ahead of schedule. Furthermore, mills face restrictions on new steel capacity. China's State Council announced it intends to prevent new steel capacity additions in the Beijing-Tianjin-Hebei, Guangdong province, and Yangtze River Delta regions, and a cap set at 200mm MT in Hebei by 2020. The capacity replacement plan, which allows a maximum of 0.8 MT of new capacity for each MT of eliminated capacity, will ensure capacity does not grow going forward. In fact, not all mills are eligible to take advantage of the replacement policy. Among others, now-shuttered induction furnace capacity, as well as producers that previously benefited from cash and policy support will not meet the requirements for this program. Steel And Iron Ore Prices Will Not Reconverge As a result of China's reform policies in the steel industry, iron ore prices have diverged from steel. Reduced steel production lowers demand for raw materials, including iron ore. This is reflected in falling Chinese iron ore imports amid contracting production (Chart 5). Chart 5Weak Demand For Iron Ore Chart 6EAF Penetration In China: Still Some Catching Up To Do China's reform and anti-pollution campaigns have had serious consequences on iron ore markets. For starters, China is encouraging the adoption of electric arc furnaces (EAF), rather than additional new blast furnaces.8 While the latter primarily uses iron ore, the former uses scrap steel. EAF penetration in China's steel industry significantly lags the rest of the world (Chart 6). This means that even if the capacity-replacement program allows eliminated furnaces to be replaced with newer, more up-to-date capacity, this will not spur demand for iron ore. Instead, we expect to see higher scrap steel prices (Chart 7). Furthermore, as we first highlighted in our January report, China's anti-pollution campaign coupled with high steel profit margins has incentivized the use of higher grade iron ore and iron ore pellets, widening the price spread between high- and low- grade ores (Chart 8).9 Chart 7EAFs Support Scrap Steel Demand Chart 8IO Grade Premiums Will Remain Elevated While high-grade ores are more expensive, they emit less pollution in the steelmaking process. Similarly, unlike fines, pellets which are direct charge feedstock, are not required to undergo the highly polluting sintering stage and can be fed directly into the furnace. China's Steel Dynamics Overshadow Global Markets The ongoing supply-side reforms in China are overshadowing events in other markets. Globally, steel is expected to remain in physical deficit this year (Chart 9). This is largely on the back of an increase in world ex-China demand, and the decline in Chinese supply, despite expectations of weaker Chinese demand, and increased supply from the rest of the world (Table 2). Chart 9Physical Steel Deficit Will Persist... Table 2...Despite Weaker Chinese Demand And Stronger RoW Supply These figures do not consider the impact of the ongoing Sino - U.S. trade dispute, which could evolve into a full-blown trade war, weighing on EM incomes and demand. In such a scenario, global demand for steel would take a hit, potentially shifting global markets into surplus. In theory, trade barriers on U.S. steel imports could lead to weaker domestic supply for American users and at the same time, leave more of the metal for use by the rest of the world. The net effect of that would be a higher price for American steel relative to the rest of the world. However, since May, 20,000 requests for steel tariff exemptions have been filed in the U.S., of which the Commerce Department has denied 639. To the extent that American steel users are able to obtain tariff exemptions, the impact of the barriers on global steel markets will be muted. Bottom Line: We expect China's steel market to tighten as we go into the winter season, during which capacity cuts will be broadened to 82 cities, from last year's 28. This will keep steel prices elevated. At the same time, we expect prices of 62% Fe material and lower iron ore grades to weaken, as appetite for the steelmaking raw material contracts during these months. Mills still running in the mid-November to mid-March period will have a preference for higher-grade ores and pellets, keeping premiums on these grades elevated. Barring a significant demand-side shock, expect more upside to steel prices and downside to iron ore prices over the coming 9 months. Based on our research, we are recommending a long China rebar futures on the SHFE in 1Q19 vs. short 62% Fe iron ore futures on the Dalian DCE in 1Q19 at tonight's close. Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see "BHP asks for government mediation in talks at Chile's Escondida," published August 6, 2018, by uk.reuters.com. 2 Please see "Economic Watch: China can cut soybean imports in 2018 by over 10 mln tonnes," published August 5, 2018, by xinhuanet.com. 3 Please see Commodity & Energy Strategy Weekly Report titled "Chinese Steel, Aluminum Markets Well Supplied Despite Winter Capacity Cuts," dated April 12, 2018, available at ces.bcaresearch.com. 4 Please see "Chinese steel output cuts to vary from mill to mill next winter," dated July 21, 2018, available at reuters.com. 5 The restrictions will not only apply to the city's steel mills, but also to copper smelters, chemical makers as well as cement producers. Please see "China's Changzhou plans to enforce output curbs in steel, chemical plants," dated July 30, 2018, available at reuters.com. 6 Please see "Shanghai steel resumes rise, coke rallies as China eyes winter curbs," dated August 2, 2018, available at reuters.com. 7 Low-quality steel produced by induction furnaces, also referred to as ditiaogang, is made by melting scrap steel using induction heat, preventing sufficient control over the quality of the steel. Platts estimates ditiaogang production in 2016 to be 30-50mm MT. As we explain in our September 7, 2017 Weekly Report titled "Slow-Down In China's Reflation Will Temper Steel, Iron Ore In 2018," given that ditiaogang is illegal, these closures are not reflected in official steel production figures. Thus the closures of these mills have no impact on actual steel production, but instead raise the capacity utilization rates for Chinese steel producers. 8 China launched a carbon trading system in January 2018, which penalizes blast furnace operators with higher environmental taxes relative to EAF processes. 9 Please see Commodity & Energy Strategy Weekly Report titled "China's Environmental Reforms Drive Steel & Iron Ore," dated January 11, 2018, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017