Emerging Markets

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

Highlights To shed light on the dichotomies that have surfaced in China's money and credit variables, we have calculated a new credit-money. This new measure is currently corroborating a very downbeat outlook for Chinese growth and China-related plays. We do not mean that investors should put all of their faith in this new measure. Yet, other measures of money and credit such as M1, M2 and banks' total assets all point to an impending deceleration in economic growth in China. While many global investors take for granted that the central government will underwrite credit risk in the entire economy, the top leadership in Beijing is sending the opposite message, at least for now. A new fixed income trade: pay Czech / receive Polish 10-year swap rates. Feature Chart I-1China: A Business Cycle Top Is In The Making Typically, the phrase 'Follow The Money' is used in the investment community to advise in favor of chasing investment flows. Today, we use this phrase in the context of not following investor crowds, per se, but money growth - especially in China. Judging from market actions and elevated inflows into EM assets and investable Chinese stocks, we can infer that investor consensus on China/EM is rather bullish. In the meantime, China's money/credit growth is sending a bearish signal. Investors should heed the downbeat message from Chinese money/credit and not chase EM risk assets higher. To reconcile the different messages from various measures of Chinese money and credit aggregates (more on the differences below), we calculated a new measure of money/credit creation - commercial banks' total credit (referred to below as banks' credit-money). Banks' credit/-oney is the sum of commercial banks' claims on companies, households, non-bank financial institutions, and all levels of government, as well as commercial banks'' and PBoC's foreign assets. Also, we deduct government deposits at the central bank (see below for the rationale). This measure, a de-facto aggregate of credit/money originated by banks and the PBoC, is computed using the asset side of banks' balance sheets. The key message from this report is that mainland banks' credit-money growth has already decelerated meaningfully, and points to a considerable slump in China's business cycle and imports in the months ahead (Chart I-1). Notably, banks' credit-money growth is at the lowest level of the past 10 years, excluding the Lehman crisis. It is also well below 2015 lows when the economy was acutely struggling. Exploring Money And Credit Dichotomies In China There has lately been a puzzling divergence between the growth rates of banks' credit-money, M2, and total social financing (TSF) (Chart I-2). Chart I-2Dichotomy Among Various Credit And Money Aggregates In China In 2016, banks' credit-money growth accelerated to 20%, while the pick-up in M2, and bank loan growth was modest. At the same time, TSF and corporate and household credit growth was largely flat. Lately, M1 growth has slowed, M2 and banks' total asset growth have dropped to all-time lows, while banks' loan and total social financing have remained flat. So, what is the true picture of money and credit growth in China? What are these critical variables telling us about the growth outlook? Our measure of banks' credit-money should by and large match broad money (M2) because the former is calculated by adding up various assets, and the latter by aggregation of various liabilities. Indeed, both were correlated well in the past, but decoupled in 2013 (Chart I-3, top panel). There has been another money/credit paradox: banks' credit-money on the one hand, and TSF and banks' RMB loans on the other, also have decoupled since 2013 (Chart I-3, middle and bottom panels). Overall, neither M2 nor TSF and banks' RMB loans mirrored the surge in banks' money-credit origination in 2015 and 2016, as portrayed in Chart I-3. We have been relying on the M2 and TSF aggregates published by China's central bank. Their tame readings in 2016 were the main reason we underestimated the duration and magnitude of China's economic recovery in the past year or so, as well as its impact on the rest of EM and commodities. As to components of banks' credit-money, Chart I-4 demonstrates that the deceleration has been due to the claims on non-financial organizations (companies), non-bank financial institutions and government. In brief, the slowdown has been broad-based; only claims on households continue expanding at a robust rate of 25% from a year ago (Chart I-4, bottom panel). Chart I-3M2 And Total Social Financing Have Not ##br##Reflected Money Created by Banks Chart I-4Individual Components Of Commercial ##br##Banks' Money Origination We suspect burgeoning financial engineering in China, credit shenanigans, and the non-encompassing nature of the People's Bank of China's broad money (M2) calculation along with the local government debt swap conducted in 2015 have all distorted credit and money data in recent years, producing the above dichotomies. To shed light on these dichotomies and calculate what has been true money/credit origination in China, we have revisited the basics of money and credit creation and have attempted to make sense of the data and the underlying trends. Overall, we have the following observations and comments: New nominal purchasing power in any economy is created by banks when they originate new loans. Hence, measuring properly the amount of new credit/money origination is of paramount importance to forecasting business cycle dynamics in any country. As we argued in our trilogy of Special Reports on Money, Credit and Savings, banks do not need savings or deposits to originate loans.1 They simultaneously create an asset (a loan) and a liability (a deposit) when extending credit to a borrower, which creates purchasing power in the economy. Importantly, there is no need for someone to save (i.e., forego consumption) in order for a bank to create a new loan / originate new money. In the case of China, commercial banks have an enormous amount of deposits - not because households and companies save a lot but because the banking system altogether has originated a lot of credit/money. The household and national savings rates quoted by economists refer to excess production/overcapacity in the real economy and not deposits in the banking system. We have discussed this issue in the past2 and will revisit it in future reports. The restraining factors for banks to originate new credit/money are their capital, regulations, loan demand, and liquidity - but not deposits. Liquidity is banks' excess reserves at the central bank. Commercial banks create deposits but they cannot engender reserves at the central bank, i.e., liquidity. Only the central bank can expand or shrink the amount of liquidity/reserves commercial banks hold with it. Finally, commercial banks do not lend their reserves; they use the reserves to settle transactions with other banks. In turn, central banks do not create new money/purchasing power unless they lend to or buy assets from governments and non-bank entities or issue currency. Central banks have a monopoly over the creation of bank reserves and currency in circulation - high-powered money. A liquidity crunch at a bank occurs when a bank runs out of excess reserves at the central bank, and it cannot borrow/attract additional reserves. Nowadays, many central banks targeting interest rates supply reserves and lend to commercial banks unlimited amounts of reserves on demand to assure interbank rates stay close to their policy target rate. Therefore, in such settings one can infer that banks are not restrained by liquidity to produce new money/expand their assets. In the case of China, the PBoC's claims on banks have skyrocketed - they have surged by 4.5-fold since 2014 (Chart I-5) - entailing that the former has supplied a lot of liquidity to commercial banks. Such liquidity expansion by the PBoC has in turn allowed banks to create tremendous amounts of new money (new purchasing power). To put the amount of money/credit originated by Chinese commercial banks in context, we have calculated the ratio of their credit/money stock to China's nominal GDP and global nominal GDP (Chart I-6). Chart I-5The PBoC Has Injected A Lot Of##br## Liquidity/Reserves Into The System Chart I-6Chinese Banks' Colossal ##br##Money Creation The broad measure of banks' credit/money created presently stands at 250% of Chinese GDP and 32% of global GDP, or US$29 trillion. The latter compares with the U.S. Wilshire 5000 equity market cap of US$ 26 trillion at a time when American share prices are at all-time highs, and the median P/E ratio is at a record high as well. In 2016 alone, Chinese banks' originated RMB 21 trillion, or US$1.7 trillion in new money-credit. Since January 2009, when the credit boom commenced, mainland commercial banks have cumulatively generated RMB 141 trillion, or US$21.12 trillion, of new money/credit. Banks create new money/deposits when they lend or acquire assets. Exceptions are when banks lend to the central bank or to other commercial banks. In those circumstances, a bank draws on its reserves at the central bank, and no new money - and by extension purchasing power - is created. Fluctuations in reserves/liquidity affect purchasing power in an economy indirectly rather than directly. Expanding reserves/liquidity encourage banks money/credit creation and vice versa. In China, commercial banks' excess reserves at the PBoC are presently contracting and stand at historically low level relative to outstanding stock of credit/money (Chart I-7). This is one of the reasons why banks have been scaling back their credit/money origination. Chart I-7China: Banks' Liquidity/##br##Excess Reserves Are Thin The fiscal authorities play a unique role in money creation. Because of the authorities typically have accounts at both the central bank and commercial banks, they can alter the money supply by shifting deposits back and forth between their accounts at the central bank and commercial banks. By transferring deposits from a commercial bank to the central bank, the fiscal authorities can destroy money; by the same token, they can create money by doing the opposite. This is why when computing Chinese banks' credit-money aggregate we have deducted from the credit/money aggregate government deposits at the PBoC. Finally, there is a difference between credit-money originated by banks, and non-bank credit. Non-banks are financial intermediaries that transfer existing deposits into credit. By doing so they do not create new purchasing power. When banks lend or acquire various assets, they do generate new purchasing power - i.e., they create new deposits that did not exist before. This is why banks are not financial intermediaries. This is true for any country and financial system. For more detailed analysis on the difference between banks and non-banks, please refer to the linked paper.3 When examining leverage in the system, one should consider bank and non-bank credit. Yet, when looking to gauge the outlook for growth and inflation, one should consider new credit/money originated by banks. The purpose of this report is to examine and compute new credit-money that determine nominal economic growth in China rather than discuss leverage even though they are often interlinked. Therefore, we are focused on new credit-money originated by banks, and not on the amount of and changes in leverage in the economy. Bottom Line: Whether one prefers M2, banks' total assets or our new measure of banks' credit/money, the message is by and large the same: money-credit growth is slowing and is very weak. Credit-Money And Business Cycle Chart I-8Comparing Two Impulse Indicators How good is the bank credit-money in terms of being an indicator for China's business cycle? We have one caveat to mention before we illustrate its relevance: Banks' credit-money is a stock variable, and our goal is to gauge business cycle trends - i.e., changes in flow variables such as output, capital spending, profits and imports. Also, the first derivative of a stock variable is a flow, while the second derivative of a stock variable is a change in its flow. Therefore, we have calculated credit/money impulse as the second derivative of outstanding credit/money, or a change in annual change, to align it with the growth rate of flow variables. The following illustrates that banks' credit-money impulse has been an extremely good leading indicator for many economic and financial variables. The new impulse of banks' credit-money has since 2014 diverged from the nation's credit and fiscal impulse (Chart I-8). Nevertheless, the new credit-money impulse leads numerous business cycle variables such as nominal GDP, producer prices, electricity output, machinery sales, freight volumes, and manufacturing PMI (Chart I-9A and Chart I-9B). Chart I-9AChina's Growth To Decelerate A Lot (II) Chart I-9BChina's Growth To Decelerate A Lot (I) Not surprisingly, this impulse also leads property sales and starts as well as construction nominal GDP (Chart I-10). This impulse often precedes swings in the LMEX industrial metals index and iron ore prices (Chart I-11). Further, it is also a reasonably good indicator for EM EPS growth (Chart I-11, bottom panel). As discussed above, banks' new credit-money creation determines nominal - not real - growth. Chart I-10China: Property / Construction ##br##Are At A Major Risk Chart I-11Downbeat Message For Industrial ##br##Metals And EM Profits By expanding their assets, banks generate new purchasing power, but they do not have any control over whether this new purchasing power is used to boost real output or prices. The recovery of the past 12 months have in some cases boosted prices more than volumes. It might be that China is inching closer to an inflation inflection point. We are not saying that China has runaway inflation at the moment, but persistent enormous overflow of money-credit will inevitably produce higher inflation. If inflation does indeed rise materially, policymakers will have no choice but to tighten. Monetary tightening will be devastating for an economy with already high leverage. Bottom Line: The new measure of banks' credit-money is currently corroborating a very downbeat outlook for Chinese growth and China-related plays. Beijing's Priorities And Investment Implications It is generally believed in the global investment community that China's authorities will not allow the economy to slump - they will boost credit/money growth and fiscal spending to ensure solid growth. It is true that no government wants to see their economy crumble, and China is no exception. However, there are several reasons to expect growth to slump considerably before the government responds: The central bank has been guiding interest rates higher across the entire yield curve. Short-term interbank rates (7-day Interbank Fixing Rate) and 5-year AA domestic corporate bond yields have risen by about 100 and 200 basis points, respectively, since November 2016. In addition, financial regulators are clamping down on off-balance-sheet and fancy financial engineering practices of banks and other financial institutions. Monetary policy works with a time lag, and the current tightening along with the government's regulatory clampdown will impact economic growth in the months ahead. The sharp deceleration in banks' credit/money confirms this. Even though interest rates have recently stopped rising, the damage to banks' credit/money growth has been done as shown in Chart I-12. Business activity is lagging money/credit and will be next to suffer. The central government in Beijing has largely lost control over credit creation/leverage build-up since 2009. The top leadership in Beijing did not want credit to explode and speculative behavior to profligate. Two recent articles by Caixin news agency (links are in footnote4) corroborate that Beijing is unhappy with credit creation and allocation practices prevailing in the financial system as well as among SOEs and local governments. The top leadership appears decisive, at least for now, in clamping down on ballooning credit/money growth and the ensuing misallocation of capital and bubbles. Interestingly, while many global investors take for granted that the central government will underwrite credit risk in the entire economy, or at least among state-owned companies, Beijing is sending the opposite message for now. True, when an economy and financial system crumbles, the central government will undoubtedly step in. However, investors do not want to be on the long side of China-related markets when this occurs. Buying opportunities may occur at that point, but for now the risk-reward profile is extremely poor. The authorities in Beijing tolerated colossal money/credit creation and misallocation of capital when growth in the advanced economies was extremely feeble. Now, with DM economies expanding at a solid pace and China's growth having recovered, they are comfortable tightening. As for the resulting investment strategy conclusions, it is too late to chase this rally in EM risk assets and other China-related assets. We do not mean that investors should put all of their faith in our new measure of China's credit/money. Yet, other measures of money and credit such as M1, M2 or banks' total assets all point to an impending deceleration in economic growth in China. In EM ex-China, narrow (M1), broad money and private credit growth have been and remain lackluster (Chart I-13). As China's growth and imports slump, the majority of EM economies will be materially affected. Chart I-12China: Interest Rates And Money Creation Chart I-13EM Ex-China: Subdued Money / Credit Growth There is no change in our overall investment strategy. Specific country recommendations and positions across all asset classes are always presented at the end of our reports, presently on pages 18-19. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Caitlynn Qi Zeng, Research Assistant caitlynnz@bcaresearch.com Central Europe: A New Fixed-Income Trade In a Special Report titled Central Europe: Beware Of An Inflation Outbreak from June 21st 2017 - the link is available on page 20, we argued that labor shortages in central Europe have been pushing up wage growth, generating genuine inflationary pressures. The Polish, Czech and Hungarian economies are overheating, warranting imminent monetary policy tightening. We elaborated on the reasons why this is happening in that report and as such we will not go through it in detail again here. Based on this theme, our primary investment recommendation was in the currency market: go long the PLN and CZK versus the euro and/or EM currencies. This recommendation remains intact. Today we recommend a new trade based on the same theme: pay Czech / receive Polish 10-year swap rates (Chart II-1). The negative 143 basis points yield gap between Czech and Polish 10-year swap rates is unsustainable and it will mostly close for the following reasons: The relative output gap between the Czech Republic and Poland is showing that the Czech economy is overheating faster than in Poland (Chart II-2). This will eventually lead to inflation rising faster in Czech Republic than in Poland as per Chart II-2. Markedly, relative trend in headline inflation warrants shrinking swap spread between Czech and Polish swap rates (Chart II-3). In effect, the Czech National Bank (CNB) will be forced to hike rates at a faster pace and more than the National Bank of Poland (NBP). The CNB has been artificially depressing the value of its exchange rate by pegging it to the euro since November 2013. Despite the fact that the CNB abandoned its peg in April of this year, the CNB continues to artificially suppress the exchange rate by printing money and accumulating foreign exchange reserves. Chart II-1Pay Czech / Receive Polish ##br##10-year Swap Rates Chart II-2Czech Economy Will Overheat ##br##Faster Than Poland's Chart II-3Inflation Dynamics Warrant ##br##Smaller Swap Spread Foreign exchange reserves, measured in euros, in the Czech Republic are growing at an astronomical 60% annually while growth and inflation are already in full upswing (Chart II-4, top panel). Due to the ongoing foreign currency accumulation - accompanied by insufficient sterilization - the CNB has generated an overflow of liquidity and money/credit in the Czech economy (Chart II-4, middle panels). Chart II-4Monetary Conditions Are Easier In ##br##Czech Republic Relative To Poland In turn, this liquidity overflow has led a real estate boom and has super-charged overall growth (Chart II-4, bottom panel). On the contrary, the NBP has been much less aggressive in easing monetary conditions. The policy rate in Poland is at 1.5% while it is 0.05% in Czech Republic. Therefore, any potential upside in inflation and bond yields will be more limited in Poland than in the Czech Republic. Even though both Czech and Polish economic growth are robust, the Czech economy is showing more imminent signs of overheating and inflationary outbreak than Poland. The CNB is further behind the curve than the NBP. When a central bank is behind the curve, its yield curve should be steeper than a central bank that is not. However, the 10/1-year swap curve is as steep in Poland as it is in the Czech Republic. With the policy rate at a mere 0.05%, the Czech economy is sitting on the verge of an inflationary precipice. The longer the CNB maintains such a low policy rate, the higher long-term bond yields will rise. The basis being that the longer policymakers wait, the more they will have to tighten to slow growth and bring down inflation. Finally, this relative trade offers a hefty 143 basis points carry and is thus very attractive. Investment Conclusions In the fixed income and currency space in central Europe, we have been and continue recommending the following relative positions: A new fixed income trade: pay Czech / receive Polish 10-year swap rates Continue betting on yield curve steepening in Hungary: Receive 1-year / paying 10-year Hungarian swap rates Long Polish and Hungarian 5-year local currency bonds / short South African and Turkish domestic bonds. Long PLN and CZK versus EM currencies and/or the euro - we are long the following crosses: PLN/HUF, PLN/IDR, CZK/EUR For dedicated EM equity investors, we continue to recommend overweighting central Europe within an EM equity portfolio. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Reports titled, "Misconceptions About China's Credit Excesses", dated October 26, 2016; "China's Money Creation Redux And The RMB", dated November 23, 2016; "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017; links available on page 20. 2 Please refer to the Emerging Markets Strategy Special Report titled, "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017; link available on page 20. 3 Werner, R. (2014b), "How Do Banks Create Money, and Why Can Other Firms Not Do the Same?", International Review of Financial Analysis, 36, 71-77. 4 Please see, "Local Officials Now Liable for Bad Debt-Management Decisions for Life", July 17th 2017, Caixin Global, available at http://www.caixinglobal.com/2017-07-17/101117307.html Please see, "Local Governments Find New Ways to Play Debt Game", July 14th 2017, Caixin Global, available at http://www.caixinglobal.com/2017-07-14/101116048.html Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The "Trump Put" rumbles on, spurring equities, driving U.S. Treasury yields down, and hurting the dollar; White House incompetence, which underpins the "Trump Put," is about quantitative and qualitative staffing decisions, not the Russia collusion investigation; Tax reform will happen, but Congress is now in charge; Watch for the next Fed Chair nomination, more dollar downside could be ahead; China has preempted the next financial crisis with new regulatory oversight; The death of Abenomics is overstated. Feature We introduced the "Trump Put" in a recent report as a risk to our view that President Trump would get his populist economic agenda through Congress.1 The Trump Put posits that White House disarray and congressional incompetence will combine with decent earnings growth and steady global growth to produce Goldilocks conditions for U.S. equities, while simultaneously weakening the USD and supporting Treasuries. Thus far, the Trump Put continues to be in effect (Chart 1). Our House Views of further yield-curve steepening and a stronger USD have suffered from the ongoing "gong show" that is the Trump administration. The saving grace has been our high-conviction bullish equity view (Chart 2).2 Chart 1The Trump Put: Good For Equities,##br## Bad For Everything Else Chart 2S&P 500 Does Not##br## Care About Russia That said, we maintain our high-conviction view that the GOP will pass tax legislation in Q1 2018. Why? First, the failure to repeal Obamacare means that congressional Republicans will enter the midterm election season with no legislative wins. That is extraordinary given Republican control of both chambers of Congress and the executive. The House GOP members will not want to face an angry electorate in primary elections a year from now, or the general election, without a single major accomplishment. Second, Trump's low popularity will be an albatross around the neck of GOP candidates in the November 2018 elections, with potentially ominous results (Chart 3). Trump needs to pass a major piece of legislation; GOP congressmen have an interest in lifting Trump's popularity. Third, the House has passed the FY2017 budget resolution, which includes reconciliation instructions for tax reform. Given that only one budget resolution can be effective at any one time, the Obamacare replacement effort will end with the current fiscal year, on October 1.3 Chart 3GOP Is Running Out Of Time While we remain confident that some form of tax legislation will ultimately pass - either watered down tax reform or mere tax cuts - we are far less confident that it will be stimulative. In other words, it will be done according to the congressional, not the White House, blueprint. House Speaker Paul Ryan has long demanded revenue-neutral reform. The just-passed budget resolution calls for $203 billion in spending cuts in order to make tax cuts revenue-neutral. This is a reversion to form after the period earlier this year in which several fiscal conservatives, like Representatives Kevin Brady and Mark Meadows, intoned that they would be comfortable with tax reform that was not revenue-neutral. At the beginning of the year, it looked like Trump would be able to use his bully pulpit to cajole the Congressional Republicans into stimulative tax reform or tax cuts. Previous Presidents, including Obama with the Affordable Care Act, have been able to punish overly ideological legislators for the sake of pragmatism and/or expediency. Certainly Trump remains popular with GOP voters (Chart 4), suggesting that he might be able to do so as well. Chart 4Trump Retains Political ##br##Capital With GOP Voters Six months into his presidency, however, Trump remains a no-show in terms of leadership. This is not merely the result of distraction with the "Russian collusion" charges against his campaign team and inner circle. The White House is simply not playing its traditional coordinating role to shepherd key bills through Congress. Political insiders, even the ones close to Trump, are signaling privately and via the media that the White House is in disarray and understaffed both quantitatively and qualitatively. It is in no shape, in other words, to coordinate the legislative process and play the role of peacemaker between the different congressional factions. At the heart of the disarray is an elite dispute within the White House itself between what we call the "Goldman" and "Breitbart" factions of the administration. The Goldman Clique: Donald Trump has staffed his administration with several financial sector luminaries whom he met while building his business empire. At the head of this faction is Gary Cohn, Director of the National Economic Council and leading candidate for the next Chair of the Board of Governors of the Federal Reserve System (more on that later). Other members are Treasury Secretary Steven Mnuchin, Commerce Secretary Wilbur Ross, and the most recent addition to the administration, the new White House Communications Director Anthony "the Mooch" Scaramucci. This faction is pragmatic, un-ideological (Cohn and "the Mooch" are essentially Democrats), and focused on passing tax reform and pro-business regulation. They prefer tax reform to mere tax cuts, and want middle class tax cuts to be balanced with pro-business corporate tax reform. The Breitbart Clique: Most commentators see the Goldman clique as the more powerful of the two White House factions, but Trump owes his electoral victory to a campaign molded along the ideological bent in line with the Breitbart faction. This group is led by Chief Strategist Steven Bannon and policy advisor Steven Miller.4 Behind the scenes, Bannon and Miller have managed to staff the White House with several Breitbart alumni, such as presidential advisors Sebastian Gorka and Julia Hahn, and (until her departure this month) Security Council Deputy Chief of Staff Tera Dahl. Factional fighting is not new to the White House. For example, the Obama administration was divided between foreign policy hawks - Secretary of State Hillary Clinton and Secretary of Defense Robert Gates - and doves - National Security Advisor Susan Rice and Ambassador to the UN Samantha Power. White House policy is often a product of compromise between different factions, producing sub-optimal outcomes. The problem with the Trump administration, however, is that the Breitbart faction is severely outmatched and unqualified for the job of coordinating legislative policy. Putting aside its ideological zealotry, this faction consists mainly of journalists without policy experience. This inexperience came to light with Trump's original executive order banning entry into the U.S. of nationals of several countries, penned by Bannon and Miller, which would have barred green card holders from entry. While that order may or may not have been constitutional, it was clearly impractical and aggressive. Another clear problem for the Trump administration is that its current Chief of Staff, former RNC Chairman Reince Priebus, is weak and ineffective. Priebus was a compromise candidate between the two factions and someone seen as acceptable to Republicans in Congress. Since his appointment, however, he has been a no-show. It was his idea to focus on replacing Obamacare ahead of tax reform (despite the absence of a GOP blueprint for the former and the existence of a blueprint for the latter), and it was his idea to give the overmatched Sean Spicer the role of managing the press. The chief of staff should be a force of nature, capable of instilling fear into the president's congressional allies in order to get legislation moving and reduce cliquish in-fighting. A successful chief of staff is usually a controversial and abrasive figure, such as Rahm Emanuel at the beginning of President Obama's first term. He bullied and cajoled Democrats into passing Obamacare with legendary brutality. BCA's Geopolitical Strategy rarely delves into personality-driven analysis. It is too idiosyncratic, not systematic. However, as a country's political leadership becomes more "charismatic"5 - driven by personality rather than institutions - individuals, factions, and court intrigue matter more. What does all of this mean for investors? First, the White House is failing in its coordinating role. As such, Republicans in the House will take the lead on tax reform. Revenue neutrality will be emphasized. For this to change, the White House would have to reshuffle its personnel more extensively, including replacing Priebus. Second, if fiscal policy fails to take off, Trump will put greater stock in monetary policy. Our colleagues - who are economists, not political analysts - believe that the U.S. is likely to enter into recession in 2019, as the 2020 electoral campaign heats up. However, folks like Gary Cohn and Steve Mnuchin can see the same writing on the wall, and will probably try to avoid such a badly timed recession. Chart 5 shows that household debt has continued to decline as a share of disposable income; the share of national income going to labor has increased; and wage growth among lower-income workers who tend to spend most of their paychecks has accelerated. All of this should give consumers the wherewithal to spend more, warranting higher interest rates. Meanwhile, financial conditions have significantly eased due to USD weakness and declining bond-yields, which should boost growth in the second half of this year (Chart 6). Chart 5Households Have The ##br##Wherewithal To Spend More Chart 6Financial Conditions##br## Have Eased With Congress increasingly in charge of fiscal policy and a recession possible in 2019, we would expect Trump to do everything he can to ensure that the Fed retains its dovish bias when Chair Janet Yellen's term expires on February 3. This means that he is likely to favor a non-economist and a loyal adviser, like Gary Cohn, over any of the more traditional, and hawkish, Republican candidates. While there is some speculation regarding Cohn's policy preference, we are yet to find an insider (either of the FOMC or the White House) who denies that he is a dove. The intrigue should not last long. Both Yellen and Bernanke were nominated with considerable lead time: 114 days before the end of her predecessor's term for Yellen, and 91 days for Bernanke (Chart 7). We would therefore expect the next Fed Chair to be known by Thanksgiving. Is Cohn a controversial pick? Not really. As our colleague John Canally of BCA's U.S. Investment Strategy has pointed out, lack of Fed experience does not make Cohn particularly unique as a candidate. Since the late 1970s, presidents have tended to select the Fed Chair based on their relationship with a candidate, not previous central banking experience (Table 1).6 Cohn would only break the orthodoxy by being the first candidate to be appointed from across the ideological aisle, given that he is a Democrat. (Although several chairs have been reappointed by presidents from opposing political parties.) Chart 7How Long Does It Take To Confirm The Fed Chair? Table 1Characteristics Of Fed Chairs Since 1970 A number of previous Fed chairs were selected for loyalty over academic merit or central banking experience. President Nixon's pick for the chair, Arthur Burns (Chair from 1970-1978), was the head of President Eisenhower's Council of Economic Advisors (CEA) and was a special counselor to Nixon before being appointed. William Miller (Chair from 1978-1979), although having served as an outside director for the Boston Fed, was appointed largely because of his work on the political campaigns of Hubert Humphrey and Jimmy Carter. Alan Greenspan (1987-2006) served as Chair of President Reagan's Social Security Commission in the early 1980s, Chair of President Ford's CEA, and advised Nixon's campaign in 1968. Only Volcker, Bernanke, and Yellen had previously held posts in the Federal Reserve System. The market cares about the appointment of the Fed chair. In 2013, for example, Larry Summers and Janet Yellen were in the running for the position, with Summers viewed as the more hawkish of the two. When he withdrew from the race on September 15, the market's expected pace of rate hikes plunged and long-dated TIPS breakevens surged on the expectations of a more dovish Fed (Chart 8). Given that the market is currently discounting just 27.4 bps of rate hikes during the next 12 months, down from the recent peak of 36 bps (Chart 9), there may not be much room to get more dovish.7 Chart 8Yellen Vs. Summers Drove Markets In 2013 Chart 9Market May Be Right? Nonetheless, President Trump may not want to gamble with his Fed appointments. If we are right to assume that he is an economic populist, and that his fiscally stimulative agenda is slipping away, then we would expect the White House to err on the side of Fed appointments that would be behind the proverbial curve. In addition to Yellen, Trump will have the opportunity to appoint a new Vice Chairman of the Fed in place of Stanley Fischer on June 12, 2018 (Diagram 1), as well as another candidate for the Board of Governors (after already having nominated Marvin Goodfriend and Randal Quarels). By mid-2018, the Fed will start to take on a new composition altogether. Diagram 1Federal Reserve Board Of Governors Calendar Staffing the Fed with doves fits at least two of President Trump's campaign promises. First, if the Fed were to fall behind the curve, nominal GDP would likely surprise to the upside. Second, the USD would continue its downward trajectory, helping rebalance America's trade deficit. As such, we take the potential nomination of Gary Cohn seriously. And we expect the market will as well. That said, a Cohn-led Fed would not be a fundamental break with the past. In fact, Yellen has herself intoned that the Fed may want to let inflation run above 2% in past speeches. In addition, Trump's first two nominees to the Fed do not fit a dovish mold. Conservative economist Marvin Goodfriend is a hawk and favors rule-based policymaking. Randal Quarels will focus on regulating the financial sector, or rather deregulating it, although his policy orientation is largely unknown. Furthermore, other potential Fed Chair nominees, such as Kevin Warsh and Richard Fisher, would be more hawkish than Yellen. And if they are not selected to replace Yellen, they could replace the current Vice-Chairman Fischer. As such, investors should not overreact to a Cohn appointment. However, currency markets might, given that the Trump White House has been highly unorthodox. Bottom Line: There is likely more downside to the USD over the rest of the year. China: A Preemptive Dodd-Frank Last week we argued that China is likely to escalate financial regulation considerably over the next 6-12 months.8 Essentially, the "financial crackdown" or "deleveraging campaign" seen in H1 of this year was just a dress rehearsal for what is to come. The larger policy shift will exert downward pressure on economic growth in H2 2017 and throughout 2018, essentially putting a cap of about 7% on China's growth rate. True, the Chinese government will strive to avoid letting the new regulatory push lead to a sharp slowdown, i.e., shattering its preexisting commitment to an average GDP growth rate of 6.5% per year through 2020. However, the risks lie to the downside over the next 18 months due to the combination of unaddressed structural imbalances, cyclically fading economic tailwinds, and further policy tightening. We have outlined the structural flaws before. In brief, they include: Demographics: The working-age population is declining, yet the social systems to improve productivity are not yet adequate. Economic model: The investment-led model has become inefficient, requiring China to add more and more debt in order to generate the same amount of growth, in a manner reminiscent of South Korea prior to the Asian Financial Crisis (Chart 10). The transition to consumer-led growth is incomplete, with households still reluctant to take over from corporates in driving spending. Financial transmission: China's banking sector has expanded quickly, leading to a rise in bad loans and "special mention" assets, as losses from large companies remain elevated (Chart 11). The shadow banking sector is highly leveraged, poorly regulated, and extremely risky, and has mushroomed since 2008. Fiscal system: Local governments lack stable sources of funding and therefore rely on SOE debt and manipulation of the land market in order to fund their 85% share of China's fiscal spending. The government's recent fiscal reforms (the VAT extension) have actually further deprived local governments of revenues. Inequality and social ills: Wealth inequality, social immobility, regressive taxation (Chart 12), and an inadequate social safety net have hindered the development of the consumer society as well as innovation and entrepreneurship. Centralized authoritarianism: The political system perpetuates the above ills by disallowing free speech, free association, free movement, and other freedoms that would encourage innovation and total factor productivity. Chart 10More And More Reliant On Debt For Growth Chart 11Bad Loans Rising Chart 12Communism Fails To Redistribute Income Meanwhile, we have several reasons for anticipating a larger, less accommodative policy shift over the next six-to-twelve months: Policy drift: China's economic policy has been adrift over the past year and a half, as reflected by elevated economic policy uncertainty. While President Xi Jinping's anti-corruption campaign is no longer relevant in a macroeconomic sense - and this theoretically opens the way for him to pursue his ambitious economic reform agenda - he has so far chosen stimulus over restructuring due to the instability of 2015-16. Now, as the latest stimulus measures fade (Chart 13), the question of how to go forward is pressing, since to re-apply the same policy mix in 2018 would be to forgo his reform agenda until 2019 ... and probably once and for all. Warning signs: The central government's launch of a deleveraging campaign this year was risky and surprising. It was risky because central financial authorities in any country threaten a liquidity squeeze when they tighten financial conditions into large and rapidly growing leverage. It was surprising because the authorities chose to do so when a mistake could have upset political stability in advance of the midterm party congress. The implication is: (1) authorities intended a limited campaign from the beginning; (2) the newly appointed leaders of financial regulatory bodies are no-nonsense people.9 They take very seriously, as we do, China's systemic financial risks. They believe risky measures are necessary to prevent the dangerous credit excesses. The National Financial Work Conference: The conference concluded with Xi putting his imprimatur on a renewed policy focus on the financial sector: Reducing systemic risk, reducing speculation (lending to the real economy), and eventually putting the sector back on the path of liberalization. The specific outcomes amount to something like a preemptive Dodd Frank: The People's Bank of China will take on a larger role in identifying and monitoring systemically important institutions; it will also host a new inter-agency body - the Financial Stability and Development Committee (FSDC) - that will ostensibly ensure better cooperation and coordination between the regulators of banks, stock markets, insurance, etc. Finally, the meeting signaled that this year's deleveraging campaign would expand (beyond shadow banking, insurance companies, and private companies roving overseas) to affect over-leveraged SOEs and local government financing vehicles. Significantly, local government officials will be made accountable for excessive debt. This last point should not be underrated. At the height of the anti-corruption campaign, in late 2014, fiscal spending numbers remained depressed and government agency cash deposits continued rising even after the central government tried to encourage faster growth (Chart 14), suggesting that local officials were refraining from spending due to fears that they would be punished for it.10 We consider these announcements to be substantive - i.e., not the usual propaganda - even if they take some time to get off the ground. The financial conference was frowned upon by much of the mainstream media because some interpret the FSDC as failing to live up to the rumor that China would create a new "financial super-ministry." But the rise of super-ministries under the Hu Jintao administration resulted in very little substantive change to Chinese policy. By contrast, Xi Jinping signaled that the PBoC would be the chief instrument of the new financial regulatory push, and he has already shown he can operate exceedingly effectively through existing institutions - namely the Central Discipline and Inspection Commission (CDIC), which went from being an ineffective intra-party corruption watchdog to a nationwide vehicle for the party's most aggressive corruption investigations and personnel purges in recent memory. We are willing to bet that the PBoC's new powers, including the new financial stability committee, will be more aggressive than the merely status quo multiplication of administrative functions that the financial media and markets apparently expect. The changing of the PBoC's Guard: It is not a coincidence that greater regulatory powers are being planned for the PBoC in the final months of Governor Zhou Xiaochuan's term. Zhou has been in office since late 2002. He has been a cornerstone figure in China's financial stability and reform throughout this period, including during the global crisis and the various financial panics from 2010-16. He has allegedly desired a more muscular central bank to tackle the country's ballooning credit risks. By handing off the baton, he clears the way for a new, ambitious governor to succeed him, one who will maintain policy continuity while also taking the opportunity of the transition to implement a new and tougher regulatory framework. Consider that after Xi put the ambitious Guo Shuqing in charge of the China Banking Regulatory Committee in February, Guo immediately launched a notable crackdown on shadow banking.11 Guo is a possible contender for the central banker position; the other likely contenders have strong credentials in regulatory oversight as well as banking. The 19th National Party Congress: The midterm leadership reshuffle will mark Xi's consolidation of power, which will enable him to pursue his policy preferences more effectively in 2018-22. He could still be prevented by exogenous events, but domestic politics should be less of an obstacle for him going forward. Chart 13China's Economic##br## Tailwinds Fading Chart 14Anti-Corruption Campaign Hindered##br## Local Government Spending What about Xi's political capital within the top Communist Party bodies? We are in the thick of major decisions as we go to press. The highest level of leadership - the Politburo Standing Committee (PSC) - is expected to have its members chosen, in secret, in August when the current PSC and other party heavyweights will likely convene at Beidaihe to settle the list. The fall of Chongqing Party Secretary Sun Zhengcai in mid-July gives a few hints as to what might occur. Sun was ostensibly sympathetic with Xi, and until now the likeliest candidate for Premier Li Keqiang's replacement in 2022. His ouster means that four of the top five candidates on the PSC come from the rival camp to President Xi, i.e., the "Hu Jintao faction," which is rooted in the Chinese Communist Youth League (CCYL) (Diagram 2). Diagram 2Lineup Of New Politburo Standing Committee Yet To Take Shape - Factions Evenly Balanced? There are two likely pathways from here: either Sun's fall is part of a bargaining process and other CCYL members will soon be removed from the running for the PSC; or they will not be removed, which would mean that Xi gets along much better with the top CCYL members than is generally believed. The latter is unlikely, but possible, given that Xi and former President Hu Jintao did cooperate on critical power arrangements in the 2012 leadership transition. However, the most recent reports suggest that several CCYL members who were seen as rising stars (for 2022 leadership and beyond) have not received invitations to the party congress, including the current party secretary of the CCYL.12 If this proves to be the case, then it strongly suggests that Xi is continuing to undercut the CCYL. That, in turn, suggests that Xi will not tolerate the current scenario in which he stands to be outnumbered four-to-one on a five-member PSC. Instead, we should expect at least one major CCYL contender for the PSC to be removed in the coming months. This would enable Xi to gain the balance on a seven-member PSC. If the PSC is to be reduced to five members, then he would have to oust two major CCYL members - a more dramatic power play, but presumably within his reach given what he has achieved so far. Ultimately it is impossible to predict the PSC (and broader Politburo) membership precisely. All we can point out is that a failure by Xi to consolidate control on the top bodies - which is no longer our baseline view - would have bullish short-term but bearish long-term implications for growth. It would suggest, first, that Xi is weaker than he appears; second, that the aggressive financial regulatory drive outlined above, as well as other painful but necessary reforms, will be watered down as a result of resistance at top levels; third, that China is increasingly resisting the "creative destruction" that Xi threatens to bring about in the pursuit of making China more efficient. Bottom Line: A number of signs suggest that Chinese politics will become a headwind, rather than tailwind, to growth after the party congress. Xi's move to undercut the opposing CCYL faction ahead of the party congress confirms this view. His new policy will focus on deleveraging and financial sector restrictions. The commitment to stability will remain in place, however. Japan: Abe Is Not Yet Dead, Long Live Abenomics Shinzo Abe's approval rating has plummeted since June (Chart 15). His Liberal Democratic Party (LDP) has also seen its popularity fall. This has been notable in relation to the flat polling of the LDP's main coalition partner, New Komeito (Chart 16). Chart 15Abe's Luck Runs Out? Chart 16Ruling LDP Also In Trouble Abe has been buffeted by a combination of spiraling corruption scandals and the loss of the Tokyo Metropolitan legislature in the local election of July 2. As if this were not bad enough, the Japanese economy is set to slow down (Chart 17).13 Chart 17A Slowdown In Japan Our readers will recall that we think there is a deeper cause for Abe's sudden loss of popularity: his proposed constitutional revisions, which he laid out in detail in May. Ever since he secured a virtual two-thirds supermajority in the House of Councillors (the Upper House) in July 2016, we have maintained that he would push ahead with controversial constitutional revisions that aim to enshrine the Japanese military. We expected that these changes would sap Abe's support - as did the debate over the new national security law in 2015 (Chart 18), only bigger this time because the matter is constitutional.14 However, the Tokyo election loss does not portend the death of Abe, and regardless, Abenomics itself will survive. Why? Because it is Abe's constitutional and security agenda that is unpopular, not Abenomics. Understood as economic reflation with elements of restructuring, like wage growth, Abenomics will actually intensify over the next year and a half as a result of the new threats to Abe's and the LDP's popularity and agenda, to which they will respond. Abe is more deeply committed to this constitutional mission than to Abenomics. It is his most ambitious plan and his economic policy supports it. Revising the constitution is about Japan seizing its own destiny again as a sovereign nation and also locking in the American alliance by offering greater military assistance to the U.S. Hence, at this point, economic reflation is not only an end in itself but also a means to a constitutional end. First, note that Abe's coalition in the upper house is not as "super" of a super-majority as is widely believed. He needs the support of smaller right-wing parties that are sympathetic toward his constitutional revisions to cross the 162-seat threshold for a two-thirds vote in the upper House of Councillors to approve constitutional reforms. But the LDP's three partner parties that are in favor of revision, as well as at least one independent, could raise objections and that would sink the revisions (Diagram 3). There are others with misgivings. Economic slowdown is not a recipe for Diet members to make big political sacrifices on Abe's account, so we expect monetary and fiscal policy to remain easy. Chart 18Abe Loses Support When He Talks ##br##Security Instead Of Economy Diagram 3Super-Majority ##br##Barely Within Reach Second, if the constitutional changes pass the upper and lower houses of the Diet by two-thirds votes, they must pass a nationwide referendum. While there is majority support for revisions of some sort, there is a roughly 50-50 division on the question of altering Article 9 (Chart 19), the article that forbids Japan to maintain military forces. This is the bullseye of Abe's proposal. The need for 50% of the nation to vote "yes" is an even bigger reason for Abe to pull policy levers to keep the economy humming before a potential referendum date in December 2018. Finally, even in the unlikely scenario that Abe's approval rating drops into the mid-20s or below and the LDP ousts him, we do not expect the next LDP leader to alter Abenomics in any significant way. The frontrunners for Abe's replacement in the September 2018 LDP party leadership poll, such as Foreign Minister Fumio Kishida, would likely soften their predecessor's policy on remilitarization and constitutional revision, but would also launch a substantively similar economic policy that the media would promptly dub "Kishidanomics," "Ishibanomics," or "Asonomics." Thus, on fiscal policy, the focus will remain on fiscal support and lifting wages and social spending. Rules calling for fiscal restraint will be relaxed. On monetary policy, BoJ Governor Haruhiko Kuroda is eligible for reappointment on April 8, 2018. So are his two deputies. Furthermore, the monetary policy committee members appointed since Kuroda have also been ultra-dovish like him.15 In short, the BoJ underwent a regime change in 2012 and will not revert back to the norms that prevailed before the global financial crisis, before the LDP lost power to a serious opposition party (2009), and before the shock to the national psyche that occurred during the 2011 earthquake, tsunami, and nuclear crisis. Further, Japanese households are only hardly net savers anymore (Chart 20), and have for five years voted for a more reflationary policy. And aside from the current path of stealth debt monetization, there is no other way of managing the nation's debt other than fiscal austerity, which is not an option for an increasingly elderly population dependent on government social spending. The era of BoJ unorthodoxy is here to stay, at least as long as the LDP is in power (December 2018), if not longer. Chart 19Revise The Constitution? Yes.##br## End Pacifism? Maybe. Chart 20Japanese No Longer ##br##Savers Who Fear Inflation Bottom Line: Abe's downfall is not assured, and would portend the end of Abenomics in name only. The next LDP government would maintain Abenomics, as it is driven by structurally limited options. Fade any selloff in Japanese equities. However, in the long run, Abenomics may prove a failure in terms of defeating deflation. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "How Long Can The 'Trump Put' Last?" dated June 14, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," dated May 31, 2017, available at gps.bcaresearch.com. 4 As a reminder to the uninitiated readers, Breitbart is a conservative magazine that has been a platform for a slew of unorthodox right-wing views more in line with modern nationalist European political movements than the American conservative movement. 5 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. 6 Please see BCA U.S. Investment Strategy Weekly Report, "Global Monetary Policy Recalibration," dated July 17, 2017, available at usis.bcaresearch.com. 7 Please see BCA U.S. Bond Strategy Weekly Report, "Every Which Way But Loose," dated July 18, 2017, available at usbs.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. 10 Please see BCA China Investment Strategy Weekly Reports, "Questions From The Road," dated July 1, 2015, and "Policy Mistakes And A Silver Lining," dated October 7, 2015, available at cis.bcaresearch.com. 11 Please see Gabriel Wildau, "China bank overseer launches 'regulatory windstorm,'" Financial Times, April 18, 2017, available at www.ft.com. 12 Please see Jun Mai, "Guess who's not invited to China's key Communist Party congress," South China Morning Post, July 23, 2017, available at www.scmp.com. 13 Please see BCA Foreign Exchange Strategy Weekly Report, "A Soft-Spoken Yellen," dated July 14, 2017, available at fes.bcaresearch.com. 14 Please see footnote 11 above. 15 The last two dissenters, Takehiro Sato and Takehide Kiuchi, stepped down when their terms expired on July 23, 2017. They were replaced by Goshi Kataoka and Hitoshi Suzuki, who are expected to support Governor Haruhiko Kuroda's dovish approach. Now all nine policy board members have been appointed by the Abe administration. Please see "Two new Bank of Japan policymakers join board," Japan Times, July 24, 2017, available at www.japantimes.co.jp.

Highlights China's strong second-quarter growth numbers released early this week confirmed the synchronized global growth upturn within the major economies. Our model is predicting an imminent increase in the PBoC's benchmark lending rate. Higher rates in China are reflective rather than restrictive. The PBoC will likely maintain a tightening bias, but this should not lead to major growth disappointments. The latest MFWC pledges "re-regulation" of the financial industry and remains committed to developing capital markets. Increasing supplies of equities through IPOs will put some downward pressure on stock prices - especially in the domestic small cap space. Feature The Bank of Canada hiked its policy rate by 25 basis points last week, the second major central bank to tighten after the Federal Reserve in the current cycle. While it is unclear whether central bankers maintain secret communication channels, effectively there appears to be a "coordinated recalibration" of monetary policies among major central banks, due largely to a synchronized growth upturn within the major economies. China's strong second-quarter growth numbers released early this week fit with this broad theme. There are rising odds that the People's Bank of China (PBoC) will join the proverbial global party with rate hikes. In addition, the Chinese authorities have pledged a tougher stance on the financial industry. Reflective Or Restrictive? China's latest data have shown across-the-board strength of late. Most indicators have surprised to the upside, rectifying our positive assessment.1 With the latest growth numbers, our model is predicting an imminent increase in the PBoC's benchmark lending rate (Chart 1). The model follows a modified version of "Taylor's Rule," in which external factors are also considered for open economies. In China's case, both improvement in growth and the Fed's interest rate hikes have played a strong role in setting the stage for higher policy rates in China. The model currently predicts 50 to 75 basis points in rate hikes by the PBoC. Historically, our interest rate model has done a reasonably good job in capturing the major turning points in China's policy rate cycles. This time around, the country's interest rate reforms may have complicated the model's predicting power. In short, the PBoC is in the process of diminishing the importance of the benchmark lending rate, while promoting market-based interest rates. The central bank has theoretically fully liberalized commercial bank interest rates since 2015, and therefore it is unclear whether it will abandon benchmark policy rates, which is viewed as an outdated tool. Instead, the PBoC has been trying to build an interest rate "corridor" in which it uses monetary and liquidity measures to guide market interest rates. The upper band of the interest rate corridor appears to be the interest rates of the PBoC's lending facilities - the cost for financial institutions to borrow from the central bank - while the lower band is the interest rate the PBoC pays on commercial banks' excess reserves (Chart 2). In this vein, the 6-month Medium Term Lending Facilities (MLF) interest rate has already been raised by 20 basis points since late last year, and interbank rates have been guided higher. Chart 1Rising Odds Of PBoC Rate Hikes Chart 2Interest Rate Corridor' ##br##Has Been Lifted Higher Chart 3Bank Loan Rate Is On The Rise Nonetheless, the upturn in our interest rate model justifies higher rates engineered by the PBoC. Regardless of whether the PBoC explicitly raises its policy lending rate, interest rates in China have already moved higher (Chart 3). Tighter liquidity and higher bond yields since late 2016 suggest that average bank lending rates should have increased by probably 50 basis points in recent months. Higher rates in China are a reflection of stronger growth rather than policy tightening to tame business activity, at least for now. After all, China's nominal GDP growth has rebounded from 6.4% in late 2015 to 11.1% in the second quarter of 2017 - a sharp turnaround in nominal business activity that calls for higher interest rates. Similarly, recent hawkish - or less dovish - rhetoric from other central banks all reflect improving growth where "emergency" levels of monetary accommodation are no longer needed (Chart 4). With the exception of Japan, BCA Central Bank Monitors, which measure pressure on central bankers to raise or reduce interest rates, have mostly climbed above zero of late, underscoring the need for tighter money among most developed countries. By the same token, it is premature to conclude that any policy tightening by the PBoC will lead to major growth problems in China. Chart 4Emergency' Levels Of Accommodation No Longer Needed Where does the RMB fit in? The PBoC's tightening bias suggests there is less incentive to target a lower exchange rate, both against the dollar and in trade-weighted terms. The central bank will continue to intervene to smooth out volatility. From investors' perspectives, the risk-return profile of taking a direct bet on the RMB is not attractive in either direction: we doubt there is meaningful upside in the RMB against the dollar in the near term, but the odds of significant RMB/USD depreciation have been further reduced. In other words, the RMB/USD exchange rate is still largely dominated by broader dollar performance, and the RMB is not a "high beta" currency to play the dollar. In short, we maintain our positive view on China's growth outlook, as discussed in greater detail in last week's bulletin. The PBoC will likely maintain a tightening bias, but this should not lead to major growth disappointments. Financial Reforms And Markets As growth has mostly surprised to the upside, policymakers' focus appears to have shifted to controlling financial risks, as highlighted by the key messages from the 5th National Financial Work Conference (NFWC) this past weekend. The NFWC convenes twice a decade, and usually sets the policy tone for the following years. Compared with the previous meeting five years ago that featured "deepening reforms and promoting development" as the key theme of the financial industry, the current session clearly strikes a more conservative tone. Top leadership declared that the financial sector must serve the needs of the "real economy," and that preventing systemic financial risks is the government's "eternal theme." Importantly, a cabinet level committee has been established to coordinate regulatory oversight on the financial industry - a task currently shared between the central bank and three regulators. The overall message from the latest NFWC is consistent with the regulatory crackdown on financial excesses since late last year.2 Overall, we share policymakers' sentiment that China's financial sector deregulation in recent years has gone too far.3 The dramatic leverage-fueled equity market boom-bust cycle in 2015 offered a crude awakening to the authorities against imprudent financial deregulation. Meanwhile, reform measures also ushered in a proliferation of institutions that prolonged financial intermediation channels. Without proper regulatory coordination, the authorities' attempts to reduce excesses has typically pushed speculative activity off the books of financial institutions, making it even more difficult to monitor and regulate. In fact, regulations on the financial sector have already been tightened of late. Derivatives, internet-based financing firms and asset-backed securities have all been put under much tighter regulatory scrutiny. The macro-prudential assessment (MPA) on financial institutions has been adopted since earlier this year - the latest MFWC suggests that "re-regulation" of the financial industry will continue in the coming years. The long-term impact of tighter control over the financial sector on the economy and financial markets remains to be seen. On one hand, imprudent financial deregulation and prolonged financial intermediation channels have done little to address the financing needs of small private enterprises, but have amplified risks and raised funding costs for the overall corporate sector - a suboptimal outcome that needs to be corrected. On the other hand, China's vast domestic savings need to be properly intermediated to the economy. We have long held the view that so long as the banking sector and debt instruments play the dominant role in financial intermediation, the accumulation of debt in the overall economy is all but inevitable.4 In this vein, any attempt to block financial intermediation aimed at "deleveraging" will prove both ineffective and counterproductive, with unintended consequences. An easier bet is that the authorities will remain committed to developing capital markets, both equities and corporate bonds, to provide alternative funding sources for the corporate sector. Procedures for initial public offerings (IPOs) and debt issuances will be simplified. The share of debt and equities in total social financing will continue to grow from a structural point of view (Chart 5). From investors' perspective, increasing supplies of equities through IPOs will put some downward pressure on stock prices - especially in the domestic small cap space, where multiples are unsustainably high and will continue to be de-rated (Chart 6). There are certainly some compelling growth stories among small caps that are worth cherry-picking, but overall investors should remain cautious for this asset class. Chart 5Debt And Equity Issuance##br## On A Structural Uptrend Chart 6Domestic Small Caps##br## Will Continue To Derate Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China Outlook: A Mid-Year Revisit," dated July 13, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China: Financial Crackdown And Market Implications," dated May 18, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "Legacies Of 2015," dated December 16, 2015, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Special Reports, "Chinese Deleveraging? What Deleveraging!" dated June 15, 2016, and "The Great Debate: Does China Have Too Much Debt Or Too Much Savings?" dated March 23, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Reduced demand in oil-exporting countries and higher supplies from distressed states is whittling down the amount of oil being removed from the market this year, based on our latest supply-demand balances. As a result, even though OECD inventories will be drawn down to their five-year average levels by year end, this average will be a higher end-point than we projected last month. The Kingdom of Saudi Arabia (KSA) continues to reassure markets through anonymous media leaks it will cut production further to accommodate higher Libyan and Nigerian production. This is not unexpected, but it still is speculative. Ecuador's opting out of OPEC 2.0's production cuts raises the odds other financially distressed non-Gulf producers also will head for the exits. Energy: Overweight. Crude oil prices remain supported by actual production cuts, and the promise of further reductions by KSA and possibly other OPEC 2.0 members. Base Metals: Neutral. Labor and management at the Zaldívar copper mine in Chile are negotiating, according to Metal Bulletin. Separately, a three-year deal was agreed at the Centinela copper mine in Chile last week. Precious Metals: Neutral. Gold rallied on the back of lower inflation readings in the U.S., which suggested the Fed will back off aggressively pursuing its rates normalization policy. This would leave real rates low. Our strategic long portfolio hedge is up 1.0% since it was initiated May 4, 2017. Ags/Softs: Underweight. We maintain our bearish view on grains. Fears that extreme heat in the U.S. Midwest and Plains will not be sufficient to counter the still-high ending-stocks expectations published in the USDA's WASDE last week. Feature Higher oil production is seeping into global balances. Lower prices, which are stimulating demand in oil-importing markets, are reducing incomes and demand in oil-exporting provinces. As a result, the rate at which inventories will draw this year is slowing. Our latest supply - demand balances shown in Table 1 indicate the net 900k b/d physical deficit we expected for 2017 has been whittled down to just under 500k b/d, as a result of production increases in Libya and Nigeria, and slower demand growth in oil exporters generally (Chart of the Week). Table 1BCA Global Oil Supply -##BR##Demand Balances (mm b/d) Chart of the WeekHigher Production And Lower Demand Reduce##BR##Physical Deficits Versus Last Month's Projections Ecuador, a small-ish OPEC member producing about 550k b/d, opted out of the Agreement negotiated by KSA and Russia to remove some 1.8mm b/d of production from the markets. This indicates weaker states that are party to the OPEC 2.0 Agreement are finding it impossible to maintain compliance with the cuts they've obliged themselves to undertake in the face of lower oil prices. As a result, they are compelled to increase production in an attempt to recover lost revenue (R), by increasing their quantity (Q) sold when prices (P) are weak, so as to maximize P*Q = R while they can. This only works if they are alone in increasing production while others - notably KSA, other Gulf states and Russia - restrict output to revive prices. Otherwise, if all the distressed states in the OPEC 2.0 coalition took the same action, markets would be flooded with oil. This was demonstrated in the mid-1980s during KSA's netback-pricing regime, when the Kingdom priced its oil as a function of prices received by refiners. This collapsed prices, and, eventually, reined in free-riding on KSA's production cuts.1 While few of these states, mostly outside the Gulf, are capable of significantly increasing production, at the margin, they can have an impact. Production Increases In OPEC, U.S. Partly Counter OPEC 2.0's Best Efforts Year-to-date to June, Iran and Libya have added 110k and 140k b/d of production to the market vs. their respective Oct/16 benchmark levels of 3.7mm and 550k b/d against which the OPEC 2.0 deal is being assessed. June production for these states was up 120k and 300k b/d for Iran and Libya, respectively, vs. October levels, while Nigeria's output was up 90k b/d (Chart 2). Libya and Nigeria are not parties to the OPEC 2.0 deal. Nonetheless, these states together with Iran added close to 500k b/d vs. their Oct/16 output levels in June, without an offsetting decline from members of the OPEC 2.0 coalition. Gulf OPEC ex Iran production is down some 850k b/d on average at 24.6mm b/d in 1H17 vs. Oct/16 levels, while non-Gulf OPEC production is down 215k b/d at 7.5mm b/d. We still see OPEC 2.0's production significantly below the EIA's estimate to March 2018 (Chart 3), which drives our view of inventory behavior. U.S. production also was higher in 1H17, as WTI prices rallied in response to the OPEC 2.0 production-cutting deal (Chart 4). For 1H17, U.S. crude oil production was up 230k b/d vs. 4Q16 levels, at 9.04mm b/d, led by higher shale-oil output. Chart 2Almost 500k b/d Added To Oct/16 Output##BR##By Iran, Libya, And Nigeria In June Chart 3OPEC 2.0 Cuts Drive##BR##Inventory Draws Chart 4U.S. Crude Production##BR##Grows In 1H17 Slower Demand Growth Reduces Storage Draw On the demand side, we've lowered our estimate of demand growth this year to close to 1.37mm b/d, down nearly 110k b/d vs. our earlier May estimate. This results from lower consumption in oil exporting states. The combination of stronger supply growth and weaker demand growth reduces our estimated physical deficit for this year to 470k b/d from close to 900k b/d in our May balances estimates. These revised supply - demand estimates still produce enough of a physical deficit to allow storage to fall to five-year average levels (Chart 5). However, with the drawdowns prolonged by slower supply losses and reduced demand, inventories are now projected to remain above 2.8 billion bbls versus our earlier estimate of inventories declining to ~2.75 billion barrels by end-2017 or early 2018. Chart 5OECD Storage Draws To Five-Year Average Levels, But Higher Supply And Lower Demand Keep This Level Higher Chart 5OECD Storage Draws To Five-Year Average Levels, But Higher Supply And Lower Demand Keep This Level Higher Net, at the end of this drawdown, storage will be higher than expected, even if it does make it to five-year average levels. This will leave less room for OPEC 2.0 members to implement a strategy to backwardate the forward WTI curve so as to slow the rate at which shale-oil rigs return to the field, which we've discussed in previous research.2 More Cuts Required By OPEC 2.0 Going into its St. Petersburg meetings next week, there are clearly defined issues to be addressed by OPEC 2.0. The foregoing suggests additional cuts will be needed to empty storage sufficiently by yearend for OPEC 2.0 to be able to move to the next phase of its plan to regain some influence over the evolution of oil prices, particularly the U.S. benchmark WTI price, which drives hedging and profitability of U.S. shale producers. Over the short term, this effort likely will be clearly supported by KSA's stated intention to reduce exports to the U.S. market (Chart 6). All else equal, this will result in sharper draws in the high-frequency U.S. weekly inventory data, by augmenting reduced shipments to the U.S. from OPEC overall (Chart 7). Chart 6KSA's To Reduce##BR##Exports To The U.S. Chart 7OPEC Exports To The U.S. To Fall Further##BR##When KSA Reduces Shipments More substantive price-support and inventory-draining measures, as noted at the top of this article, will have to involve further production cuts by OPEC 2.0. KSA again is signaling it is open to additional production cuts, in order to normalize oil inventories.3 We have no doubt the Kingdom's Gulf allies - particularly Kuwait and the UAE - will support KSA in this effort. We also expect Russia to be supportive of this effort. The size of the cuts likely will exceed 500k b/d, so as to offset the production gains of Libya and Nigeria. Iran's higher production discussed herein, and Iraq's recent assertiveness in claiming "the right" to increase its production given the size of its reserves, suggests a short and a long game for the leadership of OPEC 2.0. In the short-term, Iran, Iraq, Libya and Nigeria will be constrained by lack of funds to significantly increase production. Thus, OPEC 2.0 - mostly KSA and its allies - can cut production without triggering an immediate response from these states, which will allow storage to resume drawing at a faster rate. For OPEC 2.0 to have a meaningful effect on U.S. shale production, the stronger storage draws in the near term would have to be accompanied by forward guidance from KSA, Russia and their allies that production will be increased in the medium term - 6 months or so out - so that continued demand growth can be accommodated by higher supplies. This would require storage and production flexibility by OPEC 2.0's leaders. Should all of this fall in place, we would expect a backwardation to develop toward yearend, which would be the first step in a longer-term strategy by OPEC 2.0 to slow the rate at which horizontal rigs return to drilling in the shale fields. Bottom Line: Higher oil production from Libya, Iran and Nigeria, coupled with a slight downgrade in demand growth, will reduce the physical deficit we expected this year. This will, all else equal, reduce the rate at which OECD storage draws, and raise the level of five-year average inventory levels by yearend. We do not believe this is a favorable outcome for OPEC 2.0, particularly KSA and Russia, if they are intent on regaining some influence over the evolution of oil prices. For this reason, we believe KSA and its Gulf Arab allies will reduce production further to put the inventory draws back on track. We remain long low-risk calls spreads in Dec/17 WTI and Brent - long $50/bbl strikes vs. short $55/bbl strikes - and will look for opportunities to gain upside exposure once we get clear signaling from OPEC 2.0 leadership. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see BCA's Commodity & Energy Strategy Weekly Report "Sideshow In Vienna," published October 23, 2014, for a review of netback pricing by KSA. It is available at ces.bcaresearch.com. 2 Please see BCA Research's Commodity & Energy Strategy Weekly Reports of April 6, 2017, entitled "The Game's Afoot In Oil, But Which One," and March 30, 2017, entitled "KSA's, Russia's End Game: Contain U.S. Shale Oil" for a discussion of this strategy. Both are available at ces.bcaresearch.com. 3 Please see "Saudi Arabia still aims to reduce supply; weighs Nigerian, Libyan barrels," published by reuters.com on July 18, 2017. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights To change our EM strategy, we would need to change our view on China and accept that China's credit bubble - especially in combination with the ongoing policy tightening - does not constitute a material risk to mainland growth in the foreseeable future. We are simply not ready to make this call. It is a matter of time until mainland's growth relapses and China-related plays (including commodities and EM) enter a bear market. Even though the headline growth numbers out of China have so far remained solid, their second derivatives - change in growth rate - have turned negative. Asian export growth has already rolled over, and a slowdown will become pronounced in the months ahead. This will likely halt and reverse the EM rally. Having taken into consideration various factors, we believe it would be wrong to change our strategy at the moment. Feature The U.S. dollar has tumbled and EM risk asset prices have spiked following last week's testimony by Federal Reserve Chair Janet Yellen to Congress. This week we review what has gone wrong with respect to our view, as well as weigh the pros and cons of altering strategy at this point. Our bearish view on EM has been contingent on two pillars: Our downbeat view on EM over the past year has rested on higher U.S. bond yields pushing up the U.S. dollar. This view played out in the second half of last year but has been wrong since early this year. We have continuously argued that EM risk assets are vulnerable due to China's growth relapse amid ongoing liquidity tightening and the lingering credit bubble. Even though the headline growth numbers out of China have so far remained solid, their second derivatives - change in growth rate - have turned negative (more details are provided in the section below). We maintain that our theme of slower mainland growth still has high odds of playing out later this year. We expect meaningfully weak data (on a first-, not second-derivative basis) out of China before year end. If equity markets are forward-looking, they should start pricing in such a scenario now. What has surprised us is the fact that EM investors have utterly and altogether ignored political woes in a number of EM countries, lower commodities prices and lingering structural and cyclical problems in many developing economies, as well as China's tightening amid the credit excesses. Instead, EM investors have singularly focused on downward surprises in U.S. inflation - even ignoring strong employment data in America. Remarkably, EM share prices historically plunged when U.S. inflation and inflation expectations dropped (Chart I-1). Hence, the year-to-date negative correlation between EM stocks and U.S. inflation is out of sync with the historical relationship. We review some other inconsistencies and contradictions below. Chart I-1U.S. Inflation And EM Stocks Were Historically Positively Correlated, But Not This Year Inconsistencies In Prevalent Narrative The purpose of this section is not to justify our investment strategy, which has been wrong-footed, but to elaborate on financial markets' nuances that have been much less clear-cut than popular financial market narratives imply. The reality is much more complicated than the following prevalent among investors narrative: low U.S. inflation entails little tightening by the Fed, resulting in a weak U.S. dollar and an EM rally. There are some contradictions in this story: If U.S. household consumption growth in nominal terms is as weak as portrayed by the latest retail sales and inflation readings (Chart I-2), how can U.S. corporate earnings continue to grow at a double-digit rate, as most investors currently expect? The only way this can happen is if productivity growth is really strong and profit margins continue to expand. Productivity is a black box that no one can measure accurately in real time. If underlying productivity growth is indeed robust, the bull market will persist and bears will be humiliated. The snag is that productivity assessment is a judgement call, and only time will reveal true productivity dynamics. Not having more insight, we have so far assumed that the official statistics on productivity in the U.S. and EM are generally right. If U.S. productivity data are close to reality, unit labor costs - calculated as wages divided by productivity - are rising faster than underlying inflation (Chart I-3, top panel). This entails that U.S. corporate profit margins should be contracting. The middle and bottom panels of Chart I-3 portray our macro proxy for U.S. corporate profit margins based on core PCE inflation and unit labor costs. Chart I-2The U.S.: Very Low Nominal Growth Chart I-3A Macro Proxy For U.S. Corporate Profit Margins Entails Shrinking Margins Overall, if low inflation and weak U.S. nominal retail sales data are a true representation of current U.S. economic conditions, the corporate profit outlook cannot be benign, and American stock prices should be lower - not higher. If lower inflation and nominal growth of recent months in the U.S. were an aberration, U.S. interest rate expectations will have to be revised higher and the U.S. dollar will rally. We are even more puzzled by the nature of the drop in U.S. bond yields, and EM financial markets' reaction to it. Typically, EM risk assets negatively correlate with real (TIPS) yields (Chart I-4), and positively correlate with the inflation component of U.S. bond yields (Chart I-1 on page 1). The decline in U.S. bond yields since the beginning of the year has been almost entirely driven by the inflation component, with U.S. real yields actually not dropping at all. Yet, EM risk assets have rallied sharply. This goes against the predominant correlation of the past several years and is very puzzling. In short, the historical correlations between EM stocks and currencies on one hand and U.S. real yields and inflation expectations on the other, have in the past six months reversed for no reason. If the weaker U.S. dollar and lower U.S. bond yields/rate expectations represent an unwinding of the "Trump trade", why has the S&P 500 - which has surged amid "Trump trade" - not yet corrected? Broadly speaking, if U.S. bond yields drop further and the greenback continues deprecating, it would signal a major relapse in U.S. growth and U.S. share prices will dive. On the contrary, if U.S. growth is solid, the dollar selloff is overdone and the greenback is close to a major bottom. In addition, EM risk assets have decoupled from commodities prices, as we have detailed many times since early this year. Also, as a side note, the broad trade-weighted U.S. dollar decoupled from precious metals prices this whole year up until last week. These are non-trivial divergences that are by and large puzzling. Finally, EM net earnings-per-share revisions have rolled over, yet share prices have continued to move higher (Chart I-5). Such decoupling has simply never happened before. Chart I-4Another Breakdown In Correlations: ##br##EM Currencies And U.S. TIPS Yields Chart I-5EM EPS Net Revisions ##br##Have Failed To Turn Positive Besides, EM EPS net revisions have not turned positive throughout this 18-month rally. In short, analysts in aggregate have not upgraded their EPS estimates for EM companies at all. Bottom Line: There are a number of contradictions and inconsistencies that cannot be explained by the prevailing financial market narrative. What About Global Growth? One way to square the above inconsistencies is to argue that the drop in the U.S. dollar and the EM rally have little to do with U.S. dynamics and much to do with strength in the rest of the world, especially outside the U.S. This is coherent reasoning. We review global growth dynamics in this section and elaborate on China in the following one. Without disputing the fact that there has been a notable recovery in global growth and trade in the past year, we would like to emphasize that on a rate-of-change (second derivative) basis, global trade, and particularly Asian export growth, has already rolled over, and a slowdown will become pronounced in the months ahead. Consistently, the U.S. dollar should rise or EM risk assets should reverse their gains in the near future, if and as global trade/EM growth falters: The pace of export growth in key Asian manufacturing hubs such as Korea, Taiwan and Singapore has already rolled over (Chart I-6). Both Taiwanese exports of electronic parts and the country's overall exports to China have rolled over - the latter two lead global export volumes and Chinese exports, respectively, by a few months, as shown in Chart I-7. Chart I-6Asian Export Growth Has Rolled Over Chart I-7Global Export Growth Has Peaked The reason why Taiwanese exports of electronic parts lead global trade cycles is because these parts are used in the assembly of final products, and producers order and receive these parts before final products are made and shipped. Similarly, a lot of Taiwanese exports to China serve as inputs into final products assembled in China and are shipped worldwide. This is why Taiwanese shipments to China lead mainland aggregate exports. Provided U.S. consumer spending has recently weakened, as depicted by core retail sales, U.S. imports are bound to slump sooner than later (Chart I-8). Consequently, Asian and European shipments to America are likely to roll over soon. Imports are more volatile than domestic demand, reflecting inventory re-stocking and de-stocking cycles. The decoupling between the not-so-strong U.S. final demand and robust imports suggests an inventory re-stocking cycle in the U.S. has recently been taking place. As such, this will be followed by a period of destocking, i.e., weaker imports, weighing on the rest of the world's shipments to the U.S.. A genuine area of global growth acceleration has been continental Europe. Undoubtedly, growth is extremely robust in these economies, and there is no reason for European economies to plunge into recession. That said, U.S. growth dynamics following the 2008 crisis have generally been "two steps forward, one step back." This has typically held true for post-crisis economic recoveries in all major economies. There is no reason why Europe's economic recovery will be any different. As such, having experienced "two steps forward" in the past year, European growth is more than likely to take a "one step back" - i.e., slow down a bit. In brief, if growth dynamics in Europe were to resemble that of the U.S. post-crisis era, mean reversion in European growth is overdue. Finally, global auto sales growth has rolled over decisively (Chart I-9, top panel). The deceleration is very broad-based including the U.S., Europe (Chart I-9, bottom panel) and China (please refer to Chart I-12 on page 10). Chart I-8Weak U.S. Retail Sales Entail ##br##U.S. Import Deceleration Chart I-9Global Vehicle Sales ##br##Growth Heading South Bottom Line: If the global growth recovery has been behind the U.S. dollar selloff and the EM rally, the forthcoming reversal in global trade will at minimum halt and reverse the EM rally. China is critical to our theme of slowdown in global trade. China's Growth: Looking Beyond Headlines China's headline growth numbers for GDP and industrial production have been on the strong side, but forward-looking variables such as money growth and various liquidity measures entail a major deceleration by the end of this year: Narrow and broad money growth - which have historically led the business cycle in China - have relapsed (Chart I-10). Although credit growth has not yet decelerated, money often leads or coincides with credit growth, suggesting a credit slowdown is forthcoming. Furthermore, commercial banks' excess reserves at the central bank are key to their lending capacity. The top panel of Chart I-11 demonstrates that China's money multiplier - the ratio of broad money-to-excess reserves, or banks' assets-to-excess reserves - have surged, implying that banks are over-extended. Chart I-10China: Money Leads Business Cycle Chart I-11China: Bank Loan Growth To Slow In addition, banks' shrinking excess reserves point to a rollover in bank loan growth in the months ahead (Chart I-11, bottom panel). The pace of growth in China's many economic indicators has already rolled over - i.e., their second derivative has turned negative. These include total and ex-oil imports, electricity output and auto production (Chart I-12). Finally, the central bank will continue to tighten liquidity. The recent softness in interest rates may have been temporary, as June is a month in which liquidity demand spikes, and the People's Bank of China probably did not want a replay of the June 2013 SHIBOR crisis. Notably, both core consumer prices and consumer services inflation measures in China are grinding higher (Chart I-13). This, along with "a mandate of preventing bubble formations," will all but ensure that the PBoC tightens further. Chart I-12China: The Pace Of Growth Has Already Rolled Over Chart I-13China: Inflation Is Rising Tighter liquidity/higher interest rates along with regulatory tightening on banks and shadow banking will cause credit growth to slow down considerably, weighing on the real economy. Bottom Line: In China, liquidity is tightening and interest rates are rising amid a credit bubble. Meanwhile, investors remain complacent, and the overwhelming majority of the global investment community believes that China will be able to deflate its financial bubbles and deleverage its corporate sector without a meaningful impact on the real economy. The reality is there has been no historical precedent of this occurring in any country. Strategy Considerations: The Dollar And China Hold The Key The greenback holds the key to EM strategy - not only because it mechanically drives the performance of EM financial markets, but also because it reflects many global financial and economic trends. Having taken into consideration various factors, we believe it would be wrong to change our strategy at a time when: There has already been capitulation by U.S. dollar bulls, the greenback is technically oversold and the Fed will soon commence reduction of its balance sheet. All of this makes us reluctant to change our view on the U.S. dollar and EM at the moment. Notably, the U.S. dollar is at a critical technical level against numerous currencies (Chart I-14A and I-14B). Chart I-14AThe U.S. Dollar Is At A Critical Technical Level (II) Chart I-14BThe U.S. Dollar Is At A Critical Technical Level (I) In short, it is too late to abandon a positive view on the dollar. We have been and remain much more certain about the U.S. dollar strength versus EM, commodities, and Asian currencies than against the euro. Meanwhile, EM financial markets are overbought, and implied volatility across most global financial markets in general and EM in particular is at record-low levels (Chart I-15). Chart I-15Implied Volatilities Are Depressed ##br##Across Most Asset Markets The Fed will shrink its balance sheet, and high-power U.S. dollar liquidity will diminish. Besides, the PBoC will continue to tighten liquidity and guide interest rates higher amid lingering credit excesses. These developments are at the margin bullish for the greenback, and invariably bearish for EM/China-related plays. China's industrial cycle has peaked and Asian exports have rolled over, as we have illustrated above. China's narrow money (M1) growth is slowing, and broad money (M2) growth is at an all-time low. Money leads business cycles in China. Our biggest concerns have been and remain continued strong flows to EM and how well risk assets have been trading. Past flows are no guarantee of future flows. However, both DM and EM risk assets have been trading really well. It is hard to know and forecast when this will change. That said, we maintain that the next 20% move in EM share prices and commensurate moves in other EM risk assets will be down - not up. Weighing the pros and cons, we are reluctant to alter our view and recommended strategy at the moment. To change our EM strategy, we would need to change our view on China and accept that China's credit bubble - especially in combination with the ongoing policy tightening - does not constitute a material risk to mainland growth in the foreseeable future. We are simply not ready to make this call. It is a matter of time until mainland growth relapses and China-related plays (including commodities and EM) enter a new bear market. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Special Report

Highlights Chinese political risks are heating back up; The 19th National Party Congress will replenish President Xi's political capital; Xi will escalate financial deleveraging and reboot his reform agenda in 2018; Yet the Chinese leadership is becoming more populist - holding reforms back; Volatility is going up; go long Chinese equities versus EM, and long big banks versus others. Feature China's economy grew at a faster-than-expected 6.9% rate in the second quarter (Chart 1), the result of easing financial conditions, healthy external demand, and domestic stimulus efforts that have enabled the country to shake off a range of serious risks since 2015. Chart 1As Good As It Gets Chart 2Exports And Monetary Conditions = Reflation The nominal rate of growth is at the top of what one can reasonably expect out of China today; the upside is limited. Stimulus is likely to wane, while the RMB, exports, and financial conditions are likely to be less supportive going forward (Chart 2). Moreover, the latest improvements came at the expense of China's structural reform agenda, which would rebalance growth toward consumption and services while encouraging private entrepreneurship and cutting back state-owned enterprises (SOEs) (Chart 3). As a result, risks are skewed to the downside. If China's total government and quasi-government fiscal-and-credit impulse rolls over, the recent improvements in industrial profits and domestic demand will come under threat (Chart 4). No surprise then that Chinese economic policy uncertainty remains elevated despite the growth recovery and stifling of capital outflows (Chart 5). Chart 3A Setback To##br## Economic Rebalancing Chart 4A Weaker Fiscal/Credit##br## Impulse Would Threaten Profits Chart 5Policy Uncertainty##br## Remains High The critical question going forward is: How will policymakers respond? Will they continue on the current path of waxing and waning stimulus combined with ad hoc reform efforts? Or will they attempt aggressive structural reforms to try to break out of the current cycle and escape the dreaded middle income trap?1 Between now and March of next year, China's political leaders will make a series of crucial decisions that have the potential to reshape the country's future over the long run. Though it is impossible to predict the precise outcome of the Communist Party's 19th National Party Congress - the crucial "midterm" leadership reshuffle set to take place in late October or November - there are nevertheless structural factors that will constrain the options available to the new leaders. Why Does The Party Congress Matter? The paradox of China's recovery from the turbulence of 2015-16 is that it coincided with the stagnation of President Xi Jinping's ambitious reform agenda, outlined to great fanfare at the 18th Central Committee's Third Plenum in 2013. Moreover, the impending 19th National Party Congress has implied that China would be even more vigilant than usual in maintaining stability. As we have argued, this meant that there would be neither dramatic reflation nor dramatic reform this year, which has (so far) been the case (Chart 6). Chart 6No Aggressive Stimulus Prior To Five-Year Party Congresses Now the party congress is approaching. In August, top leaders will convene at Beidaihe, a small seaside tourist village, to hammer out the final roster of the Chinese leadership for the next five years. Later the party congress delegates will mostly ratify this roster as well as any changes to the party's constitution. The historic average turnover of leaders in the Central Committee is significant, at about 60%. And this time around, almost the entire Politburo Standing Committee (PSC), the supreme decision-making body in China, will retire. A new PSC will literally emerge from behind a curtain for the world to see for the first time. China will have a substantially new set of decision-makers. Xi Jinping, who will give a report on where the party stands, will remain the "core" leader. The post-Mao system of power transition is relatively young and not as institutionalized as one might think. Still, some clear rules and norms are in place. In even-numbered years, party congresses mark a changeover in the top leaders (Hu Jintao and Wen Jiabao in 2002, Xi Jinping and Li Keqiang in 2012), while in odd years they have served as a "midterm" reshuffle (as under Jiang Zemin in 1997, Hu in 2007, and now Xi). Crucially, the midterm reshuffle marks the point at which a leader "consolidates" his power over the party and state, after which he has a freer hand to push his policy agenda. The meeting is often preceded by the removal of key rivals, the promotion of key protégés, and the launching of a leader's priority policies. Witness the sudden ousting of Sun Zhengcai, Chongqing party boss, who was until this week the likeliest candidate to succeed Li Keqiang as premier in 2022.2 The question is political capital Xi will have after the congress. There is no chance of him becoming a lame duck, but there is potential for him to be checked if his followers make a poor showing on the PSC, the 25-member Politburo, and the 300-member Central Committee.3 China watchers will pore over the new membership rosters. Here are the important issues at stake: Institutionalization: Will Chinese politics become more or less institutionalized and predictable? Of particular importance is whether Xi retains existing age limits, term limits, the size of party bodies.4 Any drastic changes would suggest that Chinese power is becoming more personalized, "charismatic," and dictatorial.5 That would feed rumors that Xi intends to stay in power beyond his term limit of 2022. Succession: Will Xi and Premier Li Keqiang promote successors to take over their positions in 2022? They will be expected to elevate their favorites to the PSC, just as they were elevated by their predecessors in 2007.6 If the new PSC does not include two conspicuously younger officials who are clearly being groomed to take over the country in 2022, then political uncertainty will spike. It will suggest that Xi is following in Vladimir Putin's and Recep Erdogan's footsteps. Re-centralization: The size of the Politburo and PSC have fluctuated over the years. In 2012, Xi notably reduced the PSC from nine to seven members, which was the norm in the 1990s. This move was seen as a re-centralization of power after the 2002-12 nine-member PSC came to be seen as slower-moving, indecisive, and less effective. Now there is speculation that Xi will again reduce the PSC to five members, further concentrating power. We think this unlikely but the result would be in keeping with the trend of re-centralization. Factionalization: China only has one party, but the party is divided into factions. The Communist Youth League (CCYL) faction is the most coherent. It includes current Premier Li Keqiang, former President Hu Jintao, and at least four of the ten most likely candidates to ascend to the PSC this fall. It is also called simply the "Hu faction" (see Diagram 1) and is broadly associated with populist policies. By contrast, Xi Jinping, in addition to being part of an elite group of "princelings," or sons of revolutionary founders, is forming his own clique. It is very roughly allied with other "elitists" from former President Jiang Zemin's faction (hence the label "Jiang/Xi faction" in Diagram 1). Xi has recently criticized the CCYL and cut its funding - he is also believed to have taken the economic portfolio away from Li Keqiang. Hence the predominance of Xi's or Hu's faction on the PSC and Politburo will be important. And if Xi were to replace Li, that would be a sign of extreme factionalization and political risk. Diagram 1Lineup Of New Politburo Standing Committee Yet To Take Shape - Factions Evenly Balanced? These issues can be debated ad nauseam, but for investors the chief takeaways are as follows: Chinese politics are not institutionalized: While we expect that Xi will largely adhere to party norms, we also expect him to make some tweaks. Unless he suffers a shocking setback at the party congress (very low probability), he is already lined up to be the most powerful leader in China through the 2020s. That is true even if he steps down from all formal positions as scheduled in 2022. Why? Because Chinese leaders - especially "core" leaders like Xi - continue to wield great power behind the scenes.7 In other words, many of China's underlying tendencies over the past five years (e.g. ideological purity, foreign policy ambition) will be with us for quite some time. Succession is what matters: We expect Xi to promote a successor. If he fails to do so, he will appear to be a true strongman who may stay in office after 2022. If the party congress points in that direction, then China's consensual political norms of the past thirty years will be in jeopardy. Rumors will say that Xi plans to revive the "chairman" position that Mao Zedong held and thus rule indefinitely. The factional balance in China will be upset and internal power struggle will ignite. Western governments will see China moving toward dictatorship. Capital flight pressure will intensify. Re-centralization will continue: China is in a re-centralization phase regardless of whether the PSC has five or seven members. Xi has charted this course and we expect it largely to continue due to his focus on regime security and international prestige. What matters is whether Xi is outnumbered by a rival faction on the PSC, since that could water down his policies or implementation. Factions do not predict policies: Factions reveal differences in the party that could weaken policy or stability, but they are limited in terms of predicting policy orientation. Xi has delayed difficult structural economic reforms with stimulus and promoted socially accommodative policies like his predecessor Hu Jintao.8 As such early expectations that Xi would be pro-market have dissipated. The real difference is that Xi has removed formidable enemies, giving him greater flexibility than Hu ever had. He may choose to use that flexibility for painful reforms in future, but he has notably refrained from doing so thus far. Chart 7Balance Of Institutions On China's Politburo A victory for the CCYL would be an "upset" for Xi, hindering his dominance, but would also be status quo for China as a whole. It would call into question Xi's political capital and ability to drive through his preferred policies. China would be seen as less economically promising, though possibly more politically mature. Xi's effectiveness in his first five years leads us to believe that this will not happen. We think he will secure control of the top policymaking bodies. Yet, as stated above, we also think Xi will broadly adhere to party norms and not lay the groundwork to become "leader for life." Why? The Communist Party has developed an informal but empirically verifiable history of balancing the members of the top leadership so that different institutions, regions, and skill-sets are represented. Hence the representation of leaders on the Politburo with key backgrounds in the party bureaucracy, the state bureaucracy, the regional governments, and the military have been remarkably stable since the 1980s (Chart 7). The balance is even more jealously guarded on the PSC than on the Politburo. Hence, the party congress is most likely to be a determiner of which way the balance tilts (more on that below), rather than whether the balance is entirely overthrown. Our expectation is probably the best short-term political outcome for financial markets: Xi enhances his political capital through 2022, but does not jeopardize the stability of the Chinese political system by resurrecting a Maoist "cult of personality" and embroiling the country in a future succession crisis. The country is thus more politically mature and (potentially) more economically promising. Bottom Line: Chinese politics are not institutionalized. Dramatic changes are taking place as we go to press; more are likely to occur before and after the party congress. Nevertheless, we expect Xi to uphold most of the party's rules even as he clinches full control of the party for the next five-year term. He will push the envelope but not break it. This is marginally positive for Chinese H-shares. What Comes Afterwards? The party congress provides an important infusion of political capital with which policymakers can try to get things done. For instance, after the 1997 congress, Jiang launched a massive "reform and restructuring" campaign of banks and state-owned enterprises (SOEs) that led to a spike in unemployment and bankruptcies to purge the system of inefficiencies (Chart 8). These policies ultimately transformed China - by one estimate they contributed about 20% of China's aggregate increase in total factor productivity through 2007.9 We expect the Xi administration to reinvigorate its policy agenda after this fall. The first five years of his presidency have centered on power consolidation - i.e. the sweeping anti-corruption campaign, breaking the fiscal and judicial independence of the provinces, and party purge. This campaign is likely to continue to some extent, but it has peaked in intensity (Chart 9) and the party congress should settle many of the most important power struggles, at least for a time. Chart 8China Embraced Creative Destruction In 1990s Chart 9Anti-Corruption Campaign Has Peaked Hence the central leadership's policy effectiveness should intensify in 2018. This is significant because Xi's reform agenda is incredibly ambitious. Our clients will remember that, in a deliberate echo of Deng Xiaoping's famous "reform and opening up" measures launched at the Third Plenum in 1978, Xi Jinping announced a raft of major reforms at the latest Third Plenum in 2013.10 The intention was to push forward the next wave of China's development and make market forces "decisive" in China's economy, namely by: rebalancing growth toward consumers, services, and private investors; deregulating upstream and downstream markets; reforming the fiscal system to give local governments sustainable finances; injecting private capital, competition and market discipline into the state-owned corporate sector; and stabilizing the business environment and broader society by fighting pollution and establishing the rule of law. As mentioned, this agenda has since been compromised, with Xi reverting to infrastructure spending and credit growth to avoid confronting the socio-political blowback of painful adjustments. With limited reforms, total factor productivity has continued on its post-GFC decline throughout Xi's term (Chart 10). Xi has also gone easy on SOEs, the weakest link in China's economy, maintaining the time-tried policy of rolling up inefficient ones into bigger conglomerates rather than letting them fail. The market has not perceived any loss of policy support for SOEs (Chart 11). Chart 10Productivity Weak In Xi's First Term Chart 11SOE Reforms Put On Hold Will the party congress change any of this? Will Xi be less pragmatic - i.e. more concerned with building a legacy as a historic reformer - in the coming five years? We cannot predict the precise membership of the next PSC or Politburo - especially given the furious horse-trading taking place after Sun Zhengcai's fall. But looking at key trends in the PSC's membership in recent decades, and assuming the top five likeliest candidates for 2017, the following trends become apparent (see Charts 12A & 12B): Chart 12ALeadership Characteristics Of ##br##The Politburo Standing Committee Chart 12BLeadership Characteristics Of ##br##The Politburo Standing Committee From technocrats to generalists: The "fourth generation" of Chinese leaders (Hu Jintao's generation) will finally rotate out of top posts this year. This is the last generation to have gone to college prior to the Cultural Revolution (1966-76), when schools and universities were disrupted, and to have largely studied natural sciences or engineering. Xi Jinping's "fifth generation" - and those beneath it - tend to come from educational backgrounds that are less technical and scientific and more legal and humanistic.11 The rise of the humanities may translate to a more ideologically doctrinaire outlook (pro-Communist Party, anti-West, anti-liberal) among the leadership, as opposed to the practicality of Deng Xiaoping and Jiang Zemin. Rule by provincial chieftains: Leaders with executive experience either as governors or party secretaries of the provinces have taken up an ever-greater share of the PSC and Politburo. This suggests that leaders have made tough decisions and have a broad conception of China that encompasses its vast regional, demographic, and economic disparities. They have dealt closely with poverty, ethnic minorities, border and security issues, and social instability. They are presumably less afraid to make decisions, or to crack heads, than central bureaucrats. The central government knows best: The share of leaders with experience at the top of the state bureaucracy is also rising. This means that leaders have experience administering key government agencies and ministries. They are not, however, "technocrats," as defined above - they are simply politicians capable of handling a policy portfolio that applies across the country. Fewer soldiers and business executives: PSC members with military experience have declined since Deng Xiaoping's era. Meanwhile, PSC members with experience as executives of state-owned enterprises have vanished since the days that one of them (Jiang Zemin) led China. But this does not portend sweeping privatization and liberalization.12 The bottom line is that China is being ruled more and more by politicians and less by business leaders and generals. This should also portend greater ideological purity and loyalty to the Communist Party. The heartland's revenge: Leaders who hail from the thickly populated and poorer provinces of central China have recently outnumbered those from the wealthy coastal provinces. But while PSC leaders increasingly come from the interior, their executive experience is still mostly in rich coastal areas. They straddle - and maybe know how to balance - the country's stark regional divide. In essence, China's political elite is gradually shifting toward greater "populism." The Han Chinese heartland has reasserted control of the Communist Party to which it gave birth in 1921. China's leaders, as a result of their provincial governing experience, are increasingly primed to maintain socio-political stability through redistribution or force rather than to promote economic efficiency via competition and liberalization (Chart 13). Chart 13More Social Spending Needed Further, these leaders have grown more aloof from the hard sciences and business acumen that gave rise to China's industrial prowess and are more intent on supporting the Communist Party's foundational myths and regime control - as well as keeping the country's rapid social and technological development under that control. What does this mean for Xi Jinping's second term? Xi is seen as an "elitist" both in his policy preferences - the demand for greater economic competition, efficiency, and technological advances - and in his personal background as a princeling. Yet these preferences will likely be compromised in his second term, as in his first, because the economic drivers of the "populist" trend will persist. Insofar as leadership characteristics are a reliable predictor, the radical liberalizing agenda of the Third Plenum - soon to be supplanted by another Third Plenum in 2018 - will only briefly benefit from an infusion of new energy, say in 2018-19, before being moderated, postponed, or watered-down. The leadership is increasingly aware of the need to maintain minimum levels of growth, development, and income redistribution for the sake of stability. The creative destruction of the late 1990s is no longer an option. Xi will still make an attempt to revive his reforms - and therein lies a risk to short-run growth, as China's cyclical growth is simultaneously set to slow in 2018. But he will fail to launch a transformative new period of productivity growth in China over the long run. Bottom Line: The final line-up of the Politburo and PSC will enable us to revise the above sketch of China's elite with new data. But the main trends and implications are unlikely to be altered. Not only is Xi Jinping aiming to stabilize and preserve the regime and re-centralize power, but so too is the Communist Party. Xi's reform agenda will undoubtedly be rebooted after the party congress - with non-negligible risks to short-term growth - but Xi will not ride roughshod over these institutional constraints. At least, not for very long. Whither China? The structural constraints that will stymie Xi's new reform push are well known. Capital formation has been well above the range staked out by other emerging economies during similar phases of national development (Chart 14). This is a source of instability: the investment-led economic model has expired and yet the country has not weaned itself off of capital-intensive policies. China's debt load and debt-servicing costs have exploded upward both because of the inefficiencies of the state sector (SOEs and state banks) and because local governments rely on SOEs (and their own shady financing vehicles) to generate growth. Household debt is low but rising rapidly (Chart 15). Chart 14Excess Investment Is A Real Problem Chart 15Corporate Debt: The Achilles Heel The central government's surprising "deleveraging campaign" this year - which was softened to avoid mistakes ahead of the party congress - shows that China's leaders do not expect the view that the country's financial risks are negligible due to the large pool of savings. Instead, this year's financial crackdown serves as a dress-rehearsal for what is likely to be a much stricter crackdown on the financial sector as Xi reboots reforms in 2018. Financial tightening alone is a major aspect of restarting the reform agenda. Tighter controls on banks and leverage will translate into greater market discipline. This will in turn maintain the pressure on the sector most in need of change - the SOEs. The key question is how much of an appetite Xi has for bankruptcies and unemployment, since traditionally Chinese governments have not had much. Today's manufacturing employment indicators are weak despite the past two years' stimulus and growth recovery (Chart 16). The Xi administration will push forward with "supply side reforms" meant to weed out excess capacity - including at least some redundant workers13 - but this is precisely where any reformist intentions are likely to be compromised after the initial burst. The Communist Party has also placed greater emphasis on improving living standards and per capita disposable income, which will further limit the regime's appetite for self-imposed deleveraging (Chart 17). The hundredth anniversary of the Communist Party in 2021 will mark another politically sensitive calendar year and hence another reason for the party to backtrack after a spell of greater economic discipline. Xi will want to leave on a high note in 2022. Furthermore, excessive tightening would pose enormous risks for Xi's outward-looking economic and foreign policy agendas: not only the highly touted international development projects under the Belt and Road Initiative (OBOR), which require extensive Chinese investment, but also China's military rise in a region that is increasingly militarily competitive (Chart 18). Chart 16Employment Weak Despite Stimulus Chart 17Communist Party Expects Higher Incomes Chart 18Another Reason To Avoid Economic Slowdown Bottom Line: The Xi administration will renew its reform drive - particularly by curbing leverage, shadow banking, and local government debt. Growth risks are to the downside. But Beijing will eventually backtrack and re-stimulate, even as early as 2018, leaving the reform agenda in limbo once again. Investment Implications China's fundamental transition has already occurred. The demographic profile of the country no longer favors cheap labor or an ever-larger pool of savings that state authorities can easily direct into productivity-enhancing basic investments (Chart 19). The cost of capital is set to rise in the long run and that will put sustained pressure on the inefficient parts of the economy. "Reform" will become more an issue of withholding financial assistance, which the government will eventually be forced to grant out of concern for stability. As the pool of savings declines, the government faces the unprecedented challenge of moderating the wealth disparities that widened so rapidly during the boom years and that threaten regime stability (Chart 20). Chart 19The Savings Glut Is Coming To An End Chart 20Inequality: A Liability For The Party This will involve increasing the redistributive effect of taxes - which is remarkably low in China, and which in turn will generate higher levels of political tension between the haves and have nots, both households and regions. The Communist Party is only beginning to navigate these difficulties, which will stir up resentment among the large and ambitious middle class. Yet the middle class must be encouraged to thrive, as the rebalance of the Chinese economy cannot rest solely on the decline of investment. For that to occur, there needs to be a change in household, government, and corporate relations such that the government absorbs the excess debt created by corporations and instills greater efficiency among them, while devoting more resources to social wellbeing, thus enabling households to reduce precautionary savings. So far, Chinese households continue to save up for a rainy day (Chart 21), which leaves economic growth at the mercy of corporate borrowing and exports, the very dependencies that the Xi administration aims to reduce. Unfortunately for Xi, the chance to turn attention to these internal problems will coincide with bigger international challenges - especially tensions with the United States. We expect Sino-American distrust to worsen as long as China continues its more aggressive foreign policy and tries to carve out a sphere of influence in Asia. This is not a policy reliant on Xi's preferences alone but rather on China's growing domestic economic and security needs. In the event that Xi attempts to stay in power beyond 2022 - which we consider a low probability outcome - we expect U.S.-China confrontations to occur sooner than otherwise. Our long-term theme of global multipolarity will receive a steroid injection. There is no clear trend for Chinese H-shares around party congresses - sometimes they rally, sometimes they sell off (Chart 22). China's fiscal/credit impulse has ticked up and the coming slowdown may take time to develop, so we would not be surprised to see a rally leading into or following this year's congress. Chinese H-shares are cheap relative to their peers. Chart 21Chinese Still Saving For A Rainy Day Chart 22China Rallies Versus EM In Times Of Reform On the other hand, China's economic structure is worse than Xi found it. If he grabs the bull by the horns - as we think he will do - markets will sell off for fear of growth disappointments and policy mistakes, at least until investors are convinced it is safe to buy into China's long-term efficiency gains from reform. We recommend going long Chinese equities relative to EM. Xi's renewed reform drive will be attractive to EM dedicated investors in the context of un-reforming EMs like South Africa, Turkey, and Brazil, while EM will suffer from the negative short-term growth impact of Chinese reforms. This trade performed well during the major reforms of 1997-2002 and after the Third Plenum in 2014-15. Certainly we would bet against the continuation of extreme low volatility in Chinese assets, as measured by the CBOE China ETF Volatility Index. Both China's foreign and domestic political risks are understated. Finally, we recommend investors go tactically long Chinese Big Five banks versus small and medium-sized banks, a trade initiated by our fellow BCA Emerging Markets Strategy in October for a gain of 7.7% (Chart 23). Our EM Equity Sector Strategy has also lent credence to this view.14 The larger banks are better provisioned and prepared for credit losses and the financial tightening that we expect to come. Chart 23Big Banks Can Weather The Storm This trade has lost some altitude over the past month as a result of the perception that Chinese authorities would scale back their financial crackdown. However, the National Financial Work Conference held over the weekend of July 14-16 signaled that the Xi administration will expand its deleveraging campaign not only throughout the financial sector but also to SOEs and local governments to rein in China's formidable systemic risks. The new Financial Stability and Development Committee is likely to be more significant than market participants realize - Xi will have new political capital after this fall and is already shifting his attention to the sector. Moreover the announcement that the People's Bank of China will take a greater oversight role in the financial sector and for systemically important institutions is especially significant in light of the impending retirement of Governor Zhou Xiaochuan, which will usher in a new chapter in the PBoC's governance. Fortifying the country against financial risk is a regime security issue, as well as a basis for eventual financial reform and liberalization, and we expect the coming regulatory tightening to have far-reaching consequences. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 The "middle income trap" is a concept in economics describing developing countries that fail to make the transition into developed economies, despite showing rapid developmental progress for a time, and thus remaining stuck in the "middle income" GDP per capita range. Please see Indermit Gill and Homi Kharas et al, "An East Asian Renaissance: Ideas For Economic Growth," World Bank (2007), available at siteresources.worldbank.org. For a recent review of the literature, please see Linda Glawe and Helmut Wagner, "The middle-income trap - definitions, theories and countries concerned: a literature survey," MPRA Paper 71196, dated May 13, 2016, available at mpra.ub.uni-muenchen.de. 2 The dismissal of Beijing Mayor Chen Xitong, for example, is seen as evidence of Jiang Zemin's consolidation of power ahead of the 15th National Party Congress, while the fall from grace of Shanghai Party Secretary Chen Liangyu in 2006 is seen as proof of Hu Jintao's consolidation ahead of the 17th Party Congress in 2007. 3 Indeed judging solely by the cyclical rotation of Chinese leaders according to generation and faction, Hu Jintao's acolytes are favored to outnumber Jiang Zemin's and Xi Jinping's in the 2017 reshuffle. Please see BCA Geopolitical Strategy, "China: Two Factions, One Party," dated September 2012, available at gps.bcaresearch.com. However, Xi's effectiveness and good luck since coming to power lead us to believe that he will secure his followers on the PSC and Politburo this year: please see BCA Geopolitical Strategy Strategic Outlook 2017, "We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 4 For instance, this time around there are rumors that Xi will keep his anti-corruption chief, Wang Qishan, on the PSC beyond the standard retirement age, and that he may even go so far as to oust Premier Li Keqiang. Such drastic changes are unlikely, particularly the latter, but certainly not unthinkable. 5 For our long-term investment theme of "charismatic leadership," please see our Strategic Outlook cited in note 3 above. 6 Please see Alice L. Miller, "China's New Party Leadership," Hoover Institution, China Leadership Monitor 23 (Winter 2008), available at www.hoover.org. For this discussion of factions please also see Willy Wo-Lap Lam, “The Eclipse of the Communist Youth League and the Rise of the Zhejiang Clique,” Jamestown Foundation, May 11, 2016. 7 For instance, Jiang Zemin has continued to be a powerbroker to this day: Xi's vaunted anti-corruption campaign over the past five years has largely aimed at rooting out the influence of Jiang's faction. This includes the ouster of Sun Zhengcai this past week. And that is thirteen years after Jiang gave up a formal post! 8 Note that Xi rose to power as a princeling and member of Jiang Zemin's faction, as opposed to Hu Jintao and the CCYL. Yet Xi combined with Hu to oust the princeling Bo Xilai, and his anti-corruption campaign has largely focused on eradicating Jiang's influence. 9 Please see Chang-Tai Hsieh and Zheng (Michael) Song, “Grasp the Large, Let Go of the Small: The Transformation of the State Sector in China,” Brookings Papers on Economic Activity, March 19 2015, available at www.brookings.edu. At the seventeenth party congress in 2007, Hu also launched major reforms, aiming to reduce income inequality, urban-rural disparities, and lack of development in western China, but his efforts were cut short by the global financial crisis. Please see Hu Jintao, "Hold High the Great Banner of Socialism with Chinese Characteristics and Strive for New Victories in Building a Moderately Prosperous Society," Report to the 17th National Congress of the Communist Party of China, October 15, 2007, available at www.china.org.cn. 10 Please see BCA Geopolitical Strategy Monthly Report, "Reflections On China's Reforms," in "The Great Risk Rotation - December 2013," dated December 11, 2013; and Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. Please also see BCA China Investment Strategy, "Understanding China's Master Plan," dated November 20, 2013, available at cis.bcaresearch.com. 11 There are obviously pros and cons to this change: the industrial era required leaders with technical skills; the modern era requires services, branding, and innovation. But, in the Chinese context, the humanities are not focused on critical thinking and questioning authority to the same extent as in the West. 12 In fact, Xi Jinping's recent promotions have re-emphasized SOE managers and his policies have supported SOEs. Please see Cheng Li and Lucy Xu, "The rise of state-owned enterprise executives in China's provincial leadership," Brookings, February 22, 2017, available at www.brookings.edu. 13 Even the official unemployment measure, which hardly ever moves, is slated to rise from 4.02% to 4.5% this year. Please see BCA China Investment Strategy Weekly Report, "Messages From The People's Congress," dated March 9, 2017, available at cis.bcaresearch.com. 14 Please see BCA Emerging Market Strategy Special Report, "Chinese Banks' Ominous Shadow," dated June 15, 2016, available at ems.bcaresearch.com. Please see also BCA EM Equity Sector Strategy Portfolio Update, "Ranking Model And China Banks," dated July 18, 2017, available at emes.bcaresearch.com. Appendix

Highlights The strong tailwinds behind China's recovery since early 2016 are likely to wane in the coming months. Diminishing reflationary forces will not immediately lead to a growth relapse, as the domestic economy has developed some self-feeding momentum. China's PPI inflation will continue to drift lower. Disinflation in PPI is less positive for the economy, but is not outright negative, unless PPI deflates. Odds are low that PPI will deflate anytime soon. Without a major growth relapse and PPI deflation, the upturn in the Chinese profit cycle should have further to run, which bodes well for asset prices - particularly for investable Chinese shares and corporate bonds. Feature China's GDP figures to be released next week will likely show that the economy continued to accelerate in the second quarter, as indicated by recent high-frequency macro indicators (Chart 1). Looking forward, the near-term outlook remains promising, but the strong tailwinds behind China's recovery since early 2016 are likely to wane in the coming months, which could lead to softer growth down the road. However, the Chinese economy has regained some self-sustaining momentum, which will allow it to glide at cruising speed without major growth difficulties. For investors, H-shares and onshore corporate bonds should continue to advance, aided by the profit cycle upturn and a largely accommodative policy setting over the next six to nine months. Chart 1Chinese GDP Likely Accelerated In Q2 Chart 2Exports And Monetary Conditions ##br##Drive Chinese Industrial Activity Tailwinds Are Waning... China's seemingly static GDP growth figures disguise much greater volatility in the underlying economy, especially in the industrial sector. The famed Keqiang index, named after China's incumbent premier which incorporates electricity consumption, railway transportation and bank lending, has shown dramatic swings in the past two decades (Chart 2). The index has roared back from rock bottom in late 2015 to currently a one sigma overshoot above its long-term trend, underscoring a sharp recovery in industrial activity. Some have attributed this to a massive dose of fiscal and monetary stimuli - we disagree. In our view, the swings in China's industrial sector performance can be fully explained by the performance of exporters and the country's Monetary Conditions Index (MCI). Our "Reflation Indicator," a combination of export growth and MCI, shows a very tight correlation with the Keqiang Index in the past several cycles. In other words, the rapid recovery in industrial activity since early 2016 was boosted by tailwinds from both accelerating export growth and easing monetary conditions. Currently, the tailwinds are likely passing maximum strength and will wane on both fronts going forward: Global demand appears to be in a synchronized upturn, which bodes well for Chinese exports. The manufacturing PMI new export orders component has been in expansionary territory for eight consecutive months and made a new recovery high in June, pointing to upside surprises in export growth in the near term. Looking further out, our model predicts export growth will likely peak out before the end of the year (Chart 3). After all, it is unrealistic to expect Chinese exports to always grow at double-digit rates - particularly with global trade having downshifted structurally post-global financial crisis. On monetary conditions, the depreciation of the trade-weighted RMB, a major reflationary force for the Chinese economy since late 2015, has stalled in recent weeks. Broad dollar weakness of late has failed to further push down the trade-weighted RMB - either because of the People's Bank of China's intervention, or because bearish bets on the RMB by investors are now off the table (Chart 4). Regardless, a stable RMB exchange rate decreases investors' anxiety on China's macro situation, but also reduces a reflationary source for the overall economy. Overall, recent changes in China's macro environment suggest growth tailwinds are diminishing, but have not yet become headwinds. This on margin is bad news for the economy, but should not lead to a significant growth slowdown. Chart 3Exports: Upside Is Limited Chart 4The RMB Is No Longer Falling ...But Growth Drivers Remain Largely In Place We expect Chinese business activity to remain reasonably buoyant going into the second half of the year. It is not realistic to expect growth figures, measured by year-over-year growth rates, to accelerate in perpetuity, but downside risks to the economy will stay low. Some major growth drivers in the economy remain largely in place. Looking at the consumer sector, the growth recovery and labor market improvement have significantly lifted consumer confidence, which historically is positive for retail sales (Chart 5). Chinese households are under-levered and over-saved, and improving confidence should on margin reduce savings and further boost consumption. Retail sales have already bottomed out and will likely accelerate. The corporate sector's inventory restocking cycle is likely still at an early stage, as the inventory component of the manufacturing Purchasing Managers' Index (PMI) surveys has never moved above 50 since 2012, underscoring increasingly lean stock of finished goods. Industrial firms' inventory levels relative to sales are still standing at close to record low levels (Chart 6). Going forward, inventory re-stocking may supercharge production, should new orders remain elevated. At a minimum, very lean inventory levels limit the downside in industrial production - even if the improvement in new orders stalls. Chart 5Consumer Spending Should Remain Strong Chart 6Inventory Restocking Has Further To Go Furthermore, China's capital spending cycle has likely bottomed out, especially among private enterprises and in the resource sectors. The corporate profit cycle recovery has continued to unfold, and business confidence has improved sharply - both of which are conducive for private sector expansion (Chart 7). There has been dramatic improvement in resource sector profits, which at a minimum will put a floor under the relentless contraction in capex these industries have experienced in recent years. Overall, it is premature to expect a major boom, but the case for a modest upturn in private capital spending continues to strengthen. Finally, the risk of a significant housing growth slowdown due to the government's tightening measures, a major concern among investors earlier this year, has abated. Home sales have cooled off due to local government restrictive policies, but developers' inventories have declined substantially following booming sales in previous years. Therefore, housing starts have continued to improve, which should lift real estate investment going forward (Chart 8). Anecdotal evidence suggests land purchases by developers have been buoyant. Meanwhile, developers' stocks have been outperforming the benchmark, which historically has led housing transactions. All of this means a sharp reduction in real estate investment is highly unlikely, at least from a cyclical point of view. Chart 7Private Sector Capex ##br##Will Likely Accelerate Chart 8Real Estate: Near Term Outlook Improving ##br##The Chain Reactions In Housing In short, we see limited downside risks in the Chinese economy in the near term. Diminishing reflationary forces will not immediately lead to a growth relapse, as the domestic economy has developed some self-feeding momentum. Will PPI Deflate Again? Chinese producer prices have quickly rolled over in the past several months, falling from a peak of 7.8% in February to 5.5% in June. Rising PPI last year was regarded as a key signpost of China's reflationary trend; in this vein, the latest deterioration in PPI indeed raises a red flag. Our model predicts that PPI inflation will likely drift even lower, reaching 3% before year end (Chart 9). We rely on our models to understand the trend rather than to make number forecasts. It now appears a sure bet that Chinese PPI will continue to surprise to the downside in the coming months. How investors will react to likely increasingly disappointing PPI numbers remains to be seen. Our sense is that disinflation in PPI is less positive, but is not outright negative, unless PPI deflates. For now, we see low odds that PPI will deflate anytime soon. Chart 9PPI Will Continue To Moderate Chart 10Industrial Goods Prices Are Fairly Robust A key reason for the rapid decline in PPI inflation is an increasingly unfavorable "base effect," where the year-over-year growth rate naturally tapers off after a period of rapid acceleration. In terms of levels, overall PPI should remain largely stable, according to our model. The recent softness in Chinese PPI largely reflects weakness in crude oil prices, while prices of most basic industrials prices have been fairly robust, including some products that are widely perceived as suffering chronic overcapacity (Chart 10). This suggests the weakness in PPI is fairly concentrated, and likely reflects the unique supply demand dynamics of the oil market, rather than a demand slowdown in the broader economy. More importantly, China's PPI deflation that lasted between February and June was to a large extent due to policy tightening by the Chinese authorities, which, together with weak global demand amplified strong deflationary pressures in the Chinese economy. This time around, the PBoC is highly unlikely to repeat the policy mistakes of draconian credit and monetary tightening. Even if the central bank intends to tighten policy, it will be a lot more cautious and data-dependent. We will follow up on this issue in the coming weeks. The bottom line is that falling PPI inflation should be closely monitored. For now, we expect continued disinflation rather than outright PPI deflation. Profits And Markets Without a major growth relapse and PPI deflation, the upturn in the Chinese profit cycle should have further to run, which bodes well for asset prices - particularly for investable Chinese shares and corporate bonds. For stocks, net earnings revisions of Chinese companies have been rising, confirming the profit cycle upturn (Chart 11). Even if profit growth rolls over along with other macro numbers, a profit contraction is unlikely. Meanwhile, Chinese stocks are among the cheapest of the major bourses (Chart 12), particularly H shares. Overall, Chinese stocks should continue to do well from a cyclical perspective, and will outperform global and EM peers. For bonds, we went long onshore corporate bonds after the sharp selloff earlier this year - namely because the selloff was entirely triggered by the authorities' liquidity tightening rather than corporate fundamentals. The upturn in the profit cycle should also improve the corporate sector's balance sheet, which should be good news for corporate bonds. This trade has been profitable so far, but we expect further narrowing in corporate bond spreads, as they are still elevated both compared with their global counterparts and their historical norms (Chart 13). Investors should hold. Chart 11Earnings Outlook ##br##Will Continue To Improve Chart 12Chinese Stocks Multiples ##br##Are Among The Lowest Globally Chart 13Chinese Corporate Bond Spreads Set ##br##To Narrow Further Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights The market will not give OPEC 2.0 until March to sort out a durable modus operandi to manage supply and maintain the discipline required to defend crude oil prices. While the odds of Libya and Nigeria being able to keep production at current levels - much less grow output - are less than 50:50 in our estimation, the fact remains the Kingdom of Saudi Arabia (KSA) and Russia need to start communicating post-haste how OPEC 2.0 will manage higher Libyan and Nigerian production. Critically, these leaders will need to follow through on whatever they guide the market to expect. We think OPEC 2.0 will stand by its "whatever it takes" proclamations. Not acting in the face of more than 300k b/d of unexpected supply from a once-moribund Libya placed in the market since October will send a signal, as well: OPEC 2.0 will not defend its Agreement. Should this occur, it likely would result in a breakdown in production discipline within the coalition, sending crude oil prices lower. Energy: Overweight. Crude oil prices remain under pressure as markets price the likelihood of continued increases in production in Libya and the U.S. Spoiler alert: We think OPEC 2.0 will act to accommodate Libya's and Nigeria's return to export markets. Base Metals: Neutral. Workers at the Zaldivar copper mine owned by Antofagasta and Barrick Gold voted to strike earlier this week. If government mediation fails to resolve the issues separating labor and management this week, workers will walk. Precious Metals: Neutral. Gold is recovering from last week's "flash crash" in silver, but markets continue to process recent hawkish guidance from systematically important central banks that could lift real rates and pressure precious metals. Ags/Softs: The USDA's WASDE was published just before our deadline. We will review it in next week's publication. Feature Markets may have tacitly assumed OPEC 2.0 would have until March to figure out how KSA, Russia, and their respective allies would work together to re-gain some control over oil prices. However, given almost-daily reductions in banks' oil-price forecasts in the wake of steadily increasing Libyan and U.S. production, belief in OPEC 2.0's strategy and commitment appears to be all but exhausted. Stronger-than-expected output from Libya and Nigeria - up some 400k b/d vs. the October production levels OPEC 2.0 benchmarks to (Chart of the Week) - is being offset by strong inventory draws in high-frequency data from the U.S. and Europe, as we expected. In addition, a reduction in 2018 U.S. shale-growth forecasts in the EIA's just-released estimates of global supply and demand boosted sentiment some. Even so, markets remain skeptical. Libya's production now is estimated at 850k b/d, and accounts for 300k b/d of newly arrived OPEC supply since October. Nigeria, at close to 1.6mm b/d, accounts for another 90k b/d of the unexpected supply on the market since October. OPEC's total crude output is running at just over 32.6mm b/d, down 470k b/d from October's levels, based on the EIA's tally.1 This was 300k b/d more than May's output. Taking Libyan and Nigerian output out of the tally leaves OPEC crude production at 30.21mm b/d, or 860k b/d below October's level. Close to 26mm b/d of OPEC's output is being exported, according to Thompson Reuters data, surpassing OPEC's 4Q16 export levels when Cartel members' output was surging ahead of the OPEC 2.0 production cuts that took effect in January.2 Although benchmark crude oil prices had recovered from their bear-market lows of late June, the steady increase in Libyan production, in particular, reversed this recovery, taking $2.70 and $2.80/bbl off the interim highs registered by WTI and Brent prompt contracts between July 3 and July 10 (Chart 2). Chart of the WeekLibya, Nigeria Add Close ##br##To 400k b/d To OPEC 2.0 Production Chart 2Libya's Resurgence Clobbers ##br##Benchmark Prices Prices have since moved higher of the back on larger-than-expected draws in crude and products in the OECD, led by the U.S. On Wednesday, the EIA reported U.S. crude inventories declined by a whopping 10.7 million barrels, although product inventories grew by 3.7 million barrels for the week ended July 7. These sharp draws (over 17 million barrels of crude storage reduction in the past two weeks, including SPR withdrawals) are what we have been expecting, so we are not surprised, although this is the second week in a row in which the inventory draws exceeded market expectations for the EIA's reporting week. WTI was trading just above$45/bbl, while Brent was just over $47.60/bbl as we went to press. OPEC 2.0's Problem The problem for OPEC 2.0 is that Libya's unexpectedly strong return will retard the drawdown in OECD inventories around which the reformed Cartel is organized. This is compounded by higher U.S. production, which the EIA's latest estimates put at 9.2mm b/d. U.S. crude production in June was up 410k b/d vs. 4Q16 levels, and 510k b/d yoy, by the EIA's reckoning. The bulk of this increase comes from shale-oil production, which is running at ~ 5.1mm b/d (Chart 3). Lower prices will slow the growth of U.S. shale-oil output, but it won't reverse the absolute increase unless prices once again push below $40/bbl for an extended period. We do not expect such an evolution of prices, and continue to expect Brent will average $55/bbl and will reach $60/bbl by the end of the year, with WTI trading at ~ $58/bbl by then. OPEC 2.0's production is not as sensitive to price as the U.S. shales. The coalition banded together to remove some 1.8mm b/d of oil production from the market, and, based on media reports, continues to maintain production discipline. We reckon actual cuts have been on the order of 1.4 to 1.5mm b/d from OPEC 2.0, favoring the lower end of that range, given the latest estimates of the EIA. Given demand growth of ~ 1.6mm b/d on average this year and next, we are expecting a net physical deficit this year of ~ 900k b/d (Chart 4). This will draw OECD inventories down by March below five-year average levels (Chart 5). Chart 3Higher Prices Lifted U.S. ##br##Shale-Oil Production, But Lower Prices Will Slow The Growth Chart 4Output Declines And Demand ##br##Gains Will Produce A Physical Deficit ... Chart 5OPEC 2.0 Has To Defend Its Strategy, ##br##If OECD Inventories Are To Fall It is worth remembering Libya and Nigeria are not parties to the OPEC 2.0 deal. Nor did the leaders of this coalition anticipate a sustained increase in production by these states when the OPEC 2.0 deal was agreed at the end of last year. This is particularly true for Libya, which is a failed state. The suggestion by Kuwait that Libya and Nigeria be brought into the OPEC 2.0 production-cutting agreement beggars belief: The Arab Spring destroyed Libya as a state, and its oil production. Since March 2011, when the state collapsed, Libya's oil production has averaged 650kb/d, versus 1.65mm b/d in 2010. Even if there were a government in place, it is unlikely it would agree to cap its production. Nigeria's production also has been hampered by civil unrest, particularly in the Niger Delta region, where insurgents periodically sabotage pipelines and loading platforms, which forces oil exports to be suspended until repairs can be made. Nigeria's production averaged over 2mm b/d until 2013, when it fell to 1.83mm b/d. Since then, it has averaged 1.66mm b/d, with 2017 production to June averaging 1.43mm b/d. Any increase in production resulting in export sales is "found money" for these states. And their need for this money is as great, if not greater, than that of the OPEC 2.0 coalition members. Who In OPEC 2.0 Is Likely To Cut Production? KSA, Kuwait and the UAE were producing close to 2.4mm b/d more in June than they were in 2010, the last year Libya was an intact state, even with the cuts agreed under the OPEC 2.0 deal accounted for. Even at its recent high of 850k b/d of production, Libya still is producing 800k b/d less than it did in 2010. We believe an accommodation involving KSA, and possibly Kuwait and the UAE, can and will be reached at the upcoming OPEC 2.0 technical committee meeting in St. Petersburg on July 24. Something on the order of 500k b/d from these Gulf Arab producers will allow Libya and Nigeria to flex into higher production without undermining the OPEC 2.0 production-cutting deal. The stakes are sufficiently high for the OPEC 2.0 members - KSA and Russia in particular - that an accommodation for Libya will be found. Libya's maximum production likely is no more than 1mm b/d, given the damage years of neglect has caused its fields and productive capital. Rebuilding this province will take years, if a way can be found to reconstitute the organs of a functioning state. Absent an accommodation, OPEC 2.0's leaders risk undermining the credibility of the coalition and causing production discipline to collapse as each state in the group rushes to increase output before prices take their inevitable dive. This would severely reduce the proceeds KSA could expect from IPO'ing Aramco, and would again put Russia's revenue under pressure, forcing it to draw down foreign reserves. OPEC 2.0's End Game Hasn't Changed Neither KSA nor Russia wants to re-visit the conditions that prevailed in 1Q16, when markets were pricing a global full-storage event that would require prices to push through $20/bbl to kill off supply so that storage could drain. For this reason, both have shown their commitment to the production-cutting pact they negotiated at the end of last year. Both, we are convinced, are working closely to map a strategy to allow U.S. shale production to co-exist - within limits - with OPEC and Russian production. In earlier research, we laid out a strategy that could work to achieve this result - draw storage down enough to backwardate the WTI forward curve so that deferred prices trade below prompt-delivery prices. This will moderate - but not stop - the rate at which horizontal rigs return to the shale fields.3 OPEC 2.0's leaders will have to find a way to use their production and storage - which is why it is critical to open some space now - to guide markets to expect higher production and crude availability in the future and tighter market conditions in the present. Bottom Line: We expect OPEC 2.0 to accommodate Libya's and Nigeria's increased production with further cuts in their own production, particularly from KSA, Kuwait and the UAE. This will allow Libya and Nigeria to flex into higher output, should they find a way to maintain it going forward. We continue to believe the odds of sustained higher production from these states is less than 50:50, but that does not matter. What matters is that markets see OPEC 2.0 defending their production-cutting strategy so that inventories continue to draw. OPEC 2.0's end-game has not changed. But the leaders of the coalition will have to adapt if they are to succeed in drawing storage to five-year averages or lower. Critically, they must begin to communicate their longer-term strategy to the market, or risk undermining their coalition. 2Q17 Trade Recommendations Re-Cap We closed out 2Q17 with an average loss of 77% on trades recommended and closed during the quarter (Table 1). The primary driver of this underperformance was a return to contango in the WTI and Brent forward curves, as inventories failed to draw as quickly as we expected. Directional trade recommendations anticipating higher prices also performed poorly. Table 1Trade Recommendation Performance In 2Q17 Open trades at the end of 2Q17 were up an average of 26%, led by good performances in option recommendations - i.e., long call spreads in WTI and Brent in Dec/17. Year to date, our trade recommendations are up 72.6%, on the back of strong 1Q17 results. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 This is adjusted for the inclusion of Equatorial Guinea and the recent opting out of Indonesia. We will be updating our global supply-demand balances next week. 2 Please see "Oil slides as OPEC exports rise, prices end 8 days of gains," published by reuters.com July 5, 2017. 3 Please see BCA Research's Commodity & Energy Strategy reports of April 6, 2017, entitled "The Game's Afoot in Oil, But Which One," and March 30, 2017, entitled "KSA's, Russia's End Game: Contain U.S. Shale Oil." Both are available at ces.bcaresearch.com. Investment Views And Themes Recommendations Strategic Recommendations Tactical Trades Trades Open And Closed In 2017 Summary Of Trades Closed In 2016 Trades Closed In 2017 Commodity Prices And Plays Reference Table

Highlights The G20 summit highlighted our theme of multipolarity, which encourages global instability; U.S.-China tensions have resumed their escalation after a brief pause; The Middle East is still a "red herring" for investors this year, but tail risks are rising; Any negative impact on oil production from these risks should be minor; Iran stands to benefit; Egypt is a buy on the back of cyclical recovery and Saudi support. Feature For the first time in the history of G20 summits, the "sherpas" (emissaries) who prepared the event failed to reach any notable policy agreements. Allegedly, the only policy that the U.S. administration endorsed prior to the summit was women's entrepreneurialism, Ivanka Trump's pet project. Why should investors care? G20 meetings have always been abstract, retroactive (as opposed to proactive), and barely able to move the markets. But they have occasionally mattered. The summits in Washington D.C. (November 2008) and London (April 2009) set the agenda for economic stimulus and global financial regulatory reform that brought the world back from the brink of abyss. The London summit, in particular, set the stage for coordinated, global, fiscal policy that reflated the economy. At the September 2009 Pittsburgh summit, the G20 replaced the Western-dominated G8 as the premier economic governance platform. (The latter is now the G7 because of Russia's exclusion after annexing Crimea.) The idea behind the expanded forum was to give emerging markets like China, India, and Brazil a say in the global economic architecture. It was the forum's expansion that ultimately doomed its effectiveness. To our knowledge, no multilateral framework has ever successfully coordinated global affairs. Global stability has always been underpinned by hegemony, which is why we have warned our readers since 2011 that emerging global multipolarity - caused by America's relative geopolitical decline - would lead to instability.1 The press will inevitably blame President Trump's "America First" for the failures of the G20. We do not disagree, but there is more to it than just politics. "America First" is a natural political reaction to the reality of American geopolitical decline. It is also a reaction to nearly two decades of foreign policy decisions to commit massive amounts of U.S. hard and soft power to pursuing nation-building policies in the Middle East. As such, "America First" is a symptom, not the cause, of global multipolarity. The "Trump Doctrine" could indeed be highly destabilizing, if followed through to its logical conclusion.2 Ostensibly, President Trump seeks to renegotiate global security and economic arrangements that have taken advantage of American magnanimity. But it was America that initially designed these arrangements, at the height of its power in the immediate aftermath of the Second World War, to secure its own interests. Institutions like NATO, the IMF, and the World Bank underpin, they do not undermine, American hegemony. Without these institutions, American allies will seek their own negotiated arrangements more freely and frequently with U.S. adversaries, slowly eroding Washington's global influence. Over the long term, the Trump Doctrine could also undermine the U.S. dollar's status as the global reserve currency. The dollar's reserve currency status is a privilege that monetizes American geopolitical hegemony. America's allies are essentially already paying for American hegemony: through their investments in U.S. dollar assets.3 Chart 1 illustrates this so-called "exorbitant privilege."4 Foreigners hold U.S. assets because of the size of the economy, the sustainability of the market, and its deep liquidity, but also because the U.S. provides them with assurances of peace through security. If Washington raises barriers to its markets and becomes a doubtful provider of security, states may gradually see less of a payoff in holding U.S. assets and thus diversify more rapidly. They could also be forced to diversify by new security guarantors, regional hegemons, and geopolitical bullies. Chart 1Exorbitant Privilege The concept of exorbitant privilege - and its economic benefits - cannot easily be explained to voters. What voters understand is that China's rapid industrialization has been accomplished at the cost of American manufacturing jobs. Candidate Trump successfully tapped into this angst during the campaign. President Trump, however, initially shied away from seriously applying the "America First" doctrine. The April Trump-Xi summit at Mar-a-Lago was hailed as evidence that fears of global protectionism were overblown and that the "globalist" camp of advisers in the White House were prevailing over the nationalists. As we expected, however, the détente did not last long. Over the past several weeks, China and the U.S. have clashed over several key issues: Taiwan: On June 29, the U.S. announced that it will sell $1.42 billion worth of arms to the island nation.5 Secondary sanctions: At the end of June, the Trump administration sanctioned a Chinese shipping company, bank, and two citizens for their ties to North Korea. Human rights: Also at the end of June, the U.S. State Department announced it would list China among the worst human trafficking offenders, which could trigger punitive actions and complicate trade negotiations in the future. Steel tariffs: President Trump asked the Department of Commerce back in April to study whether steel imports were harming national security, under the authority of the Trade Expansion Act of 1962, and a potential decision by Trump on tariffs is due within days. While China only accounts for 2% of U.S. steel imports, new tariffs could set in motion more protectionist measures that target additional industries. Sovereignty claims: The U.S. Navy and Air Force have made sojourns into disputed maritime areas. The navy conducted a "freedom of navigation" operation in the South China Sea in July, with USS Stethem steaming within 12 nautical miles of Triton Island. The air force also conducted separate missions sending B-1 bombers over the South China Sea, and over the Korean peninsula and East China Sea along with Japanese and South Korean F-15 fighter jets. This flurry of brinkmanship has largely emanated from Washington, not Beijing. As Trump's domestic political agenda stalled - with both health care and tax reform now in doubt - the administration has set its sights on the policy realm where the U.S. president has few constraints: foreign and trade policy. That is not to say that Beijing has not invited these actions. It has continued to militarize its artificial islands in the South China Sea and has failed to impose meaningful sanctions on North Korea. The Trump administration is clearly disappointed that its Mar-a-Lago summit failed to produce any tangible effect on these fronts, particularly with North Korea having launched a purported intercontinental ballistic missile for the first time. It is the Trump administration itself, however, that is to be blamed for China's lack of enthusiasm. One of the first acts of the Trump administration was to bring into question Washington's "One China" policy. As we remarked at the time, this would have serious implications for Sino-American policies. Defending sovereignty is a core pillar of the Chinese Communist Party; it is part of its "creation myth," and this is nowhere truer than in regard to Taiwan. When Trump brought into question the "One China" principle, he signaled to Beijing policymakers that Washington is not to be trusted. North Korea is both formally and in practical terms a Chinese ally. Though the Xi administration evidently wishes that the North was not providing the U.S. with excuses to enhance the American position on the Korean Peninsula, nevertheless it is longstanding Chinese policy to avoid destabilizing the North Korean regime. A collapse, possibly followed by a unified Korean Peninsula, could benefit the U.S. in the region. In other words, China will pressure the North enough to encourage a new round of talks but not enough to risk fracturing the regime. Chart 2Mar-A-Lago Summit Is Over What investors are seeing today is the impact of words - "signaling" to be technical - in geopolitics. To be fair to President Trump, he has not pursued a revolutionary foreign policy yet. However, his mere words - literally dithering on NATO's Article V and calling into question the "One China" policy - have pushed other global powers into realignment. The rest of the world takes Trump very seriously because he may one day act on his unorthodox policies, or because American voters may elect someone in the future who will. The likely result is further erosion of U.S. global influence. Notably, the U.S. president stood alone on several crucial global issues at the G20 summit in Germany, making it look more like a "G19" summit. American isolation makes sense from Trump's short-term, domestic-political vantage. In the long term, however, it accelerates the drift toward geopolitical multipolarity and thus encourages global instability. Over the near term, we are particularly concerned that Sino-American tensions could escalate and spill over into a trade war. Since Donald Trump's election, and particularly since the Mar-a-Lago summit, the market has largely priced out economic tensions between the two superpowers, with China-exposed S&P 500 equities outperforming the market (Chart 2). We would bet against the continuation of this trend. Lack of cooperation over North Korea is a sign that the Sino-American relationship is systematically broken. Middle East Update: Watch Power Vacuums In Iraq And Syria At the beginning of this year, we made a forecast that geopolitics in the Middle East would not be investment relevant.6 So far we are correct. However, we continue to worry that vacuums in Iraq and Syria - in the Sunni-dominated territories formerly occupied by the now-collapsing Islamic State - could become greater sources of instability in the region. We are particularly concerned about three potential flash points: North Iraq, North Syria, and East Syria. East Syria In East Syria, the Syrian Arab Army (SAA) loyal to President Bashar al-Assad - as well as its Lebanese Shia ally Hezbollah - has aggressively moved to establish control over the Syrian-Iraqi border. As indicated on Map 1, SAA forces have created a land-bridge through Islamic State territory to Tayyara on the Iraqi border. This has put SAA troops in close proximity to "Free Syrian Army" (FSA) forces operating in the southeast of the country. Map 1Syria's Army Has Created A Land-Bridge To Iraq The FSA was created by the U.S. and its allies. Its forces are trained by the U.S., and the U.S. Air Force provides cover for its territory. The recent downing of Syrian fighter jets and Iranian drones have occurred near the U.S. FSA base, which is based in the proximity of the FSA stronghold at Al Tanf. Without committing land troops, however, the best the U.S. can hope for is to limit SAA incursions into FSA-held territory. The push by SAA and Hezbollah to the Iraqi border creates an all-important land-bridge from Iran to the Mediterranean. It allows Tehran to reinforce Assad's SAA and Hezbollah by land, rather than relying on sea routes - which can be intercepted by the U.S. and Israel's superior naval capabilities in the Mediterranean - or through air. Not only will Iran and Shia-dominated Iraq be able to supply Assad with weapons, but also with troops. After a five-year war of attrition, the main resource that has been depleted on all sides is manpower. A significant influx of "fresh blood" means that the power balance will shift more easily in favor of Assad. Following the collapse of the Islamic State in Mosul, Iraq will be able to deploy significant resources from its Shia militias to Syria. This could be the game changer that ends the conflict in Syria in Assad's favor over the next 12 months. The SAA penetration to Tayyara has now set up the next target: Al Bukamal to the north and also on the Iraqi border. From there, the SAA will be able to round back deep into Islamic State territory and capture Deir ez-Zor. This will give Assad control over most of Syria's border with Iraq as well as the country's highway infrastructure. It will also pin the U.S.-backed FSA to a largely irrelevant corner of Syria. The success of Iranian and Russian-backed SAA in Eastern Syria is very important for the geopolitics of the region. By creating a land-bridge between Iran and the Mediterranean, Syrian forces have now opened up the possibility of one day hosting massive natural gas and oil pipeline infrastructure that would link natural gas from the Persian Gulf, developed jointly by Qatar and Iran, and oil from Iran and Iraq to European markets (Map 2). Map 2The Path Is Opening For Iranian Pipelines Through Syria Such an alternative route to Iranian energy exports would give Tehran an upper hand over Saudi Arabia and its GCC allies. In a hypothetical conflict scenario between Iran and Saudi Arabia, for example, Tehran would be more willing to try to close shipping in the Straits of Hormuz if it possessed an alternative route for energy exports. This is clear to Saudi Arabia, which is why it has lashed out against Qatar in recent weeks. The main Saudi demand of Qatar is that it abandon its pro-Iranian foreign policy. It is becoming clear to Saudi Arabia that Iran's power is set to grow in the wake of the Islamic State's defeat in Iraq and Syria. As such, Saudi Arabia is trying to tie loose ends in its own coalition, starting with Qatar. Despite the reported Trump-Putin ceasefire agreed at the G19, U.S. and Russian forces could still become entangled as their proxies battle in the strategic regions near the Syrian-Iraqi border. SAA troops have also begun to operate near Raqqa, where the Kurdish forces supported by the U.S. are currently encircling the Islamic State capital. Final stages of wars tend to be erratic and even more violent. As belligerents glimpse the end of conflict they rush to seize as much territory as possible before negotiations begin. This is effectively what is happening in East Syria and around Raqqa today. Northern Syria In the Kurdish dominated northern Syria, the People's Protection Units (YPG) have massively increased the territory under their control. Supported by the U.S., YPG have encircled Raqqa and will soon defeat the Islamic State in the North. Assad's SAA will concede Raqqa in order to move onto the more strategic Resafa and Deir ez-Zor, effectively abandoning northern Syria to the Kurds to focus on establishing the land-bridge with Iraq. Turkey, however, is not interested in conceding northern Syria to YPG. The latter are allied to the Kurdistan Workers' Party (PKK) that Ankara considers a terrorist organization. With SAA focused on controlling population centers and the Syrian-Iraqi border, northern Syria will descend further into Kurdish domination. This would give PKK militants a large territory from which to regroup and resupply operations in Turkey. It is therefore a real possibility that Turkey will invade YPG-controlled northern Syria as soon as the operations against the Islamic State end. This will put the U.S. into a difficult position. On one hand, Turkey is a NATO ally. On the other, the Kurds are informal U.S. allies. The YPG have fought valiantly against the Islamic State and are perhaps the group most deserving of thanks for the defeat of its so-called Caliphate. Northern Iraq In northern Iraq, a similar dynamic has emerged where the Kurds have benefited the most from the rise of the Islamic State (Map 3). Operations in Mosul will soon end the Islamic State's dominion over parts of Iraq, which will allow Iraqi forces to focus on two tasks. First, resupplying Assad's SAA with weapons and troops. Second, turning to Kurdish gains in the north, particularly in the city of Kirkuk. Map 3Kurdish Gains Threaten Conflicts With Iraqi Government ... And Turkey Iraqi Kurds, for their part, have called an independence referendum for September 25, 2017. President Masoud Barzani will not necessarily proclaim an independent Kurdistan following the referendum. The exercise could be a bid to negotiate more autonomy with Baghdad or a pre-election ploy to secure a majority in upcoming general elections and bolster the eventual presidential bid of his nephew, Nechirvan Barzani (current Prime Minister of Iraqi Kurdistan). Iraqi Kurds may be able to find some sort of an arrangement with Baghdad for greater autonomy. The problem is that both sides claim parts of the region. Kirkuk, for example, is not officially part of Iraqi Kurdistan. However, Kurds see it as their ancient capital and thus seized it in June 2014 as a preventative move to ensure that it did not fall into the hands of the Islamic State. Not only is Kirkuk a major Iraqi population center, but it is also a significant oil-producing region. Investment Implications Over the next several months, we would expect tensions in these three geographies to increase. Given the proximity of Russian, Iranian, Turkish, and American forces, we would expect the probability of accidents to rise significantly. This could temporarily move the markets and assign some geopolitical risk premium to oil prices. However, investors should realize that the regions involved are not major producers of oil, aside from Iraqi Kurdistan where we do not expect large-scale warfare. As such, any effect on oil production would be a minor blip in the global supply. Over the long term, the clear winner in the region remains Iran. Bashar al-Assad, Iran's ally in Syria, will stay in power. It is also clear that the Sunni Islamic State Caliphate will disappear, giving back the Shia-dominated Iraqi government control over its territory. For Saudi Arabia, this is a reality that cannot be changed at the moment. As we have pointed out before, low oil prices are a constraint to war.7 They reduce government revenue and force leaders to focus on domestic stability. A major conflict between Saudi Arabia and Iran is therefore unlikely. However, Saudi Arabia will respond by building a Sunni alliance against Iran. With Syria and Iraq now in the Iranian sphere, the imperative for Saudi Arabia is to counter Iranian regional hegemony through alliances. Egypt will remain a clear beneficiary of this strategy. The country is already the Middle East's candidate for the "too big to fail" moniker. Its population, economy, demographics, and security challenges all make it the main candidate for chief regional security risk. As such, it will continue to receive support from the international community. For Saudi Arabia, Egypt is a way to diversify its security portfolio away from the aloof United States. As such, we would expect the Saudis to continue to prop up the Egyptian economy with loans and grants in return for being able to call on the Egyptian military in time of need. Given a cyclical recovery in Egypt, which BCA's Frontier Markets Strategy has recently elucidated, this creates a structural buying opportunity in the country's equity market.8 Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Oleg Babanov, Editor/Strategist EM Equity Sector Strategy obabanov@bcaresearch.co.uk 1 The closest the world ever got to a powerful and effective multilateral structure was the nineteenth-century "Concert of Europe," which kept general peace in Europe for a century (1814-1914), but at the cost of dividing up the rest of the planet into imperial spheres of influence where European states could play out their mercantilist rivalries. Ultimately, even that architecture crumbled as the British hegemony that underpinned it weakened after the 1870s. 2 Please see BCA Geopolitical Strategy Weekly Report, "The Trump Doctrine," dated February 1, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Monthly Report, "The Socialism Put," dated May 11, 2016, available at gps.bcaresearch.com. 4 While the U.S. runs a massively negative net international investment position, its net international income remains positive. In other words, foreigners receive almost nothing for holding U.S. assets, while the U.S. benefits from risk premia in foreign markets. 5 The deal is not particularly significant in a military sense, and it is smaller in value than the last deal in December 2015, but it still sends a signal that angers Beijing, which also expects more controversial deals to be forthcoming given the Trump administration's signals that it plans to strengthen the Taiwan alliance. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Saudi Arabia's Choice: Modernity Or Bust?" dated May 11, 2016, available at gps.bcaresearch.com. 8 Please see BCA Frontier Markets Strategy Special Report, "Egypt: A Cyclical Recovery Amid Lingering Structural Challenges," dated June 20, 2017, available at fms.bcaresearch.com.