Trade / BOP

Highlights The DXY correction has a bit more to run as G10 economic surprises are likely to roll over. EM-related plays like commodity currencies can rally for a few more months, but the outlook for 2017 is troublesome. China is at risk of a deceleration. Global liquidity is tightening. Protectionism is rising. Feature Dollar Correction: It Ain't Over 'til It's Over Can the dollar correction advance further, or is the dollar bull market about to resume? We prefer to position ourselves for additional dollar weakness in the coming months. Despite persistently high bond yields, the DXY is still softening. It is being dragged down by a euro supported by strong economic news such as this week's Belgian business confidence, our favorite bellwether for the euro area. The pound too continues to show some vigor, which is also a byproduct of economic data pointing toward better growth (Chart I-1). We expect the support for the greenback from higher Treasury yields to be temporary. Momentum in U.S. 10-year government bond yields is driven by G10 economic surprises (Chart I-2). Currently, economic surprises are flirting with the upper end of their distribution of the past 12 years. Chart I-1The British Economy Is Picking Up The British Economy Is Picking Up The British Economy Is Picking Up Chart I-2G10 Economic Surprises Drive Treasury Yields G10 Economic Surprises Drive Treasury Yields G10 Economic Surprises Drive Treasury Yields Accentuating the odds of a rollover in surprises are two factors: First, as bond yields and risk-asset prices attest, investors are revising their growth expectations upward, lifting the hurdle for data to surprise to the upside. Second, having expanded for 10 months, the global credit impulse has experienced its longest upswing in a decade. Yet, the increase in global borrowing costs, along with the widening in cross-currency basis swap spreads, points to tightening global liquidity conditions, a poison for the credit cycle (Chart I-3). As credit slows, the economy will deteriorate. Chart I-3The Credit Cycle Is Stretched The Credit Cycle Is Stretched The Credit Cycle Is Stretched This means that the key factor that has supported the stronger dollar in recent months - higher U.S. yields - will begin to dissipate, putting downward pressure on the USD. Finally, our dollar capitulation index, after hitting overbought conditions, is now falling. Moreover, it currently stands below its 13-week moving average, conditions under which the greenback has recorded an average 8.1% annualized weekly loss since 1994, and an average 5.3% annualized weekly loss since 2011 (Chart I-4). Chart I-4Negative Momentum For The Dollar Negative Momentum For The Dollar Negative Momentum For The Dollar We continue to play this correction by shorting USD/JPY. As we have pointed out before, USD/JPY remains a function of the level of global bond yields (Chart I-5). Additionally, a negative surprise in global growth is likely to hurt risk assets. To conclude with the favorable backdrop for the yen, the high degree of uncertainty created by the seemingly erratic policy changes of the new Trump administration suggests that equity implied volatility remains too low. After all, we do not know what changes will hit global tax regimes, what the Fed policy will look like, nor how protectionist Trump will really be. Imbedding a premium for these risks will require higher equity implied vols. A higher VIX tends to support the yen against the USD (Chart I-6). Chart I-5USD/JPY And G10 Bond Yields USD/JPY And G10 Bond Yields USD/JPY And G10 Bond Yields Chart I-6The Yen Likes Uncertainty The Yen Likes Uncertainty The Yen Likes Uncertainty Bottom Line: The correction in the dollar should continue, as bond yields still have downside on a one- to three-month basis. The yen remains the best-placed currency to take advantage of these dynamics, especially if risk assets experience a correction. Focus - Emerging Markets and Liquidity: A March To The Scaffold This week, we re-examine our bearish view on emerging markets, a key theme underpinning our bearish stance on commodity currencies. EM assets, and therefore commodity currencies, have outperformed our expectations, reflecting the percolation of previous positive economic surprises in EM relative to the U.S. (Chart I-7). EM and commodity currencies are priced for perfection, with the risk-reversals on EM currencies displaying elevated levels of optimism (Chart I-8). For EM and commodity currencies to rally further, EM economies need to continue to outperform durably. This requires the Chinese economy and the global liquidity backdrop to only improve further. Can this happen? Chart I-7Surprise Beat In EM Versus The U.S. Has ##br##Helped EM And Commodity Currencies Surprise Beat In EM Versus The U.S. Has Helped EM And Commodity Currencies Surprise Beat In EM Versus The U.S. Has Helped EM And Commodity Currencies Chart I-8EM And Commodity Currencies ##br##Priced For Perfection EM And Commodity Currencies Priced For Perfection EM And Commodity Currencies Priced For Perfection While the next month or two may continue to generate generous returns for EM-related plays, the rest of 2017 may not prove as kind. The China Syndrome Let's begin with China. The recent upsurge in metal prices has reflected an improvement in Chinese economic activity (Chart I-9). As we have pinpointed before, the Keqiang index is near cycle highs, and, Chinese railway freight volumes have been growing at their fastest pace since 2010. This situation is unlikely to continue much longer. The upsurge in Chinese commodity intake - metals in particular - has been fueled by a vigorous rebound in Chinese real estate construction. However, Chinese real estate price appreciation has hit dangerous levels, and the authorities are already leaning against it, with the PBoC increasing rates by 10 basis points this week. The roll-over in Chinese real estate activity should deepen Chart I-10), hurting commodity prices - particularly iron ore, steel and copper - and commodity currencies along the way. Chart I-9China's Rebound Explains ##br##The Metals Rally China's Rebound Explains The Metals Rally China's Rebound Explains The Metals Rally Chart I-10The Risk Of A China Real Estate ##br##Slowdown Is Growing The Risk Of A China Real Estate Slowdown Is Growing The Risk Of A China Real Estate Slowdown Is Growing Moreover, some of the upswing in Chinese economic activity was also related to large amounts of fiscal stimulus in that nation. In mid-2015, the Middle Kingdom was inching ever closer to a hard landing, prompting a panicked Beijing to boost fiscal support and to speed up the roll-out of US$1.2 trillion of infrastructure public-private partnerships. Today, this fiscal hand-out is fading (Chart I-11). This could once again cause industrial activity and investments to weaken as Chinese capacity utilization remains near recession troughs. The recent disappointing investment growth reading in the latest Chinese GDP release could be a harbinger of this reality. Finally, as we have highlighted last week, Chinese monetary conditions have massively improved as Chinese producer-price inflation rebounded, pushing down Chinese real rates in the process. However, with commodity price inflation set to slow - courtesy of a dissipating base effect and of last year's dollar rally - Chinese PPI should roll over, pulling up real rates and tightening monetary conditions (Chart I-12). A tightening in Chinese monetary conditions represents a big problem for EM as it portends a slowdown in economic activity (Chart I-13). This will ultimately lead to a big drag on DM commodity producers, as EM commodity intake decreases, pushing down the likes of the AUD, CAD, and NZD as their terms of trade suffer. Chart I-11Fading Chinese##br## Fiscal Stimulus Fading Chinese Fiscal Stimulus Fading Chinese Fiscal Stimulus Chart I-12Commodity Inflation Will Peak, ##br##So Will Chinese Inflation Commodity Inflation Will Peak, So Will Chinese Inflation Commodity Inflation Will Peak, So Will Chinese Inflation Chart I-13Tightening China Monetary Conditions##br## Will Hurt EM Economic Activity Tightening China Monetary Conditions Will Hurt EM Economic Activity Tightening China Monetary Conditions Will Hurt EM Economic Activity Bottom Line: In early 2016, global markets were not positioned for a rebound in Chinese economic activity. Yet, Chinese industrial activity improved, resulting in a rebound in EM assets, commodity prices, and commodity currencies. The crackdown on real estate activity, the removal of Chinese fiscal stimulus, and the expected tightening in Chinese monetary conditions should result in a reversal of these trends, hurting commodity producers and their currencies in the process. Global Liquidity In Retreat While China represents a problem for EM plays and commodity currencies, deteriorating global liquidity could prove an even stronger hurdle. Our tactical expectation of a lower dollar and lower rates may support EM plays temporarily, but the cyclical outlook remains grim. To begin with, EM economies are dependent on global liquidity as they run a current account deficit expected to hit US$140 billion in 2017, or US$400 billion if China is excluded. Moreover, they sport large external debts of US$4.8 trillion, excluding Taiwan and China. Especially worrisome are the large funding requirements of many EM countries, especially for Turkey, Malaysia, and Colombia. (Chart I-14). Chart I-14EM Debt Vulnerability Ranking Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism Why is this a problem? Two reasons: Global Interest rates and the dollar. Global Interest rates, driven by higher Treasury yields, are rising as the U.S.'s economic slack vanishes, suggesting that the current tightening campaign by the Fed will be durable (Chart I-15). Higher U.S. rates lift the U.S. dollar against EM currencies, tightening EM liquidity conditions. But an unrelated shock is also putting exogenous upward pressure on the dollar. This force is the widening in LIBOR spreads (Chart I-16). This is the result of the regulation-related 90% melt down in the asset under management of U.S. prime money-market funds, an important source of global dollar liquidity. Moreover, U.S. banks, with their balance sheets under pressure by the binding constraints of Basel III, have not been able to fill the gap. Chart I-15The Fed has A Green Light To Hike The Fed has A Green Light To Hike The Fed has A Green Light To Hike Chart I-16Stresses In The Libor Market Remain Stresses In The Libor Market Remain Stresses In The Libor Market Remain The end result has been a widening of cross-currency basis swap spreads, which usually tends to boost the dollar (Chart I-17). This phenomenon increases the hedging costs to foreign investors of holding U.S. dollar assets. These investors become increasingly tolerant of purchasing U.S. assets unhedged, pushing up the value of the dollar in the process. This is best illustrated by the fact that net portfolio investments in the U.S. moved from a deficit of US$300 billion in Q1 2015 to a surplus of more than US$550 billion. Yet, hedges put in place, as approximated by the BIS's volume of OTC FX derivatives, have flat-lined since 2013 (Chart I-18). Chart I-17Widening Cross-Currency Basis Swap Spreads Equals A Higher Dollar Widening Cross-Currency Basis Swap Spreads Equals A Higher Dollar Widening Cross-Currency Basis Swap Spreads Equals A Higher Dollar Chart I-18Hedging Activity is Receding Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism A rising dollar and LIBOR stresses are tightening global dollar liquidity, creating a big problem for EM. Wider-than-normal cross-currency basis swap spreads have been associated with declining global trade (Chart I-19). The stronger dollar plays a role, as it hurts the price of globally-traded good prices. Also, higher borrowing costs result in a mild disintermediation of global trade flows. As physical exports are 26% of EM GDP versus 13% for the U.S., this represents a huge drag on EM currencies, especially versus the USD. As a corollary, it is also a problem for the small open commodity producing DM economies like Australia, Canada, or New Zealand. Furthermore, the strength in the dollar associated with LIBOR shocks further hurts EM domestic economies by impeding EM credit growth (Chart I-20). The combined assault of a stronger dollar and higher rates increases the cost of EM foreign debt. Also, according to the BIS, between 2002 and 2014, 55% of EM commodity producers' debt issuance has been in USD.1 When the dollar rises, they see both their borrowing costs rise and the prices of the products they sell fall. Altogether, these forces preempt capex and credit accumulation in EM nations. Chart I-19Tightening Global Liquidity##br##Is Bad For Trade Tightening Global Liquidity Is Bad For Trade Tightening Global Liquidity Is Bad For Trade Chart I-20A Stronger Dollar Will Hamper##br## EM Credit Growth A Stronger Dollar Will Hamper EM Credit Growth A Stronger Dollar Will Hamper EM Credit Growth Bottom Line: The global liquidity backdrop is deteriorating. DM rates are rising cyclically, which is lifting the dollar. Moreover, a global dollar shortage is also supporting the greenback, further hurting EM liquidity conditions. Thus, we expect EM growth to deteriorate, hurting EM assets and commodity currencies. Protectionism The final issue affecting EM economies is the rise of protectionism, especially in the United States. EM - Asia and China in particular - have been the main beneficiaries of globalization (Chart I-21). Currently, they are in the line of sight of President Trump. Thus, we expect that any potential trade war between the U.S. and the rest of the world will focus on EM economies and China. Chart I-21EM And Asia Are In Trump's Line Of Sight Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism EM are much more dependent on the U.S. than the other way around. As an example, China's exports to the U.S account for 3.5% of Chinese GDP, while U.S. exports to China account for less than 1% of U.S. GDP. EM economies have a lot more to lose from a trade war than the U.S. Because of this imbalance in relative trade-exposures, EM economies are at risk from the border-adjustment tax being discussed in the U.S. These taxes would be very deflationary for EM economies as they could force a downward adjustment in EM labor costs and further depress capex in these nations. To ease these adjustments, falling EM exchange rates would be required. Once again, commodity currencies would suffer from these developments. First, lower capex in EM hurts Australian, New Zealand, or Canadian terms of trade. Second, lower EM exchange rates means that that exports from the dollar bloc to EM would suffer. Finally, and most perversely, lower EM exchange rates will give EM commodity producers an advantage versus DM producers, in that a stronger U.S. dollar means their local-currency costs are falling. EM commodity producers would keep producing more than warranted, putting additional downward pressure on commodity prices and stealing market shares from the dollar bloc producers. This is not a pretty picture. Bottom Line: EM should bear the brunt of the pain of any rise in U.S. protectionism. The tight link between EM economies and DM commodity producers suggests that this pain should adversely affect the AUD, the CAD, and the NZD. Risks To Our View Chart I-22Chinese Tariffs Are Falling Chinese Tariffs Are Falling Chinese Tariffs Are Falling The biggest risk to our view is a redoubling of Chinese fiscal stimulus. The threat of U.S. tariffs and trade sanctions is obviously deflationary and negative for the Chinese economy. We know this, as do the relevant powers in Beijing. A tool to mitigate any of these negative repercussions on the Chinese economy might be for Beijing to press on the gas pedal once more. Additionally, as our colleague Yan Wang wrote in this week's China Investment Strategy, key members of the new U.S. administration have been on record saying that the threat of tariffs is not an end game, but rather a negotiating tool to extract concessions from U.S. trade partners, implying a potentially more pragmatic stance from the U.S. than current rhetoric suggests.2 Moreover, the Chinese side of the negotiation table is also more open minded than most observers fear. China has been cutting its own tariffs and could continue to do so (Chart I-22). Moreover, Premier Li Keqiang has made a new pledge to move faster toward opening and liberalizing Chinese markets for access by foreign companies. A deal may be less elusive than feared. Finally, regarding the global liquidity deterioration, the recent rebound in gold and silver prices may be a harbinger of improving liquidity conditions globally. We doubt that the economic situation will let this rally be durable, but it remains something to monitor. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Bruno Valentina, and Hyun Song Shin, "Global Dollar Credit And Carry Trades: A Firm-level Analysis", BIS, Working Papers, August 205. 2 Please see China Investment Strategy Special Report, "Dealing With The Trump Wildcard", dated January 6, 2017, available at cis.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 U.S. data was mixed this week. The labor market saw both continuing and initial jobless claims rise above expectations. However, the economy is still near full employment and the Fed will not respond to this news. Furthermore, the Beige Book, released last week, also highlights that the U.S. economy remains resilient with employment and pricing activity particularly strong. This week the DXY broke through the key 100 level, as the market continues to reprice capricious assumptions of Trump's policies. Nevertheless, it has rebounded since then. The dollar is unlikely to see any real movement until the administration releases concrete information about its policies. For the time being, the Fed also seems to be on the sidelines in anticipation of more information. Report Links: U.S. Border Adjustment Tax: A Potential Monster Issue For 2017 - January 20, 2017 Update On A Tumultuous Year - January 6, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Although the euro area has seen a brighter economic environment as of late, this week's data has been mixed: German and overall euro area services and composite PMI underperformed, while manufacturing PMI outperformed consensus. The IFO Business Climate and Expectations both underperformed consensus, while the Current Assessment remained in line with consensus. All measures still remain over 100. Finally, Belgian Business Confidence accelerated sharply. The ECB is unlikely to change its dovish stance. The euro will therefore see little upside. The recent uptrend in EUR/USD is due to dollar weakness, but the recent downtrend in EUR/GBP and EUR/SEK indicate that the market is not necessarily hopeful that the ECB will reach its inflation target anytime soon. Report Links: GBP: Dismal Expectations - January 13, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data indicates that last year's sharp depreciation of the yen is helping the Japanese economy: Exports increased by 5.4% YoY, crushing expectations of 1.2% growth. Nikkei Manufacturing PMI reached 52.8, also beating expectations. In November machinery orders grew by more than 10% YoY. The BoJ will be more resolute on its radical monetary measures, as recent data shows that their approach is working. This will prove very bearish for the yen on a cyclical basis, given that the cap in Japanese rates will cause the rate differential between the U.S. and Japan to widen. In the short term, USD/JPY will resume its correction. We estimate that USD/JPY will cease to be attractive as a short opportunity at around 110. Report Links: Update On A Tumultuous Year - January 6, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Party Likes It's 1999 - November 25, 2016 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 On Tuesday, the Supreme Court upheld the decision of the High Court, requiring a parliamentary vote to authorize the exit of the U.K. from the European Union. This news is an added boon for cable, which has surged by almost 5% after bottoming at 1.20 about 10 days ago. As political risks start to dissipate, and the currency trades more on economic fundamentals, the pound should become a more attractive buy, particularly against the euro, given that the U.K. economy should outperform the market's dismal expectations. Recent data supports this view: Average earning growth outperformed expectations in November. GDP growth was 2.2% YoY in Q4, also outperforming expectations. Furthermore, short-term technicals point to a stronger pound. EUR/GBP has broken through its 100-day moving average, which indicates that momentum should continue to drive this cross downwards for the time being. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Two weeks ago, we argued that the rally in AUD lacks fundamental domestic causes. This week, the momentum of the recent AUD rally, caused by rising iron ore and copper prices, has seemingly paused. Exacerbating this change of pace is recent data which indicates a weak economic backdrop: the RBA trimmed mean CPI, and the more common CPI measure, underperformed consensus at both a quarterly and yearly pace. This could be due to depressed consumer sentiment, as the labor market remains mired in a slump, with the unemployment rate increasing to 5.8%, and total hours worked falling. Given recent data, it is likely that markets reprice growth prospects in Australia. U.S. trade policies could also potentially curtail global trade, painting a bearish picture for AUD. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 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 The Kiwi has appreciated 4.4% since the start of 2017. Although this rally might eventually be limited against the U.S. dollar, the NZD will likely have more upside against its crosses, particularly the AUD. Indeed it seems that low inflation, one of the only sore spots for the RBNZ in an otherwise stellar kiwi economy, has turned the corner, surging to 1.3% on the latest reading Wednesday. More importantly, not only did inflation beat expectations but it also surpassed 1% for the first time since 2014. This is a significant development, given that persistently low inflation in New Zealand was keeping the dovish bias of the RBNZ. With this hurdle gone, and an economy that continues to be the best performing in the G10, this dovish bias should disappear, which will ultimately lift the NZD against its crosses. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Despite the dissipating oil slump, potential risks may weigh on Canada's future. These risks are likely to emanate from an international sphere. Key concerns revolve around U.S. policies: recent statements have increased yields and tightened financial conditions, but global trade worries are not fully priced in. Recent news indicates that Trump has no ill-intentions aimed at Canada, however, protectionist policies could hurt global trade, indirectly curtailing Canadian exports. A U.S. corporate tax cut can also deviate investment from Canada to the U.S. The recent appreciation in the CAD against major currencies can also hurt Canadian competitiveness going forward. As oil is likely to remain relatively stable in the near future, we may again see a disassociation of CAD with oil, and a continued tight relationship with interest rate spreads. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Yesterday, EUR/CHF fell below the crucial 1.07 level. As we have recommended many times, any time that this cross falls below this threshold, it becomes an excellent buying opportunity. The SNB has not been shy to intervene in the currency markets, and they have been very clear that they will not tolerate any currency strength past a certain threshold as it could add additional deflationary pressures to an economy that has not had a positive inflation rate since 2014. We have identified a level of 1.07 for EUR/CHF as this threshold. Moreover given that the euro is the currency of reference for interventions, the behavior of USD/CHF should roughly mirror the behavior of the dollar against the Euro. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 The Norwegian Krone has rallied along other commodity currencies so far this year, in spite of the meek performance of oil over this timeframe. This surge might prove unsustainable in the short term, as USD/NOK is very close to oversold territory. In the long term, the outlook for the NOK is more positive, particularly against other commodity currencies. Rising oil prices resulting from the OPEC cuts should supercharge the already high inflationary pressures in the Norwegian economy. This factor will eventually push the Norges Bank off its dovish bias, and the NOK higher in the process. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 The Swedish economy seems to be finally benefitting from last year's weaker krona; PPI numbers came in at 2.1% MoM, and 6.5% YoY, higher than previous numbers. This will feed into CPI in the near future. Additionally, 1-year, 2-year, as well as the important 5-year Prospera Inflation Expectations have all picked up, with the 5-year at 2%, in line with the Riksbank's target. The bank is aware of the krona's recent strength against major currencies, and realizes that it is important that the appreciation slows. In the short term, the SEK could continue to rally on the back of the dollar's correction and the Swedish economic outperformance vis-à-vis the euro area. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Trump administration will likely at least initially negotiate with China on trade issues rather than rush to meaningful punitive measures. Bilateral negotiations will likely focus on correcting China's allegedly unfair trade practices and increasing market access for American firms. It is, however, not difficult to find common ground that China is able or even willing to accommodate. A more inward looking U.S. generates a mutual desire among China and other economies to work more closely, potentially creating a new "globalization process" with distinct Chinese characteristics. Feature Fears of a trade war between the U.S. and China are now firmly on investors' radar screens, with President Donald Trump's inauguration speech last week doing little to assuage concerns. Even though he fell short of his campaign promise to label China as a currency manipulator in his first days in office, there is little doubt that trade tensions between the world's two largest economies will rise going forward. The challenge for investors is that U.S. trade policy under the new administration has simply become unpredictable. This week's report lays out our base case scenario for how things might evolve. Threat Or Policy? The biggest unknown at the moment is whether President Trump's threats to impose sanctions on Chinese goods are a mere negotiating tactic in order to gain concessions, or a real policy choice and direction. Unless one assumes that Trump will completely resort to radical and reckless policies that intentionally lead to a loss-loss situation for both the U.S. and China, we suspect the Trump administration will at least initially negotiate with China on trade issues rather than rush to meaningful punitive measures. Chart 1Exports Also Matter For the U.S. Exports Also Matter For the U.S. Exports Also Matter For the U.S. First, the grand strategy of President Trump on trade is to reduce America's massive and growing current account deficit. However, basic economics suggests that a country's current account deficit is fundamentally determined by its domestic savings and domestic capital spending. A deficit country, like the U.S., means its domestic savings fall short of its domestic investment, and therefore it needs to import capital from abroad to fill the gap. On the contrary, surplus countries, like China, have domestic savings in excess of their domestic investments, and therefore "export" capital abroad. In the U.S.'s case, the fact that the dollar is the main global reserve currency has allowed it to run chronic current account deficit without experiencing a balance-of-payments crisis. Unless 'Trumponomics' fundamentally changes the savings and investment balance in the U.S. economy, protectionism will not shrink the U.S. current account deficit. Punitive tariffs against Chinese goods will only shift America's deficit to China's competitors, often higher-cost producers, thus likely jacking up prices and hurting American consumers. Second, the U.S., although much less dependent on global trade than most countries, is not as isolated as commonly perceived. Exports of goods and services account for about 13% of U.S. GDP, compared with 22% for China and a global average of 30% (Chart 1). Moreover, exports as a share of the Chinese economy have almost halved since the global financial crisis, while exports' share in the U.S. economy has continued to climb to near all-time high levels. Major disruptions in global trade certainly hurt China more, but they would have also removed a major economic driver for the U.S. in recent years, which contradicts Trump's pro-growth objective. Chart 2China's Growing ATP Demands Offers Potential ##br##For U.S. Manufacturing Jobs China's Growing ATP Demands Offers Potential For U.S. Manufacturing Jobs China's Growing ATP Demands Offers Potential For U.S. Manufacturing Jobs Third, Trump's economic white paper released in September prepared by Peter Navarro and Wilbur Ross,1 both now senior administration staff, explicitly states that "tariffs will be used not as an end game but rather as a negotiating tool to encourage our trading partners to cease cheating," and "If, however, the cheating does not stop, Trump will impose appropriate defensive tariffs to level the playing field." Moreover, in the confirmation hearing process, Treasury Secretary nominee Steven Mnuchin hinted that he would go through the existing statutory process on the currency manipulation issue, which reduces the odds of naming China as a manipulator, as China currently does not fit the Treasury's criteria.2 All of this means the Trump administration will at least try to negotiate with the Chinese on trade-related issues. Finally, creating manufacturing jobs is one of President Trump's primary goals, and some advanced-technology products (ATP) and industries have been singled out in the September economic white paper that the administration intends to promote, such as aerospace, chemicals, electronics, motor vehicles, pharmaceuticals, railroad rolling stock, and robotics. On the other hand, high-tech products have been a growing share in China's total imports, and its demand for global ATP will continue to increase as its economy becomes more sophisticated (Chart 2). Since the early 2000s, however, the U.S. has been losing market share in China's high-tech imports. In this vein, re-gaining market share for American ATP goods in Chinese imports may be a crucial part of Trump's job creation plan. Bottom line: Cooperation rather than confrontation is the rational policy choice of President Trump, given the prevailing economic circumstances. What Trump Wants, And Can China Budge? If tariffs are indeed used as a negotiation chip, it is important to understand what specific concessions the Trump administration will seek from China, which so far have not been made clear. In the September economic white paper, Trump's senior advisors laid out the "sins" that China has committed to gain unfair trade advantages, including "currency manipulation, theft of intellectual property, forced technology transfers, a widespread reliance upon both 'sweat shop' labor and pollution havens, illegal export subsidies, and massive dumping of select products such as aluminum and steel below cost." Moreover, President Trump has openly complained that Chinese tariffs on certain goods are prohibitively high for foreign producers, and that American firms have been much more restricted in doing business in certain industries in China than vice versa. Therefore, bilateral negotiations, if any, will likely focus on correcting China's allegedly unfair trade practices and increasing market access for American firms. It is, however, not difficult to find common ground that China is able or even willing to accommodate on the issues. On currency manipulation. The RMB is now under significant downward pressure, and the People's Bank of China may not be against the idea of cooperating with the U.S. to support the yuan and weaken the greenback. On intellectual property and technology transfers. China's attitude towards technology and intellectual property rights has changed dramatically in recent years, not only because of improving legal procedures, but more importantly because of the growing awareness of IPR protection among the Chinese business community. China's patent applications have skyrocketed in recent years, which naturally pushes the country's IPR practices towards the western standard (Chart 3). Chinese patent applications topped 1 million in 2015, by far the largest in the world and almost as many as the next three largest applicants, the U.S., Japan and Korea, combined. In short, China has developed a keen self-interest for better IPR protection, simply because it now has a lot more to protect than in the past. On "sweat shop" and pollution havens. There is little doubt among Chinese leadership that China has long passed the "sweat shop" model. Cheap labor-intensive sectors account for an increasingly smaller share in China's total industrial output and exports, and they will be further marginalized as the country's income level continues to rise (Chart 4). In fact, Chinese entrepreneurs have been leading the exodus of moving production capacities in these industries to lower-cost countries. Moreover, pollution has become an overwhelming social issue in major metropolitan centers, and there is a growing sense of urgency in Chinese society to take immediate action on environmental protection. In other words, there is not much interest among the Chinese leadership to protect these "sweat shops" and pollution havens that the Trump administration is complaining about. Chart 3China's Developing Self-Interest In IPR protection China's Developing Self-Interest In IPR protection China's Developing Self-Interest In IPR protection Chart 4"Sweat Shops" Are Already Marginalized "Sweat Shops" Are Already Marginalized "Sweat Shops" Are Already Marginalized On illegal export subsidies and dumping of base metals. It is an open secret that the Chinese government subsidizes certain labor-intensive industries in growth downturns to prevent excessive job losses. It is important to note, however, that the government has systemically phased out subsidies as a lifeline for the corporate sector. Government subsidies for loss-generating enterprises, which accounted for over 20% of fiscal expenditures in the early 1990s, have now essentially disappeared (Chart 5). In addition, the Chinese government has also been trying to weed out excess capacity in the base metal industries such as steel and aluminum that President Trump has singled out for "massive dumping." Moreover, the anti-dumping measures adopted by the Obama administration targeting these Chinese products have already dramatically curtailed Chinese sales in the U.S. market in recent years. For example, the U.S. accounts for a mere 1% of Chinese steel exports, down from almost 10% in 2010 (Chart 6). It is possible that the Trump administration will continue to target industries it perceives as illegally subsidized by the Chinese government. However, the macro implications of such measures should not be significant. On further market access and lower tariffs for American goods. Even though state-owned enterprises still enjoy a monopoly in certain industries, the big picture of China's economic progress has been characterized by deregulation, privatization and increasing openness. Last week, the State Council released a new plan to further open up to foreign investment, removing or easing restrictions on foreign investment in rail equipment, motorbikes, ethanol fuel, shale gas, oil sands and other mineral resources sectors. It is also aiming to lower restrictions on foreign investment in financial services, such as the banking, securities, investment management, futures, insurance, credit ratings and accounting sectors, as well as in telecom, the Internet, culture, education and transportation. The latest push on "opening up" appears to be timed to supplement President Xi Jinping's speech at the Davos World Economic Forum last week - and possibily to offer an olive branch to the newly inagurated U.S. president - it nonetheless fits with the long-standing strategy of China's economic reforms. Chart 5Subsidies Are ##br##No Longer Vital Subsidies Are No Longer Vital Subsidies Are No Longer Vital Chart 6Chinese Steels Are No Longer ##br##Dumped In The U.S. Chinese Steels Are No Longer "Dumped" In The U.S. Chinese Steels Are No Longer "Dumped" In The U.S. Meanwhile, China's average tariff rate has declined dramatically in the past two decades (Chart 7), and is now not much higher than the global average and developed nation levels (Chart 8). Chinese tariffs on certain consumer goods are indeed punitively high. However, excessively high tariffs have only pushed Chinese consumers to travel overseas to buy these products, which has done little to help domestic producers. There have long been proposals among Chinese policy circles to cut tariffs and taxes to boost consumption and create local jobs. Chart 7Chinese Tariffs Have Already Collapsed... Chinese Tariffs Have Already Collapsed... Chinese Tariffs Have Already Collapsed... Chart 8...But Still Room For Improvement Dealing With The Trump Wildcard Dealing With The Trump Wildcard In short, on all the pressure points that could lead to trade disputes between the U.S. and China, the positions on both sides are not as deeply divided as perceived. China may have different perspectives by varying degrees, and may push back on specific issues, but the country's economic reform is not fundamentally against what Trump demands. This offers a hopeful starting point of bilateral engagement and negotiations. The primary risk to the negotiations is that Trump attempts to punish China retroactively for the cumulative effect of its past transgressions on the above issues, or makes ultimatums on the speed of the reform process that China either cannot or will not accept. Globalization With Chinese Characteristics? Regardless of whether the Trump's administration simply wants to deal "fairly" or intends to start a trade war, China will inevitably continue to push for a more predictable global growth environment for its exporters. A more inward-looking U.S. casts a long shadow on global trade, but it will also generate a mutual desire among China and other economies to work more closely, potentially creating a new "globalization process" with distinct Chinese characteristics. First, similar to existing trade agreements that intend to eliminate tariffs and other trade and investment barriers, China will continue to explore bilateral and multilateral free trade agreements (FTA) with its main trade partners. China currently has 19 FTAs under construction, among which 14 agreements have been signed and implemented. President Trump's decision to withdraw from the Trans Pacific Partnership (TPP) will also push other countries to participate in China-led free-trade initiatives as the only other viable alternative. In fact, China is a far bigger trade partner of TPP signatories than the U.S. (Chart 9). It will not be surprising to see the pace of negotiations for the "Regional Comprehensive Economic Partnership (RCEP)" accelerate. Second, besides tariff reductions, China also aims to extend its trade reach through expansion of transportation infrastructure via the ambitious "One Belt One Road" (OBOR) mega project. The OBOR promises to link China, Eurasia, South Asia, Oceania and North Africa with railway, highway and seaports, and has been quietly gaining momentum since it was unveiled in October 2013. Routine railway freight between China and western European countries has already been established, adding to existing air and maritime trade routes. The Silk Road Fund, a state-owned fund of the Chinese government to foster investment in countries along the OBOR, is already in operation. The Asian Infrastructure Investment Bank, a China-led international financial institution to aid the OBOR strategy, was established in December 2015 with 57 member countries, and is expected to add another 25 soon. With promises of improving infrastructure, it should be easier for China to sell its version of "globalization" to other countries. The impact of the OBOR will likely become increasingly visible going forward. Finally, China has been offering capital and technical aid to lesser-developed resource-rich countries, particularly in Africa (Chart 10). Unlike financial aid from other developed countries, which is often associated with governance and human right demands, Chinese investment in these regions is mostly offered with no political conditions attached, something that has generated a great deal of controversy. Some have accused China of being "neo-colonialist" to exploit the continent's natural resources, while others support the initiatives to build and upgrade local infrastructure such as roads, railways and telecom systems, as they will benefit Africa's manufacturing sector and the welfare of the local population. Regardless, China is likely to continue to push forward on these investment projects, which will also intensify the trade links between China and these countries. Chart 9China Matters More For TPP Countries China Matters More For TPP Countries China Matters More For TPP Countries Chart 10China's Strengthening Ties With Africa China's Strengthening Ties With Africa China's Strengthening Ties With Africa How Will The Market Respond? Brewing trade tensions between the world's two largest economies are undoubtedly negative for both the global economy and financial markets. A full-fledged trade war conjures up dreadful images of the 1930s Great Depression, which is full-stop bearish for risk assets. Investors should certainly hedge against such a scenario with a small portion of their portfolios, with long positions on the dollar, gold, and the VIX. Chart 11Industrial Stocks Will Remain Depressed Industrial Stocks Will Remain Depressed Industrial Stocks Will Remain Depressed Table 1Chinese H Shares Are Mostly Domestic Driven Dealing With The Trump Wildcard Dealing With The Trump Wildcard Barring such an extreme scenario, targeted tariffs and low-profile trade disputes will hurt specific industries and companies, but the impact on the broader market should not be significant. Specifically, Chinese H share-listed companies are heavily concentrated in domestic businesses (Table 1). Some heavyweights in the H-share index such as financials, telecom and utilities are mostly domestic driven. The industrial sector, which is more exposed to global demand, has already been chronically underperforming (Chart 11), and will likely continue to struggle amid growing global uncertainty. However, industrials are only about 5% of total China investable market cap, much smaller than both the Chinese A-share index and the U.S. market (Table 2). From this perspective, A shares are more vulnerable to trade disruptions given their higher weight in industrial stocks. The IT sector accounts for almost a third of the MSCI China Free index, but the largest constituents of the Chinese tech sector such as Alibaba, Tencent and Baidu derive almost all of their revenue from domestic sources (Table 2). Some smaller Chinese hardware producers with heavy exposure to global markets are vulnerable, but they represent a negligible share in the Chinese investable index. Table 2Top Ten Chinese Tech Firms And Their Foreign Exposure Dealing With The Trump Wildcard Dealing With The Trump Wildcard Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 "Scoring the Trump Economic Plan: Trade, Regulatory, & Energy Policy Impacts" available at https://assets.donaldjtrump.com/Trump_Economic_Plan.pdf 2 Please see China Investment Strategy Weekly Report, "China As A Currency Manipulator?" dated November 24, 2016 available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights President Trump is as protectionist as Candidate Trump; USD shortage to tighten global financial conditions; Go Long MXN/RMB as a tactical play on U.S.-China trade war; Brexit risks are now overstated; EU will not twist the knife. EUR/GBP is overbought; go short. Feature "We assembled here today are issuing a new decree to be heard in every city, in every foreign capital, and in every hall of power. From this day forward, a new vision will govern our land. From this moment on, it's going to be America First." U.S. President Donald Trump, January 20, 2017, Inaugural Address What are the investment implications of an "America First" world? First, it may be useful to visualize the "America Second" world that President Trump is looking to leave in the rear-view mirror. Chart 1 shows the cost of hegemony. Since the Nixon shock in 1971, the U.S. has seen its trade balance deepen and its military commitments soar, in absolute terms. For President Donald Trump, the return on American investment has been low. Wasteful wars, crumbling infrastructure, decaying factories, stagnant wages, this is what the U.S. has to show for two decades of hegemony. Chart 1United States: The Cost Of Hegemony The "What Can You Do For Me" World? The "What Can You Do For Me" World? On the other hand, the U.S. has enjoyed the exorbitant privilege of its hegemonic position. In at least one major sense, America's allies (and China) are already paying for American hegemony: through their investments in U.S. dollar assets. Chart 2 illustrates this so-called "exorbitant privilege." Despite a deeply negative net international investment position, the U.S. has a positive net investment income.1 Chart 2The "Exorbitant Privilege" The "What Can You Do For Me" World? The "What Can You Do For Me" World? Being the global hegemon effectively lowers U.S. borrowing costs and domestic interest rates, giving U.S. policymakers and consumers an "interest rate they do not deserve." That successive administrations decided to waste this privilege on redrawing the map of the Middle East and giving the wealthiest Americans massive tax cuts, instead of rebuilding Middle America, is hardly the fault of the rest of the world! Foreigners hold U.S. assets because of the size of the economy, the sustainability and deep liquidity of the market, and the perceived stability of its political system. More importantly, they hold U.S. assets because the U.S. acts as both a global defender and a consumer of last resort. If Washington were to raise barriers to its markets and become a doubtful provider of security, states may gradually see less of a payoff in holding U.S. assets and decide to diversify more rapidly. Investors can interpret Trump's "America First" agenda broadly as an effort to dramatically reduce the U.S. current account deficit. Certainly we see his statements on renegotiating NAFTA, facing off against China on trade, and encouraging U.S. exports with tax legislation as parts of a broad effort aimed at improving the U.S. trade balance. If the U.S. were to pursue these protectionist policies aggressively, the end result would be a massive shortage of U.S. dollars globally, a form of global financial tightening. The rest of the world is not blind to the dangers of an America focused on reducing its current account deficit. According to the reporting of Der Spiegel magazine, Chancellor Angela Merkel sent several delegations to meet with the Trump team starting in 2015! No doubt Berlin was nervous hearing candidate Trump's protectionist talk, given that Germany runs one of the largest trade surpluses with the U.S. (Chart 3). In the last such meeting, taking place after the election was decided, Trump's son-in-law and White House advisor, Jared Kushner, asked the Germans a point-blank question, "What can you do for us?"2 In the 1980s, the U.S. asked West Germany and Japan the same question. The result was the 1985 Plaza Accord that engineered the greenback's depreciation versus the deutschmark and the yen (Chart 4). Recent comments from Donald Trump suggest that he would like to follow a similar script, where dollar depreciation does the heavy lifting in adjusting the country's current account deficit.3 Chart 3Trump's Black List Trump's Black List Trump's Black List Chart 4The Impact Of The Plaza Accord The Impact Of The Plaza Accord The Impact Of The Plaza Accord The Trump administration may have dusted off the Reagan playbook from the 1980s, but the world is playing a different game in 2017. First, the Soviet Union no longer exists and certainly no longer has more than 70,000 tanks ready to burst through the "Fulda Gap" towards Frankfurt. President Trump will find China, Germany, and Japan less willing to help the U.S. close its current account deficit, particularly if Trump continues his rhetorical assault on everything from European unity to Japanese security to the One China policy. Second, China, not U.S. allies Germany and Japan, has the largest trade surplus with the U.S. It is very difficult to see Beijing agreeing to a coordinated currency appreciation of the RMB, particularly when it is being threatened with a showdown over Taiwan and the South China Sea. Third, even if China wanted to kowtow to the Trump administration, it is not clear that RMB appreciation can be engineered. The country's capital outflows have swelled to a record level of $205 billion (Chart 5) and the PBoC has continued to inject RMB into the banking system via outright lending to banks and open-market operations (Chart 6). Unlike Japan in 1985, China is at the peak of its leveraging cycle and thus unwilling to see its currency - and domestic interest rates - appreciate. At best, Beijing can continue to fight capital outflows and close its capital account. But even this creates a paradox, since the U.S. administration can accuse it of currency manipulation even if such manipulation is preventing, not enabling, currency depreciation!4 Chart 5China: Unrecorded Capital Outflows China: Unrecorded Capital Outflows China: Unrecorded Capital Outflows Chart 6PBoC Injects Massive Liquidity PBoC Injects Massive Liquidity PBoC Injects Massive Liquidity To conclude, the world is (re)entering a mercantilist era and sits at the Apex of Globalization.5 The new White House is almost singularly focused on bringing the U.S. current account deficit down. It intends to do this by means of three primary tools: Protectionism: The Republicans in the House of Representatives have proposed a "destination-based border adjustment tax," which would effectively subsidize exports and tax imports. (It would levy the corporate tax on the difference between domestic revenues and domestic costs, thus giving a rebate to exporters who make revenues abroad while incurring costs domestically.)6 While the proponents of the new tax system argue it is equivalent to the VAT systems in G7 economies, the change would nonetheless undermine America's role as "the global consumer of last resort." In our view, it would be the opening salvo of a global trade war. Dirigisme: President Trump has not shied away from directly intervening to keep corporate production inside the U.S. He has also insisted on a vague proposal to impose a 35% "border tax" on U.S. corporates that manufacture abroad for domestic consumption. (Details are scant: His Treasury Secretary Steven Mnuchin has denied an across-the-board tax of this nature, but has confirmed that one would apply to specific companies.) Structural Demands: Trump's approach suggests that he wishes to force structural changes on trade surplus economies in order to correct structural imbalances in the American economy - and in this process he is not adverse to lobbing strategic threats. While he holds out the possibility of charging China with currency manipulation, in fact he can draw from a whole sheet of American trade grievances not limited to the currency to demand major changes to their trade relationship. The fundamental problem for the global economy is that in order to reduce the U.S. current account deficit, the world must experience severe global tightening. Dollars held by U.S. multinationals abroad, which finance global credit markets, will come back to the U.S. and tighten liquidity abroad. And emerging market corporate borrowers who have overextended themselves borrowing in U.S. dollars will struggle to repay debts in appreciating dollars. These structural trends are set to exacerbate an already ongoing cyclical process. As BCA's Emerging Markets Strategy has recently pointed out, global demand for U.S. dollars is rising faster than the supply of U.S. dollars.7 Our EM team's first measure of U.S. dollar liquidity is "the sum of the U.S. monetary base and U.S. Treasury securities held in custody for official and international accounts." The second measure "is the sum of the U.S. monetary base and U.S. Treasury securities held by all foreign residents." As Chart 7 and Chart 8 illustrate, both calculations indicate that dollar liquidity is in a precipitous decline already. Meanwhile, foreign official holdings of U.S. Treasury securities is contracting, while the amount of U.S. Treasury securities held by all foreigners has stalled (Chart 9). Chart 7Dollar Liquidity Declining... Dollar Liquidity Declining... Dollar Liquidity Declining... Chart 8... Any Way You Look At It ... Any Way You Look At It ... Any Way You Look At It Chart 9Components Of U.S. Dollar Liquidity Components Of U.S. Dollar Liquidity Components Of U.S. Dollar Liquidity Chart 10It Hurts To Borrow In USD It Hurts To Borrow In USD It Hurts To Borrow In USD Concurrently, U.S. dollar borrowing costs continue to rise (Chart 10). Our EM team expects EM debtors with U.S. dollar liabilities to either repay U.S. dollar debt or hedge it. This will ultimately increase the demand for U.S. dollars in the months ahead. Near-term U.S. dollar appreciation will only reinforce and accelerate the mercantilist push in the White House and Congress. President Trump and the GOP in the House will find common ground on the border-adjustment tax, which Trump recently admitted he did not understand or look favorably upon. The passage of the law, or some such equivalent, has a much greater chance than investors expect. So does a U.S.-China trade war, as we argued last week.8 How should investors position themselves for the confluence of geopolitical, political, and financial factors we have described above? The world is facing both the cyclical liquidity crunch that BCA's Emerging Markets Team has elucidated and the potential for a secular tightening as the Trump administration focuses its efforts on closing the U.S. current account deficit. Five investment implications are top of our mind: Chart 11Market Response To Trump Win On High End Market Response To Trump Win On High End Market Response To Trump Win On High End Chart 12Market Is Priced For 'Magnificent' Events Market Is Priced For 'Magnificent' Events Market Is Priced For 'Magnificent' Events Buy VIX. The S&P 500 has continued to power on since the election, buoyed by positive economic surprises, strong global earnings, and the hope of a pro-business shift in the White House. The equity market performance puts the Trump presidency in the upper range of post-election market outcomes (Chart 11). However, with 10-year Treasuries back above fair value, the VIX near 12, and EM equities near their pre-November high, the market is pricing none of the political and geopolitical risks of an impending trade war between the U.S. and China, nor is it pricing the general mercantilist shift in Washington D.C. (Chart 12). As a result, we recommend that clients put on a "mercantilist hedge," like deep out-of-the-money S&P 500 puts, or VIX calls. For instance, a long VIX 20/25 call spread for March expiry. Long DM / Short EM. Mercantilism and the U.S. dollar bull market are the worst combination possible for EM risk assets. We therefore reiterate our long-held strategic recommendation of being long developed markets / short emerging markets. Overweight Euro Area Equities. Investors should overweight euro area equities relative to the U.S. As we have discussed in the 2017 Strategic Outlook, political risks in Europe this year are a red herring.9 We will expand on the upcoming French elections in next week's report. Meanwhile, investors appear complacent about protectionism and what it may mean for the S&P 500, which sources 44% of its earnings abroad. European companies, on the other hand, could stand to profit from a China-U.S. trade war. Chart 13Peso Is A Buy Versus Trump's Enemy #1 Peso Is A Buy Versus Trump's Enemy #1 Peso Is A Buy Versus Trump's Enemy #1 Chart 14Peso As Cheap As During Tequila Crisis Peso As Cheap As During Tequila Crisis Peso As Cheap As During Tequila Crisis Long MXN/RMB. As a tactical play on the U.S.-China trade war, we recommend clients go long MXN/RMB (Chart 13). The peso is now as cheap as it was in early 1995, at the heights of the Tequila Crisis, as per the BCA's Foreign Exchange Strategy model (Chart 14). While Mexico remains squarely in Trump's crosshairs on immigration and security, the damage to the currency appears to be done and has ironically made the country's exports more competitive. In addition, Trump's pick for Commerce Secretary, Wilbur Ross, has informed his NAFTA counterparts that "rules of origin" will be central to NAFTA re-negotiation. This can be interpreted as the U.S. using every tool at its disposal to impose punitive measures on China, including forcing NAFTA partners to close off the "rules of origin" loophole.10 But the reality is that the U.S. trade deficit with its NAFTA partners is far less daunting than that with China (Chart 15). Meanwhile, we remain negative on the RMB for fundamental reasons that we have stressed in our research. Small Is Beautiful. We continue to recommend that clients find protection from rising protectionism in small caps. Small caps are traditionally domestically geared irrespective of their domicile. Anastasios Avgeriou, Chief Strategist of BCA's Global Alpha Sector Strategy, also points out that small caps in the U.S. will benefit as the new administration follows through with promised corporate tax cuts, which will benefit small caps disproportionally to large caps given that the effective tax rate of multinationals is already low. Moreover, small companies will benefit most from any cuts in regulations, most of which have been written by multinationals in order to create barriers to entry (Chart 16). Of course, we could just be paranoid! After all, much of Trump's proposed policies - massive tax cuts, infrastructure spending, major rearmament, the border wall - would increase domestic spending and thus widen the current account deficit, not shrink it. And all the protectionism and de-globalization could just be posturing by the Trump administration, both to get a better deal from China and Europe and to give voters in the Midwest some political red meat. Chart 15China, Not NAFTA, In Trump's Crosshairs China, Not NAFTA, In Trump's Crosshairs China, Not NAFTA, In Trump's Crosshairs Chart 16Small Is Beautiful Small Is Beautiful Small Is Beautiful But Geopolitical Strategy analysts get paid to be paranoid! And we worry that much of Trump's promises that would widen U.S. deficits are being watered down or pushed to the background. Yes, we have held a high conviction view that infrastructure spending would come through, but now it appears that it will be complemented with significant spending cuts. The next 100 days will tell us which prerogatives the Trump Administration favors: rebuilding America directly, or doing so indirectly via protectionism. If the former, then the current market rally is justified. If the intention is to reduce the current account deficit, look out. Marko Papic, Senior Vice President marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Brexit: A Brave New World Miranda: O brave new world! Prospero: 'Tis new to thee. — Shakespeare, The Tempest The U.K. Supreme Court ruled on January 24 that parliament must have a say in triggering Article 50 of the Lisbon Treaty, which enables the U.K. to "exit" the European Union. This decision, as well as Theresa May's January 17 "Brexit means exit" speech, caught us in London while visiting clients. Reactions were mixed. The pound continues to rally. January 16 remains the low point in the GBP/USD cross since the vote to leave on June 23 last year (Chart 17). Chart 17Has Brexit Uncertainty Bottomed? Has Brexit Uncertainty Bottomed? Has Brexit Uncertainty Bottomed? Should investors expect more downside to the pound or do the recent events mark a bottom in political uncertainty? The market consensus suggests that further volatility in the pound is warranted for three reasons: Europeans will seek to punish the U.K. for Brexit, to set an example to their own Euroskeptics; Prime Minister May's assertion that the U.K. would seek to exit the common market is negative for the country's economy; Legal uncertainties about Brexit remain. We disagree with this assessment, at least in the short and medium term. Therefore, the pound rally on the day of May's speech was warranted, although we agree that exiting the EU Common Market will ultimately be suboptimal for the country's economy. First, by setting out a clean break from the EU, including the common market, Prime Minister May has removed a considerable amount of political uncertainty. As we pointed out in our original net assessment of Brexit, leaving the EU while remaining in its common market is illogical.11 Paradoxically, the U.K. stood to lose rather than regain sovereignty if it left the EU yet remained in the common market (Diagram 1). Diagram 1The Quite Un-British Lack Of Common Sense Behind Soft Brexit The "What Can You Do For Me" World? The "What Can You Do For Me" World? Why? Because membership in the common market entails a financial burden, full adoption of the acquis communautaire (the EU body of law), and acceptance of the "Four Freedoms," including the freedom of movement of workers. Given that the Brexit vote was largely motivated by concerns of sovereignty and immigration (Chart 18), it did not make sense to vote to leave the EU and then seek to retain membership in the common market. Apparently May and her cabinet agree. Chart 18It's Sovereignty, Stupid! The "What Can You Do For Me" World? The "What Can You Do For Me" World? Second, now that the U.K. has chosen to depart from the common market, the EU no longer needs to take as hostile of a negotiating position as before. The EU member states were not going to let the U.K. dictate its own terms of membership. That would have set a precedent for future Euroskeptic governments looking for an alternative relationship with the bloc, i.e. the so-called "Europe, à la carte" that European policymakers dread. But now that the U.K. is asking for a clean exit, with a free trade agreement to be negotiated in lieu of common market membership, the EU has less reason to punish London. An FTA arrangement will be beneficial to EU exporters, who want access to the U.K. market, and it will send a message to Euroskeptics on the continent that there is no alternative to full membership. Leaving the EU means leaving the market and falling back - at best - to an FTA-level relationship that the EU shares with Mexico and (most recently) Canada. Third, leaving the EU and the common market are political, not legal, decisions, and the lingering legal battles are neither avoidable nor likely to be substantive. Theresa May had already stolen thunder when she said that the final deal with the EU would be put to a vote in parliament. The Supreme Court ruling - as well as other legal hangups - could conceivably give rise to complications that bind the government's hands, but most likely parliament will pass a simple bill or motion granting permission for the government to invoke Article 50. That is because the referendum, and public opinion since then, speak loud and clear (Chart 19). The Conservative Party remains in a comfortable lead over the Labour Party (Chart 20), which itself is not opposing the referendum outcome. In addition, the House of Commons has already approved the government's Brexit timetable by a margin of 372 seats in a 650-seat body - with 461 ayes. That is a stark contrast with a few months ago when around 494 MPs were said to be against Brexit. Chart 19No 'Bremorse' Or 'Bregret' The "What Can You Do For Me" World? The "What Can You Do For Me" World? Chart 20Tories Still Triumphant Tories Still Triumphant Tories Still Triumphant The bigger question comes down to the parliamentary vote on the deal that is to be negotiated over the next two years. Could the Parliament vote down the final agreement with the EU? Absolutely. However, it is unlikely. The economic calamity predicted by many commentators has not happened, as we discuss below. Bottom Line: The combination of the Supreme Court decision and Prime Minister May's speech has reduced political uncertainty regarding Brexit. The EU will negotiate hard with the U.K., but the main cause of consternation - the U.K. asking for special treatment with respect to the common market - is now off the table. Yes, the EU does hold all the cards when it comes to negotiating an FTA agreement, and the process could entail some alarming twists and turns (given the last-minute crisis in the EU-Canada FTA). But we do not expect EU-U.K. negotiations to imperil the pound dramatically beyond what we've already seen. Will Leaving The Common Market Hurt Britain? Does this mean that Brexit is "much ado about nothing?" In the short and medium term, we think the answer is yes. In the long-term, leaving the EU Common Market is a suboptimal outcome for three reasons: Trade - Net exports rarely contribute positively to U.K. growth (Chart 21) and the trade deficit with the EU is particularly deep. As such, proponents of Brexit claim that putting up modest trade barriers against the EU could be beneficial. However, the U.K. has a services trade surplus with the EU (Chart 22). While it is not as large as the trade deficit, there was hope that the eventual implementation of the 2006 EU's Services Directive would have opened up new markets for U.K.'s highly competitive services industry and thus reduced the trade deficit over time. As the bottom panel of Chart 22 shows, the U.K.'s service exports to the rest of the world have outpaced those to the EU, suggesting that there is much room for improvement. This hope is now dashed and the EU may go back to putting up non-tariff barriers to services that reverse Britain's modest surplus with the bloc. Free Trade Agreements rarely adequately cover services, which means that the U.K.'s hope of expanding service exports to a new high is probably gone. Chart 21U.K. Is Consumer-Driven U.K. Is Consumer-Driven U.K. Is Consumer-Driven Chart 22Service Exports At Risk After Brexit Service Exports At Risk After Brexit Service Exports At Risk After Brexit Foreign Investment - FDI is declining, whether for cyclical reasons or because foreign companies fear losing access to Europe via the U.K. It remains to be seen how FDI will respond to the U.K.'s renunciation of the common market, but it is unlikely to be positive (Chart 23). The U.K.'s financial sector will also be negatively impacted since leaving the common market will mean that London will no longer have recourse to the EU judiciary in order to stymie European protectionism.12 This is unlikely to destroy London's status as the global financial center, but it will impact FDI on the margin. Labor Growth - The loss of labor inflow will be the biggest cost of Brexit. A decrease of immigration from the EU could reduce the U.K.'s labor force growth by a maximum of two-thirds, translating to a 25% loss in the potential GDP growth rate (Chart 24). While the U.K. is not, in fact, closing off all immigration, labor-force growth will decline, and potential GDP with it. Chart 23FDI To Suffer From Brexit? FDI To Suffer From Brexit? FDI To Suffer From Brexit? Chart 24Labor Growth Suffers Most From Brexit The "What Can You Do For Me" World? The "What Can You Do For Me" World? In addition, the EU Common Market forces companies to compete for market share in the developed world's largest consumer market. This competition is supposed to accelerate creative destruction and thus productivity, while giving the winners of the competition the spoils, i.e. a better ability to establish "economies of scale." In a 2011 report, the Bank of International Settlements (BIS) published an econometric study that compared four scenarios: the U.K. remains in the common market as the EU fully liberalizes trade; the U.K. remains in the EU's single market, but does not fully liberalize trade with the rest of the EU; the U.K. leaves the common market; the U.K. enters NAFTA.13 Of the four scenarios, only the first leads to an increase in wealth for the U.K., with 7.1% additional GDP over ten years. U.K. exports would increase by 47%, against 38.1% for its imports. Wages of both skilled and unskilled workers would increase as well. Meanwhile, the report finds that closer integration with NAFTA would not compensate for looser U.K. ties with the EU. In fact, the U.K. national income would be 7.4% smaller if the U.K. tied up with NAFTA instead of taking part in further trade liberalization on the continent. Why rely on a 2011 report for the assessment of benefits of the common market? Because it was written by a competent, relatively unbiased international body and predates the highly politicized environment surrounding Brexit that has since infected almost all think-tank research. And yet the more recent research echoes the 2011 report in terms of the negative consequences of leaving the common market.14 In addition, the BIS study actually attempts to forecast the benefit of further removing trade barriers in the single market, which is at least the intention of the EU Commission. That said, our concerns regarding the U.K. economy are long-term. It may take years before the full economic impact of leaving the common market can be assessed. In addition, much of our analysis hinges on the Europeans fully liberalizing the common market and removing the last remaining non-tariff barriers to trade, particularly of services. At the present-day level of liberalization, the U.K. may benefit by leaving. In addition, we do not expect a balance-of-payments crisis in the U.K. any time soon. The U.K. current account is deeply negative, unsurprisingly so given the deep trade imbalance with the EU and world. However, our colleague Mathieu Savary, Vice-President of BCA's Foreign Exchange Strategy, has pointed out that the elasticity of imports to the pound is in fact negative, a very surprising result. This reflects an extremely elevated import content of British exports. A lower pound is therefore unlikely to be the most crucial means of improving the current-account position. Certainly leaving the common market will not improve the competitiveness of British exports in the EU. Chart 25The U.K.'s Basic Balance Is Healthy The U.K.'s Basic Balance Is Healthy The U.K.'s Basic Balance Is Healthy But this raises a bigger question: why does the U.K. have to improve its current account deficit? As our FX team points out in Chart 25, despite having a current-account deficit of nearly 6% of GDP, the U.K. runs a basic balance-of-payments surplus of 12%, even after the recent fall in FDI inflows. The reason for the massive balance-of-payments surplus is the financial account surplus of 6.17% of GDP, a feature of the U.K. being a destination for foreign capital, which flows from its status as a global financial center and prime real estate destination. In other words, leaving the common market will not change the fundamentals of the U.K. balance of payments much. The country will remain a global financial center and will still run a capital account surplus, which will suppress the country's interest rates, buoy the GBP, and give tailwinds to imports of foreign goods. Meanwhile, exports will not benefit as they will face marginally higher tariffs as the country exits the EU Common Market. At best, new tariffs will be offset by a cheaper GBP. As such, leaving the common market is not going to be a disaster for the U.K. Nor will it be a panacea for the country's deep current account deficit. And that is okay. The U.K. will not face a crisis in funding its current account deficit. What is clear is that for the time being, the U.K. economy is holding up. Our forex strategists recently argued that U.K.'s growth has surprised to the upside and that the improvement is sustainable: Monetary and fiscal policy are both accommodative (Chart 26); Inflation is limited; Tight labor market drives up wages and puts cash in consumers' pockets (Chart 27); Credit growth remains robust (Chart 28). Chart 26Easy Money Smooths The Way To Brexit Easy Money Smooths The Way To Brexit Easy Money Smooths The Way To Brexit Chart 27British Labor Market Tightening British Labor Market Tightening British Labor Market Tightening Chart 28U.K. Credit Growth Looking Good U.K. Credit Growth Looking Good U.K. Credit Growth Looking Good This means that the political trajectory is set for the time being. "Bremorse" and "Bregret" will remain phantoms for the time being. Bottom Line: Leaving the common market is a suboptimal but not apocalyptic outcome for the U.K. The combination of decent economic performance and lowered political uncertainty in the near term will support the pound. Given the pound's 20% correction since the June referendum, we believe that the market has already priced in the new, marginally negative, post-Brexit paradigm. The Big Picture It is impossible to say whether the long-term negative economic effects of Brexit will affect voters drastically enough and quickly enough for Scotland, or parliament, to act in 2018 or 2019 and modify the government's decision to pursue a "Hard Brexit." It seems conceivable if something changes in the fundamental dynamics outlined above, but we wouldn't bet on it. At the moment even a new Scottish referendum appears unlikely (Chart 29). Scottish voters have soured on independence, perhaps due to a combination of continued political uncertainty in the EU (Scotland's political alternative to the U.K.) and a collapse in oil prices (arguably Scotland's economic alternative to the U.K.). The issue is not resolved but on ice for the time being. Chart 29Brexit Not Driving Scots To Independence (Yet) Brexit Not Driving Scots To Independence (Yet) Brexit Not Driving Scots To Independence (Yet) More likely, the government will get its way on Brexit and the 2020 elections will mark a significant popular test of the Conservative leadership and the final deal with the EU. Then the aftermath will be an entirely new ballgame for the U.K. and all four of its constituent nations. If Britain's new beginning is founded on protectionism and dirigisme - as the government suggests - then the public is likely to be disappointed. The "brave new world" of Brexit may prove to be rather mundane, disappointing, and eerily reminiscent of the ghastly 1970s.15 Hence the Shakespeare quote at the top of this report. The political circumstances of Brexit resemble the U.K. landscape before it joined the European Economic Community in 1973: greater government role in the economy, trade protectionism, tight labor market, higher wages, and inflation. Yet this was a period when the U.K. economy underperformed Europe's. The U.K.'s eventual era of outperformance was contingent on the structural reforms of the Thatcher era and expanded access to the European market (Chart 30). It remains to be seen what happens when the U.K. leaves the market and rolls back Thatcherite reforms. The weak pound and proactive fiscal policy will fail to create a manufacturing revolution. That is because most manufacturing has hollowed out because of automation, not foreign workers stealing Britons' jobs. Moreover, as for the pound, it is important to remember that currency effects are temporary and any boost to exports that the weak pound is generating will be short-lived, as with the case of China in the 1990s and the EU in the past two years (Chart 31). Chart 30U.K. Growth To Lag Europe's Once Again? U.K. Growth To Lag Europe's Once Again? U.K. Growth To Lag Europe's Once Again? Chart 31Export Boost From Devaluation Is Fleeting Export Boost From Devaluation Is Fleeting Export Boost From Devaluation Is Fleeting In addition, we would argue that, in an environment of de-globalization - in which tariffs are rising, albeit slowly for the time being (Chart 32) - the EU Common Market provides Europe with a mechanism by which to protect its vast consumer market. The U.K. may have chosen the precisely wrong time in which to abandon the protection of continental European protectionism. It could suffer by finding itself on the outside of the common market as global tariffs begin to rise significantly. Chart 32Protectionism On The March The "What Can You Do For Me" World? The "What Can You Do For Me" World? What about the restoration of the "Special Relationship" between the U.K. and the U.S.? Could moving to the "front of the queue" on negotiating an FTA with the world's largest economy make a difference for the U.K.? Perhaps, but as the BIS study above indicates, an FTA with North America or the U.S. alone is unlikely to replace the benefits of the common market. In addition, it is difficult to imagine how a protectionist U.S. administration that is looking to massively decrease its current account deficit will help the U.K. expand trade with the U.S. By contrast, Trump's election in the United States poses massive risks to globalization, both through his protectionism and the strong USD implications of his core policies. This will reverberate negatively across the commodities and EM space. In such an environment, the U.K. may not be able to make much headway in its "Global Britain" initiatives to conclude fast trade deals with EM economies that stand to lose the most in the de-globalization era. Bottom Line: As a trading nation, the U.K. is likely to lose out in a prolonged period of de-globalization. Membership in the EU could have served as a bulwark against this global trend. Investment Implications We diverge from our colleagues in the Foreign Exchange Strategy and European Investment Strategy when it comes to the assessment of political risk looming over Brexit.16 The decision to leave the common market will alleviate the pressure on Europeans to seek vindictive punishment. Earlier, the U.K. was forcing them to choose between making an exception to the rules and demonstrating the negative consequences of leaving the bloc. Now the U.K. is self-evidently taking on its own punishment - the economic burden of leaving the common market - and the EU will probably deem that sufficient. Will the EU play tough? Yes, especially since the EU retains considerable economic leverage over Britain (Chart 33). But the stakes are far smaller now. Furthermore, investors should remember that core European states - especially France and Germany - remain major military allies of the U.K. and will continue to be deeply intertwined economically. As such, we believe that the pound has already priced in the new economic paradigm and that the expectations of political uncertainty ahead of the U.K.-EU negotiations may be overdone. We therefore recommend that investors short EUR/GBP outright. Our aforementioned forex strategist Mathieu Savary argues that, on an intermediate-term basis, the outlook for this cross is driven by interest rate differentials and policy considerations. Due to the balance-sheet operations conducted by the BoE and ECB, interest rates in the U.K. and the euro area do not fully reflect domestic policy stances. Instead, Mathieu uses the shadow rates. Currently, shadow rates unequivocally point toward a lower EUR/GBP (Chart 34). In fact, balance-sheet dynamics point toward shorting EUR/GBP. Chart 33EU Holds The Cards In FTA Negotiation EU Holds The Cards In FTA Negotiation EU Holds The Cards In FTA Negotiation Chart 34Shadow Rates Point To Stronger GBP Shadow Rates Point To Stronger GBP Shadow Rates Point To Stronger GBP For full disclosure, Mathieu cautions clients to wait on executing a short EUR/GBP until after Article 50 is enacted. By contrast, we think that political uncertainty regarding Brexit likely peaked on January 16. Matt Gertken, Associate Editor mattg@bcaresearch.com Marko Papic, Senior Vice President marko@bcaresearch.com 1 While the U.S. runs a massively negative net international investment position, its net international income remains positive. In other words, foreigners receive a much lower return on U.S. assets while the U.S. benefits from risk premia in foreign markets. 2 Please see Spiegel Online, "Donald Trump and the New World Order," dated January 20, 2017, available at Spiegel.de. 3 In a widely-quoted interview with The Wall Street Journal, Donald Trump said that the U.S. dollar is "too strong." He continued that, "Our companies can't compete with [China] now because our currency is too strong. And it's killing us." Please see The Wall Street Journal, "Donald Trump Warns on House Republican Tax Plan," dated January 16, 2017, available at wsj.com. 4 We would note that the Trump administration and its Treasury Department have considerable leeway over how they choose to interpret China's foreign exchange practices. In 1992, when the U.S. government last accused China of currency manipulation, it issued a warning in its spring report before leveling the accusation in the winter report. The RMB did not depreciate in the meantime but remained stable, and Treasury noted this approvingly; however, Treasury chose 1989 as the base level for its assessment, and found manipulation. The Trump administration could use much more aggressive interpretive methods than this to achieve its ends. 5 Please see BCA Geopolitical Strategy Monthly Report, "Mercantilism Is Back," dated February 10, 2016, and Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 14, 2014, available at gps.bcaresearch.com. 6 Please see BCA Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. 7 Please see BCA Emerging Markets Strategy Weekly Report, "The U.S. Dollar's Uptrend And China's Options," dated January 11, 2017, available at ems.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 9 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. 10 Critics, including Trump supporters, claim that NAFTA sets too low of a threshold for the domestic content of a good deemed to have originated within the NAFTA countries. Goods that are nearly 40% foreign-made can thus be treated as NAFTA-made. This is one of many contentious points in the trade deal. 11 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 12 In 2015, the U.K. took the ECB to court over its decision to require financial transactions denominated in euros to be conducted in the euro area, i.e. out of the City, and won. This avenue of legal redress will no longer be available for the U.K., allowing EU member states to slowly introduce rules and regulations that corral the financial industry - or at least to the parts focused on transactions in euros - out of London. 13 Please see Bank of International Settlements, "The economic consequences for the U.K. and the EU of completing the Single Market," BIS Economics Paper No. 11, dated February 2011, available at www.gov.uk. 14 Please see Her Majesty's Government, "H.M. Treasury Analysis: The Long-Term Economic Impact Of EU Membership And The Alternatives," Cmnd. 9250, April 2016, available at www.gov.uk. and Jagjit S. Chadha, "The Referendum Blues: Shocking The System," National Institute Economic Review 237 (August 2016), available at www.niesr.ac.uk. 15 We were going to use "grey" to describe Britain in the 1970s. However, our colleague Martin Barnes, BCA's Chief Economist, insisted that "grey" did not do the "ghastly" 1970s justice. When it comes to the U.K. in the 1970s, we are going to defer to Martin. 16 Please see BCA Research European Investment Strategy Weekly Report, “May’s Brexit Speech: No Substance,” dated January 19, 2017, available at eis.bcaresearch.com. Geopolitical Calendar

Highlights Mexico and China are not the only countries that could suffer from U.S. trade protectionism. Malaysia, Korea, Taiwan and Thailand are also at risk. The global inflationary versus deflationary impact of U.S. trade protectionism will depend on the magnitude of exchange rate adjustments. Currencies will adjust to redistribute the inflationary and deflationary impact of U.S. tariffs and Border Adjustment Taxes between the U.S. and the rest of the world. Go long three-month volatility in the KRW, the MYR and the THB. The Turkish lira has approached our target of TRY/USD 3.9. Investors should book profits for now and reinstate short if the lira rebounds to 3.5 Feature Chart I-1Are Share Prices Discounting ##br##U.S. Trade Protectionism? Are Share Prices Discounting U.S. Trade Protectionism? Are Share Prices Discounting U.S. Trade Protectionism? The odds of a considerable rise in U.S. trade protectionism have ratcheted up since President Donald Trump's victory in early November, yet global share prices have been sanguine about it. Equities have instead focused on the positives of Trump's agenda such as fiscal stimulus and deregulation. Does this mean that the marketplace is overly complacent? One can argue that potential trade wars are a well-known risk, and as such are already discounted in share prices. It is also possible to argue that the equity markets did not fall at all ahead of and following Trump's victory to discount potential negatives from trade protectionism. The only market that has reacted to discount looming trade restrictions is Mexico, specifically the peso and its fixed-income markets. However, the ramifications of U.S. trade protectionism will reverberate well beyond Mexico. Global ex-U.S. share prices have not corrected at all to discount the potential negatives (Chart I-1). Unless the U.S. dollar surges, U.S. manufacturers will likely benefit from protectionist measures. However, U.S inflation and interest rates will rise in this scenario, weighing on equity valuation multiples. Overall, the majority of America's trade partners are at risk. In this week's report, we assess the vulnerability of various EM countries to the U.S. trade assault. U.S. trade restrictions will take the form of either import tariffs, a Border Adjustment Tax (BAT),1 or a mix of both. We conclude that buying volatility of select EM currencies is one way to profit from budding U.S. protectionism. Vulnerability To A U.S. Trade Assault Below we analyze which EM economies are most at risk from U.S. import tariffs and BAT. Given it is impossible to know whether the U.S. will adopt import tariffs, a BAT, or some combination of the two, we evaluate the impact on developing countries from both measures. Import tariffs: To assess each country's exposure to potential import tariffs, we examine the size of export shipments to America relative to that country's GDP. Table I-1 shows that Mexico, Canada, Malaysia, Taiwan and Thailand have the largest exports to the U.S. as a share of their economy. For Mexico, Canada and Malaysia, we exclude oil shipments to the U.S., as it is not clear whether oil will be subject to import tariffs. BAT: The principal variable gauging a country's vulnerability to a BAT is its trade balance with the U.S. This is because a BAT is both a penalty on imports into the U.S. as well as a subsidy on American exports. Hence, this analysis has to take into consideration not only a country's shipments to the U.S. but also American producers' exports to that country. Table I-2 shows the size of each country's trade balance with the U.S. as a share of its GDP. Table I-1Vulnerability To U.S. Import Tariffs EM Vulnerability To U.S. Trade Protectionism EM Vulnerability To U.S. Trade Protectionism Table I-2Vulnerability To BATs EM Vulnerability To U.S. Trade Protectionism EM Vulnerability To U.S. Trade Protectionism Again, for Mexico, Canada and Malaysia, we exclude the oil trade balance with the U.S. from the calculation. 3. Combined vulnerability ranking. Lack of clarity on trade policy specifics the U.S. is going to adopt means that we may need to synthesize the above analysis, combining the vulnerability ranking on both measures into one. Chart I-2 plots trade balances on the X axis and exports to the U.S. on the Y axis. It appears Malaysia, Mexico, Taiwan and Thailand are the most vulnerable, based on both criteria. Chart I-2Vulnerability To U.S. Import Tariffs And Border Adjustment Taxes EM Vulnerability To U.S. Trade Protectionism EM Vulnerability To U.S. Trade Protectionism Another way to generate a vulnerability ranking is to calculate an aggregate score based on Tables I-1 and I-2 because either import tariffs, a BAT or some combination of the two will be adopted by the U.S. The aggregate vulnerability score is presented in Chart I-3. Chart I-3U.S. Trade Protectionism Vulnerability Ranking EM Vulnerability To U.S. Trade Protectionism EM Vulnerability To U.S. Trade Protectionism According to the overall vulnerability score, Mexico, Malaysia, Taiwan, Thailand and Korea are the most exposed to potential U.S. trade protectionism measures. By contrast, Turkey, Brazil and Chile are the least exposed. Bottom Line: Mexico and China are not the only countries that could suffer from U.S. trade protectionism. Malaysia, Korea, Taiwan and Thailand are also at risk. On the flip side, Turkey and Brazil are the least exposed to a U.S. trade assault. We remain short many EM exchange rates versus the U.S. dollar including the Malaysian, Korean and Colombian currencies, and reiterate these positions today. Traders who are not positioned this way or have been stopped out should consider reinstating these trades (the full list of our currency recommendations). As for the Mexican peso, it has undershot relative to other EM currencies. We have not been bullish on the MXN versus the USD, though in recent months have recommended going long the MXN versus the BRL and ZAR. These trades have so far produced large losses, but we expect the MXN to recover some of those losses on its crosses. Are Trade Barriers Inflationary Or Deflationary? We consider three scenarios: Chart I-4U.S.: Rising Unit Labor Costs ##br##Warrant Higher Core Inflation U.S.: Rising Unit Labor Costs Warrant Higher Core Inflation U.S.: Rising Unit Labor Costs Warrant Higher Core Inflation 1. Without an exchange rate adjustment (U.S. dollar appreciation), import tariffs and BATs will be inflationary for the U.S. and deflationary for the rest of the world. In this scenario, the prices of imported goods will rise in U.S. dollars and U.S. consumers will end up paying for the tariff/border taxes or exporters will see their U.S. dollar revenues plummet or some combination of the two. U.S. manufacturers will become competitive with higher prices of imported goods, and U.S. employment and resource utilization will mount, heightening domestic inflationary pressures. Even though non-energy imports make up only 11% of U.S. GDP, the inflationary impact of trade protectionism will be pervasive. The reason being that it will tighten the resource utilization in the American economy in general, and the labor market in particular. Currently, the U.S. labor market is tight, wages are accelerating and unit labor costs are rising (Chart I-4). Further strength in demand due to potential fiscal stimulus, import substitution, and a further revival of confidence, will lead to even higher wage inflation and an acceleration in unit labor costs. This, along with rising prices for imported goods, will produce higher inflation. That said, it is likely that American consumers cannot handle a drastic price hike in imported goods, so higher selling prices will entail less demand. For the rest of the world, the same scenario will be very deflationary. Countries with large exports to the U.S. will experience a plunge in their shipments to America, income/profit growth will tank, and domestic demand will dwindle. In aggregate, this scenario will be inflationary for the U.S. and deflationary for the rest of the world - there will be meaningful losses in global output. 2. With "full" exchange rate adjustments, the import tariffs and BATs will be neutral for the U.S. and the rest of the world. But for this to occur, the U.S. dollar has to overshoot. Chart I-5Exchange Rates Have##br## Made A Difference Exchange Rates Have Made A Difference Exchange Rates Have Made A Difference In this scenario, imported goods prices in U.S. dollars will remain the same, given tariffs/BATs are entirely offset by a strong dollar. For exporters, their U.S. dollar revenues will plunge but their currency depreciation will restore the value of shipments to the U.S. in local currency terms (Chart I-5). In brief, the "full" currency depreciation will reflate exporter economies in local currency terms. Given that the rate of tariffs or BATs will likely exceed 15-20%, potential U.S. dollar appreciation will need to be dramatic to produce this scenario. In turn, the considerable dollar appreciation will cap inflationary pressures in the U.S. There will be little, if any, impact on global output. 3. With "partial" exchange rate adjustment (moderate dollar appreciation), the impact of tariffs or BATs will be split between U.S. consumers facing somewhat higher prices for imports and exporters who will suffer declines in revenues in local currency terms, though not as much as in the case of no currency deprecation. Consequently, this scenario will be mildly inflationary for the U.S. and modestly deflationary for the rest of the world. Yet, there will also be a small loss of global output - i.e., global GDP growth will be negatively impacted. Odds favor scenarios two and three - i.e., the greenback is set to appreciate, but it is not clear whether it will rise enough to entirely offset the impact of import tariffs or BATs and preclude decline in global growth. Bottom Line: The inflationary versus deflationary impact of U.S. trade protectionism will depend on exchange rate adjustments and their magnitude - i.e., currencies will move to redistribute the inflationary and deflationary impact of U.S. tariffs and BATs. Overall, the U.S. dollar is set to appreciate meaningfully and probably overshoot before topping out. Go Long EM FX Volatility Given central banks outside the U.S. - both in DM ex-U.S. and EM - are attempting to keep interest rates low, odds favor considerable appreciation in the U.S. dollar, or at least a material rise in exchange rate implied volatility. When monetary authorities control interest rates, the entire burden of adjustment falls on exchange rates. In brief, exchange rates have to move a lot - the U.S. dollar would have to overshoot - to prevent a hit to global output. Investors should consider betting on higher exchange rate volatility. In spite of rising odds of U.S. trade protectionism, EM and DM currency volatility has so far remained surprisingly tame (Chart I-6). We feel there is a trade opportunity here, and today we recommend investors go long select EM exchange rate volatilities. Chart I-7 plots the U.S. trade vulnerability score on the X axis, and exchange rate volatility - more specifically, the standardized 3-month implied currency volatility - on the Y axis. According to Chart I-7, it appears that by historical standards, the current level of volatility of MYR, THB and KRW are low when considering these countries' vulnerability to U.S. trade protectionism. Therefore, investors should go long 3-month implied volatility for the KRW, the MYR and the THB. Chart I-6Exchange Rate Volatility In ##br##Historical Perspective Exchange Rate Volatility In Historical Perspective Exchange Rate Volatility In Historical Perspective Chart I-7Go Long Currency VOLs in Korea, ##br##Malaysia, And Thailand EM Vulnerability To U.S. Trade Protectionism EM Vulnerability To U.S. Trade Protectionism In addition, the volatility in these Asian currencies will rise and the RMB depreciate further. Bottom Line: To capitalize on a potential rise in global currency volatility, traders should go long three-month volatility in the KRW, the MYR and the THB. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Taking Profits On Turkish Shorts For Now In our December 7, 2016 Special Report 2 we argued that the odds of the lira being vigorously defended by the authorities or some sort of capital controls being implemented in Turkey would increase as the exchange rate approached USD/TRY 3.9. Given the exchange rate has come close to that level, we recommend that traders book profits on our Turkish short positions. The idea is to protect profits and capital in the case of capital controls. It is impossible to know whether the Turkish authorities will opt for capital controls, as it is a political decision. Yet, the risk is non-trivial. Furthermore, the rhetoric from Turkish President Recep Tayyip Erdogan suggests3 he views foreign investors as the main culprits for the nation's current financial debacle. President Erdogan will not shy away from hurting foreign investors via the introduction of capital controls and create the perception of financial stability. The central bank has been very active in recent weeks. Apart from hiking the overnight lending rate this week, it has recently curtailed liquidity injections into the banking system: Chart II-1Turkey: A Decline in Liquidity Provision Turkey: A Decline in Liquidity Provision Turkey: A Decline in Liquidity Provision On January 10, the Central Bank of Turkey (CBT) announced that it will place borrowing limits of TRY $22 billion in the Interbank Money Market, effectively limiting the volume of liquidity the central bank provides to commercial banks. Given the lira continued to slide, three days later, the CBT decided to move the interbank money market borrowing limit even lower at TRY $11 billion, effective January 16. That said, since January 10, the CBT has injected TRY $9.5 billion, on average per day, via the overnight window, and TRY $27 billion via the late liquidity window, albeit at higher interest rates than at the overnight window. Hence, the CBT has still injected a meaningful amount of liquidity into the banking system, but it has done so at higher interest rates. All in all, the CBT has curtailed liquidity injections in order to avoid further lira depreciation (Chart II-1, top panel). As a result, interest rates have risen sharply (Chart II-1, bottom panel). Yet, it is not certain that the central bank has tightened liquidity enough. Going forward, there are two main risks: either the CBT's liquidity tightening will be too little, and therefore the lira will continue to plunge, or, there will be considerable liquidity tightening, which will stabilize the exchange rate, but cascade the economy into major recession. Both scenarios are bearish for foreign investors holding Turkish stocks and credit. As we have discussed at length in previous reports, monetary authorities can control either the exchange rate or interest rates, but not both simultaneously. The CBT has been trying unsuccessfully to exercise control over both. To stabilize the exchange rate, the CBT has to drastically curtail its injections of local currency liquidity into the system. In such a case, however, interest rates will surge. Continued attempts to cap interest rates entail a further collapse in the lira's value. The only other option is to introduce capital control (i.e. close the capital account) in order to get control over both interest rates and the currency. Higher interest rates are not politically acceptable, as they will push the economy into deep recession. The reason being that domestic credit growth has been enormous in recent years, and higher interest rates will suffocate the economy. Yet not hiking the policy rate, or allowing interbank interest rates to rise, will all but ensure a deeper crash in the exchange rate. With the industrial sector already showing signs of weakness and the consumer sector flat, a decrease in loan growth will send the already weak economy into recession (Chart II-2). Yet, mushrooming money and credit growth, along with very high inflation in Turkey, justify higher interest rates: Local currency money and credit growth is too strong (Chart II-3). Unless these slow down, the lira will continue to decline. Chart II-2Turkey: Economy Is Heading##br## Into Recession Turkey: Economy Is Heading Into Recession Turkey: Economy Is Heading Into Recession Chart II-3Money/Credit Creation ##br##Has Been Too Rampant Money/Credit Creation Has Been Too Rampant Money/Credit Creation Has Been Too Rampant Genuine inflationary pressures are too ubiquitous: manufacturing and service sector wages have grown by about 20% over the past 12 months (Chart II-4). In brief, such genuinely high inflation, coupled with still low rates, are bearish for the currency. Robust credit and income/wage growth are supporting import demand, and the current account deficit is wide. This is another bearish factor for the exchange rate. In short, the lira has further room to fall. Remarkably, according to the real effective exchange rates based on unit labor costs as well as consumer prices, the lira is still not very cheap, making it vulnerable to further depreciation (Chart II-5) Chart II-4Turkey: 20% Wage Inflation Turkey: 20% Wage Inflation Turkey: 20% Wage Inflation Chart II-5The Turkish Lira Can Get Cheaper The Turkish Lira Can Get Cheaper The Turkish Lira Can Get Cheaper Even more surprising, despite a more than 20% depreciation against the U.S. dollar last year, foreign investors' holdings of Turkish equities and government bonds has not dropped significantly (Chart II-6). Finally, bank share prices in local currency terms have risen despite the spike in interest rates (Chart II-7). This entails that this bourse, which is dominated by bank stocks, is not pricing in risks from higher interest rates. Chart II-6Will Foreigners Capitulate On Turkish Assets? Will Foreigners Capitulate On Turkish Assets? Will Foreigners Capitulate On Turkish Assets? Chart II-7Bank Share Prices Have Held Up So Far Bank Share Prices Have Held Up So Far Bank Share Prices Have Held Up So Far Investment Recommendations: Currency and fixed income traders should take profits on our short TRY / long USD trade, as well as our short 2-year Turkish bond trade. These have returned a 24% and a 20%, respectively, since January 17, 2011 and June 1, 2016. That said, investors should consider shorting the lira versus the U.S. dollar again if the exchange rate rebounds to TRY/USD 3.5. We recommend equity traders book profits on our short Turkish banks position, which has registered a return of 60% since June 4, 2013. Dedicated EM equity and fixed income investors (both credit and local-currency bonds) should continue to underweight Turkey. Absolute-return and non-dedicated EM investors should minimize their exposure to Turkish financial markets. Stephan Gabillard, Research Analyst stephang@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Global Investment Strategy Special Report, titled "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017", dated January 20, 2017, available at www.gis.bcaresearch.com 2 Please refer to the Emerging Markets Strategy Special Report, titled "Turkey: Military Adventurism And Capital Controls", dated December 7, 2016 available at ems.bcaresearch.com 3 President Erdogan, speaking at the 34th meeting with village chiefs at the Presidential Palace in Ankara, said "Everyone already sees and knows the attacks that Turkey has been subjected to also have an economic aspect. There is no difference between a terrorist who has a weapon or bomb in his hand and a terrorist who has dollars, euros and interest in terms of aim. The aim is to bring Turkey to its knees, to take over Turkey and to distance Turkey from its goals. They are using the foreign exchange rate as a weapon". Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Dear client, We have received several questions about a potential U.S. border tax adjustment. Peter Berezin, Senior Vice President of BCA's Global Investment Strategy service addresses this issue in the attached Special Report titled, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017". Peter analyses the economic and financial market implications of the plan and concludes it is likely to be an additional support to the dollar bull market should it be implemented in full. We trust you will find this report very interesting and relevant. As always, please do not hesitate if you have further questions. Best regards, Lenka Martinek Highlights House Republicans are pushing for a radical overhaul of the existing tax code, including adding a "border adjustment" mechanism that would effectively subsidize exports and tax imports. Despite President Trump's apparent mixed feelings about border taxation, we see a 50% chance that some version of the proposal will be implemented. This is a higher probability than the market currently is discounting. The trade-weighted dollar will rally by another 5% even in the absence of any tax changes, but could rise by 15% if the border adjustment tax is introduced. If the latter were to happen, it would take some time for the dollar to rise to its new equilibrium level. This, in conjunction with sticky import and export prices, would likely lead to a temporary narrowing of the U.S. trade deficit. Such an outcome could prompt the Fed to raise rates more aggressively than it otherwise would. Investors should underweight U.S. bonds on a currency-hedged basis. A stronger dollar will push down commodity prices and hurt external borrowers with dollar-denominated loans. A protectionist backlash against the U.S. might ensue. We are closing our long Chinese banks trade for a gain of 32%, and our long RUB/USD trade for a gain of 20%. Feature Making The Tax Code Great Again? Republicans in Congress are proposing an ambitious revamp of the tax code. A central element of their plan is the replacement of the existing corporate income tax with a so-called "destination-based cash flow tax." Key features of this plan include: Cutting the current federal corporate tax from a top rate of 35% to 20%. Allowing businesses to depreciate capital expenditures immediately, rather than writing them off over many years. Disallowing businesses from deducting interest expenses when calculating their tax bills. Moving to a system of territorial taxation, meaning that taxes would only be assessed on the value added of goods consumed in the United States. Since not all goods that are produced in the U.S. are consumed in the U.S., and not all goods that are consumed in the U.S. are produced in the U.S., a destination-based system requires what is known as a "border adjustment." Such an adjustment would tax the value added of imports and rebate the value added of exports at an equivalent rate. While border adjustments are routinely used in other settings - most notably by countries that have VATs - their application to corporate income taxes is a novel idea. As such, it is not surprising that the proposal has generated significant confusion among investors. With that in mind, we offer our thoughts on the matter using a Q&A format. Q: How exactly would a border adjustment on corporate income taxes work? A: Under current U.S. law, corporate income taxes are assessed on worldwide profits, which are the difference between worldwide revenues and worldwide costs. The introduction of a border tax adjustment would change the tax system to one where taxes are assessed only on the difference between domestic revenues and domestic costs (i.e., revenues derived in the U.S. minus costs incurred in the U.S.). Table 1 offers a simplified example to illustrate this point. Consider three types of companies: 1) A purely domestic producer whose revenues and costs are realized at home; 2) An exporter whose revenues are entirely derived from abroad but whose costs are all incurred in the U.S.; 3) An importer whose revenues are completely generated in the U.S. but whose costs are all incurred abroad. Suppose that all three companies have revenues of $100 and costs of $60 - implying $40 in pre-tax profits - and face a corporate tax rate of 20%. Before the border adjustment, each company would pay a tax of $8 ($40 times 0.2). The border adjustment is zero for the domestic producer. However, it would impose an additional tax of $12 on the importer ($60 times 0.2), while giving the exporter a rebate of $20 ($100 times 0.2). In the end, the importer and exporter face final tax bills of $20 and -$12, respectively, while the domestic producer continues to pay $8. Note that this conforms with the tax paid on domestic revenues minus domestic costs (for the domestic producer, domestic revenue minus domestic cost is equal to $40; for the exporter it is equal to -$60; and for the importer, it is equal to $100). Q: A tax on imports and a subsidy on exports? Sounds like massive protectionism! A: That depends on the extent to which the dollar appreciates. As Table 1 shows, if the dollar appreciates by 1/(1-tax rate) = 1/(1-0.2) = 25%, there would be no impact on the trade balance or on the distribution of after-tax corporate profits in the economy. This is because the stronger dollar would nullify the subsidy on exports, while reducing import costs by precisely the amount necessary to restore importers' after-tax profits to their original level. Chart Q: This seems like splitting hairs. If a country imposes a 20% tax on imports, most people would still regard this as a protectionist act, even if a currency appreciation offsets the impact. A: That's why a corresponding export subsidy is necessary. That may sound strange since export subsidies are also seen as protectionist measures, but consider the following: Imagine that the government only taxes imports. A tax on imports would curb import demand, implying less demand for foreign currency. This would push up the value of the dollar, leading to lower import prices. How high would the dollar go? Suppose it rose so much that the decline in import prices exactly offset the tariff, thereby restoring import volumes (and importer profits) back to their original level. Is that a stable equilibrium? The answer is no because a stronger dollar would also reduce the demand for U.S. exports, causing the trade deficit to swell. Thus, for the trade balance to remain unchanged, the dollar would have to rise only part of the way, leaving importers worse off than before the tariff was introduced. Such a policy would be protectionist because it would favor U.S.-based companies that produce for the domestic market over foreign exporters. Only in the case where importers are subject to a tax and exporters receive a subsidy will the dollar strengthen to the point that neither exports nor imports change. Intuitively, this is because an export subsidy indirectly benefits importers by pushing up the value of the dollar, while directly benefiting exporters by offsetting the effect of a stronger dollar on profits. Q: If there is no change in the trade balance, what is the advantage of border-adjusting the corporate income tax? A: Contrary to Donald Trump's assertion that border adjustments are "too complicated," their chief advantage is their simplicity. Accurately assessing taxes on worldwide income is hard. Companies routinely engage in practices that purposely lower taxable profits. In particular, importers may overstate the value of their imports and exporters may understate the value of their exports. In a world where many companies have overseas subsidiaries, such "transfer pricing" machinations are easy to pull off. Border adjustments eliminate such incentives in one fell swoop. Recall that with a border adjustment, taxes are assessed on the difference between domestic revenues and domestic costs - both of which the IRS has the means to monitor. Yes, a U.S. company that overstates imports will be able to report a lower gross profit to the IRS, but now it will be on the hook for a higher import tax. What it puts in one pocket it takes from the other. Likewise, an exporter that understates its overseas sales will end up with a lower gross profit, but will now receive a smaller subsidy. Q: And I suppose that because the U.S. imports more than it exports, the border adjustment will end up raising additional revenues? A: That is correct. The annual U.S. trade deficit currently stands at $500 billion. A border adjustment tax rate of 20% would thus raise $100 billion in additional revenue. Given that the corporate income tax brings in about $350 billion, this would allow corporate taxes to be substantially cut without any loss in overall revenue. And this calculation excludes any indirect revenue that would accrue to the Treasury from reducing the incentive for U.S. companies to engage in profit-shifting behavior. Keep in mind, however, that the revenue boost from the border adjustment will decline if the U.S. trade deficit narrows over time. To the extent that the U.S. must finance its trade deficit through the sale of assets such as stocks, bonds, and property, it is possible that foreigners will one day decide to swap all these assets in exchange for U.S. goods. This would lead to an improvement in the U.S. trade balance. Indeed, to the extent that the U.S. is a net debtor to the rest of the world, it is possible that the average future U.S. trade balance will be positive. If that were to happen, the government would lose revenue from the border adjustment over the long haul. Meanwhile, a 25% appreciation in the greenback would reduce the dollar value of the assets that Americans hold abroad, without much of a corresponding decline in U.S. external liabilities. A reasonable estimate is that this would impose a paper loss on the U.S. of about 13% of GDP.1 Q: Ouch! But this assumes that a 20% border adjustment tax will lead to a 25% appreciation in the dollar. That is a mighty big can opener your fellow economists are assuming! What's to say this actually happens? A: Good point. Less than 10% of the turnover in the global foreign exchange market is directly related to the cross-border trade in goods and services. The rest represents financial market transactions. There are many things that can influence the value of the dollar beside trade flows. For example, suppose the government introduces a border adjustment tax, but the Federal Reserve fails to raise rates sufficiently fast in response to rising inflation stemming from a narrowing trade deficit. In that case, U.S. real rates could actually decline, leading to a weaker dollar. Our sense is that this won't happen, but the point is that there is no automatic link between a border tax and the dollar. Much depends on how the Fed responds and the underlying economic conditions. And even if the Fed does hike rates to keep the economy from overheating, two important forces will limit the extent of any dollar appreciation: First, questions about the timing and magnitude of the border adjustment tax - including the possibility that such a measure could be reversed by a future Congress - are likely to lead to only a partial appreciation in the dollar. Second, other central banks - particularly in emerging markets - are liable to take steps to limit the dollar's ascent so as not to place too great a burden on borrowers with dollar-denominated debt. Q: So what happens to countries with hard currency pegs to the dollar? Borrowers with dollar-denominated loans will be spared, but won't these countries end up suffering due to a sharp loss of competitiveness against other economies that have more flexible currencies? A: Correct. It is damned if you do, damned if you don't. Assuming that countries with exchange rate pegs to the dollar are strong enough to fend off a speculative attack, they will still need to engineer an equivalent real depreciation of their currencies via a decline in their nominal wages relative to U.S. wages - what economists call an "internal devaluation." That could impose a deflationary impulse on those economies. Q: You're losing me. A: Think about an extreme case - one where all countries have currency pegs to the dollar. How would the economic adjustment to a U.S. border tax work then? The answer is that initially, a tax on U.S. imports, combined with a subsidy on U.S. exports, would lead to a smaller trade deficit. This would cause the U.S. economy to overheat, putting upward pressure on prices and wages. By definition, an improving trade balance in the U.S. implies a worsening trade balance in the rest of the world. This would sap demand in other countries, putting downward pressure on prices and wages abroad. The adjustment will be complete only after relative wages have shifted enough to restore the U.S. trade balance to its original level. The important point is that in a world where some countries have flexible exchange rates while others have fixed exchange rates or dirty floats, the economic adjustment to a U.S. border tax will come through some combination of a stronger nominal dollar, higher U.S. inflation, and lower inflation abroad. Q: Bullish for the dollar, but bearish for U.S. bonds, correct? A: Precisely. The degree to which bond yields adjust around the world depends on the extent to which nominal exchange rates and domestic prices are sticky. If exchange rates are slow to change, more of the adjustment has to occur through higher inflation in the U.S. and lower inflation everywhere else. But even if nominal exchange rates adjust quickly, sticky goods prices would still push up U.S. bond yields. To see this point, consider what would happen if the dollar appreciated by 25% in response to the introduction of a border adjustment tax, but neither import prices nor export prices (expressed in U.S. dollars) changed. If that were to happen, the profit margins of U.S. importers would tumble because they would now have to pay an import tax but would not benefit from lower import prices. Meanwhile, the margins of U.S. exporters would soar as export prices stayed firm and they received a subsidy from the government. The result would be less imports and more exports, and hence, an improved trade balance. This would raise U.S. aggregate demand and put upward pressure on inflation and Treasury yields. Considering that 97% of U.S. exports and 93% of U.S. imports are denominated in dollars, such an outcome is hardly far-fetched. The bottom line is that in the "real world," the introduction of a border adjustment tax would cause Treasurys to sell off and the dollar to rally. Q: What sort of numbers are we talking about? A: Assuming a 20% border tax is introduced, a reasonable guess is that the trade-weighted dollar would rise by 10% over a 12-month period above and beyond our current forecast of a 5% gain. This would imply 15% upside from current levels. The 10-year Treasury yield would probably rise to about 3%. Q: It still puzzles me how you can claim that bond yields will rise if the dollar strengthens. Wouldn't a stronger dollar normally lead to lower bond yields? A: Your premise is wrong. It is not the stronger dollar that leads to higher bond yields. It is a third factor - namely the improvement in the trade balance arising from the decision to tax imports and subsidize exports - that causes both the dollar and bond yields to rise. This is similar to what happens when the government loosens fiscal policy. Mind you, at some point the positive correlation between the dollar and bond yields could break down. If the dollar rises too much, emerging markets will crumble under the stress. This will trigger safe-haven flows into the Treasury market, leading to a stronger dollar and lower yields. Such an outcome is not our base case, but it cannot be dismissed. Q: Got it. Presuming that the global economy holds up, it sounds like a border tax would be great news for Boeing, but bad news for Walmart? A: Yes, but there are two important qualifications to consider. First, it is possible that the dollar overshoots its new long-term equilibrium level, so that the pain to Boeing from the appreciation of the greenback ends up outweighing the benefits from the export subsidy it receives. Second, given the potential economic and financial dislocations from the shift to a destination-based tax system, there is likely to be some delay between when the tax bill is signed into law and when it is implemented. And even once implementation begins, the adjustment in tax rates may be phased in only gradually. Since the dollar will rise in anticipation of all this, it is possible that exporters will actually suffer initially, while importers receive a temporary boost to profits. Nevertheless, we think that investors will see through the near-term hit to exporter margins and focus on the medium-term gains. As such, equity investors should maintain a preference for exporting companies over those that heavily rely on imports (Chart 1). Chart 1 Q: This assumes that the market has not fully priced in this outcome already. What are the chances that this border adjustment tax proposal actually sees the light of day? A: The border tax idea originated in the House of Representatives and has its strongest support there. There might be more opposition in the Senate, but this could be overcome if enough Democrats with protectionist leanings can be found. President Trump panned the idea in an interview with the Wall Street Journal earlier this week.2 He noted that "Anytime I hear about border adjustment, I don't love it... because usually it means we're going to get adjusted into a bad deal. That's what happens." Trump's comments suggest he may not fully understand how border adjustments work. This implies that he might be persuaded to go along with the idea if Republican legislators are able to reach a "great deal" on adjustments in his eyes, whatever that means. Subjectively, we would assign 50% probability to a border tax being introduced in some form or another, although our sense is that it will be somewhat watered down so as not to generate major dislocations for the economy. This might entail excluding certain types of imports from a border tax if they are consumed disproportionately by the poor or represent an important input for U.S. manufacturing firms. Apparel and energy products would probably be on that list. It might also entail reducing the border adjustment tax to a lower level, say 10%, as Tom Barrack, head of Donald Trump's inaugural committee, has suggested. It is hard to know how much of this is already reflected in asset prices. The dollar fell after the WSJ article was published, but that may have had less to do with border adjustments and more to do with Trump's comment that he prefers a weaker dollar - an unprecedented statement for a U.S. president. Goldman Sachs' securities group has constructed two baskets using firm-level data, one comprised of "destination tax winners" and the other of "destination tax losers."3 The loser basket actually outperformed in the immediate aftermath of the election. While the relative performance of the winner basket has recovered more recently, it still remains below where it was last April (Chart 2). The limited reaction to the prospect of a border adjustment tax has been echoed in the fact that market expectations of the future volatility of the dollar has not changed much since the election, despite the possibility that the coming legislative debate could lead to wild swings in the greenback (Chart 3). Chart 2 Chart 3Dollar Volatility Has Not Escalated Dollar Volatility Has Not Escalated Dollar Volatility Has Not Escalated On balance, we conclude that investors are understating the likelihood of even a watered down border adjustment tax being introduced as part of a comprehensive tax reform program. This is broadly consistent with our client discussions, which have revealed that most investors - with a few notable exceptions - are only vaguely aware of the issue. Q: Won't the WTO rule against a border adjustment tax? That could explain why investors are discounting it. A: Yes, it probably will. The WTO permits border adjustments in the case of "indirect" taxes such VATs, but not in the case of direct taxes such as income or corporate profit taxes. Granted, the U.S. has brushed off WTO decisions in the past, such as when it ignored the trade body's ruling that U.S. laws restricting internet gambling contravened the General Agreement on Trade in Services. Considering that Donald Trump threatened to pull the U.S. out of the WTO during the election campaign, such an outcome cannot be easily dismissed. Nevertheless, given the magnitude of the border tax issue, even the Trump administration is likely to think twice about running afoul of WTO rules. Nevertheless, it might be possible to modify the border adjustment proposal to make it WTO-compliant. The distinction between direct and indirect taxes is one of those things self-styled experts like to pretend is important, but is not. It does not really matter whether a tax is levied on the sale of a good or service, or whether it is levied on income. In the end, someone has to pay the tax - be it a worker or a shareholder. The adoption by the U.S. of a border-adjusted destination tax would move the global economy in the direction of greater harmonization, not away from it. As noted at the outset, most other countries border adjust their value-added taxes. They do this so that their VATs mirror a consumption tax, as Table 2 illustrates with a simple example. Conceptually, a corporate cash flow tax coupled with a payroll tax functions in much the same way as a VAT (bottom part of Table 2). The U.S. already has both a corporate income and a payroll tax, so it is not that far away from having a VAT. All that is missing is a few tweaks to depreciation rules and the addition of the border adjustment. Chart Yes, the dollar would strengthen if that were to happen, but this would put the greenback on par with other currencies. Chart 4 shows that the U.S. has run a trade deficit with the rest of the G7 since 1990, despite the fact that the dollar has traded on average 9% below its Purchasing Power Parity (PPP) over this period. One of the reasons this has occurred is that other G7 economies have a VAT, whereas the U.S. does not (Chart 5). This has kept the dollar weaker than it otherwise would have been. Chart 4The Dollar Was Cheap For A Reason The Dollar Was Cheap For A Reason The Dollar Was Cheap For A Reason Chart 5 Q: Okay, let's wrap this up. What are the main investment implications I should take away from this? A: Our main takeaway is that investors are underestimating the likelihood that the U.S. adopts a destination-based tax system. This suggests that the risks to the dollar are to the upside, as are the risks to U.S. Treasury yields. Global investors should underweight U.S. bonds on a currency-hedged basis. The implications for global equities are more nuanced. It may take some time for the dollar to adjust to the border tax. This, combined with the fact that import and export prices tend to be sticky in the short run, implies that the U.S. trade deficit will decline, boosting U.S. aggregate demand in the process. While that is potentially good news for U.S. corporate profits, the benefits will be curtailed by the fact that the U.S. economy is approaching full employment. This means that any further stimulus could simply result in higher real wages for workers without any offsetting increase in unit sales for U.S. companies. A shrinking U.S. trade deficit will diminish America's role as "the global consumer of last resort." This is problematic for export-dependent emerging markets. While a border adjustment may be justifiable on economic grounds, politically, it could be seen as the first volley in a global trade war. This could sour sentiment towards EM stocks. To make matters worse, a stronger dollar would harm emerging markets with high levels of dollar-denominated debt such as Turkey, Malaysia, and Chile, while also weighing on commodity prices. We recommend that investors underweight EM stocks relative to their DM counterparts. With these considerations in mind, we are closing our long Chinese banks trade for a gain of 32% and our long RUB/USD trade for a gain of 20%. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 U.S. external assets amount to 133% of GDP, while foreign liabilities stand at 175% of GDP. About 68% of U.S. external assets are denominated in foreign currency, compared with only 16% of external liabilities. Thus, the paper loss to the U.S. from a 25% appreciation in the dollar would be (175*0.16-133*0.68)*(1-1/1.25) = 12.5% of GDP. 2 Please see "Donald Trump Warns On House Republican Tax Plan," The Wall Street Journal, dated January 16, 2017, available at www.wsj.com. 3 The Bloomberg tickers for these baskets are GSCBDTW1 and GSCBDTL1. For more information, please see "US Daily: What Policy Changes Is The Equity Market Expecting?" Goldman Sachs Economic Research, dated January 11, 2017.

Highlights House Republicans are pushing for a radical overhaul of the existing tax code, including adding a "border adjustment" mechanism that would effectively subsidize exports and tax imports. Despite President Trump's apparent mixed feelings about border taxation, we see a 50% chance that some version of the proposal will be implemented. This is a higher probability than the market currently is discounting. The trade-weighted dollar will rally by another 5% even in the absence of any tax changes, but could rise by 15% if the border adjustment tax is introduced. If the latter were to happen, it would take some time for the dollar to rise to its new equilibrium level. This, in conjunction with sticky import and export prices, would likely lead to a temporary narrowing of the U.S. trade deficit. Such an outcome could prompt the Fed to raise rates more aggressively than it otherwise would. Investors should underweight U.S. bonds on a currency-hedged basis. A stronger dollar will push down commodity prices and hurt external borrowers with dollar-denominated loans. A protectionist backlash against the U.S. might ensue. We are closing our long Chinese banks trade for a gain of 32%, and our long RUB/USD trade for a gain of 20%. Feature Making The Tax Code Great Again? Republicans in Congress are proposing an ambitious revamp of the tax code. A central element of their plan is the replacement of the existing corporate income tax with a so-called "destination-based cash flow tax." Key features of this plan include: Cutting the current federal corporate tax from a top rate of 35% to 20%. Allowing businesses to depreciate capital expenditures immediately, rather than writing them off over many years. Disallowing businesses from deducting interest expenses when calculating their tax bills. Moving to a system of territorial taxation, meaning that taxes would only be assessed on the value added of goods consumed in the United States. Since not all goods that are produced in the U.S. are consumed in the U.S., and not all goods that are consumed in the U.S. are produced in the U.S., a destination-based system requires what is known as a "border adjustment." Such an adjustment would tax the value added of imports and rebate the value added of exports at an equivalent rate. While border adjustments are routinely used in other settings - most notably by countries that have VATs - their application to corporate income taxes is a novel idea. As such, it is not surprising that the proposal has generated significant confusion among investors. With that in mind, we offer our thoughts on the matter using a Q&A format. Q: How exactly would a border adjustment on corporate income taxes work? A: Under current U.S. law, corporate income taxes are assessed on worldwide profits, which are the difference between worldwide revenues and worldwide costs. The introduction of a border tax adjustment would change the tax system to one where taxes are assessed only on the difference between domestic revenues and domestic costs (i.e., revenues derived in the U.S. minus costs incurred in the U.S.). Table 1 offers a simplified example to illustrate this point. Consider three types of companies: 1) A purely domestic producer whose revenues and costs are realized at home; 2) An exporter whose revenues are entirely derived from abroad but whose costs are all incurred in the U.S.; 3) An importer whose revenues are completely generated in the U.S. but whose costs are all incurred abroad. Suppose that all three companies have revenues of $100 and costs of $60 - implying $40 in pre-tax profits - and face a corporate tax rate of 20%. Before the border adjustment, each company would pay a tax of $8 ($40 times 0.2). The border adjustment is zero for the domestic producer. However, it would impose an additional tax of $12 on the importer ($60 times 0.2), while giving the exporter a rebate of $20 ($100 times 0.2). In the end, the importer and exporter face final tax bills of $20 and -$12, respectively, while the domestic producer continues to pay $8. Note that this conforms with the tax paid on domestic revenues minus domestic costs (for the domestic producer, domestic revenue minus domestic cost is equal to $40; for the exporter it is equal to -$60; and for the importer, it is equal to $100). Q: A tax on imports and a subsidy on exports? Sounds like massive protectionism! A: That depends on the extent to which the dollar appreciates. As Table 1 shows, if the dollar appreciates by 1/(1-tax rate) = 1/(1-0.2) = 25%, there would be no impact on the trade balance or on the distribution of after-tax corporate profits in the economy. This is because the stronger dollar would nullify the subsidy on exports, while reducing import costs by precisely the amount necessary to restore importers' after-tax profits to their original level. Chart Q: This seems like splitting hairs. If a country imposes a 20% tax on imports, most people would still regard this as a protectionist act, even if a currency appreciation offsets the impact. A: That's why a corresponding export subsidy is necessary. That may sound strange since export subsidies are also seen as protectionist measures, but consider the following: Imagine that the government only taxes imports. A tax on imports would curb import demand, implying less demand for foreign currency. This would push up the value of the dollar, leading to lower import prices. How high would the dollar go? Suppose it rose so much that the decline in import prices exactly offset the tariff, thereby restoring import volumes (and importer profits) back to their original level. Is that a stable equilibrium? The answer is no because a stronger dollar would also reduce the demand for U.S. exports, causing the trade deficit to swell. Thus, for the trade balance to remain unchanged, the dollar would have to rise only part of the way, leaving importers worse off than before the tariff was introduced. Such a policy would be protectionist because it would favor U.S.-based companies that produce for the domestic market over foreign exporters. Only in the case where importers are subject to a tax and exporters receive a subsidy will the dollar strengthen to the point that neither exports nor imports change. Intuitively, this is because an export subsidy indirectly benefits importers by pushing up the value of the dollar, while directly benefiting exporters by offsetting the effect of a stronger dollar on profits. Q: If there is no change in the trade balance, what is the advantage of border-adjusting the corporate income tax? A: Contrary to Donald Trump's assertion that border adjustments are "too complicated," their chief advantage is their simplicity. Accurately assessing taxes on worldwide income is hard. Companies routinely engage in practices that purposely lower taxable profits. In particular, importers may overstate the value of their imports and exporters may understate the value of their exports. In a world where many companies have overseas subsidiaries, such "transfer pricing" machinations are easy to pull off. Border adjustments eliminate such incentives in one fell swoop. Recall that with a border adjustment, taxes are assessed on the difference between domestic revenues and domestic costs - both of which the IRS has the means to monitor. Yes, a U.S. company that overstates imports will be able to report a lower gross profit to the IRS, but now it will be on the hook for a higher import tax. What it puts in one pocket it takes from the other. Likewise, an exporter that understates its overseas sales will end up with a lower gross profit, but will now receive a smaller subsidy. Q: And I suppose that because the U.S. imports more than it exports, the border adjustment will end up raising additional revenues? A: That is correct. The annual U.S. trade deficit currently stands at $500 billion. A border adjustment tax rate of 20% would thus raise $100 billion in additional revenue. Given that the corporate income tax brings in about $350 billion, this would allow corporate taxes to be substantially cut without any loss in overall revenue. And this calculation excludes any indirect revenue that would accrue to the Treasury from reducing the incentive for U.S. companies to engage in profit-shifting behavior. Keep in mind, however, that the revenue boost from the border adjustment will decline if the U.S. trade deficit narrows over time. To the extent that the U.S. must finance its trade deficit through the sale of assets such as stocks, bonds, and property, it is possible that foreigners will one day decide to swap all these assets in exchange for U.S. goods. This would lead to an improvement in the U.S. trade balance. Indeed, to the extent that the U.S. is a net debtor to the rest of the world, it is possible that the average future U.S. trade balance will be positive. If that were to happen, the government would lose revenue from the border adjustment over the long haul. Meanwhile, a 25% appreciation in the greenback would reduce the dollar value of the assets that Americans hold abroad, without much of a corresponding decline in U.S. external liabilities. A reasonable estimate is that this would impose a paper loss on the U.S. of about 13% of GDP.1 Q: Ouch! But this assumes that a 20% border adjustment tax will lead to a 25% appreciation in the dollar. That is a mighty big can opener your fellow economists are assuming! What's to say this actually happens? A: Good point. Less than 10% of the turnover in the global foreign exchange market is directly related to the cross-border trade in goods and services. The rest represents financial market transactions. There are many things that can influence the value of the dollar beside trade flows. For example, suppose the government introduces a border adjustment tax, but the Federal Reserve fails to raise rates sufficiently fast in response to rising inflation stemming from a narrowing trade deficit. In that case, U.S. real rates could actually decline, leading to a weaker dollar. Our sense is that this won't happen, but the point is that there is no automatic link between a border tax and the dollar. Much depends on how the Fed responds and the underlying economic conditions. And even if the Fed does hike rates to keep the economy from overheating, two important forces will limit the extent of any dollar appreciation: First, questions about the timing and magnitude of the border adjustment tax - including the possibility that such a measure could be reversed by a future Congress - are likely to lead to only a partial appreciation in the dollar. Second, other central banks - particularly in emerging markets - are liable to take steps to limit the dollar's ascent so as not to place too great a burden on borrowers with dollar-denominated debt. Q: So what happens to countries with hard currency pegs to the dollar? Borrowers with dollar-denominated loans will be spared, but won't these countries end up suffering due to a sharp loss of competitiveness against other economies that have more flexible currencies? A: Correct. It is damned if you do, damned if you don't. Assuming that countries with exchange rate pegs to the dollar are strong enough to fend off a speculative attack, they will still need to engineer an equivalent real depreciation of their currencies via a decline in their nominal wages relative to U.S. wages - what economists call an "internal devaluation." That could impose a deflationary impulse on those economies. Q: You're losing me. A: Think about an extreme case - one where all countries have currency pegs to the dollar. How would the economic adjustment to a U.S. border tax work then? The answer is that initially, a tax on U.S. imports, combined with a subsidy on U.S. exports, would lead to a smaller trade deficit. This would cause the U.S. economy to overheat, putting upward pressure on prices and wages. By definition, an improving trade balance in the U.S. implies a worsening trade balance in the rest of the world. This would sap demand in other countries, putting downward pressure on prices and wages abroad. The adjustment will be complete only after relative wages have shifted enough to restore the U.S. trade balance to its original level. The important point is that in a world where some countries have flexible exchange rates while others have fixed exchange rates or dirty floats, the economic adjustment to a U.S. border tax will come through some combination of a stronger nominal dollar, higher U.S. inflation, and lower inflation abroad. Q: Bullish for the dollar, but bearish for U.S. bonds, correct? A: Precisely. The degree to which bond yields adjust around the world depends on the extent to which nominal exchange rates and domestic prices are sticky. If exchange rates are slow to change, more of the adjustment has to occur through higher inflation in the U.S. and lower inflation everywhere else. But even if nominal exchange rates adjust quickly, sticky goods prices would still push up U.S. bond yields. To see this point, consider what would happen if the dollar appreciated by 25% in response to the introduction of a border adjustment tax, but neither import prices nor export prices (expressed in U.S. dollars) changed. If that were to happen, the profit margins of U.S. importers would tumble because they would now have to pay an import tax but would not benefit from lower import prices. Meanwhile, the margins of U.S. exporters would soar as export prices stayed firm and they received a subsidy from the government. The result would be less imports and more exports, and hence, an improved trade balance. This would raise U.S. aggregate demand and put upward pressure on inflation and Treasury yields. Considering that 97% of U.S. exports and 93% of U.S. imports are denominated in dollars, such an outcome is hardly far-fetched. The bottom line is that in the "real world," the introduction of a border adjustment tax would cause Treasurys to sell off and the dollar to rally. Q: What sort of numbers are we talking about? A: Assuming a 20% border tax is introduced, a reasonable guess is that the trade-weighted dollar would rise by 10% over a 12-month period above and beyond our current forecast of a 5% gain. This would imply 15% upside from current levels. The 10-year Treasury yield would probably rise to about 3%. Q: It still puzzles me how you can claim that bond yields will rise if the dollar strengthens. Wouldn't a stronger dollar normally lead to lower bond yields? A: Your premise is wrong. It is not the stronger dollar that leads to higher bond yields. It is a third factor - namely the improvement in the trade balance arising from the decision to tax imports and subsidize exports - that causes both the dollar and bond yields to rise. This is similar to what happens when the government loosens fiscal policy. Mind you, at some point the positive correlation between the dollar and bond yields could break down. If the dollar rises too much, emerging markets will crumble under the stress. This will trigger safe-haven flows into the Treasury market, leading to a stronger dollar and lower yields. Such an outcome is not our base case, but it cannot be dismissed. Q: Got it. Presuming that the global economy holds up, it sounds like a border tax would be great news for Boeing, but bad news for Walmart? Chart 1 A: Yes, but there are two important qualifications to consider. First, it is possible that the dollar overshoots its new long-term equilibrium level, so that the pain to Boeing from the appreciation of the greenback ends up outweighing the benefits from the export subsidy it receives. Second, given the potential economic and financial dislocations from the shift to a destination-based tax system, there is likely to be some delay between when the tax bill is signed into law and when it is implemented. And even once implementation begins, the adjustment in tax rates may be phased in only gradually. Since the dollar will rise in anticipation of all this, it is possible that exporters will actually suffer initially, while importers receive a temporary boost to profits. Nevertheless, we think that investors will see through the near-term hit to exporter margins and focus on the medium-term gains. As such, equity investors should maintain a preference for exporting companies over those that heavily rely on imports (Chart 1). Q: This assumes that the market has not fully priced in this outcome already. What are the chances that this border adjustment tax proposal actually sees the light of day? A: The border tax idea originated in the House of Representatives and has its strongest support there. There might be more opposition in the Senate, but this could be overcome if enough Democrats with protectionist leanings can be found. President Trump panned the idea in an interview with the Wall Street Journal earlier this week.2 He noted that "Anytime I hear about border adjustment, I don't love it... because usually it means we're going to get adjusted into a bad deal. That's what happens." Trump's comments suggest he may not fully understand how border adjustments work. This implies that he might be persuaded to go along with the idea if Republican legislators are able to reach a "great deal" on adjustments in his eyes, whatever that means. Subjectively, we would assign 50% probability to a border tax being introduced in some form or another, although our sense is that it will be somewhat watered down so as not to generate major dislocations for the economy. This might entail excluding certain types of imports from a border tax if they are consumed disproportionately by the poor or represent an important input for U.S. manufacturing firms. Apparel and energy products would probably be on that list. It might also entail reducing the border adjustment tax to a lower level, say 10%, as Tom Barrack, head of Donald Trump's inaugural committee, has suggested. It is hard to know how much of this is already reflected in asset prices. The dollar fell after the WSJ article was published, but that may have had less to do with border adjustments and more to do with Trump's comment that he prefers a weaker dollar - an unprecedented statement for a U.S. president. Goldman Sachs' securities group has constructed two baskets using firm-level data, one comprised of "destination tax winners" and the other of "destination tax losers."3 The loser basket actually outperformed in the immediate aftermath of the election. While the relative performance of the winner basket has recovered more recently, it still remains below where it was last April (Chart 2). The limited reaction to the prospect of a border adjustment tax has been echoed in the fact that market expectations of the future volatility of the dollar has not changed much since the election, despite the possibility that the coming legislative debate could lead to wild swings in the greenback (Chart 3). Chart 2 Chart 3Dollar Volatility Has Not Escalated Dollar Volatility Has Not Escalated Dollar Volatility Has Not Escalated On balance, we conclude that investors are understating the likelihood of even a watered down border adjustment tax being introduced as part of a comprehensive tax reform program. This is broadly consistent with our client discussions, which have revealed that most investors - with a few notable exceptions - are only vaguely aware of the issue. Q: Won't the WTO rule against a border adjustment tax? That could explain why investors are discounting it. A: Yes, it probably will. The WTO permits border adjustments in the case of "indirect" taxes such VATs, but not in the case of direct taxes such as income or corporate profit taxes. Granted, the U.S. has brushed off WTO decisions in the past, such as when it ignored the trade body's ruling that U.S. laws restricting internet gambling contravened the General Agreement on Trade in Services. Considering that Donald Trump threatened to pull the U.S. out of the WTO during the election campaign, such an outcome cannot be easily dismissed. Nevertheless, given the magnitude of the border tax issue, even the Trump administration is likely to think twice about running afoul of WTO rules. Nevertheless, it might be possible to modify the border adjustment proposal to make it WTO-compliant. The distinction between direct and indirect taxes is one of those things self-styled experts like to pretend is important, but is not. It does not really matter whether a tax is levied on the sale of a good or service, or whether it is levied on income. In the end, someone has to pay the tax - be it a worker or a shareholder. The adoption by the U.S. of a border-adjusted destination tax would move the global economy in the direction of greater harmonization, not away from it. As noted at the outset, most other countries border adjust their value-added taxes. They do this so that their VATs mirror a consumption tax, as Table 2 illustrates with a simple example. Conceptually, a corporate cash flow tax coupled with a payroll tax functions in much the same way as a VAT (bottom part of Table 2). The U.S. already has both a corporate income and a payroll tax, so it is not that far away from having a VAT. All that is missing is a few tweaks to depreciation rules and the addition of the border adjustment. Chart Yes, the dollar would strengthen if that were to happen, but this would put the greenback on par with other currencies. Chart 4 shows that the U.S. has run a trade deficit with the rest of the G7 since 1990, despite the fact that the dollar has traded on average 9% below its Purchasing Power Parity (PPP) over this period. One of the reasons this has occurred is that other G7 economies have a VAT, whereas the U.S. does not (Chart 5). This has kept the dollar weaker than it otherwise would have been. Chart 4The Dollar Was Cheap For A Reason The Dollar Was Cheap For A Reason The Dollar Was Cheap For A Reason Chart 5 Q: Okay, let's wrap this up. What are the main investment implications I should take away from this? A: Our main takeaway is that investors are underestimating the likelihood that the U.S. adopts a destination-based tax system. This suggests that the risks to the dollar are to the upside, as are the risks to U.S. Treasury yields. Global investors should underweight U.S. bonds on a currency-hedged basis. The implications for global equities are more nuanced. It may take some time for the dollar to adjust to the border tax. This, combined with the fact that import and export prices tend to be sticky in the short run, implies that the U.S. trade deficit will decline, boosting U.S. aggregate demand in the process. While that is potentially good news for U.S. corporate profits, the benefits will be curtailed by the fact that the U.S. economy is approaching full employment. This means that any further stimulus could simply result in higher real wages for workers without any offsetting increase in unit sales for U.S. companies. A shrinking U.S. trade deficit will diminish America's role as "the global consumer of last resort." This is problematic for export-dependent emerging markets. While a border adjustment may be justifiable on economic grounds, politically, it could be seen as the first volley in a global trade war. This could sour sentiment towards EM stocks. To make matters worse, a stronger dollar would harm emerging markets with high levels of dollar-denominated debt such as Turkey, Malaysia, and Chile, while also weighing on commodity prices. We recommend that investors underweight EM stocks relative to their DM counterparts. With these considerations in mind, we are closing our long Chinese banks trade for a gain of 32% and our long RUB/USD trade for a gain of 20%. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 U.S. external assets amount to 133% of GDP, while foreign liabilities stand at 175% of GDP. About 68% of U.S. external assets are denominated in foreign currency, compared with only 16% of external liabilities. Thus, the paper loss to the U.S. from a 25% appreciation in the dollar would be (175*0.16-133*0.68)*(1-1/1.25) = 12.5% of GDP. 2 Please see "Donald Trump Warns On House Republican Tax Plan," The Wall Street Journal, dated January 16, 2017, available at www.wsj.com. 3 The Bloomberg tickers for these baskets are GSCBDTW1 and GSCBDTL1. For more information, please see "US Daily: What Policy Changes Is The Equity Market Expecting?" Goldman Sachs Economic Research, dated January 11, 2017.

Highlights Deflation has decisively ended, and the economy is making a gradual transition towards inflation. The upshot is that growth is reviving rapidly in nominal terms. It is unrealistic to expect exports to be a main growth driver for the Chinese economy in the post-crisis world - even without protectionist pressures from President-elect Trump. The "Trump" wildcard serves as a wake-up call for Chinese policymakers to further focus on supporting domestic demand. There is a strengthening case for cyclical improvement in manufacturing investment. This further limits downside risk and sets the stage for potential positive surprises in the coming months. Feature Investors will be paying close attention to President-elect Donald Trump's inauguration speech this coming Friday, which may allow for a clearer understanding of his world view and economic policies, as well as their global implications. The inauguration will overshadow China's key economic statistics to be released later this week, and which we expect to show that the Chinese economy has picked up sequentially. As political uncertainty will stay elevated and deserves close monitoring going forward, it is equally important to keep in mind the economic big picture. In the next two months, China's economic data will once again be heavily distorted by the Chinese New Year holiday, making it more difficult to detect genuine growth trends. In last week's report, we laid out our view on China's growth and policy outlook for 2017.1 This week, we offer a reality check and our take on some key cyclical issues. Watch For Inflation Surprises The biggest change in China's macro condition in the past year, in our view, has been the sharp turnaround in producer prices. Rising PPI has lifted corporate pricing power, reduced real interest rates and eased financial stress in some heavy industries, the weakest link in the corporate sector - all of which are important reasons behind China's growth improvement of late. Looking forward, we expect inflation will remain well behaved. Improving producer prices is to a large extent attributable to RMB depreciation, which has already begun to crest. The trade-weighted RMB's depreciation has halted, and it is unrealistic to expect it to continue to depreciate at an ever-accelerating pace (Chart 1). This should cap the upside of PPI inflation. The headline consumer price index (CPI), the broader inflation measure, was fairly stable throughout last year's roller coaster ride in PPI (Chart 2). Moreover, the fluctuation in headline CPI was mainly attributable to food prices, which have been noisy due to seasonal factors and unexpected supply-demand disruptions, but have been largely trendless in recent years. There is no case for a food-induced inflation outbreak. Chart 1PPI Inflation Is Peaking PPI Inflation Is Peaking PPI Inflation Is Peaking Chart 2No Case For Food Inflation No Case For Food Inflation No Case For Food Inflation More fundamentally, although the Chinese economy has strengthened, it is still operating below potential. Historically, runaway inflation has always occurred when the economy overheated, which is far from the current situation (Chart 3). Without a strong growth rebound, it is difficult to expect genuine inflationary pressures. In short, the current environment is best characterized as "easing deflation" rather than "rising inflation," and our base case remains that inflationary pressures will stay at bay. Nonetheless, it is important to note that strong deflationary pressures have prevailed since the global financial crisis, which has led to major adjustments in the world economy. In China's case, for example, capital spending has slowed sharply. Meanwhile, cutting excess capacity has been an explicit policy priority, which, together with strengthening demand may lead to a quick rise in prices. Last year's sharp rebound in steel, thermal coal and some other raw materials prices provided clear evidence of this. Indeed, several factors warn against being overly complacent about the inflation outlook. For producers, the improvement in pricing power appears rather broad based, as both industrial firms and the service sector have been reporting rising levels in their respective output prices. In other words, rising prices are not just contained in resource sectors associated with global commodities prices and Chinese capacity cuts. For consumers, inflation expectations have begun to rise (Chart 4). Consumers' inflation expectations may be just a response to changes in prices rather than a leading indicator for future price moves. However, there has been a significant pickup in confidence on future income growth, which is likely a reflection of a tighter labor market and rising wages. If this trend holds, it would make it a lot easier for producers to pass through rising input costs to end users. Chart 3Inflation Vs Economic Overheating Inflation Vs Economic Overheating Inflation Vs Economic Overheating Chart 4Inflation Expectations Are On The Rise Inflation Expectations Are On The Rise Inflation Expectations Are On The Rise Overall, it is premature to worry about an inflation outbreak, and we do not consider inflation as a major policy constraint for the People's Bank of China. However, it appears that deflation has decisively ended, and the economy is making a gradual transition towards inflation. The upshot is that growth is reviving rapidly in nominal terms, supercharged by both improvement in real activity and a rising GDP deflator. Nominal GDP may reclaim a double-digit annual pace in the coming quarters. Exports: Why Has The Historical Correlation Broken Down? China's latest export numbers continued to disappoint, falling by 6.1% in dollar terms from a year ago. Part of the decline is due to falling prices measured in dollar terms; exports in volume terms are considerably stronger. Nonetheless, the export sector has been a chronic underperformer in the Chinese economy in recent years. Historically, China's export sector performance was highly predictable based on some key domestic and global variables - this correlation has clearly broken down since 2015 (Chart 5). If the historical correlation still held, export growth should have rebounded sharply. Many have viewed the divergence as a sign that Chinese exporters have lost competitiveness, which does not seem credible, as Chinese exports have continued to gain global market share. In our view, the chronic disappointment of the Chinese export sector's performance is due to several factors. First, the global financial crisis was a watershed event that marked structural breaks in economic correlations. Since then, consumers in the developed world have been focusing on deleveraging and fixing their balance sheets, and therefore the growth recovery has not led to a corresponding increase in demand - and imports for - consumer goods. Second, protectionist pressures have been on the rise since the global financial crisis, as all countries have tried to protect domestic producers in the face of weak final demand. Anti-dumping measures initiated by World Trade Organization member countries have increased notably in recent years, a growing share of which have been targeted at Chinese exporters (Chart 6). The high profile anti-dumping measures adopted by the Obama administration against Chinese tire and steel products have caused significant damage to Chinese producers and exporters.2 Chart 5Exports Have Disappointed Exports Have Disappointed Exports Have Disappointed Chart 6Protectionism Is Already On The Rise Protectionism Is Already On The Rise Protectionism Is Already On The Rise Finally, Chinese export numbers have been distorted by disguised capital flows driven by speculation on the RMB exchange rate. The sharp swings in Chinese exports to Hong Kong since the global financial crisis can be viewed as proxy for shifting expectations on the yuan (Chart 7). Immediately after the global financial crisis, the RMB was widely expected to rise against the dollar, leading to a massive surge in Chinese sales to Hong Kong as exporters overstated export revenues to bring more foreign currencies onshore. The tide completely reversed in early 2014 when the RMB began to drop against the greenback. Exporters may have been underreporting overseas sales so they could park part of their foreign revenues offshore in anticipation of a weaker RMB, weighing on overall export sector performance. Whatever the reason, the important point here is that it is unrealistic to expect exports to be a main growth driver for the Chinese economy in the post-crisis world - even without protectionist pressures from President-elect Trump. In recent years the Chinese authorities systematically overestimated the vigor of global demand, and export sector performance almost always lagged the government's annual targets, which contributed to chronic growth disappointments. In this regard, the "Trump" wildcard serves as a wake-up call for Chinese policymakers to further focus on supporting domestic demand. Has Investment Bottomed? With exports chronically disappointing, domestic capital spending holds the key for economic growth. Policy driven investment on infrastructure construction has held up strongly since 2013, while private sector investment mainly in the mining and manufacturing sectors has downshifted sharply. Looking forward, infrastructure spending will likely remain buoyant, supported by both public budgetary sources and public-private-partnerships (PPPs).3 What's changing is that capital spending in the manufacturing sector may have bottomed from a cyclical point of view. Inventory destocking in the manufacturing sector has become very advanced. Improving new orders and rising producer prices should lead to a restocking cycle. There has been a notable improvement in corporate sector profitability and confidence of late, which has historically led capital spending in the manufacturing sector (Chart 8). Consistently, the latest credit numbers show a significant pickup in medium- and long-term loans by the corporate sector, which are typically used to finance investment spending rather than replenish working capital. Chart 7Hong Kong Trade And The RMB Hong Kong Trade And The RMB Hong Kong Trade And The RMB Chart 8Manufacturing Capex Has Bottomed Manufacturing Capex Has Bottomed Manufacturing Capex Has Bottomed The long-term outlook for Chinese private capital spending hinges critically on structural reforms on many fronts. As far as the corporate sector is concerned, it is widely recognized that China's overall tax burden is not high by global standards, but is primarily shouldered by the corporate sector rather than households, and a rebalancing is long overdue. The government under incumbent Premier Li Keqiang has been focusing on reducing administrative red tape and mandatary employee benefits provided by employers as ways to cut corporate sector costs. If the Chinese authorities can implement reforms despite the populist resistance to shifting some of the tax burden from the corporate sector to households, it could further boost corporate profitability and revive animal spirits among Chinese entrepreneurs, leading to another round of investment boom. Any tax reform measures in this direction should be viewed as a major positive development. For now, we see a strengthening case for cyclical improvement in manufacturing investment, after decelerating for over six years. The current sub-par "new normal" growth trajectory rules out a sharp revival in capex, but the marginal change in "second derivatives" is still important as it diminishes a chronic growth headwind. This further limits downside risk and sets the stage for potential positive surprises in the coming months. Stay tuned. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1, 3 Please see China Investment Strategy Weekly Report, "China: The 2017 Outlook, And The Trump Wildcard," dated January 12, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China-U.S. Trade Relations: The Big Picture," dated November 17, 2016, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Trump's protectionism supercharges our theme of Sino-American tensions. China is at a stark disadvantage to the U.S. in a trade war. China cannot give concessions easily; it may batten down the hatches. Remain short RMB; but go long "One China," i.e. mainland stocks versus Taiwan/Hong Kong. Feature "Life's short span forbids us to enter on far reaching hopes." - Horace, Odes "Of course, you know, this means war." - Bugs Bunny, Looney Tunes President-elect Trump has said he will not designate China a "currency manipulator" on the first day of his presidency, contrary to what he promised during the campaign. Is this a sign that Trump is "normalizing" after the wild threats of his campaign? What are the real risks of a U.S.-China "trade war"? How should investors prepare? Trade War Is More Likely Than You Think BCA's Geopolitical Strategy has long cautioned investors that geopolitical tensions in East Asia were severely underestimated by the market.1 In 2013, we argued that a Sino-American military conflict was more likely than most of our clients dared to think.2 And over the past several years, in one-on-one conversations and in presentations at numerous conferences, we have stressed that tensions in East Asia could imperil the largest trade relationship. Why so alarmist? We have always based our analysis on three key pillars: Multipolarity: With the U.S. in a relative decline, containing China's rise has become a national security issue. The U.S. "Grand Strategy" operates under the imperative that no regional power is allowed to become a regional hegemon, as that would be a stepping stone to global competition. "Pivot" To Asia: The U.S. geopolitical deleveraging from the Middle East was from the start designed to free up more U.S. resources for Asia. While the Obama Administration pursued the pivot cautiously, it was putting the infrastructure in place for a confrontation with China. Regional dynamics: China is surrounded by neighbors that are cautious about Beijing's intentions for geographic, historical, and strategic reasons. They have therefore sought to balance their increasing economic addiction to China with deeper military and political links to the U.S. Chart 1China, Not NAFTA, In Trump's Crosshairs China, Not NAFTA, In Trump's Crosshairs China, Not NAFTA, In Trump's Crosshairs Trump's victory has made markets considerably less oblivious to the risks we have stressed to clients for the past five years. The idea that a trade war might erupt is now widely discussed. And Trump's repeated statements about Taiwan, North Korea, and the South China Sea have awoken some investors to the reality that a trade conflict could spill over into strategic areas, and vice versa. Nevertheless, judging by the ebullient market reaction relative to previous U.S. presidential transitions, most investors think that cool heads will inevitably prevail. They may be right, but from where we sit it is premature - and imprudent - to bet on it. Make no mistake, China, not NAFTA, will suffer the brunt of Trump's efforts to fulfill his protectionist campaign promises (Chart 1). We see 70% odds that a "crisis event" will affect U.S.-China trade patterns in a significant way over the next four years. How Did We Get Here? The Global Financial Crisis caused a sharp break in Sino-American relations: It interrupted the economic symbiosis between China and American households refused to keep re-leveraging, forcing China to become more internally driven economy (Chart 2). With final demand in the U.S. declining, China decided to re-leverage with credit, injecting its existing overproduction and overcapacity with steroids. But this only accelerated China's capture of global export market share, while supercharging the deflationary global effects (Chart 3). On top of its credit policies, China has struggled to internationalize the RMB. So now, it is not only still washing the world with its industrial overcapacity but also inadvertently - or not so innocently - reducing the prices of its goods with the weakening of its currency (Chart 4). Chart 2U.S.-China Symbiosis Has Died U.S.-China Symbiosis Has Died U.S.-China Symbiosis Has Died Chart 3China's Historic Export Grab China's Historic Export Grab China's Historic Export Grab Chart 4China Still Exporting Deflation China Still Exporting Deflation China Still Exporting Deflation U.S.-China trade disputes have a long history. China's WTO entrance was agreed only with the stipulation that China be treated as a "non-market economy" for 15 years. Punitive trade bills almost passed through Congress in 2005 and 2010-11, for instance, but were held back at the last minute.3 Since 2009, in particular, protectionist policies have emerged. President Obama began his term with an unprecedented use of the authority under Section 421 of the 1974 Trade Act to punish China for "market distorting" exports of car tires, and with protectionist "Buy America" provisions in his economic stimulus package. After that, a sequence of tit-for-tat punitive measures took place affecting a range of goods on both sides, attempted Chinese investments in the U.S., and American companies operating in China. China's meteoric rise, surging trade surpluses with the U.S., and the rapid loss of U.S. manufacturing jobs was the main cause of tension (Chart 5). Americans benefited from China's rise, namely from cheaper goods and lower interest rates, but it caused significant economic dislocations.4 Meanwhile Chinese protectionism discouraged American elites that had endorsed China's rise on the hopes of gradually unfolding market access. Amid the heightened political risks of the global recession and its aftermath, China intensified intellectual property theft, non-tariff barriers, indigenous innovation policies, and cyber-attacks.5 The saving grace, for markets, was that the aforementioned tensions always remained within bounds. The WTO was a mutually recognized adjudicator. Also, the rival American and Chinese commercial authorities played a slow, step-by-step, predictable game, with the punitive measures being mostly proportional. When pressures flared in the U.S., the executive branch stayed Congress's hand; meanwhile China's government could steamroll any internal opposition to its trade policies. No more. Hillary Clinton might have helped contain trade tensions, but the outlook has darkened irrespective of Trump. Notably, American multinational corporations have increasingly decried Chinese protectionism and lobbied for the U.S. government to help persuade China to give them greater market access and a better legal-regulatory climate (Chart 6). As the Obama administration exited the stage in December 2016, the U.S., Japan and others refused to accept China's "market economy" status despite the fifteen-year deadline coming due. This means the U.S. and its allies explicitly wanted to reserve the power to impose anti-dumping duties more easily on China, which is what "Non-Market Economy" status entails (Chart 7).6 China considers this delay an outright violation of U.S. commitments under WTO. Chart 5A Tale Of Two Manufacturers A Tale Of Two Manufacturers A Tale Of Two Manufacturers Chart 6American Business Under Pressure In China Trump, Day One: Let The Trade War Begin Trump, Day One: Let The Trade War Begin Chart 7China's Non-Market Status A Liability Trump, Day One: Let The Trade War Begin Trump, Day One: Let The Trade War Begin Further, Clinton had promised to create a special prosecutor for trade disputes and to triple the number of enforcement officers. More broadly, she wanted to continue Obama's "Pivot to Asia" policy that had roiled U.S.-China strategic relations. Bottom Line: U.S.-China trade relations had already turned sour as a result of the divergence of interests following the Global Financial Crisis. China has emerged as a trade juggernaut and the U.S. corporate and political establishments have become far more anxious about it recently. Now Trump has supercharged the situation. Will Trump "Normalize" In Office? With Trump, the U.S. is likely to undergo a "regime change" in terms of how trade policy is conducted - the only question is how long-lasting it will be. U.S. presidents have very few constraints on trade and foreign policy (Table 1). Ignore Trump's statements and look at his team: Incoming Commerce Secretary Wilbur Ross, National Trade Council chief Peter Navarro, and U.S. Trade Representative Robert Lighthizer.7 This group, especially Navarro, is stridently hawkish on China and appears ready to bring the full weight of the United States' economic and strategic advantages to the table in order to negotiate a new framework of relations. Table 1Trump Is Not Constrained On Trade Policy Trump, Day One: Let The Trade War Begin Trump, Day One: Let The Trade War Begin The model is the renegotiation of trade relations with an ascendant Japan in the 1980s. And China looks ripe for a crackdown by this yardstick. The penetration of Chinese exports meet or exceed Japan's position at its peak in the 1980s (Chart 8). Meanwhile the RMB has not appreciated nearly as much as the yen had done by this time (Chart 9). Ultimately the two resolved their differences because Japan acceded to major U.S. demands, strengthening its currency after the 1985 Plaza Accord and accelerating financial liberalization. It helped that the two were staunch allies without genuine security tensions (unlike the U.S. and China today). Chart 8China Has Gotten Away ##br##With More Than Japan Did China Has Gotten Away With More Than Japan Did China Has Gotten Away With More Than Japan Did Chart 9Reagan Forced Faster ##br##Appreciation On Japanese Yen Reagan Forced Faster Appreciation On Japanese Yen Reagan Forced Faster Appreciation On Japanese Yen From the Trump administration's point of view, the standard trade remedies have failed given that U.S. trade deficits have deteriorated all along. True, China has made considerable structural adjustments in recent years (Chart 10). But relative to the U.S., China has not really changed its ways. In fact, the current account surplus, which has collapsed from 10% to around 2% since 2008, is now roughly equal to the trade surplus with the United States (Chart 11). Chart 10China's Economic Rebalancing Under Way China's Economic Rebalancing Under Way China's Economic Rebalancing Under Way Chart 11China's Trade Surplus With U.S. Indispensable China's Trade Surplus With U.S. Indispensable China's Trade Surplus With U.S. Indispensable Therefore we do not put much stock in Trump's claim that he will not call China a currency manipulator on day one - this does not signal a "normalization" or softening of Trump's protectionist line. There was always a technical issue with this pledge that made the timing awkward.8 The manipulator charge will remain a Sword of Damocles hanging over China this year and next, but it is also only one tool in Trump's toolkit - and not the most intimidating one either (Diagram 1). Diagram 1Calling China A Currency Manipulator: The Process Trump, Day One: Let The Trade War Begin Trump, Day One: Let The Trade War Begin At a minimum, Trump could easily do what Obama did in February 2009 on tires - simply approve recommendations from his own Treasury Department for tariffs on specific goods. At a more aggressive level, he has the example of Richard Nixon before him. Nixon imposed a 10% surcharge on all dutiable goods in 1971. We would not put it beyond Trump to take arbitrary actions within the four-year term if international economic conflicts heat up dramatically. (We will be especially leery in the lead-up to the 2018 or 2020 elections if Trump's touted deal-making is not going his way.) Congress is not likely to prove a major constraint, at least not at first. Trump's election is a strong signal that the U.S. populace wants more protectionist policies. Congressional Republicans are limited, given the laws empowering the president on trade, and they will face the reality that his electoral strategy succeeded in great part because of voter demand for protectionism in key Midwestern states. Democrats, in these and other competitive states, have to perform verbal gymnastics to oppose Trump's positions on trade that substantially echo their own. And as mentioned, U.S. multinationals are not likely to "domesticate" Trump - rather, they will lobby for relative moderation or tactfulness within his general framework. Bottom Line: Trump is relatively unconstrained on trade policy. We expect his administration to begin with a "shot across the bow" in the first 100 days - a mostly but not entirely symbolic punitive measure against China - and then to seek high-level negotiations toward a framework for the administration's relations with China over the next four years. We expect the initial shot to rattle markets, then for a calming period to ensue, which will give a false sense of security. But given the lack of constraints on Trump, we are not optimistic. What Are China's Options? In a trade war with the U.S., China is outgunned on every front. Its economy is far more vulnerable to a disruption of exports to the U.S. than vice versa (Chart 12). It does not have ready alternatives to the U.S., given that U.S. imports of Chinese goods are roughly equal to Japanese, South Korean, German, Vietnamese and British imports combined. And China is most competitive in goods that the U.S. can easily source elsewhere (Chart 13). Chart 12The Numbers Favor The U.S. In A Trade War The Numbers Favor The U.S. In A Trade War The Numbers Favor The U.S. In A Trade War Chart 13The U.S. Can Find Substitutes For China Trump, Day One: Let The Trade War Begin Trump, Day One: Let The Trade War Begin Yes, China can disrupt the supply chain for the iPhone, but no, the Trump administration is not going to confuse Apple's interests with what it views as the "National Interest." Certainly China will favor non-American companies - Airbus over Boeing, etc - but the U.S. growth model is not reliant on exports, so it is not clear that the Trump administration will heed Boeing's cries about long-term competitiveness. The states most exposed to Chinese retaliation - Alaska, Oregon, Washington, Louisiana, and South Carolina - will not harm his electoral base. His Midwestern Rust Belt states could suffer, according to some research, but voters there may approve of his protectionist measures and Trump's other economic policies may blunt the short-term impact of Chinese retaliation.9 Looking at major Chinese export categories to the U.S., like textiles, electrical machinery, and equipment, suggests that 30 million Chinese jobs could be affected - perhaps ten times as many as the comparable U.S. jobs at risk from Chinese retaliation (far more than proportional given population). There is one factor that stands in China's favor. The history of trade wars says something different than the raw balance of trade. Like all wars, trade wars seek political ends, and a government's internal unity and resilience can be critical to its ability to bear out the worst.10 Politically, it is not clear that the U.S. has a better stomach for a full trade war than China: The U.S. remains divided - Polarization will worsen under Trump given his low approval ratings, low favorability, narrow popular victory margin, and controversial policy inclinations. Though China-bashing and economic patriotism can win some support, and we do not expect Congress or the corporate lobby to prevent Trump from launching a trade crusade if he wishes, nevertheless we see a fair chance that Trump would lose credibility and be forced to moderate his stance once negative trade consequences began to be felt at home. China is relatively unified - Xi has set himself up to be the "core" of power in the Communist Party in anticipation of worsening domestic conditions.11 It is worth remembering that the original use of the "core leader" moniker emerged in the wake of the Tiananmen Square crackdown when the Western world imposed sanctions on a newly liberalized China and it was forced to retreat into its shell from 1989-1992 (Chart 14). China's leadership wants to make the country less dependent on the U.S., and more autarkic, but is having difficulty imposing austere changes on itself. Trump may hasten the reforms while giving Chinese leaders a convenient "foreign devil" to distract the populace from the pain of restructuring. Chart 14China Rode Out Western Pressure In 1989 China Rode Out Western Pressure In 1989 China Rode Out Western Pressure In 1989 The above should not suggest that China wants a trade war, however. Trump is threatening to kick the export leg out from under its growth model at a time when the other leg - investment - stands at risk from domestic credit excesses.12 But the recent case study of Russia and economic sanctions is instructive. President Vladimir Putin used sanctions to blame all of the economic ills that befell Russia on the West, even though the Kremlin was often at fault. That policy largely worked. Bottom Line: China stands to suffer the most economically in a trade war with the United States. Chinese policymakers may therefore choose to ride out the economic costs of a trade war while blaming the U.S. for the pain. But closing its economy today would derail global growth and cause a dramatic spike in geopolitical risk, unlike in 1989. Strategic Spillover Trump's approach is likely to increase geopolitical risk because he wants to use the strategic disagreements plaguing Sino-American relations as leverage to get concessions on trade. The three hot spots are: Taiwan - Tensions with Taiwan spiked when Trump revealed that his administration considers the "One China" policy to be up for negotiation. China has engaged in serious saber-rattling in response, both around Taiwan and in the South China Sea. By linking trade disputes with Taiwan, Trump likely made it harder for Xi to compromise on the former without looking weak on the latter. Trump's negotiating style may work in business, but will not work with China on Taiwan, which is a matter of sovereignty and a clear red line. North Korea - Trump has said North Korea will not manage to test an Intercontinental Ballistic Missile (ICBM), which it is preparing to do. He is threatening to hold China to account for not curbing the North's violations of UN resolutions on nuclear proliferation and missile development. This would likely mean an expansion of the practice adopted under Obama of sanctioning Chinese entities for dealing with North Korean partners. This situation would likely shake up markets that have normally been able to ignore North Korea. South China Sea - Trump has repeatedly signaled that China has militarized the South China Sea, and his incoming Secretary of State Rex Tillerson suggested that China be deprived of access, a policy that would trigger a shooting war if operationalized. Persistent tensions here are unlikely to go away anytime soon and could spark a diplomatic crisis or naval conflict (if not with the U.S. then with regional players like Vietnam). Thus Trump's administration is likely to make serious demands on China regarding its strategic situation and national security even while demanding an overhaul of trade policies that will force difficult economic reforms on China. Bottom Line: China's political strengths at home make it unlikely to compromise on Trump's major strategic demands. Contrary to adding leverage in trade negotiations - where the U.S. already has the upper hand - using these issues as negotiating tools is likely to cause China to fear for its security and thus become more defiant. Risks To The View The risk to this view would be that the U.S. and China manage to negotiate a new framework and actually improve relations, with the U.S. giving more respect to China's legitimate rights and regional initiatives in exchange for Chinese concessions. But is China capable of conceding significantly on Trump's major demands? RMB appreciation? No. Many commentators have pointed out that Trump's view of the RMB is outdated - the PBoC is now propping it up, not suppressing it. The driver of RMB weakness is China's excessive monetary and credit expansion, weakening productivity growth, domestic investors' desires to move capital out, corporate deleveraging, the need for stimulus, tightening Fed policy, and rising geopolitical risks. While it is possible that the PBoC will defend the RMB to the hilt, the near-term path of least resistance is down, and that sets China on a collision course with the Trump administration. Market access and dumping? Yes. Trump complains that China taxes U.S. imports unfairly and dumps goods into the American market, killing jobs. To appease the U.S., China could take concrete steps to remove non-tariff barriers and open wider investment avenues for U.S. businesses - it has recently suggested it might do so.13 Less likely, it could accelerate overcapacity cuts and reduce subsidies to state-owned enterprises. These moves would fit with its avowed reform goals and strengthen Chinese self-sufficiency in the long run, and Xi's administration likely has the power to do them. China could also improve intellectual property protections and declare a ceasefire on cyber-attacks on companies. All of this is possible, but clearly extremely difficult to achieve. Strategic concerns? Maybe. It is conceivable but unlikely that China could de-escalate matters in the South China Sea and agree to a "freedom of navigation" guarantee for the United States, which is not a party to the territorial disputes. A significant compromise on North Korea would be even less likely, since China is unwilling to move beyond the usual, ineffective management and impose real hardship on the regime for its violations of UN resolutions and improving nuclear and missile capabilities. One impetus for China to concede on these points is that it is fearful of creating instability in a politically sensitive year in which it will oversee a major five-year leadership rotation at its National Party Congress. Trump may deliberately threaten to disrupt the transition in order to extract concessions. Bottom Line: We operate on a constraint-based methodology: Trump has very few constraints on trade policy, China has major constraints on making these concessions, so there is no basis for assuming that the two countries will skip conflict and go directly to a new level of cooperation. Investment Recommendations We remain short the RMB. The currency has fallen by 5.62% since we initiated this trade. The trade itself has suffered a bit since the end of last year as a result of the PBoC's efforts to fight speculation. But monetary expansion sans productivity improvements continues apace in China, and we expect USD strength to persist, so we think there is room for the RMB to fall further. In the near term, however, the USD could experience further pullback as investors start pricing the negatives of the Trump administration. Therefore we are closing our long USD/EUR trade for a 4.55% gain. We remain somewhat positive on China relative to EM - because of the relative unity and centralization of its government and financial resources at its disposal - but we would not recommend investing in Chinese assets in the absolute due to the heightened internal and external risks outlined above. Hence we propose going long the "One China" policy, i.e. long Chinese mainland stocks versus Taiwan and Hong Kong (Chart 15). This enables us to play the fact that mainland valuations are depressed while the global trend of de-globalization and the conflicts within Greater China and with the U.S. are likely to increase uncertainties about Hong Kong and Taiwan. These two are particularly vulnerable to tighter regulations or sanctions from Beijing. Yan Wang, Senior Vice-President at BCA's China Investment Strategy, argues that while there is no case for a clear directional move in Chinese stocks - especially given the ongoing tightening of policies on the property sector - nevertheless they should be favored relative to global equities, given that growth is improving, fiscal policy will remain accommodative, and valuations are depressed (Chart 16).14 Meanwhile our negative outlook on China in absolute terms supports a globally negative outlook on cyclical equities relative to defensives. Cyclicals move with EM in general and China in particular. Anastasios Avgeriou, Vice President in charge of U.S. Equity Strategy, notes that EM performance does not warrant the sharp rise in U.S. cyclicals versus defensives, nor that in globally oriented versus domestically oriented stocks (Chart 17).15 This creates the opportunity for a tactical short. Chart 15Chinese Stocks Are Cheap Chinese Stocks Are Cheap Chinese Stocks Are Cheap Chart 16China Trades With Cyclicals China Trades With Cyclicals China Trades With Cyclicals Chart 17Go Long The 'One China Policy' Go Long The 'One China Policy' Go Long The 'One China Policy' Finally, we caution investors about investing in companies with major exposure to China (Table 2). We would recommend that clients short a "China, Inc" Index of the top 20 S&P 500 stocks exposed to trade with China relative to the rest of S&P 500. The "China, Inc" stocks have been outperforming the market for a while (Chart 18). We fear that China may retaliate against some of these firms as the trade war with the U.S. heats up. Table 2'China, Inc.' May Suffer From Trade War Trump, Day One: Let The Trade War Begin Trump, Day One: Let The Trade War Begin Chart 18Short 'China, Inc.' Relative To Market Short 'China, Inc.' Relative To Market Short 'China, Inc.' Relative To Market Matt Gertken, Associate Editor mattg@bcaresearch.com Marko Papic, Senior Vice President, marko@bcaresearch.com Jesse Anak Kurri, Research Analyst 1 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, available at gps.bcaresearch.com. 3 Please see Imad Moosa, The U.S.-China Trade Dispute: Facts, Figures And Myths (Northampton, MA: Edward Elgar, 2012). 4 For prominent research on this topic, please see David H. Autor, David Dorn, and Gordon H. Hanson, "The China Shock: Learning From Labor-Market Adjustment To Large Changes In Trade," Annual Review of Economics 8 (2016), pp. 205-40, available at www.annualreviews.org; Autor et al., "Foreign Competition And Domestic Innovation: Evidence From U.S. Patents," NBER Working Paper No. 22879, December 2016, available at www.nber.org. 5 Please see BCA Geopolitical Strategy Special Reports, "Reflections On China's Reforms," dated December 11, 2013, and "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 6 Scholars have shown that countries granting China market economy status have subsequently initiated fewer antidumping cases against it. Please see Francisco Urdinez and Gilmar Masiero, "China And The WTO: Will The Market Economy Status Make Any Difference After 2016?" The Chinese Economy 48:2 (2015), pp. 155-172. Technically speaking, the difference in duty rates can be substantial between market and non-market economies; please see the U.S. Government Accountability Office, "U.S.-China Trade: Eliminating Nonmarket Economy Methodology Would Lower Antidumping Duties For Some Chinese Companies," GAO-06-231, January 2006, available at www.gao.gov. 7 Ross has criticized China more heavily since joining Trump; Navarro is the author of Death By China: Confronting The Dragon, A Global Call To Action (Pearson, 2011); together they criticized China in a paper for Trump's campaign, "Scoring The Trump Economic Plan: Trade, Regulatory, & Energy Policy Impacts," dated September 29, 2016, available at assets.donaldjtrump.com. Lighthizer worked on Ronald Reagan's Treasury Department's team that engaged in the tough trade negotiations with Japan in the mid-1980s. 8 The existing statutory procedure, now enshrined in Title VII of the Trade Facilitation and Trade Enforcement Act of 2015, involves the Treasury Department making semi-annual assessments and potentially initiating bilateral or multilateral negotiations. According to the more or less standard time frame since 1988, any charges of currency manipulation would occur in the April report at earliest, and more likely in the October report or thereafter. For Trump to have designated China a manipulator on day one, he would either have had to issue a simple statement of intent or an executive directive that bypassed the formal foreign exchange review process. 9 Please see Andy Kiersz, "Here's Every State's Biggest International Trading Partner," Business Insider, October 20, 2016, available at www.businessinsider.com. See also Marcus Noland et al, "Assessing Trade Agendas In The US Presidential Campaign," Peterson Institute for International Economics, PIIE Briefing 16-6, dated September 2016, available at piie.com. 10 Serbia "defeated" the much larger Austria-Habsburg in their "Pig War" in the early 1900s, while Ireland won most of its key demands from England despite losing the "Economic War" of the 1930s. Russia's attempts over the past decade to bully Ukraine into submission have not succeeded in achieving Russia's political aims. In each of these cases, a far greater economic disparity existed than currently exists between the U.S. and China, and yet even then the weaker country's popular support, and the willingness of neighbors to exploit the new trade opportunities that opened up, enabled the weaker country to win the political clash of wills. 11 Please see "China: Xi Is A "Core" Leader... So What?" in BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 12 Please see BCA Emerging Markets Strategy Special Report, "Misconceptions About China's Credit Excesses," dated October 26, 2016, available at ems.bcaresearch.com. 13 Please see "China unveils new plan to further open economy to foreign investment," Reuters, January 17, 2017, available at www.reuters.com. 14 Please see BCA China Investment Strategy Weekly Report, "China: The 2017 Outlook, And The Trump Wildcard," dated January 12, 2017, available at cis.bcaresearch.com. 15 Please see BCA U.S. Equity Strategy Weekly Report, "2017 High-Conviction Calls," dated January 9, 2017, available at uses.bcaresearch.com.

Highlights Argentina's structural reform story keeps getting better and the bull market in the nation's assets has further to go. Further interest rate cuts means a cyclical economic recovery is in the making. The South American nation will continue to attract, and retain, global capital. Stay with the long ARS / short BRL trade. Dedicated EM and FM investors should remain overweight Argentine equities, and stay with the long Argentina / short Brazil relative equity trade. Sovereign credit traders should stay overweight Argentine credit within EM credit portfolios. In addition, go overweight Argentine local currency government bonds versus the EM benchmark. A new trade: go long 7-year Argentine local currency government bonds, currency unhedged. Feature After taking a pause over the past few months, Argentine share prices have once again begun to climb (Chart 1), and rightfully so. Yet another round of reforms and needed policy adjustments by the all-star cabinet of President Mauricio Macri have been rolled out. In fact, the sheer volume and frequency of orthodox policy measures deployed so far has been so extensive that not a week has gone by when seemingly yet another price control has been lifted or incentive-distorting subsidy scrapped. This is also a sign of how many distortions were in place to begin with, but clearly the government's reform momentum remains in high gear. Chart 1The Bull Market In Argentine Equities Has More To Go The Bull Market In Argentine Equities Has More To Go The Bull Market In Argentine Equities Has More To Go With positive long-term reform, however, comes short-term pain, as we highlighted back in September.1 Unsurprisingly, Argentina's recession has been deep and prolonged. This is about to change. A strong disinflationary momentum is starting emerge, and will re-animate growth in the months to come as interest rates drop significantly. Ultimately, what matters for investors is the outlook for the economy's return on capital, and signs point towards a potentially multi-year and sustainable economic expansion in the making. The re-rating process has further to go. Stay long/overweight Argentine assets, including equities, sovereign and local credit, and the Argentine peso versus the Brazilian real. Full-Out Structural Transformation Continues 2017 has been kicked off with a full reform swing in Argentina, as the Macri administration has implemented another round of orthodox measures. Among them: Capital Markets Liberalization. Capital controls have been eliminated. The 120-day holding period for repatriating capital has been abolished. In addition, the central bank has done away the maximum monthly amount of foreign exchange purchases. Energy Reform. A major agreement with oil companies and oil unions has been announced regarding the nation's massive Vaca Muerta shale oil and gas basin. Competitiveness will be boosted via lower labor costs as unions have agreed to more flexible contracts and to limit benefits. In addition, firms have pledged to invest US$5 billion in 2017. Also, export taxes on crude oil and derivatives have been removed, and oil price subsidies will continue to be reduced. Telecom Reform. For the first time since 2001, the government is no longer intervening to block price increases, even for regulated services where tariffs had not increased since 2001. In addition, regulations in the telecommunications sector will be loosened in a bid to increase competition, boost investment and modernize the nation's internet service. On top of these recent reforms, the government is already beginning to implement an ambitious infrastructure plan while currently drafting a long-term strategy - its so-called 2020 Production Plan. The plan boasts eight main pillars, among them: developing and deepening local capital markets to attract more foreign investment; lowering the cost of capital for firms; working towards much needed tax reforms to lower the incredibly high tax burden on corporations; improving labor legislation; fostering innovation; increasing competition; reducing red tape; and boosting infrastructure. This continued supply-side reform push, coupled with a big pullback in the role of the state in the economy to crowd in investment, is exactly what this capital-starved economy needs (Chart 2). Startlingly, even among low savings/investment South American economies, at 14% of GDP, Argentina's capex-to-GDP is the lowest in the region, with Brazil now in a close second-to-last place (Chart 3). As a capex-boom materializes in Argentina, the potential upside for return-on-capital of such a mismanaged and underinvested economy is enormous. Chart 2Argentina: More Investment, Less Government? Argentina: More Investment, Less Government? Argentina: More Investment, Less Government? Chart 3Structural Reforms Will Improve Argentina's Abysmal Investment Rate Structural Reforms Will Improve Argentina's Abysmal Investment Rate Structural Reforms Will Improve Argentina's Abysmal Investment Rate A clear advantage is that the nation boasts an overall well-educated population, at least by South American standards. The country's tertiary educational enrollment rate, a quantity measure, currently stands at 80% - a high level both in absolute terms and relative to South American peers (Chart 4). And when looking at standardized test scores, a quality measure, Argentina stands close to the middle of the pack relative to other emerging market (EM) and frontier market (FM) economies, but near the top versus its Latin American peers (Chart 5). Overall, a supply-side reform bonanza, agile and orthodox policymaking and a relatively educated population means Argentina's overall return on capital and languishing labor productivity growth could experience a similar surge to the one seen during the 1990s (Chart 6). Chart 4Argentina Versus South America: ##br##Educational Attainment Argentina Versus South America: Educational Attainment Argentina Versus South America: Educational Attainment Image Chart 6Labor Productivity Is Set To Improve,##br##Significantly Labor Productivity Is Set To Improve, Significantly Labor Productivity Is Set To Improve, Significantly Bottom Line: Argentina's structural outlook is extremely positive. A Dollar Deluge... In Argentina? Argentina has been known much more for repelling capital (i.e. capital flight) than attracting it. However, its ongoing structural transformation means that foreign capital will continue to make its way back in. Attracting sufficient foreign capital is key to finance the Macri administration's ambitious capex-led growth plan. Yet at 15% of GDP, Argentina's domestic savings rate is low, also reflected by its current account deficit (Chart 7). Will the nation be able to attract sufficient capital to finance its current account deficit of 2.8% of GDP, or US$16 billion dollars? We believe so. If an economy offers a high return on capital, as is likely in Argentina at present for the reasons mentioned above, it will attract more than enough capital to finance its current account deficit - possibly even more than it requires. So far, this appears to be the case in Argentina. For instance: Portfolio inflows have gone vertical over the past year, reaching an astounding annualized level of US$29.1 billion dollars, a 20-year high (Chart 8, top panel). Chart 7Argentina's Domestic Savings Rate Is Low Argentina's Domestic Savings Rate Is Low Argentina's Domestic Savings Rate Is Low Chart 8Capital Will Likely Continue ##br##To Flood Into Argentina Capital Will Likely Continue To Flood Into Argentina Capital Will Likely Continue To Flood Into Argentina Moreover, cross-border M&A deals, a robust leading indicator for net FDI capital inflows, have surged (Chart 8, bottom panel). Chart 9Argentine Banks Are Flush With Dollars Argentine Banks Are Flush With Dollars Argentine Banks Are Flush With Dollars The first phase of a tax amnesty scheme that ran from May to last December has been a massive success. Roughly US$100 billion dollars' worth of assets were repatriated and/or declared, which generated ARS 108 billion, or 1.3% of GDP worth of tax revenues. The second round ends this March, and there may be much more to come. The Federal Reserve has suggested that due to decades of crises, Argentineans along with former Soviet countries have hoarded an enormous amount of (most likely undeclared) U.S. dollars.2 The result of repatriated or undeclared dollar financial assets as well as a boom in agricultural exports receipts, which followed from a more competitive currency and the elimination of almost all export taxes a year ago, has caused foreign currency deposits at commercial banks to soar to US$24 billion, or 20% of total deposits (Chart 9). Chart 10Argentina: Falling Foreign Lending Rates, ##br##Despite Rising U.S. LIBOR Argentina: Falling Foreign Lending Rates, Despite Rising U.S. LIBOR Argentina: Falling Foreign Lending Rates, Despite Rising U.S. LIBOR As foreign currency loans can only be made to exporters with revenue streams in U.S. dollars, the government has recently loosened regulations so that banks can use the equivalent of half the amount they lend out to exporters, currently US$9 billion in total, to underwrite dollar-denominated Treasury bonds. This means that at least US$4.5 billion worth of U.S. dollar sovereign debt will be able to be bought by local banks, something not possible since 2001. This will provide an additional source of demand for Argentine dollar-denominated debt in the event of any major global financial stress. Lastly, such an ample supply of foreign currency is being reflected in local dollar interest rates, which have been plummeting at a time when U.S. LIBOR rates have been rising fast (Chart 10). This will provide a cushion of cheaper U.S. financing for Argentine exporters as U.S. interest rates continue to rise.3 Importantly, the reason the Argentine peso has been relatively weak in the face of large capital inflows is largely due to the sizable pent-up demand for foreign capital (hard currency assets), following the removal of capital controls in place for so many years. Thus, it was natural there would be some sort of capital flight by households and firms. In addition, corporates that had been previously unable to repatriate profits abroad did so. However, we believe these were one-off's. Going forward the currency should stabilize and/or likely strengthen as the nation's robust macro policy framework boosts the country's return-on-capital, attracting further global capital. Bottom Line: Only a year ago Argentina was locked out of international debt markets and starved for foreign currency. Now, in the face of rising global interest rates, it is flush with foreign currency, with more on the way. A Disinflationary Boom Is On Its Way While the recession in Argentina will likely last a bit longer, there are already signs of an economic recovery in the making. Mainly: Not only has inflation begun to drop in earnest, but importantly inflation expectations are plunging (Chart 11). This is an incredibly significant development as inflation expectations tend to be "adaptive", meaning that they are set based on past experience rather than through some rational, forward-looking thought process. Therefore, such a dramatic fall in inflation expectations appears to be marking the end of Argentina's most recent battle with hyperinflation. Hoping to avoid a major policy mistake on its way toward implementing an inflation-targeting framework, the central bank has been relatively cautious. However, further rate cuts are on their way, which should re-ignite the credit cycle and boost economic activity (Chart 12 and 13). Chart 11Has Hyperinflation Finally Come To An End? Has Hyperinflation Finally Come To An End? Has Hyperinflation Finally Come To An End? Chart 12Much Lower Interest Rates Should Help Support Growth Much Lower Interest Rates Should Help Support Growth Much Lower Interest Rates Should Help Support Growth Chart 13Argentina's Credit Cycle Is About To Turn Up Argentina's Credit Cycle Is About To Turn Up Argentina's Credit Cycle Is About To Turn Up For their part, wages in real (inflation-adjusted) terms will be slow to recover (Chart 14), as dislocations to the labor market caused by the Macri government's shock therapy will take time to work themselves out. This is bullish for corporate profit margins and return on capital. In turn, high potential profitability will incentivize local and international companies to ramp up their capital spending in Argentina. Notably, capital goods imports are already rising, a sign that investment is recovering (Chart 15, top panel). As Argentine firms faced foreign currency restrictions for years, an increase in imported capital is bound to go a long way toward boosting productivity. Chart 14Incomes Will Take Time To Recover From Shock Therapy Incomes Will Take Time To Recover From Shock Therapy Incomes Will Take Time To Recover From Shock Therapy Chart 15Early Signs Of A Recovery In Investment? Early Signs Of A Recovery In Investment? Early Signs Of A Recovery In Investment? In addition, rising apparent consumption of cement suggests that the collapse in construction activity is in late stages (Chart 15, bottom panel). Lastly, as to external accounts, chances are the pros and cons will mostly balance out (Chart 16). Chart 16External Accounts Will Not Be A Drag ##br##On Growth External Accounts Will Not Be A Drag On Growth External Accounts Will Not Be A Drag On Growth Argentina's agribusiness exports will be aided by a competitive currency, and the current investment boom taking place in the sector. However, the country's single largest trading partner, Brazil, which consumes 15% of all its exports and most of its manufactured exports, has so far failed to even recover. Thus, gains from commodities exports will be offset by weak exports to Brazil, which at least will help keep the trade and current account balances in check as import demand recovers. Bottom Line: Aided by structural tailwinds, a cyclical economic recovery is in the making. Politics And Fiscal Policy Exactly one year ago the key risks we highlighted to our bullish Argentine view centered around the ability of the Macri administration to navigate the turbulent waters of shock therapy successfully.4 Specifically, history has shown the failure of Argentine center-right leaders to effectively balance meaningful economic reform with labor relations. In addition, the Macri administration and its alliance – made up mainly of Macri’s Republican Proposal (PRO), the Civic Coalition ARI (CC), the Radical Civic Union (UCR) parties – did not have a majority in either house of Congress, making restoring fiscal discipline challenging, given the deep hole dug by the previous government. While closing the fiscal deficit of 5% of GDP has indeed proved quite difficult in the midst of a recession and full-out structural transformation of the economy, as we expected, Macri's team has brilliantly managed all other risks. Now, as growth is set to recover, the deficit will be lifted by higher tax revenues in real (inflation-adjusted) terms. Chart 17Can Macri Walk On Water? Can Macri Walk On Water? Can Macri Walk On Water? Importantly, with US$19 billion, or 3.1% of GDP, in external debt service due this year (principal and interest), fixed-income markets have been jittery over the 2017 debt financing plan. However, the latest news is once again incredibly bullish for Argentine assets. Just last week the administration unveiled its 2017 debt plan and it has already secured an 18-month repo line with international banks worth US$6 billion. The country also plans on borrowing another US$4 billion from multilateral agencies, and will tap global capital markets with US$10 billion worth of sovereign paper. The government is front-loading the debt issues and tapping global capital before U.S. President-elect Donald Trump takes office on January 20 to hedge against possible market turbulence. External debt service requirements will also drop off considerably after this year - making tapping debt markets now an equally prudent move. To be sure, this year's legislative elections, to be held in October, will be important to monitor, as the balance of power in Congress may speed up or slow down the government's ambitious reform agenda. At present, we do not expect any major change. As a result, Macri's reform efforts will likely continue, particularly if the economy continues to recover. Besides, Macri's team has already proved not only incredibly capable of negotiating with labor unions, but also with politicians of diverse stripes, as was the case during last December's tax reform. To conclude, we warned investors last January that Macri would not "walk on water" when it came to suddenly reining in the fiscal accounts and engineering economic shock therapy. To his and his administration's credit, however, a year on and it appears they have managed to tip-toe on razor-thin ice rather successfully and even maintain a high approval rating to boot (Chart 17). Bottom Line: Argentina's fiscal situation seems poised to improve considerably, which is very bullish for Argentine fixed-income assets. Investment Recommendations Chart 18Stay Overweight Argentine Sovereign ##br##Debt Versus The EM Credit Benchmark Stay Overweight Argentine Sovereign Debt Versus The EM Credit Benchmark Stay Overweight Argentine Sovereign Debt Versus The EM Credit Benchmark Stay long ARS / short BRL. The Argentine peso is not expensive and structural reforms and orthodox macroeconomic policies will likely attract more than enough FDI to fund the nation's balance of payments. And while FDI inflows have also been strong in Brazil, we believe these FDI inflows are set to decelerate,5 in contrast to accelerating inflows in Argentina. Sovereign credit traders should stay overweight Argentine credit within EM credit portfolios (Chart 18), as the growth recovery will greatly improve the nation's fiscal metrics. Fiscal revenues in real (inflation-adjusted) will grow helping contain the fiscal deficit, and the recovery in economic activity will bring down the public debt-to-GDP ratio which currently stands at 57% of GDP. In addition, now that capital controls have been completely lifted, local fixed-income instruments yielding a 1400-basis-point spread above duration-matched U.S. Treasurys are incredibly attractive. Overweight local currency government bonds as well. A new trade: go long 7-year Argentine local currency government bonds, currency unhedged, yielding 15%. Dedicated EM and FM investors should remain overweight Argentine equities via the local market or the more liquid ADR market versus their respective benchmarks, and stay with the long Argentina/short Brazil equity trade. The Argentine FM benchmark and local Merval index are energy heavy, with 20% and 33% of their total market cap, respectively, comprising of energy companies. As we believe energy plays will outperform other commodities plays, particularly industrial metals, Argentine equities will benefit.6 Meanwhile, bank stocks, which account for 38% and 15% of the FM and Merval markets, respectively, are poised to perform well. As there was no credit buildup, unlike in many EMs, the looming rise in non-performing loans (NPL) will not hit earnings much. Moreover, private commercial banks have shifted massively into government bonds since 2014. Public debt holdings have risen 4-fold since 2014, and banks will reap capital gains on these investments as local rates drop. As government bond holdings now stand at nearly 20% of commercial banks total assets, these earnings streams will compensate from a compression in net interest margins (NIM) as interest rates continue falling. As to valuations, although price-to-book values seem elevated, we believe that these valuations have been distorted by hyperinflation. The value of shareholder equity did not rise as much as stock prices and earnings rose with hyperinflation. Thus, we believe Argentine equities will continue to benefit from a genuine re-rating story, and valuations are much cheaper than may appear using conventional metrics. Santiago E. Gómez, Associate Vice President Santiagog@bcaresearch.com 1 Please refer to the Emerging Markets Strategy and Frontier Markets Strategy Special Report titled, "Argentina: Short-Term Pain, Long-Term Gain," dated September 7, 2016, available at fms.bcaresearch.com 2 Please see Judsun, Ruth (2012), "Crisis and Calm: Demand for U.S. Currency at Home and Abroad From the Fall of the Berlin Wall to 2011," International Finance Discussion Papers, no. 1058. Board of Governors of the Federal Reserve System November 2012. 3 Please refer to the Emerging Markets Strategy Weekly Report, titled "The U.S. Dollar's Uptrend And China's Options," dated January 11, 2017, available on at ems.bcaresarch.com 4 Please refer to the Emerging Markets Strategy Weekly Report, titled "Assessing Political And Financial Landscapes In Argentina, Venezuela And Brazil," dated January 6, 2016, available on at ems.bcaresarch.com 5 Please refer to the Emerging Markets Strategy Special Report, titled "Brazil: The Honeymoon Is Over," dated August 3, 2016, available at ems.bcaresarch.com 6 Please refer to the Emerging Markets Strategy Weekly Report, titled "EM Got "Trumped," dated November 16, 2016, available at ems.bcaresarch.com

Highlights Barring major external disruption, Chinese GDP growth will likely continue to accelerate into the first half of 2017. The overall policy stance will stay accommodative to safeguard against potentially negative shocks from abroad. Trade tensions between the world's two largest economies will inevitably increase, the degree of which matters greatly for how the Chinese economy as well as the global economy perform in the medium to long term. The dollar trend will continue to dictate the USD/RMB cross rate in the near term. The PBoC will continue to intervene heavily to prevent excessive currency weakness. Shorting the CNH/USD is not much different from a direct bet on the dollar index. Aggressive directional bet on Chinese shares is not warranted in the near term. Strategically favor Chinese equities over their global peers. Feature China has rung into 2017 with strengthening growth momentum that has been building in recent months, but the New Year clearly brings new challenges. China is on the receiving end of two major external uncertainties - namely, the anti-globalization backlash from the U.S. under President-elect Donald Trump and the outlook for the U.S. dollar, both of which are completely beyond its control. 2017 will also be a highly charged year in Chinese politics, as the ruling Communist Party prepares for a generational leadership reshuffle. This means the Chinese leadership will be more sensitive to perceived "provocations" from abroad, making political risk between the U.S. and China even less predictable. The Chinese authorities will remain highly vigilant about economic and financial stability. Meanwhile, the government will continue to mobilize the public sector and fiscal resources to support the economy, as external uncertainties mount. Domestic Demand Should Remain Buoyant Most of the recent data releases coming out of China have surprised to the upside, and the regained strength appears rather broad-based (Chart 1). Some indicators that are highly sensitive to industrial activity such as transportation freight, electricity generation and construction machine sales have rebounded sharply, partly due to last year's low base. Meanwhile, the consumer sector has remained buoyant, with strong expansion in durable goods sales such as cars and air conditioners. Looking forward, we expect the economy to continue to improve, at least in the next two quarters. Leading indicators are still strengthening. The latest PMI figures, both manufacturing and non-manufacturing, have continued to climb, and remain above the boom-bust threshold. The labor market is on the mend. The employment component of the PMIs has been rising in recent months, indicating increased hiring as the economy picks up (Chart 2). This could lead to a self-feeding virtuous cycle where an improving labor market leads to rising income growth and strengthening aggregate demand, which further boosts overall business activity and the labor market. Chart 1Broad-Based Recovery Broad-Based Recovery Broad-Based Recovery Chart 2Labor Market On The Mend Labor Market On The Mend Labor Market On The Mend The corporate sector is recovering. Inventories are exceptionally low, setting the stage for inventory restocking, which could further boost production (Chart 3). Profit growth among both private and state-owned enterprises has continued to accelerate. Rising profits are easing financial stress, particularly for debt-laden, asset-heavy sectors. This is also reflected in banks' asset quality; banks' non-performing loan accumulation has slowed sharply of late (Chart 4). In addition, recovery in the corporate sector should also bode well for investment, which is still subdued. The housing crackdown since early October has once again set the stage for negative surprises. Home sales have already begun to slow, and the government appears determined to check housing demand. A key difference between now and previous rounds of housing crackdowns is that developers have been quite cautious throughout the current cycle1: confidence has been downbeat, and housing starts have remained quite weak. Consequently, housing inventories have been quickly depleted nationwide. The demand crackdown has dashed hopes for a housing-led growth recovery, but low inventories and sluggish housing construction has also reduced the risk of another housing-led investment bust, which has typically followed previous housing tightening campaigns. Chart 3Inventory Restocking Will ##br##Further Boost Production Inventory Restocking Will Further Boost Production Inventory Restocking Will Further Boost Production Chart 4Corporate Sector Recovery ##br## Also Helps Banks Corporate Sector Recovery Also Helps Banks Corporate Sector Recovery Also Helps Banks Our model shows that Chinese GDP growth likely accelerated notably in the final quarter of the year, and the momentum will probably carry forward into the first half of 2017, assuming no major external disruption (Chart 5). The inauguration of Donald Trump next week marks the biggest uncertainty for China's growth outlook in recent history due to his well-publicized anti-globalization stance, especially his proposed harsh anti-China trade policies. Chart 5Growth Should Continue To Improve Growth Should Continue To Improve Growth Should Continue To Improve The Trump Wildcard Speculation on President-elect Trump's forthcoming China policies run amok, ranging from pragmatic deal-making, simmering frictions and tit-for-tat retaliation, to the inevitability of a full-fledged trade war and even to a geo-strategic alliance with Russia against China. It is impossible to tell at the moment where reality will eventually end up, but what is clear is that trade tensions between the world's two largest economies will inevitably increase, the degree of which matters greatly for how the Chinese economy as well as the global economy perform in the medium to long term. Low-profile trade tensions and punitive barriers will prove damaging to specific sectors and industries, but should not have a major macro impact. Chinese products that are likely to be subject to American punitive tariffs are some heavy industries such as metals. The usual suspects that may fall victim to Chinese retaliation are American transportation equipment and agricultural products - two main American export items to China. At the macro level, however, China's export sector performance should improve on a cyclical basis, especially if "Trumponomics" successfully lifts U.S. economic growth this year (Chart 6). As one of the major beneficiaries of globalization, China stands to suffer if the broad globalization trend reverses. The saving grace is that exports as a share of the Chinese economy have already almost halved to below 20%, a level comparable to the early 2000s before China joined the World Trade Organization (Chart 7). In other words, China's "globalization dividends" have already diminished to some extent. Moreover, Chinese exports depend more on the U.S. market than the other way around. Therefore, it is in China's best interests to avoid an escalation of trade frictions with the U.S., simply because it has more to lose.2 Nonetheless, it goes without saying that no country gains in a trade war, and the world risks a deep economic recession if the two largest economies engage in an all-out trade battle. Geo-strategic containment of some kind further darkens the outlook for both China and the world. A "cold war" between China and the U.S. would mark a drastic break from the global environment of the past four decades that allowed China to focus solely on economic development. One can only hope that a "clash of the titans" will not drag the world into a self-destructive downward spiral. Chart 6Trumponomics Should Also ##br##Help Chinese Exports Trumponomics Should Also Help Chinese Exports Trumponomics Should Also Help Chinese Exports Chart 7Globalization Dividends ##br## Have Already Diminished Globalization Dividends Have Already Diminished Globalization Dividends Have Already Diminished In short, it is too early to evaluate the impact of America's new trade policy on China's growth outlook. We suspect the near-term impact should be limited, as it is unlikely that trade tensions will immediately erupt once Trump takes office. Nonetheless, the situation needs to be monitored closely going forward. Policy: Fiscal Takes The Helm We expect the Chinese authorities will further downplay the significance of the annual GDP growth target as a binding policy constraint. Growth recovery and improvement in labor market conditions reduce the need for further pump-priming, but the overall policy stance will stay accommodative to safeguard against potentially negative shocks from abroad. On the monetary policy front, the case for further interest rate cuts has diminished (Chart 8). The People's Bank of China (PBoC) recently reiterated that its monetary stance will stay decisively "neutral." In our view, this means the PBoC will continue to fine-tune interbank liquidity, but any symbolic policy move in either direction can be ruled out, unless the economic situation takes a sudden turn. In contrast, fiscal policy will be more stimulative. The annual budget deficit will likely be further increased in the March session of the People's Congress. Moreover, some high-profile investment plans have been released in recent weeks, meaning policy-led investment spending will remain elevated going forward. The country aims to invest RMB 2 trillion, or US$290 billion, in tourism between 2016 and 2020. This would translate into annual growth of more than 14% in direct investment in the industry. China's National Energy Administration (NEA) plans to invest RMB 2.5 trillion (US$360 billion) to develop the nation's energy sector over the next five years, with a focus on renewable resources. Installed renewable power capacity including wind, hydro, solar and nuclear is expected to contribute to about half of new electricity generation in five years, which will boost growth and reduce pollution. The government continues to promote private-public partnerships (PPPs) to build infrastructure. The published PPP proposals so far amount to a whopping RMB 12.5 trillion, with a heavy concentration on the transportation network and urban development (Chart 9). Chart 8Expect No Change In Policy Interest Rate Expect No Change In Policy Interest Rate Expect No Change In Policy Interest Rate Chart 9Fiscal Takes The Helm China: The 2017 Outlook, And The Trump Wildcard China: The 2017 Outlook, And The Trump Wildcard It is worth noting that recent growth improvement has been accompanied by a notable slowdown in fiscal spending, leaving room for reacceleration going forward (Chart 10). In short, fiscal spending and policy-led investment will remain the key tools for the Chinese government to stabilize the economy. Chart 10Fiscal Spending Is Set To Reaccelerate Fiscal Spending Is Set To Reaccelerate Fiscal Spending Is Set To Reaccelerate Chart 11Weak RMB Or Strong Dollar? Weak RMB Or Strong Dollar? Weak RMB Or Strong Dollar? The RMB: Which Way Will The Wind Blow? Since the New Year, offshore RMB (CNH) liquidity has tightened dramatically, which has led to a massive surge in the Hong Kong Interbank Offered Rate (HIBOR) of the RMB and a sharp rebound in the CNH/USD cross rate. This is widely viewed as a successful short squeeze engineered by the PBoC to punish speculators. It is certainly true that the authorities "allowed" offshore RMB liquidity to dry up, but the sharp spike in the HIBOR rate also closely resembles a classic emerging market currency crisis: speculative attacks on the exchange rate forces the monetary authorities to dramatically jack up interest rates to maintain exchange rate stability - a textbook example of the "Impossible Trinity" thesis at work. In China's case, however, the offshore HIBOR rate bears no relevance on the funding cost of the Chinese corporate sector. As such, the PBoC couldn't care less about periodic tightening in CNH liquidity, as it has no consequence on the domestic economy. This bodes poorly for the internationalization of the RMB, but is a low-cost tool for the PBoC to maintain control over the exchange rate. Two observations can be made from this episode: It is unlikely that the PBoC will completely give up control over the RMB exchange rate, especially in this politically charged year. Sharp depreciation in the RMB/USD may be viewed as a sign of systemic financial risk and economic weakness, a taboo ahead of the Party Congress later this year. Since the New Year, the Chinese authorities have further tightened capital account controls to restrict capital outflows - a reflection of the PBoC's determination to maintain exchange rate stability. There is now an almost universal consensus that the U.S. dollar will strengthen further this year, and that the RMB will decline. It is of course foolish to blindly bet against consensus, but it also means shorting the CNH/USD has already become a very crowded trade. The sharp rebound of the CNH/USD a few days ago is a classic example of a market stampede where investors rush to a narrow exit when conditions change. All this has made the risk-return profile of shorting the RMB against the dollar unfavorable, as the PBoC, with its formidable resources, could unexpectedly hit back at any time. Indeed, the performance of the CNH/USD cross rate has closely tracked the broad U.S. dollar index over the past two years, a situation unlikely to change going forward (Chart 11). The bottom line is that the dollar trend will continue to dictate the USD/RMB cross rate in the near term. The PBoC will continue to intervene heavily to prevent excessive currency weakness. For investors, shorting the CNH/USD is not much different from a direct bet on the dollar index. What To Do With Chinese Stocks? Chart 12Chinese Shares Valuation Perspective Chinese Shares Valuation Perspective Chinese Shares Valuation Perspective Chinese stocks will likely range-bound in the near term. The downside is limited by accommodative policy, stable/improving growth and depressed valuation, especially for H shares (Chart 12). The upside is capped by the ongoing macro concerns and brewing tension with the incoming U.S. administration. Chinese shares may also be vulnerable if the more frothy global bourses correct. Therefore, aggressive directional bet is not warranted in the near term. From a big picture point of view, however, we remain convinced that market concerns on China's macro conditions are overdone, and Chinese equities have been unduly punished. Investors with longer-term horizons should hold H shares. Strategically we favor Chinese equities over their global peers. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010," dated October 13, 2016, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China-U.S. Trade Relations: The Big Picture," dated November 17, 2016, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations