Trade / BOP

Highlights Geopolitical tensions will stay elevated. We are not changing our strategic views. So long as the situation does not degenerate into a major military conflict or escalating trade wars with significant economic damages, the impact on both the broader growth outlook and financial markets should be limited. President Trump's recent decision to probe China's IPR practices is his first direct trade measure against China, and therefore is of important symbolic significance, but the near term impact should be limited. There is enough common ground for the two sides to avoid direct confrontation. We expect Beijing to cooperate with the U.S. administration to intensify pressure on North Korea. Short KRW/JPY as a hedge against geopolitical risk in The Korean Peninsula. There is an economic case for the trade, even without geopolitical considerations. Feature The Chinese economy is experiencing a summer lull, as most recent growth figures have disappointed, albeit slightly. Exports, production, investment and retail sales have all decelerated, underscoring that growth momentum is softening across the board. Investors have largely shrugged off the weaker-than-expected numbers, a sign that the market is not overly concerned about a major relapse down the road. We share investors' optimism, as discussed in some recent reports,1 but are watchful for signs of market complacency.2 After the most recent rally, multiples of Chinese equities are no longer exceptionally cheap by historical norms, even though they are still a lot cheaper compared with most other major global and EM bourses. We will discuss Chinese equity valuations in greater detail in the coming weeks. Geopolitical risks have dominated Greater China markets of late. The escalation of tensions surrounding North Korea briefly took their toll in the past week. On Monday, U.S. President Donald Trump authorized U.S. Trade Representative Robert Lighthizer to determine whether to launch an investigation into China's alleged theft of intellectual property. Overall, both events underscore rising geopolitical tensions globally, particularly around China. So long as the situation does not degenerate into a major military conflict or an escalating trade war that causes major economic damage, the tensions should not have a material impact on the outlook for the Chinese and global economy, as well as financial markets. A short position on the Korean won versus the Japanese yen offers a low-risk hedge against a sudden escalation of geopolitical tensions in the region. Intellectual Property Investigation: The Knowns And Unknowns It is unclear at the moment whether Trump is simply using the investigation as a bargaining chip to seek concessions/cooperation from China, or to start a trade war with lose-lose outcomes. The situation needs to be closely monitored and assessed continuously. For now, a few observations are in order: This is the first direct trade measure by the Trump administration against China, and therefore is of important symbolic significance, but the near-term impact should be limited. President Trump has only authorized his administration to determine whether or not to formally investigate Chinese policies and practices. It may take a year to finalize the decision, and even longer to begin negotiations and discussions with Chinese officials for solutions and remedies. Previous similar investigations against Chinese products resulted in bilateral agreements rather than all-out confrontations. Trump's decision is based on Section 301 of the Trade Act of 1974, which allows the president to unilaterally impose tariffs or other trade restrictions to protect U.S. industries from "unfair trade practices" of foreign countries. This was a popular trade tool in the 1980s and was used to impose tariffs against certain Japanese and Korean products, but has been rarely used in the past decade. In 2010 the Obama administration also accepted a petition under Section 301 to investigate China's state support for clean-energy exports, particularly solar panels and wind turbines, and the Chinese government later promised to limit some of these practices through bilateral negotiations. The World Trade Organization (WTO) has ruled that taking any such actions against other member countries without first securing approval under WTO rules is, in of itself, a violation of the WTO Agreement, and can be challenged under the WTO framework. In fact, section 301 investigations have not resulted in any trade sanctions since the WTO was set up in 1995. Table 1Top Challenges Doing Business In China China's Geopolitical Pressure Points: Knowns, Unknowns And A Hedge China's Geopolitical Pressure Points: Knowns, Unknowns And A Hedge More importantly, we see common ground enabling the U.S. and China to work together to improve China's Intellectual Property Rights, or IPR practices. From the U.S.'s perspective, while Trump's blunt accusations on China's trade policies are not completely justified and will not solve the massive trade imbalances between the two countries, his challenge on China's IPR infringement has legitimate ground, and resonates well within the broader American business community. American companies doing business in China have long listed intellectual property rights infringement and protectionism as top challenges, especially among industrial and resources businesses (Table 1). In other words, Trump's complaints on China's IPR practices reflects corporate America's rational voice rather than a sensational rant. China's own practices are also in conflict with its intentions to build a more open and market-friendly policy environment. Indeed, China has also been making notable progress to enhance IPR protections. In September 2015, in his state visit to the U.S., President Xi promised to limit the scope of national security reviews on investment, refrain from cyber-enabled IP theft, and uphold WTO agreements regarding market access for information and communications technology (ICT) products. China's deficits in IP royalty fees has increased sharply in recent years, while America's royalties surpluses have been expanding (Chart 1). Furthermore, 90% of American firms doing business in China believe that China's IPR enforcement has improved over the last five years, according to American Chamber Of Commerce In China (AmCham China) surveys.3 In short, there is certainly room for further improvement in China's IPR practices, and the broad direction fits with Trump's expectations, creating common ground for the two sides to avoid direct confrontation. We expect China's IPR practices will continue to converge towards international standards going forward. Chart 2 shows Chinese patent applications have exploded in recent years. As the country's technology continues to advance and local businesses are growing more aware of the value of intellectual property, China will develop a keen interest to safeguard its own IPRs. We are hopeful that Trump's investigation will provide a catalyst for further improvement in Chinese IPR practices, rather than derail broader bilateral trade. Chart 1China's Widening Deficits In IPR Royalty China's Widening Deficits In IPR Royalty China's Widening Deficits In IPR Royalty Chart 2China's Exploding Patent Applications ##br##Will Demand Stricter IPR Protections China's Exploding Patent Applications Will Demand Stricter IPR Protections China's Exploding Patent Applications Will Demand Stricter IPR Protections North Korea Tensions, And Short KRW/JPY As A Crisis Hedge The escalation of geopolitical tensions surrounding North Korea briefly took a toll on global and Greater China markets in the past week. The situation remains highly fluid, and the stakes are exceedingly high - both of which will put investors on edge in the weeks and months ahead. Our Geopolitical team in their latest assessment concludes that the U.S. is not likely to preemptively attack North Korea. However, the U.S. has an interest in signaling that it may conduct precisely such an attack, and brinkmanship could last for a long time.4 As far as China is concerned, there is genuine interest among the Chinese leadership to de-escalate tensions on the Korean Peninsula, but there is no easy solution. On one hand, it is absolutely against the country's best interests to collapse the North Korea regime. Such an outcome could see a surge of refugees to its densely populated and economically struggling Northeast region. Moreover, it could also potentially lead to a strong and unified Korea at the Chinese border that is a military ally to the United States. On the other hand, Beijing also feels that it has fallen victim to North Korea's nuclear ambitions, and has become growingly frustrated by its escalating provocations. China also fears that North Korea's nuclear program could encourage countries in the region, particularly Japan, to develop their own nuclear arsenals, which would be viewed as strategically threatening to China's national security. For now, we expect Beijing to cooperate with the U.S. administration to intensify pressure on North Korea. Already, China has supported the United Nations Security Council in imposing new sanctions on North Korea last week. Early this week, the Commerce Ministry announced a ban on imports of iron ore, iron, lead and coal from North Korea. These actions may have contributed to the softened tones from North Korea since, but it remains to be seen whether the impact will be long-lasting. The upshot is that the shared interests between China and the U.S. on various major global issues mean that the risk of an escalating trade war between the two countries should remain under control. For investors, bouts of geopolitical tension will likely bid up traditional safe-haven assets such as gold and the Swiss franc going forward. Another way to play the geopolitical risk is to short the Korean won (KRW) and long the Japanese yen (JPY). The KRW will obviously suffer devastating losses in even mild military skirmishes between the U.S. and North Korea, while the JPY may benefit from any "risk-off" unwinding of the yen carry trade. More importantly, economic fundamentals are not supportive of a stronger KRW, especially against the JPY, which means the downside risk in shorting the KRW/JPY is quite low, even without geopolitical considerations. Chart 3The Won Is Expensive Against The Yen The Won Is Expensive Against The Yen The Won Is Expensive Against The Yen The KRW is expensive against the JPY, based on a purchasing power parity (PPP) assessment (Chart 3). The 30% rally of KRW/JPY since 2012 has pushed it to an over two-sigma overshoot above its PPP fair value. Historically the won has rarely been sustainable at such elevated levels. Korea's economic outlook remains uninspiring. Capacity utilization has continued to decline, pricing power is weak, money growth is decelerating and real retail sales growth has stalled (Chart 4). Exports have been the bright spot in the overall growth picture, recovering strongly from last year's slump, but it is unrealistic to expect the export sector to continue to accelerate if growth numbers in China downshift. Softening exports will further weigh on Korea's growth outlook. In contrast, the latest growth numbers confirm that the Japanese economy has improved notably (Chart 5). Real GDP expanded by 1% in the second quarter compared with the previous three months, significantly beating expectations. While it remains to be seen whether Japan is able to maintain its regained momentum going forward, its growth gap with Korea has narrowed considerably of late, which will also lend support to the yen against its Korean counterpart. Chart 4Korea Growth Is Set To Moderate Korea Growth Is Set To Moderate Korea Growth Is Set To Moderate Chart 5Japan And Korea: Growth Gap Has Narrowed Japan And Korea: Growth Gap Has Narrowed Japan And Korea: Growth Gap Has Narrowed The bottom line is that geopolitical tensions in the Korean Peninsula will stay elevated. We are not changing our strategic views. So long as the situation does not degenerate into a significant military conflict that causes major economic damage, the geopolitical skirmishes should not have a material impact on both the broader growth outlook and financial markets. Investors may consider shorting the KRW/JPY as a hedge for geopolitical risks. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Reports, "China Outlook: A Mid-Year Revisit", dated July 13, 2017, and "Rising Odds Of PBoC Rate Hikes", dated July 20, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China: What Could Go Wrong?" dated August 3, 2017, available at cis.bcaresearch.com. 3 AmCham In China 2016 White Paper 4 Please see Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, available at gps.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights A number forward-looking indicators for EM corporate profits point to a major deceleration in the next several months, and potentially a contraction early next year. The most reliable forward-looking indicators for EM EPS have been EM/China narrow and broad money growth and they herald a bearish outlook for EM EPS. We continue deciphering the differences between China's various money and credit aggregates. Irrespective of which money measure we use, and regardless of their past track record, all of them are currently extremely weak and point to a major and imminent slump in China's growth in the next six to 12 months. We recommend shifting the underweight EM corporate and sovereign credit position versus U.S. high-yield to underweight versus U.S. investment-grade corporate credit. Feature Chart I-1Asian Exports And EM EPS Asian Exports And EM EPS Asian Exports And EM EPS The recovery in EM earnings per share (EPS) has been instrumental to the EM stock rally this year. As such, the equity strategy at the moment hinges on the outlook for corporate profits. In this report, we revisit coincident and leading indicators for EM profits. At the moment, EM corporate profit growth still appears robust, though several forward-looking indicators point to a major deceleration in the next several months, and potentially a contraction early next year. Korean and Taiwanese exports can be used as proxy for global trade. The latest data for July reveal that the sum of Taiwanese exports and Korean total exports excluding vessels has rolled over (Chart I-1). Historically, the U.S. dollar values of both economies' exports have correlated with EM EPS, and Chart I-1 entails that EM EPS growth will roll over very soon. The reason why we exclude vessel exports in the case of Korea is because vessel shipments are one-off occurrences and when they take place, they distort export growth. This was the case in the last several months - vessel (shipbuilding) exports surged by 75% from a year ago, distorting the annual growth rate of total exports. Overall, Korea's and Taiwan's overseas shipments in the past three months have averaged about 10%, which is lower than the mid-teen growth rates recorded earlier this year. In China, export growth is close to 9% in the past three months, and it is also rolling over. On a similar note, Korea's and Taiwanese shipments-to-inventory ratios lead EM EPS cycles, and they are presently sending a downbeat message (Chart I-2). China's import growth has relapsed, as suggested by both Chinese trade data and their counterparties export data to China (Chart I-3). Chart I-2Asia's Shipment-To-Inventory Ratios And EM EPS Asia's Shipment-To-Inventory Ratios And EM EPS Asia's Shipment-To-Inventory Ratios And EM EPS Chart I-3Exports To China And Chinese Imports Exports To China And Chinese Imports Exports To China And Chinese Imports The recovery in Chinese imports has been responsible for a considerable part of the recovery in global trade. Importantly, Chinese import cycles correlate very well with EM EPS growth (Chart I-4). The key pillar of our view remains that Chinese imports will contract going forward, which will depress both advanced and developing countries' shipments to China. Exports to China are much more important for EM than DM economies, and deteriorating sales to China will weigh considerably on EM profits and currencies. The most reliable forward-looking indicators for EM EPS have been EM/China narrow and broad money growth. Chart I-5A and Chart I-5B demonstrate that both EM narrow (M1) growth and China's broad money impulse (the second derivative) - herald a major slump in EM EPS. This is the main reason behind our negative stance on EM share prices and other risk assets. Chart I-4Chinese Imports And EM EPS Chinese Imports And EM EPS Chinese Imports And EM EPS Chart I-5AChina Broad Money Impulse And EM EPS EM Narrow Money And EM EPS EM Narrow Money And EM EPS Chart I-5BEM Narrow Money And EM EPS EM Narrow Money And EM EPS EM Narrow Money And EM EPS Both narrow and broad money growth in China have already relapsed, and it is a matter of time until economic growth and imports downshift enough to produce a major selloff in EM risk assets. We discuss China's monetary aggregates in the section below. Finally, if Chinese imports and commodities prices relapse, any reasonable strength in DM domestic demand will not be sufficient to preclude a meaningful EM slowdown. The basis is that exports to the U.S. and EU only make up 7% of GDP for China, 8% for Korea and 11% for Taiwan. While exports to China account for 10% of Korean GDP and 15% of Taiwanese GDP. The same holds true for most East Asian countries. With the exceptions of India and Turkey, non-Asian EM countries are primarily commodities producers. These two have their own idiosyncratic problems. Most of our analysis is not applicable to smaller central European economies that are leveraged to the EU business cycle. That said, neither Turkey, India, nor central European markets have large enough financial markets to make a difference in the EM benchmarks. The above is the primary reason behind our bearish view on EM growth and profits. That said, there are a few other interesting considerations regarding EM corporate profits dynamics. First, EM share prices lead EM EPS by six to nine months. Therefore, to be bullish on EM stocks, it is not sufficient to expect EM EPS growth to be robust over the next three months. Rather, to be bullish on EM stocks at the current juncture, one should have a bullish view on EM EPS by the end of this year and into the early part of 2018. Consistently, we believe that EM EPS growth will decelerate materially by the end of this year and shrink in the early part of 2018. Second, the top-line shrinkage in 2015 and the consequent recovery for EM exporters has been mostly driven by prices rather than volumes. Chart I-6A illustrate that Korean, Taiwanese and Chinese manufacturing production growth is rather muted. Chart I-6ACorporate Pricing Power Asian Manufacturing Production Asian Manufacturing Production Chart I-6BAsian Manufacturing Production Corporate Pricing Power Corporate Pricing Power Price fluctuations affect profits much more than output volume changes. Therefore, if global tradable goods prices deflate - at the moment they have rolled over (Chart I-6B) - EM EPS will contract materially. Third, in EM excluding China, Korea and Taiwan, there has been little economic recovery, as evidenced by Chart I-7. Along the same lines, the latest (July) manufacturing PMI for EM ex-China, Korea and Taiwan has dropped below the crucial 50 line (Chart I-7, bottom panel). This and the majority of other economic aggregates we use are equity market-cap weighted averages, so they are relevant to investors. This corroborates the fact that outside China, Korea and Taiwan there has been little genuine growth improvement in EM domestic demand - despite the decent recovery in global trade. This challenges the prevailing widespread consensus of a synchronized global economic recovery/expansion. This is also consistent with the fact that the overwhelming EM profit recovery has occurred in technology and resource sectors while domestic sectors have not seen much of corporate earnings recovery (Chart I-8). Chart I-7EM Ex-China, Korea And Taiwan: ##br##No Strong Recovery EM Ex-China, Korea And Taiwan: No Strong Recovery EM Ex-China, Korea And Taiwan: No Strong Recovery Chart I-8EM Sectors' EPS: Exporters ##br##Have Outperformed Domestic EM Sectors' EPS: Exporters Have Outperformed Domestic EM Sectors' EPS: Exporters Have Outperformed Domestic Finally, bottom-up equity analysts have recently downgraded their EPS estimates for listed EM companies (Chart I-9). Typically, analysts alter their forecasts simultaneously with swings in share prices. Hence, the latest decoupling is puzzling. Chart I-9EM EPS And Analysts' Net Revisions EM EPS And Analysts' Net Revisions EM EPS And Analysts' Net Revisions Notably, EM net EPS revisions have failed to move into positive territory in the past 7 years. This entails that analysts' expectations have been chronically high in recent years, and/or that companies have failed to deliver profits that match these projections. Bottom Line: The EM EPS outlook is downbeat, and listed companies profits will likely contract early next year. Deciphering China's Money Puzzle Based on our assessment of multiple measures, our conclusion with respect to Chinese broad money growth is as follows: Irrespective of which measure we use, and regardless of their individual past track records, all Chinese monetary growth aggregates are currently weak (Chart 10), and point to a major and imminent slump in China's growth in the next six to 12 months. In recent weeks, we have been working to understand differences among various measures of money growth in China. Our motivation is because neither M2 nor total social financing and fiscal spending - variables that we relied on last year - did a good job of forecasting the duration and magnitude of China's economic and profit revival in the past 12 months. In our July 26 report,1 we introduced the concept of broad money calculated using commercial banks' assets. We called it credit-money. This week, we discuss a different broad money calculation based on commercial banks' liabilities, and refer to it as deposit-money. Deposit-money is an aggregate of non-financial companies' time and demand deposits, household deposits, transferable and other deposits, other liabilities, bonds issued and liabilities to non-depository financial corporations. This measure is broader than official broad money (M2) because the latter includes only non-financial companies' time and demand deposits, household deposits and some of liabilities to non-depository financial corporations. In brief, our deposit-money calculation is more comprehensive than the official broad money figures (M2). In turn, banks' credit-money is the sum of commercial banks' claims on companies, households, non-bank financial institutions and all levels of government, as well as banks' foreign assets. Also, we deduct government deposits at the central bank (see July 26 Emerging Markets Strategy report1 for more details). Chart I-10 illustrates the differences between credit-money, deposit-money, total social financing and M2. Based on our calculations, deposit-money grew faster in 2015-'16 than both M2 and total social financing. Yet its current and ongoing slowdown is as bad as that of credit-money or M2. Chart I-10Dichotomy Among Various Money And Credit Aggregates In China Dichotomy Among Various Money And Credit Aggregates In China Dichotomy Among Various Money And Credit Aggregates In China The reason why M2 growth has lagged behind deposit-money growth since the middle of 2015 until now is the fact that the latter's components that are not included in the official M2 measure have outpaced M2 growth by a wide margin since late 2015. The main components of deposit-money are shown in Chart I-11. This is one of the main reasons why we missed the latest China-play rally - we relied on the official measure of money and credit published by the PBoC that has been much tamer than the broader money and credit, as banks have originated credit and hence money in a way that official monetary aggregates have not captured. In addition, banks' credit-money and deposit-money measures should theoretically be identical, but this has not been the case in China in recent years. Deposit-money is larger and it may well be more comprehensive than credit-money (Chart I-12). Chart I-11China: Components Of Deposit-Money Aggregate China: Components Of Deposit-Money Aggregate China: Components Of Deposit-Money Aggregate Chart I-12The Outstanding Stock And Flow Of Money The Outstanding Stock And Flow Of Money The Outstanding Stock And Flow Of Money Understanding these discrepancies is an ongoing work-in-progress for us, and we will be refining these measures going forward. For now, we would say that these differences are probably due to banks' efforts to misrepresent/hide their assets and liabilities to meet the regulatory ratios and avoid penalties, as well as maximize short-term profits. All that said, the gaps between M2 and deposit-money has recently narrowed: both deposit-money and M2 growth and their impulses are at all-time lows (Chart I-13). Furthermore, we expect deposit-money to slow further because of the lagged impact of higher interest rates and regulatory tightening that is intended to curb commercial banks' ability to originate more money via shadow banking activities. Finally, as can be seen from Chart I-14A, Chart I-14B and Chart I-15, deposit-money's impulse - its second derivative - leads many cyclical economic variables such as nominal GDP, producer prices, freight index, and imports. Chart I-13China: Two Measures Of Broad Money China: Two Measures Of Broad Money China: Two Measures Of Broad Money Chart I-14ADeposit-Money Leads Real Business Cycle Deposit-Money Leads Real Business Cycle Deposit-Money Leads Real Business Cycle Chart I-14BDeposit-Money Leads Real Business Cycle Deposit-Money Leads Real Business Cycle Deposit-Money Leads Real Business Cycle There are several other data points from China's real economy that portend developing weakness. Specifically, car sales growth has almost ground to a halt, real estate floor space sold and started are decelerating (Chart I-16). Chart I-15Deposit-Money Leads Metals Prices And Construction Deposit-Money Leads Metals Prices And Construction Deposit-Money Leads Metals Prices And Construction Chart I-16China: More Signs Of Slowdown China: More Signs Of Slowdown China: More Signs Of Slowdown Bottom Line: Regardless of which money measure we use, and regardless of their past track record, all of them are currently weak and point to a major and imminent slump in China's growth in the next six to 12 months. This gives us confidence in reiterating our negative view on China plays (including commodities) and EM. Credit Markets Strategy We have been recommending a strategy of shorting/underweighting EM sovereign and corporate credit versus U.S. high-yield (HY) credit and this strategy has shown strong performance, producing 15% gains with low volatility since August 2011 (Chart I-17). However, today we recommend shifting the underweight EM corporate and sovereign credit position from U.S. HY to U.S. investment grade (IG) corporate credit. The primary reason is that credit spreads are extremely tight and odds favor credit spreads widening in both U.S. and EM. Chart I-18 shows that when U.S. TIPS yields rise U.S. IG usually outperforms U.S. HY on an excess return basis. We expect U.S. Treasurys and TIPS yields to grind higher in the near term because U.S. growth and inflation are much stronger than the bond market is currently pricing in. Chart I-17Book Gains On This Strategy Book Gains On This Strategy Book Gains On This Strategy Chart I-18Higher U.S. Bond (TIPS) Yields Warrant Rotation Higher U.S. Bond (TIPS) Yields Warrant Rotation Higher U.S. Bond (TIPS) Yields Warrant Rotation Rising U.S. bond yields also warrants EM credit underperformance versus U.S. IG because the EM credit benchmark is riskier than U.S. IG. While the two segments have similar durations, the duration times spread measure of risk is greater for EM credit. Furthermore, U.S. HY spreads have narrowed versus both EM sovereign and corporate spreads since early 2016 (Chart I-19, top panel). Hence, there is little value favoring the former versus EM credit. In contrast, U.S. IG spreads versus both EM sovereign and corporate credit are appealing historically (Chart I-19, bottom panel). Therefore, there is a valuation aspect to this strategy change. Relative spread differences have historically correlated quite well with the subsequent 12-month return. Given where relative spreads are, the subsequent 12-month return for investing in U.S. IG relative EM credit is positive (Chart I-20, top panel) but it is negative for investing in U.S. HY versus EM credit (Chart I-20, bottom panel). Chart I-19EM Credit Offers Value Relative ##br##To U.S. HY But Not Versus U.S. IG EM Credit Offers Value Relative To U.S. HY But Not Versus U.S. IG EM Credit Offers Value Relative To U.S. HY But Not Versus U.S. IG Chart I-20Projected Returns Of EM Credit ##br##To Both U.S. IG And HY Projected Returns Of EM Credit To Both U.S. IG And HY Projected Returns Of EM Credit To Both U.S. IG And HY As to the rationale of favoring U.S. credit to EM credit, this is consistent with our theme that the growth outlook, corporate leverage, and health of the banking system are in much better shape in the U.S. than in EM. Bottom Line: Book profits on the short EM sovereign and corporate credit / long U.S. HY credit position. Institute a new position: short EM sovereign and corporate credit / long U.S. IG corporate credit. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report, titled "Follow The Money, Not The Crowd", dated July 26, 2017, link available on page 18. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The bottom in the dollar will have to wait for clearer signs that U.S. inflation has hit a trough. DXY is unlikely to punch below its May 2016 low. We examine balance of payments dynamics across the G10. This analysis shows that while the euro has long-term upside, it is too early to bet on any move above 1.20. The Japanese balance of payment dynamics will deteriorate as the BoJ keeps pressing on the gas pedal. Markets will have to price out rate hikes from the U.K. Feature Our most recent attempt at selling EUR/USD ended promptly in failure, as the euro is currently supported by a perfect storm of factors, making the timing of a reversal of its powerful bull run a tricky exercise. On the one hand, European politics continue to enjoy a re-rating among investors. As 2017 began, observers were worried that France was about to fall under the control of populists - euro-skeptic politicians like Marine Le Pen. This could well have spelled the end of the euro. Instead, the French electorate delivered a pro-market outcome with Emmanuel Macron clinching the keys to the Elysée Palace, and his centrist, pro-reform party now controlling Parliament. Meanwhile, German politics remain steady, and the Italian political risk has been pushed back to 2018. On the other hand, investors started the year expecting a hyperactive Trump presidency that would deliver de-regulation and tax reforms. Instead, the U.S. has a Twitterer-in-Chief and a chaotic White House that has been able to only achieve political paralysis. While political developments have grabbed the most headlines, economics have played an even more crucial role. Most importantly, inflation dynamics have been at the crux of the euro's rally. Namely, U.S. inflation has been a big source of disappointment, as the core PCE deflator has fallen from 1.9% in late 2016 to 1.5% today - a move away from the Federal Reserve's 2% target. As a result, the dollar and interest rates have moved away from discounting the Fed's path as implied by the "dot plot" (Chart I-1). However, our work on capacity utilization and financial conditions highlights that the U.S. inflation slowdown has been a reflection of the lagged impact of massive financial tightening in late 2014, and subsequent deceleration in economic activity. In fact, improvements in both capacity utilization and financial conditions witnessed since then point to a turnaround in inflation this fall (Chart I-2). Chart I-1Downward Move In Inflation Rate Expectations Downward Move In Inflation Rate Expectations Downward Move In Inflation Rate Expectations Chart I-2U.S. Inflation To Trough Soon U.S. Inflation To Trough Soon U.S. Inflation To Trough Soon What should investors do in the meantime? The market will only believe the Fed's hiking intensions once inflation rears its head again. After so many false starts and disappointments, signs that inflation might be coming will not be enough, as narratives of a near-permanent state of zero percent inflation are taking hold of the general discourse. Because investors have purged their excess dollar longs and are now heavily positioned for a euro rally, the dollar downside is currently limited, and a significant breach below the May 5, 2016 low in the DXY is unlikely. However, the dollar-rebound camp will have to wait for clear evidence that U.S. inflation is exiting its doldrums. This is a story for the fall. A Look At Balance-Of-Payments Dynamics The U.S. Chart I-3U.S. Balance Of Payments U.S. Balance Of Payments U.S. Balance Of Payments The U.S. current account deficit has been hovering below -2% of GDP for most of the post-great-financial-crisis period, and therefore has played little to no role in explaining the dollar's moves since 2011. However, the U.S. basic balance (current account plus net foreign direct investments) registered a sharp improvement in 2015 on the back of a surge in net FDI into the U.S. Despite a small pullback in the past 18 months, the U.S. basic balance remains consistent with levels recorded during the dollar bull market of the 1990s (Chart I-3). Portfolio flows in the U.S. have moved back into positive territory after a period of net outflows in 2015 and 2016. Yet, the total amount of net portfolio flows remains very low by historical standards, suggesting investors have not wagered aggressively on the U.S. economy's outperformance. Together, the aggregate U.S. balance-of-payment paints a neutral picture for the U.S. The deep imbalances in the current account and basic balance that prevailed prior to the financial crisis have been purged, but portfolio flows into the U.S. do not show any excessive optimism. In fact, the recent period of dollar weakness will likely help the U.S. balance of payments: It should support the trade balance, and make FDI and portfolio flows more attractive going forward as easing U.S. financial conditions help economic activity and asset returns. The Euro Area Chart I-4Euro Area Balance Of Payments Euro Area Balance Of Payments Euro Area Balance Of Payments Since the euro area crisis, the region's current account has surged to a very large surplus of 3.5% of GDP (Chart I-4). This mostly reflects a large correction of imbalances in peripheral nations. Countries like Spain and Italy have seen their own current account balances morph from deficits of 10.2% of GDP and 3.8% of GDP in 2008 and 2011, respectively, to surpluses of 1.9% of GDP and 2.7% of GDP today. The large contraction in imports on the back of moribund domestic demand has been the key driver of this phenomenon. The euro area remains an exporter of FDIs, experiencing near-constant outflows since 2004. As a result, the euro area's basic balance has not experienced as pronounced an improvement as the current account. It is still nonetheless in surplus - something that did not prevent EUR/USD from experiencing a 25% decline from June 2014 to March 2015. Net portfolio flows in the euro area have moved into deeply negative territory, reflecting massive outflows from the bond market. European investors have also been avid buyers of foreign equities, despite the recent increase in foreign buying of euro area stocks. In aggregate, we would interpret the current balance-of-payments dynamic in Europe as potentially supportive of the euro down the line. Aggregate portfolio flows are so depressed that there is a greater likelihood they will improve than deteriorate. However, while the basic balance and portfolio flows bottomed in 2000, the euro was not able to rally durably until 2002. Together, this suggests the euro is unlikely to re-test parity this cycle, but could remain capped below 1.20 for a few more quarters. Japan Chart I-5Japan Balance Of Payments Japan Balance Of Payments Japan Balance Of Payments Thanks to large investment income emanating from a net international investment position of 62% of GDP, Japan sports a current account surplus 2.5% of GDP greater than its trade balance. However, as the country continues to export capital abroad, it still carries a 3.1%-of-GDP deficit in terms of net FDI. This means that the Japanese basic balance of payments remains around 0% of GDP (Chart I-5). Meanwhile, net portfolio flows into Japan have improved greatly in 2017, explaining the yen's strength this year. While we see more upside for equity inflows into Japan, the efforts by the Bank of Japan to suppress JGB yields are likely to result into continued outflows on the fixed-income front. Since BCA is calling for higher global bond yields, fixed income portfolio outflows are likely to grow bigger, making the recent improvement in the Japanese balance of payments a fleeting phenomenon. This will weigh on the yen. We continue to expect the JPY to be one of the worst-performing currencies over the next 12-18 months. The U.K. Chart I-6U.K. Balance Of Payments U.K. Balance Of Payments U.K. Balance Of Payments Financing the U.K.'s current account deficit of 4% of GDP has taken center stage in the wake of the Brexit vote last year. However, while the trade-weighted pound has depreciated 12% since then, the British basic balance of payments has improved and moved back into positive territory. Net FDI inflows lie behind this stunning development. FDI into the U.K. has been surging since 2016 (Chart I-6). However, the recent slowdown in M&A deals into the U.K. points to a potential end for this GBP support. The key costs of controlling the free movement of people in the U.K. - a demand of Brexit voters - will be the loss of passporting rights for the financial services sector. Since this sector has been the biggest magnet for FDI in the U.K., net FDI could soon become a drag on the basic balance of payments. In contrast to FDI, net portfolio flows into the U.K. have followed the anticipated post-Brexit script, falling from 5% of GDP in Q2 2016 to zero earlier this year. This development was the biggest contributor to the pound's weakness last year. Going forward, the case for the Bank of England to turn hawkish is likely to dissipate as the inflation pass-through from the weak pound dissipates (see below). For the pound to rally further, a continued expansion in global liquidity will be necessary. However, we anticipate global liquidity to deteriorate for the remainder of 2017 as the Fed begins the runoff of its balance sheet, and the PBoC keeps tightening the screws on the bubbly Chinese real estate market. Hence, we would position ourselves for pound weakness against the USD in the second half of 2017. Canada Chart I-7Canada Balance Of Payments Canada Balance Of Payments Canada Balance Of Payments Canada runs a current account deficit of 3% of GDP. This is not a new development. Canada has been running a current account deficit since 2009 (Chart I-7), as weakness in the CAD from 2011 to 2016 was counterbalanced by weak export growth to the U.S. and poor oil prices. From a balance-of-payment perspective, the capacity of the CAD to rally may be limited. A surge in FDI to boost the basic balance of payments is unlikely. In 2001, the Canadian dollar was much cheaper than at present, and the impact of the tech bubble was still influencing M&A inflows into the country. In 2008, oil was trading near US$150/bbl. Today, Canada is a high-cost oil producer in a world of cheap oil, making Canadian oil plays unattractive, at least much more so than in 2007-2008. Additionally, net portfolio inflows into the country are already at near-record high levels, explaining the strong performance of the CAD since January 2016. However, going forward, oil prices are unlikely to double once more, and the combination of elevated Canadian indebtedness along with bubbly house prices and rising interest rates will create headwinds for the Canadian economy. Such an outcome would hurt expected returns on Canadian assets, and thus portfolio flows. However, if the hole in Canadian banks' balance sheets proves much bigger than BCA anticipates, this could prompt a repatriation of funds held abroad by banks - assets that currently equal nearly 50% of their balance sheets, temporarily helping the CAD. Australia Chart I-8Australia Balance Of Payments Australia Balance Of Payments Australia Balance Of Payments While the Australian trade balance has moved back in positive territory, the current account remains in deficit, burdened with negative international incomes associated with a negative net international investment position of -60% of GDP. Yet, because the current account has nonetheless improved, the Australian basic balance of payments is back in positive territory, as net FDI inflows have remained steady around 4% of GDP (Chart I-8). From a balance-of-payments perspective, the Australian dollar looks good. The current account balance is likely to remain well supported as the capex needs of Western Australia have decreased - exerting downward pressure on imports - but new mines are coming online and generating revenues and exports. Meanwhile, portfolio flows in Australia are quite depressed, suggesting some long-term upside as investors seem to be underweight Australian assets. That being said, the Aussie is currently trading at 12% above its long-term fair value. Moreover, any tightening in global liquidity thanks to the Fed and the PBoC could increase the cost of financing Australia's large negative net international investment position, and cause a last down leg in metals prices and the AUD. New Zealand Chart I-9New Zealand Balance Of Payments New Zealand Balance Of Payments New Zealand Balance Of Payments New Zealand's current account has been stable at around -3% of GDP since 2010. While New Zealand has been a constant magnet for FDI (Chart I-9), the positive balance in this account has not been able to lift the national basic balance of payments above the zero line. Interestingly, despite still-higher interest rates offered by New Zealand compared to the rest of the G10, the kiwi has been experiencing net portfolio outflows so far this year, potentially explaining why NZD/USD has not been able to break out like AUD/USD. Balance-of-payment dynamics looks supportive for the AUD relative to the NZD, as Australia runs a positive basic balance while New Zealand does not. Additionally, while Australian portfolio flows are very depressed, New Zealand's could suffer more downside. Mitigating these positives for AUD/NZD, the New Zealand economy is much stronger than that of Australia, and the Reserve Bank of New Zealand is in much better position to increase rates than the Reserve Bank of Australia is.1 Switzerland Chart I-10Switzerland Balance Of Payments Switzerland Balance Of Payments Switzerland Balance Of Payments The Swiss franc may be expensive relative to its purchasing power parity, and it may also be contributing to the country's strong deflationary tendencies, but it does not seem to be hampering its international competitiveness. The Swiss trade balance is at a massive 6% of GDP. Additionally, thanks to the international income generated by Switzerland's gigantic net international investment position of 127% of GDP, the country runs an incredible current account surplus of around 11% of GDP (Chart I-10). Being a nation with a steady current account surplus, Switzerland re-exports much capital abroad, generating a nearly permanent deficit in its net FDI account. However, this deficit is not enough to generate a basic balance-of-payments deficit. Instead, the BBoP still stands at 6% of GDP, creating a long-term support for the CHF. In terms of portfolio flows, Switzerland has historically run a deficit, reflecting its status as a capital exporter. Only at the height of the euro area crisis did Switzerland experience net portfolio inflows. Today, portfolio flows continue to leave the country, albeit at a slower pace than before the euro area crisis. Over the next 12 months, the CHF is likely to experience continued downside against both the euro and the USD, as the Swiss National Bank remains steadfast in its fight against domestic deflationary forces. However, from a long-term perspective, Switzerland will continue to run a balance-of-payments surplus that will support the structural upward trend in the real trade-weighted CHF. Sweden Chart I-11Sweden Balance Of Payments Sweden Balance Of Payments Sweden Balance Of Payments The Swedish trade balance recently moved into deficit territory, but the nation's current account remains in a healthy surplus of more than 4% of GDP, reflecting large amounts foreign income extracted by Sweden's thanks to its large amount of assets held abroad - a legacy of decades of current account surpluses. The net FDI balance has recently moved into positive territory, as Sweden possesses some of the strongest long-term economic fundamentals in Western Europe. Thanks to this development, the basic balance of the largest Nordic economy is at its highest level in eight years (Chart I-11), representing a long-term positive for the cheap SEK. Finally, portfolio flows into Sweden are at a neutral level. However, we expect the Riksbank to begin increasing rates early next year, putting it well ahead of its European peers. This should result in growing inflows into the country, supporting the SEK, at least against the EUR and the GBP. Norway Chart I-12Norway Balance Of Payments Norway Balance Of Payments Norway Balance Of Payments Due to the collapse in oil prices since 2014, the Norwegian trade surplus has melted from a gargantuan 15% of GDP to a more modest 5% of GDP (Chart I-12). However, falling oil prices and North-Sea production have also resulted in a collapse of FDIs into the country. Because of these developments, the Norwegian basic balance of payments has fallen into deficit for the first time in more than 20 years. This combination could explain why the NOK has been trading at its deepest discount to long-term fair value in decades. Ultimately, the constantly positive BBoP has historically been one of the key drivers of the krone. Without this support, since the Norges Bank stands among the most dovish central banks in the G10, the NOK does need a greater-than-normal discount. Norway too has historically experienced net portfolio outflows, also a consequence of its massive current account surplus. Thus, we do not read today's relatively small portfolio outflows as a positive. Instead, they simply reflect the deterioration in the current account and basic balance. Putting it all together, while balance-of-payment dynamics do explain why the NOK is trading at a historically large discount to fair value, we remain positive on this currency relative to the euro. When all is said and done, even accounting for these exceptional factors, the NOK is too cheap. Additionally, BCA does expect oil prices to move back toward US$60/bbl, which should help move the basic balance back into positive territory. Bottom Line: Balance-of-payment dynamics rarely have much impact on G10 currencies in the short run. However, in the long run, they can become paramount. Using this framework, while the USD could experience some upside in the next 12 months or so, any such upside is likely to mark the last hurrah of the bull market: the U.S. balance of payments is relatively neutral, but Europe's is currently excessively handicapped by extremely depressed portfolio flows. This latter situation is likely to be reversed in the coming years. The yen balance-of-payment dynamics will become increasingly tenuous if the BoJ continues on its current policy path. Among commodity currencies, the AUD has the best long-term profile in terms of balance-of-payment dynamics. Finally, the SNB faces a Herculean task: While it is currently keeping the CHF at bay in order to alleviate deflationary tendencies in Switzerland, the country's perennially strong balance of payment will ultimately prove too great a hurdle to overcome. The CHF could overtake the yen as the true risk-off currency of the world in future. BoE Is Stuck With Low Rates For Now In our January 13 Special Report titled, "GBP: Dismal Expectations,"2 we discussed why fears of any calamity that Brexit could bring to the British economy was overdone, and thus why buying the pound was an attractive opportunity. So far, our view has been validated, as cable has rallied by almost 8%. However, although we stand by our analysis on a cyclical horizon, a tactical selloff in the pound may be due. At the beginning of the year, the U.K. economy outperformed almost every forecast. Since then, expectations have risen along with the pound, but the British economy has shifted from star performer to disappointment (Chart I-13). For example, house price growth has collapsed to levels not seen since the euro area crisis (Chart I-14, top panel). Furthermore, the rapid rise in inflation has also caused a contraction in real disposable income comparable to that of 2012 (Chart I-14, bottom panel). Chart I-13Shift In U.K. Surprises Shift In U.K. Surprises Shift In U.K. Surprises Chart I-14Cracks In The U.K. Cracks In The U.K. Cracks In The U.K. Rate expectations have become too lofty. After the 2016 collapse in the pound, both headline and core inflation rose above the BoE's target. Consequently, rate expectations spiked, particularly after three MPC members voted for hikes. But can this rate of inflation continue? Looking at individual components of inflation, it is clear that the pound selloff was an important culprit behind the inflation surge. Thus, as the pass-through from the currency dissipates, inflation will also subside (Chart I-15). Falling inflation and weaker growth are already forcing the BoE to retreat from its relative hawkishness. Yesterday, as the "Old Lady" curtailed both its growth and wage forecast for 2017 and 2018, only two members voted for a hike. Political dynamics have also supported cable so far this year. Today, the U.K. policy uncertainty index is at par with that of the U.S. as the Trump White House continues to be in disarray, and the outlook for tax reform and/or infrastructure spending looks grim (Chart I-16). But the U.S. is not the country engaging in its most contentious and significant treaty negotiation in 50 years. Instead, the U.K. is this country, with a weakened government at its helm following its recent electoral debacle. Thus, we would expect a reversal of the currently pro-pound relative political uncertainty indexes, as Brexit negotiations heat up in the coming quarters. Chart I-15U.K. Inflation Is Peaking U.K. Inflation Is Peaking U.K. Inflation Is Peaking Chart I-16Does Trump Really Trump Brexit? Does Trump Really Trump Brexit? Does Trump Really Trump Brexit? While policy and political considerations are likely to hurt the pound this fall, for GBP/USD to correct, a fall in the euro will be needed as well. In the meantime, investors may look to continue to buy EUR/GBP. Since July 7th, we have been anticipating this cross to hit the 0.93 level. This analysis confirms this view. Bottom Line: The U.K. economy should be able to weather its exit from the European Union. This should help the pound on a cyclical horizon. However, the pound has become overbought and interest rate expectations are too elevated, as the market has forgotten that a price still has to be paid for Brexit. GBP/USD is too dependent on the EUR/USD dynamics to short cable outright right now. As such, investors may keep buying EUR/GBP for now, and look to sell GBP/USD near 1.33. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Juan Manuel Correa, Research Analyst juanc@bcaresearch.com 1 Please see Foreign Exchange Strategy and Global Alpha Sector Strategy Special Report titled, "Who Hikes Next?", dated June 30, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report titled "GBP: Dismal Expectations", dated January 13, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The U.S. has shown some signs of strength this week, however the data remains mixed: Both headline PCE and core PCE beat expectations, coming in at 1.4% and 1.5% respectively; While the headline ISM manufacturing number weakened, the Price Paid component rebounded to 62. Initial jobless claims beat expectations by 2,000; however, continuing claims underperformed; Factory orders improved on a monthly basis. While the U.S. is still in an inflation slump, we believe that inflation is close to bottoming out. The depreciation in the greenback and the rally in risk assets have greatly eased financial conditions, creating support for the economy. This should push the greenback up as the markets begin to reprice Fed hikes. Report Links: Who Hikes Next? - June 30, 2017 Look Ahead, Not Back - June 9, 2017 Capacity Explosion = Inflation Implosion - June 2, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Euro appreciation has continued. While the general tone of data remains strong, some leading indicators are showing early cracks: Unemployment, a lagging indicator, decreased to 9.1%, outperforming expectations; Headline inflation remained steady at 1.3%, however core inflation increased to 1.2%; GDP numbers came in as expected, growing at a 0.6% quarterly rate, and a 2.1% annual rate; However, German and EMU Markit Manufacturing PMIs both underperformed expectations. Momentum is on the euro's side, which traded above 1.19 on Wednesday. The euro area owes much of its economic growth to the 25% depreciation since mid-2014. While data has surprised to the upside, the ECB remains the central bank of the peripheries, where inflation has failed to emerge as strongly. Rate differentials will weigh on the euro towards the end of the year, but momentum could continue to push the euro up in the coming weeks. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Japanese data came in positive: Overall household spending yearly growth came in above expectations at 2.3% Japan's job-to-applicants ratio came in at 1.51. Above expectations and growing from the previous month. The unemployment rate fell to 2.8%, coming in below expectations of 3%. These two last data points are important, as they show that the Japanese labor market is getting increasingly tight. However, as evidenced by the last 2 years, inflation will not be able to rise sustainably without a depreciating yen, even if the labor market is tight. Thus, the recent selloff in USD/JPY will only incentivize authorities to remain very accommodative while other central banks are exiting maximum accommodation, reinforcing our negative cyclical view on the yen. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Updating Our Intermediate Timing Models - April 28, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Data in the U.K. was mixed this week: Both Markit Manufacturing and Markit Services PMI beat expectations coming in at 55.1 and 53.8 respectively. However both consumer credit and mortgage approvals fell from the previous month and underperformed expectations. Up to yesterday the pound had gained almost 2% during the week, however following the interest rate decision by the BoE, the pound fell by roughly 1%. The reason for this fall, was that the BoE is becoming less hawkish. Not only did the number of MPC members voting for a hike decrease from 3 to 2, but the bank also lowered its forecast for growth and wages. We believe this will start a trend toward a less hawkish BoE, which will weigh on the pound on the short term. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Momentum is showing signs of topping out. The MACD is rolling over, and is converging with the Signal line; and the RSI is weakening from deeply overbought levels. This week, AUD has displayed broad-based weaknesses. Despite one key blotch, data relevant to Australia has been good: TD Securities Inflation increased at a 2.7% rate in July; Chinese Caixin Manufacturing PMI came out better than expected at 51.1; Building permits increased at a striking 10.9% monthly rate. They contracted at a 2.3% yearly pace, a sharp improvement over the the previous month's 18.7% contraction. However, the trade balance underperformed missed expectations by a large margin, coming in at AUD856mn, compared to the expected AUD1,800mn. The recent RBA statement highlighted that the recent appreciation in the Australian dollar "is expected to contribute to subdued price pressures", and "is weighing on the outlook for output and employment". This could add substantial pressure on the AUD in the near future. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Even as the dollar has fallen, the kiwi has depreciated by almost 1.4% this week, as New Zealand data has come in weak: Both the ANZ Activity outlook and the ANZ business confidence came in below the previous month reading at 40.3% and 19.4 respectively. The participation rate came below expectations at 70%. Meanwhile employment also came below expectations contracting by 0.2% Month-on-Month. Overall we continue to be bearish on commodity currencies in general and the kiwi in particular. Recently, the Chinese authorities have been getting tougher on credit excesses. This could be the trigger for a risk off period in emerging markets, which wouldweigh on the NZD. That being said, we are more bearish on AUD/NZD, as the kiwi economy is on much stronger footing than the Australian one. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The CAD has displayed some considerable broad-based weakness this week following weak data releases: Industrial Product Price contracted monthly by 1% in June; The Raw Material Price Index also contracted, at 3.7%; However, the Markit Manufacturing PMI saw an increase to 55.5 from 54.7. Markets have priced in a 75% probability of a hike by the end of this year by the BoC, compared to 42% for the Fed. Although we agree with the market's perception of the BoC, we disagree that the probability of the Fed hiking is this low. We therefore believe the CAD could correct further in the upcoming weeks. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been positive: The KOF leading indicator came at 106.8, beating expectations. Real retail sales grew by 1.5% year on year, increasing from last month number and beating expectations. The SVME Purchasing Manager Index came in very strong at 60.9, beating expectations and also increasing from last month's reading. While data was positive, EUR/CHF went vertical this week, rising by more than 3%. At this point EUR/CHF is the most overbought it has been in more than 4 years, and at least a small correction seems overdue. The SNB will be satisfied with a depreciating currency, as this dramatic fall should help ease deflationary pressures in the alpine country. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data has been mixed in Norway: The Labor forced survey, which measures unemployment, came in at 4.3% outperforming expectations of 4.5%. The above data point was confirmed by the registered unemployment reading, which also outperformed expectations, coming in at 2.8%. However retail sales contracted by 0.6% month-on-month. Even as the dollar continues to fall, USD/NOK has stayed relatively flat this week. Curiously this has also happened amid rising oil prices. Overall, we expect USD/NOK to rally in the fall, as the Norwegian economy remains tepid, and inflation is not likely to rise above target any time soon, while investors are still underestimating the Fed's will to push interest rates higher. That being said, we are bearish on EUR/NOK, as this cross trades as a mirror image of oil, and the OPEC deal should continue to remove excess supply from the market and push prices higher. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Sweden has been generating substantial inflationary pressures, and increasing economy activity is likely to support these pressures, hence the Riksbank's recent hawkishness. With China tightening policy, SEK strength could be a story of rate differentials going forward, appreciating against EUR, AUD, NZD and NOK, as the Riksbank is likely to become increasingly nervous in the face of rising inflationary pressures. However, as the market currently underprices the risk of a more hawkish Fed, the picture for USD/SEK is less clear. Report Links: Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The neutral real rate of interest, R*, is low in most economies, and will only rise gradually over the coming years. Currency movements tend to dampen differences in neutral rates across countries. The fact that R* is higher in the U.S. will limit further downside risk for the dollar. While a variety of structural forces will cap the increase in the neutral real rate, the neutral nominal rate could rise more briskly as inflation picks up. As such, investors should reduce duration risk and increase exposure to inflation-linked securities. We are closing our long GBP/JPY trade for a gain of 9.9% and opening a new trade going short EUR/GBP. EUR/USD will trade in a range of $1.10-to-$1.20 over the next 6-to-9 months before moving lower in the second half of next year. Feature Where Is Neutral? As the global economy continues to recover, central banks are increasingly turning to the question of how to best normalize monetary policy. A key issue in this debate concerns the level of the neutral real rate of interest, commonly referred to as R*. If central banks raise rates too far above the neutral rate, growth could stall. If they don't raise rates enough, inflation could accelerate. The concept of the neutral rate is somewhat difficult to grasp, and we apologize in advance that this report is more abstract than what we are normally accustomed to writing. However, we think that readers who stick with the logic of the piece will be well rewarded with the practical implications that it provides. A Conceptual Framework In thinking about the neutral rate, it is worthwhile to recall the familiar macro identity which states that the difference between what a country saves and what it invests is equal to its current account balance.1 Since one country's current account surplus is another's deficit, globally, the current account balance must equal zero. This, in turn, implies that globally, savings must equal investment. What happens when desired global savings exceed desired investment? The answer is that interest rates will fall.2 Lower rates will incentivize firms to undertake more investment projects, while discouraging household savings. Investment will rise and savings will decline by just enough to ensure that the global savings-investment identity is satisfied. The discussion above aptly captures what happened to the global economy after the financial crisis. The desire of households to boost savings and firms to cut capital spending led to a sharp and sustained drop in the neutral rate. Those who understood this point back in 2010, when the 10-year Treasury yield briefly hit 4%, made a lot of money by being long bonds when most others were fretting about the inflationary effects of QE and large government budget deficits. The Exchange Rate As A Mitigating Force The ability of countries to export their excess savings abroad by running current account surpluses implies that the neutral rate has a large global component. To appreciate this point, consider a simple thought experiment. Suppose the global trading system completely breaks down and every country ends up with a trade balance of zero. For the sake of argument, let us ignore the immense economic dislocations that this would cause and focus simply on the arithmetic impact that this would have on aggregate demand. The U.S. trade deficit currently stands at $567 billion (3% of GDP). Getting rid of it would add about six million jobs. This would likely cause the economy to overheat, forcing the Fed to raise rates. In contrast, the German economy would fall into a deep recession if its €224 billion (7.1% of GDP) trade surplus vanished. The ECB would not be able to raise rates for years. Thus, in the absence of trade, the neutral rate would be higher in the U.S. and lower in the euro area. This simple thought experiment illustrates why the neutral rate partly depends on the value of a country's currency.3 If a country's currency strengthens, all things equal, its neutral rate will fall. The extent to which the currency appreciates will depend on how long the forces causing neutral rates to diverge across countries are expected to persist. In general, if the forces are more structural than cyclical in nature, currencies will adjust to a greater degree (Chart 1).4 Chart 1The Longer The Interest Rate Gap Persists, The Bigger The Exchange Rate Overshoot The Future Of The Neutral Rate The Future Of The Neutral Rate The discussion above helps make sense of currency movements over the past three years. A key reason the dollar began to strengthen against the euro in the second half of 2014 is that investors became convinced that the neutral rate in the U.S. would exceed that of the euro area for a very long period of time. The rally in the euro this year largely reflects a reappraisal of that view. Stronger euro area growth has convinced many investors that the neutral rate in the region may not be as low as previously imagined. The Outlook For The Neutral Rate The savings-investment balance provides a useful framework for thinking about how the neutral rate will evolve over the coming years. With this framework in mind, let us consider the various forces affecting the neutral rate and how they might change over time. The Debt Supercycle Today, almost 60% of Americans want to save more money according to a recent Gallop poll; before the financial crisis, that number was less than 50% (Chart 2). A slower pace of debt accumulation implies less spending and more desired savings. It is possible that households will become more willing to take on debt as the memories of the Great Recession fade. However, a return to the reckless lending standards of the pre-crisis period is unlikely. Thus, while the end of the deleveraging cycle in the U.S. will push up R*, it will remain low by historic standards. Globally, efforts to reduce leverage have been more halting. In fact, in many emerging markets, debt levels are higher today than in 2008 (Chart 3). This will weigh on R*. Chart 2Return To Thrift Return To Thrift Return To Thrift Chart 3EM Debt At All-Time Highs EM Debt At All-Time Highs EM Debt At All-Time Highs The "Amazonification" Of The Economy Chart 4Savings Heavily Skewed Towards Top Earners Savings Heavily Skewed Towards Top Earners Savings Heavily Skewed Towards Top Earners Technological progress is nothing new, but unlike past inventions which typically replaced man with machine, many of today's innovations appear to be reducing the need for both labor and physical capital.5 Companies like Amazon are laying waste to America's retail sector. Uber and Airbnb are providing ways to use the existing stock of capital more efficiently. Fewer shopping malls, taxis, and hotels means less investment, and less investment means a lower neutral rate. Inequality One of the distinguishing features of the "Amazon economy" is that it is dominated by a few winner-take-all firms. This has generated huge payoffs for their owners, but paltry returns for everyone else. While this is not the only trend fueling income inequality, it has certainly exacerbated it. Rising inequality redistributes income from households that tend to live paycheck-to-paycheck to those who save a lot (Chart 4). This increases aggregate desired savings, leading to a lower neutral rate. However, rising inequality may also generate a political backlash. Donald Trump's ability to take over the Republican party was partly driven by the disillusionment of Republican voters over the GOP's pro-business positions on issues such as immigration and trade. Historically, populism has been associated with larger budget deficits. To the extent that budget deficits soak up savings, they lead to a higher neutral rate. Rising populism could also lead to stronger calls for anti-trust policies. Our sense is that we are slowly moving in this direction. Slower Population Growth Demographic shifts can be tricky to assess because they affect savings and investment in offsetting ways and over different time horizons (Chart 5). A decrease in the growth rate of the population will reduce the incentive to expand capacity. Less investment means a lower neutral rate. Slower population growth may also lead to higher savings for a while, as a larger fraction of the population enters its peak saving years (ages 30-to-50). This also means a lower neutral rate. Eventually, however, aging will push more of the population into retirement, increasing the number of people who are dissaving rather than saving. Rising government spending on health care and pensions could also lead to larger fiscal deficits, further depleting national savings. We may be approaching this outcome. Chart 6 shows that the global "support ratio" - defined as the number of workers relative to the number of consumers - has peaked globally and will start falling sharply over the coming years. Chart 5An Aging Population Eventually Pushes Up Interest Rates The Future Of The Neutral Rate The Future Of The Neutral Rate Chart 6The Ratio Of Workers To Consumers Have Peaked The Ratio Of Workers To Consumers Have Peaked The Ratio Of Workers To Consumers Have Peaked Slower Productivity Growth As with population growth, slower productivity growth is likely to depress R* at first, but could raise R* over time (Chart 7). Initially, slower productivity growth will prompt firms to curb investment spending. It could also lead to less consumer spending, as households react to the prospect of smaller gains in real incomes. All this implies a lower neutral rate. Eventually, however, chronically weak income growth is likely to deplete national savings, leading to a higher neutral rate. The U.S. and a number of other economies may be getting increasingly close to that inflection point (Chart 8). Chart 7A Decline In Productivity Growth Is Deflationary In The Short Run, But Inflationary In The Long Run The Future Of The Neutral Rate The Future Of The Neutral Rate Chart 8Weak Supply Growth Has Narrowed Output Gaps Weak Supply Growth Has Narrowed Output Gaps Weak Supply Growth Has Narrowed Output Gaps Lower Commodity Prices Swings in commodity prices may also generate offsetting pressures on the neutral rate that manifest themselves over different time horizons. At the outset, lower commodity prices tend to depress investment spending in the resource sector. This implies a lower neutral rate. Over time, however, lower commodity prices may generate new investment opportunities in downstream industries that use fuel as an input. Lower commodity prices also put money into the pockets of poorer households who are likely to spend it. This raises the neutral rate. Investment Implications Given the conflicting forces affecting R*, it is difficult to have much certainty over how it will evolve. Our best guess is that R* will increase over the next few years, as the scars from the financial crisis recede, deleveraging headwinds abate, fiscal deficits in some economies widen, and population aging and lower productivity growth make more of a dent in national savings. However, the rise in R* is likely to be gradual and from what is currently a very low base. Where we do have greater conviction is on two points: First, the neutral nominal rate will rise more quickly than the neutral real rate, as inflation picks up in most economies. As discussed last week, central banks have a strong incentive to try to engineer more inflation in situations where the economy needs a low real rate to maintain full employment.6 Getting inflation up has been a struggle ever since the financial crisis began, but now that spare capacity around the world is dissipating, central banks are likely to gain more traction over monetary policy. As such, investors should reduce duration risk and increase exposure to inflation-linked securities. Second, the forces pushing down R* outside the U.S. will remain more pronounced than those in the U.S. This, in turn, will provide some support to the beleaguered U.S. dollar. Investors, in particular, may be getting too optimistic about the ability of the ECB to engineer a full-fledged tightening cycle. The euro area is further behind the U.S. in the deleveraging process, suggesting that desired private-sector savings will remain higher there. The overall stance of fiscal policy is also much tighter in the euro area. The IMF estimates that the euro area's structural primary budget surplus currently stands at 0.7% of GDP, compared to a deficit of 1.9% in the U.S. Thus, fiscal policy is currently adding 2.6% of GDP more to aggregate demand in the U.S. than in the euro area. The Fund expects this relative contribution to increase to nearly 4% of GDP by the end of the decade (Chart 9). Furthermore, investment spending has more scope to fall in the euro area. According to the OECD, gross fixed capital formation is actually higher in the euro area than in the U.S. as a share of GDP, despite the fact that potential GDP growth is slower in the euro area (Chart 10). Chart 9Fiscal Policy Is More Stimulative In The U.S. The Future Of The Neutral Rate The Future Of The Neutral Rate Chart 10Euro Area Investment Spending: Higher Than In The U.S. Euro Area Investment Spending: Higher Than In The U.S. Euro Area Investment Spending: Higher Than In The U.S. The appreciation of the euro has led to a tightening in euro area financial conditions in recent weeks, whereas U.S. financial conditions have continued to ease (Chart 11). This will cause relative growth to shift back in favor of the U.S. later this year. Chart 11Diverging Financial Conditions##br## Favor U.S. Over The Euro Area Diverging Financial Conditions Favor U.S. Over The Euro Area Diverging Financial Conditions Favor U.S. Over The Euro Area Chart 12The Neutral Rate Is Lowest In The Euro Area The Neutral Rate Is Lowest In The Euro Area The Neutral Rate Is Lowest In The Euro Area The 30-year U.S. Treasury yield is currently 95 basis points higher than the 30-year GDP-weighted euro area government bond yield. This gap in yields does not strike us as being especially large considering that both the neutral rate and long-term inflation expectations are lower in the euro area. We expect EUR/USD to trade in a range of $1.10-to-$1.20 over the next 6-to-9 months before moving lower in the second half of 2018, by which time the Fed will be forced to pick up the pace of rate hikes. The resurgent euro has approached all-time highs against the pound, abetted by a somewhat more dovish-than-expected BoE meeting this week. Yet, with U.K. inflation above target and the unemployment rate at the lowest level since 1975, the Bank of England may need to deliver more than the mere 36 basis points in rate hikes the market is expecting over the next two years. Holston, Laubach and Williams estimate that R* is 1.6 percentage points higher in the U.K. than in the euro area (Chart 12). As such, the balance of risks now favor a stronger pound over a cyclical horizon of 12 months. With that in mind, we are closing our long GBP/JPY trade for a gain of 9.9% and opening a new short EUR/GBP position (Note: The returns of all closed trades are displayed at the back of this report). Peter Berezin, Global Chief Strategist Global Investment Strategy peterb@bcaresearch.com 1 The difference between what a country saves and what it invests is also equal to the difference between what it earns and what it spends. To see this, note that S=Y-C-G where S is national savings, Y is national income, C is personal consumption, and G is government spending. Hence, the identity S-I=CA can be re-written as Y-(C+G+I)=CA where CA is the current account balance. 2 An obvious question is what happens if desired savings exceed desired investment, but interest rates are already equal to zero. In that case, income will contract. Workers will lose their jobs, making it impossible for them to save. Firms will suffer lower profits or even incur losses in the face of flagging demand. Governments will see tax revenues dry up and spending on welfare programs escalate. This means that household, corporate, and government savings will all decline. Of course, since firms are likely to reduce investment in response to slower growth, this could usher in a vicious cycle where falling demand leads to higher unemployment and even less spending - in other words, a recession or even a depression. 3 Suppose, for example, that the interest rate in Country A were to rise above that of Country B for a period of say, ten years. Country A's currency would appreciate. This would reduce net exports in Country A, leading to a decline in aggregate demand. This, in turn, would prevent the neutral rate in Country A from rising as much as it otherwise would. On the flipside, the cheapening of Country B's currency would push up its neutral rate. 4 In the extreme case where the structural forces are expected to last forever, currencies will adjust to the point where the neutral rate across countries is equalized. Intuitively, this must happen because it is impossible for currency-hedged, risk-adjusted interest rates to be lower in one country than in another for an indefinite amount of time. 5 From a neoclassical economics perspective, one might imagine a "production function" that includes labor, physical capital, and digital capital. Many of today's innovations are raising the return on digital capital relative to those on labor and physical capital. This generates outsized rewards to the owners of this particular form of capital (i.e., internet companies), while potentially undercutting the income of workers and owners of physical capital. 6 Please see Global Investment Strategy Weekly Report, “A Secular Bottom In Inflation,” dated July 28, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Strengthening income growth is apparent in DM and EM trade volumes, real wages in the U.S., and industrial commodity prices, chiefly oil and copper. This indicates inflation at the consumer level will move higher in the near future, most likely in 2H2018. We believe 10-year U.S. Treasury Inflation-Indexed securities (TIPS) trading below 0.52 do not reflect the risk of higher inflation and are, therefore, going long at tonight's close. Energy: Overweight. Crude oil prices rallied 4.6% this week, following the OPEC 2.0 meeting in St. Petersburg. Although ministers did not announce additional cuts to the 1.8mm b/d agreed at the end of last year, Saudi Energy Minister Khalid al-Falih said the Kingdom would reduce August exports to 6.6mm b/d, which is more than 300k b/d below May's level, the latest month for which data are available from JODI. Given strong global demand, if this export reduction persists - and if others join the Kingdom - it would speed the drawdown in global inventories. Base Metals: Neutral. Copper pushed through $2.80/lb on the COMEX, a level not seen since May 2015. Underlying strength in EM economic activity - seen most recently in global trading activity (discussed below) - and a weaker USD are supporting base metals. Precious Metals: Neutral. Gold fell below $1,257/oz earlier this week, and was trading ~ $1,250/oz going to press Wednesday. We remain long gold as a portfolio hedge; the position is up 1.7% since it was initiated on May 4, 2017. Ags/Softs: Underweight. Harsh weather is impacting grains. The USDA rated 62% of the U.S. corn crop in the 18 states comprising 92% of total output good or excellent last week, down from 76% in 2016. For beans, the split was 58% last week vs. 71% last year. Feature The expansion in global trade that began toward the end of last year continues, which, based on our modeling, indicates inflation at the consumer level likely will move higher in the short run (Chart of the Week). Trade expansion, particularly in EM economies, is consistent with rising incomes, which, all else equal, will keep industrial commodities - oil and copper, in particular - well supported, given income and demand for these commodities are closely aligned.1 These fundamentals dovetail with other indications of stronger growth, particularly in DM economies, where trade volumes also are growing (Chart 2). In the U.S., for example, wage growth continues to outpace inflation, and monetary conditions remain benign (Chart 3). Our colleagues at BCA Research's Global Investment Strategy believe the Fed actually may be behind the curve in reacting to nascent inflationary pressures emerging in the U.S.2 Chart of the WeekRising EM Trade Volumes Consistent##BR##With Higher U.S. CPI Inflation Rising EM Trade Volumes Consistent With Higher U.S. CPI Inflation Rising EM Trade Volumes Consistent With Higher U.S. CPI Inflation Chart 2DM Trade Volumes Are Expanding##BR##At ~ 5% Pace ... DM Trade Volumes Are Expanding At ~ 5% Pace ... DM Trade Volumes Are Expanding At ~ 5% Pace ... Chart 3U.S. Labor Market Tightening,##BR##Financial Conditions Remain Loose U.S. Labor Market Tightening, Financial Conditions Remain Loose U.S. Labor Market Tightening, Financial Conditions Remain Loose Trade Growth Supports Higher Inflation U.S. CPI is highly correlated with EM trade volumes (imports and exports) as shown in the Chart of the Week. In recent research into inflation and trade, we also showed EM oil demand and world base metals demand are highly correlated with EM trade volumes.3 Chart 4EM Trade Volumes##BR##Continue To Strengthen Growth EM Trade Volumes Continue To Strengthen Growth EM Trade Volumes Continue To Strengthen Growth EM import growth continues to expand at a faster pace than DM growth (Chart 4). Year-on-year (yoy) EM import growth came in at 7.7%, a full 2 percentage points above DM growth. This is not to minimize DM growth - it finally broke out of its lethargy in May with a sharp advance of close to 6%, which will lift the trend rate of growth (the 12-month moving average, or 12mma) higher going forward. EM export growth in May was only slightly above DM growth for the month - 5.4% yoy vs. 5.2% yoy. These stout monthly trade performances will, in the next few months, offset the lethargic growth seen in EM and DM prior to the expansion begun at the end of 2016, as weaker monthly performance falls off the trend calculations. Over the year ended in May, within EM markets the annual trend in imports (the 12mma to May 2017) has barely grown more than 1% yoy, dragged down by a 6% contraction in the Middle East and Africa (MEA) and a 2.1% contraction in Latin American growth. The trend in EM - Asia's imports is up, rising 3.2% over the same period. For the year ended in May, imports into central and Eastern Europe were mostly flat; however, since November 2016, the trend turned sharply positive with 3.3% yoy growth. The trend in export volumes is expanding for in MEA and Latin America economies - 3.5% yoy trend growth (12mma) in MEA, and 4.4% growth in Latin America, which is slightly higher than the overall 2.2% rate of trend growth in EM exports. Still, lower oil and commodity prices, along with reduced volumes are curtailing an income recovery in these regions. Central and Eastern Europe's rate of export expansion leads EM generally at close to 4% yoy trend growth. Favor Gold And TIPS Ahead Of Higher Inflation As the labor market tightens and real-wage growth continues to outpace productivity growth, we expect U.S. inflation to pick up. Growth in trade volumes also will support growth in EM oil demand and world base metal demand, as noted above. This will feed into U.S. core PCE, the Fed's preferred inflation gauge (Chart 5). As we've highlighted in the past, there is very strong co-movement among these variables: We've found that, all else equal, a 1% increase in the non-OECD oil demand implies an increase in the core PCE of slightly less than 50bp. If the trend in overall EM trade volumes persists, the likelihood we will be increasing our estimate of non-OECD oil consumption for 2H17 and 2018 increases. U.S. CPI and EM trade volumes show similar co-movement properties, as the Chart of the Week shows. A 1% increase in EM import volumes translates into a 0.53% increase in the U.S. CPI, while a 1% increase in EM export volumes implies a 0.49% increase in the CPI. EM import volumes over the January - May 2017 interval have been growing at slightly more than 8% yoy, while exports have been growing at slightly more than 3%. Continued strength in the EM trade data implies U.S. CPI could grow well above what's currently being priced in inflation markets and by Fed policymakers. This leads us to favour gold and TIPS as inflation hedges. If we do get a larger-than-expected move in the U.S. CPI, gold should respond well. The modelling depicted in Chart 6 shows a 1% increase in the CPI translates into a 4.1% increase in gold. Chart 5Core PCE Will Pick Up##BR##As Commodity Demand Grows Core PCE Will Pick Up As Commodity Demand Grows Core PCE Will Pick Up As Commodity Demand Grows Chart 6Gold Will Pick Up##BR##Larger-Than-Expected CPI Moves Gold Will Pick Up Larger-Than-Expected CPI Moves Gold Will Pick Up Larger-Than-Expected CPI Moves For this reason we recommend getting long U.S. Treasury Inflation-Protected Securities (TIPS), which will appreciate as the U.S. CPI moves higher.4 We will be getting long as of tonight's close. We remain long low-risk calls spreads in Dec/17 WTI and Brent - long $50/bbl strikes vs. short $55/bbl strikes. We are up 39.3% and 32.9% on the Brent and WTI positions, respectively, from last week, and 47.2% and 89.2% since inception. U.S. Monetary Policy Remains A Huge Risk To EM Trade As we've noted in the past, U.S. monetary policy can have an outsized effect on EM trade volumes. In an update of an earlier model using U.S. M2 and the broad trade-weighted USD (TWIB), we find a 1% increase in the broad trade-weighted USD translates into a 1.1% drop in EM imports, while a 1% increase in U.S. M2 (broad money) implies an 85bp increase in EM imports (Chart 7).5 Chart 7EM Trade Volumes Highly Sensitive##BR##To U.S. Monetary Policy EM Trade Volumes Highly Sensitive To U.S. Monetary Policy EM Trade Volumes Highly Sensitive To U.S. Monetary Policy This demonstrates the feedback loop we've identified between U.S. monetary policy and EM trade. EM trade volumes affect inflation at a global level. We've found inflation in the U.S., EU and China to be co-integrated - i.e., these price gauges all follow the same long-term trend. Inflation and inflation expectations drive Fed policy, which drives the price formation of the USD - i.e., the FX rates included in the USD TWIB - and affect Fed policy on M2. These U.S. monetary variables, in turn, affect EM trade volumes. And so it goes ... Too-aggressive a tightening by the Fed as it normalizes its interest-rate policy regime could destabilize EM economies - either via too-sharp an appreciation in the USD TWIB, a larger-than-expected deceleration in M2 growth, or both - and negatively affect trade flows. At the end of the day, this would redound to the detriment of the U.S. economy, as the different feedback mechanisms kick in. This says the Fed's policy doesn't just affect the U.S. economy, or that EM economies essentially are on their own in the policy tools they deploy to adjust to Fed innovations. Like it or not, the Fed has to consider these types of feedback loops in its decision-making, since the Open Market Committee will be dealing with the fallout of its earlier policies. Bottom Line: EM trade volumes continue to grow yoy, continuing the trend that began at the end of last year. This performance, coupled with a tightening labor market in the U.S. and a still-loose financial backdrop, raises the odds inflation will exceed what's currently priced into market and Fed expectations. We are getting long U.S. 10-year TIPS at tonight's close, and remain long gold as a strategic portfolio hedge. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 The income elasticity for industrial commodities in EM economies is ~ 1.0, according to the OECD. Please see "The Price of Oil - Will It Start Rising Again?" OECD Economics Department Working Paper No. 1031, p. 6 (2013). 2 Please see BCA's Global Investment Strategy Weekly Report titled "Are Central Banks Behind The Curve Or Ahead Of It?," published on July 21, 2017. It is available at gis.bcaresearch.com. Among other things, the Global Investment Strategy team notes labor-market slack is dissipating, real wages are increasing, and easier financial conditions are spurring credit growth. Our colleagues note, "The prospect of stronger growth over the next few quarters implies that the unemployment rate is likely to fall below 4% early next year, possibly breaking through the 2000 low of 3.8%." BCA's Global Investment Strategy believes U.S. inflation could move higher by 2H18. 3 Please see BCA Commodity & Energy Strategy Weekly Reports titled "EM Trade Volumes Continue Trending Higher, Supporting Metals" and "Strong EM Trade Volumes Will Support Oil," published June 29, and June 8, 2017. Both are available at ces.bcaresearch.com. 4 U.S. TIPS increase in value as the Consumer Price Index (CPI) rises, and fall in value as the index declines. Please see "TIPS: Rates & Terms" on the UST's TreasuryDirect web page (https://www.treasurydirect.gov/indiv/research/indepth/tips/res_tips_rates.htm). 5 This model covers 2000 to the present, using monthly data. The R2 for the cointegrating regression is 0.96. These variables do not explain EM exports, which are not cointegrated with U.S. monetary variables. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade And Commodity Data Point To Higher Inflation Trade And Commodity Data Point To Higher Inflation Commodity Prices and Plays Reference Table Trade And Commodity Data Point To Higher Inflation Trade And Commodity Data Point To Higher Inflation Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights Unilateral economic sanctions show that geopolitical risks are rising in Asia Pacific; China is using sanctions to get its way with its neighbors; South Korea was the latest victim, and will be rewarded for its pro-China shift; Trump's Mar-a-Lago honeymoon with Xi Jinping is over; Tactically, go long South Korean consumers / short Taiwanese exporters. Feature Geopolitical risk is shifting to the Asia Pacific region - and the increasing use of economic sanctions is evidence of the trend. Korean stocks have rallied sharply since the leadership change from December 2016 through May of this year (Chart 1). The impeachment rally was entirely expected after a year of domestic political turmoil.1 The election is also eventually expected to decrease Korean geopolitical risks - the country's new President Moon Jae-in, of the left-leaning Democratic Party, aims to patch up relations with China and revive diplomacy with North Korea.2 Chart 1South Korean Impeachment Rally Over South Korean Impeachment Rally Over South Korean Impeachment Rally Over A key barometer of Moon's success will be whether he convinces China to remove economic sanctions imposed since last summer as punishment for his predecessor's agreement to host the U.S. THAAD missile defense system. Moon has suspended the system's deployment in a nod to China.3 South Korea is thus the latest example of an important trend in the region: China's successful use of "economic statecraft" to pressure wayward neighbors into closer alignment with its interests. Since 2014, Thailand, Malaysia, Vietnam and the Philippines have each sought in different ways to reorient their foreign policies toward China, either to court Chinese assistance or get relief from Chinese pressure. Judging by our research below, the rewards are palpable, and a sign of Beijing's rising global influence. Because U.S.-China tensions are rising structurally, we see these country-by-country shifts toward China not as a decisive loss for the U.S. alliance but rather as the latest phase in a long game of tug-of-war that will intensify in the coming years.4 Hence the trend of unilateral economic sanctions will continue. Who is next on China's hit list? How will the U.S. respond? What countries are most and least likely to be affected? And what are the market implications? China's Economic Statecraft The United States launched a "pivot to Asia" strategy under the Obama administration to reassert American primacy in Asia Pacific and address the emerging challenge from China. The U.S.'s Asian partners largely welcomed this shift. Over the preceding decade, they had struggled with China's emergence as a military and strategic superior. The most prominent flashpoints came in the East and South China Seas. Beijing's newfound naval and air power caused regional anxiety. As the allies invited a larger U.S. role, Beijing began to assert its sovereignty claims over disputed waters and rocks, most ambitiously by creating artificial islands in the South China Sea and fortifying them with military capabilities. In three notable periods since the Great Recession, China's tensions with its neighbors have splashed over into the economic realm, prompting Beijing to impose punitive measures: Chart 2Japan's 2012 Clash With China Japan's 2012 Clash With China Japan's 2012 Clash With China Chart 3Chinese Boycotted Japanese Cars... Chinese Boycotted Japanese Cars... Chinese Boycotted Japanese Cars... Japan 2010-2012: In 2010, China and Japan clashed as the former challenged Japan's control of the Senkaku (Diaoyu) islands in the East China Sea. In the September-November 2010 clash, China notoriously cut off exports of rare earths to Japan.5 A greater clash occurred from July-November 2012. Chinese people rose up in large-scale protests, damaging Japanese and other foreign property and assets. Impact: The growth of Japanese exports to China slowed noticeably between the 2010 and 2012 clashes, underperforming both that of China's neighbors and Europe (Chart 2). In particular, Chinese consumers stopped buying as many Japanese cars and switched to other brands (Chart 3). Chinese investment in Japan, which is generally very small, fell sharply in the year after the major 2012 clash, by contrast with the global trend (Chart 4). Chinese tourism to Japan also fell sharply after both incidents, though only for a short period of time (Chart 5). Chart 4...And Cut Investments In Japan... ...And Cut Investments In Japan... ...And Cut Investments In Japan... Chart 5...While Tourists Went Elsewhere ...While Tourists Went Elsewhere ...While Tourists Went Elsewhere Philippines 2012-2016: Tensions between China and the Philippines over the contested Spratly Islands and other rocks in the South China Sea have a long history. The latest round began in the mid-2000s, and the two countries have skirmished many times since then, including in a major showdown at Scarborough Shoal in 2012 that required the intercession of the United States to be resolved. The pressure intensified after January 2013, when the Philippines brought a high-profile case against China's maritime-territorial claims to the Permanent Court of Arbitration at the Hague. The U.S. and the Philippines upped the ante in April 2014 by signing an Enhanced Defense Cooperation Agreement. Ultimately, the court dealt a humiliating blow to China's maritime-territorial claims in July 2016, but a bigger confrontation was avoided because of what had happened in the remarkable May 2016 Philippine elections, which put China-friendly populist President Rodrigo Duterte in Manila on July 1. Impact: China tightened phytosanitary restrictions on Philippine bananas during the 2012 crisis and Philippine exports to China underperformed those of its neighbors after the onset of diplomatic crisis in 2013 (Chart 6). Nevertheless, the overall impact on headline exports is debatable. Tourism suffered straightforwardly both after the 2012 showdown at sea and after the new U.S.-Philippines military deal in 2014 (Chart 7). As with Japan, the impact was temporary. Chart 6Philippine Clash With China Over Sovereignty Philippine Clash With China Over Sovereignty Philippine Clash With China Over Sovereignty Chart 7Chinese Tourists Snub The Philippines Chinese Tourists Snub The Philippines Chinese Tourists Snub The Philippines Vietnam 2011-14: China's quarrels with Vietnam go back millennia, but in recent years have centered on the South China Sea. As with the Philippines, frictions began rising in the mid-2000s and flared up after the global financial crisis. In the summer of 2012, Vietnam and China engaged in a dispute over new laws encompassing their territorial claims. In May 2014, the two countries fought a highly unorthodox sea-battle near the Paracel Islands. Anti-Chinese protests erupted throughout Vietnam, prompting China to restrict travel.6 Impact: It is not clear that China imposed trade measures against Vietnam - export growth was plummeting in 2012 because of China's nominal GDP slowdown as well - but certainly exports skyrocketed after the two sides began tothaw diplomatic relations in August 2014 (Chart 8).7 Direct investment from China into Vietnam fell in 2014, even as that from the rest of the world rose. Chinese tourism to Vietnam shrank in the aftermath. Chart 8Vietnam Reboots China Trade Vietnam Reboots China Trade Vietnam Reboots China Trade The above incidents complement a growing body of academic research demonstrating China's use of unilateral economic sanctions and their trade and market impacts.8 Bottom Line: China has employed unilateral, informal, and discrete economic sanctions and has encouraged or condoned citizen boycotts and popular activism against Japan, the Philippines, Vietnam, Taiwan, and other states since at least the early 2000s. Moreover, three international confrontations since 2010 suggest that China's foreign policy is growing bolder - it is not afraid to throw its economic weight around to get what it wants politically or to deter countries from challenging its interests. How Significant Is China's Wrath? Both our evidence and the scholarly literature reveal that China-inflicted economic damage tends to be temporary and sometimes ambiguous from a macro-perspective.9 For instance, if there were negative trade effects of Vietnam's 2014 clash with China, they were overwhelmed by Vietnam's rising share of China's market in the following years (Chart 9). And, as hinted above, Chinese sanctions on Philippine banana exports in 2012 can be overstated according to close inspection of the data.10 Nevertheless, since 2016, three new episodes have reinforced the fact that China's punitive measures are a significant trend with potentially serious consequences for Asian economies: Taiwan 2016: Taiwanese politics have shifted away from mainland China in recent years. The "Sunflower Protests" of 2014 marked a shift in popular opinion away from the government's program of ever-deeper economic integration with the mainland. Local elections later that year set the stage for a sweeping victory by the Democratic Progressive Party (DPP), taking both the presidency and, for the first time, the legislature, in January 2016.11 Tsai is a proponent of eventual Taiwanese independence and dissents from key diplomatic agreements with the mainland, the "One China Policy" and "1992 Consensus." Within six months of the election Beijing had cut off diplomatic communication. Impact: The number of mainland visitors has nosedived, by contrast with global trends (Chart 10). Taiwan's exports and access to China's market are arguably weaker than they would otherwise be. Given the historic cross-strait Economic Cooperation Framework Agreement in 2010, and the strong export growth in the immediate aftermath of that deal, it is curious that exports have been so weak since 2014 (Chart 11). Chart 9China Flings Open Doors To Vietnam China Flings Open Doors To Vietnam China Flings Open Doors To Vietnam Chart 10Mainland Tourists Punish Rebel Taiwan Mainland Tourists Punish Rebel Taiwan Mainland Tourists Punish Rebel Taiwan Chart 11So Much For Cross-Strait Trade Deals? So Much For Cross-Strait Trade Deals? So Much For Cross-Strait Trade Deals? South Korea 2016-17: China and South Korea are on the cusp of improving relations after a year of Beijing-imposed sanctions. The former government of President Park Geun-hye, who was impeached in December 2016 and removed from office in March this year, moved rapidly with the U.S. to deploy the THAAD missile defense system on South Korean soil while her government was collapsing, so as to make it a fait accompli for her likely left-leaning (and more China-friendly) successor. Her government agreed to the deployment in July 2016 and since then China has exacted substantial economic costs via Korean exports and Chinese tourism.12 The new President Moon Jae-in is now calling on China to remove these sanctions, while initiating an "environmental review" that will delay deployment of THAAD, possibly permanently. Impact: South Korean exports to China have underperformed the regional trend throughout the downfall of the Park regime and its last-minute alliance-building measures with both the U.S. and Japan (Chart 12). South Korea has also lost market share in China since agreeing to host THAAD in July 2016 (Chart 13). Furthermore, Korean car sales on the mainland have deviated markedly both from their long-term historical trend and from Japan's contemporary sales (Chart 14), the inverse of what occurred in 2012 (see Chart 3 above). Chinese tourism to South Korea has sharply declined. Chart 12China Cools On Korean Imports China Cools On Korean Imports China Cools On Korean Imports Chart 13China Hits South Korea Over THAAD China Hits South Korea Over THAAD China Hits South Korea Over THAAD Chart 14Korean Car Sales And Tourist Sales Slump Korean Car Sales And Tourist Sales Slump Korean Car Sales And Tourist Sales Slump North Korea 2016-17: Ironically, China brought sanctions against both Koreas last year - the South for THAAD, the North for its unprecedented slate of missile and nuclear tests. These provoked the United States into pressuring China via "secondary sanctions." Impact: China's sanctions on the North - which include a potentially severe ban on coal imports - are limited so far, according to the headline trade data, as China is wary of destabilizing the hermit kingdom (Chart 15). But if China does grant President Trump's request and increase the economic pressure on North Korea, it will be no less of a sign of a greater willingness to utilize economic statecraft, especially given that the North is China's only formal ally. Other countries will not fail to see the implications should they, like either Korea, cross Beijing's interests. Bottom Line: Doubts about China's new foreign policy "assertiveness" are overstated. China is increasing its unilateral use of economic levers to pressure political regimes in its neighborhood, including major EMs like Taiwan and South Korea over the past year. Korean President Moon Jae-in's rise to power is likely to produce better Sino-Korean relations, but neither it nor Taiwan is out of the woods yet, according to the data. Moreover, the rest of the region may be cautious before accepting new U.S. military deployments or contravening China's demands in other ways. The Asian "Pivot To China" Over the past two years, several Asian states have begun to vacillate toward China, not because they fear American abandonment but because the U.S. "pivot" gave them so much security reassurance that it threatened to provoke conflict with China - essentially risking a new Cold War. They live on the frontlines and wanted to discourage this escalation. At the same time, the growth slump in China/EM in 2014 - followed by China's renewed stimulus in 2015 - encouraged these states to improve business with China. Thailand began to shift in 2014, when a military junta took power in a coup and sought external support. China's partnership did not come with strings attached, as opposed to that of the U.S., with its demands about democracy and civil rights.13 The rewards of this foreign policy shift are palpable (Chart 16). China signed some big investment deals and improved strategic cooperation through arms sales. It did the same with Malaysia for similar reasons.14 China's "One Belt One Road" (OBOR) economic development initiative provided ample opportunities for expanding ties. Chart 15No Chinese Embargo On North Korea... Yet No Chinese Embargo On North Korea... Yet No Chinese Embargo On North Korea... Yet Chart 16China Opens Doors To Thai Junta China Opens Doors To Thai Junta China Opens Doors To Thai Junta The year 2016 was a major turning point. Three of China's neighbors - two of which U.S. allies - underwent domestic political transitions ushering in more favorable policies toward China: Vietnam: The Vietnamese Communist Party held its twelfth National Congress in January 2016. Prime Minister Nguyen Tan Dung, a pro-market reformer from the capitalist south, failed to secure the position of general secretary of the party and retired. The incumbent General Secretary Nguyen Phu Trong retained his seat, and oversaw the promotion of key followers, strengthening Vietnam's pro-China faction. Since then Trong has visited President Xi in Beijing and signed a joint communique on improving strategic relations. As mentioned above, Vietnamese exports to China have exploded since tensions subsided in 2014. South Korea: In April 2016, South Korean legislative elections saw the left-leaning Democratic Party win a plurality of seats, setting the stage for the 2017 election discussed above, when Korea officially moved in a more China-friendly direction under President Moon. The Philippines: In May 2016, the Philippines elected Duterte, a firebrand southern populist who declared that the Philippines would "separate" itself from the U.S. and ally with Russia and China. Though Duterte has already modified his anti-American stance - as we expected - he is courting Chinese trade and investment at the expense of the Philippines' sovereignty concerns.15 Trump's election contributed to this regional trend. By suggesting a desire for the U.S. to stop playing defender of last resort in the region, Trump reinforced the need for allies like Thailand, the Philippines, and South Korea to go their own way. And by canceling the Trans-Pacific Partnership, Trump forced Malaysia and Vietnam to make amends with China, while vindicating those (like Thailand and Indonesia) that had remained aloof. Bottom Line: Having brandished its sticks, China is now offering carrots to states that recognize its growing regional influence. These do not have to be express measures, given that China is stimulating its economy and increasing outbound investment for its own reasons. All China need do is refrain from denying access to its market and investment funds. Whom Will China Sanction Next? Geopolitical risk on the Korean peninsula remains elevated given that North Korea remains in "provocation mode" and Trump has prioritized the issue. However, we expect that Moon will cooperate with China enough to give a boost to South Korean exports and China-exposed companies and sectors. With South Korea's shifting policy, Beijing has a major opportunity to demonstrate the positive economic rewards of pro-China foreign policy. If a new round of international negotiations gets under way and North Korean risk subsides for a time (our baseline view),16 then East Asian governments will turn to other interests. We see two key places of potential confrontation over the next 12-24 months: Taiwan is the top candidate for Chinese sanctions going forward. The cross-strait relationship is fraught and susceptible to tempests. The ruling DPP lacks domestic political constraints, which could be conducive to policy mistakes. Moreover, Trump has signaled his intention to strengthen the alliance with Taiwan, which could cause problems. China is likely to oppose the new $1.4 billion package of U.S. arms more actively than in the past, given its greater global heft. Trump's initial threat of altering the One China Policy has not been forgotten. In terms of timing, China may not want to give a tailwind to the DPP by acting overly aggressive ahead of the 2018 local elections, which are crucial for the opposition Kuomintang's attempt to revive in time for the 2020 presidential vote. But this is not a hard constraint on Beijing's imposing sanctions before then. Japan is the second-likeliest target of Chinese economic pressure. Japanese Prime Minister Shinzo Abe is up for re-election no later than December 2018 and is becoming more vulnerable as he shifts emphasis from pocketbook issues to Japan's national security.17 Needless to say, the revival of the military is the part of Abe's agenda that Beijing most opposes. China would like to see Abe weakened, or voted out, and would especially like to see Abe's proposed constitutional revisions fail in the popular referendum slated for 2020. China would not want to strengthen Abe by provoking Japanese nationalism. But if Abe is losing support, and Beijing calculates that the Japanese public is starting to view Abe and his constitutional revisions as too provocative and destabilizing, then a well-timed diplomatic crisis with economic sanctions may be in order.18 Next in line are Hong Kong and Singapore, though Beijing has already largely gotten its way in recent disputes with the two city-states.19 Other possibilities on the horizon: The eventual return to a fractious civilian government in Thailand, or improved U.S.-Thai relations, could spoil China's infrastructure plans and sour its willingness to support an otherwise lackluster Thai economy. Also, a surprise victory by the opposition in Malaysian general elections (either this year or next) could see the recent rapprochement with China falter. The latter would be cyclical tensions, whereas suppressed structural tensions with Vietnam and the Philippines could boil back up to the surface fairly quickly at any time and provoke Chinese retaliation. Bottom Line: The most likely targets of Chinese economic sanctions in the near future are Taiwan and Japan. South Korea could remain a target if events should force Moon to abandon his policy agenda, though we see this as unlikely. Hong Kong and Singapore also remain in the danger zone, as do Vietnam and the Philippines in the long run. Investment Implications Cyclical and structural macro trends drive exports and investment trends in Asia Pacific. The biggest immediate risk to EM Asian economies stems not from Chinese sanctions - given that most of these economies have adjusted their policies to appease China to some extent - but from China's economic policy uncertainty, which remains at very elevated levels (Chart 17). It was after this uncertainty surged in 2015 that China's neighbors took on a more accommodating stance with a focus on economic cooperation rather than strategic balancing. Chart 17Chinese Economic Policy Uncertainty Still Asia's Biggest Risk Does It Pay To Pivot To China? Does It Pay To Pivot To China? Currently Chinese economic policy uncertainty is hooking back up as a result of the decision by state authorities to intensify their financial crackdown - the so-called "deleveraging campaign." BCA's Emerging Markets Strategy has recently pointed out that China's slowing fiscal and credit impulse will drag down both Chinese import volumes and emerging market corporate earnings in the coming months (Chart 18). Already commodity prices and commodity currencies have dropped off, heralding a broader slowdown in global trade as a result of China's policy tightening. This trend will overwhelm the effect of almost any new geopolitical spats or sanctions. The same can be said for Chinese investment as for Chinese trade. Over the past couple of decades, China has emerged as one of the world's leading sources of direct investment (Chart 19). This is a secular trend. Thus while foreign relations have affected China's investment patterns - most recently in giving the Philippines a boost under Duterte - the general trend of rising Chinese investment abroad will continue regardless of temporary quarrels. This is particularly true in light of China's efforts to energize OBOR. Chart 18China: Stimulus Fading China: Stimulus Fading China: Stimulus Fading Chart 19China's Emergence As Major Global Investor Does It Pay To Pivot To China? Does It Pay To Pivot To China? The key question is how will China's political favor or disfavor impact neighboring economies on the margin, in relative terms, on a sectoral basis, or in the short term? The evidence above feeds into several trends in relative equity performance: China fights either Japan or Korea: Going long Korea / short Japan would have paid off throughout the major Sino-Japanese tensions 2010-12, and would have paid off again during the South Korean impeachment rally (Chart 20). Of course, geopolitics is only one factor. But even Japan's economic shift in 2012 (Abenomics) is part of the geopolitical dynamic. Chart 20China Fights Either Japan Or Korea China Fights Either Japan Or Korea China Fights Either Japan Or Korea Chart 21Taiwan's Loss = Japan's Gain Taiwan's Loss = Japan's Gain Taiwan's Loss = Japan's Gain Taiwan's loss is Japan's gain: China's measures against Japanese exporters from 2010-12 coincided with a period of intense cross-strait economic integration that benefited Taiwanese exporters. Then Japan adopted Abenomics and dialed down tensions with China, and Taiwan underwent a pro-independence turn, provoking Beijing's displeasure (Chart 21). If one of these countries ends up quarreling with China in the near future, as we expect, the other country's exporters may reap the benefit. If relations worsen with both, South Korea stands to gain. Favor EM reformers: Vietnamese and Philippine equities outperformed EM from 2011-16 despite heightened tensions in the South China Sea (Chart 22). During this time, we recommended an overweight position on both countries relative to EM, even though we took the maritime tensions very seriously, because we favored EM reformers and both countries were undertaking structural reforms.20 Later, in May 2016, we downgraded the Philippines to neutral, expecting a loss of reform momentum after Duterte's election. The Philippines has notably underperformed the EM equity benchmark since that time.21 The "One China Policy": We closed out our "long One China Policy" trade on June 14 as a result of China's persistence in its crackdown on the banks, which we see as very risky.22 However, we may reinitiate the trade in the future, as Hong Kong and Taiwan remain vulnerable both to the slowdown in globalization and to Beijing's sanctions over deepening political differences (Chart 23). Chart 22Reforms Pay... Even During Island Tensions Reforms Pay... Even During Island Tensions Reforms Pay... Even During Island Tensions Chart 23The 'One China Policy' As A Trade The 'One China Policy' As A Trade The 'One China Policy' As A Trade From Sunshine to Moonshine: South Korea's Moon Jae-in has substantial political capital and we expect that he will succeed in boosting growth, wages, and the social security net, all of which will be bullish for South Korean consumer stocks. Yet we remain wary of the fact that North Korea is not yet falling into line with new negotiations. A way to hedge is to go long the South Korean consumer relative to Taiwanese exporters (Chart 24), which will live under the shadow of Beijing's disfavor at least until the 2020 elections, if not beyond. Taiwan has also allowed its currency to appreciate notably against the USD since Trump's post-election phone call with President Tsai, which is negative for Taiwanese exporters. Chart 24Go Long Korean Consumer /##br## Short Taiwanese Exporter Go Long Korean Consumer / Short Taiwanese Exporter Go Long Korean Consumer / Short Taiwanese Exporter China's sanctions are essentially a "slap on the wrist" in economic terms. But sometimes they reflect deeper structural tensions, and thus they may foreshadow far more damaging clashes down the road that could have longer term consequences, just as the Sino-Japanese incident of 2012 demonstrated. That is all the more reason to hedge one's bets on Taiwan today. These sanctions are bound to recur and will provide investors with trading opportunities, if not long-term investment themes. It will pay to capitalize quickly at the outset of any serious increase in tensions going forward. As a final word, the Trump administration's recent moves to impose economic penalties on China - namely through "secondary sanctions" due to North Korea, but also through potential trade tariffs and/or penalties related to human trafficking and human rights - highlight the fact that the use of unilateral sanctions is not limited to China. Geopolitical risk is rising in Asia as a result of actions on both sides of the Pacific. Sino-American antagonism in particular poses the greatest geopolitical danger to global markets, as we have frequently emphasized.23 And as Trump's domestic agenda struggles he will seek to get tougher on China, as he promised to his populist base on the campaign trail. In the event of a major geopolitical crisis in the region, we recommend the same mix of safe-haven assets that we have recommended in the past: U.S. treasuries, Swiss bonds, JGBs, and gold.24 Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. For our longstanding investment theme of rising geopolitical risk in East Asia, please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, and Monthly Report, "The Great Risk Rotation," dated December 11, 2013, available at gps.bcaresearch.com. 2 Please see BCA Emerging Market Equity Sector and Geopolitical Strategy Special Report, "South Korea: A Comeback For Consumer Stocks?" dated June 27, 2017, available at gps.bcaresearch.com. 3 However, Moon is walking a tight rope in relation to the United States. During his visit to Washington on June 29, he assured Congressman Paul Ryan among others that he did not necessarily intend to reverse the THAAD agreement as a whole. That would depend on the outcome of the environmental review and due legal process in South Korea as well as on whether North Korea's behavior makes the missile defense system necessary. Please see Kim Ji-eun, "In US Congress, Pres. Moon Highlights Democratic Values Of Alliance With US," The Hankyoreh, July 1, 2017, available at English.hani.co.kr. 4 Please see BCA Geopolitical Strategy Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 5 Please see Jeffrey R. Dundon, "Triggers of Chinese Economic Coercion," Naval Postgraduate School, September, 2014, available at calhoun.nps.edu. 6 For a very conservative estimate of China's actions during the Haiyang Shiyou 981 incident, please see Angela Poh, "The Myth Of Chinese Sanctions Over South China Sea Disputes," Washington Quarterly 40:1 (2017), pp. 143-165. 7 Please see "Vietnam Party official heads to China to defuse tensions," Thanh Nien Daily, August 25, 2014, available at www.thanhniennews.com. 8 Please see Faqin Lin, Cui Hu, and Andreas Fuchs, "How Do Firms Respond To Political Tensions? The Heterogeneity Of The Dalai Lama Effect On Trade," University of Heidelberg Department of Economics Discussion Paper Series 628, August 2016, available at papers.ssrn.com. This study improves upon earlier ones, notably Andreas Fuchs and Nils-Hendrik Klann, "Paying A Visit: The Dalai Lama Effect On International Trade," Journal Of International Economics 91 (2013), pp 164-77. See also Christina L. Davis, Andreas Fuchs, and Kristina Johnson, "State Control And The Effects Of Foreign Relations On Bilateral Trade," October 16, 2016, MPRA Paper No. 74597, available at https://mpra.ub.uni-muenchen.de/74597/ ; Yinghua He, Ulf Nielsson, and Yonglei Wang, "Hurting Without Hitting: The Economic Cost of Political Tension," Toulouse School of Economics Working Papers 14-484 (July 2015), available at econpapers.repec.org; Raymond Fisman, Yasushi Hamao, and Yongxiang Wang, "Nationalism and Economic Exchange: Evidence from Shocks to Sino-Japanese Relations," NBER Working Paper 20089 (May 2014) available at www.nber.org; Scott L. Kastner, "Buying Influence? Assessing the Political Effects of China's International Trade," Journal of Conflict Resolution 60:6 (2016), pp. 980-1007. 9 The "Dalai Lama effect," in which countries that host a visit from the Dalai Lama suffer Chinese trade retaliation, has been revised downward over the years - the trade costs are only statistically significant in the second quarter after the visit. Please see "How Do Firms Respond," cited in footnote 8. 10 See "Myth Of Chinese Sanctions," cited in footnote 6. Chinese sanctions on Norwegian salmon exports after Liu Xiaobo's Nobel Peace Prize in 2010 also fall under this category. 11 Please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, available at gps.bcaresearch.com. 12 Please see Lee Ho-Jeong, "Thaad may lead to $7.5B in economic losses in 2017," Joongang Daily, May 4, 2017, available at www.joongangdaily.com. 13 Please see Ian Storey, "Thailand's Post-Coup Relations With China And America: More Beijing, Less Washington," Yusof Ishak Institute, Trends in Southeast Asia 20 (2015). 14 Malaysia began to move closer to China after its 2013 election, which initiated a period of political turbulence and scandal. This trend, along with economic slowdown, prompted the ruling coalition to turn to Beijing for support. 15 He is also, as current chair of the Association of Southeast Asian Nations (ASEAN), assisting China's negotiations toward settling a "Code of Conduct" in the South China Sea. This is not likely to be a binding agreement - China will not voluntarily reverse its strategic maritime-territorial gains - but it could dampen tensions for a time in the region and encourage better relations between China and Southeast Asia. For the 2016 Asian pivot to China discussed above, please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, and Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 17 The LDP's dramatic defeat in Tokyo's local elections on July 2 is the first tangible sign that the constitutional agenda, Abe's corruption scandals, and the emergence of a competing political leader, Yuriko Koike, are taking a toll on the LDP. 18 Also, Beijing may at any point rotate its maritime assertiveness back to the East China Sea, where tensions with Japan have quieted since 2013-14. Further, Beijing will want to exploit worsening relations between Japan and South Korea, and drive a wedge between Japan and Russia as they attempt a historic diplomatic thaw. 19 Beijing is attempting to steal a march on these states, especially in finance, while putting pressure on them to avoid activities that undermine Beijing's regional influence. So far there is only small evidence that tensions have affected trade. First, Hong Kong saw a drop in tourists and a block on cultural exports amid the Umbrella Protests of 2014. China's central government has acted aggressively over the past year to suppress Hong Kong agitation, by excluding rebel lawmakers from office and by drawing a "red line" against undermining Chinese sovereignty. Yet agitation will persist because of the frustration of local political forces and the youth, both of which resent the mainland's increasing heavy-handedness. Meanwhile, China and Singapore are in the process this month of improving relations after the November-January spat relating to Singapore-Taiwanese military ties. But China's encroachment on Singapore's traditional advantages - finance, oil refining, freedom of navigation, strong military relations with the U.S. and Taiwan, political stability - is likely to continue. 20 Please see BCA Geopolitical Strategy Monthly Report, "The Coming Bloodbath In Emerging Markets," dated August 12, 2015, "Geopolitical Risk: A Golden Opportunity?" dated July 9, 2014, and "In Need Of Global Political Recapitalization," dated June 2012, available at gps.bcaresearch.com. See also Frontier Markets Strategy Special Report, "Buy Vietnamese Stocks," dated July 17, 2015, available at fms.bcaresearch.com. 21 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Weekly Report, "Has Europe Switched From Reward To Risk," dated June 7, 2017, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 24 Please see The Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Unilateral economic sanctions show that geopolitical risks are rising in Asia Pacific; China is using sanctions to get its way with its neighbors; South Korea was the latest victim, and will be rewarded for its pro-China shift; Trump's Mar-a-Lago honeymoon with Xi Jinping is over; Tactically, go long South Korean consumers / short Taiwanese exporters. Feature Geopolitical risk is shifting to the Asia Pacific region - and the increasing use of economic sanctions is evidence of the trend. Korean stocks have rallied sharply since the leadership change from December 2016 through May of this year (Chart 1). The impeachment rally was entirely expected after a year of domestic political turmoil.1 The election is also eventually expected to decrease Korean geopolitical risks - the country's new President Moon Jae-in, of the left-leaning Democratic Party, aims to patch up relations with China and revive diplomacy with North Korea.2 Chart 1South Korean Impeachment Rally Over South Korean Impeachment Rally Over South Korean Impeachment Rally Over A key barometer of Moon's success will be whether he convinces China to remove economic sanctions imposed since last summer as punishment for his predecessor's agreement to host the U.S. THAAD missile defense system. Moon has suspended the system's deployment in a nod to China.3 South Korea is thus the latest example of an important trend in the region: China's successful use of "economic statecraft" to pressure wayward neighbors into closer alignment with its interests. Since 2014, Thailand, Malaysia, Vietnam and the Philippines have each sought in different ways to reorient their foreign policies toward China, either to court Chinese assistance or get relief from Chinese pressure. Judging by our research below, the rewards are palpable, and a sign of Beijing's rising global influence. Because U.S.-China tensions are rising structurally, we see these country-by-country shifts toward China not as a decisive loss for the U.S. alliance but rather as the latest phase in a long game of tug-of-war that will intensify in the coming years.4 Hence the trend of unilateral economic sanctions will continue. Who is next on China's hit list? How will the U.S. respond? What countries are most and least likely to be affected? And what are the market implications? China's Economic Statecraft The United States launched a "pivot to Asia" strategy under the Obama administration to reassert American primacy in Asia Pacific and address the emerging challenge from China. The U.S.'s Asian partners largely welcomed this shift. Over the preceding decade, they had struggled with China's emergence as a military and strategic superior. The most prominent flashpoints came in the East and South China Seas. Beijing's newfound naval and air power caused regional anxiety. As the allies invited a larger U.S. role, Beijing began to assert its sovereignty claims over disputed waters and rocks, most ambitiously by creating artificial islands in the South China Sea and fortifying them with military capabilities. In three notable periods since the Great Recession, China's tensions with its neighbors have splashed over into the economic realm, prompting Beijing to impose punitive measures: Chart 2Japan's 2012 Clash With China Japan's 2012 Clash With China Japan's 2012 Clash With China Chart 3Chinese Boycotted Japanese Cars... Chinese Boycotted Japanese Cars... Chinese Boycotted Japanese Cars... Japan 2010-2012: In 2010, China and Japan clashed as the former challenged Japan's control of the Senkaku (Diaoyu) islands in the East China Sea. In the September-November 2010 clash, China notoriously cut off exports of rare earths to Japan.5 A greater clash occurred from July-November 2012. Chinese people rose up in large-scale protests, damaging Japanese and other foreign property and assets. Impact: The growth of Japanese exports to China slowed noticeably between the 2010 and 2012 clashes, underperforming both that of China's neighbors and Europe (Chart 2). In particular, Chinese consumers stopped buying as many Japanese cars and switched to other brands (Chart 3). Chinese investment in Japan, which is generally very small, fell sharply in the year after the major 2012 clash, by contrast with the global trend (Chart 4). Chinese tourism to Japan also fell sharply after both incidents, though only for a short period of time (Chart 5). Chart 4...And Cut Investments In Japan... ...And Cut Investments In Japan... ...And Cut Investments In Japan... Chart 5...While Tourists Went Elsewhere ...While Tourists Went Elsewhere ...While Tourists Went Elsewhere Philippines 2012-2016: Tensions between China and the Philippines over the contested Spratly Islands and other rocks in the South China Sea have a long history. The latest round began in the mid-2000s, and the two countries have skirmished many times since then, including in a major showdown at Scarborough Shoal in 2012 that required the intercession of the United States to be resolved. The pressure intensified after January 2013, when the Philippines brought a high-profile case against China's maritime-territorial claims to the Permanent Court of Arbitration at the Hague. The U.S. and the Philippines upped the ante in April 2014 by signing an Enhanced Defense Cooperation Agreement. Ultimately, the court dealt a humiliating blow to China's maritime-territorial claims in July 2016, but a bigger confrontation was avoided because of what had happened in the remarkable May 2016 Philippine elections, which put China-friendly populist President Rodrigo Duterte in Manila on July 1. Impact: China tightened phytosanitary restrictions on Philippine bananas during the 2012 crisis and Philippine exports to China underperformed those of its neighbors after the onset of diplomatic crisis in 2013 (Chart 6). Nevertheless, the overall impact on headline exports is debatable. Tourism suffered straightforwardly both after the 2012 showdown at sea and after the new U.S.-Philippines military deal in 2014 (Chart 7). As with Japan, the impact was temporary. Chart 6Philippine Clash With China Over Sovereignty Philippine Clash With China Over Sovereignty Philippine Clash With China Over Sovereignty Chart 7Chinese Tourists Snub The Philippines Chinese Tourists Snub The Philippines Chinese Tourists Snub The Philippines Vietnam 2011-14: China's quarrels with Vietnam go back millennia, but in recent years have centered on the South China Sea. As with the Philippines, frictions began rising in the mid-2000s and flared up after the global financial crisis. In the summer of 2012, Vietnam and China engaged in a dispute over new laws encompassing their territorial claims. In May 2014, the two countries fought a highly unorthodox sea-battle near the Paracel Islands. Anti-Chinese protests erupted throughout Vietnam, prompting China to restrict travel.6 Impact: It is not clear that China imposed trade measures against Vietnam - export growth was plummeting in 2012 because of China's nominal GDP slowdown as well - but certainly exports skyrocketed after the two sides began tothaw diplomatic relations in August 2014 (Chart 8).7 Direct investment from China into Vietnam fell in 2014, even as that from the rest of the world rose. Chinese tourism to Vietnam shrank in the aftermath. Chart 8Vietnam Reboots China Trade Vietnam Reboots China Trade Vietnam Reboots China Trade The above incidents complement a growing body of academic research demonstrating China's use of unilateral economic sanctions and their trade and market impacts.8 Bottom Line: China has employed unilateral, informal, and discrete economic sanctions and has encouraged or condoned citizen boycotts and popular activism against Japan, the Philippines, Vietnam, Taiwan, and other states since at least the early 2000s. Moreover, three international confrontations since 2010 suggest that China's foreign policy is growing bolder - it is not afraid to throw its economic weight around to get what it wants politically or to deter countries from challenging its interests. How Significant Is China's Wrath? Both our evidence and the scholarly literature reveal that China-inflicted economic damage tends to be temporary and sometimes ambiguous from a macro-perspective.9 For instance, if there were negative trade effects of Vietnam's 2014 clash with China, they were overwhelmed by Vietnam's rising share of China's market in the following years (Chart 9). And, as hinted above, Chinese sanctions on Philippine banana exports in 2012 can be overstated according to close inspection of the data.10 Nevertheless, since 2016, three new episodes have reinforced the fact that China's punitive measures are a significant trend with potentially serious consequences for Asian economies: Taiwan 2016: Taiwanese politics have shifted away from mainland China in recent years. The "Sunflower Protests" of 2014 marked a shift in popular opinion away from the government's program of ever-deeper economic integration with the mainland. Local elections later that year set the stage for a sweeping victory by the Democratic Progressive Party (DPP), taking both the presidency and, for the first time, the legislature, in January 2016.11 Tsai is a proponent of eventual Taiwanese independence and dissents from key diplomatic agreements with the mainland, the "One China Policy" and "1992 Consensus." Within six months of the election Beijing had cut off diplomatic communication. Impact: The number of mainland visitors has nosedived, by contrast with global trends (Chart 10). Taiwan's exports and access to China's market are arguably weaker than they would otherwise be. Given the historic cross-strait Economic Cooperation Framework Agreement in 2010, and the strong export growth in the immediate aftermath of that deal, it is curious that exports have been so weak since 2014 (Chart 11). Chart 9China Flings Open Doors To Vietnam China Flings Open Doors To Vietnam China Flings Open Doors To Vietnam Chart 10Mainland Tourists Punish Rebel Taiwan Mainland Tourists Punish Rebel Taiwan Mainland Tourists Punish Rebel Taiwan Chart 11So Much For Cross-Strait Trade Deals? So Much For Cross-Strait Trade Deals? So Much For Cross-Strait Trade Deals? South Korea 2016-17: China and South Korea are on the cusp of improving relations after a year of Beijing-imposed sanctions. The former government of President Park Geun-hye, who was impeached in December 2016 and removed from office in March this year, moved rapidly with the U.S. to deploy the THAAD missile defense system on South Korean soil while her government was collapsing, so as to make it a fait accompli for her likely left-leaning (and more China-friendly) successor. Her government agreed to the deployment in July 2016 and since then China has exacted substantial economic costs via Korean exports and Chinese tourism.12 The new President Moon Jae-in is now calling on China to remove these sanctions, while initiating an "environmental review" that will delay deployment of THAAD, possibly permanently. Impact: South Korean exports to China have underperformed the regional trend throughout the downfall of the Park regime and its last-minute alliance-building measures with both the U.S. and Japan (Chart 12). South Korea has also lost market share in China since agreeing to host THAAD in July 2016 (Chart 13). Furthermore, Korean car sales on the mainland have deviated markedly both from their long-term historical trend and from Japan's contemporary sales (Chart 14), the inverse of what occurred in 2012 (see Chart 3 above). Chinese tourism to South Korea has sharply declined. Chart 12China Cools On Korean Imports China Cools On Korean Imports China Cools On Korean Imports Chart 13China Hits South Korea Over THAAD China Hits South Korea Over THAAD China Hits South Korea Over THAAD Chart 14Korean Car Sales And Tourist Sales Slump Korean Car Sales And Tourist Sales Slump Korean Car Sales And Tourist Sales Slump North Korea 2016-17: Ironically, China brought sanctions against both Koreas last year - the South for THAAD, the North for its unprecedented slate of missile and nuclear tests. These provoked the United States into pressuring China via "secondary sanctions." Impact: China's sanctions on the North - which include a potentially severe ban on coal imports - are limited so far, according to the headline trade data, as China is wary of destabilizing the hermit kingdom (Chart 15). But if China does grant President Trump's request and increase the economic pressure on North Korea, it will be no less of a sign of a greater willingness to utilize economic statecraft, especially given that the North is China's only formal ally. Other countries will not fail to see the implications should they, like either Korea, cross Beijing's interests. Bottom Line: Doubts about China's new foreign policy "assertiveness" are overstated. China is increasing its unilateral use of economic levers to pressure political regimes in its neighborhood, including major EMs like Taiwan and South Korea over the past year. Korean President Moon Jae-in's rise to power is likely to produce better Sino-Korean relations, but neither it nor Taiwan is out of the woods yet, according to the data. Moreover, the rest of the region may be cautious before accepting new U.S. military deployments or contravening China's demands in other ways. The Asian "Pivot To China" Over the past two years, several Asian states have begun to vacillate toward China, not because they fear American abandonment but because the U.S. "pivot" gave them so much security reassurance that it threatened to provoke conflict with China - essentially risking a new Cold War. They live on the frontlines and wanted to discourage this escalation. At the same time, the growth slump in China/EM in 2014 - followed by China's renewed stimulus in 2015 - encouraged these states to improve business with China. Thailand began to shift in 2014, when a military junta took power in a coup and sought external support. China's partnership did not come with strings attached, as opposed to that of the U.S., with its demands about democracy and civil rights.13 The rewards of this foreign policy shift are palpable (Chart 16). China signed some big investment deals and improved strategic cooperation through arms sales. It did the same with Malaysia for similar reasons.14 China's "One Belt One Road" (OBOR) economic development initiative provided ample opportunities for expanding ties. Chart 15No Chinese Embargo On North Korea... Yet No Chinese Embargo On North Korea... Yet No Chinese Embargo On North Korea... Yet Chart 16China Opens Doors To Thai Junta China Opens Doors To Thai Junta China Opens Doors To Thai Junta The year 2016 was a major turning point. Three of China's neighbors - two of which U.S. allies - underwent domestic political transitions ushering in more favorable policies toward China: Vietnam: The Vietnamese Communist Party held its twelfth National Congress in January 2016. Prime Minister Nguyen Tan Dung, a pro-market reformer from the capitalist south, failed to secure the position of general secretary of the party and retired. The incumbent General Secretary Nguyen Phu Trong retained his seat, and oversaw the promotion of key followers, strengthening Vietnam's pro-China faction. Since then Trong has visited President Xi in Beijing and signed a joint communique on improving strategic relations. As mentioned above, Vietnamese exports to China have exploded since tensions subsided in 2014. South Korea: In April 2016, South Korean legislative elections saw the left-leaning Democratic Party win a plurality of seats, setting the stage for the 2017 election discussed above, when Korea officially moved in a more China-friendly direction under President Moon. The Philippines: In May 2016, the Philippines elected Duterte, a firebrand southern populist who declared that the Philippines would "separate" itself from the U.S. and ally with Russia and China. Though Duterte has already modified his anti-American stance - as we expected - he is courting Chinese trade and investment at the expense of the Philippines' sovereignty concerns.15 Trump's election contributed to this regional trend. By suggesting a desire for the U.S. to stop playing defender of last resort in the region, Trump reinforced the need for allies like Thailand, the Philippines, and South Korea to go their own way. And by canceling the Trans-Pacific Partnership, Trump forced Malaysia and Vietnam to make amends with China, while vindicating those (like Thailand and Indonesia) that had remained aloof. Bottom Line: Having brandished its sticks, China is now offering carrots to states that recognize its growing regional influence. These do not have to be express measures, given that China is stimulating its economy and increasing outbound investment for its own reasons. All China need do is refrain from denying access to its market and investment funds. Whom Will China Sanction Next? Geopolitical risk on the Korean peninsula remains elevated given that North Korea remains in "provocation mode" and Trump has prioritized the issue. However, we expect that Moon will cooperate with China enough to give a boost to South Korean exports and China-exposed companies and sectors. With South Korea's shifting policy, Beijing has a major opportunity to demonstrate the positive economic rewards of pro-China foreign policy. If a new round of international negotiations gets under way and North Korean risk subsides for a time (our baseline view),16 then East Asian governments will turn to other interests. We see two key places of potential confrontation over the next 12-24 months: Taiwan is the top candidate for Chinese sanctions going forward. The cross-strait relationship is fraught and susceptible to tempests. The ruling DPP lacks domestic political constraints, which could be conducive to policy mistakes. Moreover, Trump has signaled his intention to strengthen the alliance with Taiwan, which could cause problems. China is likely to oppose the new $1.4 billion package of U.S. arms more actively than in the past, given its greater global heft. Trump's initial threat of altering the One China Policy has not been forgotten. In terms of timing, China may not want to give a tailwind to the DPP by acting overly aggressive ahead of the 2018 local elections, which are crucial for the opposition Kuomintang's attempt to revive in time for the 2020 presidential vote. But this is not a hard constraint on Beijing's imposing sanctions before then. Japan is the second-likeliest target of Chinese economic pressure. Japanese Prime Minister Shinzo Abe is up for re-election no later than December 2018 and is becoming more vulnerable as he shifts emphasis from pocketbook issues to Japan's national security.17 Needless to say, the revival of the military is the part of Abe's agenda that Beijing most opposes. China would like to see Abe weakened, or voted out, and would especially like to see Abe's proposed constitutional revisions fail in the popular referendum slated for 2020. China would not want to strengthen Abe by provoking Japanese nationalism. But if Abe is losing support, and Beijing calculates that the Japanese public is starting to view Abe and his constitutional revisions as too provocative and destabilizing, then a well-timed diplomatic crisis with economic sanctions may be in order.18 Next in line are Hong Kong and Singapore, though Beijing has already largely gotten its way in recent disputes with the two city-states.19 Other possibilities on the horizon: The eventual return to a fractious civilian government in Thailand, or improved U.S.-Thai relations, could spoil China's infrastructure plans and sour its willingness to support an otherwise lackluster Thai economy. Also, a surprise victory by the opposition in Malaysian general elections (either this year or next) could see the recent rapprochement with China falter. The latter would be cyclical tensions, whereas suppressed structural tensions with Vietnam and the Philippines could boil back up to the surface fairly quickly at any time and provoke Chinese retaliation. Bottom Line: The most likely targets of Chinese economic sanctions in the near future are Taiwan and Japan. South Korea could remain a target if events should force Moon to abandon his policy agenda, though we see this as unlikely. Hong Kong and Singapore also remain in the danger zone, as do Vietnam and the Philippines in the long run. Investment Implications Cyclical and structural macro trends drive exports and investment trends in Asia Pacific. The biggest immediate risk to EM Asian economies stems not from Chinese sanctions - given that most of these economies have adjusted their policies to appease China to some extent - but from China's economic policy uncertainty, which remains at very elevated levels (Chart 17). It was after this uncertainty surged in 2015 that China's neighbors took on a more accommodating stance with a focus on economic cooperation rather than strategic balancing. Chart 17Chinese Economic Policy Uncertainty Still Asia's Biggest Risk Does It Pay To Pivot To China? Does It Pay To Pivot To China? Currently Chinese economic policy uncertainty is hooking back up as a result of the decision by state authorities to intensify their financial crackdown - the so-called "deleveraging campaign." BCA's Emerging Markets Strategy has recently pointed out that China's slowing fiscal and credit impulse will drag down both Chinese import volumes and emerging market corporate earnings in the coming months (Chart 18). Already commodity prices and commodity currencies have dropped off, heralding a broader slowdown in global trade as a result of China's policy tightening. This trend will overwhelm the effect of almost any new geopolitical spats or sanctions. The same can be said for Chinese investment as for Chinese trade. Over the past couple of decades, China has emerged as one of the world's leading sources of direct investment (Chart 19). This is a secular trend. Thus while foreign relations have affected China's investment patterns - most recently in giving the Philippines a boost under Duterte - the general trend of rising Chinese investment abroad will continue regardless of temporary quarrels. This is particularly true in light of China's efforts to energize OBOR. Chart 18China: Stimulus Fading China: Stimulus Fading China: Stimulus Fading Chart 19China's Emergence As Major Global Investor Does It Pay To Pivot To China? Does It Pay To Pivot To China? The key question is how will China's political favor or disfavor impact neighboring economies on the margin, in relative terms, on a sectoral basis, or in the short term? The evidence above feeds into several trends in relative equity performance: China fights either Japan or Korea: Going long Korea / short Japan would have paid off throughout the major Sino-Japanese tensions 2010-12, and would have paid off again during the South Korean impeachment rally (Chart 20). Of course, geopolitics is only one factor. But even Japan's economic shift in 2012 (Abenomics) is part of the geopolitical dynamic. Chart 20China Fights Either Japan Or Korea China Fights Either Japan Or Korea China Fights Either Japan Or Korea Chart 21Taiwan's Loss = Japan's Gain Taiwan's Loss = Japan's Gain Taiwan's Loss = Japan's Gain Taiwan's loss is Japan's gain: China's measures against Japanese exporters from 2010-12 coincided with a period of intense cross-strait economic integration that benefited Taiwanese exporters. Then Japan adopted Abenomics and dialed down tensions with China, and Taiwan underwent a pro-independence turn, provoking Beijing's displeasure (Chart 21). If one of these countries ends up quarreling with China in the near future, as we expect, the other country's exporters may reap the benefit. If relations worsen with both, South Korea stands to gain. Favor EM reformers: Vietnamese and Philippine equities outperformed EM from 2011-16 despite heightened tensions in the South China Sea (Chart 22). During this time, we recommended an overweight position on both countries relative to EM, even though we took the maritime tensions very seriously, because we favored EM reformers and both countries were undertaking structural reforms.20 Later, in May 2016, we downgraded the Philippines to neutral, expecting a loss of reform momentum after Duterte's election. The Philippines has notably underperformed the EM equity benchmark since that time.21 The "One China Policy": We closed out our "long One China Policy" trade on June 14 as a result of China's persistence in its crackdown on the banks, which we see as very risky.22 However, we may reinitiate the trade in the future, as Hong Kong and Taiwan remain vulnerable both to the slowdown in globalization and to Beijing's sanctions over deepening political differences (Chart 23). Chart 22Reforms Pay... Even During Island Tensions Reforms Pay... Even During Island Tensions Reforms Pay... Even During Island Tensions Chart 23The 'One China Policy' As A Trade The 'One China Policy' As A Trade The 'One China Policy' As A Trade From Sunshine to Moonshine: South Korea's Moon Jae-in has substantial political capital and we expect that he will succeed in boosting growth, wages, and the social security net, all of which will be bullish for South Korean consumer stocks. Yet we remain wary of the fact that North Korea is not yet falling into line with new negotiations. A way to hedge is to go long the South Korean consumer relative to Taiwanese exporters (Chart 24), which will live under the shadow of Beijing's disfavor at least until the 2020 elections, if not beyond. Taiwan has also allowed its currency to appreciate notably against the USD since Trump's post-election phone call with President Tsai, which is negative for Taiwanese exporters. Chart 24Go Long Korean Consumer /##br## Short Taiwanese Exporter Go Long Korean Consumer / Short Taiwanese Exporter Go Long Korean Consumer / Short Taiwanese Exporter China's sanctions are essentially a "slap on the wrist" in economic terms. But sometimes they reflect deeper structural tensions, and thus they may foreshadow far more damaging clashes down the road that could have longer term consequences, just as the Sino-Japanese incident of 2012 demonstrated. That is all the more reason to hedge one's bets on Taiwan today. These sanctions are bound to recur and will provide investors with trading opportunities, if not long-term investment themes. It will pay to capitalize quickly at the outset of any serious increase in tensions going forward. As a final word, the Trump administration's recent moves to impose economic penalties on China - namely through "secondary sanctions" due to North Korea, but also through potential trade tariffs and/or penalties related to human trafficking and human rights - highlight the fact that the use of unilateral sanctions is not limited to China. Geopolitical risk is rising in Asia as a result of actions on both sides of the Pacific. Sino-American antagonism in particular poses the greatest geopolitical danger to global markets, as we have frequently emphasized.23 And as Trump's domestic agenda struggles he will seek to get tougher on China, as he promised to his populist base on the campaign trail. In the event of a major geopolitical crisis in the region, we recommend the same mix of safe-haven assets that we have recommended in the past: U.S. treasuries, Swiss bonds, JGBs, and gold.24 Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. For our longstanding investment theme of rising geopolitical risk in East Asia, please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, and Monthly Report, "The Great Risk Rotation," dated December 11, 2013, available at gps.bcaresearch.com. 2 Please see BCA Emerging Market Equity Sector and Geopolitical Strategy Special Report, "South Korea: A Comeback For Consumer Stocks?" dated June 27, 2017, available at gps.bcaresearch.com. 3 However, Moon is walking a tight rope in relation to the United States. During his visit to Washington on June 29, he assured Congressman Paul Ryan among others that he did not necessarily intend to reverse the THAAD agreement as a whole. That would depend on the outcome of the environmental review and due legal process in South Korea as well as on whether North Korea's behavior makes the missile defense system necessary. Please see Kim Ji-eun, "In US Congress, Pres. Moon Highlights Democratic Values Of Alliance With US," The Hankyoreh, July 1, 2017, available at English.hani.co.kr. 4 Please see BCA Geopolitical Strategy Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 5 Please see Jeffrey R. Dundon, "Triggers of Chinese Economic Coercion," Naval Postgraduate School, September, 2014, available at calhoun.nps.edu. 6 For a very conservative estimate of China's actions during the Haiyang Shiyou 981 incident, please see Angela Poh, "The Myth Of Chinese Sanctions Over South China Sea Disputes," Washington Quarterly 40:1 (2017), pp. 143-165. 7 Please see "Vietnam Party official heads to China to defuse tensions," Thanh Nien Daily, August 25, 2014, available at www.thanhniennews.com. 8 Please see Faqin Lin, Cui Hu, and Andreas Fuchs, "How Do Firms Respond To Political Tensions? The Heterogeneity Of The Dalai Lama Effect On Trade," University of Heidelberg Department of Economics Discussion Paper Series 628, August 2016, available at papers.ssrn.com. This study improves upon earlier ones, notably Andreas Fuchs and Nils-Hendrik Klann, "Paying A Visit: The Dalai Lama Effect On International Trade," Journal Of International Economics 91 (2013), pp 164-77. See also Christina L. Davis, Andreas Fuchs, and Kristina Johnson, "State Control And The Effects Of Foreign Relations On Bilateral Trade," October 16, 2016, MPRA Paper No. 74597, available at https://mpra.ub.uni-muenchen.de/74597/ ; Yinghua He, Ulf Nielsson, and Yonglei Wang, "Hurting Without Hitting: The Economic Cost of Political Tension," Toulouse School of Economics Working Papers 14-484 (July 2015), available at econpapers.repec.org; Raymond Fisman, Yasushi Hamao, and Yongxiang Wang, "Nationalism and Economic Exchange: Evidence from Shocks to Sino-Japanese Relations," NBER Working Paper 20089 (May 2014) available at www.nber.org; Scott L. Kastner, "Buying Influence? Assessing the Political Effects of China's International Trade," Journal of Conflict Resolution 60:6 (2016), pp. 980-1007. 9 The "Dalai Lama effect," in which countries that host a visit from the Dalai Lama suffer Chinese trade retaliation, has been revised downward over the years - the trade costs are only statistically significant in the second quarter after the visit. Please see "How Do Firms Respond," cited in footnote 8. 10 See "Myth Of Chinese Sanctions," cited in footnote 6. Chinese sanctions on Norwegian salmon exports after Liu Xiaobo's Nobel Peace Prize in 2010 also fall under this category. 11 Please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, available at gps.bcaresearch.com. 12 Please see Lee Ho-Jeong, "Thaad may lead to $7.5B in economic losses in 2017," Joongang Daily, May 4, 2017, available at www.joongangdaily.com. 13 Please see Ian Storey, "Thailand's Post-Coup Relations With China And America: More Beijing, Less Washington," Yusof Ishak Institute, Trends in Southeast Asia 20 (2015). 14 Malaysia began to move closer to China after its 2013 election, which initiated a period of political turbulence and scandal. This trend, along with economic slowdown, prompted the ruling coalition to turn to Beijing for support. 15 He is also, as current chair of the Association of Southeast Asian Nations (ASEAN), assisting China's negotiations toward settling a "Code of Conduct" in the South China Sea. This is not likely to be a binding agreement - China will not voluntarily reverse its strategic maritime-territorial gains - but it could dampen tensions for a time in the region and encourage better relations between China and Southeast Asia. For the 2016 Asian pivot to China discussed above, please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, and Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 17 The LDP's dramatic defeat in Tokyo's local elections on July 2 is the first tangible sign that the constitutional agenda, Abe's corruption scandals, and the emergence of a competing political leader, Yuriko Koike, are taking a toll on the LDP. 18 Also, Beijing may at any point rotate its maritime assertiveness back to the East China Sea, where tensions with Japan have quieted since 2013-14. Further, Beijing will want to exploit worsening relations between Japan and South Korea, and drive a wedge between Japan and Russia as they attempt a historic diplomatic thaw. 19 Beijing is attempting to steal a march on these states, especially in finance, while putting pressure on them to avoid activities that undermine Beijing's regional influence. So far there is only small evidence that tensions have affected trade. First, Hong Kong saw a drop in tourists and a block on cultural exports amid the Umbrella Protests of 2014. China's central government has acted aggressively over the past year to suppress Hong Kong agitation, by excluding rebel lawmakers from office and by drawing a "red line" against undermining Chinese sovereignty. Yet agitation will persist because of the frustration of local political forces and the youth, both of which resent the mainland's increasing heavy-handedness. Meanwhile, China and Singapore are in the process this month of improving relations after the November-January spat relating to Singapore-Taiwanese military ties. But China's encroachment on Singapore's traditional advantages - finance, oil refining, freedom of navigation, strong military relations with the U.S. and Taiwan, political stability - is likely to continue. 20 Please see BCA Geopolitical Strategy Monthly Report, "The Coming Bloodbath In Emerging Markets," dated August 12, 2015, "Geopolitical Risk: A Golden Opportunity?" dated July 9, 2014, and "In Need Of Global Political Recapitalization," dated June 2012, available at gps.bcaresearch.com. See also Frontier Markets Strategy Special Report, "Buy Vietnamese Stocks," dated July 17, 2015, available at fms.bcaresearch.com. 21 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Weekly Report, "Has Europe Switched From Reward To Risk," dated June 7, 2017, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 24 Please see The Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com.

Highlights Expanding trade volumes - led by EM growth - will continue to support commodity demand, particularly for base metals. In the first four months of this year, EM import growth averaged 8.4% year-on-year (yoy), led by an expansion of almost 13% in EM Asia. This compares with yoy growth averaging just 0.3% in the DM imports over the January - April period. EM exports grew 5.1% yoy in this interval vs. 2.7% for DM outbound trade. Overall, EM growth led world trade volumes 4% higher yoy, versus 0.8% growth over the January - April interval last year. We expect trade volumes to continue to grow as long as the Fed doesn't tighten monetary conditions too much in the U.S. Energy: Overweight. Benchmark crude oil prices continue their lackluster performance, as high-frequency inventory data in the U.S. fail to convince markets OPEC 2.0 cuts are succeeding in draining global inventories. We expect this to reverse, and remain long Dec/17 $50 vs. $55/bbl call spreads in WTI and Brent. Base Metals: Neutral. Expanded global trade, led by EM Asia, will be supportive of base metals prices. However, we do not expect higher trade volumes to prompt a surge in base metals. We remain neutral base metals generally. Precious Metals: Neutral. Palladium has consistently outperformed platinum in post-GFC markets, as has gold (see below). We remain neutral the precious-metals complex, but are keeping our long gold portfolio hedge in place. Ags/Softs: Underweight. The USDA's crop report will be released Friday. Weather-related crop distress in the grains could start showing up in the data. We remain bearish, but recommend staying on the sidelines. Feature Chart of the WeekStrong Growth In Global Trade Volumes##BR##Will Be Supportive Of Base Metals EM Trade Volumes Continue Trending Higher, Supporting Metals EM Trade Volumes Continue Trending Higher, Supporting Metals Growth in EM imports and exports continues to lead the expansion of global trade volumes. This is important, as the growth in trade supports EM income growth, which, in turn, supports commodity demand. EM growth is the principal source of commodity demand growth globally, particularly for oil and base metals. Global trade volumes expanded yoy in April, with imports up 3.7% and exports up 3.2%, down slightly from the pace in 1Q17, according to the CPB World Trade Monitor (Chart of the Week). The notional value of trade for the year ended in April was $16.3 trillion. The uptrend in global trade begun in 4Q16 continues, however, which we noted earlier this month. As was the case with oil, this expansion of global trade volumes, particularly out of the EM economies, will be supportive of base metals demand generally.1 Similar to EM oil demand, we find EM exports and imports are highly correlated with world base metals demand post-GFC (Chart 2). This is not unexpected, given the prominence of Chinese base metals demand, which accounts for roughly half of base metals demand globally. Given the low level of growth in DM imports and exports, we conclude that the bulk of the increase in global trading volumes is increasingly accounted for by trade within the EM economies with each other. This can be seen in Chart 3, which shows growth of EM imports and exports surpasses DM trade performance, shown in Chart 4. Chart 2World Base Metals Demand,##BR##Highly Correlated With EM Trade Volumes World Base Metals Demand, Highly Correlated With EM Trade Volumes World Base Metals Demand, Highly Correlated With EM Trade Volumes Chart 3Increased Trade Within##BR##EM Economies Powers Global Trade Growth Increased Trade Within EM Economies Powers Global Trade Growth Increased Trade Within EM Economies Powers Global Trade Growth Chart 4DM Growth Not##BR##Keeping Up With EM Growth DM Growth Not Keeping Up With EM Growth DM Growth Not Keeping Up With EM Growth Going Through The Trade Numbers For the year ended in April 2017, yoy world import levels grew 2.5% on average each month. DM imports averaged 1.8% yoy growth, while EM imports grew at twice that level. The notional value of DM imports was $9.6 trillion for the year ended in April. EM notional imports were $6.7 trillion, with EM Asia accounting for $4.7 trillion of this. For exports, world trade volumes grew at an average rate of 2.3% yoy each month for the 12 months ending in April, with DM growth coming in at 1.6%, and EM growth clocking in at 3.1% on average, just shy of double the rate of DM growth. The notional value of DM exports was $8.8 trillion for the year ended in April. EM notional exports were $7.4 trillion, with EM Asia responsible for $4.9 trillion of this. For April alone, DM imports were up 1.8% yoy, while EM imports were up 6.5%, down from a 9.1% average rate in 1Q17. DM exports in April were up 1.7% yoy, down from a 3% average rate in 1Q17, while EM exports rose 5%, equal to the 1Q17 average rate. Import volumes for EM Asia led global growth by a wide margin vs. other EM markets, particularly in Latin America and the Middle East (Chart 5). Average yoy import growth for the year ended in April was 6.6% for EM Asia, with yoy growth for April alone registering 10.4%. EM Asia also leads export volume growth (Chart 6), with average yoy outbound trade up 7.1% yoy. Chart 5EM Asia Dominates Import Growth YoY... EM Asia Dominates Import Growth YoY... EM Asia Dominates Import Growth YoY... Chart 6...And EM Export Growth ...And EM Export Growth ...And EM Export Growth As always, the evolution of China's economy will have an outsized influence on trade and EM growth. We continue to expect China's growth to moderate but not slow sharply, in line with our colleagues at our sister publication China Investment Strategy. The recent credit tightening likely will abate, given the central bank has reversed its credit contraction and injected liquidity into the interbank system in recent weeks, according to BCA's China Investment Strategy service.2 We agree with China Investment Strategy's assessment that, "The Chinese economy will likely continue to moderate, but the downside risk appears low at the moment and overall business activity will remain buoyant."3 Update On Global Inflation Vs. EM Trade Volumes World base metals demand is highly correlated with global consumer price inflation. In fact, these variables are cointegrated, meaning they share a common long-term trend. A 1% increase in world base metals demand can be expected to produce a 0.32% increase in U.S. CPI, a 0.25% increase in the Euro Area Harmonized CPI, and a 0.43% increase in China's CPI. Like the relationships between EM oil demand and EM trade volumes, which we presented earlier this month, the relationships between world base metal demand and EM trade volumes also allows us to track EM income levels. This is because the income elasticity of base metals demand also is ~ 1.0 for EM economies, according to the OECD, meaning a 1% increase in EM income can be expected to produce an increase in base metals demand of ~ 1%.4 Likewise, consumer inflation worldwide also is highly correlated with EM trade volumes post-GFC.5 In the regressions we ran for U.S., Euro Area and China CPI as a function of EM trade volumes, we find a 1% increase in EM imports can be expected to produce a 0.51% increase in the U.S. CPI, a 0.41% increase in the Euro Area harmonized CPI, and a 0.67% increase in the China CPI. A 1% increase in EM exports produces increases of 0.47%, 0.35% and 0.65%, respectively. These relationships can be seen in Charts 7, 8, and 9. Chart 7U.S. CPI Highly Correlated##BR##With EM Trade Volumes... U.S. CPI Highly Correlated With EM Trade Volumes... U.S. CPI Highly Correlated With EM Trade Volumes... Chart 8...Along With The Euro Area##BR##Harmonized CPI... ...Along With The EMU Harmonized CPI... ...Along With The EMU Harmonized CPI... Chart 9...And##BR##China's CPI ...And China's CPI ...And China's CPI Bottom Line: World base metals demand will continue to be supported by continued growth in EM trade volumes this year. While these volumes are up nicely, the rate of growth is moderating somewhat, suggesting global base metals demand will hold up this year, but won't surge ahead. We certainly do not see base metals prices falling precipitously this year, given the growth in EM imports and exports, which started to revive toward the end of last year. We remain neutral base metals, but will be watching the interplay between base metals demand and EM trade volumes for any sign global demand is being re-ignited. Inflation appears to be quiescent globally, but we would expect it to start ticking up if we see an uptick in base metals demand and EM trade volumes. Precious Metals Update PGM Notes Price relationships within the precious-metals complex, particularly vis-à-vis Platinum Group Metals (PGMs), have undergone profound transformations since the end of the Global Financial Crisis (GFC). These changes have been bolstered by technology shifts in the automotive sector as well. Two trading relationships - palladium's relationship to platinum, and platinum's relationship to gold - best illustrate these changing fundamentals. Unlike gold and platinum prices, palladium is heavily influenced by automotive sales, in this case, gasoline-powered automobile sales. Gasoline-powered cars use palladium in their pollution-control catalysts. Such usage was up 5% last year to 7.4mm oz, according to Thomson Reuters GMFS data.6 Autocatalyst demand accounts for slightly more than three-quarters of palladium demand, according to GFMS data.7 Importantly, the two largest car markets in the world - the U.S. and China - are predominantly gasoline-powered, and sales in both have been strong, although the rate of growth has slowed (Chart 10). This is supportive of palladium prices, particularly as the metal registered a 1.2mm physical deficit last year. There is an increase in Chinese platinum-based auto catalyst demand for diesel cars, due to tightening regulation on emissions, but still is a small share of the total demand for platinum. Post-GFC, the value of palladium relative to platinum has consistently strengthened (Chart 11). Chart 10U.S. Sales Growth Down,##BR##But China Remains Strong U.S. Sales Growth Down, But China Remains Strong U.S. Sales Growth Down, But China Remains Strong Chart 11Platinum Eclipsed By##BR##Palladium And Gold Platinum Eclipsed By Palladium And Gold Platinum Eclipsed By Palladium And Gold Platinum's Discount To Gold Endures Platinum traded premium to gold until the GFC (Chart 11). Since then, gold has behaved more like a currency, with its price mostly dependent on financial variables (USD, real U.S. interest rates, and equity risk premium). Importantly, the yellow metal has traded premium to platinum since the GFC ended. While platinum prices are somewhat sensitive to the same financial factors as gold, and also can be modeled as a function of these financial variables, the metal also has a real-demand driver: diesel-powered car sales. These vehicles use platinum in their pollution-control catalysts. Autocatalysts accounted for 3.3mm oz of platinum sales last year, or 42% of demand, according to Thomson Reuters GFMS. Most of this goes to diesel catalysts, which are mainly sold in Europe. Diesel-powered car sales have been trending lower (Chart 12) in Europe, where they are the dominant type of car sold. The second largest demand segment for platinum is jewelry sales, which fell 12% last year to 2.2mm oz, following a 3.6% decline the prior year. Both gold and platinum will be responsive to the same set of financial variables, meaning a stronger USD along with higher real rates will be bearish for both, and vice versa. However, given platinum is also sensitive to the diesel-powered auto market, its price evolution has a component strongly influenced by physical platinum demand and supply. Supply comes from mines and recycling, which increases when steel prices rise. Sales of diesel-powered cars are falling in Europe partly due to the Volkswagen emissions-testing scandal and a longer-lasting trend of cities attempting to lower pollution by restricting where diesel-powered vehicles can drive (e.g., Athens, Madrid, Paris and Mexico City are eliminating diesel traffic by 2025).8 In addition, high steel prices will increase platinum recycling volumes this year (people scrap their cars more when steel prices are high). High steel prices also incentivize the scraping of gasoline-powered vehicles, which use palladium in their pollution-control catalysts. Platinum competes at the margin in the pollution-control catalyst market with palladium. The ratio between palladium and platinum is at its highest level since 2002 (Chart 11). The premium of platinum against palladium (platinum minus palladium) went from $1200/oz. in 2010 to close to parity recently (Chart 13). Chart 12EU Sales Still Growing,##BR##But Diesel Loses Share EU Sales Still Growing, But Diesel Loses Share EU Sales Still Growing, But Diesel Loses Share Chart 13Platinum's Premium To##BR##Palladium Disappears Platinum's Premium To Palladium Disappears Platinum's Premium To Palladium Disappears Continue To Favor Palladium We are more favorably disposed toward palladium than platinum. Given palladium's price is dominated by sales of gasoline-powered cars, which should, all else equal, do well relative to diesel-powered auto sales, even with a globally synchronized economic upturn. With the U.S. Fed expected to continue tightening, gold and platinum will face financial headwinds that will restrain price appreciation. Palladium, on the other hand, will be less sensitive to these headwinds, although higher interest rates in the U.S. relative to the rest of the world will restrain demand for goods purchased on credit like autos. While we remain neutral the precious metals complex generally, we recently recommended a long spot-gold position as a portfolio hedge against rising inflation and inflation expectations.9 Even though inflation has remained quiescent, and markets are trading as if the odds of a return of inflation are extremely low, BCA's Global Investment Strategy argues "the combination of faster growth and dwindling spare capacity will cause inflation to rise. This is particularly the case for the U.S., where the economy has already reached full employment."10 We believe the strengthening of household incomes resulting from the tight U.S. labor market likely will keep the Fed on track to continue with its rates-normalization policy, vs. market expectations of a mere 21 basis points in cumulative Fed rate hikes over the next 12 months. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Strong EM Trade Volumes Will Support Oil," published June 8, 2017, available at ces.bcaresearch.com. The CPB World Trade Monitor is published monthly by the CPB Netherlands Bureau for Economic Policy Analysis. Please see https://www.cpb.nl/en/worldtrademonitor for data and documentation. We use CPB's volumetric data for imports and exports in our analysis, which are indexed to 2010 = 100; we converted these data to USD values to see how the composition of imports and exports is changing so as to better see how the relative shares of EM and DM are evolving. 2 Please see BCA Research's China Investment Strategy Weekly Report "Chinese Financial Tightening: Passing The Phase Of Maximum Strength," published by on June 22, 2017, available at cis.bcaresearch.com. 3 Please see BCA Research's China Investment Strategy Weekly Report "A Chinese Slowdown: How Much Downside," published on June 8, 2017, available at cis.bcaresearch.com. 4 As we noted in our research earlier this month, the read-through on this is EM trade volumes are closely tied to income levels, given this income elasticity in non-OECD economies. Please see "The Price of Oil - Will It Start Rising Again?" OECD Economics Department Working Paper No. 1031, p. 6 (2013). In our modeling, we assume the GFC ended in 2010. Our oil results vis-à-vis EM income elasticities can be found in BCA Research's Commodity & Energy Strategy Weekly Report "Strong EM Trade Volumes Will Support Oil," published June 8, 2017, available at ces.bcaresearch.com. 5 We originally published these results for EM oil demand vs. EM trade volumes in the June 8, 2017 article referenced above in footnote 1, in BCA Research's Commodity & Energy Strategy Weekly Report "Strong EM Trade Volumes Will Support Oil," available at ces.bcaresearch.com. The average R2 coefficient of determination for the regressions on imports was 0.89, while the average for the regressions on exports was 0.89. 6 Palladium supply totalled 8.6mm oz, while demand came in at 9.8mm oz, according to the Thomson Reuters - GFMS Platinum Group Metals Survey 2017. 7 In our modelling, we treat palladium as an industrial metal, given the overwhelming influence auto demand - particularly gasoline-powered vehicles - has on its price. Please see BCA Research's Commodity & Energy Strategy Weekly Report "2016 Commodity Outlook: Precious Metals," published by December 3, 2015, available at ces.bcaresearch.com. 8 A number of cities are looking to ban diesel cars entirely from their central districts. Please see https://www.theguardian.com/environment/2016/dec/02/four-of-worlds-biggest-cities-to-ban-diesel-cars-from-their-centres. 9 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Go Long Gold As A Strategic Portfolio Hedge," published May 4, 2017, available at ces.bcaresearch.com. 10 Please see BCA Research's Global Investment Strategy Weekly Report "Stocks Are From Mars, Bonds Are From Venus?," published June 23, 2017, available at gis.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016 EM Trade Volumes Continue Trending Higher, Supporting Metals EM Trade Volumes Continue Trending Higher, Supporting Metals

Highlights Crude oil prices will find support from stronger EM trade volumes, which broke out of an extended low-growth period at the end of last year and finished 1Q17 on a very strong note. Sustained growth in EM trade volumes will boost inflation at the consumer level in the U.S. and Europe, and will lift the Fed's preferred inflation gauge, provided the Fed does not constrict the growth of money supply this year and next. Energy: Overweight. We remain long Dec/17 WTI and Brent vs. short Dec/18 WTI and Brent, expecting the extended OPEC 2.0 production cuts and stronger oil demand to drain inventories this year. Base Metals: Neutral. China's Caixin manufacturing PMI for May fell below 50, indicating the manufacturing sector may be contracting. We will wait to see if this is confirmed this month and next, but for now this keeps us neutral with a negative tilt on the base metals complex. Precious Metals: Neutral. A weaker USD, and market expectations the Fed will be constrained in lifting interest rates later this year is supporting our strategic gold portfolio hedge, which is up 5.1% since it was initiated May 4, 2017. Ags/Softs: Underweight. Front-month corn is trading through the top of the $3.55 to $3.75/bushel range it has occupied since the beginning of the year. We are not inclined to play the momentum. Feature EM import and export volumes moved sharply higher in 1Q17 after breaking out of an extended low-growth funk late last year (Chart of the Week). The year-on-year (yoy) increase in the volume of imports and exports for EM economies reported by the CPB World Trade Monitor were up on average 8.74% and 5.29% in 1Q17, respectively, versus 12-month moving average levels of 2.2% and 2.5%.1 EM trade volumes are highly correlated with EM oil demand (Chart 2), particularly in the post-Global Financial Crisis (GFC) era, when EM import and export growth made significant gains relative to DM trade volumes (Chart 3).2 Indeed, EM imports and exports both grew at twice the rate of DM trade between the end of 2010 and the end of 1Q17: EM import volumes grew 22% vs. DM growth of 10% over the period, while EM export volumes grew 21% vs. DM growth of 11%. Chart of the WeekEM Imports And Exports##BR##Surge In 1Q17 EM Imports And Exports Surge In 1Q17 EM Imports And Exports Surge In 1Q17 Chart 2EM Oil Demand Closely##BR##Tracks Trade Volumes EM Oil Demand Closely Tracks Trade Volumes EM Oil Demand Closely Tracks Trade Volumes Chart 3EM Trade-Volume Growth##BR##Surpasses DM Growth EM Trade-Volume Growth Surpasses DM Growth EM Trade-Volume Growth Surpasses DM Growth We expect EM demand will account for some 80% of ~1.53mm b/d of global oil demand growth this year. If the strong 1Q17 performance in EM trade were to carry into 2Q, we will be raising our estimated oil-demand growth for the year significantly. We will be updating our global supply-demand balances next week. Coupled with the extension to end-March 2018 of the 1.8mm-barrel-per-day crude-oil production cuts recently agreed by the OPEC 2.0, the strong EM oil-demand growth could accelerate the draw-down in global storage levels, putting the WTI and Brent forward curves into backwardation sooner than the late-2017/early-2018 timeframe we currently expect.3 EM Trade Growth Will Stoke Oil Prices And Inflation Because EM demand is the driving force of global oil-demand growth, a continuation of the strong trade performance from this sector will support oil prices going forward, and likely will lift inflation as the year progresses. In the post-GFC period, we would expect a 1% increase in EM import and export volumes to boost oil prices by a little more than 2%, and vice versa.4 This is almost twice the effect an increase in trade produces in estimates beginning pre-GFC in 2000; most likely, it reflects the increase in EM trade volumes relative to DM trade volumes post-GFC.5 Our modeling confirms key inflation gauges - particularly the Fed's preferred gauge, the core PCE; the U.S. CPI; and EMU Harmonized CPI - all are highly sensitive to EM oil demand, as expected, and, no surprise, to EM trade volumes.6 In the post-GFC period, a 1% increase (decrease) in EM oil demand can be expected to lift (drop) core PCE and the U.S. CPI by a little more than 50bps; for the EMU CPI, a 40bps increase (decrease) can be expected.7 In addition, we have found the EM trade data also is a highly explanatory variable for these inflation gauges. Imports explain ~ 84%, 91% and 89% of core PCE (Chart 4), U.S. CPI (Chart 5), and EMU CPI (Chart 6), respectively, in the post-GFC period, while exports explain 94%, 93% and 81% of these inflation gauges. The elasticities for the U.S. gauges is ~ 50bps, similar to the EM oil demand estimates, and ~35bps for the EMU CPI. Chart 4Core PCE Is Highly Sensitive To EM Trade Volumes... Core PCE Is Highly Sensitive To EM Trade Volumes... Core PCE Is Highly Sensitive To EM Trade Volumes... Chart 5...As Is U.S. CPI... ... As Is U.S. CPI ... ... As Is U.S. CPI ... Chart 6...And EMU CPI ... And EMU CPI ... And EMU CPI A continued expansion of EM trading volumes this year can be expected to lift inflation in the U.S. and Europe. We also would expect this to hold for China as well, given the results of our earlier research.8 Fed Could Kill The Party Chart 7U.S. M2 Is Important To EM Trade Volumes U.S. M2 Is Important To EM Trade Volumes U.S. M2 Is Important To EM Trade Volumes One variable we are watching closely is U.S. money supply, M2 in particular, vis-à-vis EM trade volumes (Chart 7). We find that in the post-GFC world, EM trade volumes are highly sensitive to M2, with M2 explaining 92% of EM exports and 82% of imports. This relationship did not exist in the pre-GFC world, or in estimates starting pre-GFC and extending to the present day. This no doubt is related to massive monetary accommodation and QE experiments post-GFC, but, as of this writing, we are not at all sure how this relationship will evolve going forward. Bottom Line: EM trade volumes have broken out of a long-term funk, which will be supportive of crude oil prices and will lift inflation going forward. Strong EM trade growth at the pace at which it ended 1Q17 would cause us to lift our expectation for global oil demand significantly for this year. This, combined with the extension of the OPEC 2.0 production cuts to March 2018 could normalize global inventories faster than markets currently expect. EM trade is, importantly, highly exposed to U.S. monetary policy, particularly to what happens to U.S. M2 money supply. This is a feature of the global trade picture that was not present pre-GFC. Our research affirms our conviction on the bullish oil exposure we have on - chiefly the long Dec/17 Brent and WTI vs. short Dec/18 Brent and WTI backwardation trades. Our results also support remaining long gold as a strategic portfolio hedge against inflation and geopolitical risk, and remaining long commodity-index exposure. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 The CPB World Trade Monitor is published monthly by the CPB Netherlands Bureau for Economic Policy Analysis. Please see https://www.cpb.nl/en/worldtrademonitor for data and documentation. We use CPB's volumetric data for EM imports and exports in our analysis, which are indexed to 2010 = 100; we converted these data to USD values to see how the composition of imports and exports was changing so as to better see how the relative shares of EM and DM are evolving. 2 EM export and import volumes are cointegrated with non-OECD oil consumption, our proxy for EM oil demand, in regressions starting pre- and post-GFC, meaning they share a common trend and are in a long-term equilibrium. The adjusted R2 coefficient of determination for EM oil demand as a function of EM export volumes is 0.91 for estimates starting in 2003 and 2010 (the pre- and post-GFC periods); for EM imports, it is 0.84 post-GFC, and 0.90 pre-GFC. Post-GFC, we estimate a 1% increase (decrease) in EM import and export volumes translates to an 88bp and 85bp gain (decline) in EM oil demand. The read-through on this is EM trade volumes are closely tied to income growth, given the income-elasticity of demand for oil is ~ 1.0 in non-OECD economies, according to the OECD. Please see "The Price of Oil - Will It Start Rising Again?" OECD Economics Department Working Paper No. 1031, p. 6 (2013). In our modeling, we assume the GFC ended in 2010. 3 Please see our discussion of this production-cut extension in the joint report we did with BCA Research's Energy Sector Strategy on June 1, 2017, entitled "Extending OPEC 2.0's Production Cuts Will Normalize Global Oil Inventories." It is available at ces.bcaresearch.com. 4 The R2 coefficients of determination for the cointegrating regressions of Brent prices on EM export and import volumes are 0.90 and 0.93, respectively, for post-GFC estimates. For estimates beginning in 2000, the R2 coefficients are 0.88, while the elasticities are ~1.20 for the EM trade variables. These models also include a parameter for the broad trade-weighted USD, which, post-GFC, has become more important to the evolution of Brent prices: A 1% increase in the currency parameter translates to a price decline of more than 5%, which is approximately twice the value of the estimates starting pre-GFC. 5 Our estimates for WTI produce similar results for the pre- and post-GFC periods. 6 We examined this in our August 4 and 11, 2016, in "Memo To The Fed: EM Oil, Metals Demand Key To U.S. Inflation," and "Global Inflation And Commodity Markets." Both are available at ces.bcaresearch.com. 7 The R2 coefficients of determination for the core PCE, U.S. CPI and EMU CPI estimates as a function of EM oil demand are 0.97, 0.94 and 0.85, respectively. It is interesting to observe that prompt measures of inflation are not correlated to oil prices, but that 5-year 5-year CPI swaps remain highly correlated with oil prices, the 3-year forward WTI futures contract in particular; the R2 for the estimate of the 5y5y CPI swap as a function of the 3-year WTI contract is 75%. 8 In the August 11, 2016, article "Global Inflation And Commodity Markets," we found Chinese inflation to be equally sensitive to EM oil demand. We will be exploring this further when we look at base metals demand vis-à-vis EM trading volumes in forthcoming research. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016 Strong EM Trade Volumes Will Support Oil Strong EM Trade Volumes Will Support Oil Strong EM Trade Volumes Will Support Oil Strong EM Trade Volumes Will Support Oil