Brazil

Highlights The presidential race between Haddad and Bolsorano will be very tight. At present, we put slightly higher odds on Haddad winning by a small margin in the second round. A Haddad victory would lead to a continuation of stress in financial markets. The prospects of Lula's release and populist policies will lead to further downside in Brazilian assets Bolsorano's victory in the second round will likely lead to a tradeable rally in Brazil's financial markets. For now continue underweighting Brazilian equities and credit and continue shorting the BRL. We will consider whether to upgrade Brazil after the outcome of the elections becomes clearer. Feature Chart 1Potential Roadmaps For Equities Relative Performance Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? Brazil's upcoming general elections will be among the closest in recent history. Current polls show a tight race between right-wing candidate Jair Bolsonaro and left-wing candidate Fernando Haddad. A victory by Bolsonaro may spark a short-term rally in Brazilian assets on the expectation of structural reforms. On the other hand, a Haddad victory and return of the Worker's Party to power would be quite negative for financial markets. The upside of this election, regardless of outcome, is that a new government with a new mandate will be formed, restoring a semblance of legitimacy for the first time since the impeachment of President Dilma Rousseff in 2016. The downside is that this mandate will be weak, the odds of a "pro-market" government are uncertain, and Congress will be fragmented. Much-needed yet painful social security reforms will face an uphill battle, with potentially another market riot needed to motivate policymakers and legislators to enact social security reforms. On the macroeconomic front, Brazil does not have a lot of room and time for maneuver. Without drastic measures to cut the budget deficit or boost nominal GDP, public debt will most likely spiral out of control. Due to the current state of polarization, we cannot have a high conviction view on the election outcome until after the congressional elections on October 7. That said, the macro forces remain negative for EM overall and Brazil in particular. Barring Bolsorano's victory in the second round, there is little reason for Brazilian risk assets to rally (Chart 1). An Anti-Establishment Victory? Media attention has centered on Bolsonaro of the Social Liberal Party. He is the frontrunner in the first round of the race, despite his controversial rhetoric and overt sympathies with Brazil's military dictatorship of the past. In polling for the second round, his considerable lead has shrunk, as he is now neck and neck with the other contenders (Chart 2). Bolsonaro is a serious candidate not because of any overarching, international "Trumpian" narrative, but because Brazil itself is ripe for an anti-establishment electoral outcome: With Lula out of the race, the combined "right-wing" and "left-wing" vote is close in the first round (Chart 3). Chart 2Second-Round Polls Very Tight Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? Chart 3A Tight Race Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? The country is still in the throes of a political crisis and a historic recession (Chart 4). The major political parties have been discredited. Years of slow economic growth have resulted in extremely low levels of public trust in government (Chart 5). Chart 4Brazil In The Wake Of A Historic Recession Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? Chart 5Low Growth Countries Suffer From Lack Of Trust In Their Government Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? This is prompting voters to seek a "change in direction" and/or a "protest vote," from which Bolsonaro is apparently benefiting. There is even a sizable audience for Bolsonaro's authoritarianism and nostalgia for military rule. Brazilians are disillusioned with democracy - with 67% of respondents in a Pew Research poll saying they are "not satisfied" with democracy, compared to a global median of 52%.1 Almost a third of educated Brazilians favor military rule, and that number is as high as 45% among the uneducated (Chart 6).2 Bolsonaro's net approval is less negative than other candidates. In fact, only former Presidents Lula and Rousseff have higher net approval (Chart 7). This is a serious risk to Bolsonaro's likeliest rivals, Fernando Haddad of the Worker's Party and Ciro Gomes of the Democratic Labor Party. Bolsonaro's stabbing at a rally on September 6 has not taken him out of the race. His social media support has become an important tool to reach out to his fan base. Chart 6Brazilian Voters Harbor Some Authoritarian Tendencies Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? Chart 7Net Approvals Advantage Bolsonaro Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? However, there are two key reasons why Bolsonaro is not the favorite to win the election: First, Brazil's two-round electoral system works against Bolsonaro because it enables left-leaning voters to vote strategically in favor of the "least bad option," i.e. the available left-of-center candidate, in the second round. Thus while polling shows Bolsonaro very close to each of his potential opponents in the second round, his final opponent will receive a boost that will not be fully accounted for until after the first round eliminates other left-wing contenders. Recent polls suggest that Haddad stands to benefit much more than Bolsonaro from the "migration" of votes after the first round, as left-wing supporters team up against Bolsonaro in the second round (Table 1). Second, with Lula disqualified from the race, Lula supporters are now in the process of switching to support Haddad. Lula has carried a high approval rating of around 35%-40% for over a year, well above all other candidates. In our "poll of polls" (average of various polls) Haddad has risen rapidly in the one month since Lula's disqualification became clear, so that he is now at equal odds with Bolsonaro (see Chart 2 above). A few polls even suggest Haddad is ahead of Bolsonaro in the second round (Chart 8).3 Table 1Second Round Migration##br## Polls Advantage Haddad Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? Chart 8Haddad Is Ahead##br## In These Polls Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? To elaborate on this last point: First, about 59% of Lula's supporters say they will shift to Haddad (Chart 9), which should be enough to position him as one of the top two contenders in the first round of voting. Only 4% of Lula supporters will shift to right-of-center candidate Alckmin- a share that is overpowered by the 71% of the Lula vote that will go to left-leaning candidates. Second, the number of undecided and "blank" Lula voters is high at 18%. These voters - if they vote - will mostly go to Haddad, and then Gomes. From the above we can conclude that Haddad will face Bolsonaro in the second round runoff. Because of strategic voting, Haddad will be favored to win the Presidency. A major risk to the left-wing candidate in the second round is that as many as 18% of Lula voters may stay home and not vote. This would mean that Haddad could lose the final vote due to low turnout.4 Overall voter turnout has been falling slightly since 2006 (from 83.3% to 80.7% in 2014) and the disillusionment of voters could result in still lower turnout in 2018. This would favor Bolsonaro, whose supporters are the most likely to vote, whereas Haddad's are the least likely, according to surveys. The profile of the most likely voters favors Bolsonaro (Table 2).5 Chart 9Lula's Migration Vote Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? Table 2Voter Profile Of Each Candidate Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? As a consequence, we give Bolsonaro 40%-50% odds of winning the presidency, with the possibility of downgrading his probability to a flat 40% if the rise in Haddad's polling continues at the current pace. Strategic voting imposes a handicap on Bolsonaro, making it hard for him to increase his odds above 50%. The lower net approval for Haddad and Gomes, and the risk that Lula voters will fail to transfer in full force to Haddad, suggests that Bolsonaro has a fair chance of winning the second round. Elections are a Bayesian process and we will update our probabilities as more information comes in. In particular, it is important to see if Haddad exceeds expectations in the October 7 first round. Bottom Line: Given strategic voting in the second round and the momentum behind Haddad, the odds of a left-wing victory in the Brazilian election are 50%-60%. However, this is a low-conviction view. Bolsonaro's odds of winning are closer to 40%-50%, particularly if Lula voters stay home. The New Government's Mandate Will Be Weak No matter who wins, there will be at least one positive takeaway for Brazilian risk assets: a new government will be elected with a fresh mandate to lead the country. The Brazilian state has suffered from a crisis of legitimacy over the past few years. A countrywide anti-corruption campaign and economic depression has led to a general loss of confidence. The latter was further exacerbated by the impeachment of President Rousseff and paralysis of the interim government of Michel Temer. Hence this election will clear the air and give a new government the chance to tackle the country's economic and political problems. However, this clearly positive factor will be overwhelmed by negative factors as the election unfolds and in the aftermath: No first round winner: As outlined above, none of the candidates are likely to win a simple majority of the vote in the first round on October 7. This has been the norm in recent elections, but it precludes the possibility that the current crisis will be matched by a leader with a strong personal mandate, like Cardoso in the 1990s. A close election may lead to contested results: The current second-round polling suggests the outcome will be close. The losing side may challenge the results, a controversy that could cause significant political uncertainty for weeks or months. Bolsonaro has already suggested that he can only lose if the Worker's Party rigs the election. Congress will be fractured: Brazil's Congress is always fractious; with numerous parties and coalitions cobbled together by presidents whose own party has a relatively small share of seats (Chart 10). The upcoming president may even have a weaker congressional base than usual. The erstwhile dominant parties, the PDMB and the PSDB, are less popular than they once were and have put forward lackluster presidential candidates, suggesting they will not win large numbers of seats. The Worker's Party, with a large support base in recent decades, was at the epicenter of the impeachment crisis and suffered huge losses in the municipal elections of 2016, also suggesting it will not win as many seats.6 Meanwhile Bolsonaro's Social Liberal Party is starting from a low base (it currently has only eight out of 513 seats in the lower house and none in the senate). Hence, no party is in a position to sweep Congress, or even come close to a majority, ensuring high diffusion of power, horse-trading, and unstable, ad hoc coalitions. Such coalitions have been a hallmark of Brazilian politics and may even be more unstable this time around. Chart 10ABrazil's Parliament Is Fractious Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? Chart 10BBrazil's Parliament Is Fractious Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? No more pork: Given the focus on fiscal austerity and corruption, the next president of Brazil will struggle to command as much "pork-barrel spending" - politically-motivated fiscal handouts to individual congress members - to grease the wheels of politics. President Lula and President Cardoso both relied on pork to ensure passage of key legislation in the 1990s and early 2000s. Polarization: Polarization will remain high as a result of the economic crisis. If Haddad wins, we expect that he will pardon President Lula, despite his assertions to the contrary, and create ill-will among the roughly 52% of the population that views Lula as corrupt. If Bolsonaro manages a victory, he will face intense opposition and resistance from civil society and possibly a left-of-center Congress. Historically, a governing coalition with a majority of seats eventually emerges from Brazil's fragmented Congress. However, periods of political crisis - and transitions from one leading party to the next - often require more time to form such coalitions. It took Lula two years, from 2002-04, to form a majority coalition during his first term in office, according to research by Taeko Hiroi of the University of Texas at El Paso (Chart 11). Chart 11Historical Profile Of Governing Coalitions Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? Bottom Line: The formation of a new government with a new mandate is positive but it will not bestow as much political capital as the market expects: in all likelihood the new president's mandate will be weak and Congress will, at least initially, be divided. Will Reforms Be Reactive Or Proactive? What are the likely market reactions from the different election scenarios? And will policymakers be proactive or reactive in their pursuit of any structural reforms? While we cannot rule out a knee-jerk rally if Bolsonaro wins, the length and breadth of the market reaction will depend on the government's political capital (e.g. popular margin of victory and strength in Congress) and willingness to be proactive about structural reforms. On the left, both Haddad and Gomes are "populist," left-leaning, candidates whose victory would exacerbate the selloff. Haddad's vice-presidential candidate and coalition partner is Manuela D'Avila, from the Brazilian Communist Party (PCdoB). Their platform states that the solution to low economic growth is expansionary fiscal and monetary policies, such as a removal of the cap on government spending and a reduction in interest rates. Meanwhile the Gomes campaign has denied that Brazil has a pension deficit.7 Neither Haddad nor Gomes faces the IMF-imposed constraints that Lula faced when he took power in 2002. The market pressure surrounding his election in 2002 and the IMF proposals at that time essentially forced Lula to continue his predecessor Cardoso's reforms. Compared to 2002-03, today's profile of Brazilian share prices suggests that more downside is warranted (see Chart 1, page 1). Hence, we believe more market turmoil would be necessary to force Haddad or Gomes to adopt any difficult and unpopular fiscal reforms. We believe that both could be capable of executing reforms if pressed by the market, but a market riot is needed first. On the other hand, a Bolsonaro victory would likely trigger a meaningful rally on the expectation of pro-market reforms. Bolsonaro's economic advisor Paulo Guedes, a University of Chicago economics PhD holder, is a supply-side reformer who has proposed to privatize state-owned assets, enact tax and pension reforms, and scale back the bureaucracy. Crucially, Bolsonaro's camp wants to use the proceeds from privatization to repurchase public debt and buy time before reforming the pension system. Hence, in the eyes of many investors, Bolsonaro represents a market-friendly candidate despite his tough talk and anti-establishment tendencies. The problem is that Guedes has spent far more time giving interviews to the financial press than campaigning on draconian structural reforms. As such, it is not clear that Bolsonaro's economic team's promises jive with the desires of the median voter in the country. Bolsonaro, meanwhile, will likely be limited in forming a coalition in the Chamber of Deputies.8 The ability to form and maintain alliances in the Chamber of Deputies is a key constraint for any Brazilian president, especially from a smaller party. Obstructionism is common.9 Even large parties with strong alliances have fallen into gridlock, most obviously in attempting structural reforms. In late 1998, for instance, President Cardoso's own PSDB party deprived him of the votes needed to seal a painstakingly negotiated deal with the IMF, which led to a loss of confidence among creditors and a sharp devaluation of the real in January 1999. In short, it will be difficult for the new president to implement reforms at the beginning of his term even though, as noted above, Brazilian presidents tend to cobble together a coalition over time. It should be noted that Bolsonaro's authoritarian tendencies and desire to rewrite the 1988 constitution - a partisan Pandora's Box - could result in a further deterioration of Brazilian governance (Chart 12). This would push up the risk premium on assets over the long run, though in the short run Bolsonaro may be positively received by financial markets. Bottom Line: Bolsonaro would likely want to be a proactive structural reformer, but he would also be constrained at first due to his small party base in Congress and need to form a coalition. In addition, the days of liberally soothing partisan battles with pork-barrel spending are over. Brazil is both fiscally constrained and increasingly sensitive to corruption. Moreover, fiscal austerity would come with a negative hit to growth in the short term. It is not clear whether Bolsonaro will be able to form a Congressional coalition that can push through the painful part of the "J-Curve" of structural reform (Diagram 1). Chart 12Brazilian Governance Set To Fall Further Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? Diagram 1The J-Curve Of Structural Reform Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? On the other hand, neither Haddad's nor Gomes's platforms are market-friendly. Neither is likely to attempt structural reforms proactively. The market would have to sell off further, as in 2002, to pressure them into such policies. At that point, however, they might ultimately have a better ability to push legislation through Congress than Bolsonaro due to their ability to form larger coalitions amongst leftist parties. Either way Brazilian risk assets have further downside from where they stand today. A market riot is likely necessary to galvanize the population's support for painful structural reforms. That support currently does not exist. What Is At Stake? Chart 13The Achilles Heel Of The Brazilian Economy Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? Brazil's public debt is out of control. Weak nominal GDP growth and high borrowing costs are increasing the public debt burden. This debt stems in large part from a sizable social security deficit that will continue expanding without the above-mentioned reforms (Chart 13). Thus, the next president will face a dilemma: implement austerity to satisfy creditors or increase spending to satisfy voters. A close look at voter preferences suggests that top priorities are improving health services and raising the minimum wage, while pension reform is at the bottom of the list (Chart 14). This reinforces our view that the left-of-center candidates are likely to be the closest to the median voter, and that fiscal austerity is not forthcoming. However, voters are also demanding that inflation be controlled, taxes be cut, and jobs be created - all of which could result in support for right-of-center candidates. Two possibilities to stabilize or reduce the debt load are: (1) restoring a primary budget surplus by enacting social security cuts and/or (2) privatizing state assets to raise fiscal revenues. In Europe throughout the early 2000s, peripheral countries with large public debt imbalances ran large primary budget deficits, just as Brazil has been running (Chart 15, top panel). Portugal, Ireland, Italy, Greece, and Spain stabilized their debt-to-GDP ratios by cutting social spending and capping fiscal expenditures (Chart 15, bottom panel). This will prove challenging as Brazil's pension system is one of the most generous in the world, with retirement ages of 54 and 52 for men and women, respectively, and a much lower contribution period relative to other countries. Furthermore, replacement rates for both men and women are 61%, or 10 percentage points above the OECD average and over 15 percentage points above other countries' reformed pension systems.10 Finally, the dependency ratio will continue to increase, as rising life expectancy and a declining working-age population remain structural headwinds for years to come.11 In our conversations with clients, the reality of Brazil's aging demographics usually comes as a complete surprise. Chart 14Brazil's Population Is ##br##Not Open To Fiscal Austerity Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? Chart 15Eurozone Debt Crisis Resulted ##br##In Lower Spending And Stable Debt Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? Therefore, social security reforms require outright cuts in spending, rather than soft caps on the budget balance. The present soft cap on government expenditures is not adequate to stabilize or reduce government debt levels. Could privatization help stabilize public debt dynamics? The privatization program during the 1990s under the Collor, Franco, and Cardoso governments led to the sale of $91 billion (around R$ 100 billion or 9% of GDP) worth of assets from 107 state-owned enterprises over the course of a decade. Presently, in order to re-balance the primary deficits of R$93 and R$79 billion for 2018 and 2019 respectively, the government would be required to frontload the sale of large state-owned entities, such as Petrobras or Banco do Brasil. This will prove challenging, since the sale of state-owned enterprises requires legislative approval. In fact, over the past two years, under interim President Temer, the government has struggled to sell its assets such as Electrobras. Even assuming that a Brazilian government under Bolsonaro conducts large-scale asset sales, previous privatization programs have failed to yield targeted sums and have required a longer time to implement than originally expected. Overall, privatization is not a feasible option to reduce high debt levels in Brazil in the short run. Bottom Line: Stabilizing or reducing the public debt as a share of GDP will be challenging under the current set of preferences set by voters. Moreover, demographic headwinds and structural constraints embodied in Brazil's two-tier legislative system will slow down the process of privatization and pension reform. The market is forward-looking and will cheer attempts to enact supply-side reforms in the short run, should they emerge, despite long-term uncertainties. The key questions are (1) whether the election produces a proactive Bolsonaro regime or a reactive left-wing regime (2) whether coalition formation - in Bolsonaro's case - or exogenous market pressure - in Haddad's case - are sufficient to initiate reforms in a timely manner in 2019. Amidst a broad EM selloff driven by external factors as well as Brazil's and other EM's internal fundamentals, we expect the markets to be largely disappointed in 2019. The evolution of the political context throughout the year will then determine when and if a buying opportunity emerges. Investment Implications In the late 1990s, faced with high foreign debt levels, a large current account deficit, and weak nominal growth, the Brazilian central bank devalued the real by 66% in January 1999 (Chart 16). This led to a rebound in nominal growth which helped the country relieve itself from built up excesses. In today's context, a weaker currency and lower interest rates are required to boost nominal GDP and contain Brazil's public debt as a share of GDP. There are already signs that the central bank is easing liquidity amid currency depreciation - which stands in contrast of the recent past (Chart 17). More liquidity provisioning by the central bank will cause the real to depreciate further. In light of this, we recommend that investors continue shorting the currency versus the U.S. dollar. Furthermore, due to our expectation of further deceleration in global growth stemming from China and a strong dollar, investors should expect more downside in broader EM and Brazilian share prices in U.S. dollar terms. With respect to the outcome of the elections, investors should continue underweighting Brazilian equities and credit in their respective portfolios for now (Chart 18). Chart 16Brazil Needs A Weaker Currency To##br## Boost Nominal Growth Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? Chart 17A New##br## Paradigm Shift? Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? Chart 18Sovereign Credit Spreads Will##br## Continue Widening Brazil: Can The Election Change Anything? Brazil: Can The Election Change Anything? We will consider whether an upgrade of Brazil is warranted after electoral outcomes become known. Particularly, the balance of the parties in Congress and the new president's coalition formation options will dictate the relative performance of Brazilian equities and credit over the next 6-12 months. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see, Wike, R. et al., "Globally, Broad Support for Representative and Direct Democracy", October 16th, 2017, available at http://www.pewglobal.org/2017/10/16/many-unhappy-with-current-political-system/ 2 In addition to the Pew Research data cited in Chart 5, please see Dora Saclarides, "Do Brazilians Believe In Democracy?" InoVozes, The Wilson Center, November 21, 2017, available at www.wilsoncenter.org. 3 Please see "Brazil: Vox Populi Poll Gives Haddad Lead In Presidential Race," Telesur, September 13, 2018, available at www.telesurtv.net, & Data Poder 360 poll from September 21st, available at: https://www.poder360.com.br/datapoder360/datapoder360-bolsonaro-tem-26-e-haddad-22-os-2-empatam-no-2o-turno/ 4 Please see, BTG Pactual September 15-16 poll, page 18. The Polls states that 57% of Lula voters would "not vote at all" while 41% would vote for Haddad. While turnout will improve for the second round, this is a risk to Haddad. 5 A poll by Empiricus Research and Parana Pesquisas p56 shows that 89.5% intend to vote (which is unrealistic), and that 95.7% of Bolsonaro voters intend to vote while 91.6% of Haddad voters intend to vote. 6 "The PT lost four of the five state capitals it had run, including Sao Paulo, the country's economic powerhouse where the leftist party was born. The PT lost two-thirds of the municipalities it won in 2012, dropping to 10th place from third in the number of mayors controlled by each party." Please see Anthony Broadle, "Brazil parties linked to corruption punished in local elections," Reuters, October 2, 2016, available at www.reuters.com. 7 Gomes has, however, admitted the need for some adjustments to the retirement age and public sector worker privileges, which suggests that he could be brought to pursue structural reforms under the right circumstances. https://todoscomciro.com/en_us/pnd/ciro-gomes-previdencia-social/ 8 Bolsonaro's legislative experience is also surprisingly thin. As a congressional representative for 27 years, he has only passed two laws, after presenting a total of 171 bills and one amendment to the constitution. Only three of these bills presented were of economic nature. It is unclear whether he has what it takes to galvanize the legislature in pursuit of tricky reforms. 9 Please see BCA Geopolitical Strategy Special Report, "Separating The Signal From The Noise," dated September 10, 2014, available at gps.bcaresearch.com. 10 A replacement rate is the percentage of a worker's pre-retirement income that is paid out by a pension program upon retirement. 11 Ratio measuring number of dependent zero to 14 and over the age of 65 to total working age population

Highlights President Trump has little to do with the ongoing EM selloff; The macro backdrop is the real culprit behind Turkey's woes, particularly the strong dollar... ... Which is a product of global policy divergence, with the U.S. stimulating while China pursues growth-constraining reforms; Chinese stimulus is important to watch, as it could change the game, but we do not expect China to save EM as it did in 2015; Turkey's troubles are a product of its late-stage populist cycle and will not end with Trump's magnanimity; The positive spin on the EM bloodbath is that it may force the Fed to slow its rate hikes, prolonging the business cycle. Feature Chart 1EM: Bloodbath EM: Bloodbath EM: Bloodbath Markets are selling off in Turkey and the wider EM economies (Chart 1), with the financial media focusing on the actions taken by the U.S. President Donald Trump in the escalating diplomatic spat between the two countries. Investors should be very clear what it means to ascribe the ongoing selloff to President Trump's aggressive posture with Ankara in particular and trade in general. If President Trump started EM's troubles with his tweets, he can then end them with another late-night missive. This is not our view. Turkey is enveloped in a deep morass of populism and weak fundamentals since at least 2013. What is worse, the ongoing selloff is likely going to ensnare at least the other fragile EM economies and potentially take down EM as an asset class. In this Report, we recount the pernicious macro backdrop - both geopolitical and economic - that EM economies face today. We then focus on Turkey itself and show that President Trump has little to do with the current selloff. The Bloodbath Is Afoot, Again Every financial bubble, and every financial bust, begins with a compelling story grounded in solid fundamentals. The now by-gone EM "Goldilocks Era" (2001-2011) was primarily driven by exogenous factors: a generational debt-fueled consumption binge in DM; an investment-fueled double-digit growth rate in China that kicked off a structural commodity bull market; and the unleashing of pent-up EM consumption/credit demand (Chart 2).1 These EM tailwinds petered out by 2011. Subsequently, China and EM economies entered a major downtrend that culminated in a massive commodity rout that began in 2014. But before the bloodbath could motivate policymakers to initiate painful structural reforms, Chinese policymakers stimulated in earnest. In the second half of 2015, Beijing became unnerved and injected enormous amount of credit and fiscal stimulus into the mainland economy (Chart 3). The intervention, however, did not change the pernicious fundamentals driving EM economies but merely caused "a mid-cycle recovery, or hiatus, in an unfinished downtrend," as our EM strategists have recently pointed out (Chart 4).2 Chart 2Goldilocks Era##BR##Is Over For EM Goldilocks Era Is Over For EM Goldilocks Era Is Over For EM Chart 3Is China About To Cause Another##BR##EM Mid-Cycle Recovery? Is China About To Cause Another EM Mid-Cycle Recovery? Is China About To Cause Another EM Mid-Cycle Recovery? Take Brazil, for example. Instead of using the 2014-2015 generational downturn to double-down on painful fiscal and pension reforms, the country's politicians declared President Dilma Rousseff to be the root-cause of all evil that befell the nation, impeached her in April 2016, and then proceeded to unceremoniously punt all painful reforms until after this year's election (if ever). They were enabled to do so by the "mid-cycle recovery" spurred by Chinese stimulus. In other words, Brazil's policymakers did nothing to actually deserve the recovery in asset prices but got one anyway. The country now will experience "faceoff time" with the markets, with no public support for painful reforms (Chart 5) and hardly an orthodox candidate in sight ahead of the October general election.3 Chart 4Where Are China/EM In The Cycle? Where Are China/EM In The Cycle? Where Are China/EM In The Cycle? Chart 5Brazil's Population Is Not Open To Fiscal Austerity The EM Bloodbath Has Nothing To Do With Trump The EM Bloodbath Has Nothing To Do With Trump Could Brazilian and Turkish policymakers be in luck, as Chinese policymakers have blinked again?4 Our assessment is that the coming stimulus will not be as stimulative as in 2015. First, President Xi's monetary and fiscal policy, since coming into office in 2012, has been biased towards tightening (Chart 6). Second, Chinese leverage has plateaued (Chart 7). In fact, "debt servicing" is now the third-fastest category of fiscal spending growth since Xi came to power (Table 1). Third, the July 31 Politburo statement pledged to make fiscal policy "more proactive" and "supportive," but also reaffirmed the commitment to continue the campaign against systemic risk. Chart 6Xi Jinping Caps##BR##Government Spending And Credit Xi Jinping Caps Government Spending And Credit Xi Jinping Caps Government Spending And Credit Chart 7The Rise And Plateau##BR##Of Macro Leverage The EM Bloodbath Has Nothing To Do With Trump The EM Bloodbath Has Nothing To Do With Trump Whether China's mid-year stimulus will be globally stimulative is now the question for global investors. The key data to watch out of China will be August credit numbers, to be released September 9th through 15th. Is President Trump not to be blamed at all for the EM selloff? What about the trade war against China? If anything, tariffs against China have caused Beijing to "blink" and implement some stimulative measures this summer. If one must find fault in U.S. policy, it is the double dose of fiscal stimulus that has endangered EM economies. A key theme for BCA's Geopolitical Strategy this year has been the idea that global policy divergence would replace the global growth convergence.5 Populist economic stimulus in the U.S. and structural reforms in China would imperil growth in the latter and accelerate it in the former, forming a bullish environment for the U.S. dollar (Chart 8). Table 1Total Government Spending Preferences (Under Leader's General Control) The EM Bloodbath Has Nothing To Do With Trump The EM Bloodbath Has Nothing To Do With Trump Chart 8U.S. Outperformance Should Be Bullish USD U.S. Outperformance Should Be Bullish USD U.S. Outperformance Should Be Bullish USD As such, the White House is partly responsible for the EM selloff, but not in any way that can be changed with a tweet or a handshake. Furthermore, we do not see the upcoming U.S. midterm election as somehow capable of altering the global growth dynamics.6 It is highly unlikely that Democrats will seek to spend less, and they cannot raise taxes under Trump. Bottom Line: EM economies have never adjusted to the end of their Goldilocks era. A surge in global liquidity pushed investors further down the risk-curve, propping up EM assets despite poor macro fundamentals. China's massive 2015-2016 stimulus arrested the bear market, giving investors a perception that EM economies had recovered. This mid-cycle hiatus, however, has now been overtaken by the global policy divergence between Washington and Beijing, which is bullish USD. President Trump's trade tariffs and aggressive pressure on Turkey do not help. However, they are merely the catalyst, not the cause, of the selloff. As such, investors should not "buy" EM on a resolution of China-U.S. trade tensions or of the Washington-Ankara diplomatic dispute. Contagion Risk BCA's Emerging Market Strategy is clear: in all episodes of a major EM selloff, the de-coupling between different regions proved to be unsustainable, and the markets that showed initial resilience eventually re-coupled to the downside (Chart 9).7 One reason to expect contagion risk among all EM markets is that the primary export market for China and other East Asian exporters are other EM economies, particularly the commodity producers (Chart 10). As such, it is highly unlikely that East Asian EM economies will be able to avoid a downturn. In fact, leading indicators of exports and manufacturing, such as Korea's manufacturing shipments-to-inventory ratio and Taiwan's semiconductor shipments-to-inventory ratio herald further deceleration in their respective export sectors (Chart 11). Chart 9Asian And Latin American Equities:##BR##Unsustainable Divergences Asian And Latin American Equities: Unsustainable Divergences Asian And Latin American Equities: Unsustainable Divergences Chart 10EM Trades##BR##With EM EM Trades With EM EM Trades With EM Chart 11Asia Export##BR##Slowdown Is Afoot Asia Export Slowdown Is Afoot Asia Export Slowdown Is Afoot In respect of foreign funding requirements of EM economies, our EM strategists have pointed out that there is a substantive amount of foreign currency debt coming due in 2018 (Table 2), with majority EM economies facing much higher foreign debt burdens than in 1996 (Table 3).8 Investors should not, however, rely merely on debt as percent of GDP ratios for their vulnerability assessment. For example, Malaysia's private sector FX debt load stands at 63.7% of GDP, the second highest level after Turkey. But relative to total exports (a source of revenue for its indebted corporates) and FX reserves (which the central bank can use to plug the gap in the balance of payments), Malaysia actually scores fairly well. Table 2EM: Short-Term (Due In 2018) FX Debt The EM Bloodbath Has Nothing To Do With Trump The EM Bloodbath Has Nothing To Do With Trump Table 3EM Private Sector FX Debt: 1996 Versus Today The EM Bloodbath Has Nothing To Do With Trump The EM Bloodbath Has Nothing To Do With Trump Chart 12 shows the most vulnerable EM economies in terms of foreign currency private sector debt exposure relative to FX reserves and total exports. Unsurprisingly, Turkey stands as the most vulnerable economy, along with Argentina, Brazil, Indonesia, Chile, and Colombia. Chart 12BCA's Emerging Markets Strategy Has Already Pinned Turkey As The Most Vulnerable EM Economy The EM Bloodbath Has Nothing To Do With Trump The EM Bloodbath Has Nothing To Do With Trump Will the EM selloff eventually ensnare DM economies as well, particularly the U.S.? We think yes. The drawdown in EM will bid up safe-haven assets like the U.S. dollar. The dollar can be thought of as America's second central bank, along with the Fed. If both the greenback and the Fed are tightening monetary conditions, eventually the U.S. economy will feel the burn. As such, it is dangerous to dismiss the ongoing crisis in Turkey as a merely localized problem that could, at its worst, spread to other EM economies. In 1997, Thailand played a similar role to that of Turkey. The Fed tightened rates in early 1997 and largely remained aloof of the developing East Asia crisis that eventually spread to Brazil and Russia, ignoring the tumult abroad until September 1998 when it finally cut rates three times. Fed policy easing at the end of 1998 ushered in the stock market overshoot and dot-com bubble, whose burst caused the end of the economic cycle. The same playbook may be occurring today. The Fed, motivated by the strong U.S. economy and fears of being too close to the zero-bound ahead of the next recession, is proceeding apace with its tightening cycle. It is likely to ignore troubles in the rest of the world until the USD overshoots or U.S. equities are impacted directly. At that point, perhaps later this year or early next year, the Fed will back off from tightening, ushering the one last overshoot phase ahead of the recession in 2020 - or beyond. Bottom Line: Research by BCA's EM strategists shows that EM contagion is almost never contained in just a few vulnerable economies. For investors who have to remain invested in EM economies, we would recommend that they go long Chinese equities relative to EM, given that Beijing policymakers are stimulating the economy to ensure that Chinese growth is stabilized. While this will be positive for China, it is likely to fall short of the 2015 stimulus that also stimulated non-China EM. An alternative play is to go long energy producers vs. the rest of EM - given our fundamentally bullish oil view combined with rising geopolitical risks regarding sanctions against Iran.9 We eventually expect EM risks to spur an appreciation in the USD that the Fed has to lean against by either pausing its tightening cycle, or eventually reversing it as it did in the 1997-1998 scenario. This decision will usher in the final blow-off stage in U.S. equities that investors will not want to miss. What About Turkey? Chart 13Turkey: Volatile Politics, Volatile Stocks Turkey: Volatile Politics, Volatile Stocks Turkey: Volatile Politics, Volatile Stocks In 2013, we called Turkey a "canary in the EM coal mine" arguing that its historically volatile financial markets would mean-revert as domestic politics became turbulent (Chart 13).10 Turkey is a deeply divided society equally split between the secularist cities, which are primarily located on the Mediterranean (Istanbul, Izmir, Bursa, Adana, etc.), and the religiously conservative Anatolian interior. This split dates back to the founding of the modern Turkish Republic in the post-World War I era (and in truth, even before that). The ruling Justice and Development Party (AKP), a religiously conservative but initially pro-free-market party, managed to appeal to the conservative Anatolia while neutering the most powerful secularist institution in Turkey, its military. Investors hailed AKP's dominance because it reduced political volatility and initially promised both pro-market policies and even accession to the EU. However, the AKP has struggled to win more than 50% of the popular vote in a slew of elections and referendums since coming to power (Chart 14), a fact that belies its supposed iron-grip hold on Turkish politics since it came to power in 2002. The vulnerability behind AKP's hold on office has largely motivated President Recep Tayyip Erdogan's attempt to consolidate political power. While we disagree with the consensus view that Erdogan's constitutional changes have turned Turkey into a dictatorship, some of his actions do suggest a deep fear of losing power.11 Populist leadership is characterized by a strategy of "giving people what they want" so that the policymakers in charge remain in office. Erdogan's perpetually slim hold on power has motivated several populist policy decisions that have stretched Turkey's macro fundamentals. First, Turkey's central bank has essentially been conducting quantitative easing since 2013 via net liquidity injections into the banking system (Chart 15). Notably, these injections began at the same time as the May 2013 Gezi Park protests, which saw a huge outpouring of anti-government sentiment across Turkey's large cities. Essentially, politics has been motivating Ankara's monetary policy over the past five years. Chart 14AKP's Stranglehold On Power Is Overstated The EM Bloodbath Has Nothing To Do With Trump The EM Bloodbath Has Nothing To Do With Trump Chart 15Turkey's Populist Policies Began##BR##With Gezi Park Protests Turkey's Populist Policies Began With Gezi Park Protests Turkey's Populist Policies Began With Gezi Park Protests Second, Turkey's current account balance has suffered under the weight of rising energy costs, with no attempt to improve the fiscal balance (Chart 16). The government has done little in terms of structural reforms or fiscal austerity, instead President Erdogan has continued to challenge central bank independence on interest rates, despite a clear sign that the country is experiencing a genuine inflationary breakout (Chart 17). Chart 16Populism Means No Austerity Is In Sight Populism Means No Austerity Is In Sight Populism Means No Austerity Is In Sight Chart 17Genuine Inflation Breakout Genuine Inflation Breakout Genuine Inflation Breakout Overall, Turkey is a classic example of how populism in a highly divided and polarized country can get out of control. Foreign investors have long assumed that Erdogan's populism was benign, if not even positive, given the presumably ample political capital at the president's disposal. However, with every election or referendum, the government did not double-down on pro-market structural reforms. Instead, the pressure on the central bank only increased while Turkey's expensive and extravagant geopolitical adventures in neighboring Syria accelerated. In this pernicious macro context, it has not taken much to knock Turkey's assets off balance. President Trump's threats to expand sanctions to Turkish trade are largely irrelevant, given that the vast majority of Turkey's exports and FDI sources are non-American (Chart 18). However, given past behavior - such as after the shadowy Gülen "plot" to take over power or the 2016 coup d'état - markets are by now conditioned to expect that Turkish policymakers will double-down on populist policies in the face of renewed pressure. Chart 18Turkey-U.S. Relationship Is Not Economic Turkey-U.S. Relationship Is Not Economic Turkey-U.S. Relationship Is Not Economic What of Turkey's membership in NATO? Should investors fear broader geopolitical instability due to the domestic crisis? No. Ankara has used its membership in NATO, and particularly the U.S. reliance on its Incirlik air base in southern Turkey, as levers in previous negotiations and diplomatic spats with Europe and the U.S. If Ankara were to renege on its commitments to the Western military alliance, it would likely face a united front from Europe and the U.S. As such, we would expect Turkey neither to threaten exit from NATO, which it has not done in the past, nor even to threaten U.S. operations in Incirlik, which Erdogan's government has threatened before. The most likely outcome of the ongoing diplomatic spat, in fact, would be to see Ankara give in to U.S. demands, given the accelerating financial and economic crisis. Such an outcome, however, will not arrest the downturn. Turkey's economy and assets are fundamentally under pressure due to the realization by investors that this year's main macro theme is not the resynchronized global growth recovery, but rather the global policy divergence between the U.S. and China, which has appreciated the U.S. dollar. No amount of kowtowing by Ankara will change this macro trend. Bottom Line: The list of Turkish policy sins is long. Erdogan's reign has been characterized by deep polarization and populism, leading to suboptimal policy choices since at least 2013. The latest U.S.-Turkey spat is therefore merely one of many problems plaguing the country. As such, its resolution will not be a buying opportunity for investors. Investment Implications Our main investment theme in 2018 was that the global policy divergence between the U.S. and China - emblematized by fiscal stimulus in the U.S. and structural reforms in China - would end the global growth resynchronization. As the U.S. economy outperformed the rest of the world, the U.S. greenback would appreciate, imperiling EM economies. The best cognitive roadmap for today is the late 1990s, when the U.S. economy continued to grow apace as the rest of the world suffered from an EM crisis. The problems eventually washed onto American shores in the form of a stronger dollar, forcing the Fed to back off from tightening in mid-1998. Policy easing then led to the overshoot phase in U.S. equities in 1999. Investors should prepare for a similar roadmap by being long DXY relative to EM currencies, long DM equities (particularly U.S.) relative to EM equities, and tactically cautious on all global risk assets. Strategically, however, it makes sense to remain overweight equities as a Fed capitulation would be a boon for risk assets. If the current selloff in EM gets worse, we would expect that the Fed would again back off from tightening as it did in 1998, ushering in a blow-off stage in equities ahead of the next recession. Once the dollar peaks and EM assets bottom, U.S. equities will become the laggard, with global cyclicals outperforming. A secondary conclusion is that President Trump's trade rhetoric in general, and aggressive policies towards Turkey in particular, are merely a catalyst for the selloff. As such, if President Trump changes his mind, we would fade any rally in EM assets. The fundamental policy decisions that have led to the greenback rally have already been taken in 2017 and early 2018. The profligate tax cuts and the two-year stimulative appropriations bill, combined with Chinese policymakers' focus on controlling financial leverage, are the seeds of the current EM imbroglio. Finally, a small bit of housekeeping. We are booking gains on our long Malaysian ringgit / short Turkish lira trade for a gain of 51.2% since May. We are also closing our speculative long Russian equities relative to EM trade for a loss of -0.9% as a result of the persistent headwind from U.S. sanctions. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "The Coming Bloodbath In Emerging Markets," dated August 12, 2015, available at gps.bcaresearch.com. 2 Please see BCA Emerging Markets Strategy Weekly Report, "Understanding The EM/China Cycles," dated July 19, 2018, available at ems.bcaresearch.com. 3 Please see BCA Emerging Markets Special Report, "Brazil: Faceoff Time," dated July 27, 2018, available at ems.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "China: How Stimulating Is The Stimulus?" dated August 8, 2018, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Strategic Outlook, "Three Questions For 2018," dated December 13, 2017, and Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Weekly Report, "Will Trump Fail The Midterm?" dated April 18, 2018, available at gps.bcaresearch.com. 7 Please see BCA Emerging Markets Strategy Weekly Report, "EM: Sustained Decoupling, Or Domino Effect?" dated June 14, 2018, available at ems.bcaresearch.com. 8 Please see BCA Emerging Markets Strategy Special Report, "A Primer On EM External Debt," dated June 7, 2018, available at ems.bcaresearch.com. 9 Please see BCA Geopolitical Strategy and Commodity & Energy Strategy Special Report, "U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic," dated July 19, 2018, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Monthly Report, "Turkey: Canary In The EM Coal Mine?" in "The Coming Political Recapitalization Rally," dated June 13, 2013, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Weekly Report, "Turkey: Deceitful Stability," in "EM: The Beginning Of The End," dated April 19, 2017, available at ems.bcaresearch.com.

This week we are publishing Part 1 of an overview of the cyclical profiles of emerging market (EM) economies. This all-in-charts presentation illustrates the business cycle conditions of the largest EMs. The aim of this report is to provide investors with a quick assessment of where each EM economy stands. In addition, we provide our view on each market. The rest of the countries will be covered in next week’s Part 2. Chart A CHART A CHART A Chart B CHART B CHART B Korea: Overweight Equities Korea: Overweight Equities CHART 1 CHART 1 Korea: Overweight Equities CHART 2 CHART 2 Korea: Overweight Equities CHART 3 CHART 3 ...But Negative On Currency ...But Negative On Currency CHART 6 CHART 6 ...But Negative On Currency CHART 4 CHART 4 ...But Negative On Currency CHART 5 CHART 5 ...But Negative On Currency CHART 7 CHART 7 Taiwan: Overweight Equities But... Taiwan: Overweight Equities... CHART 8 CHART 8 Taiwan: Overweight Equities... CHART 10 CHART 10 Taiwan: Overweight Equities... CHART 9 CHART 9 Taiwan: Overweight Equities... CHART 11 CHART 11 ...Absolute Return Investors Should Mind Cracks In Semi Sector ...Absolute Return Investors Should ##br##Mind Cracks In Semi Sector CHART 12 CHART 12 ...Absolute Return Investors Should ##br##Mind Cracks In Semi Sector CHART 13 CHART 13 India: Remain Overweight India: Remain Overweight CHART 14 CHART 14 India: Remain Overweight CHART 17 CHART 17 India: Remain Overweight CHART 15 CHART 15 India: Remain Overweight CHART 16 CHART 16 India: Strong Domestic Growth & Advanced NPL Recognition India: Strong Domestic Growth & ##br##Advanced NPL Recognition CHART 18 CHART 18 India: Strong Domestic Growth & ##br##Advanced NPL Recognition CHART 20 CHART 20 India: Strong Domestic Growth & ##br##Advanced NPL Recognition CHART 19 CHART 19 India: Strong Domestic Growth & ##br##Advanced NPL Recognition Cyclical Profiles Of EM Economies: Part 1 Cyclical Profiles Of EM Economies: Part 1 South Africa: On Shaky Foundations - Underweight South Africa: On Shaky Foundations CHART 22 CHART 22 South Africa: On Shaky Foundations CHART 23 CHART 23 South Africa: On Shaky Foundations CHART 24 CHART 24 South Africa: On Shaky Foundations CHART 25 CHART 25 South Africa: Strong Consumption, No CAPEX And No Competitiveness South Africa: Strong Consumption, ##br##No CAPEX And No Competitiveness CHART 26 CHART 26 South Africa: Strong Consumption, ##br##No CAPEX And No Competitiveness CHART 28 CHART 28 South Africa: Strong Consumption, ##br##No CAPEX And No Competitiveness CHART 27 CHART 27 South Africa: Strong Consumption, ##br##No CAPEX And No Competitiveness CHART 29 CHART 29 Brazil: Heading Towards A Fiscal Debacle - Underweight Brazil: Heading Towards A Fiscal Debacle CHART 30 CHART 30 Brazil: Heading Towards A Fiscal Debacle CHART 31 CHART 31 Brazil: Heading Towards A Fiscal Debacle CHART 32 CHART 32 Brazil: More Downside In Financial Assets Brazil: More Downside In Financial Assets CHART 33 CHART 33 Brazil: More Downside In Financial Assets CHART 35 CHART 35 Brazil: More Downside In Financial Assets CHART 34 CHART 34 Brazil: More Downside In Financial Assets CHART 36 CHART 36 Mexico: Domestic Fundamentals Are Improving - Overweight Mexico: Domestic Fundamentals Are Improving CHART 44 CHART 44 Mexico: Domestic Fundamentals Are Improving CHART 45 CHART 45 Mexico: Domestic Fundamentals Are Improving CHART 46 CHART 46 Mexico: External Sector Is Faring Well Mexico: External Sector Is Faring Well CHART 47 CHART 47 Mexico: External Sector Is Faring Well CHART 49 CHART 49 Mexico: External Sector Is Faring Well CHART 48 CHART 48 Russia: Orthodox Monetary And Fiscal Policies Russia: Orthodox Monetary And Fiscal Policies CHART 37 CHART 37 Russia: Orthodox Monetary And Fiscal Policies CHART 38 CHART 38 Russia: Orthodox Monetary And Fiscal Policies CHART 39 CHART 39 Russia: Orthodox Monetary And Fiscal Policies CHART 40 CHART 40 Russia: Gradual Cyclical Improvements - On Upgrade Watchlist Russia: Gradual Cyclical Improvements CHART 40 CHART 40 Russia: Gradual Cyclical Improvements CHART 42 CHART 42 Russia: Gradual Cyclical Improvements CHART 43 CHART 43 Turkey: A Genuine Inflation Breakout Amidst Credit Excesses Turkey: A Genuine Inflation ##br##Breakout Amidst Credit Excesses CHART 50 CHART 50 Turkey: A Genuine Inflation ##br##Breakout Amidst Credit Excesses CHART 51 CHART 51 Turkey: A Genuine Inflation ##br##Breakout Amidst Credit Excesses CHART 54 CHART 54 Turkey: A Genuine Inflation ##br##Breakout Amidst Credit Excesses CHART 52 CHART 52 Turkey: A Genuine Inflation ##br##Breakout Amidst Credit Excesses CHART 53 CHART 53 Turkey: Still In Dangerous Territory - Underweight Turkey: Still In Dangerous Territory CHART 55 CHART 55 Turkey: Still In Dangerous Territory CHART 58 CHART 58 Turkey: Still In Dangerous Territory CHART 56 CHART 56 Turkey: Still In Dangerous Territory CHART 57 CHART 57 Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Without swift and considerable fiscal austerity or aggressive privatization, Brazil's public debt situation will become uncontrollable. Brazilian voters' priorities and preferences are for more public spending, not fiscal austerity. Hence, the upcoming president will not have a mandate to pursue fiscal austerity. The sole politically viable solution to stabilize Brazil's public debt situation is to boost nominal GDP growth - something that can only be achieved by sacrificing the exchange rate. The real is set to depreciate considerably. Provided the currency is key to the performance of Brazilian asset prices, the latter will remain in a bear market. Stay put/underweight on Brazilian risk assets. Feature Brazil is approaching a major showdown between creditors and the government. The country's public debt burden is out of control and unsustainable, unless immediate and drastic actions on the fiscal front are undertaken. At the same time, the economy has barely recovered after an extended period of depression, and the general population does not have the appetite for fiscal austerity. Crucially, the nation is heading into presidential and general elections in October. Whoever is elected, the new president will struggle to stabilize public debt dynamics amid a weak economy and the public's intolerance for fiscal tightening. On the surface, the plunge in Brazilian financial markets in recent months could well be attributed to the truckers' strike following the liberalization of fuel prices. The authorities hiked fuel prices because the deteriorating budget situation forced them to discontinue subsiding it. However, the strike was a symptom of a much deeper problem: the government's debt dynamics are degenerating, while the population and businesses have grown tired of the prolonged depression - and are deeply opposed to any kind of fiscal austerity. The sole macro solution to this debt problem is to boost nominal growth. This can be achieved via much lower real interest rates and/or a major currency devaluation. The latter will be detrimental to foreign investors holding Brazilian assets. Fiscal Austerity Is Required... Chart I-1Nominal Growth (A Proxy For Revenue) Is Lower Than Borrowing Costs Nominal Growth (A Proxy For Revenue) Is Lower Than Borrowing Costs Nominal Growth (A Proxy For Revenue) Is Lower Than Borrowing Costs Brazil continues to head towards a fiscal debacle. Not only does the government's fiscal position remain untenable, but nominal GDP growth has also relapsed to its 2015 lows (Chart I-1). The lack of nominal growth is depressing government revenues. Importantly, the widened gap between nominal GDP growth that currently stands at 4% and local currency borrowing rates of 10% is not sustainable (Chart I-1). Barring swift and substantial fiscal tightening, weak economic growth and high borrowing costs will ensure that the public debt-to-GDP ratio continues to rise into the foreseeable future. A rising debt-to-GDP ratio without clear government policies and actions to tackle indebtedness will feed into a higher risk premium in the exchange rate as well as government borrowing costs. Hence, a vicious cycle will likely unravel: escalating public debt will exert upward pressure on the government's borrowing costs, rising interest rate payments on public debt will keep the fiscal deficit wide and, consequently, the debt-to-GDP ratio will continue to escalate. Table 1 presents three scenarios for Brazil's public debt trajectory. In our base case scenario, the gross debt-to-GDP ratio1 reaches 82% by the end of 2019. In fact, even under the optimistic scenario, the gross public debt-to-to GDP ratio will continue to rise and end up at 80%. Table 1Brazil: Public Debt Sustainability Test Brazil: Faceoff Time Brazil: Faceoff Time Chart I-2High Debt Is Not A Problem In The U.S. High Debt Is Not A Problem In The U.S. High Debt Is Not A Problem In The U.S. A public debt burden above 80% of GDP would not be alarming if interest rates on that debt were not in the double digits. For example, the U.S.'s public debt burden of 100% of GDP is not a problem because interest rates are low, in fact well below nominal GDP growth (Chart I-2). To stabilize the public debt dynamics, the Brazilian government must run primary fiscal surpluses. In the late 1990s and early 2000s, Brazil escaped a public debt trap because the government tightened fiscal policy considerably. They adopted Fiscal Responsibility Law in 2000, whereby the authorities were required by law to keep government expenditures limited to 50% of net revenues for that year. In turn, this allowed governments to run comfortable primary fiscal surpluses of 3% and above (Chart I-3). As shown on this chart, Brazil ran primary surpluses of 3-4% from 2001 through to 2012. Presently, the primary fiscal balance stands at -1.5% of GDP (Chart I-3, bottom panel). To stabilize the public debt dynamics, the government must undertake fiscal tightening of about 3% of GDP within the next 12-24 months to bring the primary surplus to around 1.5% of GDP. However, such fiscal tightening at a time when the economy is still very weak will push it back into recession. More importantly such fiscal tightening is politically unfeasible, as discussed below. Brazil's Achilles heel has been and remains social security finances. The social security deficit at the moment amounts to 3% of GDP (Chart I-4). According to IMF projections,2 social security expenditures will rise to 15% of GDP by 2021, bringing the total social security deficit to 12% of GDP under the current system. Chart I-3Brazilian Public Debt Dynamics Are Unsustainable Brazilian Public Debt Dynamics Are Unsustainable Brazilian Public Debt Dynamics Are Unsustainable Chart I-4Brazil's Social Security Deficit Brazil's Social Security Deficit Brazil's Social Security Deficit Crucially, Brazil is facing demographic headwinds that are contributing to the ballooning social security deficit. In particular, a rapidly aging population and rising life expectancy are all expected to drag government finances lower in the coming decades (Chart I-5). The social security deficit has increased in recent years to 40% of the overall deficit. Chart I-5Deteriorating Demographics Deteriorating Demographics Deteriorating Demographics Major and front-loaded cuts in social security expenditures are vital to stabilize government finances and debt dynamics. However, there is little support among the population and Congress for such austerity measures (we discuss this in more detail in the next section). Aggressive privatization could be a one-off short-term solution if the proceeds are used to reduce public debt. This could avert a vicious cycle of rising risk premiums, higher interest rates and larger debt burdens, at least for a while. However, the recent case of the privatization of Eletrobras shows that the process has been much slower than expected. Moreover, the total estimated sale price of Eletrobras will only produce BRL 12 billion. This compares with a BRL 104 billion annual primary deficit. Further, a sale of the Brazilian government's ownership of oil giant Petrobras would bring in an estimated BRL 90-95 billion, or 1.6% of GDP (this assumes a sale of a 64% stake in common shares, including government, BDNES and Caixa shares). This is still less than the annual primary deficit of BRL 104 billion (1.5% of GDP). Consequently, even aggressive privatization will not be sufficient to reduce debt or improve the nation's fiscal position on a sustainable basis. Further, aggressive privatization is not politically feasible as it lacks public support, and Congressional approvals on this matter will be a challenge. Bottom Line: The public debt burden is surging and fiscal dynamics remain unsustainable. Without swift and considerable fiscal austerity or aggressive privatization, Brazil's public debt situation will become uncontrollable. ...But Is Politically Unfeasible The prospects for fiscal reforms and improved public debt sustainability are dependent on the upcoming presidential elections. As October's vote approaches, social security and privatization reforms will be key determinants of the path of Brazil's risk premium for the foreseeable future. The presidential elections are scheduled for October 7 and 28 (a second round will be held if no candidate achieves an absolute majority of the vote). Uncertainty is unusually high. Yet investors need to understand the constraints that underpin the current presidential race. First, Brazilian voters' priorities and preferences are for more public spending, not fiscal austerity. According to polls conducted by Confederacao Nacional da Industria (CNI), the top five priorities of respondents are to improve health and education, and raise wages (Chart I-6). By contrast, only 3% of respondents believe that pension reform (cutting spending) should be a top government priority. Chart 6Brazil's Population Is Not Open To Fiscal Austerity Brazil: Faceoff Time Brazil: Faceoff Time This polling confirms our thesis that the median voter in Brazil remains firmly on the left of the economic policy spectrum.3 The combined support for left-leaning candidates Lula, Marina Silva and Ciro Gomes remains close to 50% (Table 2). Table 2The Left Is Ahead Brazil: Faceoff Time Brazil: Faceoff Time On the whole, fiscal austerity and privatization, as proposed by centrist and right-leaning candidates, will garner little support from the electorate. Second, Brazil's Congress is one the most fractious in the world. With over 20 political parties in Congress, the key to passing critical reforms is contingent on the ability of the president to form, maintain and reward a coalition that can muster majority votes in Congress. Crucially, reforms requiring constitutional amendments, such as the pension system, would need a supermajority of 308 out of 513 seats in the Chamber of Deputies, or 60% of congressmen. As the recent experience of acting president Temer shows, this will be difficult. Temer was an experienced political operator and the head of the largest party in Congress, yet even he failed to gain sufficient support to pass social security reforms, even when they were watered down and their costs back-loaded. There are low odds that any of the existing presidential candidates - all of whom have single-digit or low double-digit support rates - will be able to get enough votes to adopt meaningful social security reforms. True, the right-wing candidate, Jair Bolsonaro, has proposed aggressive privatization and spending cuts to rein in the public debt. Ultimately, only policies of this kind can reduce spending, correct the debt trajectory, stabilize the foreign exchange rate, and enable the country to avoid a vicious cycle of escalating risk premiums in financial markets. That, in turn, would give the economy some breathing room -- a buying opportunity in financial markets might emerge. However, Jair Bolsonaro faces an uphill battle in the presidential election given that the median voter is on the left. Even if elected, he is unlikely to garner support for privatization and austerity in a fractionalised Congress. Bottom Line: Brazilian voters' priorities and preferences are for more public spending, not fiscal austerity. Hence, the upcoming president will not have a mandate to pursue fiscal austerity. Monetary Policy And The Exchange Rate Given fiscal austerity is politically unviable, the other option to stabilize the debt-to-GDP ratio is to boost nominal GDP. Yet the nominal GDP growth rate has relapsed to 2015 lows (refer to Chart I-1 above). Even though real GDP is slowly recovering, inflation has plunged, depressing nominal growth (Chart I-7). As a result, real rates in Brazil remain very high (Chart I-7, bottom panel). This in turn has curbed the economic recovery. Low income growth and high real rates are not only impairing public sector creditworthiness, but they are also hurting the private sector's ability to service its debt. Consistently, weaker nominal GDP growth points to a renewed rise in NPLs and NPL provisions at banks (shown inverted in the chart) (Chart I-8). Chart I-7Real Rates Are Still Punishingly High In Brazil Real Rates Are Still Punishingly High In Brazil Real Rates Are Still Punishingly High In Brazil Chart I-8Banks' Bad Loans And Provisions Are Set To Rise Banks' Bad Loans And Provisions Are Set To Rise Banks' Bad Loans And Provisions Are Set To Rise Monetary policy in Brazil is constrained by exchange rate movements. With the exchange rate currently under selling pressure, the central bank is unlikely to reduce interest rates for now. The next government will have no option but to force the central bank to reduce nominal and real interest rates in an attempt to both boost nominal growth and decrease public debt servicing costs. The victim of this policy will be the currency: the Brazilian real will plunge. The good news for the government is that 96% of its debt is in local currency. Hence, sizable currency depreciation will not have much of an effect on the public debt burden. Table 3External Debt As Of Q4 2017 Brazil: Faceoff Time Brazil: Faceoff Time That said, companies and banks have high levels of external debt (Table 3), and they will suffer at the hands of significant currency depreciation. However, this is the most politically viable and economically feasible way to avoid a public debt fiasco. If the government's pressure on the central bank to reduce interest rates leads to a riot in financial markets and borrowing costs on government debt rise, the government may put pressure on the central bank and state-owned commercial banks to monetize public debt - i.e., purchase government bonds to bring bond yields down. In short, Brazil could institute quantitative easing to reduce and cap government bond yields. The U.S., the UK, Japan, the euro area and Sweden have all done this, and the new government in Brazil may also opt for such a solution. It might either be done in a transparent way, as central banks in the developed economies did, or it might be done in a disguised manner. Chart I-9Divergence Between Central Bank Reserves & The Real Divergence Between Central Bank Reserves & The Real Divergence Between Central Bank Reserves & The Real Interestingly, there are some indications the central bank is trying to err on the side of easier money, despite the latest currency depreciation. Specifically, it has in recent months been injecting more liquidity into the banking system, despite the sharp selloff in the real, as illustrated in Chart I-9. This constitutes a departure from past policy reactions to selloffs in the real, and in a way is a form of disguised easing. The central bank's recent liquidity additions have prevented interbank rates - and hence the entire structure of interest rates - from increasing more than they otherwise would have. In short, the upcoming government might resort to open or disguised public debt monetization to prevent a fiscal debacle. Needless to say, the Brazilian real will plummet in such a scenario. Bottom Line: The sole politically viable solution to stabilize Brazil's public debt situation is to boost nominal GDP growth - something that can only be achieved by sacrificing the exchange rate. Financial Markets The currency is the key to the performance of Brazilian asset prices. The real will depreciate much further. In addition to the above factors, the following will continue to weigh on the currency: Export growth is decelerating (Chart I-10), and this trend is likely to persist as China's growth slows further and commodities prices drop. The currency is not yet very cheap, according to the real effective exchange rate based on consumer and producer prices (Chart I-11). Chart I-10Brazilian Export Growth Is Decelerating Brazilian Export Growth Is Decelerating Brazilian Export Growth Is Decelerating Chart I-11The Real Is Not Cheap The Real Is Not Cheap The Real Is Not Cheap Foreign debt obligations - external debt servicing over the next 12 months - are elevated both in dollars and from a historical perspective relative to exports (Chart I-12). Not surprisingly, demand for dollars is very strong, as evidenced by rising U.S. dollar funding rates (Chart I-13 ). Finally, even though interest rate differentials over the U.S. have never been a key driving force behind the real, they are currently at a record low (Chart I-14). Chart I-12Foreign Private Sector Debt Is High Foreign Private Sector Debt Is High Foreign Private Sector Debt Is High Chart I-13Demand For U.S. Dollars Is Strong Demand For U.S. Dollars Is Strong Demand For U.S. Dollars Is Strong Chart I-14Brazilian Interest Rate Differentials: At A Historical Low Brazilian Interest Rate Differentials: At A Historical Low Brazilian Interest Rate Differentials: At A Historical Low Chart I-15Brazil: Weak Trade Balance Is Negative For Equities Brazil: Weak Trade Balance Is Negative For Equities Brazil: Weak Trade Balance Is Negative For Equities With respect to equities, Brazilian share prices perform poorly when the current account and trade balances are deteriorating (Chart I-15). Falling commodities prices are negative for resource companies. Finally, the stock market's long-term technical profile seems to suggest that a major top has been reached in share prices in U.S. dollar terms and the path of least resistance is down (Chart I-16). Chart I-16Brazilian Stocks In U.S. Dollars Brazilian Stocks In U.S. Dollars Brazilian Stocks In U.S. Dollars Investment Conclusions We remain negative on Brazil's financial markets. Further depreciation in the currency will continue, and will cause a selloff in equities, local bonds and sovereign and corporate credit markets. Dedicated EM portfolios should continue to underweight Brazil in equity and fixed-income portfolios. We continue recommending a long position in the nation's sovereign CDSs. The BRL is among our favoured currency shorts - we are maintaining both our short BRL/long USD and our short BRL/long MXN positions. Among equity sectors, we are reiterating our short position in bank stocks. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthur@bcaresearch.com Andrija Vesic, Research Analyst AndrijaV@bcaresearch.com 1 In our simulations, we used gross government debt, which is calculated as total government public debt excluding central bank holdings of government securities. Gross public debt-to-GDP ratio is now at 74%. Under the older methodology, which included accounting for government debt held by the central bank, the public debt-to-GDP ratio would have been 85%. 2 Cuevas et al. IMF Working Paper; Fiscal Challenges of Population Aging in Brazil, March 2017 3 Pease see Emerging Markets Strategy Special Report "Brazil's Election: Separating Signal From The Noise", dated September 10, 2014, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Feature Valuations, whether for currencies, equities or bonds, are always at the top of the list of the determinants of any asset's long-term performance. This means that after large FX moves like those experienced so far this year, it is always useful to pause and reflect on where currency valuations stand. In this optic, this week we update our set of long-term valuation models for currencies that we introduced In February 2016 in a Special Report titled, "Assessing Fair Value In FX Markets". Included in these models are variables such as productivity differentials, terms-of-trade shocks, net international investment positions, real rate differentials and proxies for global risk aversion.1 These models cover 22 currencies, incorporating both G-10 and EM FX markets. Twice a year, we provide clients with a comprehensive update of all these long-term models in one stop. The models are not designed to generate short- or intermediate-term forecasts. Instead, they reflect the economic drivers of a currency's equilibrium. Their purpose is therefore threefold. First, they provide guideposts to judge whether we are at the end, beginning or middle of a long-term currency cycle. Second, by providing strong directional signals, they help us judge whether any given move is more likely to be a countertrend development or not, offering insight on its potential longevity. Finally, they assist us and our clients in cutting through the fog, and understanding the key drivers of cyclical variations in a currency's value. The U.S. Dollar Chart 1Dollar: Back At Fair Value Dollar: Back At Fair Value Dollar: Back At Fair Value 2017 was a terrible year for the dollar, but the selloff had one important positive impact: it erased the dollar's massive overvaluation that was so evident in the direct wake of U.S. President Donald Trump's election. In fact, today, based on its long-term drivers, the dollar is modestly cheap (Chart 1). Fair value for the dollar is currently flattered by the fact that real long-term yields are higher in the U.S. than in the rest of the G-10. Investors are thus betting that U.S. neutral interest rates are much higher than in other advanced economies. This also means that the uptrend currently evident in the dollar's fair value could end once we get closer to the point where Europe can join the U.S. toward lifting rates - a point at which investors could begin upgrading their estimates of the neutral rate in the rest of the world. This would be dollar bearish. For the time being, we recommend investors keep a bullish posturing on the USD for the remainder of 2018. Not only is global growth still slowing, a traditionally dollar-bullish development, but also the fed funds rate is likely to be moving closer to r-star. As we have previously showed, when the fed funds rate rises above r-star, the dollar tends to respond positively.2 Finally, cyclical valuations are not a handicap for the dollar anymore. The Euro Chart 2The Euro Is Still Cheap The Euro Is Still Cheap The Euro Is Still Cheap As most currencies managed to rise against the dollar last year, the trade-weighted euro's appreciation was not as dramatic as that of EUR/USD. Practically, this also means that despite a furious rally in this pair, the broad euro remains cheap on a cyclical basis, a cheapness that has only been accentuated by weakness in the euro since the first quarter of 2018 (Chart 2). The large current account of the euro area, which stands at 3.5% of GDP, is starting to have a positive impact on the euro's fair value, as it is lifting the currency bloc's net international investment position. Moreover, euro area interest rates may remain low relative to the U.S. for the next 12 to 18 months, but the 5-year forward 1-month EONIA rate is still near rock-bottom levels, and has scope to rise on a multi-year basis. This points toward a continuation of the uptrend in the euro's fair value. For the time being, despite a rosy long-term outlook for the euro, we prefer to remain short EUR/USD. Shorter-term fair value estimates are around 1.12, and the euro tends to depreciate against the dollar when global growth is weakening, as is currently the case. Moreover, the euro area domestic economy is not enjoying the same strength as the U.S. right now. This creates an additional handicap for the euro, especially as the Federal Reserve is set to keep increasing rates at a pace of four hikes a year, while the European Central Bank remains as least a year away from lifting rates. The Yen Chart 3Attractive Long-Term Valuation, But... Attractive Long-Term Valuation, But... Attractive Long-Term Valuation, But... The yen remains one of the cheapest major currencies in the world (Chart 3), as the large positive net international investment position of Japan, which stands at 64% of GDP, still constitutes an important support for it. Moreover, the low rate of Japanese inflation is helping Japan's competitiveness. However, while valuations represent a tailwind for the yen, the Bank of Japan faces an equally potent headwind. At current levels, the yen may not be much of a problem for Japan's competitiveness, but it remains the key driver of the country's financial conditions. Meanwhile, Japanese FCI are the best explanatory variable for Japanese inflation.3 It therefore follows that any strengthening in the yen will hinder the ability of the BoJ to hit its inflation target, forcing this central bank to maintain a dovish tilt for the foreseeable future. As a result, while we see how the current soft patch in global growth may help the yen, we worry that any positive impact on the JPY may prove transitory. Instead, we would rather play the yen-bullish impact of slowing global growth and rising trade tensions by selling the euro versus the yen than by selling the USD, as the ECB does not have the same hawkish bias as the Fed, and as the European economy is not the same juggernaut as the U.S. right now. The British Pound Chart 4Smaller Discount In The GBP Smaller Discount In The GBP Smaller Discount In The GBP The real-trade weighted pound has been appreciating for 13 months. This reflects two factors: the nominal exchange rate of the pound has regained composure from its nadir of January 2017, and higher inflation has created additional upward pressures on the real GBP. As a result of these dynamics, the deep discount of the real trade-weighted pound to its long-term fair value has eroded (Chart 4). The risk that the May government could fall and be replaced either by a hard-Brexit PM or a Corbyn-led coalition means that a risk premia still needs to be embedded in the price of the pound. As a result, the current small discount in the pound may not be enough to compensate investors for taking on this risk. This suggests that the large discount of the pound to its purchasing-power-parity fair value might overstate its cheapness. While the risks surrounding British politics means that the pound is not an attractive buy on a long-term basis anymore, we do like it versus the euro on a short-term basis: EUR/GBP tends to depreciate when EUR/USD has downside, and the U.K. economy may soon begin to stabilize as slowing inflation helps British real wages grow again after contracting from October 2016 to October 2017, which implies that the growth driver may move a bit in favor of the pound. The Canadian Dollar Chart 5CAD Near Fair Value CAD Near Fair Value CAD Near Fair Value The stabilization of the fair value for the real trade-weighted Canadian dollar is linked to the rebound in commodity prices, oil in particular. However, despite this improvement, the CAD has depreciated and is now trading again in line with its long-term fair value (Chart 5). This lack of clear valuation opportunity implies that the CAD will remain chained to economic developments. On the negative side, the CAD still faces some potentially acrimonious NAFTA negotiations, especially as U.S. President Donald Trump could continue with his bellicose trade rhetoric until the mid-term elections. Additionally, global growth is slowing and emerging markets are experiencing growing stresses, which may hurt commodity prices and therefore pull the CAD's long-term fair value lower. On the positive side, the Canadian economy is strong and is exhibiting a sever lack of slack in its labor market, which is generating both rapidly growing wages and core inflation of 1.8%. The Bank of Canada is therefore set to increase rates further this year, potentially matching the pace of rate increase of the Fed over the coming 24 months. As a result of this confluence of forces, we are reluctant to buy the CAD against the USD, especially as the former is strong. Instead, we prefer buying the CAD against the EUR and the AUD, two currencies set to suffer if global growth decelerates but that do not have the same support from monetary policy as the loonie. The Australian Dollar Chart 6The AUD Is Not Yet Cheap The AUD Is Not Yet Cheap The AUD Is Not Yet Cheap The real trade-weighted Australian dollar has depreciated by 5%, which has caused a decrease in the AUD's premium to its long-term fair value. The decline in the premium also reflects a small upgrade in the equilibrium rate itself, a side effect of rising commodity prices last year. However, despite these improvements, the AUD still remains expensive (Chart 6). Moreover, the rise in the fair value may prove elusive, as the slowdown in global growth and rising global trade tensions could also push down the AUD's fair value. These dynamics make the AUD our least-favored currency in the G-10. Additionally, the domestic economy lacks vigor. Despite low unemployment, the underemployment rate tracked by the Reserve Bank of Australia remains nears a three-decade high, which is weighing on both wages and inflation. This means that unlike in Canada, the RBA is not set to increase rates this year, and may in fact be forced to wait well into 2019 or even 2020 before doing so. The AUD therefore is not in a position to benefit from the same policy support as the CAD. We are currently short the AUD against the CAD and the NZD. We have also recommended investors short the Aussie against the yen as this cross is among the most sensitive to global growth. The New Zealand Dollar Chart 7NZD Vs Fair Value NZD Vs Fair Value NZD Vs Fair Value After having traded at a small discount to its fair value in the wake of the formation of a Labour / NZ first coalition government, the NZD is now back at equilibrium (Chart 7). The resilience of the kiwi versus the Aussie has been a key factor driving the trade-weighted kiwi higher this year. Going forward, a lack of clearly defined over- or undervaluation in the kiwi suggests that the NZD will be like the Canadian dollar: very responsive to international and domestic economic developments. This gives rise to a very muddled picture. Based on the output and unemployment gaps, the New Zealand economy seems at full employment, yet it has not seen much in terms of wage or inflationary pressures. As a result, the Reserve Bank of New Zealand has refrained from adopting a hawkish tone. Moreover, the populist policy prescriptions of the Ardern government are also creating downside risk for the kiwi. High immigration has been a pillar behind New Zealand's high-trend growth rate, and therefore a buttress behind the nation's high interest rates. Yet, the government wants to curtail this source of dynamism. On the international front, the kiwi economy has historically been very sensitive to global growth. While this could be a long-term advantage, in the short-term the current global growth soft patch represents a potent handicap for the kiwi. In the end, we judge Australia's problems as deeper than New Zealand's. Since valuations are also in the NZD's favor, the only exposure we like to the kiwi is to buy it against the AUD. The Swiss Franc Chart 8The SNB's Problem The SNB's Problem The SNB's Problem On purchasing power parity metrics, the Swiss franc is expensive, and the meteoric rise of Swiss unit labor costs expressed in euros only confirms this picture. The problem is that this expensiveness is justified once other factors are taken into account, namely Switzerland's gargantuan net international investment position of 128% of GDP, which exerts an inexorable upward drift on the franc's fair value. Once this factor is incorporated, the Swiss franc currently looks cheap (Chart 8). The implication of this dichotomy is that the Swiss franc could experience upward pressure, especially when global growth slows, which is the case right now. However, the Swiss National Bank remains highly worried that an indebted economy like Switzerland, which also suffers from a housing bubble, cannot afford the deflationary pressures created by a strong franc. As a result, we anticipate that the SNB will continue to fight tooth and nail against any strength in the franc. Practically, we are currently short EUR/CHF on a tactical basis. Nonetheless, once we see signs that global growth is bottoming, we will once again look to buy the euro against the CHF as the SNB will remain in the driver's seat. The Swedish Krona Chart 9What The Riksbank Wants What The Riksbank Wants What The Riksbank Wants The Swedish krona is quite cheap (Chart 9), but in all likelihood the Riksbank wants it this way. Sweden is a small, open economy, with total trade representing 86% of GDP. This means that a cheap krona is a key ingredient to generating easy monetary conditions. However, this begs the question: Does Sweden actually need easy monetary conditions? We would argue that the answer to this question is no. Sweden has an elevated rate of capacity utilization as well as closed unemployment and output gaps. In fact, trend Swedish inflation has moved up, albeit in a choppy fashion, and the Swedish economy remains strong. Moreover, the country currently faces one of the most rabid housing bubbles in the world, which has caused household debt to surge to 182% of disposable income. This is creating serious vulnerabilities in the Swedish economy - dangers that will only grow larger as the Riksbank keep monetary policy at extremely easy levels. A case can be made that with large exposure to both global trade and industrial production cycles, the current slowdown in global growth is creating a risk for Sweden. These risks are compounded by the rising threat of a trade war. This could justify easier monetary policy, and thus a weaker SEK. When all is said and done, while the short-term outlook for the SEK will remained stymied by the global growth outlook, we do expect the Riksbank to increase rates this year as inflation could accelerate significantly. As a result, we recommend investors use this period of weakness to buy the SEK against both the dollar and the euro. The Norwegian Krone Chart 10The NOK Is The Cheapest Commodity Currency In The G-10 The NOK Is The Cheapest Commodity Currency In The G-10 The NOK Is The Cheapest Commodity Currency In The G-10 The Norwegian krone has experienced a meaningful rally against the euro and the krona this year - the currencies of its largest trading partners - and as such, the large discount of the real trade-weighted krone to its equilibrium rate has declined. On a long-term basis, the krone remains the most attractive commodity currency in the G-10 based on valuations alone (Chart 10). While we have been long NOK/SEK, currently we have a tactical negative bias towards this cross. Investors have aggressively bought inflation protection, a development that tends to favor the NOK over the SEK. However, slowing global growth could disappoint these expectations, resulting in a period of weakness in the NOK/SEK pair. Nonetheless, we believe this is only a short-term development, and BCA's bullish cyclical view on oil will ultimately dominate. As a result, we recommend long-term buyers use any weakness in the NOK right now to buy more of it against the euro, the SEK, and especially against the AUD. The Yuan Chart 11The CNY Is At Equilibrium The CNY Is At Equilibrium The CNY Is At Equilibrium The fair value of the Chinese yuan has been in a well-defined secular bull market because China's productivity - even if it has slowed - remains notably higher than productivity growth among its trading partners. However, while the yuan traded at a generous discount to its fair value in early 2017, this is no longer the case (Chart 11). Despite this, on a long-term basis we foresee further appreciation in the yuan as we expect the Chinese economy to continue to generate higher productivity growth than its trading partners. Moreover, for investors with multi-decade investment horizons, a slow shift toward the RMB as a reserve currency will ultimately help the yuan. However, do not expect this force to be felt in the RMB any time soon. On a shorter-term horizon, the picture is more complex. Chinese economic activity is slowing as monetary conditions as well as various regulatory and administrative rules have been tightened - all of them neatly fitting under the rubric of structural reforms. Now that the trade relationship between the U.S. and China is becoming more acrimonious, Chinese authorities are likely to try using various relief valves to limit downside to Chinese growth. The RMB could be one of these tools. As such, the recent strength in the trade-weighted dollar is likely to continue to weigh on the CNY versus the USD. Paradoxically, the USD's strength is also likely to mean that the trade-weighted yuan could experience some upside. The Brazilian Real Chart 12More Downside In The BRL More Downside In The BRL More Downside In The BRL Despite the real's recent pronounced weakness, it has more room to fall before trading at a discount to its long-term fair value (Chart 12). More worrisome, the equilibrium rate for the BRL has been stable, even though commodity prices have rebounded. This raises the risk that the BRL could experience a greater decline than what is currently implied by its small premium to fair value if commodity prices were to fall. Moreover, bear markets in the real have historically ended at significant discounts to fair value. The current economic environment suggests this additional decline could materialize through the remainder of 2018. Weak global growth has historically been a poison for commodity prices as well as for carry trades, two factors that have a strong explanatory power for the real. Moreover, China's deceleration and regulatory tightening should translate into further weakness in Chinese imports of raw materials, which would have an immediate deleterious impact on the BRL. Additionally, as we have previously argued, when the fed funds rate rise above r-star, this increases the probability of an accident in global capital markets. Since elevated debt loads are to be found in EM and not in the U.S., this implies that vulnerability to a financial accident is greatest in the EM space. The BRL, with its great liquidity and high representation in investors' portfolios, could bear the brunt of such an adjustment. The Mexican Peso Chart 13The MXN Is A Bargain Once Again The MXN Is A Bargain Once Again The MXN Is A Bargain Once Again When we updated our long-term models last September, the peso was one of the most expensive currencies covered, and we flagged downside risk. With President Trump re-asserting his protectionist rhetoric, and with EM bonds and currencies experiencing a wave of pain, the MXN has eradicated all of its overvaluation and is once again trading at a significant discount to its long-term fair value (Chart 13). Is it time to buy the peso? On a pure valuation basis, the downside now seems limited. However, risks are still plentiful. For one, NAFTA negotiations are likely to remain rocky, at least until the U.S. mid-term elections. Trump's hawkish trade rhetoric is a surefire way to rally the GOP base at the polls in November. Second, the leading candidate in the polls for the Mexican presidential elections this summer is Andres Manuel Lopez Obrador, the former mayor of Mexico City. Not only could AMLO's leftist status frighten investors, he is looking to drive a hard bargain with the U.S. on NAFTA, a clear recipe for plentiful headline risk in the coming months. Third, the MXN is the EM currency with the most abundant liquidity, and slowing global growth along with rising EM volatility could easily take its toll on the Mexican currency. As a result, to take advantage of the MXN's discount to fair value, a discount that is especially pronounced when contrasted with other EM currencies, we recommend investors buy the MXN versus the BRL or the ZAR instead of buying it outright against the USD. These trades are made even more attractive by the fact that Mexican rates are now comparable to those offered on South African or Brazilian paper. The Chilean Peso Chart 14The CLP Is At Risk The CLP Is At Risk The CLP Is At Risk We were correct to flag last September that the CLP had less downside than the BRL. But now, while the BRL's premium to fair value has declined significantly, the Chilean peso continues to trade near its highest premium of the past 10 years (Chart 14). This suggests the peso could have significant downside if EM weakness grows deeper. This risk is compounded by the fact that the peso's fair value is most sensitive to copper prices. Prices of the red metal had been stable until recent trading sessions. However, with the world largest consumer of copper - China - having accumulated large stockpiles and now slowing, copper prices could experience significant downside, dragging down the CLP in the process. An additional risk lurking for the CLP is the fact that Chile displays some of the largest USD debt as a percent of GDP in the EM space. This means that a strong dollar could inflict a dangerous tightening in Chilean financial conditions. This risk is even more potent as the strength in the dollar is itself a consequence of slowing global growth - a development that is normally negative for the Chilean peso. This confluence thus suggests that the expensive CLP is at great risk in the coming months. The Colombian Peso Chart 15The COP Is Latam's Cheapest Currency The COP Is Latam's Cheapest Currency The COP Is Latam's Cheapest Currency The Colombian peso is currently the cheapest currency covered by our models. The COP has not been able to rise along with oil prices, creating a large discount in the process (Chart 15). Three factors have weighed on the Colombian currency. First, Colombia just had elections. While a market-friendly outcome ultimately prevailed, investors were already expressing worry ahead of the first round of voting four weeks ago. Second, Colombia has a large current account deficit of 3.7% of GDP, creating a funding risk in an environment where liquidity for EM carry trades has decreased. Finally, Colombia has a heavy USD-debt load. However, this factor is mitigated by the fact that private debt stands at 65% of Colombia's GDP, reflecting the banking sector's conservative lending practices. At this juncture, the COP is an attractive long-term buy, especially as president-elect Ivan Duque is likely to pursue market-friendly policies. However, the country's large current account deficit as well as the general risk to commodity prices emanating from weaker global growth suggests that short-term downside risk is still present in the COP versus the USD. As a result, while we recommend long-term investors gain exposure to this cheap Latin American currency, short-term players should stay on the sidelines. Instead, we recommend tactical investors capitalize on the COP's cheapness by buying it against the expensive CLP. Not only are valuations and carry considerations favorable, Chile has even more dollar debt than Colombia, suggesting that the former is more exposed to dollar risk than the latter. Moreover, Chile is levered to metals prices while Colombia is levered to oil prices. Our commodity strategists are more positive on crude than on copper, and our negative outlook on China reinforces this message. The South African Rand Chart 16The Rand Will Cheapen Further The Rand Will Cheapen Further The Rand Will Cheapen Further Despite its more than 20% depreciation versus the dollar since February, the rand continues to trade above its estimate of long-term fair value (Chart 16). The equilibrium rate for the ZAR is in a structural decline, even after adjusting for inflation, as the productivity of the South African economy remains in a downtrend relative to that of its trading partners. This means the long-term trend in the ZAR will continue to point south. On a cyclical basis, it is not just valuations that concern us when thinking about the rand. South Africa runs a deficit in terms of FDI; however, portfolio inflows into the country have been rather large, resulting in foreign ownership of South African bonds of 44%. Additionally, net speculative positions in the rand are still at elevated levels. This implies that investors could easily sell their South African assets if natural resource prices were to sag. Since BCA's view on Chinese activity as well as the soft patch currently experienced by the global economy augur poorly for commodities, this could create potent downside risks for the ZAR. We will be willing buyers only once the rand's overvaluation is corrected. The Russian Ruble Chart 17The Ruble Is At Fair Value The Ruble Is At Fair Value The Ruble Is At Fair Value There is no evidence of mispricing in the rubble (Chart 17). Moreover the Russian central bank runs a very orthodox monetary policy, which gives us comfort that the RUB, with its elevated carry, remains an attractive long-term hold within the EM FX complex. On a shorter-term basis, the picture is more complex. The RUB is both an oil play as well as a carry currency. This means that the RUB is very exposed to global growth and liquidity conditions. This creates major risks for the ruble. EM FX volatility has been rising, and slowing global growth could result in an unwinding of inflation-protection trades, which may pull oil prices down. This combination is negative for both EM currencies and oil plays for the remainder of 2018. Our favorite way to take advantage of the RUB's sound macroeconomic policy, high interest rates and lack of valuation extremes is to buy it against other EM currencies. It is especially attractive against the BRL, the ZAR and the CLP. The only EM commodity currency against which it doesn't stack up favorably is the COP, as the COP possesses a much deeper discount to fair value than the RUB, limiting its downside if the global economy were to slow more sharply than we anticipate. The Korean Won Chart 18Despite Its Modest Cheapness, The KRW Is At Risk Despite Its Modest Cheapness, The KRW Is At Risk Despite Its Modest Cheapness, The KRW Is At Risk The Korean won currently trades at a modest discount to its long-term fair value (Chart 18). This suggests the KRW will possess more defensive attributes than the more expensive Latin American currencies. However, BCA is worried over the Korean currency's cyclical outlook. The Korean economy is highly levered to both global trade and the Chinese investment cycle. This means the Korean won is greatly exposed to the two largest risks in the global economy. Moreover, the Korean economy is saddled with a large debt load for the nonfinancial private sector of 193% of GDP, which means the Bank of Korea could be forced to take a dovish turn if the economy is fully hit by a global and Chinese slowdown. Moreover, the won has historically been very sensitive to EM sovereign spreads. EM spreads have moved above their 200-day moving average, which suggests technical vulnerability. This may well spread to the won, especially in light of the global economic environment. The Philippine Peso Chart 19Big Discount In The PHP Big Discount In The PHP Big Discount In The PHP The PHP is one of the rare EM currencies to trade at a significant discount to its long-term fair value (Chart 19). There are two main reasons behind this. First, the Philippines runs a current account deficit of 0.5% of GDP. This makes the PHP vulnerable in an environment where global liquidity has gotten scarcer and where carry trades have underperformed. The second reason behind the PHP's large discount is politics. Global investors remain uncomfortable with President Duterte's policies, and as such are imputing a large risk premium on the currency. Is the PHP attractive? On valuation alone, it is. However, the current account dynamics are expected to become increasingly troubling. The economy is in fine shape and the trade deficit could continue to widen as imports get a lift from strong domestic demand - something that could infringe on the PHP's attractiveness. However, on the positive side, the PHP has historically displayed a robust negative correlation with commodity prices, energy in particular. This suggests that if commodity prices experience a period of relapse, the PHP could benefit. The best way to take advantage of these dynamics is to not buy the PHP outright against the USD but instead to buy it against EM currencies levered to commodity prices like the MYR or the CLP. The Singapore Dollar Chart 20The SGD's Decline Is Not Over The SGD's Decline Is Not Over The SGD's Decline Is Not Over The Singapore dollar remains pricey (Chart 20). However, this is no guarantee of upcoming weakness. After all, the SGD is the main tool used by the Monetary Authority of Singapore to control monetary policy. Moreover, the MAS targets a basket of currencies versus the SGD. Based on these dynamics, historically the SGD has displayed a low beta versus the USD. Essentially, it is a defensive currency within the EM space. The SGD has historically moved in tandem with commodity prices. This makes sense. Commodity prices are a key input in Singapore inflation, and commodity prices perform well when global industrial activity and global trade are strong. This means that not only do rising commodity prices require a higher SGD to combat inflation, higher commodity prices materialize in an environment where this small trading nation is supported by potent tailwinds. Additionally, Singapore loan growth correlates quite closely with commodity prices, suggesting that strong commodity prices result in important amounts of savings from commodity producers being recycled in the Singaporean financial system. To prevent Singapore's economy from overheating in response to these liquidity inflows, MAS is being forced to tighten policy through a higher SGD. Today, with global growth softening and global trade likely to deteriorate, the Singaporean economy is likely to face important headwinds. Tightening monetary policy in the U.S. and in China will create additional headwinds. As a result, so long as the USD has upside, the SGD is likely to have downside versus the greenback. On a longer-term basis, we would expect the correction of the SGD's overvaluation to not happen versus the dollar but versus other EM currencies. The Hong Kong Dollar Chart 21The HKD Is Fairly Valued The HKD Is Fairly Valued The HKD Is Fairly Valued The troughs and peaks in the HKD follow the gyrations of the U.S. dollar. This is to be expected as the HKD has been pegged to the USD since 1983. Like the USD, it was expensive in early 2017, but now it is trading closer to fair value (Chart 21). Additionally, due to the large weight of the yuan in the trade-weighted HKD, the strength in the CNY versus the USD has had a greater impact on taming the HKD's overvaluation than it has on the USD's own mispricing. Moreover, the HKD is trading very close to the lower bound of its peg versus the USD, which has also contributed to the correction of its overvaluation. Even when the HKD was expensive last year, we were never worried that the peg would be undone. Historically, the Hong Kong Monetary Authority has shown its willingness to tolerate deflation when the HKD has been expensive. The most recent period was no different. Moreover, the HKMA has ample fire power in terms of reserves to support the HKD if the need ever existed. Ultimately, the stability created by the HKD peg is still essential to Hong Kong's relevance as a financial center for China, especially in the face of the growing preeminence of Shanghai and Beijing as domestic financial centers. As a result, while we could see the HKD become a bit more expensive over the remainder of 2018 as the USD rallies a bit further, our long-term negative view on the USD suggests that on a multiyear basis the HKD will only cheapen. The Saudi Riyal Chart 22The SAR Remains Expensive The SAR Remains Expensive The SAR Remains Expensive Like the HKD, the riyal is pegged to the USD. However, unlike the HKD, the softness in the USD last year was not enough to purge the SAR's overvaluation (Chart 22). Ultimately, the kingdom's poor productivity means that the SAR needs more than a 15% fall in the dollar index to make the Saudi economy competitive. However, this matters little. Historically, when the SAR has been expensive, the Saudi Arabia Monetary Authority has picked the HKMA solution: deflation over devaluation. Ultimately, Saudi Arabia is a country that imports all goods other than energy products. With a young population, a surge in inflation caused by a falling currency is a risk to the durability of the regime that Riyadh is not willing to test. Moreover, SAMA has the firepower to support the SAR, especially when the aggregate wealth of the extended royal family is taken into account. Additionally, the rally in oil prices since February 2016 has put to rest worries about the country's fiscal standing. On a long-term basis, the current regime wants to reform the economy, moving away from oil and increasing productivity growth. This will be essential to supporting the SAR and decreasing its overvaluation without having to resort to deflation. However, it remains to be seen if Crown Prince Mohamed Bin Salman's ambitious reforms can in fact be implemented and be fruitful. Much will depend on this for the future stability of the riyal. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 For a more detailed discussion of the various variables incorporated in the models, please see Foreign Exchange Strategy Special Report, "Assessing Fair Value In FX Markets", dated February 26, 2016, available at fes.bcaresearch.com 2 For a more detailed discussion of the various variables incorporated in the models, please see Foreign Exchange Strategy Special Report, "Assessing Fair Value In FX Markets", dated February 26, 2016, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "Yen: QQE Is Dead! Long Live YCC!", dated January 12, 2018, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary

Highlights So long as EM corporate and sovereign bond yields continue to rise, EM share prices will remain in a downtrend. EM corporate earnings growth has peaked while EM corporate profitability remains structurally weak. We recommend re-establishing a short Brazilian bank stocks position, and to continue shorting the BRL versus the U.S. dollar. Put Malaysian stocks on an upgrade watch list as the elections outcome is a long-term positive. However, its financial markets will likely face meaningful headwinds in the months ahead. Stay short MYR versus the U.S. dollar. Feature Monitoring Market Signals Rising U.S. bond yields are wreaking havoc on EM risk assets. Not only are EM currencies plunging, but sovereign and corporate bond yields are also spiking. In fact, EM share prices always decline when EM corporate and sovereign bond yields rise (Chart I-1). There is less correlation between EM equity and U.S. bond yields. Chart I-1EM Share Prices Always Decline When EM Corporate Bond Yields Rise EM Share Prices Always Decline When EM Corporate Bond Yields Rise EM Share Prices Always Decline When EM Corporate Bond Yields Rise The basis: So long as the rise in U.S. bond yields is offset by compressing EM credit spreads, EM corporate bond yields decline and EM share prices rally. But when EM corporate (or sovereign) yields rise, irrespective of whether this is due to rising U.S. Treasury yields or widening EM credit spreads, EM equity prices come under considerable selling pressure. Lately, both EM credit spreads have been widening and U.S. bond yields have been mounting. That said, EM sovereign and corporate credit spreads still remain tight by historical standards, suggesting this asset class is still pricing in little risk. Hence, as EM currencies continue to sell off, EM credit spreads will widen further (Chart I-2). Meanwhile, U.S. government bond yields in our view have more upside: U.S. growth is robust (nominal GDP growth is 5%) and inflationary pressures are heightening. Long-term Treasury yields have risen much less than 2- and 5-year bond yields. Therefore, it is not surprising that a bit of catch-up is now underway. Rising U.S. bond yields will inevitably inflict more damage on EM risk assets. EM share prices are sitting on their 200-day moving average (Chart I-3, top panel). Relative to DM, EM share prices have decisively broken below their 200-day moving average (Chart I-3, bottom panel). Chart I-2Weaker EM Currencies = Wider Credit Spreads Weaker EM Currencies = Wider Credit Spreads Weaker EM Currencies = Wider Credit Spreads Chart I-3A Breakdown In The Making? A Breakdown In The Making? A Breakdown In The Making? In addition to widening EM corporate and sovereign bond yields, there are some other market-based indicators that investors should monitor: The ratio of total return (including carry) of commodities currencies relative to safe-haven currencies1 is hovering around 200-day moving average (Chart I-4). A breakdown in this ratio will herald that the rally in EM risk assets is over and a bear market is underway. Chinese offshore and onshore corporate spreads are widening (Chart I-5). This could be the canary in the proverbial coal mine predicting a nascent downturn in Chinese share prices and China-related plays globally. Chart I-4Watch This Market Indicator bca.ems_wr_2018_05_17_s1_c4 bca.ems_wr_2018_05_17_s1_c4 Chart I-5China' On- And Off-Shore Credit Spreads China' On- And Off-Shore Credit Spreads China' On- And Off-Shore Credit Spreads Finally, investor sentiment on EM equities remains bullish. For example, net long positions of asset managers and leveraged funds in EM stock index futures was still extremely elevated as of May 11th (Chart I-6). Bottom Line: We continue to recommend a bearish stance on EM risk assets in absolute terms and underweighting EM stocks, currencies and credit markets versus their DM counterparts. The list of our recommended fixed-income and currency positions is available on page 19. EM Corporate Profits And Profitability It appears that EM profit growth has topped out, regardless of whether we consider net profits (Chart I-7, top panel), EBITDA or cash earnings2 (Chart I-7, bottom panel). These data are for EM non-financial companies included in the MSCI EM overall equity index. The blue lines are from Datastream's World Scope database, and the dotted lines are from MSCI. Chart I-6Investors Remain Positive On EM Equities Investors Remain Positive On EM Equities Investors Remain Positive On EM Equities Chart I-7EM Corporate Earnings Have Topped Out EM Corporate Earnings Have Topped Out EM Corporate Earnings Have Topped Out The last data points for World Scope's net income and EBITDA are as of the end of March 2018, before EM currencies began to plunge. It seems that net income and EBITDA data from World Scope slightly leads the comparable series from MSCI at turning points. This is due to statistical data compilation processes these sources employ. We examine non-financials' corporate profits because EM financials/banks' earnings are often distorted by provisions and other adjustments.3 As a result, they are a poor timing tool for profit cycle turning points. Our negative viewpoint on EM equities is contingent on a significant slowdown, and probably an outright contraction in EM corporate profits in the next 12 months. We have several observations on the EM profit cycle: China's credit plus fiscal spending as well as broad money impulses nicely lead EM corporate profit cycles, and they presently point to an impending cyclical downturn (Chart I-8). As a top-line slowdown transpires, consistent with our expectations, EM profit margins will shrink. If this indeed occurs, EM non-financial profit margins will roll over at levels on par with previous bottoms (Chart I-9). This holds when using both net income and EBITDA. Chart I-8China's Credit Cycle And ##br##EM Non-Financial Profits bca.ems_wr_2018_05_17_s1_c8 bca.ems_wr_2018_05_17_s1_c8 Chart I-9EM Non-Financials: ##br##Profit Margins Are Still Low EM Non-Financials: Profit Margins Are Still Low EM Non-Financials: Profit Margins Are Still Low The same point is pertinent for return on assets (RoA) of listed EM non-financial companies. Chart I-10 portends two versions of RoA measures using net income and EBITDA. If RoA were to peak now in this cycle - which is our baseline scenario - it would roll over at levels on par with previous bottoms reached in 2002 and 2008. Chart I-10EM Non-Financials: Return On Assets EM Non-Financials: Return On Assets EM Non-Financials: Return On Assets Bottom Line: If our outlook for a considerable slowdown in EM revenue growth this year materializes, EM non-financials' profit margins and RoA will relapse at very low levels - the levels that prevailed at previous cycle lows. Hence, EM corporate profitability remains structurally weak, consistent with our view that there has been little corporate restructuring in recent years. Among EM bourses, we are overweighting Taiwan, Korea, Thailand, India, central Europe, Mexico and Chile. Our underweights are Brazil, Turkey, South Africa, Peru, Malaysia and Indonesia. Brazil: Reinstate Short Bank Stocks Position Brazilian markets have sold off sharply of late. The currency has been the main culprit of the selloff. As we have repeatedly argued in the past, the exchange rate holds the key in Brazil. The country's stocks and local bonds as well as sovereign and corporate credit do well when the currency is strong or stable, and sell off during periods of real depreciation. We expect more downside in the currency, which will lead to escalating selling pressure in equity, credit and probably fixed-income markets. We are therefore reiterating our negative stance on Brazilian financial markets: The pace of real economic activity might be rolling over (Chart I-11A). This is occurring at a time when levels of economic activity are still severely depressed, well below their 2012 peak (Chart I-11B). Chart I-11ABrazil: Signs Of Growth Rollover... Brazil: Signs Of Growth Rollover... Brazil: Signs Of Growth Rollover... Chart I-11B...At Low Levels ...At Low Levels ...At Low Levels Business confidence also remains weak amid uncertainty ahead of this fall's presidential elections, which will continue to inhibit hiring and investment. In the meantime, the export sector, which has led growth since 2015, is facing headwinds. Exports in terms of volumes as well as value (U.S. dollars) have decelerated considerably (Chart I-12). As China's growth slows and commodities prices dwindle in the second half of this year, Brazil exports will contract. Nominal GDP growth has relapsed to its 2015 lows - a period when the country's financial markets were rioting (Chart I-13, top panel). Even though economic activity in real terms has rebounded, inflation has plunged resulting in extremely weak nominal income growth. Chart I-12Brazil: Exports Are Slowing Brazil: Exports Are Slowing Brazil: Exports Are Slowing Chart I-13Brazil Suffers From Low Inflation Brazil Suffers From Low Inflation Brazil Suffers From Low Inflation The GDP deflator and core consumer price inflation have plummeted to 20-year lows (Chart I-13, bottom panel). As a result, interest rates deflated by inflation - i.e., real interest rates - remain extremely high. Fiscal policy is restrained by a rule that limits current year spending growth to last year's inflation rate. This year's fiscal expenditure growth is going to be 3% in nominal terms. Given that inflation is still very depressed, this means that fiscal spending growth will be extremely low next year too. Furthermore, the central bank is unlikely to cut interest rates amid the turmoil in the currency market. The central bank also typically shrinks the banking system's reserves - tightens liquidity - during periods of exchange rate depreciation, as illustrated in Chart I-14. Therefore, the combination of weak nominal growth and high real interest rates will slip Brazil into a debt deflation dynamic - where indebtedness rises as nominal income/revenue growth remains below borrowing costs (Chart I-15). Chart I-14Falling BRL = Tighter Liquidity Falling BRL = Tighter Liquidity Falling BRL = Tighter Liquidity Chart I-15Brazil: An Unsustainable Gap Brazil: An Unsustainable Gap Brazil: An Unsustainable Gap This is especially true for government debt in Brazil. We maintain that the nation's public debt dynamics will remain on an unsustainable trajectory as long as government revenue growth does not exceed the level of nominal interest rates. In turn what Brazil needs are much lower real interest rates and a weaker currency to boost nominal GDP/income growth. This would ultimately stabilize public and private debt dynamics and improve debtors' ability to service debt. However, a sizable exchange rate depreciation, which is all but required to boost nominal growth, will in the interim be bad for financial markets, especially foreign investors. Chart I-16Brazil: Markets Have Hit Critical Levels Brazil: Markets Have Hit Critical Levels Brazil: Markets Have Hit Critical Levels Finally, there are a number of technical patterns that suggest a major top has been reached in Brazilian financial markets, and that downside from current levels will likely be significant. In particular, Brazil share prices in U.S. dollar terms have failed to break above their multi-year moving average, which has served as both a support and resistance in the past (Chart I-16, top panel). Likewise the real's total return including carry versus the dollar has been unable to break above its previous high. This, combined with the head-and-shoulder pattern of BRL (Chart I-16, bottom panel), suggests the real might be entering a bear market. Bank stocks are a large part of the equity index, and they have lately been under severe selling pressure. We are reinstating our short position in Brazilian banks. We closed this position last week when we removed our short Brazilian banks / long Argentine banks equity recommendation due to the selloff in Argentine banks.4 The currency depreciation is forcing local interest rates to rise, which is causing liquidity to tighten in Brazil. High borrowing costs in real terms are inhibiting credit demand. In particular, banks' aggregate loans to companies and households in both nominal and real terms are still shrinking. Although consumer loans are rising, the contraction in corporate lending has more than offset the recovery in household credit. Further, Chart I-17 demonstrates that the relapse in nominal GDP growth (shown inverted in the chart) heralds a rise in the rate of change of non-performing loans (NPL) as well as their provisions. As provisions begin to rise, banks' earnings will take a hit. Chart I-18 illustrates that banks have been reducing NPL provisions to boost profits and a rate of change in provisions has been a decisive factor driving bank equity prices in recent years. Chart I-17Slower Nominal Growth = Higher Provisions & NPLs Slower Nominal Growth = Higher Provisions & NPLs Slower Nominal Growth = Higher Provisions & NPLs Chart I-18NPL Provisions And Bank Stocks NPL Provisions And Bank Stocks NPL Provisions And Bank Stocks Bottom Line: Re-establish a short bank stocks position, and continue to short the BRL versus the U.S. dollar and MXN. Remain underweight Brazilian stocks as well as sovereign and corporate credit within respective EM portfolios. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Analyst andrijav@bcaresearch.com Malaysia: Short-Term Challenges, Long-Term Opportunities Chart II-1Malaysia: Banks Have Been ##br##'Cooking Their Books' Malaysia: Banks Have Been 'Cooking Their Books' Malaysia: Banks Have Been 'Cooking Their Books' The election victory by the Malaysian opposition coalition, Pakatan Harapan, offers a major opportunity to reverse the significant deterioration in Malaysia's governance and, hence, poor productivity growth that has occurred under the former Prime Minister Najib Razak. The political change is therefore a bullish development for Malaysia in the long-run. As such, we are placing the Malaysian bourse on an upgrade watch list. Yet the performance of Malaysia's financial markets in the coming months will remain challenged by vulnerabilities emanating from the country's weak banking system and potential negative forces that will subdue its external sector. These factors will slow growth in the months ahead, hurt the ringgit and exert downward pressures on Malaysian share prices: The health of Malaysian commercial banks is questionable. Since the economic downturn started in 2014, banks have grossly underreported their non-performing loans (NPLs) (Chart II-1). Additionally, they have been lowering NPL provisions to artificially boost their earnings in the past year or so (Chart II-1, bottom panel). Hence, banks' reported earnings are inflated. The former government tolerated these actions to ensure "economic and financial stability". Yet this sense of false "stability" will reverse under the new government. The latter headed by incoming Prime Minister Mahathir Mohamad will likely attempt to change leadership of state institutions and SOEs and also clean the financial system in order to improve its transparency and soundness. We suspect as a part of this restructuring, the authorities and the central bank will begin exerting pressure on commercial banks to recognize and provision for NPLs. It is always new leadership within financial regulatory institutions or banks that opt to open the books and recognize NPLs. Higher provisioning will cause bank earnings to slump considerably, jeopardizing their share prices (Chart II-2). Malaysian banks account for 34% of the MSCI Malaysia index and 40% of its total earnings. Finally, bank stocks are not cheap with a price-to-book value ratio of 1.6 and a trailing P/E ratio at 15. On the external front, rising U.S. bond yields will cause the U.S. dollar to strengthen versus the ringgit, which will not bode well for Malaysian financial assets. Chart II-3 shows that spreads of Malaysian local government bond yields over U.S. Treasurys have reached new cyclical lows. As such, local yields offer little caution for foreign bond investors. Given that around 29% of domestic currency bonds are owned by foreigners, the ringgit depreciation will likely generate selling pressure in the local bond market. Chart II-2Malaysia: Bank Stocks Are At Risk Malaysia: Bank Stocks Are At Risk Malaysia: Bank Stocks Are At Risk Chart II-3Malaysia: Local Bond Yields ##br##Spreads Over U.S. Treasurys Malaysia: Local Bond Yields Spreads Over U.S. Treasurys Malaysia: Local Bond Yields Spreads Over U.S. Treasurys Further, the outlook for Malaysia's trade balance is negative due to potential cracks in the semiconductors industry and in commodities. Semiconductors account for 15% of Malaysia's exports while commodities account for around a quarter of its exports; with energy making up 14% exports and palm oil accounting for 8%. Malaysian exports of semiconductors are likely peaking. Chart II-4 shows that the average of Taiwan's and Korea's semiconductors shipment-to-inventory ratios is pointing to a deceleration in Malaysia's semiconductor exports. Taiwan and Korea are major semiconductor manufacturing hubs that ship some of their chips to Malaysia for testing and assembly. On this note, Chart II-5 shows that Taiwanese semiconductor exports to Malaysia are decelerating. This is confirming a forthcoming slump in Malaysia's semiconductor exports. And finally, various semiconductor prices are beginning to decline. Chart II-4Malaysia's Semiconductor Industry At Risk Malaysia's Semiconductor Industry At Risk Malaysia's Semiconductor Industry At Risk Chart II-5Malaysia's Semi Exports To Slow Malaysia's Semi Exports To Slow Malaysia's Semi Exports To Slow As for commodities, palm oil prices have been weak (Chart II-6). The industry is facing significant headwinds due to import restrictions from India and the EU. Besides, Malaysia is probably bound to lose palm oil market share to Indonesia. China and Indonesia signed an agreement last week with the former agreeing to purchase more of this commodity from Indonesia. Chart II-6Unusual Divergence Between ##br##Oil And Palm Oil Prices Unusual Divergence Between Oil And Palm Oil Prices Unusual Divergence Between Oil And Palm Oil Prices Meanwhile, as our colleagues from the Geopolitical Strategy service argued this week, the incoming Prime Minister Mahathir Mohamad plans to review some Chinese investments in Malaysia that were undertaken by his predecessor.5 Doing so could induce China to retaliate by limiting Malaysian palm oil imports and reducing imports of other Malaysian products as well. Around 13% of Malaysian exports are shipped to China. A final word on oil is warranted. The surge in oil prices is unambiguously bullish for this economy. However, it is important to realize that this price surge is driven by escalating geopolitical risks and mushrooming traders' net long positions in crude rather than global demand. The former might persist for some time as U.S.-Iran hostilities linger. Continued strength in the dollar, however, could trigger a considerable decline in oil prices as traders head for the exits. On the whole, Malaysia's current account balance will deteriorate which will weigh on the Malaysian currency and hurt U.S. dollar returns of Malaysian financial assets. Faced with currency depreciation, the Malaysian central bank is unlikely to defend the currency by hiking interest rates or selling its foreign exchange reserves (doing so would also tighten banking system liquidity). The Malaysian economy cannot bear much higher interest rates as private-sector debt-to-GDP stands at a whopping 134%. In the meantime, currency depreciation will inflict pain on debtors with foreign currency liabilities. Malaysian companies are amongst the largest foreign currency borrowers in the developing economies univers. In short, the ringgit will come under material selling pressure like many other EM currencies and this will hurt the economy. This will also weigh on the equity index - which is dominated by banks. Bottom Line: While we recommend investors to maintain an underweight position in Malaysian equities for now, we are placing this bourse on upgrade watch list given the positive election results. We are waiting for the following to occur before upgrading Malaysia's stock market: (1) Commodities prices to fall and the semiconductor cycle to slow and (2) Malaysian commercial banks to recognize more NPLs and increase provisioning for bad loans. Meanwhile, currency traders should stay short MYR versus the U.S. dollar and equity investors should remain short banks. Finally, for fixed-income traders we continue to recommend long Thai / short Malaysia local bonds. Credit portfolios should underweight this sovereign credit for now. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 This index is constructed using an equal-weighted index of six total return commodities currencies such as BRL, CLP, ZAR, AUD, NZD and CAD divided by the total returns of the safe-haven currencies: JPY and CHF. 2 Cash earnings are defined and calculated by MSCI as earnings per share including depreciation and amortization as reported by the company - i.e. depreciation and amortization expenses are added to earnings in order to calculate cash earnings. 3 For example, please refer to discussion on Brazilian and Malaysian banks on pages 7 and 13, respectively. 4 Please refer to Emerging Markets Strategy Weekly Report "EM: A Correction Or Bear Market?" dated May 10, 2018, link is available on page 20. 5 Pleas see Geopolitical Strategy Weekly Report "Are You Ready For "Maximum Pressure?" dated May 16, 2018, available on gps.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights There is growing evidence that China's industrial sector is slowing, as are Asian trade flows. EM stocks have seen their tops. Even though current trade tensions between the U.S. and China could well dissipate, we are at the beginning of a long-term geopolitical standoff between these two superpowers. We are reinstating our long MXN / short BRL and ZAR trade. We are also upgrading Mexican sovereign credit and local bonds to overweight within their respective EM benchmarks. This week we review our recommended country allocation for the EM sovereign credit space. Feature The combination of budding signs of deceleration in both China and global trade, the trade confrontation between the U.S. and China as well as elevated equity valuations, leaves EM stocks extremely vulnerable. Odds are that EM share prices have made a major top. A few financial indicators point to a top in EM risk assets and commodities, while several leading economic indicators herald a global trade slowdown. Taken together we are reiterating our bearish stance on EM risk assets. Market- And Liquidity- Based Indicators Financial market indicators are signalling a major top in EM risk assets and commodities prices: The relative total return (carry included) of four equally weighted EM (ZAR, RUB, BRL and CLP) and three DM (AUD, NZD and CAD) commodities currencies versus an equally weighted average of two safe-haven currencies - the Japanese yen and Swiss franc - has rolled over at its previous highs, and is about to break below its 200-day moving average (Chart I-1). This technical profile points to rising odds of a major down-leg in this carry adjusted ratio of seven 'risk-on' versus two 'safe-haven' currencies, herein referred to as the risk-on / safe-haven currency ratio. Importantly, Chart I-2 demonstrates that this risk-on / safe-haven currency ratio has historically been coincident with EM share prices. A breakdown in this ratio would herald a major downtrend in EM equities. This is consistent with our qualitative assessment that EM equities have seen the peak in this rally. Chart I-1A Major Top In Risk-On Versus ##br##Safe-Haven Currency Ratio bca.ems_wr_2018_03_29_s1_c1 bca.ems_wr_2018_03_29_s1_c1 Chart I-2Risk-On Versus Safe-Haven Currency Ratio##br## And EM Share Prices: Twins? bca.ems_wr_2018_03_29_s1_c2 bca.ems_wr_2018_03_29_s1_c2 The annual rate of change in the risk-on / safe-haven currencies ratio leads global export volumes by several months. It currently indicates that global trade has already peaked, and a meaningful slowdown is in the cards (Chart I-3). As we documented in March 15 report,1 global cyclical sectors - mining, machinery and chemicals - have been underperforming since January. Industrial metals prices, including copper, are gapping down, as are steel and iron ore prices in China (Chart I-4). Chart I-3Global Trade Is Set To Slow bca.ems_wr_2018_03_29_s1_c3 bca.ems_wr_2018_03_29_s1_c3 Chart I-4A Breakdown In Metals Prices Is In The Making A Breakdown In Metals Prices Is In The Making A Breakdown In Metals Prices Is In The Making Our aggregate credit and fiscal spending impulse for China projects considerable downside risks for industrial metals prices (Chart I-5). In this context, a question arises: Why is oil doing well so far? Chart I-6 illustrates that industrial metals prices typically lead oil at peaks. Oil prices have historically been a lagging variable of global business cycles. Chart I-5China's Slowdown Is Far From Over China's Slowdown Is Far From Over China's Slowdown Is Far From Over Chart I-6Industrial Metals Lead Oil Prices At Tops Industrial Metals Lead Oil Prices At Tops Industrial Metals Lead Oil Prices At Tops Furthermore, our two measures of U.S. dollar liquidity have rolled over. These two measures have a high correlation with EM share prices and are inversely correlated with the trade-weighted U.S. dollar (Chart I-7A and Chart I-7B). The dollar is shown inverted on Chart I-7B. The rollover in these measures of U.S. dollar liquidity is due to shrinking U.S. banks' excess reserves at the Federal Reserve. The Fed's ongoing balance sheet reduction and the Treasury's replenishment of its account at the Fed will continue to shrink banks' excess reserves, and thereby weigh on these measures of U.S. dollar liquidity. In short, downside risks to EM stocks and upside risks to the U.S. dollar have increased. Last but not least, China's yield curve has recently ticked down again and is about to invert, signaling weaker growth ahead (Chart I-8). Chart I-7AU.S. Dollar Liquidity And EM Stocks... U.S. Dollar Liquidity And EM Stocks... U.S. Dollar Liquidity And EM Stocks... Chart I-7B...And Trade-Weighted Dollar (Inverted) ...And Trade-Weighted Dollar (Inverted) ...And Trade-Weighted Dollar (Inverted) Chart I-8China's Yield Curve Is About To Invert China's Yield Curve Is About To Invert China's Yield Curve Is About To Invert Hard Data In addition, certain economic data have also decisively rolled over, in particular: Taiwanese shipments to China lead global trade volumes by several months, and they now portend a meaningful slowdown in global export volumes (Chart I-9). The basis for this relationship is that Taiwan sends a lot of intermediate products to mainland China. These inputs are in turn assembled by China and then shipped worldwide. Therefore, diminishing trade flow from Taiwan to China is a sign of a slowdown in world trade. The three-month moving average of Korea's 20-day exports growth rate, which includes the March data point, reveals that considerable softness in global trade is underway (Chart I-10). Chart I-9Another Sign Of Peak In Global Trade Another Sign Of Peak In Global Trade Another Sign Of Peak In Global Trade Chart I-10Korean Export Growth Is Already Weak Korean Export Growth Is Already Weak Korean Export Growth Is Already Weak China's shipping freight index - the freight rates for containers out of China - is softening, and its annual rate of change points to weaker Asian exports (Chart I-11). The annual growth rate of vehicle sales in China has dropped to zero, with both passenger cars and commercial vehicles registering no growth in the past three months from a year ago (Chart I-12). Chart I-11Container Freight Rates In Asia Are Softening Container Freight Rates In Asia Are Softening Container Freight Rates In Asia Are Softening Chart I-12China's Auto Sales: Post-Stimulus Hangover China's Auto Sales: Post-Stimulus Hangover China's Auto Sales: Post-Stimulus Hangover Finally, measures of industrial activity in China such as total freight volumes and electricity output growth continue to downshift (Chart I-13). Next week we are planning to publish a Special Report on China's property market. Our initial research shows that structural imbalances remain acute in the nation's real estate market, and a downturn commensurable if not worse than those that occurred in 2011 and 2014-'15 is very likely. Will the Fed and the People's Bank of China (PBoC) reverse their stance quickly to stabilize growth or preclude a downdraft in global risk assets? In the U.S., the primary trend in core inflation is up. Chart I-14 demonstrates that measures of core inflation have recently risen. This, along with the tight labor market, potential upside surprises in U.S. wages and a still-large fiscal stimulus entails that the bar for the Fed to turn dovish will be somewhat higher this year. It may take a large drawdown in the S&P 500 and a meaningful appreciation in the dollar for the Fed to come to the rescue of risk assets. Chart I-13Chinese Industrial Sector Is Decelerating Chinese Industrial Sector Is Decelerating Chinese Industrial Sector Is Decelerating Chart I-14U.S. Core Inflation Has Bottomed U.S. Core Inflation Has Bottomed U.S. Core Inflation Has Bottomed The Chinese authorities on the other hand, had already been facing enormous challenges in balancing the needs for structural reforms and achieving robust growth before the eruption of the trade confrontation with the U.S. As such, the balancing task is becoming overwhelming. Even if the Chinese authorities stop tightening liquidity now, the cumulated impact of earlier liquidity and regulatory tightening will continue to work its way into the economy, thereby slowing growth. Bottom Line: There is growing evidence that China's industrial sector is slowing, as are Asian trade flows. This is bearish for commodities and EM risk assets. Geopolitics: Icing On The Cake The recent U.S. trade spat with China has arrived at a time when global trade and China's industrial cycle have already begun to downshift, as discussed above. At the same time, investor sentiment on global risk assets remains very complacent, and equity and credit markets are pricey. As such, the U.S.-China trade confrontation has become the icing on the cake. U.S. equity valuations are elevated - the median stock's P/E ratio is at an all-time high (Chart I-15). While EM share prices are not at record expensive levels, valuations are on the pricey side. The top panel of Chart I-16 shows the equal-weighted average of trailing and forward P/E, price-to-book, price-to-cash earnings and price-to-dividend ratios for the median EM sub-sector. This valuation indicator is about one standard deviation above its historical mean. Chart I-15U.S. Equities: Median P/E ##br##Is At Record High U.S. Equities: Median P/E Is At Record High U.S. Equities: Median P/E Is At Record High Chart I-16EM Stocks Are Expensive##br## In Absolute Term bca.ems_wr_2018_03_29_s1_c16 bca.ems_wr_2018_03_29_s1_c16 The bottom panel of Chart I-16 illustrates the same valuation ratio relative to DM. Contrary to prevailing consensus, EM equities are not cheap relative their DM peers. Using median multiples of sub-sectors helps remove outliers. We discussed EM stock valuations in greater detail in our January 24 and March 1 special reports; the links to these reports are available on page 17. As to the duration and depth of the U.S.-China trade confrontation, we have the following remarks: If the U.S.'s plan to impose import tariffs on Chinese goods is primarily about domestic politics ahead of the mid-term elections later this year, as well as to obtain some trade concessions from China, then the current standoff will be resolved in a matter of months. If the true intention of the U.S. is to contain China's geopolitical rise to preserve its global hegemony, this episode of import tariffs will likely mark the beginning of a much longer and drawn-out geopolitical confrontation. In such a case, the U.S.-China relationship will likely witness a roller-coaster pattern with periods of ameliorations followed by periods of escalation and confrontation. Critically, mutual distrust will set in - if not already the case - which will hamper cooperation on various issues. As trade tensions ebb and flow in the months ahead, the reality is that America is worried about losing its geopolitical hegemony to the Middle Kingdom. Our colleagues at BCA's Geopolitical Strategy service have been noting for several years that a U.S.-China confrontation is unavoidable.2 Bottom Line: Even though the current trade tensions between the U.S. and China could well dissipate, we are at the beginning of a long-term geopolitical standoff between these two superpowers. Re-Instating Long MXN / Short BRL and ZAR Trade Chart I-17MXN's Carry Is Above Those Of BRL And ZAR MXN's Carry Is Above Those Of BRL And ZAR MXN's Carry Is Above Those Of BRL And ZAR Odds are that the Mexican peso will begin outperforming the Brazilian real and the South African rand. The main reason why we closed these trades in October was due to NAFTA renegotiation risks. Presently, with the U.S.-Sino trade confrontation escalating, the odds of NAFTA abrogation are declining. In fact, the U.S. may attempt to strike a deal with its allies, including its NAFTA partners, to focus more directly on China. Consequently, a menace hanging over the peso from the Sword of Damocles, i.e., NAFTA retraction, will continue to diminish. Consistently, the risk premium priced into Mexican risk assets will wane, helping Mexican markets outperform their EM peers. Interestingly, for the first time in many years, the Mexican peso's carry is above those of the Brazilian real and the South African rand (Chart I-17). Therefore, going long MXN versus ZAR and BRL are carry positive trades. Importantly, the Mexican peso is cheap. Chart I-18A illustrates the peso is cheap in absolute terms, according to the real effective exchange rate (REER) based on unit labor costs. Chart I-18B shows the peso's relative REER against those of the rand and real. These measures are constructed using consumer and producer prices-based REERs. The peso is cheaper than the South African and Brazilian currencies. Not only is Mexico's currency cheap versus other EM currencies, but Mexican domestic bonds and sovereign spreads also offer great value relative to their EM benchmarks (Chart I-19).Finally, the Mexican equity market has massively underperformed the EM benchmark and is beginning to look attractive on a relative basis. Chart I-18AMXN Is Cheap In Trade-Weighted Terms... MXN Is Cheap In Trade-Weighted Terms... MXN Is Cheap In Trade-Weighted Terms... Chart I-18B...And Relative BRL And ZAR ...And Relative BRL And ZAR ...And Relative BRL And ZAR Chart I-19Mexican Local Currency And Dollar Bonds Offer Value Mexican Local Currency And Dollar Bonds Offer Value Mexican Local Currency And Dollar Bonds Offer Value If and as dedicated EM portfolios rotate into Mexican domestic bonds and equities, this will bid up the peso. Brazil and South Africa are leveraged to China and metals, while Mexico is exposed to the U.S. and oil. Our main theme remains that U.S. growth will do much better than that of China. While a potential drop in oil prices is a risk to the peso, Mexican goods shipments to the U.S. will remain strong, benefiting the nation's balance of payments. Macro policy in Mexico has been super-orthodox: the central bank has hiked interest rates significantly, and the government has tightened fiscal policy (Chart I-20, top panel). This has hurt growth but is positive for the trade balance and the currency (Chart I-20). Mexico will elect a new president in July, and odds of victory by leftist candidate Lopez Obrador are considerable. However, we do not expect a massive U-turn in macro policies after the elections. Importantly, the starting point of Mexico's macro settings is very healthy. In Brazil, government debt dynamics remain unsustainable, yet its financial markets have been extremely complacent. Brazil needs much higher nominal GDP growth and much lower interest rates to stabilize its public debt dynamics. As we have repeatedly argued, a major currency depreciation is needed to boost nominal GDP and government revenues. Besides, Brazil is set to hold general elections in October, and there is no visibility yet on the type of government that will enter office. In South Africa, financial markets have cheered the election of President Cyril Ramaphosa, but the outlook for structural reforms is still very uncertain. The recent decision to consider a constitutional change in Parliament that would allow the confiscation of land from white landlords may be an indication that investors have become overly optimistic on the outlook for structural reforms. In short, the median voter in both Brazil and South Africa favors leftist and populist policies. This entails that the odds of supply side reforms without meaningful riots in financial markets are not great. Finally, the relative performance of the MXN against the BRL and ZAR, including carry, seems to be attempting to make a bottom (Chart I-21). Chart I-20Mexico: Improved Macro Fundamentals Mexico: Improved Macro Fundamentals Mexico: Improved Macro Fundamentals Chart I-21A Major Bottom In MXN's Cross? A Major Bottom In MXN's Cross? A Major Bottom In MXN's Cross? Bottom Line: Go long MXN versus an equally weighted basket of BRL and ZAR. Consistently, we also recommend overweighting Mexican local currency bonds and sovereign credit relative to their respective EM benchmarks. We will review the outlook for Mexican stocks in the coming weeks. EM Sovereign Credit Space: Country Allocation Asset allocators should compare EM sovereign and corporate credit with U.S. and European corporate bonds rather than EM local bonds or equities. The basis is that EM sovereign U.S. dollar bonds are a credit market, and vastly differ from local bonds and equities in terms of volatility, risk-reward trade-off and many other parameters. In short, EM credit markets should be compared to DM credit markets and EM equities to DM equities. EM local currency bonds are a separate, unique asset class.3 We continue to recommend underweighting EM sovereign and corporate credit versus U.S. and European corporate bonds. Within the EM sovereign space, our overweights are: Mexico, Argentina, Russia, Hungary, Poland, the Philippines, Chile and Peru. Neutral: Colombia, Indonesia, Egypt and Nigeria. Our underweights are: Brazil, Venezuela, Malaysia, Turkey and South Africa. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "EM: Disguised Risks", dated March 15, 2018; the link is available on page 17. 2 Please see Geopolitical Strategy Weekly Report "We Are All Geopolitical Strategies Now", dated March 28, 2018, available at gps.bcaresearch.com. 3 You may request May 7, 2013 Emerging Markets Strategy Weekly Report discussing our perspectives on how asset allocation for EM financial markets should be done. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights China and Brazil are two extremes in regard to investment and savings - the former saves and invests a lot, the latter very little. The key difference between Brazil and China is neither the existing amount of deposits nor their propensity to save. Rather, it is their real economies' capacity to produce goods and services. Regardless of how capital expenditures are financed, when inputs for capital spending are procured domestically it is recorded as national "savings," but when they are imported there is no change in the level of national "savings." In China, policymakers are currently being forced to walk a very thin line between inflation and deflation. Brazilian consumers do not need to save more for companies to get financing for their investments. Instead, businesses - along with facilitation from the government - should build the supply side. Banks can finance the latter by originating loans "out of thin air." However, the natural consequence of this adjustment in Brazil will be considerable currency deprecation. Feature The Fallacy This is the fifth report in our series on money, credit, savings and investment. Its objective is to show that financing of investments is not constrained by national and foreign savings. This report argues against a postulate in mainstream economic literature which holds that in order to invest, nations with low savings rates need to either reduce consumption and boost national savings or to borrow foreign savings. Some examples of this economic thesis can be seen here: As Lindner neatly summarizes: "Many economists hold the position that "saving finances investment." They argue that saving - a reduction of consumption relative to income - is necessary for the provision of loans and the financing of investment." (Lindner 2015).1 Linder also provides other examples suggesting that this thesis is well entrenched in the economic theory and analysis. For example, he cites Gregory Mankiw's influential introductory macroeconomics textbook that upholds: "Saving is the supply of loans - individuals lend their saving to investors, or they deposit their saving in a bank that makes the loan for them. [. . . ] At the equilibrium interest rate, saving equals investment, and the supply of loans equals the demand." (1997, p. 63) (Lindner 2015).2 This mainstream economic thesis - that financing is constrained by savings - is intuitive, and not surprisingly many investors take it for granted. Yet this is a false proposition. This thesis is correct for barter economies but is not pertinent to modern economies with their own banking systems and national currencies. Further, Lindner (2015)3 argues: "The fallacies loanable funds theory commits might be explainable by the mis-application of some ideas and concepts of neoclassical growth models - especially the Ramsey (1928), Solow (1956) and Diamond (1965) models - to the sphere of money and finance... The Ramsey and Solow models are models of real investment only. Financial markets, financial assets and financial saving do not play any role in those models. There is only one good which, for simplicity, will be called "corn". Corn has three functions: it can be consumed, invested and used as a means of payment since wages and interest payments are made with it..." Clearly, modern economies with their fiat money systems are much more complicated than a barter economies with no banks and money. The Veracity: Financing Is Different From "Savings" This and previous reports4 clarify and elaborate on the following aspects of banking, money creation and financing as well as savings and investments: 1. Attributing the lack of investment in many emerging market (EM) economies to their low savings is a major fallacy. Borio (2015)5 argues: "Crucially, the provision of financing does not require someone to abstain from consuming. It is purely a financial transaction and hence distinct from saving... The equality of saving and investment is an accounting identity that always holds ex post and reveals nothing about financing patterns. In ex post terms, being simply the outcome of expenditures, saving does not represent a constraint on how much agents are able to spend ex ante. If we step back from comparative statics and consider the underlying dynamics, it is only once expenditures take place that income and investment, and hence saving, are generated." 2. Banks do not need deposits or "savings" to lend. They create money/deposits when they originate loans or buy assets from non-banks. To settle payments with their peers as well as the central bank, they require reserves at the central bank. Reserves at the central bank - not client deposits - constitute true liquidity for banks. For a more detailed discussion on loan origination and money creation in absence of new deposits entering into the banking system, please refer to Appendix 1 and 2 on pages 14 and 18. Certainly, there are several factors such as regulations and shareholder preferences that can curtail banks' ability to expand their balance sheets. However, households' or nations' "savings" do not constrain banks' ability to originate new loans/create deposits. 3. In an economy where banks exist, "savings" and financing are very different things. Many investors use the term "savings" to refer to bank deposits. Yet, in macroeconomics, national and household "savings" are not related to deposits or money in the banking system at all. Chart I-1 demonstrates that there is no relationship between the savings and changes in the amount of money in the banking system. Savings And New Money Creation Do Not Correlate Savings And New Money Creation Do Not Correlate The confusion between national "savings" and financing creation is dealt with nicely again by Fabian Lindner. Having modelled it, Lindner argues: "... the aggregate economy's saving is equal to the newly produced tangible assets and inventories. That total saving is equal to just the increase in tangible assets ... (because) all changes in net financial assets in the economy add up to zero... Thus, for every economic agent increasing her net financial assets, there is a corresponding decrease in net financial assets of all other economic agents in the economy (Lindner 2015).6 Put in more general terms: An economic agent can only save financially if other agents dis-save financially by the same amount... That is why in the entire economy (that is the world economy or a closed economy) only the increase in tangible assets, thus investment, is saving...." In another paper, Lindner asserts: "Investment is the production of any non-financial asset in an economy and thus is always directly and unambiguously savings: it increases the economy's net worth... The economy as a whole cannot change its net financial wealth since it always equals zero. The aggregate economy can only save in the form of non-financial assets...The only way an economy can save is by increasing its non-financial wealth, i.e., its physical capital stock" (Lindner 2012).7 On the whole, deposits are a monetary concept; they represent money savings. Deposits are created by banks "out of thin air," as illustrated in Appendix 1 on page 14. Meanwhile, "savings" are a net addition to capital stock. Not surprisingly, there is no relationship between "real savings" and money savings, as illustrated in Chart I-1. In a nutshell, "savings" is an addition to the capital stock of a nation, which is the same as investment. Hence, the Savings = Investment identity for a closed economy is nothing other than a tautology as it de-facto means Investment = Investment. That is why in this report we use "savings" in quotations whenever we refer to it in the traditional sense of economic theory. 4. Households' (or businesses') propensity to save alters the velocity of money, not the amount of deposits/money in the banking system. A decision by a household to spend more rather than save does not change the amount of deposits in the banking system and does not affect the banking system's ability to provide more financing. When households or companies decide to spend their deposits, the velocity of money rises. Conversely, when households and companies decide to save (retain) their deposits, the velocity of money drops. The amount of deposits in the banking system stays constant. In turn, the amount of deposits and hence broad money supply in any banking system equals the cumulative net money creation by banks and the central bank over the course of their history. This has nothing to do with household and national "savings," which form the country's capital stock. 5. In a country with its own national currency, the true macro constraint on commercial banks' ability to expand financing infinitely are inflation and currency depreciation - not "savings." This is of course apart from demand for loans, regulations and shareholder preferences that can limit commercial banks' capacity to expand their balance sheets. Bottom Line: In an economy with banks, one does not need to save in the form of a deposit in a bank for the latter to lend money to another entity. Tales Of Brazil And China We use China and Brazil solely for illustrative purposes. One can use any country with a low savings rate instead of Brazil or a high savings rate economy such as Korea, Taiwan or Singapore in place of China. Two Extremes Of Investment And Savings: China And Brazil Two Extremes Of Investment And Savings: China And Brazil China has enjoyed a very high national savings rate and has been investing substantially (Chart I-2). In contrast, both the national savings rate and the investment-to-GDP ratio in Brazil have been depressed. It is very tempting to argue that Brazil has been experiencing very low investment because it saves so little. The narrative goes like this: Brazil's national savings rate is low because households save so little and the public sector dis-saves a lot - i.e., the government runs enormous fiscal deficits. This constrains the pool of available "savings" to finance private capital expenditures. This typical analysis concludes that Brazil needs to boost its "savings" - i.e., reduce its spending. This will allegedly enlarge the pool of available "savings" for investment and allow the country to invest, and consequently boost productivity and its potential growth rate. This narrative is misplaced in our view, because as we have shown in the past and in this report, banks do not need households, businesses or the government to save in order to provide financing. Banks can provide financing by simply expanding the money multiplier, among other things (see a more detailed discussion about the money multiplier below). So what is the true difference between Brazil and China? How has the latter achieved such high savings and investment rates, while the former has failed to finance its capital spending? Why have Brazilian banks not expanded their balance sheets more rapidly to finance investment (Chart I-3)? Snapshot Of Bank Assets-To-GDP Ratios Snapshot Of Bank Assets-To-GDP Ratios Let's consider a hypothetical example. For simplicity and illustrative purposes, we assume there are two economies of equal size and have the same level of investment: savings and net exports. In short, they have identical starting points. We refer to these economies as Brazil and China. Now, commercial banks in both countries provide new financing of $50 - or equal to 5% of their respective GDP - to businesses for infrastructure building. This is new purchasing power created by commercial banks "out of thin air" in both economies. We assume that the only difference between these two countries is that in China, 100% of inputs for infrastructure (materials, machinery/equipment and so on) are produced/purchased domestically. In contrast, in Brazil, 100% of the inputs for infrastructure construction are imported, because this economy lacks production capacity. Table I-1 illustrates this hypothetical numerical example. As this infrastructure project is implemented, Brazil's imports will surge, and its net exports will deteriorate. Chart I-4 shows that this indeed is the case in Brazil - when capital spending expands, its current accounts deficit widens, entailing that Brazil imports a considerable portion of inputs for its investments. Is Investment Constrained By Savings? Tales Of China And Brazil Is Investment Constrained By Savings? Tales Of China And Brazil Foreign Content Of Brazil's Capital Spending Is High Foreign Content Of Brazil's Capital Spending Is High If there is no matching rise in foreign investor demand for Brazilian assets, the nation's currency will depreciate. Consequently, to support the plunging currency, Brazilian interest rates would have to rise. As a result, higher borrowing costs short-circuit the credit cycle. In China, because inputs for infrastructure are sourced and procured locally, there is no impact on its exchange rate or interest rates. If there is excess capacity in China to produce these inputs for infrastructure building, this new purchasing power will not lift inflation. A caveat is in order: Similar dynamics in trade balance deterioration, currency depreciation and inflation will prevail if there is a rise in consumer spending instead of capital expenditures. Importantly, the outcome will be the same in both economies if investment spending is done using existing money savings (deposits), not new credit. This example illustrates that a similar amount of capital expenditures financing via money creation "out of thin air" in both economies has increased national savings in China from $250 to $300, yet Brazilian savings stayed at $250 (Table I-1). In terms of savings rate, China will record a rise in its national savings rate from 25% to 28.6% of GDP (Table I-1). In Brazil, however, the national savings rate will remain at 25% of GDP, even though its banks, like Chinese ones, originated money "out of thin air" to finance infrastructure spending. The starting-point difference between China and Brazil is neither their banking systems' ability to expand their balance sheets nor the existing amount of deposits and assets. Rather, it is their real economies' capacity to produce goods and services. Therefore, we conclude: Regardless of how capital expenditures are financed - via new borrowing from banks or non-banks or using the investing company's own financial resources - when inputs for capital spending are procured domestically it is recorded as an increase in national "savings" level, but when they are imported there is no change in the level of national "savings." Over the decades, China, Korea, Taiwan, Singapore and Japan have all aggressively expanded their capacity to produce goods and services. They funded this capacity build-up via both money creation "out of thin air" and by attracting foreign capital. In the meantime, their large exports shielded their currencies from abrupt depreciation - as and when local bank financing was used to acquire foreign inputs. In the past decade, in China, loans - which banks have originated to build infrastructure - were largely spent on domestic inputs: cement, steel, chemicals, machinery and equipment all produced in the mainland. Even though some of that money/loans was used to purchase foreign inputs (commodities and equipment), China had large U.S. dollar revenues from exports that acted as an offset in its balance of payments. In short, Brazil and other low "savings" rate nations do not need to raise interest rates to curtail consumption and boost savings in order to release funds for financing capital expenditures. Chart I-5 demonstrates that there has been no positive relationship between real interest rates and the national savings rate in Brazil. Remarkably, real interest rates in this nation were often very high but that still did not lead to high "savings." Real Interest Rates And Savings Are Not Correlated Real Interest Rates And Savings Are Not Correlated What Brazil and other low "savings" rate economies need is to build efficient and competitive productive capacity - i.e., they need changes in the supply side of their economies. Only then can their banks expand their balance sheets and provide financing similar to how banks in high "savings" countries do. However, to shield the exchange rate from depreciation, these nations need to boost their exports first. This can be done by depreciating the currency and developing their global competitiveness. This is in effect what China has done in the past 25-30 years. Bottom Line: The key difference between Brazil and China is not their propensity to consume versus save, but their ability to produce goods and services domestically. So long as a nation builds and maintains excess productive capacity, its banks can originate loans "out of thin air" and finance capital and consumer expenditures. Money Multiplier Versus "Savings" Redundancy of the mainstream economic view that a pool of "savings" represents a constraint on financing investments becomes apparent when one applies the money multiplier concept, which is in fact accepted by mainstream economic theory. The money multiplier is the ratio of broad money relative to excess reserves. A rise in the money multiplier will lead to more money creation and financing in an economy per one unit of excess reserves (liquidity provided by the central bank), everything else held constant. In brief, money supply/the amount of deposits in the banking system will change regardless of the level of national or household "savings." Let's assume two countries with the same level of income per capita and GDP have identical national savings and investment rates as well as money supply and excess reserves. In short, they have indistinguishable macro parameters. Now suppose their banking systems in the past year had different money multipliers. The monetary authorities in both countries maintain the banking system's excess reserves at 10 units. If the money multiplier were to remain constant, say at 15, the money supply/deposits in both banking systems would remain at 150 units (10x15). Let's assume the money multiplier increased to 20 in Country A while held constant at 15 in Country B. In such a case, broad money supply would have risen to 200 units (10x20) in Country A and would stay at 150 (10x15) units in Country B. This entails that banks in Country A increased their funding yet those in Country B did not. That is despite the fact that the savings rates (and amount of savings) were identical before the change in the money multipliers occurred. This is one way to prove that a nation does not need to cut consumption for its banks to provide financing. China: Money Multiplier Has Risen A Lot China: Money Multiplier Has Risen A Lot The reason why the money multipliers could vary in these two countries with otherwise similar macro-economic parameters is due to animal spirits: In Country A, banks may have felt increasingly confident to lend more per one unit of their excess reserves, and there was demand for credit from borrowers. In the meantime, the money multiplier remained the same in Country B. In China, the money multiplier - the ratio of broad money to excess reserves - has risen dramatically since 2013 (Chart I-6). Interestingly, the amount of excess reserves at the People's Bank of China has been broadly the same over the past five years, yet broad money has grown by an enormous 75% (Chart I-6, middle and bottom panel). The exponential money/credit creation in China since 2009 has to a large extent been due to the rising money multiplier - wild animal spirits among bankers and borrowers - rather than high national "savings." Bottom Line: In any country, banks can provide more financing simply by expanding the money multiplier. This can happen regardless of the country's savings rate. Investment Relevance Why is this analysis pertinent to investors? First, this issue is critical to assess whether China's excessive credit expansion is an outcome of the nation's high savings - like many economists and investors claim - or due to the enormous amount of money/deposits and credit originated by the mainland's banks "out of thin air." If it is the former, investors have no need to worry about China's money and credit dynamics. If it is the latter, we are facing a typical banking and money/credit bubble. This report corroborates that it is the latter. Chart I-7 shows that China's broad money has grown 4-fold since January 2009 and has reached RMB 200 trillion, or the equivalent of $30 trillion. A Money Bubble In China? A Money Bubble In China? Does this enormous quantity of RMBs pose an inflation and/or currency depreciation risk? Or will the ongoing policy tightening cause another deflationary slump in China? It is clear that Chinese policymakers are currently being forced to walk a very thin line: On the one hand, the immense amount of money created "out of thin air" could stoke inflation or currency depreciation. It may not take much of a rise in the velocity of money for inflation to become a problem. On the other, tightening policy amid high leverage in an economy that is addicted to money and credit could push it into a growth slump and deflation. There is always a chance that policymakers will get it right and manage it perfectly so that neither inflation/currency depreciation nor a growth slump transpire. We would assign a 25-30% probability to this benign outcome. Hence, in our opinion there are 70-75% odds of either inflation or deflation in China in the next 12-24 months. Given these odds, we have been and remain reluctant to chase the rally in EM and China-related plays. In particular, the Chinese authorities have been tightening liquidity and banking/shadow banking regulation as well as projecting the ongoing anti-corruption campaign into the financial industry. This poses a meaningful risk given the existing macro imbalances. Second, this analysis re-shapes how investors should think about economic development and understand how nations with low savings can grow without relying on foreign funding. This provides us with a framework to assess the developmental path and the sustainability of growth in various developing economies. These include but are not limited to nations with low national savings rates such as Brazil, South Africa, Turkey, Russia, Colombia and many others. Finally, this analysis leads us to argue that Brazil does not need to maintain high real interest rates as a way to force consumers to cut spending and boost savings. In fact, this is the wrong prescription for Brazil. The most optimal macro adjustment path for Brazil is to reduce interest rates much further and encourage banks to finance private investment. Brazil needs to build an efficient supply side, and banks can provide funding by originating loans "out of thin air." Brazilian consumers do not need to save more for companies to get financing for their projects and invest. Brazil Needs To Reduce Interest Rates Much Further Brazil Needs To Reduce Interest Rates Much Further The natural causality of this adjustment will be considerable currency deprecation. However, Brazil is currently suffering from low inflation and high real interest rates (Chart I-8). Hence, reflationary policies are the right policy prescription. Foreign investors are therefore at risk due to potential currency depreciation. The new leaders to be elected in the October presidential elections may well adopt such a macro policy mix. Markets will front run this by pushing the real down and this will be negative for foreign investors. However, there will be a buying opportunity after the currency finds a floor. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Analyst andrijav@bcaresearch.com   Appendix 1: Loan Origination, Deposits/Money Creation And Settlement The amount of deposits is not a constraint on a banking system's ability to make loans and buy assets from non-banks. Figure I-1 and I-2 present stylized cases of how commercial banks can originate new loans without requiring a new deposit or extra excess reserves entering the banking system. Specifically Figure I-1 illustrates how commercial banks can originate loans with the subsequent net settlements among themselves taking place via inter-bank borrowing/lending. In this stylized example, the banking system is comprised of three commercial banks. These commercial banks hold all deposits in the system. Cash does not exist and all payments are done via wire transfers. Is Investment Constrained By Savings? Tales Of China And Brazil Is Investment Constrained By Savings? Tales Of China And Brazil Is Investment Constrained By Savings? Tales Of China And Brazil Is Investment Constrained By Savings? Tales Of China And Brazil 1. Loan Origination/Money Creation In the morning, Bank 1 originates a new loan worth $100 for Client 1. This transaction creates a new asset and, for the balance sheet to balance, Bank 1 should also increase the liabilities side of its balance sheet. Therefore, it simultaneously credits Client 1's chequing account by $100. Bank 1 does not transfer other depositors' money to Client 1's chequing account; it creates a new $100 deposit. The rest of the bank's depositors still have their full deposits, which they can draw on. In a nutshell, both assets and liabilities of Bank 1 rose by $100 - this was done "out of thin air" by just pressing the enter button on the computer. That also means that a $100 of new money was created by Bank 1 which increases the overall money stock in the banking system. Meanwhile, Bank 2 lends $200 to Client 2 and Bank 3 lends $300 to Client 3. Let's assume these were the only lending transactions during that day. In aggregate, the three banks originated $600 of new loans, and consequent new deposits/money "out of thin air." 2. Money Transfer / Payments Debtors do not borrow money and leave it sitting idle. They borrow money to pay their suppliers and others they owe. Even though Clients 1, 2 and 3 wire their payments to their respective suppliers on the same day, the total amount of deposits in the banking system does not change: Deposits simply move from one bank to another or from one bank client to another. In Figure I-1, Client 1 wires its $100 from Bank 1 to Supplier B that has an account at Bank 2; Client 2 pays its $200 invoice to Supplier C which in turn has an account at Bank 3; and finally Client 3 transfers $300 to Supplier A, who holds an account at Bank 1. The amount of money/deposits in the overall banking system has not changed as a result of these wire transfers. 3. Multilateral Net Settlement At the end of the day, banks should settle with other banks. Many countries employ a multilateral net settlement system typically operated by the central bank. In a multilateral net settlement system, at the end of the day, each bank pays (receives from) the system only the net amount they are due to pay to (receive from) other banks combined. Importantly, banks settle their payments with other banks using their excess reserves (herein called reserves) at the central bank, not the deposits of their clients. This entails that banks do not need deposits to pay their dues to other banks or the central bank. Figure I-1 illustrates the impacts on the banks' reserves under the multilateral net settlement system: Bank 1's reserves at the central bank change as follows: -$100 (Client 1's wire transfer out) + $300 (this is the amount that Supplier A with an account in Bank 1 gets from Client 3) = $200. The impact on Bank 2's reserves is as follows: -$200 (Client 2's wire transfer out) + $100 (this is the amount that Supplier B with an account in Bank 2 gets from Client 1) = -$100. The net change in Bank 3's reserves is: -$300 (Client 3's wire transfer out) + $200 (this is the amount that Supplier C with an account in Bank 3 gets from Client 2) = -$100. If we assume that all banks had no excess reserves before this day, then how do they settle their accounts? There are various alternatives, but we highlight two: Figure I-1 demonstrates the case of interbank lending. As a result of the settlements, Bank 1 has $200 in extra reserves, while Bank 2 and Bank 3 each have a $100 deficit in reserves. As such, Bank 1 lends $100 to each of Bank 2 and Bank 3. Why does it lend to other banks rather than keeping these reserves at the central bank? Because interbank rates are typically slightly above the central bank's rate - the rate Bank 1 would get if it were to lend the $200 to the central bank. Figure I-2 portends the same transactions with the sole difference being the reserves flow. Unlike Figure I-1, here banks do not lend to/borrow from each other. Banks lend excess reserves to the central bank as well as borrow deficient reserves from the central bank. This is done to settle their payments with other banks. Bank 1 lends its free reserves of $200 to the central bank. Bank 2 and Bank 3 each borrow $100 reserves from the central bank to settle with the system at the end of the day. As a result, the aggregate amount of reserves at the central bank does not change. On the whole, banks created $600 of new deposits/money/loans during the day without requiring savings from households, companies, the government or foreigners. Thereby, the money supply was expanded and new financing in the amount of $600 was provided "out of thin air." Appendix 2: Deposits Versus Liquidity Below are additional questions that we seek to answer to provide further elaboration on the issues of banks creating money and the difference between deposits and liquidity: 1. Why would central banks provide reserves to banks? When a central bank targets interest rates, which is nowadays the most common policy framework in both advanced and developing countries, it must provide liquidity to banks: the latter is required to preclude interbank rates from deviating from the policy rate. Under an interest rate targeting regime, the central bank does not have complete control over banks' reserves nor broad money supply. A central bank can control either the quantity of money or the price of money (interest rates), but not both simultaneously. The following two quotes from the New York Federal Reserve Chairman William Dudley and the European Central Bank confirm that central banks nowadays provide banks with reserves on demand - i.e., the amount of reserves is determined by demand from banks. "The Federal Reserve has committed itself to supply sufficient reserves to keep the fed funds rate at its target. If banks want to expand credit and that drives up the demand for reserves, the Fed automatically meets that demand in its conduct of monetary policy. In terms of the ability to expand credit rapidly, it makes no difference whether the banks have lots of excess reserves or not." (Dudley, 2009) European Central Bank (2012), May 2012 Monthly Bulletin: "The Eurosystem ... always provides the banking system with the liquidity required to meet the aggregate reserve requirement. In fact, the ECB's reserve requirements are backward-looking, i.e. they depend on the stock of deposits (and other liabilities of credit institutions) subject to reserve requirements as it stood in the previous period, and thus after banks have extended the credit demanded by their customers." 2. Why do banks compete for deposits if they create deposits themselves? The true reason banks compete for deposits is not that they require more deposits, but because they require more reserves. When a bank attracts a deposit from another bank, the latter must transmit to the former reserves equal to the amount of the deposit transferred. When a bank is experiencing a liquidity shortage, more deposits are of no help. Banks can always create more deposits themselves, but they cannot create reserves at the central bank. The true liquidity for banks is their reserves at the central bank - not deposits. Reserves are solely created by central banks "out of thin air." A central bank may decide not to provide funding to certain banks in some cases when the authorities deem these banks insolvent and/or in breach of regulations. Otherwise, if the central bank wants to keep policy rates stable, it must provide all liquidity (reserves) banks require. 3. Why do banks attract deposits if the central bank provides liquidity on demand? The primary reason why banks seek to attract deposits instead of borrowing from the central bank is due to the cost of funding and duration of liabilities as well as regulatory requirements. Deposits may be cheaper and have longer duration than short-term funding from the central bank.   1 Lindner, F. (2015), "Does Savings Increase the Supply of Credit? A Critique of Loanable Funds Theory", Macroeconomic Policy Institute, World Economic Review 4, 2015. 2 Lindner, F. (2015), "Did Scarce Global Savings Finance the US Real Estate Bubble? The Global Saving Glut thesis from a stock flow Consistent Perspective", Macroeconomic Policy Institute, Working Paper 155, July 2015. 3 Lindner, F. (2015), "Does Savings Increase the Supply of Credit? A Critique of Loanable Funds Theory", Macroeconomic Policy Institute, World Economic Review 4, 2015. 4 Please refer to the Emerging Markets Strategy Special Reports from October 26, 2016, November 23, 2016, January 18, 2017 and December 20, 2017; available on ems.bcaresearch.com 5 Borio, C. and Disyatat, P. (2015), "Capital flows and the current account: Taking financing (more) seriously", BIS Working Papers, No. 525, October 2015. 6 Lindner, F. (2015), "Did Scarce Global Savings Finance the US Real Estate Bubble? The Global Saving Glut thesis from a stock flow Consistent Perspective", Macroeconomic Policy Institute, Working Paper 155, July 2015. 7 Lindner, F. (2012), "Savings does not finance Investment: Accounting as an indispensable guide to economic theory", Macroeconomic Policy Institute, Working Paper 100, October 2012.

Highlights China and Brazil are two extremes in regard to investment and savings - the former saves and invests a lot, the latter very little. The key difference between Brazil and China is neither the existing amount of deposits nor their propensity to save. Rather, it is their real economies' capacity to produce goods and services. Regardless of how capital expenditures are financed, when inputs for capital spending are procured domestically it is recorded as national "savings," but when they are imported there is no change in the level of national "savings." In China, policymakers are currently being forced to walk a very thin line between inflation and deflation. Brazilian consumers do not need to save more for companies to get financing for their investments. Instead, businesses - along with facilitation from the government - should build the supply side. Banks can finance the latter by originating loans "out of thin air." However, the natural consequence of this adjustment in Brazil will be considerable currency deprecation. Feature The Fallacy This is the fifth report in our series on money, credit, savings and investment. Its objective is to show that financing of investments is not constrained by national and foreign savings. This report argues against a postulate in mainstream economic literature which holds that in order to invest, nations with low savings rates need to either reduce consumption and boost national savings or to borrow foreign savings. Some examples of this economic thesis can be seen here: As Lindner neatly summarizes: "Many economists hold the position that "saving finances investment." They argue that saving - a reduction of consumption relative to income - is necessary for the provision of loans and the financing of investment." (Lindner 2015).1 Linder also provides other examples suggesting that this thesis is well entrenched in the economic theory and analysis. For example, he cites Gregory Mankiw's influential introductory macroeconomics textbook that upholds: "Saving is the supply of loans - individuals lend their saving to investors, or they deposit their saving in a bank that makes the loan for them. [. . . ] At the equilibrium interest rate, saving equals investment, and the supply of loans equals the demand." (1997, p. 63) (Lindner 2015).2 This mainstream economic thesis - that financing is constrained by savings - is intuitive, and not surprisingly many investors take it for granted. Yet this is a false proposition. This thesis is correct for barter economies but is not pertinent to modern economies with their own banking systems and national currencies. Further, Lindner (2015)3 argues: "The fallacies loanable funds theory commits might be explainable by the mis-application of some ideas and concepts of neoclassical growth models - especially the Ramsey (1928), Solow (1956) and Diamond (1965) models - to the sphere of money and finance... The Ramsey and Solow models are models of real investment only. Financial markets, financial assets and financial saving do not play any role in those models. There is only one good which, for simplicity, will be called "corn". Corn has three functions: it can be consumed, invested and used as a means of payment since wages and interest payments are made with it..." Clearly, modern economies with their fiat money systems are much more complicated than a barter economies with no banks and money. The Veracity: Financing Is Different From "Savings" This and previous reports4 clarify and elaborate on the following aspects of banking, money creation and financing as well as savings and investments: 1. Attributing the lack of investment in many emerging market (EM) economies to their low savings is a major fallacy. Borio (2015)5 argues: "Crucially, the provision of financing does not require someone to abstain from consuming. It is purely a financial transaction and hence distinct from saving... The equality of saving and investment is an accounting identity that always holds ex post and reveals nothing about financing patterns. In ex post terms, being simply the outcome of expenditures, saving does not represent a constraint on how much agents are able to spend ex ante. If we step back from comparative statics and consider the underlying dynamics, it is only once expenditures take place that income and investment, and hence saving, are generated." 2. Banks do not need deposits or "savings" to lend. They create money/deposits when they originate loans or buy assets from non-banks. To settle payments with their peers as well as the central bank, they require reserves at the central bank. Reserves at the central bank - not client deposits - constitute true liquidity for banks. For a more detailed discussion on loan origination and money creation in absence of new deposits entering into the banking system, please refer to Appendix 1 and 2 on pages 14 and 18. Certainly, there are several factors such as regulations and shareholder preferences that can curtail banks' ability to expand their balance sheets. However, households' or nations' "savings" do not constrain banks' ability to originate new loans/create deposits. 3. In an economy where banks exist, "savings" and financing are very different things. Many investors use the term "savings" to refer to bank deposits. Yet, in macroeconomics, national and household "savings" are not related to deposits or money in the banking system at all. Chart I-1 demonstrates that there is no relationship between the savings and changes in the amount of money in the banking system. Chart I-1Savings And New Money ##br##Creation Do Not Correlate Savings And New Money Creation Do Not Correlate Savings And New Money Creation Do Not Correlate The confusion between national "savings" and financing creation is dealt with nicely again by Fabian Lindner. Having modelled it, Lindner argues: "... the aggregate economy's saving is equal to the newly produced tangible assets and inventories. That total saving is equal to just the increase in tangible assets ... (because) all changes in net financial assets in the economy add up to zero... Thus, for every economic agent increasing her net financial assets, there is a corresponding decrease in net financial assets of all other economic agents in the economy (Lindner 2015).6 Put in more general terms: An economic agent can only save financially if other agents dis-save financially by the same amount... That is why in the entire economy (that is the world economy or a closed economy) only the increase in tangible assets, thus investment, is saving...." In another paper, Lindner asserts: "Investment is the production of any non-financial asset in an economy and thus is always directly and unambiguously savings: it increases the economy's net worth... The economy as a whole cannot change its net financial wealth since it always equals zero. The aggregate economy can only save in the form of non-financial assets...The only way an economy can save is by increasing its non-financial wealth, i.e., its physical capital stock" (Lindner 2012).7 On the whole, deposits are a monetary concept; they represent money savings. Deposits are created by banks "out of thin air," as illustrated in Appendix 1 on page 14. Meanwhile, "savings" are a net addition to capital stock. Not surprisingly, there is no relationship between "real savings" and money savings, as illustrated in Chart I-1. In a nutshell, "savings" is an addition to the capital stock of a nation, which is the same as investment. Hence, the Savings = Investment identity for a closed economy is nothing other than a tautology as it de-facto means Investment = Investment. That is why in this report we use "savings" in quotations whenever we refer to it in the traditional sense of economic theory. 4. Households' (or businesses') propensity to save alters the velocity of money, not the amount of deposits/money in the banking system. A decision by a household to spend more rather than save does not change the amount of deposits in the banking system and does not affect the banking system's ability to provide more financing. When households or companies decide to spend their deposits, the velocity of money rises. Conversely, when households and companies decide to save (retain) their deposits, the velocity of money drops. The amount of deposits in the banking system stays constant. In turn, the amount of deposits and hence broad money supply in any banking system equals the cumulative net money creation by banks and the central bank over the course of their history. This has nothing to do with household and national "savings," which form the country's capital stock. 5. In a country with its own national currency, the true macro constraint on commercial banks' ability to expand financing infinitely are inflation and currency depreciation - not "savings." This is of course apart from demand for loans, regulations and shareholder preferences that can limit commercial banks' capacity to expand their balance sheets. Bottom Line: In an economy with banks, one does not need to save in the form of a deposit in a bank for the latter to lend money to another entity. Tales Of Brazil And China Chart I-2Two Extremes Of Investment ##br##And Savings: China And Brazil Two Extremes Of Investment And Savings: China And Brazil Two Extremes Of Investment And Savings: China And Brazil We use China and Brazil solely for illustrative purposes. One can use any country with a low savings rate instead of Brazil or a high savings rate economy such as Korea, Taiwan or Singapore in place of China. China has enjoyed a very high national savings rate and has been investing substantially (Chart I-2). In contrast, both the national savings rate and the investment-to-GDP ratio in Brazil have been depressed. It is very tempting to argue that Brazil has been experiencing very low investment because it saves so little. The narrative goes like this: Brazil's national savings rate is low because households save so little and the public sector dis-saves a lot - i.e., the government runs enormous fiscal deficits. This constrains the pool of available "savings" to finance private capital expenditures. This typical analysis concludes that Brazil needs to boost its "savings" - i.e., reduce its spending. This will allegedly enlarge the pool of available "savings" for investment and allow the country to invest, and consequently boost productivity and its potential growth rate. This narrative is misplaced in our view, because as we have shown in the past and in this report, banks do not need households, businesses or the government to save in order to provide financing. Banks can provide financing by simply expanding the money multiplier, among other things (see a more detailed discussion about the money multiplier below). So what is the true difference between Brazil and China? How has the latter achieved such high savings and investment rates, while the former has failed to finance its capital spending? Why have Brazilian banks not expanded their balance sheets more rapidly to finance investment (Chart I-3)? Chart I-3Snapshot Of Bank Assets-To-GDP Ratios Snapshot Of Bank Assets-To-GDP Ratios Snapshot Of Bank Assets-To-GDP Ratios Let's consider a hypothetical example. For simplicity and illustrative purposes, we assume there are two economies of equal size and have the same level of investment: savings and net exports. In short, they have identical starting points. We refer to these economies as Brazil and China. Now, commercial banks in both countries provide new financing of $50 - or equal to 5% of their respective GDP - to businesses for infrastructure building. This is new purchasing power created by commercial banks "out of thin air" in both economies. We assume that the only difference between these two countries is that in China, 100% of inputs for infrastructure (materials, machinery/equipment and so on) are produced/purchased domestically. In contrast, in Brazil, 100% of the inputs for infrastructure construction are imported, because this economy lacks production capacity. Table I-1 illustrates this hypothetical numerical example. As this infrastructure project is implemented, Brazil's imports will surge, and its net exports will deteriorate. Chart I-4 shows that this indeed is the case in Brazil - when capital spending expands, its current accounts deficit widens, entailing that Brazil imports a considerable portion of inputs for its investments. Table I-1A Hypothetical Example Of Investment - Saving Dynamics Is Investment Constrained By Savings? Tales Of China And Brazil Is Investment Constrained By Savings? Tales Of China And Brazil Chart I-4Foreign Content Of Brazil's ##br##Capital Spending Is High Foreign Content Of Brazil's Capital Spending Is High Foreign Content Of Brazil's Capital Spending Is High If there is no matching rise in foreign investor demand for Brazilian assets, the nation's currency will depreciate. Consequently, to support the plunging currency, Brazilian interest rates would have to rise. As a result, higher borrowing costs short-circuit the credit cycle. In China, because inputs for infrastructure are sourced and procured locally, there is no impact on its exchange rate or interest rates. If there is excess capacity in China to produce these inputs for infrastructure building, this new purchasing power will not lift inflation. A caveat is in order: Similar dynamics in trade balance deterioration, currency depreciation and inflation will prevail if there is a rise in consumer spending instead of capital expenditures. Importantly, the outcome will be the same in both economies if investment spending is done using existing money savings (deposits), not new credit. This example illustrates that a similar amount of capital expenditures financing via money creation "out of thin air" in both economies has increased national savings in China from $250 to $300, yet Brazilian savings stayed at $250 (Table I-1). In terms of savings rate, China will record a rise in its national savings rate from 25% to 28.6% of GDP (Table I-1). In Brazil, however, the national savings rate will remain at 25% of GDP, even though its banks, like Chinese ones, originated money "out of thin air" to finance infrastructure spending. The starting-point difference between China and Brazil is neither their banking systems' ability to expand their balance sheets nor the existing amount of deposits and assets. Rather, it is their real economies' capacity to produce goods and services. Therefore, we conclude: Regardless of how capital expenditures are financed - via new borrowing from banks or non-banks or using the investing company's own financial resources - when inputs for capital spending are procured domestically it is recorded as an increase in national "savings" level, but when they are imported there is no change in the level of national "savings." Over the decades, China, Korea, Taiwan, Singapore and Japan have all aggressively expanded their capacity to produce goods and services. They funded this capacity build-up via both money creation "out of thin air" and by attracting foreign capital. In the meantime, their large exports shielded their currencies from abrupt depreciation - as and when local bank financing was used to acquire foreign inputs. In the past decade, in China, loans - which banks have originated to build infrastructure - were largely spent on domestic inputs: cement, steel, chemicals, machinery and equipment all produced in the mainland. Even though some of that money/loans was used to purchase foreign inputs (commodities and equipment), China had large U.S. dollar revenues from exports that acted as an offset in its balance of payments. In short, Brazil and other low "savings" rate nations do not need to raise interest rates to curtail consumption and boost savings in order to release funds for financing capital expenditures. Chart I-5 demonstrates that there has been no positive relationship between real interest rates and the national savings rate in Brazil. Remarkably, real interest rates in this nation were often very high but that still did not lead to high "savings." Chart I-5Real Interest Rates And Savings Are Not Positively Correlated As They Are Supposed To Be Real Interest Rates And Savings Are Not Correlated Real Interest Rates And Savings Are Not Correlated What Brazil and other low "savings" rate economies need is to build efficient and competitive productive capacity - i.e., they need changes in the supply side of their economies. Only then can their banks expand their balance sheets and provide financing similar to how banks in high "savings" countries do. However, to shield the exchange rate from depreciation, these nations need to boost their exports first. This can be done by depreciating the currency and developing their global competitiveness. This is in effect what China has done in the past 25-30 years. Bottom Line: The key difference between Brazil and China is not their propensity to consume versus save, but their ability to produce goods and services domestically. So long as a nation builds and maintains excess productive capacity, its banks can originate loans "out of thin air" and finance capital and consumer expenditures. Money Multiplier Versus "Savings" Redundancy of the mainstream economic view that a pool of "savings" represents a constraint on financing investments becomes apparent when one applies the money multiplier concept, which is in fact accepted by mainstream economic theory. The money multiplier is the ratio of broad money relative to excess reserves. A rise in the money multiplier will lead to more money creation and financing in an economy per one unit of excess reserves (liquidity provided by the central bank), everything else held constant. In brief, money supply/the amount of deposits in the banking system will change regardless of the level of national or household "savings." Let's assume two countries with the same level of income per capita and GDP have identical national savings and investment rates as well as money supply and excess reserves. In short, they have indistinguishable macro parameters. Now suppose their banking systems in the past year had different money multipliers. The monetary authorities in both countries maintain the banking system's excess reserves at 10 units. If the money multiplier were to remain constant, say at 15, the money supply/deposits in both banking systems would remain at 150 units (10x15). Let's assume the money multiplier increased to 20 in Country A while held constant at 15 in Country B. In such a case, broad money supply would have risen to 200 units (10x20) in Country A and would stay at 150 (10x15) units in Country B. This entails that banks in Country A increased their funding yet those in Country B did not. That is despite the fact that the savings rates (and amount of savings) were identical before the change in the money multipliers occurred. This is one way to prove that a nation does not need to cut consumption for its banks to provide financing. The reason why the money multipliers could vary in these two countries with otherwise similar macro-economic parameters is due to animal spirits: In Country A, banks may have felt increasingly confident to lend more per one unit of their excess reserves, and there was demand for credit from borrowers. In the meantime, the money multiplier remained the same in Country B. In China, the money multiplier - the ratio of broad money to excess reserves - has risen dramatically since 2013 (Chart I-6). Interestingly, the amount of excess reserves at the People's Bank of China has been broadly the same over the past five years, yet broad money has grown by an enormous 75% (Chart I-6, middle and bottom panel). The exponential money/credit creation in China since 2009 has to a large extent been due to the rising money multiplier - wild animal spirits among bankers and borrowers - rather than high national "savings." Bottom Line: In any country, banks can provide more financing simply by expanding the money multiplier. This can happen regardless of the country's savings rate. Investment Relevance Why is this analysis pertinent to investors? First, this issue is critical to assess whether China's excessive credit expansion is an outcome of the nation's high savings - like many economists and investors claim - or due to the enormous amount of money/deposits and credit originated by the mainland's banks "out of thin air." If it is the former, investors have no need to worry about China's money and credit dynamics. If it is the latter, we are facing a typical banking and money/credit bubble. This report corroborates that it is the latter. Chart I-7 shows that China's broad money has grown 4-fold since January 2009 and has reached RMB 200 trillion, or the equivalent of $30 trillion. Chart I-6China: Money Multiplier Has Risen A Lot China: Money Multiplier Has Risen A Lot China: Money Multiplier Has Risen A Lot Chart I-7A Money Bubble In China? A Money Bubble In China? A Money Bubble In China? Does this enormous quantity of RMBs pose an inflation and/or currency depreciation risk? Or will the ongoing policy tightening cause another deflationary slump in China? It is clear that Chinese policymakers are currently being forced to walk a very thin line: On the one hand, the immense amount of money created "out of thin air" could stoke inflation or currency depreciation. It may not take much of a rise in the velocity of money for inflation to become a problem. On the other, tightening policy amid high leverage in an economy that is addicted to money and credit could push it into a growth slump and deflation. There is always a chance that policymakers will get it right and manage it perfectly so that neither inflation/currency depreciation nor a growth slump transpire. We would assign a 25-30% probability to this benign outcome. Hence, in our opinion there are 70-75% odds of either inflation or deflation in China in the next 12-24 months. Given these odds, we have been and remain reluctant to chase the rally in EM and China-related plays. In particular, the Chinese authorities have been tightening liquidity and banking/shadow banking regulation as well as projecting the ongoing anti-corruption campaign into the financial industry. This poses a meaningful risk given the existing macro imbalances. Second, this analysis re-shapes how investors should think about economic development and understand how nations with low savings can grow without relying on foreign funding. This provides us with a framework to assess the developmental path and the sustainability of growth in various developing economies. These include but are not limited to nations with low national savings rates such as Brazil, South Africa, Turkey, Russia, Colombia and many others. Finally, this analysis leads us to argue that Brazil does not need to maintain high real interest rates as a way to force consumers to cut spending and boost savings. In fact, this is the wrong prescription for Brazil. The most optimal macro adjustment path for Brazil is to reduce interest rates much further and encourage banks to finance private investment. Brazil needs to build an efficient supply side, and banks can provide funding by originating loans "out of thin air." Brazilian consumers do not need to save more for companies to get financing for their projects and invest. The natural causality of this adjustment will be considerable currency deprecation. However, Brazil is currently suffering from low inflation and high real interest rates (Chart I-8). Hence, reflationary policies are the right policy prescription. Chart I-8Brazil Needs To Reduce ##br##Interest Rates Much Further Brazil Needs To Reduce Interest Rates Much Further Brazil Needs To Reduce Interest Rates Much Further Foreign investors are therefore at risk due to potential currency depreciation. The new leaders to be elected in the October presidential elections may well adopt such a macro policy mix. Markets will front run this by pushing the real down and this will be negative for foreign investors. However, there will be a buying opportunity after the currency finds a floor. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Analyst andrijav@bcaresearch.com Appendix 1: Loan Origination, Deposits/Money Creation And Settlement The amount of deposits is not a constraint on a banking system's ability to make loans and buy assets from non-banks. Figure I-1 and I-2 present stylized cases of how commercial banks can originate new loans without requiring a new deposit or extra excess reserves entering the banking system. Specifically Figure I-1 illustrates how commercial banks can originate loans with the subsequent net settlements among themselves taking place via inter-bank borrowing/lending. In this stylized example, the banking system is comprised of three commercial banks. These commercial banks hold all deposits in the system. Cash does not exist and all payments are done via wire transfers. Figure I-1Money Creation By Banks With Net Settlement Among Banks Via Inter-Bank Lending/Borrowing Is Investment Constrained By Savings? Tales Of China And Brazil Is Investment Constrained By Savings? Tales Of China And Brazil Figure I-2Money Creation By Banks With Net Settlement Between Banks & Central Bank Is Investment Constrained By Savings? Tales Of China And Brazil Is Investment Constrained By Savings? Tales Of China And Brazil 1. Loan Origination/Money Creation In the morning, Bank 1 originates a new loan worth $100 for Client 1. This transaction creates a new asset and, for the balance sheet to balance, Bank 1 should also increase the liabilities side of its balance sheet. Therefore, it simultaneously credits Client 1's chequing account by $100. Bank 1 does not transfer other depositors' money to Client 1's chequing account; it creates a new $100 deposit. The rest of the bank's depositors still have their full deposits, which they can draw on. In a nutshell, both assets and liabilities of Bank 1 rose by $100 - this was done "out of thin air" by just pressing the enter button on the computer. That also means that a $100 of new money was created by Bank 1 which increases the overall money stock in the banking system. Meanwhile, Bank 2 lends $200 to Client 2 and Bank 3 lends $300 to Client 3. Let's assume these were the only lending transactions during that day. In aggregate, the three banks originated $600 of new loans, and consequent new deposits/money "out of thin air." 2. Money Transfer / Payments Debtors do not borrow money and leave it sitting idle. They borrow money to pay their suppliers and others they owe. Even though Clients 1, 2 and 3 wire their payments to their respective suppliers on the same day, the total amount of deposits in the banking system does not change: Deposits simply move from one bank to another or from one bank client to another. In Figure I-1, Client 1 wires its $100 from Bank 1 to Supplier B that has an account at Bank 2; Client 2 pays its $200 invoice to Supplier C which in turn has an account at Bank 3; and finally Client 3 transfers $300 to Supplier A, who holds an account at Bank 1. The amount of money/deposits in the overall banking system has not changed as a result of these wire transfers. 3. Multilateral Net Settlement At the end of the day, banks should settle with other banks. Many countries employ a multilateral net settlement system typically operated by the central bank. In a multilateral net settlement system, at the end of the day, each bank pays (receives from) the system only the net amount they are due to pay to (receive from) other banks combined. Importantly, banks settle their payments with other banks using their excess reserves (herein called reserves) at the central bank, not the deposits of their clients. This entails that banks do not need deposits to pay their dues to other banks or the central bank. Figure I-1 illustrates the impacts on the banks' reserves under the multilateral net settlement system: Bank 1's reserves at the central bank change as follows: -$100 (Client 1's wire transfer out) + $300 (this is the amount that Supplier A with an account in Bank 1 gets from Client 3) = $200. The impact on Bank 2's reserves is as follows: -$200 (Client 2's wire transfer out) + $100 (this is the amount that Supplier B with an account in Bank 2 gets from Client 1) = -$100. The net change in Bank 3's reserves is: -$300 (Client 3's wire transfer out) + $200 (this is the amount that Supplier C with an account in Bank 3 gets from Client 2) = -$100. If we assume that all banks had no excess reserves before this day, then how do they settle their accounts? There are various alternatives, but we highlight two: Figure I-1 demonstrates the case of interbank lending. As a result of the settlements, Bank 1 has $200 in extra reserves, while Bank 2 and Bank 3 each have a $100 deficit in reserves. As such, Bank 1 lends $100 to each of Bank 2 and Bank 3. Why does it lend to other banks rather than keeping these reserves at the central bank? Because interbank rates are typically slightly above the central bank's rate - the rate Bank 1 would get if it were to lend the $200 to the central bank. Figure I-2 portends the same transactions with the sole difference being the reserves flow. Unlike Figure I-1, here banks do not lend to/borrow from each other. Banks lend excess reserves to the central bank as well as borrow deficient reserves from the central bank. This is done to settle their payments with other banks. Bank 1 lends its free reserves of $200 to the central bank. Bank 2 and Bank 3 each borrow $100 reserves from the central bank to settle with the system at the end of the day. As a result, the aggregate amount of reserves at the central bank does not change. On the whole, banks created $600 of new deposits/money/loans during the day without requiring savings from households, companies, the government or foreigners. Thereby, the money supply was expanded and new financing in the amount of $600 was provided "out of thin air." Appendix 2: Deposits Versus Liquidity Below are additional questions that we seek to answer to provide further elaboration on the issues of banks creating money and the difference between deposits and liquidity: 1. Why would central banks provide reserves to banks? When a central bank targets interest rates, which is nowadays the most common policy framework in both advanced and developing countries, it must provide liquidity to banks: the latter is required to preclude interbank rates from deviating from the policy rate. Under an interest rate targeting regime, the central bank does not have complete control over banks' reserves nor broad money supply. A central bank can control either the quantity of money or the price of money (interest rates), but not both simultaneously. The following two quotes from the New York Federal Reserve Chairman William Dudley and the European Central Bank confirm that central banks nowadays provide banks with reserves on demand - i.e., the amount of reserves is determined by demand from banks. "The Federal Reserve has committed itself to supply sufficient reserves to keep the fed funds rate at its target. If banks want to expand credit and that drives up the demand for reserves, the Fed automatically meets that demand in its conduct of monetary policy. In terms of the ability to expand credit rapidly, it makes no difference whether the banks have lots of excess reserves or not." (Dudley, 2009) European Central Bank (2012), May 2012 Monthly Bulletin: "The Eurosystem ... always provides the banking system with the liquidity required to meet the aggregate reserve requirement. In fact, the ECB's reserve requirements are backward-looking, i.e. they depend on the stock of deposits (and other liabilities of credit institutions) subject to reserve requirements as it stood in the previous period, and thus after banks have extended the credit demanded by their customers." 2. Why do banks compete for deposits if they create deposits themselves? The true reason banks compete for deposits is not that they require more deposits, but because they require more reserves. When a bank attracts a deposit from another bank, the latter must transmit to the former reserves equal to the amount of the deposit transferred. When a bank is experiencing a liquidity shortage, more deposits are of no help. Banks can always create more deposits themselves, but they cannot create reserves at the central bank. The true liquidity for banks is their reserves at the central bank - not deposits. Reserves are solely created by central banks "out of thin air." A central bank may decide not to provide funding to certain banks in some cases when the authorities deem these banks insolvent and/or in breach of regulations. Otherwise, if the central bank wants to keep policy rates stable, it must provide all liquidity (reserves) banks require. 3. Why do banks attract deposits if the central bank provides liquidity on demand? The primary reason why banks seek to attract deposits instead of borrowing from the central bank is due to the cost of funding and duration of liabilities as well as regulatory requirements. Deposits may be cheaper and have longer duration than short-term funding from the central bank. 1 Lindner, F. (2015), "Does Savings Increase the Supply of Credit? A Critique of Loanable Funds Theory", Macroeconomic Policy Institute, World Economic Review 4, 2015. 2 Lindner, F. (2015), "Did Scarce Global Savings Finance the US Real Estate Bubble? The Global Saving Glut thesis from a stock flow Consistent Perspective", Macroeconomic Policy Institute, Working Paper 155, July 2015. 3 Lindner, F. (2015), "Does Savings Increase the Supply of Credit? A Critique of Loanable Funds Theory", Macroeconomic Policy Institute, World Economic Review 4, 2015. 4 Please refer to the Emerging Markets Strategy Special Reports from October 26, 2016, November 23, 2016, January 18, 2017 and December 20, 2017; available on ems.bcaresearch.com 5 Borio, C. and Disyatat, P. (2015), "Capital flows and the current account: Taking financing (more) seriously", BIS Working Papers, No. 525, October 2015. 6 Lindner, F. (2015), "Did Scarce Global Savings Finance the US Real Estate Bubble? The Global Saving Glut thesis from a stock flow Consistent Perspective", Macroeconomic Policy Institute, Working Paper 155, July 2015. 7 Lindner, F. (2012), "Savings does not finance Investment: Accounting as an indispensable guide to economic theory", Macroeconomic Policy Institute, Working Paper 100, October 2012. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The call on EM local bonds boils down to the outlook for EM exchange rates. Forthcoming EM currency depreciation will halt the rally in local bonds. EM currencies positively correlate with commodities prices but not with domestic real interest rates. Widening U.S. twin deficits are not a reason to be long EM currencies. There has historically been no consistent relationship between the U.S. exchange rate and America's twin deficits in general, or its fiscal balance, in particular. For investors who have to be invested in EM domestic bonds, our recommended overweights are Russia, Argentina, Poland, the Czech Republic, Korea, India and Thailand. Feature The stampede into EM local currency bonds has persisted even amid recent jitters in global equity markets. Notably, surging U.S./DM bond yields have failed to cause a spike in EM local yields, despite past positive correlations (Chart I-1). Chart I-1Will EM Domestic Bond Yields Continue Defying Rising U.S. Treasury Yields? Will EM Domestic Bond Yields Continue Defying Rising U.S. Treasury Yields? Will EM Domestic Bond Yields Continue Defying Rising U.S. Treasury Yields? The main reason is the resilience of EM currencies. The latter have not sold off even during the recent correction in global share prices. In high-yielding EM domestic bond markets, total returns are substantially affected by exchange rates. Not only do U.S. dollar total returns on local bonds suffer when EM currencies depreciate, but also weaker EM exchange rates cause spikes in domestic bond yields (Chart I-2). Consequently, the call on EM local bonds, especially in high-yielding markets, boils down to the outlook for EM exchange rates. Chart I-2EM Currencies Drive EM Local Yields EM Currencies Drive EM Local Yields EM Currencies Drive EM Local Yields We are negative on EM currencies versus the U.S. dollar and the euro. The basis for our view is two-fold: Strong growth in the U.S. and higher U.S. bond yields should be supportive of the greenback vis-à-vis EM currencies; the same applies to euro area growth and the euro against EM exchange rates; Weaker growth in China should weigh on commodities prices and, in turn, on EM currencies. So far, this view has not played out. In fact, negative sentiment on the U.S. dollar has recently been amplified by concerns about America's widening fiscal and current account deficits. In fact, one might argue that EM local bonds stand to benefit from the potential widening in U.S. twin deficits and the flight out of the U.S. dollar. We address the issue of U.S. twin deficits first. Twin Deficits And The U.S. Dollar... The recent narrative that the dollar typically depreciates during periods of widening twin deficits is not supported by historical evidence. We are not suggesting that twin deficits lead to currency appreciation. Our argument is that twin deficits have historically coincided with both appreciation and depreciation of the U.S. dollar. Chart I-3 exhibits the relationship between the U.S. dollar and the fiscal and current account balances. It appears that there is no consistent relationship between the fiscal and current account balances and the exchange rate. Chart I-3No Stable Relationship Between U.S. Twin Deficits And Dollar No Stable Relationship Between U.S. Twin Deficits And Dollar No Stable Relationship Between U.S. Twin Deficits And Dollar To produce a quantitative measure of the twin deficits, we sum up both the fiscal and current account balances. Chart I-4 demonstrates the relationship between the latter measure and the trade-weighted U.S. dollar. This analysis encompasses the entire history of the floating U.S. dollar since 1971. Chart I-4Combination Of U.S. Twin Deficits And Real Bond Yields Better Explain Dollar Combination Of U.S. Twin Deficits And Real Bond Yields Better Explain Dollar Combination Of U.S. Twin Deficits And Real Bond Yields Better Explain Dollar The vertical lines denote the tax cuts under former U.S. President Ronald Reagan in 1981 and 1986, and under former U.S. President George W. Bush in 2001 and 2003. As can be seen from Chart I-4, there is no stable relationship between the twin deficits and the greenback. In the 1970s, there was no consistent relationship at all; In the first half of the 1980s, the twin deficits widened substantially, but the dollar rallied dramatically. The tailwind behind the rally was tightening monetary policy and rising/high real U.S. interest rates; From 1985 through 1993, there was no consistent relationship between America's twin deficits and the currency; From 1994 until 2001, the greenback appreciated as the twin deficits narrowed, particularly the fiscal deficit; From 2001 through 2011, the dollar was in a bear market as the twin deficits expanded; From 2011 until 2016, the shrinking-to-stable twin deficits were accompanied by a U.S. dollar rally. Bottom Line: We infer from these charts that there has historically been no stable relationship between the U.S. exchange rate and America's twin deficits in general, or its fiscal balance, in particular. ... And A Missing Variable: Interest Rates Twin deficits are often associated with rising inflation. In fact, a widening current account deficit can mask hidden price pressures. In particular, an economy that over-consumes - consumes more than it produces - can satisfy its demand via imports without exerting pressure on the economy's domestic productive capacity. Booming imports will lead to a widening trade deficit rather than higher consumer price inflation. Hence, in an open economy, over-consumption can lead to a widening current account deficit, rather than rising inflation. A currency is likely to plunge amid widening twin deficits if the central bank is behind the inflation curve. In such a case, the low real interest rates would undermine the value of the exchange rate. If the central bank, however, embarks on monetary tightening that is adequate, the currency can in fact strengthen amid growing twin deficits. In this scenario, rising real interest rates would support the currency. With respect to the U.S. dollar today, its future trajectory depends on the Fed, and the market's perception of its policy stance. If the market discerns that the Fed is behind the curve, the greenback will plummet. By contrast, if the market reckons that the Fed policy response is appropriate, and U.S. real interest rates are sufficiently high/rising, the dollar could in fact appreciate amid widening twin deficits. Specifically, the U.S. dollar was in a major bull market in the early 1980s, with Reagan's tax cuts in 1981 and the ensuing widening of the country's twin deficits doing little to thwart the dollar bull market (Chart I-4). In turn, the Bush tax cuts in 2001 and 2003 were followed by a major dollar bear market. The main culprit between these two and other episodes was probably real interest rates. U.S. real interest rates/bond yields rose between 1981 and 1985, generating an enormous dollar rally. In the decade of the 2000s, by contrast, U.S. real interest rates fell and that coincided with a major bear market in the greenback (Chart I-4). Overall, the combination of U.S. twin deficits and real bond yields together, help better explain U.S. dollar dynamics than twin deficits alone. We agree that America's twin deficits will widen materially. That said, odds are that the Fed commits to further rate hikes and that U.S. bond yields continue to rise. In fact, not only are U.S. inflation breakeven yields climbing, but TIPS (real) yields have also spiked significantly. Rising real yields, which in our opinion have more upside, should support the U.S. dollar. As a final point, if the Fed falls behind the curve and the dollar continues to tumble, the markets could begin to fear a material rise in U.S. inflationary pressures. That scenario would actually resemble market dynamics that prevailed before the 1987 stock market crash. Although this is a negative scenario for the U.S. currency and is, by default, bullish for EM exchange rates and their local bonds, this is not ultimately an optimistic scenario for global risk assets. Bottom Line: Twin deficits are not solely sufficient to produce a currency bear market. Twin deficits accompanied by a central bank that is behind the inflation curve - i.e., combined with low/falling real interest rates - are what generate sufficient conditions for currency depreciation. EM Currencies And Commodities Many EM exchange rates - such as those in Latin America, as well as South African, Russian, Malaysian and Indonesian currencies - are primarily driven by commodities prices. Not surprisingly, the underlying currency index of the EM local bond benchmark index (the JPM GBI index) - which excludes China, India, Korea and Taiwan - positively correlates with commodities prices (Chart I-5). Hence, getting commodities prices right is of paramount importance to the majority of high-yielding EM local bonds. We have the following observations: First, investors' net long positions in both oil and copper are extremely elevated (Chart I-6). The last datapoint is as of February 16. Any rebound in the U.S. dollar or mounting concerns about China's growth could produce a meaningful drop in commodities prices as investors rush to close their long positions. Second, we maintain that China's intake of commodities is bound to decelerate, as decelerating credit growth and local governments' budget constraints lead to curtailment of infrastructure and property investment (Chart I-7). Chart I-5EM Currencies Positively Correlate ##br##With Commodities Prices EM Currencies Positively Correlate With Commodities Prices EM Currencies Positively Correlate With Commodities Prices Chart I-6Investors Are Very Long##br## Copper And Oil Investors Are Very Long Copper And Oil Investors Are Very Long Copper And Oil Chart I-7Slowdown In ##br##China's Capex Slowdown In China's Capex Slowdown In China's Capex Strong growth in the U.S. and EU will not offset the decline in China's intake of raw materials (excluding oil). China accounts for 50% of global demand for industrial metals. America's consumption of industrial metals is about 6-7 times smaller. For crude oil, China's share of global consumption is 14% compared with 20% and 15% for the U.S. and EU, respectively. We do not expect outright contraction in China's crude imports or consumption. The point is that when financial markets begin to price in weaker mainland growth or the U.S. dollar rebounds, oil prices will retreat as investors reduce their record high net long positions. Finally, even though EM twin deficits have ameliorated in recent years, they remain wide (Chart I-8). In turn, the majority of these countries have been financing their deficits by volatile foreign portfolio flows, as FDIs into EM remain largely depressed. If commodities prices relapse and EM currencies depreciate, there will be a period of reversal in foreign portfolio inflows into EM. While EM real local bonds yields are reasonably high, they are unlikely to prevent outflows if the U.S. dollar rallies. In the past, neither high absolute EM real yields nor their wide spreads over U.S. TIPS prevented EM currency depreciation (Chart I-9). Chart I-8AEM Twin Deficits Have Ameliorated ##br##But Are Still Wide EM Twin Deficits Have Ameliorated But Are Still Wide EM Twin Deficits Have Ameliorated But Are Still Wide Chart I-8BEM Twin Deficits Have Ameliorated ##br##But Are Still Wide EM Twin Deficits Have Ameliorated But Are Still Wide EM Twin Deficits Have Ameliorated But Are Still Wide Chart I-9EM Local Real Yields Do Not ##br##Drive Their Currencies EM Local Real Yields Do Not Drive Their Currencies EM Local Real Yields Do Not Drive Their Currencies EM Local Bonds: Country Allocation Strategy Chart I-10 attempts to identify pockets of value in EM domestic bonds. It exhibits the sum of current account and fiscal balances on the X axis, and domestic bond yields deflated by headline inflation on the Y axis. Chart I-10Identifying Pockets Of Value In EM Domestic Bonds EM Local Bonds And U.S. Twin Deficits EM Local Bonds And U.S. Twin Deficits Markets in the upper-right corner should be favored as they offer high real yields and maintain healthy fiscal and current account balances. Bond markets in the lower-left corner should be underweighted. They have low inflation-adjusted yields and large current account and fiscal deficits. Based on these metrics as well as fundamental analysis, our recommended country allocation for EM domestic bond portfolios has been and remains: Overweights: Russia, Argentina, Poland, the Czech Republic, Korea, India and Thailand. Neutral: Brazil, Mexico, Indonesia, Hungary, Chile and Colombia. Underweights: Turkey, South Africa and Malaysia. The below elaborates on Brazil, Russia and South Africa. Russia Fiscal and monetary policies are extremely tight. While they are curtailing the economic recovery, they are very friendly for creditors. Interest rates deflated by both headline and core consumer price inflation are at their highest on record, government spending is lackluster, and the new fiscal rule has replenished the country's foreign currency reserves (Chart I-11). Besides, the government's budget assumption for oil prices is very conservative - in the low-$40s per barrel for this year and 2019. Commercial banks have been increasing provisions, even though the NPL ratio is falling. In fact, Russia is well advanced in terms of both corporate and household deleveraging as well as banking system adjustment. On the whole, having experienced two large recessions in the past 10 years and having pursued extremely orthodox fiscal and monetary policies, Russian markets have become much more insulated from negative external shocks than many of their peers. In brief, Russian financial markets have become low-beta markets,1 and they will outperform their EM peers in a selloff even if oil prices slide. Brazil Brazilian local bonds offer the highest inflation-adjusted yields. However, unlike Russia, Brazil has untenable public debt dynamics, and its politics remain a wild card. The public debt-to-GDP ratio is 16% in Russia and 80% in Brazil. The fiscal deficit in Brazil stands at a whopping 8% of GDP, and interest payments on public debt are equal to 6% of GDP. Without major fiscal reforms, Brazil's public debt will continue to surge and will likely reach almost 100% of GDP by the end of 2020. High real interest rates are not only holding back the recovery but are also making public debt dynamics unsustainable. Chart I-12 illustrates that nominal GDP growth is well below local government bond yields. Chart I-11Continue Favoring ##br##Russian Local Bonds Continue Favoring Russian Local Bonds Continue Favoring Russian Local Bonds Chart I-12Brazil: Borrowing Costs Are Dreadful ##br##For Public Debt Dynamics Brazil: Borrowing Costs Are Dreadful For Public Debt Dynamics Brazil: Borrowing Costs Are Dreadful For Public Debt Dynamics Brazil needs either much higher nominal growth or major fiscal tightening to stem the surge in the public debt-to-GDP ratio. The necessary fiscal reforms - social security restructuring or primary budget surpluses - are not politically feasible right now. Meanwhile, materially higher nominal growth can be achieved only if interest rates are brought down quickly and drastically and the currency is devalued meaningfully. Hence, the primary risk to Brazilian local bonds is the exchange rate. The currency is at risk from potentially lower commodities prices on the external side, and continuous public debt deterioration, debt monetization or drastic interest rate cuts on the domestic side. Remarkably, Chart I-13 demonstrates that historically real interest rates in Brazil do not explain fluctuations in the real. The currency, rather, positively correlates with commodities prices (Chart I-14). Chart I-13Brazil: No Relationship Between##br## Real Yields And Currency Brazil: No Relationship Between Real Yields And Currency Brazil: No Relationship Between Real Yields And Currency Chart I-14The Brazilian Real And ##br##Commodities Prices The Brazilian Real And Commodities Prices The Brazilian Real And Commodities Prices It is possible that policymakers find an optimal balance between these adjustment paths, and financial markets continue to rally. However, with the current government lacking any political capital and great uncertainty surrounding the October presidential elections; the outlook is very risky, We recommend a neutral allocation to Brazilian local bonds for EM domestic bond portfolios. South Africa The South African rand and fixed-income markets have surged in the wake of Cyril Ramaphosa's win of the ANC leadership elections and his taking over of the presidency from Jacob Zuma. This has been devastating to our short rand and underweight local bonds positions. Chart I-15The South African Rand And Metals Prices The South African Rand And Metals Prices The South African Rand And Metals Prices There is no doubt that President Ramaphosa will adopt some market-friendly policies. This will constitute a major change from Zuma's handling of the economy in the past nine years. Yet the outlook for the rand is also contingent on global markets. If commodities prices do not relapse and EM risk assets generally perform well, the rand will continue strengthening, and local bond yields will decline further. However, if metals prices begin to drop and EM currencies sell off, it will be hard for the South African currency to rally further (Chart I-15). While we acknowledge the potential for positive political announcements and actions from the new political leadership, the main drivers of the rand, in our opinion, remain the trends in the U.S. dollar and commodities prices. Some investors might be tempted to compare South Africa to Brazil in terms of political headwinds turning into tailwinds. From a political vantage point, it is a fair comparison. Nevertheless, investors should put Brazil's rally into perspective. If commodities prices did not rise in 2016-2017, the Brazilian real would not have rallied. In brief, external tailwinds are as - if not more - important for EM high-yielding currencies than domestic political developments. Positive political developments are magnified amid a benign external backdrop. Conversely, in a negative external environment, positive political transformations can have limited impact on the direction of financial markets. To reflect the potential for a positive political change and forthcoming orthodox macro policies, we are closing our bet on yield curve steepening in South Africa. This position was stipulated by unorthodox macro policies of the previous government. This trade has been flat since its initiation on June 28, 2017. Weighing pros and cons, we are reluctant to upgrade the South African rand and its fixed-income market at the moment because of our negative view on metals prices and EM currencies versus the U.S. dollar. Investment Conclusions The broad trade-weighted U.S. dollar is at record oversold levels (Chart I-16). Given the forthcoming U.S. fiscal stimulus, the Fed will likely lift its dots and the greenback will rebound. This is bearish for EM currencies, especially if China's growth slows and commodities prices roll over, as we expect. EM exchange rate depreciation will halt the rally in local bonds, especially in high-yielding markets. Foreign holdings of EM local bonds are elevated (Table I-1). Hence, risks of unwinding of some positions are not trivial. Chart I-16The U.S. Dollar Is Due For A Rally The U.S. Dollar Is Due For A Rally The U.S. Dollar Is Due For A Rally Table I-1Foreign Ownership Of EM Local Bonds Is High EM Local Bonds And U.S. Twin Deficits EM Local Bonds And U.S. Twin Deficits Nevertheless, as we have argued in the past, EM local bonds offer great diversification benefits to all type of portfolios, as their correlations with many asset classes are low. For domestic bond investors who have to be invested, our recommended overweights are Russia, Argentina, Poland, the Czech Republic, Korea, India and Thailand. As to the sovereign and corporate credit markets, asset allocators should compare these with U.S. corporate credit. Consistent with our negative view on EM currencies and equities vis-à-vis their U.S. counterparts, we recommend favoring U.S. corporates versus EM sovereign and corporate credit. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report, titled "Russia: Entering A Lower-Beta Paradigm," dated March 8, 2017, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations