Policy

Highlights London house prices have dropped 7% since the U.K. Government started the formal process of Brexit seven months ago. Stay underweight U.K. real estate and consumer services versus German real estate and consumer services. The global bond yield mini-cycle is driving asset allocation, sector allocation, value/growth allocation and country allocation. We are more than half way through the current mini-upswing in global bond yields. Look for opportunities to cut back overall portfolio cyclicality towards the end of the year. Feature London house prices have dropped 7% since the U.K. Government started the formal process of Brexit seven months ago (Chart of the Week). The average London home is now worth £584,000,1 down from £628,000. Moreover, our leading indicator for London house prices which compares the number of new viewings (demand) with the number of new listings (supply) suggests no imminent end to the sharpest price decline since the 2008 financial crisis (Chart I-2). Chart I-1Brexit Begins To Bite In London Chart I-2The Sharpest Decline In London House Prices Since 2008... Unsurprisingly, the many uncertainties surrounding the unfolding Brexit process are having a much greater impact on the London housing market than on the U.K. housing market as a whole. Outside London, the housing market is broadly flat-lining (Chart I-3). The average U.K. home outside London is now worth £256,500, modestly down from £260,000. Chart I-3 ...But Outside London, Prices Are Flat-Lining U.K. Households Squeezed We are writing ahead of the Bank of England monetary policy meeting, at which the BoE may deliver its first interest rate hike since July 2007. But hike or no hike, we can confidently say one thing: U.K. households will be squeezed. If the BoE does hike the base rate in an attempt to counter overshooting inflation, it could tip the precariously flat-lining housing market outside London into a downturn - as this market is much more exposed to mortgage affordability than it is to Brexit uncertainties. Alternatively, if the BoE does not hike the base rate, the boost to sterling from recent hawkish rhetoric will be priced out, and the pound will come under renewed downward pressure. This would keep U.K. inflation elevated, and further choke U.K. households' real incomes. Absent the post Brexit vote slump in the pound, U.K. inflation would be substantially lower than it is (Chart I-4 and Chart I-5). So the pound's weakness explains why the U.K. is one of the few major economies where inflation is running well north of 2%. Unfortunately for U.K. households, nominal wage inflation has not followed price inflation higher. And as we explained in Why Robots Will Kill Middle Incomes,2 nor is it likely to in the near future. Chart I-4The Weaker Pound Lifted U.K. Headline Inflation... Chart I-5...And U.K. Core Inflation But doesn't textbook economic theory say that the pound's weakness should make U.K. exports more competitive - thereby boosting the net export contribution to economic growth? Yes, the theory does say that a currency devaluation should allow firms to trade in markets that were previously unprofitable to them. However, to trade in these newly profitable markets, firms first need to invest - for example, in marketing and distribution. The trouble is that, post-Brexit, many of the newly profitable markets may be unavailable, or come with heavy tariffs. So firms will hold off making the necessary investments, unless the currency devaluation is massive. But in this case, the corresponding surge in inflation and choke on households' real incomes would also be massive. In summary, U.K. consumer spending faces a continued squeeze. If the BoE delivers a rate hike, household borrowing is likely to fade as a driver of spending. But if the BoE does not deliver the rate hike, the pound will once again weaken, keeping inflation elevated and weighing on real incomes. Stay underweight U.K. consumer services versus German consumer services (Chart I-6). And stay underweight U.K. real estate versus German real estate - expressed either through direct real estate exposure or through real estate equities (Chart I-7). Chart I-6U.K. Consumer Services Equities Are Underperforming Chart I-7U.K. Real Estate Equities Are Underperforming Investment Reductionism Illustrated Turning to markets more generally, it is crucial to understand that most of the moves in most financial markets reduce to a very small number of over-arching macro drivers. We call this very important principle Investment Reductionism. Investment Reductionism emerges from two guiding philosophies: Occam's Razor - which says that when there are competing explanations for the same effect, the simplest explanation is usually the best; and the Pareto Principle (the 80:20 rule) - which says that a small minority of causes usually explain a large majority of effects. The upshot of Investment Reductionism is that the seeming complexity of asset allocation, sector selection, the choice between value or growth, and country allocation usually reduces to something much simpler. Let's illustrate this. The global 6-month credit impulse leads the cyclical direction of the global bond yield, and thereby determines asset allocation (Chart I-8). The direction of the global bond yield drives sector selection: for example Banks versus Healthcare. This is because higher bond yields imply higher net interest margins for banks as well as an improving growth outlook, favouring cyclicals over defensives. And vice-versa (Chart I-9). Chart I-8Investment Reductionism Step 1: ##br##The Global Credit Impulse Leads The Bond Yield Cycle Chart I-9Step 2: The Bond Yield Drives ##br##Sector Performance Banks versus Healthcare determines the European Value versus Growth decision. This is because in Europe, Banks and Healthcare are the dominant value sector and growth sector respectively (Chart I-10). Banks versus Healthcare also determines the country allocation between, say, Italy's MIB - which is bank heavy - and Denmark's OMX - which is healthcare heavy (Chart I-11). Chart I-10Step 3: Sector Performance Drives Value ##br##Vs. Growth Chart I-11Step 4: Sector Performance Drives ##br##Country Performance Therefore, the important lesson from Investment Reductionism is to ignore the hundreds of things that matter little, and to focus on the very small number of things that matter a lot. And one of the things that matters a lot is the global bond yield mini-cycle. Where Are We In The Bond Yield Mini-Cycle? Empirically, the acceleration and deceleration of global bank credit flows - as measured in the global credit impulse - exhibits a remarkably regular wave like pattern, with each half-cycle lasting about 8 months (Chart I-12). The global bond yield shows a similarly regular wave like pattern with each half-cycle also averaging about 8 months (Chart I-13). Chart I-12The Global Credit Impulse Has Also Shown A Regular Wave Like Pattern Chart I-13The Global Bond Yield Has Shown A Regular Wave Like Pattern It is not a coincidence that the bank credit impulse and bond yield exhibit near identical half-cycle lengths. The global credit impulse and global bond yield are inextricably embraced in a perpetual mini-cycle. A stronger credit impulse boosts economic growth. In response to the stronger economic data, the bond yield rises, which slows credit growth. A weaker credit impulse weighs down economic growth. In response to the weaker economic data, the bond yield declines, which re-accelerates credit growth. Go back to step 1 and repeat ad perpetuam. At this moment, from an investment perspective, there are three points worth making: first, bond yield mini-upswings tend to occur mostly within the credit impulse upswing; second, credit impulse mini-upswings have a consistent duration lasting about 8 months; and third, the current mini-upswing started in May. What does this mean for investment strategy? It means that we are more than half-way through the current mini-upswing which we would expect to end around January/February. And at some point early next year we are likely to enter a mini-downswing. So it is slightly premature to cut back cyclical exposure right now. But we would certainly consider opportunities as we move to the end of the year - especially if our now tried and tested fractal timing indicators signal that the price action in specific investments has reached a technical tipping point. Stay tuned. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Source: LSL Acadata 2 Please see the European Investment Strategy Special Report "Why Robots Will Kill Middle Incomes", dated August 10 2017 available at eis.bcaresearch.com. Fractal Trading Model* This week, our model suggests that the New Zealand dollar is oversold and ripe for a technical rebound. The recommended trade is long NZD/USD with a profit target/stop loss set at 3%. In other trades, long Canada 10-year bond/short German 10-year bund achieved its profit target while short Norway/long Switzerland hit its stop loss. This leaves five open trades. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-14 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com. Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

Special Report

Dear Client, The attached report on China’s just-completed nineteenth National Party Congress marks the culmination of six years of political analysis by BCA’s Geopolitical Strategy. In it, my colleague Matt Gertken posits that President Xi Jinping’s domestic political constraints have significantly eased, allowing his administration to intensify its preference for structural reform. Our cardinal analytical rule holds that policymaker preferences are optional and subject to constraints, whereas constraints are neither optional nor subject to preferences. As a matter of methodology, we focus on constraints. In China, Xi faced formidable constraints when he took power five years ago, which is why we pushed against the enthusiastic narrative at the time that he would transform China through supply-side reforms. This narrative, strongest in the wake of the October 2013 Third Plenum, has not materialized in line with investor expectations thus far. In this report, we argue that it is time to adjust the view on China. Xi has amassed substantial political capital thanks to his anti-corruption campaign, centralization of power, and other actions largely popular with the middle class. Investors are today missing this point because they are disappointed with the lack of genuine progress since 2012. We expect that President Xi will begin spending this political capital by favoring supply-side reforms, especially by reining in the rampant credit growth that has underpinned China’s investment-led economic model. In the short term, this means that politics in China will evolve from a tailwind to a headwind to growth. In the long term, it is too soon to say what it means. For investors, however, it means that today’s synchronized global growth recovery may be at risk of a policy-induced growth slowdown in China. I sincerely hope you enjoy our report. If you are interested in similar investment-relevant geopolitical analysis, please do not hesitate to contact us for a sample of our work. Kindest Regards, Marko Papic, Senior Vice President Chief Geopolitical Strategist Highlights Xi Jinping has shed domestic political constraints that have been in place since 2012; The lack of constraints suggests his reform agenda will intensify over the next 12 months; The use of anti-corruption agencies to enforce economic policy suggests that reform implementation will become more effective; Chinese politics are shifting from a tailwind to a headwind for global growth and EM assets. Feature Chart 1Stability Continues After Party Congress? China's nineteenth National Party Congress concluded on October 25 with the new top seven leaders - the members of the Politburo Standing Committee (PSC) - taking the stage in the Great Hall of the People. The party congress is a five-year leadership reshuffle that, in this case, marks the halfway point of President Xi Jinping's term in office.1 President Xi was the center of attention throughout the event. It is widely perceived that he is the most powerful Chinese leader since Deng Xiaoping. The Communist Party chose to elevate his personal power in conspicuous ways that raises political uncertainties about the succession in 2022 as well as about the future trajectory of Chinese policy, including economic policy. BCA's Geopolitical Strategy has awaited this transition since 2012, when President Xi and Premier Li Keqiang took over the top two positions in China.2 While we are inherently skeptical of Xi's grandiose reform agenda, we are also deeply aware of the importance of political constraints in determining economic policy outcomes - and Xi has just overcome significant domestic constraints. If Xi accelerates and intensifies his reforms next year - particularly deleveraging and industrial restructuring - he will add volatility to Chinese risk assets and create a drag on Chinese growth. Xi's personal concentration of power could be an enabling factor in driving reforms. But it will certainly be a source of higher political uncertainty over the next five years (Chart 1), especially as the 2022 succession approaches. Therefore a lack of reform would be a noxious combination. Finally, China's ascendancy increases the phenomenon of global multipolarity - it is a challenge to the U.S.-led system and will eventually produce a reaction, most likely a negative one.3 In short, Chinese political and geopolitical risk is understated. This situation presents a range of risks and opportunities for investors, but it is broadly a headwind for global growth and EM assets. A Chinese "policy mistake" is also a risk to our House View of being overweight equities and underweight bonds for the next 12 months. Back To 2012 When Xi rose to power in 2012, it was widely known that China's economy had reached a pivotal moment. Exports were declining as a share of GDP in the wake of the Great Recession and end of the U.S. "debt super-cycle," and investment was weakening as the country's massive fiscal and credit stimulus wore off (Chart 2). Meanwhile the Communist Party faced a crisis of legitimacy, with an emergent middle class making ever greater demands on the system (Chart 3). The rapid rise in household income over preceding years, combined with high income inequality and poor quality of life, raised the prospect of serious socio-political challenges to single-party rule.4 President Hu Jintao searched for ways to strengthen state control over an increasingly restless society, while outgoing Premier Wen Jiabao warned openly that China's economy was unsustainable and imbalanced and that political reform would be an "urgent task." Hu Jintao's farewell address at the eighteenth party congress (2012) reflected the party's grave concerns. His successor, Xi Jinping, was in charge of drafting the report. This relationship highlighted an important degree of party consensus. The report called for fighting corruption and disciplining the party, while doing more to protect households from the negative externalities of the past decade's rapid growth, including pollution (Chart 4). Chart 2Xi Took Power Amid Economic Transition Chart 3The Communist Party's Newest Constraint Chart 4Xi Took Power Amid Instability Risks It also outlined China's hopes of becoming a more consequential global player through acquiring naval power and forging a new, peer relationship with the United States. The overriding imperative was to win back support and legitimacy for the party, lest it fall victim to the fate of the world's other Marxist-Leninist regimes - i.e. internal socio-economic sclerosis and external pressure from the U.S.-led, democratic-capitalist world order. Xi Jinping took over at this juncture, using the 2012 work report as his guideline for an ambitious policy agenda. Xi's main goals centered on power: namely, ensuring regime survival at home and increasing China's international clout abroad. Specifically, the Xi administration sought to (1) centralize political control so that difficult choices could be made and implemented effectively; (2) improve governance so that public discontent could be mitigated over the long run; and (3) restructure the economy so that productivity growth could remain robust in the face of sharply declining labor force growth, thus stabilizing the potential GDP growth rate.5 Obviously there was no guarantee that Xi would be successful. China's response to the Global Financial Crisis had required a large-scale decentralization of control: local governments, banks, state-owned enterprises and shadow lenders were encouraged to lever up and grow amid the global collapse (Chart 5). This created imbalances and liabilities for the central leadership while also creating new economic (and hence political) centers of power outside Beijing. Chart 5aLocal Government Spending Unleashed... Chart 5b...And Shadow Lending Too The central leadership also seemed to be losing control of the provinces: regional and institutional powerbrokers had emerged, challenging the party's hierarchy, and there was even reason to believe that the armed forces were deviating from central leadership.6 Without control of the local governments and other key institutions, any reform agenda would get bogged down. Finally, the political cycle was not particularly favorable to Xi. While the line-up of the all-powerful PSC looked favorable from 2012-17, the next crop of Communist leaders set to move up the ladder in 2017 seemed likely to constrain him. Moreover, the previous two presidents had chosen Xi's successors for 2022, according to party norms. Xi had very little room for maneuver - and this was negative for his policy outlook overall. As such, BCA's Geopolitical Strategy poured cold water on the more enthusiastic forecasts of economic reforms throughout Xi's first term. Our assessment was that he would focus on anti-corruption and governance reforms first and only attempt genuine economic reforms once his political capital grew significantly. Bottom Line: Xi Jinping faced major obstacles to his policy agenda of centralization, governance and economic reform in 2012. He faced a large and restless middle class, the difficulty of reining in local governments and state institutions, and the likelihood that China's previous top leaders would constrain his maneuverability in 2017 and 2022. Xi's First Term A lot has changed over the past five years. First, both global demand for Chinese goods and Chinese domestic demand have held up rather well, giving China a badly needed cushion during its economic transition. Steady consumption growth has partially offset the blow from declining investment, while Chinese exports have grown well, often faster than global trade (Chart 6).7 Second, Xi has consolidated power extensively within the party, the army, and other institutions. He executed the most aggressive purge that the party has seen in decades, enabling him to rebuild some public trust among a middle class worn out by corruption, as well as to remove political rivals (Chart 7). He also launched an extensive restructuring of the People's Liberation Army, its organizational structure and personnel, ensuring that "the party controls the gun."8 And he intensified social control, particularly in the online realm. Chart 6Changing The Economic Model Chart 7Anti-Corruption Campaign Still Going Symbolically, Xi was anointed the "core" of the Communist Party by the political elite in late 2016. Economic reform, however, has been compromised by Xi's focus on consolidating political power. True, he and Premier Li Keqiang tinkered with various policies to cut red tape, simplify domestic taxes, attract foreign investment, and encourage better SOE management, but none of the reforms launched over the past five years were painful and thus none were significant.9 Nowhere was this more apparent than during 2015-16, when economic and financial instability caused the Xi administration to delay reform initiatives and focus on reforming the economy. Beijing increased infrastructure spending, bailed out the local governments, depreciated the RMB, and imposed capital controls (Chart 8). "Old China," state-owned China, was the primary beneficiary. The stimulus-fueled rebound helped stabilize the global economy in 2016-17, particularly commodity-producing emerging markets, but it exacerbated China's internal problems - slow productivity growth, excessive debt creation, weak private sector investment, and waning foreign investment (Chart 9). Chart 8State Interventions In 2015-16 Chart 9Economic Reforms Still Needed The upside, however, was stability, which enabled Xi to approach the nineteenth National Party Congress from a position of strength. Now that the party congress has concluded, we can say that Xi has notched a series of significant "victories" and that his political capital is overflowing: Xi Jinping Thought: The congress voted to enshrine Xi's name into its constitution (Table 1), with a phrasing that echoes "Mao Zedong Thought," hence elevating Xi to immense moral authority within the party. The name of Xi's philosophy, "Socialism with Chinese Characteristics for a New Era," makes a slight adjustment to Deng Xiaoping's market-friendly philosophy. In other words, Xi's authority stems from his providing a synthesis of the regime's greatest two leaders: Mao's single-party Communist rule is being reaffirmed, but Deng's attention to economic reality and the need for pragmatic policies has also been preserved. As we have argued, this constitutional change is a reflection of the fact that Xi has already positioned himself to be the most influential leader well into the 2020s. Table 1Xi Jinping Thought Xi removes his successors: Xi managed to exclude any of China's "sixth generation" of leaders from the Politburo Standing Committee. He thus broke a very important (albeit informal) party norm. The norm was created under Deng Xiaoping to ensure a smooth transition of power, unlike the power struggle that occurred upon Mao's death. Now Xi will have a greater hand in choosing his successor, or even staying in power beyond 2022. This aids in the process of centralization, but it may well prove a step backwards in terms of governance and reform - that remains to be seen. It is a source of higher political uncertainty going forward. Xi dominates the Politburo: Xi prevented his predecessor Hu Jintao's loyalists from gaining a majority on the Politburo Standing Committee, as they seemed lined up to do in 2012. The line-up of the new Politburo and Politburo Standing Committee broadly indicates that Xi and his faction are the dominant force (Table 2). Taken with Xi's personal power, this is significant political capital with which the new administration can push its priorities, whatever they may be. Xi gets a new inquisitor: The Central Commission for Discipline Inspection (CDIC) is the party's internal watchdog. It has taken the leading role in the sweeping party purge and anti-corruption campaign over the past five years. Xi removed its chief, the hugely influential Wang Qishan, by reinforcing the retirement age and two-term PSC limit - a notable case of institutional norms being upheld. He put one of his loyalists, Zhao Leji, in this role instead. The CDIC will have a huge role over the next five years, and a market-relevant one, as we discuss below. Table 2The Magnificent Seven: China's New Politburo Standing Committee The above conclusions raise the possibility that Xi has become excessively powerful, that political institutions in China are being eroded by personal rule, and that political risks are set to explode upward in the near future. However, it is too soon to declare that Xi has staged a Maoist "power grab." There are reasons to think that Xi's accumulation of power has not overturned the delicate internal balances within the top leadership bodies.10 The result is in keeping with what we expected in our Strategic Outlook last December: Xi Jinping has amassed formidable political capital, but he has not destabilized the Chinese political system.11 He is a strongman leader within the established political system of an authoritarian state - he is not a tyrant seizing power in a bloodless revolution. (At least, not yet.) This is broadly positive for China's policy continuity and political framework - and in this sense it is also broadly market-positive, being an outgrowth of the status quo rather than a disruptive break from it. China's leaders continue to be career politicians, trained in law or economics, with considerable executive experience in governing and limited business or military experience, all unified in the name of regime preservation (Chart 10). Over the long run, this suggests that China's "Socialist Put" remains intact, i.e. that the state will intervene to prevent a crash landing.12 Nevertheless, an important corollary of the above is that Xi holds the balance, and hence there are no longer any major domestic political or governmental constraints to prevent him from pursuing his policy agenda - especially over the next 12 months, when his political capital is still fresh and the economic backdrop is favorable. The fact that Xi emphasized "sustainable and sound" growth, deliberately excluded GDP growth targets beyond 2021, and altered the definition of the Communist Party's so-called "principal contradiction" in order to prioritize quality-of-life improvements, suggests that the reform agenda is about to get rebooted. Bottom Line: Xi Jinping has consolidated power extensively, but he has not staged a silent coup d' état or overthrown the balance of power within the Communist Party. This suggests that Xi's policies and reforms will intensify over the next year. Chart 10Characteristics Of Chinese Rulers Mostly Unchanged Since 2012 Xi's Second Term: What To Expect Instead of playing it safe in the lead-up to the all-important party congress over the past twelve months, Xi surprised the markets with a series of regulatory actions designed to tamp down the property bubble, regulate the financial markets, punish speculation, and reduce industrial overcapacity and pollution (Chart 11).13 This tightening of policy strongly signaled that Xi's appetite for political risk is rising in keeping with his growing political capital. Beijing is signaling that it aims to continue with tougher financial, industrial and environmental reforms in the aftermath of the party congress. In particular, systemic financial risk has been identified as a risk to the state's overall stability. Of course, China is unlikely to sharply reduce the ratio of total debt-to-GDP out of an ill-advised, self-imposed bout of austerity. But the Xi administration is likely to suppress its growth rate (Chart 12), as well as to continue cracking down on specific institutions and financial practices deemed to be excessively risky or under-regulated, as has occurred this year in insurance and shadow lending.14 Chart 11China's Borrowing Costs Rising Chart 12Debt Growth Faces Tougher Controls This financial focus is clear from top-level appointments and meetings in 2017, including a special Politburo meeting on financial risks in April and the once-in-five-years Central Financial Work Conference in July.15 The latter declared new regulatory powers for the central bank that will be put into place in the coming 12 months. The head of the new Financial Stability and Development Committee to oversee this work will likely be named, along with a replacement for the long-serving People's Bank of China Governor Zhou Xiaochuan. This change will initiate a new generation of leadership in the central bank, and one ostensibly directed at overseeing stricter macro-prudential controls.16 Another outcome of the financial conference was the warning that, going forward, local government officials will be held accountable over the course of their entire lives if they allow excessive financial risks and debt to build up under their watch.17 These developments suggest that policy will become a headwind to growth next year. We would expect downside risks to China's implicit 6.5% growth target. Why should the new deleveraging campaign have any more effect than similar efforts in the past? Aside from Xi's stronger position to enforce policies - explained above - the nineteenth party congress reinforced an important trend in policy implementation. The Xi administration has been using the CDIC, the party's anti-corruption unit, as a political tool to ensure broader policy enforcement. We have observed this trend over the past year both in the financial regulatory crackdown and the anti-pollution and overcapacity crackdown.18 Anti-corruption officials can compel more serious implementation from local governments, SOE managers, and others because they threaten to impose job losses or jail time, rather than mere fines. The CDIC appointed two new officials to oversee its operations in China's financial regulators just as the party congress was getting underway. Moreover, on the final day of the party congress, officials have announced that corruption investigations will be conducted into the commercial housing sector.19 The message is that the regulatory storm will expand - and will have teeth. Xi went a step further at the party congress by declaring the creation of a National Supervisory Commission, which will oversee the next phase of the anti-corruption campaign.20 This commission will expand the campaign outside the ranks of the Communist Party - where it has operated so far - to the government as a whole, i.e. the state administration and bureaucracy. It implies that every official from China's top ministries down to its lowest-level governments will be subjected to new forces of scrutiny. If this effort resembles the CDIC's role in hastening compliance in other areas of economic policy, then it will be a powerful tool for the Xi administration as it attempts to engineer a top-down restructuring of China's governance and economy. An aggressive new regulatory push, with the threat of corruption charges, in China's financial and industrial sectors would create a powerful drag on economic growth. It could easily send a chill down the spines of government officials, prompting them to cut or delay key investment decisions, as the initial anti-corruption campaign did in 2013-14.21 China's leaders will eventually attempt to offset any disorderly slowdown from reform measures with additional stimulus. However, given that the deleveraging campaign cuts to the heart of the financial sector, and that sharp new tools are being put to use, we would think that the probability of a "policy mistake" is going up. Bottom Line: Risks to Chinese economy and assets are rising as politics shifts from being a tailwind to a headwind. Xi Jinping faces few policy constraints and has shown appetite for greater political risk in the pursuit of his reform agenda. His administration has signaled that China's financial imbalances pose a threat to overall stability and require tougher regulation. New enforcement mechanisms - particularly those connected with anti-corruption efforts - threaten to bring the financial sector, as well as local government debt, under the spotlight and to create a chilling-effect among local officials. Investment Conclusions On one hand, any genuine attempt to hasten the transition of China's economy to consumer-led growth, de-emphasize GDP growth targets, and pare back overbuilt and heavy-polluting industry is highly consequential and will redistribute global growth.22 Table 3Post-Party Congress Scenarios And Probabilities Broadly speaking, the transition is negative for Chinese growth in the short term, but positive in the long term, as productivity trends would improve. It is negative for China's heavy industry, yet positive for technology, health and education; negative for commodities tied to the old economy (e.g. coal, iron ore, and diesel), but positive for commodities tied to consumers (oil/gasoline, aluminum, nickel, and zinc); negative for emerging markets that are commodity- and export-reliant and China-exposed, yet positive for domestic-oriented and/or China-insulated EMs. On the other hand, there is no longer a convincing excuse for poor implementation of central government policies. If China does not take concrete steps in pursuit of Xi's reform agenda - an agenda of "supply-side reform" that is now enshrined in the party's constitution - then it follows that Xi himself is unwilling to practice what he preaches. The first big test will be whether, when the economy starts to wobble, policymakers stimulate the "old economy" with the usual fervor, or whether they hold true to a course of re-ordering the economy and concentrating any stimulative credit flows more heavily into the social safety net and consumer-led industries and services. Given Xi's and China's rare opportunity, a failure to undertake difficult reforms in the coming months and years would be a clear sign that China will never pursue significant reforms of its own accord. It would have to be forced to do so by an internal or external crisis. This would mean that China's potential GDP would continue to decline for the foreseeable future (Table 3). Chart 13China's Ascendancy Challenges The U.S. If that were the case, declining potential GDP growth would combine with political uncertainty over Xi's 2022 succession to create a noxious brew of social malaise. A final and very important consideration is China's relationship with the United States and its allies, given the ongoing strains over U.S.-China trade, North Korea's nuclear and missile advances, China's militarization of the South China Sea, Taiwan's widening ideological distance from the mainland, and Japan's accelerating re-armament. The party congress was a highly visible display of Chinese power and self-confidence, in which Xi broke with the past to suggest that China is moving into "center stage" in the world. Xi not only reaffirmed state-led growth but also emphasized that China's foreign policy assertiveness is here to stay over the long run. This is a poignant reminder of our long-term investment theme of global multipolarity. The United States is not likely to relinquish global or even regional leadership easily. So while relations may be pacified in the short term, the risk of conflict, whether economic or military, is rising over time (Chart 13). Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "China's Nineteenth Party Congress: A Primer," dated September 13, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy, "China: Two Factions, One Party," dated September 2012, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 4 Popular unrest was boiling up due to grievances over corrupt officials, mismanagement of internal migration, local government land seizures, a weak justice system, and a host of labor disputes and environmental incidents. 5 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. See also BCA Geopolitical Strategy Monthly Report, "Reflections On China's Reforms," in "The Great Risk Rotation - December 2013," dated December 11, 2013. 6 The arrest and excommunication of Chongqing Party Secretary Bo Xilai in 2012 epitomizes the regional and institutional challenge, since Bo had a network of alliances that fell under Xi Jinping's anti-corruption dragnet and sprawled across the energy sector and public security agencies. The regional problem was highlighted again this year when one of Bo's successors, Chongqing Party Secretary Sun Zhengcai, was ousted for allegedly failing to extirpate Bo's influence. Meanwhile, the People's Liberation Army became more vocal and independent in ways that raised concerns among foreign observers, such as U.S. Defense Secretary Robert Gates, who suggested that the PLA took China's civilian leadership by surprise when it conducted a test flight of its stealth J-20 fifth generation fighter during Gates's visit to Beijing in January 2011. 7 Please see BCA China Investment Strategy Weekly Report, "China's Economy - 2015 Vs Today (Part I): Trade," dated October 26, 2017, available at cis.bcaresearch.com. 8 For the military reshuffle, please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at gps.bcaresearch.com. 9 The most important reform was the loosening of the one-child policy, which was a social change with long-term economic benefits. Reforms to household registration, land rights, the property sector, SOEs, fiscal policy, private property, and the judicial system have moved slowly. 10 The PSC has a three-way balance of sorts, with two representatives of each faction (Jiang Zemin, Hu Jintao, and Xi Jinping), plus Xi presiding over all. Please see Cheng Li, "The Paradoxical Outcome Of China's 19th Party Congress," Brookings Institution, October 26, 2017. Our own analysis of the 2017 result, drawing on Cheng Li's work, shows that the party bureaucracy, state bureaucracy and the military are represented at roughly the same levels as before on the 25-member Politburo. Further, the profile of the PSC members is relatively continuous with the previous PSC profiles. Namely, the relatively high share of leaders who have spent their careers ruling the provinces, or who have mostly worked in central government, is no higher than it was before, while the relatively low share of leaders who served on the military or managed state-owned enterprises is no lower than it was before. The division between rural and urban regions on the PSC is also the same as before. Thus, the only substantial change in the character profile of the PSC is the fact that China's leaders are increasingly coming from an educational background in the "soft sciences" rather than the "hard sciences": which is to be expected as the society evolves from manufacturing and construction to a services-oriented economy, even though it also suggests growing ideological orthodoxy. 11 Please see BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Monthly Report, "The Socialism Put," dated May 11, 2016, available at gps.bcaresearch.com. 13 Please see BCA China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010," dated October 13, 2016, available at cis.bcaresearch.com. 14 Please see BCA China Investment Strategy Weekly Report, "China: Financial Crackdown And Market Implications," dated May 18, 2017, available at cis.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. 16 Please see "China: A Preemptive Dodd-Frank," in BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017, available at gps.bcaresearch.com. 18 Please see note 15 above. See also Barry Naughton, “The General Secretary’s Extended Reach: Xi Jinping Combines Economics And Politics,” dated September 11, 2017, available at www.hoover.org. 19 Please see "China To Launch Nationwide Inspection On Commercial Housing Sales," Xinhua, October 25, 2017, available at www.chinadaily.com. 20 Supervisory commissions will be created at every level of administration in all regions to ensure that the anti-corruption campaign is enforced across all government, not only within the Communist Party. The commissions will be based on experiences gained from trial programs in Beijing, Zhejiang, and Shanxi. Please see Viola Zhou, "Super anti-graft agency pilot schemes extended across China," South China Morning Post, October 30, 2017, available at www.scmp.com. 21 Please see note 5 above, "Taking Stock," and BCA China Investment Strategy, "Policy Mistakes And Silver Linings," dated October 7, 2015, available at cis.bcaresearch.com. 22 Please see note 5 above, "Taking Stock," and BCA China Investment Strategy, "Understanding China's Master Plan," dated November 20, 2013, available at cis.bcaresearch.com.

Special Report

Highlights Xi Jinping has shed domestic political constraints that have been in place since 2012; The lack of constraints suggests his reform agenda will intensify over the next 12 months; The use of anti-corruption agencies to enforce economic policy suggests that reform implementation will become more effective; Chinese politics are shifting from a tailwind to a headwind for global growth and EM assets. Feature Chart 1Stability Continues After Party Congress? China's nineteenth National Party Congress concluded on October 25 with the new top seven leaders - the members of the Politburo Standing Committee (PSC) - taking the stage in the Great Hall of the People. The party congress is a five-year leadership reshuffle that, in this case, marks the halfway point of President Xi Jinping's term in office.1 President Xi was the center of attention throughout the event. It is widely perceived that he is the most powerful Chinese leader since Deng Xiaoping. The Communist Party chose to elevate his personal power in conspicuous ways that raises political uncertainties about the succession in 2022 as well as about the future trajectory of Chinese policy, including economic policy. BCA's Geopolitical Strategy has awaited this transition since 2012, when President Xi and Premier Li Keqiang took over the top two positions in China.2 While we are inherently skeptical of Xi's grandiose reform agenda, we are also deeply aware of the importance of political constraints in determining economic policy outcomes - and Xi has just overcome significant domestic constraints. If Xi accelerates and intensifies his reforms next year - particularly deleveraging and industrial restructuring - he will add volatility to Chinese risk assets and create a drag on Chinese growth. Xi's personal concentration of power could be an enabling factor in driving reforms. But it will certainly be a source of higher political uncertainty over the next five years (Chart 1), especially as the 2022 succession approaches. Therefore a lack of reform would be a noxious combination. Finally, China's ascendancy increases the phenomenon of global multipolarity - it is a challenge to the U.S.-led system and will eventually produce a reaction, most likely a negative one.3 In short, Chinese political and geopolitical risk is understated. This situation presents a range of risks and opportunities for investors, but it is broadly a headwind for global growth and EM assets. A Chinese "policy mistake" is also a risk to our House View of being overweight equities and underweight bonds for the next 12 months. Back To 2012 When Xi rose to power in 2012, it was widely known that China's economy had reached a pivotal moment. Exports were declining as a share of GDP in the wake of the Great Recession and end of the U.S. "debt super-cycle," and investment was weakening as the country's massive fiscal and credit stimulus wore off (Chart 2). Meanwhile the Communist Party faced a crisis of legitimacy, with an emergent middle class making ever greater demands on the system (Chart 3). The rapid rise in household income over preceding years, combined with high income inequality and poor quality of life, raised the prospect of serious socio-political challenges to single-party rule.4 President Hu Jintao searched for ways to strengthen state control over an increasingly restless society, while outgoing Premier Wen Jiabao warned openly that China's economy was unsustainable and imbalanced and that political reform would be an "urgent task." Hu Jintao's farewell address at the eighteenth party congress (2012) reflected the party's grave concerns. His successor, Xi Jinping, was in charge of drafting the report. This relationship highlighted an important degree of party consensus. The report called for fighting corruption and disciplining the party, while doing more to protect households from the negative externalities of the past decade's rapid growth, including pollution (Chart 4). Chart 2Xi Took Power Amid Economic Transition Chart 3The Communist Party's Newest Constraint Chart 4Xi Took Power Amid Instability Risks It also outlined China's hopes of becoming a more consequential global player through acquiring naval power and forging a new, peer relationship with the United States. The overriding imperative was to win back support and legitimacy for the party, lest it fall victim to the fate of the world's other Marxist-Leninist regimes - i.e. internal socio-economic sclerosis and external pressure from the U.S.-led, democratic-capitalist world order. Xi Jinping took over at this juncture, using the 2012 work report as his guideline for an ambitious policy agenda. Xi's main goals centered on power: namely, ensuring regime survival at home and increasing China's international clout abroad. Specifically, the Xi administration sought to (1) centralize political control so that difficult choices could be made and implemented effectively; (2) improve governance so that public discontent could be mitigated over the long run; and (3) restructure the economy so that productivity growth could remain robust in the face of sharply declining labor force growth, thus stabilizing the potential GDP growth rate.5 Obviously there was no guarantee that Xi would be successful. China's response to the Global Financial Crisis had required a large-scale decentralization of control: local governments, banks, state-owned enterprises and shadow lenders were encouraged to lever up and grow amid the global collapse (Chart 5). This created imbalances and liabilities for the central leadership while also creating new economic (and hence political) centers of power outside Beijing. Chart 5aLocal Government Spending Unleashed... Chart 5b...And Shadow Lending Too The central leadership also seemed to be losing control of the provinces: regional and institutional powerbrokers had emerged, challenging the party's hierarchy, and there was even reason to believe that the armed forces were deviating from central leadership.6 Without control of the local governments and other key institutions, any reform agenda would get bogged down. Finally, the political cycle was not particularly favorable to Xi. While the line-up of the all-powerful PSC looked favorable from 2012-17, the next crop of Communist leaders set to move up the ladder in 2017 seemed likely to constrain him. Moreover, the previous two presidents had chosen Xi's successors for 2022, according to party norms. Xi had very little room for maneuver - and this was negative for his policy outlook overall. As such, BCA's Geopolitical Strategy poured cold water on the more enthusiastic forecasts of economic reforms throughout Xi's first term. Our assessment was that he would focus on anti-corruption and governance reforms first and only attempt genuine economic reforms once his political capital grew significantly. Bottom Line: Xi Jinping faced major obstacles to his policy agenda of centralization, governance and economic reform in 2012. He faced a large and restless middle class, the difficulty of reining in local governments and state institutions, and the likelihood that China's previous top leaders would constrain his maneuverability in 2017 and 2022. Xi's First Term A lot has changed over the past five years. First, both global demand for Chinese goods and Chinese domestic demand have held up rather well, giving China a badly needed cushion during its economic transition. Steady consumption growth has partially offset the blow from declining investment, while Chinese exports have grown well, often faster than global trade (Chart 6).7 Second, Xi has consolidated power extensively within the party, the army, and other institutions. He executed the most aggressive purge that the party has seen in decades, enabling him to rebuild some public trust among a middle class worn out by corruption, as well as to remove political rivals (Chart 7). He also launched an extensive restructuring of the People's Liberation Army, its organizational structure and personnel, ensuring that "the party controls the gun."8 And he intensified social control, particularly in the online realm. Chart 6Changing The Economic Model Chart 7Anti-Corruption Campaign Still Going Symbolically, Xi was anointed the "core" of the Communist Party by the political elite in late 2016. Economic reform, however, has been compromised by Xi's focus on consolidating political power. True, he and Premier Li Keqiang tinkered with various policies to cut red tape, simplify domestic taxes, attract foreign investment, and encourage better SOE management, but none of the reforms launched over the past five years were painful and thus none were significant.9 Nowhere was this more apparent than during 2015-16, when economic and financial instability caused the Xi administration to delay reform initiatives and focus on reforming the economy. Beijing increased infrastructure spending, bailed out the local governments, depreciated the RMB, and imposed capital controls (Chart 8). "Old China," state-owned China, was the primary beneficiary. The stimulus-fueled rebound helped stabilize the global economy in 2016-17, particularly commodity-producing emerging markets, but it exacerbated China's internal problems - slow productivity growth, excessive debt creation, weak private sector investment, and waning foreign investment (Chart 9). Chart 8State Interventions In 2015-16 Chart 9Economic Reforms Still Needed The upside, however, was stability, which enabled Xi to approach the nineteenth National Party Congress from a position of strength. Now that the party congress has concluded, we can say that Xi has notched a series of significant "victories" and that his political capital is overflowing: Xi Jinping Thought: The congress voted to enshrine Xi's name into its constitution (Table 1), with a phrasing that echoes "Mao Zedong Thought," hence elevating Xi to immense moral authority within the party. The name of Xi's philosophy, "Socialism with Chinese Characteristics for a New Era," makes a slight adjustment to Deng Xiaoping's market-friendly philosophy. In other words, Xi's authority stems from his providing a synthesis of the regime's greatest two leaders: Mao's single-party Communist rule is being reaffirmed, but Deng's attention to economic reality and the need for pragmatic policies has also been preserved. As we have argued, this constitutional change is a reflection of the fact that Xi has already positioned himself to be the most influential leader well into the 2020s. Table 1Xi Jinping Thought Xi removes his successors: Xi managed to exclude any of China's "sixth generation" of leaders from the Politburo Standing Committee. He thus broke a very important (albeit informal) party norm. The norm was created under Deng Xiaoping to ensure a smooth transition of power, unlike the power struggle that occurred upon Mao's death. Now Xi will have a greater hand in choosing his successor, or even staying in power beyond 2022. This aids in the process of centralization, but it may well prove a step backwards in terms of governance and reform - that remains to be seen. It is a source of higher political uncertainty going forward. Xi dominates the Politburo: Xi prevented his predecessor Hu Jintao's loyalists from gaining a majority on the Politburo Standing Committee, as they seemed lined up to do in 2012. The line-up of the new Politburo and Politburo Standing Committee broadly indicates that Xi and his faction are the dominant force (Table 2). Taken with Xi's personal power, this is significant political capital with which the new administration can push its priorities, whatever they may be. Xi gets a new inquisitor: The Central Commission for Discipline Inspection (CDIC) is the party's internal watchdog. It has taken the leading role in the sweeping party purge and anti-corruption campaign over the past five years. Xi removed its chief, the hugely influential Wang Qishan, by reinforcing the retirement age and two-term PSC limit - a notable case of institutional norms being upheld. He put one of his loyalists, Zhao Leji, in this role instead. The CDIC will have a huge role over the next five years, and a market-relevant one, as we discuss below. Table 2The Magnificent Seven: China's New Politburo Standing Committee The above conclusions raise the possibility that Xi has become excessively powerful, that political institutions in China are being eroded by personal rule, and that political risks are set to explode upward in the near future. However, it is too soon to declare that Xi has staged a Maoist "power grab." There are reasons to think that Xi's accumulation of power has not overturned the delicate internal balances within the top leadership bodies.10 The result is in keeping with what we expected in our Strategic Outlook last December: Xi Jinping has amassed formidable political capital, but he has not destabilized the Chinese political system.11 He is a strongman leader within the established political system of an authoritarian state - he is not a tyrant seizing power in a bloodless revolution. (At least, not yet.) This is broadly positive for China's policy continuity and political framework - and in this sense it is also broadly market-positive, being an outgrowth of the status quo rather than a disruptive break from it. China's leaders continue to be career politicians, trained in law or economics, with considerable executive experience in governing and limited business or military experience, all unified in the name of regime preservation (Chart 10). Over the long run, this suggests that China's "Socialist Put" remains intact, i.e. that the state will intervene to prevent a crash landing.12 Nevertheless, an important corollary of the above is that Xi holds the balance, and hence there are no longer any major domestic political or governmental constraints to prevent him from pursuing his policy agenda - especially over the next 12 months, when his political capital is still fresh and the economic backdrop is favorable. The fact that Xi emphasized "sustainable and sound" growth, deliberately excluded GDP growth targets beyond 2021, and altered the definition of the Communist Party's so-called "principal contradiction" in order to prioritize quality-of-life improvements, suggests that the reform agenda is about to get rebooted. Bottom Line: Xi Jinping has consolidated power extensively, but he has not staged a silent coup d' état or overthrown the balance of power within the Communist Party. This suggests that Xi's policies and reforms will intensify over the next year. Chart 10Characteristics Of Chinese Rulers Mostly Unchanged Since 2012 Xi's Second Term: What To Expect Instead of playing it safe in the lead-up to the all-important party congress over the past twelve months, Xi surprised the markets with a series of regulatory actions designed to tamp down the property bubble, regulate the financial markets, punish speculation, and reduce industrial overcapacity and pollution (Chart 11).13 This tightening of policy strongly signaled that Xi's appetite for political risk is rising in keeping with his growing political capital. Beijing is signaling that it aims to continue with tougher financial, industrial and environmental reforms in the aftermath of the party congress. In particular, systemic financial risk has been identified as a risk to the state's overall stability. Of course, China is unlikely to sharply reduce the ratio of total debt-to-GDP out of an ill-advised, self-imposed bout of austerity. But the Xi administration is likely to suppress its growth rate (Chart 12), as well as to continue cracking down on specific institutions and financial practices deemed to be excessively risky or under-regulated, as has occurred this year in insurance and shadow lending.14 Chart 11China's Borrowing Costs Rising Chart 12Debt Growth Faces Tougher Controls This financial focus is clear from top-level appointments and meetings in 2017, including a special Politburo meeting on financial risks in April and the once-in-five-years Central Financial Work Conference in July.15 The latter declared new regulatory powers for the central bank that will be put into place in the coming 12 months. The head of the new Financial Stability and Development Committee to oversee this work will likely be named, along with a replacement for the long-serving People's Bank of China Governor Zhou Xiaochuan. This change will initiate a new generation of leadership in the central bank, and one ostensibly directed at overseeing stricter macro-prudential controls.16 Another outcome of the financial conference was the warning that, going forward, local government officials will be held accountable over the course of their entire lives if they allow excessive financial risks and debt to build up under their watch.17 These developments suggest that policy will become a headwind to growth next year. We would expect downside risks to China's implicit 6.5% growth target. Why should the new deleveraging campaign have any more effect than similar efforts in the past? Aside from Xi's stronger position to enforce policies - explained above - the nineteenth party congress reinforced an important trend in policy implementation. The Xi administration has been using the CDIC, the party's anti-corruption unit, as a political tool to ensure broader policy enforcement. We have observed this trend over the past year both in the financial regulatory crackdown and the anti-pollution and overcapacity crackdown.18 Anti-corruption officials can compel more serious implementation from local governments, SOE managers, and others because they threaten to impose job losses or jail time, rather than mere fines. The CDIC appointed two new officials to oversee its operations in China's financial regulators just as the party congress was getting underway. Moreover, on the final day of the party congress, officials have announced that corruption investigations will be conducted into the commercial housing sector.19 The message is that the regulatory storm will expand - and will have teeth. Xi went a step further at the party congress by declaring the creation of a National Supervisory Commission, which will oversee the next phase of the anti-corruption campaign.20 This commission will expand the campaign outside the ranks of the Communist Party - where it has operated so far - to the government as a whole, i.e. the state administration and bureaucracy. It implies that every official from China's top ministries down to its lowest-level governments will be subjected to new forces of scrutiny. If this effort resembles the CDIC's role in hastening compliance in other areas of economic policy, then it will be a powerful tool for the Xi administration as it attempts to engineer a top-down restructuring of China's governance and economy. An aggressive new regulatory push, with the threat of corruption charges, in China's financial and industrial sectors would create a powerful drag on economic growth. It could easily send a chill down the spines of government officials, prompting them to cut or delay key investment decisions, as the initial anti-corruption campaign did in 2013-14.21 China's leaders will eventually attempt to offset any disorderly slowdown from reform measures with additional stimulus. However, given that the deleveraging campaign cuts to the heart of the financial sector, and that sharp new tools are being put to use, we would think that the probability of a "policy mistake" is going up. Bottom Line: Risks to Chinese economy and assets are rising as politics shifts from being a tailwind to a headwind. Xi Jinping faces few policy constraints and has shown appetite for greater political risk in the pursuit of his reform agenda. His administration has signaled that China's financial imbalances pose a threat to overall stability and require tougher regulation. New enforcement mechanisms - particularly those connected with anti-corruption efforts - threaten to bring the financial sector, as well as local government debt, under the spotlight and to create a chilling-effect among local officials. Investment Conclusions On one hand, any genuine attempt to hasten the transition of China's economy to consumer-led growth, de-emphasize GDP growth targets, and pare back overbuilt and heavy-polluting industry is highly consequential and will redistribute global growth.22 Table 3Post-Party Congress Scenarios And Probabilities Broadly speaking, the transition is negative for Chinese growth in the short term, but positive in the long term, as productivity trends would improve. It is negative for China's heavy industry, yet positive for technology, health and education; negative for commodities tied to the old economy (e.g. coal, iron ore, and diesel), but positive for commodities tied to consumers (oil/gasoline, aluminum, nickel, and zinc); negative for emerging markets that are commodity- and export-reliant and China-exposed, yet positive for domestic-oriented and/or China-insulated EMs. On the other hand, there is no longer a convincing excuse for poor implementation of central government policies. If China does not take concrete steps in pursuit of Xi's reform agenda - an agenda of "supply-side reform" that is now enshrined in the party's constitution - then it follows that Xi himself is unwilling to practice what he preaches. The first big test will be whether, when the economy starts to wobble, policymakers stimulate the "old economy" with the usual fervor, or whether they hold true to a course of re-ordering the economy and concentrating any stimulative credit flows more heavily into the social safety net and consumer-led industries and services. Given Xi's and China's rare opportunity, a failure to undertake difficult reforms in the coming months and years would be a clear sign that China will never pursue significant reforms of its own accord. It would have to be forced to do so by an internal or external crisis. This would mean that China's potential GDP would continue to decline for the foreseeable future (Table 3). Chart 13China's Ascendancy Challenges The U.S. If that were the case, declining potential GDP growth would combine with political uncertainty over Xi's 2022 succession to create a noxious brew of social malaise. A final and very important consideration is China's relationship with the United States and its allies, given the ongoing strains over U.S.-China trade, North Korea's nuclear and missile advances, China's militarization of the South China Sea, Taiwan's widening ideological distance from the mainland, and Japan's accelerating re-armament. The party congress was a highly visible display of Chinese power and self-confidence, in which Xi broke with the past to suggest that China is moving into "center stage" in the world. Xi not only reaffirmed state-led growth but also emphasized that China's foreign policy assertiveness is here to stay over the long run. This is a poignant reminder of our long-term investment theme of global multipolarity. The United States is not likely to relinquish global or even regional leadership easily. So while relations may be pacified in the short term, the risk of conflict, whether economic or military, is rising over time (Chart 13). Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "China's Nineteenth Party Congress: A Primer," dated September 13, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy, "China: Two Factions, One Party," dated September 2012, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 4 Popular unrest was boiling up due to grievances over corrupt officials, mismanagement of internal migration, local government land seizures, a weak justice system, and a host of labor disputes and environmental incidents. 5 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. See also BCA Geopolitical Strategy Monthly Report, "Reflections On China's Reforms," in "The Great Risk Rotation - December 2013," dated December 11, 2013. 6 The arrest and excommunication of Chongqing Party Secretary Bo Xilai in 2012 epitomizes the regional and institutional challenge, since Bo had a network of alliances that fell under Xi Jinping's anti-corruption dragnet and sprawled across the energy sector and public security agencies. The regional problem was highlighted again this year when one of Bo's successors, Chongqing Party Secretary Sun Zhengcai, was ousted for allegedly failing to extirpate Bo's influence. Meanwhile, the People's Liberation Army became more vocal and independent in ways that raised concerns among foreign observers, such as U.S. Defense Secretary Robert Gates, who suggested that the PLA took China's civilian leadership by surprise when it conducted a test flight of its stealth J-20 fifth generation fighter during Gates's visit to Beijing in January 2011. 7 Please see BCA China Investment Strategy Weekly Report, "China's Economy - 2015 Vs Today (Part I): Trade," dated October 26, 2017, available at cis.bcaresearch.com. 8 For the military reshuffle, please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at gps.bcaresearch.com. 9 The most important reform was the loosening of the one-child policy, which was a social change with long-term economic benefits. Reforms to household registration, land rights, the property sector, SOEs, fiscal policy, private property, and the judicial system have moved slowly. 10 The PSC has a three-way balance of sorts, with two representatives of each faction (Jiang Zemin, Hu Jintao, and Xi Jinping), plus Xi presiding over all. Please see Cheng Li, "The Paradoxical Outcome Of China's 19th Party Congress," Brookings Institution, October 26, 2017. Our own analysis of the 2017 result, drawing on Cheng Li's work, shows that the party bureaucracy, state bureaucracy and the military are represented at roughly the same levels as before on the 25-member Politburo. Further, the profile of the PSC members is relatively continuous with the previous PSC profiles. Namely, the relatively high share of leaders who have spent their careers ruling the provinces, or who have mostly worked in central government, is no higher than it was before, while the relatively low share of leaders who served on the military or managed state-owned enterprises is no lower than it was before. The division between rural and urban regions on the PSC is also the same as before. Thus, the only substantial change in the character profile of the PSC is the fact that China's leaders are increasingly coming from an educational background in the "soft sciences" rather than the "hard sciences": which is to be expected as the society evolves from manufacturing and construction to a services-oriented economy, even though it also suggests growing ideological orthodoxy. 11 Please see BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Monthly Report, "The Socialism Put," dated May 11, 2016, available at gps.bcaresearch.com. 13 Please see BCA China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010," dated October 13, 2016, available at cis.bcaresearch.com. 14 Please see BCA China Investment Strategy Weekly Report, "China: Financial Crackdown And Market Implications," dated May 18, 2017, available at cis.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. 16 Please see "China: A Preemptive Dodd-Frank," in BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017, available at gps.bcaresearch.com. 18 Please see note 15 above. See also Barry Naughton, “The General Secretary’s Extended Reach: Xi Jinping Combines Economics And Politics,” dated September 11, 2017, available at www.hoover.org. 19 Please see "China To Launch Nationwide Inspection On Commercial Housing Sales," Xinhua, October 25, 2017, available at www.chinadaily.com. 20 Supervisory commissions will be created at every level of administration in all regions to ensure that the anti-corruption campaign is enforced across all government, not only within the Communist Party. The commissions will be based on experiences gained from trial programs in Beijing, Zhejiang, and Shanxi. Please see Viola Zhou, "Super anti-graft agency pilot schemes extended across China," South China Morning Post, October 30, 2017, available at www.scmp.com. 21 Please see note 5 above, "Taking Stock," and BCA China Investment Strategy, "Policy Mistakes And Silver Linings," dated October 7, 2015, available at cis.bcaresearch.com. 22 Please see note 5 above, "Taking Stock," and BCA China Investment Strategy, "Understanding China's Master Plan," dated November 20, 2013, available at cis.bcaresearch.com.

Special Report

Highlights Emerging Market (EM) hard currency debt, both sovereign and corporate, has consistently outperformed the broad global bond index. However, investors should steer clear of always maintaining maximum overweights to EM given its weak volatility reduction benefits and a much higher-than normal tendency of experiencing outsized, negative returns. Our long-term analysis suggests a structural 5% allocation offers the best risk/reward potential. The Fed is still in the early stages of rate normalization. At this point in the Fed policy cycle, where the Fed is hiking rates but monetary conditions are still stimulative, EM hard currency debt has historically performed well both on a relative and absolute basis. Looking ahead, EM returns should begin to suffer in latter half of 2018 as the Fed moves to more restrictive policy stance. While global growth will remain supportive of EM credit next year, renewed U.S. dollar strength and a re-convergence to the downside with commodity prices present considerable headwinds. Maintain an underweight stance on EM hard currency debt. Favor DM spread product due to more supportive relative growth trends and valuations. Feature Emerging market (EM) sovereign and corporate debt returns have surged in 2017, returning 9.4% and 7.5%, respectively (Chart 1). Investor interest has been renewed, with the latest IMF Financial Stability Report indicating that non-resident inflows of portfolio capital to EM countries have recovered since early 2016 and reached $205 billion for 2017 through August. Against a backdrop of above-trend global economic growth, monetary policy settings from the major central banks that are still accommodative, and some diminished risks from the world's geopolitical hotspots, the current uptrend for EM debt performance could continue. Nevertheless, we urge caution. We moved to a moderate underweight stance on EM hard currency debt back in August, while at the same time increasing our current recommended overweight to U.S. investment grade (IG) corporate debt on the other side of the trade.1 Even with synchronized global growth boosting both EM export demand and industrial commodity prices, we prefer U.S. credit exposure over EM at this point in the cycle, for several reasons: The massive flow-driven EM rally has resulted in not only outsized returns but stretched valuations, with EM debt spreads now back to post-2008-crisis low (or even through those levels for EM hard currency corporates) without any major improvement in EM fundamentals; The previously reliable correlation between EM debt and commodity prices, a long-time driver of EM performance, has broken down, bullishly, for EM - potentially another sign of flow-driven overvaluation; Growing uncertainty over the near-term China growth outlook raises risks on further gains in industrial commodity demand and EM exports; The USD will appreciate once again on the back of additional Fed interest rate hikes beyond levels currently discounted by markets, which could trigger some reversal of the sharp inflows into EM seen this year. Over a strategic horizon, however, it remains difficult to argue against owning a core structural allocation of EM hard currency debt within global fixed income portfolios, given the higher yields that are typically on offer and the fairly consistent historical outperformance over Developed Market (DM) debt. Although the benefits of EM in a portfolio context are slightly overstated given its skewed risk profile (i.e. fat negative tails) and high correlation with DM spread product, specifically U.S. high-yield corporates (Chart 2). Chart 1How Much Longer Can This Rally Last? Chart 2EM Debt Offers Little Diversification Benefits In this Special Report, we examine the long-term role of EM hard currency debt within a fixed-income portfolio, and re-iterate our case for being underweight EM debt on a cyclical basis. The Long-Run Case For Owning EM Debt: A Moderate Core Allocation Makes Sense It is not a stretch to say that EM debt has become the most important part of global bond portfolios in the 21st century. Having a significant EM allocation at the right time can make a bond manager's year, while having it at the wrong time can end a bond manager's career. But what is the "right" allocation to optimize the long-run contribution to returns in a global fixed income portfolio? To answer this question, we took a look at the historical performance of a global bond portfolio that consisted of both DM and EM debt (sovereign and corporate), looking for the combination that would maximize the risk-adjusted return of the portfolio. In our analysis, we ran calculations for two different time periods as the available index data for EM sovereign debt goes back to 1994, while EM corporate debt indices begin in 2002. For DM debt, we used a single index - the Bloomberg Barclays Global Aggregate - as this has a long history and is a common benchmark used by global bond managers that includes both DM sovereign and corporate debt. Though the sample size of our combined global portfolio is limited due to the shorter history of the EM corporates asset class, the findings generally align with our intuition. On a standalone basis, modern portfolio theory proposes that an individual asset should be included within a portfolio if its excess return divided by its standard deviation is higher than the excess return of the portfolio divided by the portfolio's standard deviation, multiplied by the correlation between the portfolio and the asset. Though the correlation to the DM portfolio from 2004 was fairly high for both assets at over 0.6, when we applied this formula, both EM sovereign and corporate debt warranted an allocation in a standard global fixed-income portfolio. EM sovereign debt scored higher, by offering a considerably better Sharpe ratio with only a minimally higher correlation to DM fixed income. While EM hard currency debt has fairly consistently outperformed the DM benchmark on a 12-month rolling basis, investors must be careful not to simply maintain large positions at all times. Obviously, the majority of fixed-income investors have volatility constraints that impose limits on credit allocations. Additionally, apart from simple volatility measures, EM debt has a "hidden" risk profile when looking at the higher moments of return distributions. Table 1EM Debt Returns Are##BR##Negatively Skewed Both EM sovereign and corporate credit historical returns have exhibited significant negative skewness and excess kurtosis, indicating a much higher-than-normal tendency of experiencing outsized, negative returns (Table 1). This is confirmed through Historical Value-at-Risk (VaR) analysis, where the 5% worst returns far eclipsed those of DM investment grade and government debt. Nevertheless, it is important to view EM from a holistic perspective. For example, an asset with a high standard deviation may be less desirable as a standalone investment, but can be highly beneficial if it enhances overall the returns of a portfolio while also reducing its volatility. We tested these "portfolio effects" of EM debt by creating 21 hypothetical portfolios. We began with a DM-only portfolio (consisting of the Global Aggregate index) and increased the weighting toward EM debt by one percentage point in each portfolio, with the last portfolio having a 20% weighting toward EM. The breakdown within EM was 62% corporates and 38% sovereigns based on the market capitalizations of the relevant benchmark indices. Our calculations indicate that the highest portfolio Sharpe ratio was achieved with a 5% EM debt allocation, which also happens to be the "neutral" weighting of EM debt in the BCA Global Fixed Income Strategy model portfolio benchmark index (Chart 3).2 Global bond investors should hover around this weighting on EM hard currency debt, absent a high conviction view on EM. Chart 3The Optimal EM Hard Currency Debt Allocation Is 5% So while the data suggests that EM hard currency debt warrants a long-term allocation, its beneficial impact on a fixed-income portfolio is at least slightly exaggerated. Portfolio managers are typically seeking out assets that can both improve return and decrease overall volatility, thereby increasing the efficiency of their portfolios. This was not the case with EM debt. In our study, increasing the EM allocation consistently raised both returns and volatility. Chart 4EM/DM Correlations Should Decline In 2018 This lack of diversification benefit is a result of the high correlation between EM hard currency debt and DM fixed income. Currently, the correlation between EM and DM (the Global Aggregate) is 0.90, near the upper end of its range, indicating that diversification benefits over the last year were essentially non-existent (Chart 4). Nevertheless, this relationship clearly exhibits a mean reversion tendency. That EM/DM correlation in recent years has been itself correlated to global growth and monetary policy changes. As we show in Chart 4, our diffusion index of OECD Leading Economic Indicators (LEI) - the number of countries with a rising LEI relative to those with a declining LEI - does tend to lead the EM/DM correlation and is currently pointing to a lower correlation as global growth becomes a little less synchronized in 2018. The same goes for the growth rate of major central bank balance sheets which is already slowing and will decelerate even more in 2018 on the back of a diminished pace of bond buying by the ECB and the Fed runoff of maturing bonds on its balance sheet. The conclusion is this - the EM/DM correlation should decline in 2018 but, as we discuss below, we think that happens through relative underperformance of EM credit. Bottom Line: EM hard currency debt, both sovereign and corporate, has consistently outperformed the broad global index. However, investors should steer clear of always maintaining maximum overweights given its weak volatility reduction benefits and a much higher-than normal tendency of experiencing outsized, negative returns. Our long-term analysis suggests a structural 5% allocation offers the best risk/reward potential. The Shorter-Run Case For Owning EM Debt: Will Macro Drivers Remain Supportive? So far in 2017, EM sovereign and corporate debt have been beneficiaries of robust global growth, a declining USD and a decoupling from a broader index of commodity prices. While we expect global growth will remain strong over the medium term, our outlook for the USD is still bullish and there is a risk that commodity prices and EM debt performance re-converge to the downside. Global growth will remain strong. Outside of a major global growth slowdown, which we currently view as a low probability event, a mass flight out of EM assets anytime soon is highly unlikely. Indicators such as the global PMI index, industrial production growth and the OECD leading economic indicator are all booming (Chart 5). Inflation will head higher on the back of rising oil prices, but the increase is likely to be gradual. Importantly, this is happening alongside global monetary conditions that remain generally accommodative, even with the Fed in a tightening cycle. Credit, both DM & EM, has historically performed well against this backdrop, as we discuss in the next section of this report. A renewed upleg in the USD bull market is already underway. The correlation between EM currencies and EM debt performance has recovered after breaking down during 2013-15 (Chart 6). Year-to-date, EM currency strength - the flipside of the weaker U.S. dollar - has been a major driver of EM relative performance. Using the IMF's measure real effective exchange rates based on unit labor costs, the U.S. dollar is fairly valued.3 Neutral valuations suggest that directional market indicators are driving currency movements. As the EM business cycle slows and the Fed ramps up its rate hikes in response to rising inflation, the USD cyclical bull market should resume. Chart 5Robust Global Growth##BR##Is Supportive For EM Chart 6Can EM Ignore Another##BR##Round Of USD Strength? The de-coupling between EM debt and commodity price movements is unsustainable. EM debt has experienced a strong rally since 2016 with only a moderate rise in commodity prices compared to past periods of EM strength. We view this decoupling to be temporary (Chart 7). Many sovereign EM issuers are commodity producers, suggesting that this divergence is unsustainable. EM sovereign and corporate debt will not be able to continue their massive rallies if commodity prices relapse. We maintain a bullish view on oil prices, but there are signals that base metal prices are at risk over the next 6-12 months. Chinese monetary authorities have tightened policy and the resulting sharp slowdown in money supply growth is a worrisome sign for Chinese demand for commodities (Chart 8).4 Chart 7EM-Commodity Divergence##BR##Is Unsustainable Chart 8China Downside Risks For##BR##Industrial Commodity Prices Bottom Line: While global growth will remain supportive of EM credit, currency weakness and a re-convergence with commodity prices present considerable headwinds. EM Debt Performance & The Fed Policy Cycle Chart 9The Fed Policy Cycle As more central banks are shifting to a tightening bias, investors are becoming increasingly concerned over policy normalization and its potential impact on credit market performance. Given the strong historical linkages between EM debt performance and Fed policy changes, the current U.S. tightening cycle looms as a major potential problem for EM assets. We have found it most useful to think about changes in Fed monetary policy and asset market performance in terms of breaking up the Fed policy into four distinct phases (Chart 9).5 These are characterized by both the level of interest rates (whether they are above or below "equilibrium") and the direction of policy changes (whether the Fed is raising or cutting rates):6 Phase 1 - the Fed is hiking while the fed funds rate is below equilibrium (i.e. monetary conditions are stimulative). Phase 2 - the Fed is hiking or keeping policy on hold while the fed funds rate is above equilibrium (i.e. monetary conditions are restrictive). Phase 3 - the Fed is cutting while the fed funds rate is above equilibrium (i.e. monetary conditions are restrictive). Phase 4 - the Fed is cutting rates while the fed funds rate is below equilibrium (i.e. monetary conditions are stimulative). For EM sovereign debt where we have index data going back to 1994, there have been four episodes of Phase 1 and three episodes of the other phases. For EM corporate debt, where the index data begins in 2002, there have been two episodes of Phases 1 and 4 and only one occurrence of Phases 2 and 3. We present the excess returns of EM debt relative to other major fixed income classes by phase in Table 2. In the limited sample, EM sovereign debt and corporate debt consistently outperformed the Global Aggregate index and most individual bond classes. However, relative to DM high-yield debt, which has the most comparable risk profile, EM sovereign bonds underperformed in Phase 1 and EM corporate debt underperformed in all phases. Table 2Relative EM Debt Performance Worsens As Fed Policy Tightens Excess returns for both EM debt classes were highest in Phase 4, where the central bank is easing while conditions are stimulative. Similar to other risk assets, EM debt also outperformed in Phase 1, where the central bank is tightening while rates are below equilibrium. This makes sense, as the early stages of monetary tightening typically occur in conjunction with stable, above-trend growth. Liquidity conditions are still stimulative in Phase 1, which provides a substantial tailwind for spread product performance. On the other end of the spectrum, EM debt excess returns were relatively low during Phase 2 and Phase 3, and even negative in the case of EM corporate debt for Phase 3. Surprisingly, EM debt has been less affected by the direction of U.S. interest rates than what we would have expected. Monetary easing in Phase 3 was not enough to substantially boost EM relative returns and tightening in Phase 1 did not derail growth or lift the USD enough for EM debt to underperform. In fact, because EM debt still offers robust excess returns during Phase 1 when the central bank is tightening, while also suffering during Phase 3 during central bank easing, we can conclude that the level of policy rates relative to equilibrium has a greater impact on returns than the direction of rates. The severity of the Global Financial Crisis and the relatively subdued pace of recovery for both growth and inflation led to one of the longest Phase 4s in history. Given the low level of starting yields, indicating a large gap to equilibrium, and the 'gradual' pace of normalization, the current Phase 1 should also last longer than it typically has. This bodes well for all credit sectors, including EM sovereign and corporate debt, if history is any guide. However, there are still reasons to be concerned about the impact of U.S. monetary policy on EM assets next year. If the Fed follows through with the interest rate hikes it is currently projecting - another 100bps in total by the end of 2018 - the funds rate will be much closer to equilibrium. If the U.S. dollar rallies alongside that Fed tightening, as we expect, overall U.S. monetary conditions could end up being much closer to a restrictive level than implied by strictly looking at our Fed Policy Cycle (which only looks at the funds rate to determine monetary conditions). Also, the equilibrium funds rate may now be lower than the levels we are assuming in the Fed Policy Cycle framework, suggesting that policy could turn restrictive more quickly in the current tightening cycle. Bottom Line: The Fed is still in the early stages of rate normalization. At this point in the Fed policy cycle, where the Fed is hiking rates but monetary conditions are still stimulative, EM hard currency debt has historically performed well both on a relative and absolute basis. Looking ahead, EM returns should begin to suffer in latter half of 2018 as the Fed moves to more restrictive policy stance. Another Reason For Caution: Our EM Corporate Health Monitor The BCA EM Corporate Health Monitor (CHM) is a directional indicator aimed at modeling the path of EM corporate spread movements. Financial data from 220 emerging market companies in over 30 countries is aggregated. Only firms that issue USD-denominated bonds are included, with banks and other financials also omitted in a similar fashion to the CHMs we have constructed for DM corporates. The indicator is made up of four financial ratios: profit margins, free cash flow to total debt, liquidity and leverage. Unlike the DM CHMs, the ratios are not equally weighted in the construction of the EM CHM. Profit margins and free cash flow to debt combined represent 75% of the EM CHM. The latest available reading is from Q2 2017, showing a large decrease, with the indicator now only barely in 'Improving Health' territory (Chart 10). This has occurred in tandem with EM corporate spreads narrowing to post-crisis lows, leaving EM debt at potentially overvalued levels on a fundamental basis. While this slowdown in the EM CHM is not yet a cause for concern, if this became an extended trend of financial health deterioration, the divergence with EM corporate debt performance would be unsustainable and leave EM corporates highly vulnerable to a correction. Chart 10The BCA EM Corporate Health Monitor Has Rolled Over EM Corporate Health Monitor Is Sending A 'Sell' Signal Bottom Line: Our EM Corporate Health Monitor has declined drastically and is barely in 'Improving Health' territory. This alone is not cause for concern yet, but further deterioration in our Monitor combined with additional credit spread narrowing would be a worrisome divergence. Investment Implications Emerging market debt is facing conflicting forces. While continued robust global growth and accommodative monetary policy provide a substantial tailwind for credit performance, extended valuations, the turn in the USD and a potentially worsening commodities outlook present difficult hurdles for EM to overcome. Given the mixed messages, we prefer owning cyclical credit exposure through DM corporate debt, particularly U.S. investment grade. EM debt yields have collapsed and are expensive relative to DM investment grade debt (Chart 11). Combined with a higher risk profile in EM, elevated valuations indicate that EM sovereign and corporate debt are vulnerable to larger corrections. From a return perspective, the difference in the corporate option-adjusted spreads (OAS) has been an excellent leading indicator for relative total returns (Chart 12). This differential indicates that there is considerable relative upside potential for U.S. investment grade over EM hard currency debt. Additionally, while global growth should support credit-related plays, relative growth dynamics are more supportive of U.S. investment grade because the next phase of the global growth upturn will be driven by DM countries and not EM. The difference between the manufacturing PMIs in the U.S. and EM has historically been a good directional indicator for the spread between U.S. corporate bond spreads and EM debt spreads (Chart 13). The gap between the relative manufacturing PMI readings is at a post-crisis high, and could widen further if EM economies suffer on the back of any pullback in Chinese growth in 2018. Chart 11EM Yields & Spreads Look Full Valued Chart 12Favor U.S. IG Over EM Corporates... Chart 13...Because Of Stronger U.S. Growth What are the risks to our view? Our recommended position would suffer in the event that inflation in the U.S. slows, keeping the Fed on hold and maintaining this year's USD downtrend. Also, if China were to ease up on its policy tightening, industrial commodity prices could strengthen once again. Under these scenarios, EM hard currency debt would likely outperform DM spread product. Bottom Line: Maintain moderate underweight positions in EM hard currency debt. Favor DM spread product (especially U.S. investment grade corporates) due to more supportive relative valuations and growth trends. Patrick Trinh, Associate Editor Global Fixed Income Strategy patrick@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 This “EM versus IG” trade was implemented in both our Emerging Markets Strategy and Global Fixed Income Strategy services. Please see BCA Emerging Markets Strategy Weekly Report, “EM: The Focus Is On Profits”, dated August 16th 2017, available at ems.bcaresearch.com, as well as the BCA Global Fixed Income Strategy Weekly Report, “A Lack Of Leadership”, dated August 22nd 2017, available at gfis.bcaresearch.com. 2 The weighting to EM debt in the Global Fixed Income Strategy model bond portfolio benchmark is based on market capitalizations of all the fixed income sectors we wanted to have in the benchmark, which includes non-investment grade debt like global high-yield corporates. It is reassuring to see that our benchmark weighting is also the desired weighting from a long-run portfolio optimization perspective. 3 Please see BCA Emerging Markets Strategy Weekly Report, "Is The Dollar Expensive, And Are EM Currencies Cheap?", dated October 11th, 2017, available at ems.bcaresearch.com. 4 Please see the joint BCA Global Asset Allocation/Emerging Markets Strategy Special Report, "Global Equity Allocation: The Underwhelming Case For EM", dated August 9th 2017, available at ems.bcaresearch.com & gaa.bcaresearch.com. 5 Please see BCA U.S. Bond Strategy Special Report, "Bonds And The Fed Funds Rate Cycle", dated May 27th 2014, available at usbs.bcaresearch.com. 6 The equilibrium policy rate is a BCA calculation based on long-run real potential GDP growth and long run inflation expectations.

Special Report

Highlights Emerging Market (EM) hard currency debt, both sovereign and corporate, has consistently outperformed the broad global bond index. However, investors should steer clear of always maintaining maximum overweights to EM given its weak volatility reduction benefits and a much higher-than normal tendency of experiencing outsized, negative returns. Our long-term analysis suggests a structural 5% allocation offers the best risk/reward potential. The Fed is still in the early stages of rate normalization. At this point in the Fed policy cycle, where the Fed is hiking rates but monetary conditions are still stimulative, EM hard currency debt has historically performed well both on a relative and absolute basis. Looking ahead, EM returns should begin to suffer in latter half of 2018 as the Fed moves to more restrictive policy stance. While global growth will remain supportive of EM credit next year, renewed U.S. dollar strength and a re-convergence to the downside with commodity prices present considerable headwinds. Maintain an underweight stance on EM hard currency debt. Favor DM spread product due to more supportive relative growth trends and valuations. Feature Emerging market (EM) sovereign and corporate debt returns have surged in 2017, returning 9.4% and 7.5%, respectively (Chart 1). Investor interest has been renewed, with the latest IMF Financial Stability Report indicating that non-resident inflows of portfolio capital to EM countries have recovered since early 2016 and reached $205 billion for 2017 through August. Against a backdrop of above-trend global economic growth, monetary policy settings from the major central banks that are still accommodative, and some diminished risks from the world's geopolitical hotspots, the current uptrend for EM debt performance could continue. Nevertheless, we urge caution. We moved to a moderate underweight stance on EM hard currency debt back in August, while at the same time increasing our current recommended overweight to U.S. investment grade (IG) corporate debt on the other side of the trade.1 Even with synchronized global growth boosting both EM export demand and industrial commodity prices, we prefer U.S. credit exposure over EM at this point in the cycle, for several reasons: The massive flow-driven EM rally has resulted in not only outsized returns but stretched valuations, with EM debt spreads now back to post-2008-crisis low (or even through those levels for EM hard currency corporates) without any major improvement in EM fundamentals; The previously reliable correlation between EM debt and commodity prices, a long-time driver of EM performance, has broken down, bullishly, for EM - potentially another sign of flow-driven overvaluation; Growing uncertainty over the near-term China growth outlook raises risks on further gains in industrial commodity demand and EM exports; The USD will appreciate once again on the back of additional Fed interest rate hikes beyond levels currently discounted by markets, which could trigger some reversal of the sharp inflows into EM seen this year. Over a strategic horizon, however, it remains difficult to argue against owning a core structural allocation of EM hard currency debt within global fixed income portfolios, given the higher yields that are typically on offer and the fairly consistent historical outperformance over Developed Market (DM) debt. Although the benefits of EM in a portfolio context are slightly overstated given its skewed risk profile (i.e. fat negative tails) and high correlation with DM spread product, specifically U.S. high-yield corporates (Chart 2). Chart 1How Much Longer Can This Rally Last? Chart 2EM Debt Offers Little Diversification Benefits In this Special Report, we examine the long-term role of EM hard currency debt within a fixed-income portfolio, and re-iterate our case for being underweight EM debt on a cyclical basis. The Long-Run Case For Owning EM Debt: A Moderate Core Allocation Makes Sense It is not a stretch to say that EM debt has become the most important part of global bond portfolios in the 21st century. Having a significant EM allocation at the right time can make a bond manager's year, while having it at the wrong time can end a bond manager's career. But what is the "right" allocation to optimize the long-run contribution to returns in a global fixed income portfolio? To answer this question, we took a look at the historical performance of a global bond portfolio that consisted of both DM and EM debt (sovereign and corporate), looking for the combination that would maximize the risk-adjusted return of the portfolio. In our analysis, we ran calculations for two different time periods as the available index data for EM sovereign debt goes back to 1994, while EM corporate debt indices begin in 2002. For DM debt, we used a single index - the Bloomberg Barclays Global Aggregate - as this has a long history and is a common benchmark used by global bond managers that includes both DM sovereign and corporate debt. Though the sample size of our combined global portfolio is limited due to the shorter history of the EM corporates asset class, the findings generally align with our intuition. On a standalone basis, modern portfolio theory proposes that an individual asset should be included within a portfolio if its excess return divided by its standard deviation is higher than the excess return of the portfolio divided by the portfolio's standard deviation, multiplied by the correlation between the portfolio and the asset. Though the correlation to the DM portfolio from 2004 was fairly high for both assets at over 0.6, when we applied this formula, both EM sovereign and corporate debt warranted an allocation in a standard global fixed-income portfolio. EM sovereign debt scored higher, by offering a considerably better Sharpe ratio with only a minimally higher correlation to DM fixed income. While EM hard currency debt has fairly consistently outperformed the DM benchmark on a 12-month rolling basis, investors must be careful not to simply maintain large positions at all times. Obviously, the majority of fixed-income investors have volatility constraints that impose limits on credit allocations. Additionally, apart from simple volatility measures, EM debt has a "hidden" risk profile when looking at the higher moments of return distributions. Table 1EM Debt Returns Are##BR##Negatively Skewed Both EM sovereign and corporate credit historical returns have exhibited significant negative skewness and excess kurtosis, indicating a much higher-than-normal tendency of experiencing outsized, negative returns (Table 1). This is confirmed through Historical Value-at-Risk (VaR) analysis, where the 5% worst returns far eclipsed those of DM investment grade and government debt. Nevertheless, it is important to view EM from a holistic perspective. For example, an asset with a high standard deviation may be less desirable as a standalone investment, but can be highly beneficial if it enhances overall the returns of a portfolio while also reducing its volatility. We tested these "portfolio effects" of EM debt by creating 21 hypothetical portfolios. We began with a DM-only portfolio (consisting of the Global Aggregate index) and increased the weighting toward EM debt by one percentage point in each portfolio, with the last portfolio having a 20% weighting toward EM. The breakdown within EM was 62% corporates and 38% sovereigns based on the market capitalizations of the relevant benchmark indices. Our calculations indicate that the highest portfolio Sharpe ratio was achieved with a 5% EM debt allocation, which also happens to be the "neutral" weighting of EM debt in the BCA Global Fixed Income Strategy model portfolio benchmark index (Chart 3).2 Global bond investors should hover around this weighting on EM hard currency debt, absent a high conviction view on EM. Chart 3The Optimal EM Hard Currency Debt Allocation Is 5% So while the data suggests that EM hard currency debt warrants a long-term allocation, its beneficial impact on a fixed-income portfolio is at least slightly exaggerated. Portfolio managers are typically seeking out assets that can both improve return and decrease overall volatility, thereby increasing the efficiency of their portfolios. This was not the case with EM debt. In our study, increasing the EM allocation consistently raised both returns and volatility. Chart 4EM/DM Correlations Should Decline In 2018 This lack of diversification benefit is a result of the high correlation between EM hard currency debt and DM fixed income. Currently, the correlation between EM and DM (the Global Aggregate) is 0.90, near the upper end of its range, indicating that diversification benefits over the last year were essentially non-existent (Chart 4). Nevertheless, this relationship clearly exhibits a mean reversion tendency. That EM/DM correlation in recent years has been itself correlated to global growth and monetary policy changes. As we show in Chart 4, our diffusion index of OECD Leading Economic Indicators (LEI) - the number of countries with a rising LEI relative to those with a declining LEI - does tend to lead the EM/DM correlation and is currently pointing to a lower correlation as global growth becomes a little less synchronized in 2018. The same goes for the growth rate of major central bank balance sheets which is already slowing and will decelerate even more in 2018 on the back of a diminished pace of bond buying by the ECB and the Fed runoff of maturing bonds on its balance sheet. The conclusion is this - the EM/DM correlation should decline in 2018 but, as we discuss below, we think that happens through relative underperformance of EM credit. Bottom Line: EM hard currency debt, both sovereign and corporate, has consistently outperformed the broad global index. However, investors should steer clear of always maintaining maximum overweights given its weak volatility reduction benefits and a much higher-than normal tendency of experiencing outsized, negative returns. Our long-term analysis suggests a structural 5% allocation offers the best risk/reward potential. The Shorter-Run Case For Owning EM Debt: Will Macro Drivers Remain Supportive? So far in 2017, EM sovereign and corporate debt have been beneficiaries of robust global growth, a declining USD and a decoupling from a broader index of commodity prices. While we expect global growth will remain strong over the medium term, our outlook for the USD is still bullish and there is a risk that commodity prices and EM debt performance re-converge to the downside. Global growth will remain strong. Outside of a major global growth slowdown, which we currently view as a low probability event, a mass flight out of EM assets anytime soon is highly unlikely. Indicators such as the global PMI index, industrial production growth and the OECD leading economic indicator are all booming (Chart 5). Inflation will head higher on the back of rising oil prices, but the increase is likely to be gradual. Importantly, this is happening alongside global monetary conditions that remain generally accommodative, even with the Fed in a tightening cycle. Credit, both DM & EM, has historically performed well against this backdrop, as we discuss in the next section of this report. A renewed upleg in the USD bull market is already underway. The correlation between EM currencies and EM debt performance has recovered after breaking down during 2013-15 (Chart 6). Year-to-date, EM currency strength - the flipside of the weaker U.S. dollar - has been a major driver of EM relative performance. Using the IMF's measure real effective exchange rates based on unit labor costs, the U.S. dollar is fairly valued.3 Neutral valuations suggest that directional market indicators are driving currency movements. As the EM business cycle slows and the Fed ramps up its rate hikes in response to rising inflation, the USD cyclical bull market should resume. Chart 5Robust Global Growth##BR##Is Supportive For EM Chart 6Can EM Ignore Another##BR##Round Of USD Strength? The de-coupling between EM debt and commodity price movements is unsustainable. EM debt has experienced a strong rally since 2016 with only a moderate rise in commodity prices compared to past periods of EM strength. We view this decoupling to be temporary (Chart 7). Many sovereign EM issuers are commodity producers, suggesting that this divergence is unsustainable. EM sovereign and corporate debt will not be able to continue their massive rallies if commodity prices relapse. We maintain a bullish view on oil prices, but there are signals that base metal prices are at risk over the next 6-12 months. Chinese monetary authorities have tightened policy and the resulting sharp slowdown in money supply growth is a worrisome sign for Chinese demand for commodities (Chart 8).4 Chart 7EM-Commodity Divergence##BR##Is Unsustainable Chart 8China Downside Risks For##BR##Industrial Commodity Prices Bottom Line: While global growth will remain supportive of EM credit, currency weakness and a re-convergence with commodity prices present considerable headwinds. EM Debt Performance & The Fed Policy Cycle Chart 9The Fed Policy Cycle As more central banks are shifting to a tightening bias, investors are becoming increasingly concerned over policy normalization and its potential impact on credit market performance. Given the strong historical linkages between EM debt performance and Fed policy changes, the current U.S. tightening cycle looms as a major potential problem for EM assets. We have found it most useful to think about changes in Fed monetary policy and asset market performance in terms of breaking up the Fed policy into four distinct phases (Chart 9).5 These are characterized by both the level of interest rates (whether they are above or below "equilibrium") and the direction of policy changes (whether the Fed is raising or cutting rates):6 Phase 1 - the Fed is hiking while the fed funds rate is below equilibrium (i.e. monetary conditions are stimulative). Phase 2 - the Fed is hiking or keeping policy on hold while the fed funds rate is above equilibrium (i.e. monetary conditions are restrictive). Phase 3 - the Fed is cutting while the fed funds rate is above equilibrium (i.e. monetary conditions are restrictive). Phase 4 - the Fed is cutting rates while the fed funds rate is below equilibrium (i.e. monetary conditions are stimulative). For EM sovereign debt where we have index data going back to 1994, there have been four episodes of Phase 1 and three episodes of the other phases. For EM corporate debt, where the index data begins in 2002, there have been two episodes of Phases 1 and 4 and only one occurrence of Phases 2 and 3. We present the excess returns of EM debt relative to other major fixed income classes by phase in Table 2. In the limited sample, EM sovereign debt and corporate debt consistently outperformed the Global Aggregate index and most individual bond classes. However, relative to DM high-yield debt, which has the most comparable risk profile, EM sovereign bonds underperformed in Phase 1 and EM corporate debt underperformed in all phases. Table 2Relative EM Debt Performance Worsens As Fed Policy Tightens Excess returns for both EM debt classes were highest in Phase 4, where the central bank is easing while conditions are stimulative. Similar to other risk assets, EM debt also outperformed in Phase 1, where the central bank is tightening while rates are below equilibrium. This makes sense, as the early stages of monetary tightening typically occur in conjunction with stable, above-trend growth. Liquidity conditions are still stimulative in Phase 1, which provides a substantial tailwind for spread product performance. On the other end of the spectrum, EM debt excess returns were relatively low during Phase 2 and Phase 3, and even negative in the case of EM corporate debt for Phase 3. Surprisingly, EM debt has been less affected by the direction of U.S. interest rates than what we would have expected. Monetary easing in Phase 3 was not enough to substantially boost EM relative returns and tightening in Phase 1 did not derail growth or lift the USD enough for EM debt to underperform. In fact, because EM debt still offers robust excess returns during Phase 1 when the central bank is tightening, while also suffering during Phase 3 during central bank easing, we can conclude that the level of policy rates relative to equilibrium has a greater impact on returns than the direction of rates. The severity of the Global Financial Crisis and the relatively subdued pace of recovery for both growth and inflation led to one of the longest Phase 4s in history. Given the low level of starting yields, indicating a large gap to equilibrium, and the 'gradual' pace of normalization, the current Phase 1 should also last longer than it typically has. This bodes well for all credit sectors, including EM sovereign and corporate debt, if history is any guide. However, there are still reasons to be concerned about the impact of U.S. monetary policy on EM assets next year. If the Fed follows through with the interest rate hikes it is currently projecting - another 100bps in total by the end of 2018 - the funds rate will be much closer to equilibrium. If the U.S. dollar rallies alongside that Fed tightening, as we expect, overall U.S. monetary conditions could end up being much closer to a restrictive level than implied by strictly looking at our Fed Policy Cycle (which only looks at the funds rate to determine monetary conditions). Also, the equilibrium funds rate may now be lower than the levels we are assuming in the Fed Policy Cycle framework, suggesting that policy could turn restrictive more quickly in the current tightening cycle. Bottom Line: The Fed is still in the early stages of rate normalization. At this point in the Fed policy cycle, where the Fed is hiking rates but monetary conditions are still stimulative, EM hard currency debt has historically performed well both on a relative and absolute basis. Looking ahead, EM returns should begin to suffer in latter half of 2018 as the Fed moves to more restrictive policy stance. Another Reason For Caution: Our EM Corporate Health Monitor The BCA EM Corporate Health Monitor (CHM) is a directional indicator aimed at modeling the path of EM corporate spread movements. Financial data from 220 emerging market companies in over 30 countries is aggregated. Only firms that issue USD-denominated bonds are included, with banks and other financials also omitted in a similar fashion to the CHMs we have constructed for DM corporates. The indicator is made up of four financial ratios: profit margins, free cash flow to total debt, liquidity and leverage. Unlike the DM CHMs, the ratios are not equally weighted in the construction of the EM CHM. Profit margins and free cash flow to debt combined represent 75% of the EM CHM. The latest available reading is from Q2 2017, showing a large decrease, with the indicator now only barely in 'Improving Health' territory (Chart 10). This has occurred in tandem with EM corporate spreads narrowing to post-crisis lows, leaving EM debt at potentially overvalued levels on a fundamental basis. While this slowdown in the EM CHM is not yet a cause for concern, if this became an extended trend of financial health deterioration, the divergence with EM corporate debt performance would be unsustainable and leave EM corporates highly vulnerable to a correction. Chart 10The BCA EM Corporate Health Monitor Has Rolled Over EM Corporate Health Monitor Is Sending A 'Sell' Signal Bottom Line: Our EM Corporate Health Monitor has declined drastically and is barely in 'Improving Health' territory. This alone is not cause for concern yet, but further deterioration in our Monitor combined with additional credit spread narrowing would be a worrisome divergence. Investment Implications Emerging market debt is facing conflicting forces. While continued robust global growth and accommodative monetary policy provide a substantial tailwind for credit performance, extended valuations, the turn in the USD and a potentially worsening commodities outlook present difficult hurdles for EM to overcome. Given the mixed messages, we prefer owning cyclical credit exposure through DM corporate debt, particularly U.S. investment grade. EM debt yields have collapsed and are expensive relative to DM investment grade debt (Chart 11). Combined with a higher risk profile in EM, elevated valuations indicate that EM sovereign and corporate debt are vulnerable to larger corrections. From a return perspective, the difference in the corporate option-adjusted spreads (OAS) has been an excellent leading indicator for relative total returns (Chart 12). This differential indicates that there is considerable relative upside potential for U.S. investment grade over EM hard currency debt. Additionally, while global growth should support credit-related plays, relative growth dynamics are more supportive of U.S. investment grade because the next phase of the global growth upturn will be driven by DM countries and not EM. The difference between the manufacturing PMIs in the U.S. and EM has historically been a good directional indicator for the spread between U.S. corporate bond spreads and EM debt spreads (Chart 13). The gap between the relative manufacturing PMI readings is at a post-crisis high, and could widen further if EM economies suffer on the back of any pullback in Chinese growth in 2018. Chart 11EM Yields & Spreads Look Full Valued Chart 12Favor U.S. IG Over EM Corporates... Chart 13...Because Of Stronger U.S. Growth What are the risks to our view? Our recommended position would suffer in the event that inflation in the U.S. slows, keeping the Fed on hold and maintaining this year's USD downtrend. Also, if China were to ease up on its policy tightening, industrial commodity prices could strengthen once again. Under these scenarios, EM hard currency debt would likely outperform DM spread product. Bottom Line: Maintain moderate underweight positions in EM hard currency debt. Favor DM spread product (especially U.S. investment grade corporates) due to more supportive relative valuations and growth trends. Patrick Trinh, Associate Editor Global Fixed Income Strategy patrick@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 This “EM versus IG” trade was implemented in both our Emerging Markets Strategy and Global Fixed Income Strategy services. Please see BCA Emerging Markets Strategy Weekly Report, “EM: The Focus Is On Profits”, dated August 16th 2017, available at ems.bcaresearch.com, as well as the BCA Global Fixed Income Strategy Weekly Report, “A Lack Of Leadership”, dated August 22nd 2017, available at gfis.bcaresearch.com. 2 The weighting to EM debt in the Global Fixed Income Strategy model bond portfolio benchmark is based on market capitalizations of all the fixed income sectors we wanted to have in the benchmark, which includes non-investment grade debt like global high-yield corporates. It is reassuring to see that our benchmark weighting is also the desired weighting from a long-run portfolio optimization perspective. 3 Please see BCA Emerging Markets Strategy Weekly Report, "Is The Dollar Expensive, And Are EM Currencies Cheap?", dated October 11th, 2017, available at ems.bcaresearch.com. 4 Please see the joint BCA Global Asset Allocation/Emerging Markets Strategy Special Report, "Global Equity Allocation: The Underwhelming Case For EM", dated August 9th 2017, available at ems.bcaresearch.com & gaa.bcaresearch.com. 5 Please see BCA U.S. Bond Strategy Special Report, "Bonds And The Fed Funds Rate Cycle", dated May 27th 2014, available at usbs.bcaresearch.com. 6 The equilibrium policy rate is a BCA calculation based on long-run real potential GDP growth and long run inflation expectations.

Dear Clients, Please note there was an error in the Recommend Asset Allocation table published on November 1, 2017. This has now been amended. We apologize for the confusion and any inconvenience it may have caused. Best Regards, Garry Evans Senior Vice President Global Asset Allocation Reflation Trade Returns Recommended Allocation The market mood has shifted remarkably quickly over the past couple of months. The probability of a December Fed rate hike has moved up from 20% in early September to close to 100%, pushing the 10-year Treasury bond yield from 2.0% to 2.4% and causing the trade-weighted U.S. dollar to appreciate by 2%, and Emerging Market equities to underperform. We expect this trend to continue. Global growth continues to surprise to the upside (Chart 1). The softness in U.S. inflation this year is likely to reverse over coming quarters - an argument supported by the New York Fed's new Underlying Inflation Gauge, which indicates that sustained movements in inflation continue to trend higher (Chart 2). This makes it likely that the Fed will move ahead with its forecast three rate hikes in 2018, which the market has not yet priced in (Chart 3) - the implied probability of this is only 10%. Consequently, rates have further to rise: our fair value for the U.S. 10-year Treasury yield currently is 2.7%. And the increasing gap between U.S. and euro zone interest rates suggests that the dollar can appreciate further (Chart 4). All this supports our view that risk assets (equities and corporate credit) should outperform over the next 12 months, with developed government bonds producing a negative return, and emerging markets lagging because of rising rates and the stronger dollar (and a possible slowdown in China, as it focuses on reforming its economy and cleaning up the debt situation). Chart 1Growth Surprising To The Upside Chart 2Underlying Inflation Still Trending Up Chart 3Market Expects Fed To Move Only Slowly Chart 4Rate Gap Suggests Dollar Appreciation The key question, though, is how long this positive scenario can continue. With stock market valuations expensive (Chart 5) and investors fully invested, though not yet euphoric (Chart 6), we are clearly in late cycle. Rising rates could put a dampener on growth. Chart 5 Equities Close To Extremely Overvalued Chart 6Investors Are Fully Invested, But Cautious We find the Fed policy cycle a useful tool for thinking about probable investment returns from different assets (Chart 7). The best quadrant for risk assets is when the Fed is easing and policy is easy (with the Fed Funds Rate below the neutral rate). Currently we are in the bottom-right quadrant (Fed tightening, but not yet in the tight zone), which also has produced attractive returns for equities and credit. But once the Fed Funds Rate (FFR) moves above the neutral rate, returns from risk assets are on average poor and, historically, recession often followed quite quickly. How much longer do we have before Fed policy moves into the top-right quadrant? The Fed's own estimate of the neutral rate, in real terms, is 0.3%. The current real FFR (using core PCE inflation, 1.3%, as the deflator) is -0.17 (Chart 8). This implies that it will take only two further Fed hikes to move into the tight zone, which could happen as soon as March. This is why the outlook for inflation is critical. If, as the Fed forecasts and we also expect, core PCE inflation rises to 2%, it will be another five hikes before policy turns tight - we are unlikely to get there until early 2019. Chart 7The Fed Policy Cycle Chart 8How Far From The Tight Zone? For now, therefore, we continue to recommend an overweight on risk assets and pro-cyclical portfolio tilts. Global monetary policy remains easy and we see no indicators that suggest growth is slowing or that the risk of recession over the next 12 months is rising. The risks to this optimistic scenario (a hawkish Fed, over-eager structural reform in China, provocation from North Korea) seem limited. But we also continue to warn of the possibility of a recession in 2019 or 2020 caused, as so often, by excessive Fed tightening. We see, therefore, the possibility of our turning more defensive somewhere in mid-2018. Equities: We prefer developed over emerging market equities. Rising interest rates and an appreciating dollar will be headwinds for EM. Moreover, Xi Jinping's speech at the Communist Party Congress hinted at supply side structural reforms, overcapacity reduction, and deleveraging efforts. A renewed reform effort could dampen Chinese growth somewhat which, as in 2013-15, would negatively impact EM equities (Chart 9). Within DM, we are overweight euro zone and Japanese equities, which are higher beta, have stronger earnings momentum, and benefit from looser monetary policy. Fixed Income: We expect bonds to underperform over coming quarters, as U.S. inflation picks up and the Fed moves raises rates in line with its "dots". Corporate credit still has some attractions, provided the economic expansion continues. U.S. sub-investment grade bonds, in particular, have an attractive default-adjusted yield, as long as a strong economy keeps the default rate over the next 12 months to the historically low 2% our model suggests (Chart 10). The pick-up in inflation we expect would mean inflation-linked bonds outperform nominal bonds. Chart 9Slowing China Would Hurt EM Equities Chart 10Junk Attractive If Defaults Stay This Low Currencies: The ECB delivered a dovish tapering last month, extending its asset purchases until at least September 2018 and emphasizing that its current low interest rates will continue "well past the horizon of our net asset purchases". Given this, and the gap between U.S. and euro zone interest rates (Chart 4), we expect moderate further euro weakness over coming months. The dollar is likely to appreciate even more against the yen. There are the first tentative signs of inflation emerging in Japan (Chart 11) which, combined with the Bank of Japan sticking to its 0% 10-year JGB target and rising global interest rates, could push the yen to 120 against the dollar over coming months. Commodities: BCA's energy strategists recently revised up their crude oil forecasts on the back of strong demand, a likely extension of the OPEC agreement until at least end-2018, and possible supply disruptions in Iraq, Venezuela and other troubled regions.1 They see inventories continuing to draw down until at least 2H 2018 (Chart 12). Accordingly, they forecast $65 a barrel for Brent and $63 for WTI and flag upside risk to those projections. The outlook for industrial and precious metals, however, is less positive. A stronger dollar and a shift in the growth drivers in China will depress prices for base metals. Rising real interest rates will hurt gold, although we still like precious metals as a long-term hedge. Chart 11First Signs Of Inflation In Japan? Chart 12Oil Inventory Drawdowns Support Higher Price Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report "Oil Forecast Lifted As Market Tightens," dated 19 October 2017, available at ces.bcaresearch.com GAA Asset Allocation

Feature This week we are sending you a shorter-than-usual market update, as we are also publishing a Special Report exploring the outlook for USD cross-currency basis swap spreads. This report argues that USD basis swap spreads should widen over the next 12 months. Being a phenomenon associated with higher FX vols, this should hurt carry trades, including EM and dollar bloc currencies. It will also potentially create additional support for the USD. Also, next week, we will provide a deeper analysis of the fallout from the New Zealand government's dynamics. ECB Tapers? European Central Bank President Mario Draghi refused to call it "tapering," but he nonetheless announced that the ECB will be cutting back its asset purchases to EUR30 billion per month until at least September 2018. However, because the ECB will continue to proceed with re-investment of the stock of assets it holds, the monthly total presence of the ECB in European bond markets will stay above EUR 30 billion. Moreover, the ECB is keeping the door open to leaving its purchases in place beyond September 2019, if inflation does not keep track with the central bank's forecasts, and thus referred to the adjustment as being open-ended. Ultimately, the ECB does think that the recent rebound in inflation has been and remains a function of maintaining a very accommodative monetary setting. We think this option to keep the asset purchases in place beyond September 2018 is just this: an option. However, we do believe that yesterday's change in policy means the ECB will not increase interest rates until well into 2019. We also anticipate U.S. core inflation to begin outperforming euro area core inflation as U.S. financial conditions have eased significantly relative to the euro area - a key factor to redistribute inflationary pressures among these two economies (Chart I-1). As a result, because we anticipate that the Federal Reserve will increase the fed funds rate by more than the 67 basis points currently expected over the next two years, there could be some downside risk in EUR/USD. This downside risk is already highlighted by the large gap that has recently emerged between the 1-year/1-year forward risk-free rate spread between Europe and the U.S. versus the euro itself (Chart I-2). Chart I-1U.S. Inflation Set To Outperform Euro Area Prices Chart I-2Forward Interest Rates Point To A Lower Euro Moreover, the elevated long positioning right now further highlights the downside risk present in the euro (Chart I-3), probably explaining the European currency's rather violent reaction to what was a well-anticipated policy move. This means that EUR/USD could end 2017 in the 1.15 neighborhood, and fall further in 2018. Chart I-3Positioning Risk In EUR/USD Bottom Line: The ECB delivered exactly what was anticipated, yet the euro sold off. The ECB is unlikely to increase interest rates until well into 2019, suggesting the first anticipated rate hike in Europe is fairly priced. Thus, in order to justify any downside in the euro, one needs to be more positive on the Fed than what is currently priced into the U.S. interest rate curve. We fall into this camp. Moreover, positioning remains too long the euro. We expect EUR/USD to fall toward 1.15 by year end, and display more downside in 2018. Bank Of Canada The Bank of Canada (BoC) surprised the market this week by expressing a reversing of its recent pronounced hawkish bias, instead expressing a much more cautious tone. Where a closed output gap was once driving the need for tighter policy, residual labor market slack now warrants a more restrained approach to tightening. What has changed? NAFTA. The most recent and tenuous NAFTA negotiation round raised the specter of an end to the North American FTA. While NAFTA is still not dead, the rising probability that Canada-U.S. trade falls backs under the umbrella of the previous CUSFTA or even maybe something worse is causing a headache for Canadian policymakers. Some 20% of Canadian GDP is made up of products destined to be exported to the U.S., and this large chunk of GDP could be under some risk. Additionally, as the BoC highlighted, future investment decisions by firms in Canada may become investments in the U.S. to bypass regulatory uncertainty. Ultimately, if the Canada / U.S. trade relationship falls back under the CUSFTA umbrella, the impact on Canadian growth will be limited. Nonetheless, we think the BoC is correct to play its hand carefully, especially as the Canadian housing market is cooling. Moreover, a recent IPSOS survey revealed that around 40% of Canadian households would face financial difficulties if rates moved up significantly, which may justify a slower pace of hiking. With all this uncertainty looming, it is logical for the BoC to take its time before tightening policy anew. But in the end, we do anticipate the Canadian central bank to increase rates around two times next year, which is in line with the market's assessment: Canada's output gap is closing, and inflation is moving in the right direction. Thus, the outlook for the CAD is likely to be dominated by the outlook for oil. Robert Ryan, who runs BCA's Commodity And Energy Strategy service, expects WTI to move toward US$63/bbl next year, with upside risk to his forecast.1 This could help the CAD. However, the CAD does not seem particularly cheap against the USD when Canada's poor productivity performance is taken into account (Chart I-4), and speculators are now quite long the CAD (Chart I-5). As a result, our preferred medium to express positive views on the CAD is to be short AUD/CAD, where a valuation advantage is still present for the loonie (Chart I-6). Moreover, the AUD is more likely to suffer from China moving away from its investment-led growth model, while the CAD is less exposed to this risk. Chart I-4The CAD Is Not That Cheap Chart I-5Speculators Are Very Long The CAD Chart I-6Short AUD/CAD Bottom Line: The BoC is rightfully concerned that a breakdown of NAFTA would negatively affect the Canadian economy. While a return to CUSFTA would minimize any impact, the current high degree of uncertainty warrants that the BoC takes a more cautious stance. Ultimately, the BoC will increase rates next year, potentially two times. We continue to prefer to short AUD/CAD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report, titled "Upside Risks Dominate BCA's Oil Price Forecast", dated October 26, 2017, available at ces.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data has been strong: Manufacturing PMI came out at 54.5, stronger than expected; Services PMI came out at 55.9, also stronger than expected; Durable goods orders increased by 2.2%; New home sales increased by 18.9% monthly, the highest growth rate in 25 years; Initial jobless claims declined and beat expectations. Crucially, the DXY is above its 100-day moving average and has broken the reverse head-and-shoulders neckline, with momentum in the greenback's favor. The ECB's tapering weakened the euro by 1.4%. Further weakness in commodity currencies also allowed the dollar to gain momentum. We expect this momentum to continue as inflation in the U.S. re-emerges over the next six to twelve months. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The ECB's decision was largely in line with market consensus, but the euro nonetheless fell significantly. The ECB will halve its rate of purchases to EUR 30 bn a month starting next year until at least September 2018. However, President Mario Draghi stated that this could be extended beyond September, or even increased, if conditions warrant it. Draghi noted that "domestic price pressures are still muted overall and the economic outlook and the path of inflation remain conditional on continued support from monetary policy", also stating that rates would remain low for an extended period of time, and possibly even "past the horizon of the net asset purchases". Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: The Leading Economic Index increased from 105.2 to 107.2 in the month of August. Nikkei Manufacturing PMI surprised to the downside, coming in at 52.5, declining from 52.9 the month before. However, corporate service prices year-on-year growth came in at 0.9%, against expectations of 0.8%. Following the overwhelming victory of Prime Minister Shinzo Abe, the USD/JPY traded above 114, before stabilizing just below later in the week. Now that Abe has won the election, he is freer to implement loose fiscal policy in order to increase his chances to amend the pacifist Japanese constitution. This, accompanied by 10-year JGB rates anchored around zero, and a Federal Reserve that is likely to hike more than expected, should push USD/JPY higher. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in Britain has been mixed: Gross Domestic product yearly and quarterly growth surprised to the upside, coming in at 1.5% and 0.4% respectively. Moreover, public sector net borrowing was also lower than expected coming in at 5.236 billion pounds for the month of September. However, BBA mortgage approvals came below expectations, coming in at 41.584 thousand, which is lower than the month before. The pound has gone up following the positive GDP reading. As of now the market considers there is a 91% probability that the Bank of England hikes rates in November. However any hikes beyond that would require a significant improvement in economic activity. Thus, we would tend to fade any strength in GBP/USD, as the Fed is more likely to hike rates than the BoE on a sustainable basis. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The AUD declined on weak consumer price numbers. The trimmed mean CPI remained steady at 1.8% annually, below the expected 2% rate, and weakened to 0.4% quarterly, down from 0.5%. The largest yearly decline was in communication (services or equipment) of 1.4%, although declines in food prices and clothing were also substantial at 0.9%. This is largely in line with our view that the consumer sector is handicapped with poor wage growth. We believe inflation is unlikely to move much higher; this will keep the RBA at bay. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been negative: Imports surprised to the upside, coming in at 4.92 billion dollars. This figure also increased form last month's reading. However exports underperformed expectations, coming in at 3.78 billion dollars for the month of September. Finally the trade balance, also underperformed expectations, coming in at -1.143 billion dollars. After the election of new Prime Minister Jacinda Ardern the kiwi has plunged, and now has a negative return year-to-date. The government is trying to implement three measures which significantly affect the value of the kiwi: a dual central bank mandate, restrictions on immigration, and a stop to foreign real estate purchases. All these measures lower the terminal rate for the RBNZ. With this being said, we are still shorting AUD/NZD given that commodity dynamics will dominate the movements of this cross. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 CAD had an eventful week as the Bank of Canada came out with a monetary policy decision. The decision was in line with the consensus, but the statement was not. The Bank was particularly concerned "about political developments and fiscal and trade policies, notably the renegotiation of the North American Free Trade Agreement". Additionally, it was also noted that "because of high debt levels, household spending is likely more sensitive to interest rates than in the past". The Bank also made a U-turn in its view of the labor market, stating that "wage and other data indicate that there is still slack in the labor market". These unexpected remarks dropped the CAD's value by 1% against USD. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The Franc continues to depreciate against the Euro, even as EUR/USD has gone down more than 2.5% since peaking early in December. Meanwhile, as the franc has depreciated, economic variables have improved. The KOF Industry Survey Business Climate indicator is now positive for the first time since 2011. Meanwhile, core inflation has reached 2011 highs as well. Additionally multiple components of PMI are at their highest level in the past 6 years. All of these factors bode well for the Swiss economy, and prove that the SNB's ultra-loose monetary policy and currency intervention is working. That being said, we would like to see more strength from key economic variables to consider shorting EUR/CHF, given that the recovery is still too fragile for the SNB to change policy. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The Norges Bank left their key policy rate unchanged at 0.5% yesterday. The central bank highlighted that capacity utilization was below normal levels and that inflation was expected to be below 2.5% in the coming years. Furthermore, the comittee highlighted that although the labor market appears to be improving, inflation has been lower than expected, while the krone is also weaker than projected. The bank has reassured our view that even in the face of strong oil prices, slack is still too big in the Norwegian economy for the Norges Bank to start raising rates. Furthermore, a hawkish fed will further put upward pressure on USD/NOK. Than being said, EUR/NOK should depreciate, given that this cross is much more sensitive to oil than it is to rate differentials. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The SEK has depreciated considerably in recent weeks owing to somewhat weaker inflation figures. It has weakened particularly against the EUR, as markets are expecting the Riksbank to follow the ECB in its rate path. This was confirmed by a particularly dovish tone from the recent monetary policy statement which exacerbated this decline, with the board expecting to maintain the current monetary policy until mid-2018, and even discussed a possible extension of asset purchase programs beyond December. The Board has "also taken a decision to extend the mandate that facilitates a quick intervention in the foreign exchange market". Finally, they lowered their inflation forecasts for both 2017 and 2018. Stefan Ingves is firmly in control. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Special Report

Highlights Three factors point to stable or narrower USD cross-currency basis swap spreads: the improving health of global banks, the end of the adjustment to the regulatory change affecting prime-money market funds, and the relaxation to the Supplementary Leverage Ratio rules by the U.S. Treasury. Four factors point to wider basis swap spreads: BCA's forecast that U.S. loan growth will pick up, our view on U.S. inflation, the coming decline in the Federal Reserve's balance sheet, and the potential for U.S. repatriation. We expect USD basis swap spreads to widen again, which suggests increasing FX vol. This would hurt carry trades, EM currencies and dollar bloc currencies. Feature Three factors point to stable or narrower USD cross-currency basis swap spreads: the improving health of global banks, the end of the adjustment to the regulatory change affecting prime-money market funds, and the relaxation to the Supplementary Leverage Ratio rules by the U.S. Treasury. Four factors point to wider basis swap spreads: BCA's forecast that U.S. loan growth will pick up, our view on U.S. inflation, the coming decline in the Federal Reserve's balance sheet, and the potential for U.S. repatriation. We expect USD basis swap spreads to widen again, which suggests increasing FX vol. This would hurt carry trades, EM currencies and dollar bloc currencies. The rather arcane topic of cross-currency basis swap spreads has periodically surfaced in the news in the past few years. The widening in cross-currency basis swap spreads has been highlighted as one of the key factors explaining why covered interest rate parity relationships (the link between the price of FX forward, spot prices and interest rate differentials) have not held as closely after the Great Financial Crisis (GFC) as before. The widening of cross-currency basis swap spreads has also been highlighted as a factor behind the strength in the U.S. dollar in 2014 and 2015. Similarly, the recent narrowing in the cross-currency basis swap spread has been highlighted as a factor behind the weakness in the USD this year. This week we delve a little deeper into what cross-currency basis swap spread measures, and what some of its major determinants are. We ultimately expect the USD cross-currency basis swap spread to widen again, which should contribute to a stronger dollar and increased global FX volatility. What Is A Cross-Currency Basis Swap? To examine what drives cross-currency basis swap spreads, one first needs to understand what these instruments are. Let's begin with a regular FX swap. An FX swap in EUR/USD is a contract through which two counterparties agree to exchange EURs for USDs today, with a reversal of that exchange at the maturity of the contract - a reversal set at a predetermined exchange rate simply equal to the forward value of the EUR/USD. So, if counterparty A lends X million EURs to counterparty B, the former receives in U.S. dollars the equivalent of X million EURs times the prevalent EUR/USD spot rate from counterparty B today. The transaction does not end there. Simultaneously, the FX swap forces B to give back the X million EURs to counterparty A at maturity, while counterparty A gives back X million EUR times the EUR/USD forward rate in U.S. dollars to counterparty B. This forward rate is the rate prevalent when the contract was agreed upon. The transactions are illustrated in the top panel of Chart 1. Chart 1FX Swaps Vs. Cross Currency Basis Swaps The problem with regular FX swaps is that they offer little liquidity at extended maturities. If market players want to hedge long-term liabilities and assets, they tend to do so using a cross-currency basis swap, where much more liquidity is available at long maturities. Chart 2A Bigger Funding Gap = ##br##A Wider Basis Swap Spread A EUR/USD cross currency basis swap begins in the same way as a regular FX swap: counterparty A lends X million EURs to counterparty B, and the former receives in U.S. dollars the equivalent of X million EURs times the prevalent EUR/USD spot rate from counterparty B today. However, this is where the similarities end. A cross-currency basis swap has exchanges of cash flows through its term. Counterparty B, which provided USDs to counterparty A, receives 3-month USD Libor, while counterparty A, which provided EURs to counterparty B, received 3-month EUR Libor + a (alpha being the cross-currency basis swap spread). At the maturity of the contract, counterparty A and B both receive their regular intermediary cash flows, and also re-exchange their respective principal - but this time at the same spot rate as the one that existed at the entry of the contract (Chart 1, bottom panel). In both regular FX and cross-currency basis swaps, counterparties have removed their FX risks, except that in the latter, the interest differentials have been paid during the life of the contract instead of being factored through the forward premium/discount. This is fine and dandy, but it leaves a unexplained. The cross currency basis swap spread (a), is a direct function of the relative supply and demand for each currency. If investors demand a lot of EUR in the swap market relative to its supply, a will be positive. If they demand more USDs, a will be negative. A good example of this dynamic is the funding gap of banks. Let's take the Japanese example. Japanese banks have a surplus of domestic deposits (thanks to the massive savings of the Japanese corporate sector) relative to their yen lending. As a result, they have large dollar lending operations. To hedge their dollar assets, Japanese banks borrow USD in large quantities in the cross-currency swap market. This tends to result in a negative swap spread in the yen (Chart 2). This is particularly true if both the banking sector and the other actors in the economy (institutional investors and non-financial firms) also borrow dollars in the swap market to hedge dollar assets, which is the case in Japan (Chart 3). Chart 3Japanese Investors Are Accumulating Assets Abroad Additionally, if there are perceived solvency risks in the European banking sector, this should further weigh on the cross-currency basis swap spread, pushing it deeper into negative territory, as the viability of the main EUR counterparties becomes at risk. The same dance is true for any currency pair. Chart 4The Structural Gap In The Basis Swap Spread##br## Reflects Regulation The other factor that affects USD cross-currency basis swap spreads is the supply of U.S. dollars, especially the room on large banks' balance sheets to service these markets. The cross-currency basis swap spread could be close to zero if large arbitrageurs take offsetting positions to arbitrage the spread away, doing so until the spread disappears. However, with the imposition of Basel III and Dodd-Franks, banks have been constrained in their capacity to do this. Indeed, increased leverage ratio requirements (now banks need to post more capital behind repo transactions as well as collateralized lending and other derivatives) mean that arbitraging cross-currency basis swap spreads and deviations from covered interest rate parity has become much more expensive. Furthermore, the increase in Tier 1 capital ratios associated with these regulations has forced banks to de-lever; however, engaging in arbitrage activities still requires plenty of leverage (Chart 4). Economic Factors Driving The Spread The factors that we look at essentially relate to the supply of USD available for lending in offshore markets, as well as determinants of relative counterparty risks between the U.S. and the rest of the world. Factors Arguing For Narrower Cross-Currency Basis Swap Spreads Global Banks Health The price-to-book ratio of global banks outside the U.S. has been largely correlated with USD cross-currency swap spreads. When global banks get de-rated, spreads widen, and it becomes more expensive to hedge USD positions in the swap market (Chart 5). This is because as investors perceive the solvency of global banks deteriorating, they impose a penalty as the Herstatt risk increases. Additionally, solvency problems can force banks to scramble to access USD funding, prompting deeper spreads. Chart 5Banks Perceived Health Determines ##br##Basis Swap Spreads BCA is positive on global financials and sees continued improvement in European NPLs. This means that solvency risk concerns are likely to remain on the backburner for now, pointing to narrower basis swap spreads. Supplementary Leverage Ratio Changes In June, the U.S. Treasury announced a relaxation of some of its rules on supplementary leverage ratios, lowering the amount of capital required to support activity in the repo market behind initial margins for centrally cleared derivatives, and behind holdings of Treasurys. This means that commercial banks in the U.S. can have bigger balance sheets and more room to engage in arbitrage activity, implying a greater supply of dollars in the USD cross-currency basis swap market. In response to last June's proposal, basis swap spreads narrowed by 11 basis points. BCA believes these changes will continue to support dollar liquidity, and will further help in narrowing cross-currency basis swap spreads. Prime Money-Market Funds Debacle Is Over Chart 6More Expensive Bank Funding Equals ##br##Wider Basis Swap Spreads In October 2016, regulatory changes were implemented that allowed prime money market funds to have fluctuating net asset values. Obviously, this meant that prime money-market funds would be not-so-prime anymore. As a result, to remain the ultra-safe vehicles that they once were, prime money-market funds de-risked. As a result, they cut their exposure to risky activities in anticipation of these changes. In practice, a key source of short-term funding for banks evaporated from the market, putting upward pressure on bank financing costs. As the LIBOR-OIS spread increased, so did basis-swap spreads (Chart 6): as it became more expensive for banks to finance themselves, they had to curtail the supply of USDs provided to the swap market, an activity normally requiring intense demand on banks' balance sheets. This adjustment is now over, suggesting limited potential widening in USD basis swap spreads. Factors Arguing For Wider Cross-Currency Basis Swap Spreads 1. U.S. Loan Growth When U.S. banks increase their loan formation activity, USD cross-currency basis swap spreads widen (Chart 7). As banks increase their extension of credit through loans, they decrease the amount of securities they hold on their balance sheets (Chart 8). This means there is less supply of liquidity available for balance sheet activities, particularly providing dollar funding in the offshore market. In the Basel III / Dodd-Frank world, less-liquid bank balance sheets are synonymous with wider USD basis-swap spreads. As we argued last week, increasing U.S. capex, easing lending standards for firms and rising household income levels should result in increasing loan growth in the U.S. which will result in lower abundance of liquid assets and a widening basis swap spreads.1 Chart 7More Bank Loans Lead To Wider Swap Spreads Chart 8More Debt Equals Less Securities In Bank Credit 2. U.S. Inflation There is a fairly close relationship between U.S. inflation and the USD basis swap spread, where a higher core CPI tends to lead to a wider spread (Chart 9). The fall in U.S. inflation this year likely contributed to the narrowing in basis swap spreads. Our take on this is that as inflation falls, it gives an incentive for banks to hold low-yielding liquidity on their balance sheets as real returns on cash improve. This fuels a gigantic carry trade through the basis-swap market. We expect inflation to pick up meaningfully by mid-2018, which should widen cross-currency basis swap spreads.2 3. Central Bank Balance Sheets When the Federal Reserve increases the size of its balance sheet relative to other balance sheets, this tends to lead to a narrowing of the USD basis swap spread as the global supply of dollars relative to other currencies increases. The opposite is also true. This relationship did not work after late 2016 (Chart 10). However, during that episode, as the change in prime money-market funds caused a dislocation in banks' funding, commercial banks exhibited cautious behavior and increased their reserves with the Fed. As Chart 11 illustrates, there is a tight relationship between the change in commercial banks' reserves held at the Fed and cross-currency basis swap spreads. Going forward, as the Fed lets it balance sheet run off, we expect to see a decrease in commercial banks' excess reserves. This could contribute to upward movement in the basis swap spread. Chart 9When U.S. Inflation Increases, ##br##Swap Spreads Widen Chart 10Smaller Fed Balance Sheet Leads To##br## Wider Basis Swap Spreads Chart 11Fed Runoff Could##br## Widen Basis Swap Spreads 4. U.S. Repatriations The most revealing relationship unearthed in our study was that when U.S. entities repatriate funds at home, this tends to put strong widening pressure on the USD cross-currency basis swap spread (Chart 12). U.S. businesses hold large cash piles abroad - by some estimates more than US$2.5 trillion. However, most of these funds are held in highly liquid, high-quality U.S.-dollar assets offshore. These assets are perfect collaterals for various transactions in the interbank market. The funds held abroad by U.S. firms are a source of supply for U.S. dollars in the offshore markets. When U.S. entities bring assets back home, the widening in the basis swap spread essentially reflects a decline in the supply of USD in offshore markets, and vice versa when Americans export capital abroad. Chart 12U.s. Repatriations Support Wider Basis Swap Spreads BCA's base case is that tax cuts are likely to hit the U.S. economy in 2018, even if the growing feud between Trump and the establishment Republican party members is a growing risk. BCA still views a tax repatriation as a higher-likelihood event, as it is the easiest way for the U.S. government to bring funds into its coffers. The 2004 tax repatriation under former President George W. Bush did result in substantial fund repatriation in the U.S. This time will not be different. We expect any such tax repatriation to cause a potentially large deficit of supply in the USD offshore markets, which could create a strong widening basis on the cross-currency basis swap spread in favor of the dollar. Bottom Line: Three factors argue for USD cross-currency basis swap spreads to stay at current levels, or even narrow further. These factors are the health of global banks, the easing in U.S. supplementary leverage ratios and the end of the adjustment of U.S. bank funding to new regulations affecting prime money-market funds. On the other hand four factors points to wider USD cross-currency basis swap spreads: BCA's positive outlook for U.S. credit growth; BCA's positive outlook on U.S. inflation; the run-off of the Fed's balance sheet; and the potential for U.S. entities repatriating funds from abroad. Potential Direction And Investment Implications We anticipate USD cross-currency basis swap spreads to widen over the coming 12 months. We think the easing in the Supplementary Leverage Ratios rules by the U.S. Treasury is the most important factor pointing to narrower USD cross-currency basis swap spreads. However, Basel III rules and most of Dodd-Frank are still in place, which suggest there remains large constraints on the balance-sheet activities of global banks, which will limit the potential for a narrowing of the USD basis swap spread as U.S. banks will remain constrained in their ability to supply U.S. dollars in the offshore market. On the other hand many factors support wider USD cross-currency basis swap spreads, most important of which is the potential for more credit growth. This is in our view a very strong force as it requires banks to ration the use of their balance sheets, limiting their activity in the offshore market. Moreover, we do foresee a high probability of tax repatriation, which would put strong widening pressure on the swap spreads. In terms of implications, wider USD basis swap spreads tend to be associated with rising FX vols (Chart 13). As we highlighted in a Special Report last year, higher FX vols are poison for carry trades.3 As such, we think that widening swap spreads could spur a period of trouble for traditional carry currencies. This means EM and dollar-block currencies are likely to suffer in this environment. Chart 13Wider Basis Swap Spreads Equals Higher Vol Additionally, in China, Xi Jinping is consolidating power and has taken control of the Politburo. This implies he now has more room to implement reforms. Removal of growth targets after 2020, removal of growth as a criterion for grading local officials, a focus on balanced growth, and a focus on combatting pollution all suggest that Chinese growth is unlikely to follow the same debt-fueled, capex-led model.4 This will weigh on Chinese imports of raw materials, and hurt export volumes and prices for many EM countries and commodities producers. This means these policies represent a headwind for many carry currencies. Moreover, historically, wider USD funding costs have been associated with a stronger dollar, as it makes it more expensive to hedge dollar assets. Thus, in an environment where U.S. interest rates are rising relative to the rest of the world - making U.S. assets attractive - wider basis swap spreads are an additional factor that could lift the dollar. Bottom Line: We anticipate the USD cross-currency basis swap spread to widen over the next 12 months. This will be associated with higher FX vols, which hurt carry trades, EM currencies and dollar-block currencies. Chinese reforms will reinforce these risks. Additionally, wider basis swap spreads will create support for the USD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "All About Credit", dated October 20, 2017, available at fes.bcaresearch.com. 2 Please see Foreign Exchange Strategy Weekly Report, titled "Conflicting Forces For The Dollar", dated September 8, 2017, and "Is The Dollar Expensive?", dated October 13, 2017. 3 Please see Foreign Exchange Strategy Special Report, titled "Carry Trades: More Than Pennies And Steamrollers", dated May 6, 2016. 4 Please see Geopolitical Strategy Weekly Report, titled "Xi Jinping: Chairman Of Everything", dated October 25, 2017 and Special Report, titled "How To Read Xi Jinping's Party Congress Speech", dated October 18, 2017.