Central Europe

Analysis on Mexico and Central Europe is available on pages 6 and 10, respectively. Highlights Deflationary pressures have been intensifying in Malaysia and the central bank will be forced to cut its policy rate. To play this theme, we recommend receiving 2-year swap rates. In Mexico, pieces are falling into place for stocks to outperform the EM equity benchmark on a sustainable basis. We are also keeping an overweight allocation on Mexican sovereign credit and local currency bonds. In Central Europe (CE), inflation will continue to rise as both labor shortages and ultra-accommodative monetary and fiscal policies promote strong domestic demand. We are downgrading our allocation of CE local currency bonds from overweight to neutral. Malaysia: Besieged By Deflationary Pressures Malaysian interest rates appear elevated given the state of its economy. Deflationary pressures have been intensifying and the central bank will be forced to cut its policy rate. The Malaysian economy continues to face strong deflationary pressures. To play this theme, we recommend receiving 2-year swap rates. We are also upgrading our recommended allocation to Malaysian local currency and U.S. dollar government bonds for dedicated EM fixed-income portfolios from neutral to overweight. The Malaysian economy continues to face strong deflationary pressures, requiring significant rate cuts by the central bank: Chart I-1 shows that the GDP deflator is flirting with deflation, and nominal GDP growth has slowed to the level of commercial banks’ average lending rates. Falling nominal growth amid elevated corporate and household debt levels is an extremely toxic mix (Chart I-2, top panel). Notably, debt-servicing costs for the private sector – both businesses and households – are high at 13.5% of GDP and are also rising (Chart I-2, bottom panel).  Chart I-1The Malaysian Economy Is Flirting With Deflation The Malaysian Economy Is Flirting With Deflation The Malaysian Economy Is Flirting With Deflation Chart I-2High Leverage & Debt Servicing Costs Among Businesses & Households High Leverage & Debt Servicing Costs Among Businesses & Households High Leverage & Debt Servicing Costs Among Businesses & Households Crucially, real borrowing costs are elevated. In real terms, the prime lending rate stands at 5% when deflated by the GDP deflator, and at 3% when deflated by headline CPI. Notably, private credit growth (outstanding business and household loans) has plunged to a 15-year low (Chart I-3), underscoring that real borrowing costs are excessive. Chart I-3Malaysia: Credit Growth Is In Freefall Malaysia: Credit Growth Is In Freefall Malaysia: Credit Growth Is In Freefall Chart I-4Malaysia's Corporate Sector Is Struggling Malaysia's Corporate Sector Is Struggling Malaysia's Corporate Sector Is Struggling Malaysia’s corporate sector is struggling. The manufacturing PMI is below the critical 50 threshold and is showing no signs of recovery. Listed companies’ profits are shrinking (Chart I-4, top panel). Poor corporate profitability is prompting cutbacks in capex spending (Chart I-4, middle and bottom panels) and weighing on employment and wages. The household sector has been retrenching; retail sales have been contracting and personal vehicle sales have been shrinking (Chart I-5). The property market – in particular the residential sub-sector – is still in recession. Property sales and starts are falling, and property prices are flirting with deflation (Chart I-6).   Critically, monetary policy easing and exchange rate depreciation are the only levers available to policymakers to reflate the economy. Fiscal policy is constrained as the budget deficit is already large at 3.4% of GDP, and public debt is elevated. Prime Minister Mahathir Mohamad is in fact aiming to reduce the total national debt (including off-balance-sheet debt) back to the government’s ceiling of 54% of GDP (from 80% currently). Chart I-5Malaysian Households Are Retrenching Malaysian Households Are Retrenching Malaysian Households Are Retrenching Chart I-6Malaysia's Property Sector Is In A Downturn Malaysia's Property Sector Is In A Downturn Malaysia's Property Sector Is In A Downturn   Bottom Line: The Malaysian economy is besieged by deflationary pressures and requires lower borrowing costs. The central bank will deliver rate cuts in the coming months. Investment Recommendations A new trade idea: receive 2-year swap rates as a bet on rate cuts by the central bank. Consistently, for dedicated EM bond portfolios, we are upgrading local currency and U.S. dollar-denominated government bonds from neutral to overweight. Chart I-7Overweight Malaysian Local Currency And U.S. Dollar Government Bonds Overweight Malaysian Local Currency And U.S. Dollar Government Bonds Overweight Malaysian Local Currency And U.S. Dollar Government Bonds While we are downbeat on the ringgit versus the U.S. dollar, Malaysian domestic bonds will likely outperform the EM GBI index in common currency terms on a total return basis (Chart I-7, top panel). The same is true for excess returns on the country’s sovereign credit (Chart I-7, bottom panel).     The basis for the ringgit’s more moderate depreciation, especially in comparison with other EM currencies, is as follows: First, foreigners have reduced their holdings of local currency bonds. The share of foreign ownership has declined from 36% in 2015 to 22% now of total outstanding local domestic bonds in the past 4 years (Chart I-8). Hence, currency depreciation will not trigger large foreign capital outflows. Second, the trade balance is in surplus and improving. This will provide a cushion for the ringgit. Finally, the ringgit is cheap in real effective terms which also limits the potential downside (Chart I-9).   Dedicated EM equity portfolios should keep a neutral allocation on Malaysian stocks. We are taking profits on our long Malaysian small-cap stocks relative to the EM small-cap index position. This recommendation has generated a 6.6% gain since its initiation on December 14, 2018. Chart I-8Foreigners' Share Of Local Currency Bonds Has Dropped Foreigners' Share Of Local Currency Bonds Has Dropped Foreigners' Share Of Local Currency Bonds Has Dropped Chart I-9The Ringgit Is Cheap The Ringgit Is Cheap The Ringgit Is Cheap   Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com   Mexico: Raising Our Conviction On Equity Outperformance Mexican local currency bonds, as well as sovereign and corporate credit, have been one of our highest conviction overweights for some time. These positions have played out very well (Chart II-1). Presently, pieces are falling into place for Mexican stocks to outperform the EM equity benchmark on a sustainable basis. First, long-lasting outperformance by Mexican local currency bonds and corporate credit will lead to the stock market’s outperformance relative to the EM benchmark. Chart II-2 shows that when Mexican local currency bond and corporate dollar bond yields fall relative to their EM peers, the Bolsa tends to outperform. In brief, a relative decline in the cost of capital will eventually translate into relative equity outperformance. Chart II-1Mexico Vs. EM: Domestic Bonds And Credit Markets Mexico Vs. EM: Domestic Bonds And Credit Markets Mexico Vs. EM: Domestic Bonds And Credit Markets Chart II-2Mexico: Relative Stock Prices Are Correlated With Relative Cost Of Capital Mexico: Relative Stock Prices Are Correlated With Relative Cost Of Capital Mexico: Relative Stock Prices Are Correlated With Relative Cost Of Capital Second – as discussed in detail in our previous Special Report – market worries about Mexico’s fiscal position are overblown, especially relative to other developing nations such as Brazil and South Africa. Orthodox fiscal and monetary policies, as well as low public debt, warrant a lower risk premium in Mexico, both in absolute terms and relative to other EM countries. Moreover, market participants and credit agencies have overstated the precariousness of Pemex’s debt and financing requirements. Pemex U.S. dollar bond yields have been falling steadily compared to EM aggregate corporate bond yields since the announcements of policies aimed at supporting the company’s debt sustainability. We have discussed Pemex’s financial sustainability and its effect on public finances in past reports.1  Third, having cut rates twice since September, the Central Bank of Mexico (Banxico) has embarked on a rate cutting cycle. This is positive for stock prices, as it implies higher equity valuations and will eventually put a floor under the economy.  Given that both core and headline inflation have fallen within the target bands, this gives the monetary authorities more room to reduce interest rates. Banxico members have been vocal about their desire to cut rates further, which is being foreshadowed by the swap market (Chart II-3, top panel). Given that both core and headline inflation have fallen within the target bands, this gives the monetary authorities more room to reduce interest rates. The slowdown in the domestic economy and Andrés Manuel López Obrador’ (AMLO) administration’s tight fiscal policy will enable and encourage Banxico to further ease monetary policy (Chart II-3, bottom panel). Fourth, another positive market catalyst for Mexican equities is the ongoing outperformance of EM consumer staples versus the overall EM index. Consumer staples have a large 35% share of the overall Mexico MSCI stock index, while this sector in the EM MSCI benchmark accounts for only 7%. Therefore, durable outperformance by consumer staples often hints at a relative cyclical outperformance for the Mexican bourse (Chart II-4). Chart II-3Mexico: Continue Betting On Lower Rates Mexico: Continue Betting On Lower Rates Mexico: Continue Betting On Lower Rates Chart II-4Mexican Equities Are A Play On Consumer Staples Mexican Equities Are A Play On Consumer Staples Mexican Equities Are A Play On Consumer Staples Chart II-5Mexican Stocks Offer Reasonable Value Mexican Stocks Offer Reasonable Value Mexican Stocks Offer Reasonable Value Finally, Mexican equities are not expensive. Chart II-5 illustrates that according to our cyclically-adjusted P/E ratios, Mexican stocks offer good value in both absolute terms and relative to EM overall. We continue to believe AMLO’s administration is proving to be a pragmatic government with the aim of reducing rent-seeking activities and addressing structural issues such as poverty, corruption and crime. These policies will be positive for the economy over the long run and share prices will move higher in anticipation. Bottom Line: We are reiterating our overweight allocation on Mexican sovereign credit and domestic local currency bonds within their respective EM benchmarks. With further rate cuts on the horizon, yet upside risks to EM local currency bond yields, we continue to recommend a curve steepening trade in Mexico: receiving 2-year and paying 10-year swap rates.  We now have high conviction that Mexican share prices will stage a cyclical outperformance relative to their EM peers. The bottom panel of Chart II-4 on page 8 illustrates that Mexican stocks seem to have formed a major bottom and are about to begin outperforming the EM equity benchmark. Dedicated EM equity managers should have a large overweight allocation to Mexican stocks. Our recommendation of favoring small-caps over large-cap companies in Mexico has been very profitable since we argued for this trade last November. We are taking a 12.9% profit on this position and recommend keeping an overweight allocation to both Mexican large- and small-caps within an EM equity portfolio.   Juan Egaña Research Associate juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     Central Europe: An Inflationary Enclave In Deflationary Europe Our macroeconomic theme for Central European (CE) economies – Hungary, Poland and the Czech Republic, elaborated in the linked report, has been as follows: Inflation will continue to rise as both labor shortages and ultra-accommodative monetary as well as fiscal policies in CE promote strong domestic demand. CE economies have stood out as an inflationary enclave in Europe. Notably, CE economies have stood out as an inflationary enclave in Europe. Going forward, inflation will continue to rise across this region, despite the ongoing contraction in European manufacturing. First, Hungary’s and Poland’s central banks are behind the curve – they remain reluctant to hike rates amid rampantly rising inflation within overheating economies (Chart III-1). In turn, real policy rates across CE are becoming more negative and will promote robust money and credit growth (Chart III-2).      Chart III-1CE Central Banks Are Behind The Curve CE Central Banks Are Behind The Curve CE Central Banks Are Behind The Curve Chart III-2Low Real Rates Promote Rampant Credit Growth Low Real Rates Promote Rampant Credit Growth Low Real Rates Promote Rampant Credit Growth Policymakers are justifying stimulative policies by stressing ongoing woes in the Europe-wide manufacturing downturn. Yet, they are paying little attention to genuine inflationary pressures in their own economies. Most notably in Hungary, the National Bank of Hungary (NBH) has been aggressively suppressing its policy rate and engaging in a corporate QE program, despite rising inflation and an overheating economy. Similarly, the National Bank of Poland (NBP) seems inclined to cut rates sooner rather than later. On the other end of the spectrum though, the Czech National Bank (CNB) is the only CE central bank to have embarked on a rate hiking cycle over the past 18 months. Going forward, the CNB looks most likely to normalize rates by continuing its hiking cycle. This development will favor rate differentials between it and the rest of CE. As such, we remain long the CZK versus both the HUF and PLN (Chart III-3). Chart III-3Favor CZK Versus PLN & HUF Favor CZK Versus PLN & HUF Favor CZK Versus PLN & HUF Chart III-4Germany's Manufacturing Cycles And CE Inflation Germany's Manufacturing Cycles And CE Inflation Germany's Manufacturing Cycles And CE Inflation Second, European manufacturing cycles have historically defined CE inflation trends, with time lags of around 12 to 18 months. However, this time around, the euro area manufacturing recession will not translate into slower CE inflation and growth dynamics (Chart III-4). Above all, booming credit induced by real negative borrowing costs has incentivized robust domestic demand in general and construction activity in particular in CE. In addition, employment growth remains strong and double-digit wage growth has supported strong consumer spending (Chart III-5). As a result, manufacturing production volumes have remained relatively resilient in Hungary and Poland, even as manufacturing output volumes in both Germany and the broader euro area have been contracting (Chart III-6). Chart III-5Strong Domestic Demand In CE… bca.ems_wr_2019_10_31_s3_c5 bca.ems_wr_2019_10_31_s3_c5 Chart III-6...Entails Divergences In Manufacturing With Euro Area ...Entails Divergences In Manufacturing With Euro Area ...Entails Divergences In Manufacturing With Euro Area Third, inflationary pressures in CE are both acute and genuine. Wage growth has been rising faster than productivity growth across the region, leading to surging unit labor costs (Chart III-7). Mounting wage pressures reflect widespread labor shortages. Further, output gaps in these economies have turned positive, which has historically been a precursor of inflationary pressures. Finally, fiscal policy in CE will remain very expansionary, supporting strong business and consumer demand. Bottom Line: Super-accommodative monetary and fiscal policies have led to a classic case of overheating within CE, particularly in Hungary and Poland, and less so in the Czech Republic. Chart III-7Genuine Inflationary Pressures In Central Europe Genuine Inflationary Pressures In Central Europe Genuine Inflationary Pressures In Central Europe Chart III-8A Widening Current Account Deficit Is A Symptom Of Overheating A Widening Current Account Deficit Is A Symptom Of Overheating A Widening Current Account Deficit Is A Symptom Of Overheating Investment Implications Deteriorating current accounts (Chart III-8), rising inflation and behind-the-curve central banks warrant further currency depreciation in both Hungary and Poland. This is why we continue to recommend a short position on both the HUF and PLN versus the CZK. We are closing our Hungarian/euro area relative three-year swap rate trade with a loss of 87 basis points. Our expectation that the market would price in rate hikes in Hungary despite the central bank’s dovishness has not materialized. Investors should remain overweight CE equities within an EM portfolio due to strong domestic demand in these economies and no direct economic exposure to China. As we expect EM equities to underperform DM stocks, we continue to recommend underweighting CE versus the core European markets. We are downgrading our allocation to CE local currency bonds from overweight to neutral within an EM domestic bond portfolio. The primary reason is a risk of a selloff in core European rates.   Anddrija Vesic Research Analyst andrija@bcaresearch.com     Footnotes 1. Please see Emerging Markets Strategy, "Mexico: The Best Value In EM Fixed Income," dated April 23, 2019 and "Mexico: Crying Out For Policy Easing," dated September 5, 2019, available at ems.bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Our macroeconomic theme for Central European (CE) economies – Hungary, Poland and the Czech Republic, elaborated in the linked report, has been as follows: Inflation will continue to rise as both labor shortages and ultra-accommodative monetary as well as fiscal policies in CE promote strong domestic demand. Notably, CE economies have stood out as an inflationary enclave in Europe. Going forward, inflation will continue to rise across this region, despite the ongoing contraction in European manufacturing. First, Hungary’s and Poland’s central banks are behind the curve – they remain reluctant to hike rates amid rampantly rising inflation within overheating economies (Chart III-1). In turn, real policy rates across CE are becoming more negative and will promote robust money and credit growth (Chart III-2).      Chart III-1CE Central Banks Are Behind The Curve CE Central Banks Are Behind The Curve CE Central Banks Are Behind The Curve Chart III-2Low Real Rates Promote Rampant Credit Growth Low Real Rates Promote Rampant Credit Growth Low Real Rates Promote Rampant Credit Growth   Chart III-3Favor CZK Versus PLN & HUF Favor CZK Versus PLN & HUF Favor CZK Versus PLN & HUF Policymakers are justifying stimulative policies by stressing ongoing woes in the Europe-wide manufacturing downturn. Yet, they are paying little attention to genuine inflationary pressures in their own economies. Most notably in Hungary, the National Bank of Hungary (NBH) has been aggressively suppressing its policy rate and engaging in a corporate QE program, despite rising inflation and an overheating economy. Similarly, the National Bank of Poland (NBP) seems inclined to cut rates sooner rather than later. On the other end of the spectrum though, the Czech National Bank (CNB) is the only CE central bank to have embarked on a rate hiking cycle over the past 18 months. Going forward, the CNB looks most likely to normalize rates by continuing its hiking cycle. This development will favor rate differentials between it and the rest of CE. As such, we remain long the CZK versus both the HUF and PLN (Chart III-3). Second, European manufacturing cycles have historically defined CE inflation trends, with time lags of around 12 to 18 months. However, this time around, the euro area manufacturing recession will not translate into slower CE inflation and growth dynamics (Chart III-4). Above all, booming credit induced by real negative borrowing costs has incentivized robust domestic demand in general and construction activity in particular in CE. In addition, employment growth remains strong and double-digit wage growth has supported strong consumer spending (Chart III-5). Chart III-4Germany's Manufacturing Cycles And CE Inflation Germany's Manufacturing Cycles And CE Inflation Germany's Manufacturing Cycles And CE Inflation Chart III-5Strong Domestic Demand In CE… bca.ems_wr_2019_10_31_s3_c5 bca.ems_wr_2019_10_31_s3_c5   As a result, manufacturing production volumes have remained relatively resilient in Hungary and Poland, even as manufacturing output volumes in both Germany and the broader euro area have been contracting (Chart III-6). Third, inflationary pressures in CE are both acute and genuine. Wage growth has been rising faster than productivity growth across the region, leading to surging unit labor costs (Chart III-7). Mounting wage pressures reflect widespread labor shortages. Chart III-6...Entails Divergences In Manufacturing With Euro Area ...Entails Divergences In Manufacturing With Euro Area ...Entails Divergences In Manufacturing With Euro Area Chart III-7Genuine Inflationary Pressures In Central Europe Genuine Inflationary Pressures In Central Europe Genuine Inflationary Pressures In Central Europe   Further, output gaps in these economies have turned positive, which has historically been a precursor of inflationary pressures. Finally, fiscal policy in CE will remain very expansionary, supporting strong business and consumer demand. Bottom Line: Super-accommodative monetary and fiscal policies have led to a classic case of overheating within CE, particularly in Hungary and Poland, and less so in the Czech Republic. Investment Implications Chart III-8A Widening Current Account Deficit Is A Symptom Of Overheating A Widening Current Account Deficit Is A Symptom Of Overheating A Widening Current Account Deficit Is A Symptom Of Overheating Deteriorating current accounts (Chart III-8), rising inflation and behind-the-curve central banks warrant further currency depreciation in both Hungary and Poland. This is why we continue to recommend a short position on both the HUF and PLN versus the CZK. We are closing our Hungarian/euro area relative three-year swap rate trade with a loss of 87 basis points. Our expectation that the market would price in rate hikes in Hungary despite the central bank’s dovishness has not materialized. Investors should remain overweight CE equities within an EM portfolio due to strong domestic demand in these economies and no direct economic exposure to China. As we expect EM equities to underperform DM stocks, we continue to recommend underweighting CE versus the core European markets. We are downgrading our allocation to CE local currency bonds from overweight to neutral within an EM domestic bond portfolio. The primary reason is a risk of a selloff in core European rates.   Andrija Vesic Research Analyst andrija@bcaresearch.com

Analysis on central Europe and Pakistan is published below. Highlights There are several reasons why Chinese authorities will likely allow the yuan to depreciate 6-8% from current levels in the coming months. RMB depreciation will weigh not only on emerging Asian but also on other EM currencies via several channels. We continue to recommend shorting a basket of the following currencies versus the U.S. dollar: ZAR, CLP, COP, IDR, MYR, PHP and KRW. Feature Chinese authorities will likely allow the yuan to fall 6-8% vis-à-vis the U.S. dollar from current levels in the coming months. The value of the RMB holds the key to the broader trend in EM currencies. In turn, dynamics in EM exchange rates typically define the trajectory for EM asset classes: stocks, credit spreads and local currency bonds. Odds are that the RMB along with other emerging Asian currencies will continue to depreciate (Chart I-1). There are several reasons why Chinese authorities will likely allow the yuan to fall 6-8% vis-à-vis the U.S. dollar from current levels in the coming months. Chart I-1Emerging Asian Currency Index Emerging Asian Currency Index Emerging Asian Currency Index Chart I-2Deflating Export Prices Herald Currency Depreciation bca.ems_wr_2019_05_23_s1_c2 bca.ems_wr_2019_05_23_s1_c2 First, currency depreciation will help mitigate the impact of U.S. import tariffs. With global trade volumes shrinking and U.S. import prices from China deflating (Chart I-2, top panel), China will benefit from a cheaper currency. Second, RMB devaluation goes against the Trump’s administration’s preference. The U.S.-China trade talks have flopped, and both sides seem to be jockeying to better position themselves ahead of another round of discussions. From a negotiation strategy perspective, it makes sense for China to devalue the yuan before a new round of negotiations starts again. Third, China needs lower interest rates to reduce the strain on numerous debtors. However, narrowing interest rate differential with the U.S. has often coincided with periods of RMB depreciation over the past nine years (Chart I-3). Chart I-3CNY/USD And Interest Rate Differential CNY/USD And Interest Rate Differential CNY/USD And Interest Rate Differential One reason why policymakers in China were previously reluctant to explore RMB/USD depreciation beyond the 7 mark was due to the risk of rampant capital exodus and a potential spike in financial market volatility. In other words, authorities were mindful that even mild and controlled depreciation could spiral out of control. However, with Chinese nationalistic rhetoric on the rise and the nation rallying around the flag, authorities now have more room to maneuver. They will not have a problem restricting capital outflows by residents, and there will be little general public dissatisfaction with a devaluation. Finally, at around $3 trillion, the central bank’s foreign exchange reserves are equivalent to only 14% of all yuan deposits, and 11% of broad money (M2) supply. In turn, the overhang of local currency money supply will exert structural downward pressure on the renminbi’s exchange rate in the coming years. This may be a convenient time to release some proverbial air out of the balloon – namely, the lingering money bubble in China – by devaluing the yuan. Bottom Line: The path of least resistance for the RMB is down. EM Currencies Are In Danger In recent months, we have been highlighting that the Korean won has been at a critical technical juncture and has broken down (Chart I-4, top panel). The Taiwanese and Singaporean dollars seem to be the next shoes to drop (Chart I-4, middle and bottom panels). Chart I-4 Tapering Wedge Patterns Tapering Wedge Patterns Chart I-5No Recovery In Asian Exports So Far No Recovery In Asian Exports So Far No Recovery In Asian Exports So Far U.S. import prices from various Asian countries are deflating, as shown in the bottom panel of Chart 2 on page 2. This typically warrants currency depreciation to mitigate the impact of export price deflation on national producers. Furthermore, emerging Asian exports are still shrinking, as evidenced by the latest trade numbers. Korea’s total exports for the first 20 days of May and Taiwan’s exports of electronics parts as of April are still contracting at a rapid pace (Chart I-5). The latter leads cyclical turning points in global trade by a couple of months. Finally, the RMB is the anchor currency in emerging Asia, and its depreciation will filter through the exchange rates of other regional, export-dependent economies. Regarding other EM currencies, they are also at risk of Chinese yuan depreciation. Apart from manufacturing sector competitiveness (discussed above), China’s exchange rate affects other economies in two distinct ways: Less Chinese imports: An RMB devaluation reduces the amount of China’s U.S. dollar inflows/payments to its trade partners (Chart I-6). Many EM and some DM currencies will be negatively affected since China is a major source of demand for these economies. Less capital outflows from China: RMB depreciation will likely be accompanied with heightened controls over capital outflows from China. In fact, various proxies for capital flight out of the mainland suggest the authorities have already substantially clamped down on outflows (Chart I-7). Economies that have profited from capital flight from China over the years are already feeling pain. For example, relapsing Australian property prices can be attributed to reduced capital flows from China. Chart I-6Chinese Imports In RMB And USD Chinese Imports In RMB And USD Chinese Imports In RMB And USD Chart I-7China: Reduced Capital Flight China: Reduced Capital Flight China: Reduced Capital Flight Likewise, there will be a period of painful adjustment in many emerging economies in Asia and elsewhere that have profited from Chinese capital flows – both via official and non-official channels. Bottom Line: RMB depreciation will affect various currencies via diverse channels: (1) deteriorating export competitiveness for manufacturing-based economies; (2) diminished mainland imports from China’s trade partners; and (3) reduced capital flows from China to economies that have typically relied on Chinese capital flows. The U.S. Dollar: A Review Of The Indicators We believe that the cyclical and structural backdrops remain favorable for the dollar, and that it will likely overshoot before a major top sets in. The U.S. dollar bull market is extended, but that does not mean it is over. Odds are that the greenback will overshoot before making a major top. In our last weekly report, we revisited currency valuations and found the dollar to be only moderately (one standard deviation) expensive, according to the real effective exchange rate based on unit labor costs. The latter is our favored currency valuation metric. The greenback has been in a major structural bull market since 2011. Secular bull/bear markets do not typically end before valuations reach 1.5-2 standard deviations. We believe that the cyclical and structural backdrops remain favorable for the dollar, and that it will likely overshoot before a major top sets in. Chart I-8U.S. Equity And Economic Outperformance Warrants Dollar Appreciation U.S. Equity And Economic Outperformance Warrants Dollar Appreciation U.S. Equity And Economic Outperformance Warrants Dollar Appreciation U.S. stocks are outperforming the rest of the world in local currency terms, not only based on market-cap equity benchmarks but also when measured using equal-weighted equity indexes (Chart I-8). This signals that return on capital is higher in the U.S. relative to the rest of the world. The latter has historically been positively related with the primary trend in the trade-weighted dollar (Chart I-8). The U.S. dollar currently offers an attractive yield relative to many of its peers. Chart I-9 illustrates the interest rate (3-month swap rate) differentials between the dollar and various EM and DM currencies. For each individual exchange rate, the bar denotes the U.S. interest rate spread over other markets, and the dot is the mean of this spread over the past 20 years. Not only is the current interest rate differential in favor of the greenback in the case of many currencies, but the spread is well above its 20-year mean for virtually all of the currencies included in Chart I-9. The sole exception is the Mexican peso – the latter’s current interest rate differential versus the U.S. is wider than its 20-year mean. In fact, the peso is among our most preferable EM currencies. Chart I-9 The U.S. dollar currently offers an attractive yield relative to many of its peers. Bottom Line: Odds are in favor of a U.S. dollar overshoot, especially versus cyclical currencies such as EM and commodities-based ones. We continue to recommend shorting a basket of the following currencies versus the U.S. dollar: ZAR, CLP, COP, IDR, MYR, PHP and KRW. We are also structurally short the RMB versus the dollar. For investors who are looking for currencies with the least downside versus the U.S. dollar, our picks are MXN, RUB, THB, TWD, SGD and central European currencies. EM Credit Markets And Domestic Bonds: It’s All About Exchange Rates From a macro perspective, EM dollar-denominated and local currency bonds are primarily driven by exchange rates. EM sovereign spreads are very sensitive to both EM exchange rates and industrial metals prices (Chart I-10). The latter two are primarily driven by global trade cycles in general and China’s growth in particular. EM corporate spreads have been less sensitive to EM exchange rates. Yet they are unlikely to defy a major down-leg in EM currencies. The basis is as follows: when currencies depreciate, foreign-currency debt becomes more expensive to service warranting a period of wider credit spreads. Exchange rate fluctuations account for the bulk of domestic bonds’ total returns for foreign investors. We discussed this topic in our report titled Asset Allocation For EM Assets. Chart 11 shows the total return indexes in dollars and euros for the EM GBI local currency government bond index. Euro-based investors have fared much better than dollar-based ones. The euro’s depreciation versus the dollar explains this gap. However, from a technical point of view, total return in euros is facing a major resistance level (Chart I-11, bottom panel). European investors should take note. Chart I-10EM Sovereign Spreads Correlate With EM Currencies And Commodities EM Sovereign Spreads Correlate With EM Currencies And Commodities EM Sovereign Spreads Correlate With EM Currencies And Commodities Chart I-11Total Returns on EM Local Bonds In USD And Euros Total Returns on EM Local Bonds In USD And Euros Total Returns on EM Local Bonds In USD And Euros   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Continue Favoring Central Europe Within EM Equities: An overweight position in Central European (CE) equities within an EM equity portfolio is still warranted due to the following reasons: First, CE economies are the least exposed to a Chinese and global trade slowdown - the main causes of the EM selloff. Even though these economies are leveraged to German and euro area manufacturing - both of which are currently weak - they have little direct exposure to China and commodities. Second, currency trends are critical for the relative performance of equities. We expect EM currencies will depreciate versus the euro and against CE currencies. This argues in favor of CE stocks within an EM portfolio. Third, CE domestic demand remains strong and private credit growth robust (Chart II-1). Additionally, the authorities are maintaining a loose fiscal policy stance. As to European equity portfolios, we recommend underweighting CE bourses versus the core European markets. Chart II-2 illustrates that when EM equities underperform DM ones, CE share prices lag behind euro area stocks. Chart II-1Private Credit Growth Is Robust Private Credit Growth Is Robust Private Credit Growth Is Robust Chart II-2CE Underperforms Core Europe When EM Underperforms DM CE Underperforms Core Europe When EM Underperforms DM CE Underperforms Core Europe When EM Underperforms DM Currencies and Fixed-Income Markets: CE growth outperformance relative to EM suggests that CE exchange rates will outperform the majority of EM currencies. Critically, odds are that the euro has made a major bottom versus most EM currencies. This will facilitate CE exchange rate appreciation versus many other EM currencies. The latter warrants overweighting CE fixed-income markets against respective EM benchmarks. Currency Trades: Today we recommend closing our long CZK / short euro position. This trade has generated a 4.4% gain since September 28, 2016 with extremely low volatility. The basis for closing this position is there are signs that Czech growth and labor market tightness are peaking, warranting an end to rate hikes. Specifically, both economic activity and wage growth are slowing. This will lead the central bank to halt its rate hikes. Instead, we are opening a new trade: Go long CZK versus an equal-weighted basket of PLN and HUF. For the first time, Czech short rates have risen above those in Poland and Hungary (Chart II-3). This will be a major driver for Czech koruna appreciation against the other two currencies. The PLN and HUF will underperform the CZK because their monetary and fiscal policies are much easier than is currently warranted. Chart II-3Czech Interest Rate Differentials Versus Hungary And Poland Are Positive Czech Interest Rate Differentials Versus Hungary And Poland Are Positive Czech Interest Rate Differentials Versus Hungary And Poland Are Positive Chart II-4Trade Balances Favor CZK vs HUF & PLN Trade Balances Favor CZK vs HUF & PLN Trade Balances Favor CZK vs HUF & PLN The Hungarian central bank will launch its corporate QE program in July 2019 with a total of HUF 300 billion in corporate bond purchases. This will likely weigh on the HUF as the central bank monetizes some of the country’s outstanding corporate debt. Additionally, the Polish government has announced large fiscal stimulus ahead of this year’s elections. The fiscal deficit is projected to widen from 1% currently to 2% of GDP by 2020. Finally, trade balances in Poland and Hungary are deteriorating while the Czech Republic is running a large trade surplus (Chart II-4). Bottom Line: Continue overweighting CE within both EM equity and local currency bond portfolios. We are taking profits on our long CZK / short the euro trade and initiating a new position: Long CZK / short an equal-weighted basket of HUF and PLN.   Andrija Vesic, Research Analyst andrijav@bcaresearch.com   Pakistan: No Pain, No Gain Pakistan’s economy and stock market are currently going through painful but necessary adjustments. The country has been suffering from a severe balance-of-payment crisis. Its exchange rate has already depreciated by 30% versus the U.S. dollar since December 2017. Its stock market in U.S. dollar terms has plunged 55% from its May 2017 peak. A bottom in the stock market is likely to occur when the currency stabilizes. Odds are that the Pakistani rupee is in its late phase of adjustment (Chart III-1). First, a US$ 6 billion worth IMF bailout fund is on its way. The country reached a staff-level agreement with the IMF on May 12. The IMF will release the funds in phases over a period of 39 months. Meanwhile, Pakistan will likely also receive US$ 2-3 billion from the World Bank and the Asian Development Bank (ADB) in the next three years. Altogether, multilateral financing will amount to about US$3 billion per year over the next three years. The country will also likely continue its bi-lateral borrowings from China, Saudi Arabia and the UAE. Last year, about US$10 billion of external borrowing and a nearly US$7 billion reduction in the central bank’s foreign reserves helped fund the US$18 billion current account deficit. Over the next 12 months, we expect the financing needs to be considerably smaller due to shrinking twin deficits (Chart III-2). Chart III-1Pakistan's Rupee: Close To A Bottom? Pakistan's Rupee: Close To A Bottom? Pakistan's Rupee: Close To A Bottom? Chart III-2Twin Deficits Are Likely To Shrink Twin Deficits Are Likely To Shrink Twin Deficits Are Likely To Shrink Both trade and current account balances have started showing improvement in U.S. dollar terms due to a steep contraction in imports. Going forward, we expect export growth to turn positive on the back of currency devaluation but import contraction will deepen. Lastly, the IMF agreement might allow Pakistan to issue some Eurobonds while higher local rates might attract some foreign portfolio capital. Second, Pakistan’s top leadership has cooperated with the IMF. Just earlier this month IMF economist Reza Baqir was appointed the new central bank governor. In addition, the Finance Minister and the Federal Bureau of Revenue chairman have been replaced. These new appointments increase the odds that the IMF program will be enforced in Pakistan. Indeed, after only two weeks on the job the new central bank governor raised the policy rate this Monday by 150 basis points to 12.25%. Meanwhile, significant fiscal consolidation is on the way, as the new policymakers will be committed to the IMF program. The budget for the next fiscal year (June 2019 – May 2020), which will be presented in Parliament on May 24, will likely show a considerable reduction in non-interest expenditures. Finally, the IMF is also pushing for increased central bank independence. In the last 17 months, the central bank purchased massive amounts of government securities – a de facto monetization of public debt. This has exacerbated domestic inflation and currency depreciation. So long as the country is under the IMF program, it is reasonable to expect no public debt monetization. In summary, the ongoing substantial monetary and fiscal tightening and accompanying reduction in the twin deficits, coupled with the increased availability of foreign funding are positive for the exchange rate. It is possible that Pakistan will follow the 2016-2017 Egyptian roadmap. Egypt experienced a severe balance-of-payment crisis and agreed to a similar IMF bailout program. In the case of Egypt, a 55% depreciation in its currency in late 2016 was followed by a 77% rally in share prices in U.S. dollar terms over the subsequent 18 months (Chart III-3). We are putting Pakistani stocks on our upgrade watch list. We are reluctant to upgrade it now because currency weakness might persist for a couple of months. Further, monetary and fiscal tightening will amplify the economic downturn weighing on corporate earnings. Banks’ NPL ratios and provisions will likely rise considerably. Chart III-3The 2016-2017 Egyptian Roadmap The 2016-2017 Egyptian Roadmap The 2016-2017 Egyptian Roadmap Chart III-4Pakistani Equities: A Long-Term Profile Pakistani Equities: A Long-Term Profile Pakistani Equities: A Long-Term Profile Bottom Line: We are putting Pakistani equities on an upgrade watch list. This bourse’s technicals are becoming interesting – it might bottom at its previous highs (Chart III-4). In addition, both absolute and relative valuations of Pakistani stocks appear attractive (Charts III-5 & Chart III-6). Chart III-5Equity Valuations Look Attractive Equity Valuations Look Attractive Equity Valuations Look Attractive Chart III-6Relative Equity Valuations Also Look Attractive Relative Equity Valuations Also Look Attractive Relative Equity Valuations Also Look Attractive We are waiting for share prices and the currency to stabilize before recommending an overweight position in Pakistani equities.   Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com Footnotes Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Continue Favoring Central Europe Within EM Equities: An overweight position in Central European (CE) equities within an EM equity portfolio is still warranted due to the following reasons: First, CE economies are the least exposed to a Chinese and global trade slowdown - the main causes of the EM selloff. Even though these economies are leveraged to German and euro area manufacturing - both of which are currently weak - they have little direct exposure to China and commodities. Second, currency trends are critical for the relative performance of equities. We expect EM currencies will depreciate versus the euro and against CE currencies. This argues in favor of CE stocks within an EM portfolio. Third, CE domestic demand remains strong and private credit growth robust (Chart II-1). Additionally, the authorities are maintaining a loose fiscal policy stance. As to European equity portfolios, we recommend underweighting CE bourses versus the core European markets. Chart II-2 illustrates that when EM equities underperform DM ones, CE share prices lag behind euro area stocks. Chart II-1Private Credit Growth Is Robust Private Credit Growth Is Robust Private Credit Growth Is Robust Chart II-2CE Underperforms Core Europe When EM Underperforms DM CE Underperforms Core Europe When EM Underperforms DM CE Underperforms Core Europe When EM Underperforms DM Currencies and Fixed-Income Markets: CE growth outperformance relative to EM suggests that CE exchange rates will outperform the majority of EM currencies. Critically, odds are that the euro has made a major bottom versus most EM currencies. This will facilitate CE exchange rate appreciation versus many other EM currencies. The latter warrants overweighting CE fixed-income markets against respective EM benchmarks. Currency Trades: Today we recommend closing our long CZK / short euro position. This trade has generated a 4.4% gain since September 28, 2016 with extremely low volatility. The basis for closing this position is there are signs that Czech growth and labor market tightness are peaking, warranting an end to rate hikes. Specifically, both economic activity and wage growth are slowing. This will lead the central bank to halt its rate hikes. Instead, we are opening a new trade: Go long CZK versus an equal-weighted basket of PLN and HUF. For the first time, Czech short rates have risen above those in Poland and Hungary (Chart II-3). This will be a major driver for Czech koruna appreciation against the other two currencies. Chart II-3Czech Interest Rate Differentials Versus Hungary And Poland Are Positive Czech Interest Rate Differentials Versus Hungary And Poland Are Positive Czech Interest Rate Differentials Versus Hungary And Poland Are Positive Chart II-4Trade Balances Favor CZK vs HUF & PLN Trade Balances Favor CZK vs HUF & PLN Trade Balances Favor CZK vs HUF & PLN The PLN and HUF will underperform the CZK because their monetary and fiscal policies are much easier than is currently warranted. The Hungarian central bank will launch its corporate QE program in July 2019 with a total of HUF 300 billion in corporate bond purchases. This will likely weigh on the HUF as the central bank monetizes some of the country’s outstanding corporate debt. Additionally, the Polish government has announced large fiscal stimulus ahead of this year’s elections. The fiscal deficit is projected to widen from 1% currently to 2% of GDP by 2020. Finally, trade balances in Poland and Hungary are deteriorating while the Czech Republic is running a large trade surplus (Chart II-4). Bottom Line: Continue overweighting CE within both EM equity and local currency bond portfolios. We are taking profits on our long CZK / short the euro trade and initiating a new position: Long CZK / short an equal-weighted basket of HUF and PLN.   Andrija Vesic, Research Analyst andrijav@bcaresearch.com

Equities: An overweight position in Central European (CE) equities within an EM equity portfolio is still warranted due to the following reasons: First, CE economies are the least exposed to a Chinese and global trade slowdown - the main causes of the EM selloff. Even though these economies are leveraged to German and euro area manufacturing - both of which are currently weak - they have little direct exposure to China and commodities. Second, currency trends are critical for the relative performance of equities. We expect EM currencies will depreciate versus the euro and against CE currencies. This argues in favor of CE stocks within an EM portfolio. Third, CE domestic demand remains strong and private credit growth robust (Chart II-1). Additionally, the authorities are maintaining a loose fiscal policy stance. As to European equity portfolios, we recommend underweighting CE bourses versus the core European markets. Chart II-2 illustrates that when EM equities underperform DM ones, CE share prices lag behind euro area stocks. Chart II-1Private Credit Growth Is Robust Private Credit Growth Is Robust Private Credit Growth Is Robust Chart II-2CE Underperforms Core Europe When EM Underperforms DM CE Underperforms Core Europe When EM Underperforms DM CE Underperforms Core Europe When EM Underperforms DM   Currencies and Fixed-Income Markets: CE growth outperformance relative to EM suggests that CE exchange rates will outperform the majority of EM currencies. Critically, odds are that the euro has made a major bottom versus most EM currencies. This will facilitate CE exchange rate appreciation versus many other EM currencies. The latter warrants overweighting CE fixed-income markets against respective EM benchmarks. Currency Trades: Today we recommend closing our long CZK / short euro position. This trade has generated a 4.4% gain since September 28, 2016 with extremely low volatility. The basis for closing this position is there are signs that Czech growth and labor market tightness are peaking, warranting an end to rate hikes. Specifically, both economic activity and wage growth are slowing. This will lead the central bank to halt its rate hikes. Instead, we are opening a new trade: Go long CZK versus an equal-weighted basket of PLN and HUF. For the first time, Czech short rates have risen above those in Poland and Hungary (Chart II-3). This will be a major driver for Czech koruna appreciation against the other two currencies. The PLN and HUF will underperform the CZK because their monetary and fiscal policies are much easier than is currently warranted. Chart II-3Czech Interest Rate Differentials Versus Hungary And Poland Are Positive Czech Interest Rate Differentials Versus Hungary And Poland Are Positive Czech Interest Rate Differentials Versus Hungary And Poland Are Positive Chart II-4Trade Balances Favor CZK vs HUF & PLN Trade Balances Favor CZK vs HUF & PLN Trade Balances Favor CZK vs HUF & PLN   The Hungarian central bank will launch its corporate QE program in July 2019 with a total of HUF 300 billion in corporate bond purchases. This will likely weigh on the HUF as the central bank monetizes some of the country’s outstanding corporate debt. Additionally, the Polish government has announced large fiscal stimulus ahead of this year’s elections. The fiscal deficit is projected to widen from 1% currently to 2% of GDP by 2020. Finally, trade balances in Poland and Hungary are deteriorating while the Czech Republic is running a large trade surplus (Chart II-4). Bottom Line: Continue overweighting CE within both EM equity and local currency bond portfolios. We are taking profits on our long CZK / short the euro trade and initiating a new position: Long CZK / short an equal-weighted basket of HUF and PLN.   Andrija Vesic, Research Analyst andrijav@bcaresearch.com  

Highlights In the Philippines, inflation is breaking out while the central bank is well behind the curve. Financials markets remain at risk. As a play on surging interest rates: Go short Philippine property stocks. We appraise and modify our investment strategy across all central European markets in general and Hungary in particular - where a monetary policy shift is in the making. A new trade: We recommend paying 3-year swap rates in Hungary and receiving 3-year swap rates in the euro area. Feature The Philippines: Short Real Estate Stocks Philippine stocks are on the verge of a major breakdown (Chart I-1, top panel). Meanwhile, local currency bond yields are surging (Chart I-1, bottom panel). Chart I-1Philippine Stocks Are On The Edge Of A Breakdown Philippine Stocks Are On The Edge Of A Breakdown Philippine Stocks Are On The Edge Of A Breakdown The Philippine economy continues to overheat, and the Bangko Sentral ng Pilipinas (BSP) has fallen well behind the curve. The top panel of Chart I-2 shows that both headline and core inflation measures are rising precipitously and have breached the central bank's upper target of 4% by a wide margin. Chart I-2The Central Bank Is Far Behind The Curve The Central Bank Is Far Behind The Curve The Central Bank Is Far Behind The Curve Odds are that inflation will continue to climb higher. Overall domestic demand remains reasonably strong. Noticeably, both the current and fiscal accounts are in deficit and widening (Chart I-3). A current account deficit is a form of hidden inflation. The basis is that it gauges the degree of excess domestic demand relative to the productive capacity of the economy. Chart I-3The Philippines: A Large Twin Deficit The Philippines: A Large Twin Deficit The Philippines: A Large Twin Deficit The roots of these macro problems stem from ultra-easy monetary and fiscal policies pursued by Filipino authorities. The BSP has kept borrowing costs low and for much longer than was warranted, and has been slow to hike rates. As a result, credit has been booming relentlessly (Chart I-4). Chart I-4Bank Loans Have Boomed... Bank Loans Have Boomed... Bank Loans Have Boomed... The fiscal authorities, on the other hand, have vigorously pursued growth-at-all-costs programs. Government spending is now growing at an annual rate of 22% (Chart I-5). Chart I-5...So Have Government Expenditures ...So Have Government Expenditures ...So Have Government Expenditures Consequently, these populist policies have created excessive domestic demand that has stoked an inflation breakout. Given Philippine President Rodrigo Duterte's reluctance to cut back on fiscal expenditures, it will be up to the monetary authorities to tighten sufficiently enough to curb inflation.1 The currency was depreciating against the U.S. dollar in 2017, even as its EM peers rallied. A falling currency amid strong economic growth is generally a symptom of an overheating economy; it signals that real interest rates are low and the central bank is behind the curve. Today, the monetary authorities need to hike borrowing rates aggressively, otherwise the currency will plunge much further. The country's financial markets are quickly approaching a riot point, and local currency bond yields are already selling off as creditors are rebelling (see bottom panel of Chart I-1 on page 1). Another option the BSP could take to defend the peso without hiking rates much is to sell foreign exchange reserves. Doing so, nevertheless, will still lead to higher domestic interest rates - especially at the short end of the curve. When a central bank sells its dollar reserves, it absorbs local currency liquidity - i.e. commercial banks' excess reserves at the central bank decline. Interbank rates then rise, which pushes up short-term rates and potentially long-term ones too. This is how financial markets naturally force macro adjustments on an overheating economy when policymakers are reluctant to act. As such, Filipino share prices are now facing a major risk. Higher domestic rates amid strong loan growth will cause the economy to decelerate significantly. Certain interest rate-sensitive sectors such as vehicle sales are already shrinking. The property sector - the segment of the economy that has benefited the most from the credit binge - will be the next shoe to drop: The supply of residential real estate buildings has been booming - floor space built has risen 2.4-fold since 2003. As interest rates continue to rise, real estate and construction loans - which are still growing at a 19% annual rate - will slump. Higher borrowing costs will hurt real estate prices. Meanwhile, rent growth will decline as the economy decelerates. The slowdown in the property sector will take a heavy toll on real estate development and management companies: First, these firms' revenues and income - property sales, rental and other types of income - will decelerate significantly (Chart I-6, top panel). Chart I-6Listed Real Estate Companies Will Face Major Headwinds Listed Real Estate Companies Will Face Major Headwinds Listed Real Estate Companies Will Face Major Headwinds Second, higher interest rates will raise their interest expenses (Chart I-6, bottom panel). Remarkably, Philippine real estate stocks have remained quite resilient, despite the broad selloff in financial markets. While the former are down by 18% in dollar terms from their early 2018 peak, Chart I-7 suggests rising interest rates herald a much more pronounced drop in their prices. Chart I-7Filipino Property Stocks Are On A Cliff Filipino Real Estate Stocks Have Been Quite Resilient Filipino Real Estate Stocks Have Been Quite Resilient Besides, these property companies are also still expensive. Their price-to-book value (PBV) currently stands at 2.9. Between the years 2000 and 2005, their PBV averaged 1.6. We are therefore initiating a new trade: Short Philippine real estate stocks in absolute U.S. dollar terms. Crucially, the real estate sector makes up 27% of the Philippines MSCI index, and will therefore have a significant impact on the Philippine stock market. As to bank stocks - the other large segment of the equity market - a couple of points are in order. Commercial banks in the Philippines are exposed to the real estate sector. Hence, a slowdown in the property sector will culminate in the form of higher NPLs and provisions for bad loans on banks' balance sheets. Real estate and construction loans account for 25% of total bank loans. Crucially, NPLs and provision levels - at 1.3% and 1.9%, respectively - are very low, and have so far not risen. This is unsustainable given the magnitude of the ongoing credit boom and rising interest rates. Higher provisions will cause banks' profits and share prices to suffer materially. This will come on top of plunging net interest margins (Chart I-8). Chart I-8Philippines Commercial Bank Profits Are Getting Squeezed Philippines Commercial Bank Profits Are Getting Squeezed Philippines Commercial Bank Profits Are Getting Squeezed As to equity valuations, this bourse is not cheap, neither in absolute terms nor relative to the EM equity benchmark - both valuation measures are neutral (Chart I-9). Chart I-9Equity Valuations Are Not Attractive Equity Valuations Are Not Attractive Equity Valuations Are Not Attractive Overall, the outlook for Philippine equities as a whole remains unattractive both in absolute terms, as well as relative to the EM benchmark. Bottom Line: EM equity portfolios should continue underweighting this bourse. We are also initiating a new trade: Going short Philippine real estate stocks in absolute U.S. dollar terms. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Strategy For Central European Markets Our presiding macroeconomic theme for central Europe - which we first elaborated on in a Special Report titled, Central Europe: Beware Of An Inflation Outbreak2 - has been as follows: An accommodative policy stance in the context of strong growth and tight labor markets warrants higher inflation. Our proxy for labor shortages - calculated as the number of job vacancies divided by the number of unemployed looking for a job - is continuing to surge across all central European countries as well as in Germany. This foreshadows higher wage growth ahead (Chart II-1). Chart II-1Tight Labor Markets Means Higher Wage Growth Tight Labor Markets Means Higher Wage Growth Tight Labor Markets Means Higher Wage Growth Furthermore, monetary policy in central European countries remains accommodative - policy rates are negative in real (inflation-adjusted) terms. Consistently, private credit (bank loan) growth and domestic demand remain robust. Today, we appraise and modify our investment strategy across all central European markets in general and Hungary in particular, where a policy shift is in the making. Hungary: Moving Away From Ultra-Accommodative Monetary Policy? Last month, the NBH (National Bank of Hungary) modified its monetary policy statement to include a new paragraph explaining that the council is prepared for the gradual normalization of monetary policy, depending on the outlook for inflation.3 Given our view that inflation in Hungary will continue to rise, the NBH is likely to move away from ultra-accommodative monetary policy sooner rather than later. Besides mounting inflationary pressures, several factors lead us to believe that the NBH is more comfortable normalizing policy today than in the past: First, after seven years of deleveraging, private credit is finally on the rise, and money supply growth is booming (Chart II-2, top and middle panel). Chart II-2Hungary: Easy Monetary Conditions Will Lift Inflation Hungary: Easy Monetary Conditions Will Lift Inflation Hungary: Easy Monetary Conditions Will Lift Inflation Second, capital expenditures are recovering and business confidence is making new highs (Chart II-3, top and middle panel). Furthermore, construction is firing on all cylinders (Chart II-3, bottom panel). Chart II-3Hungary: Capex Is Robust Hungary: Capex Is Robust Hungary: Capex Is Robust Lastly, core consumer inflation is rising and the real deposit rates is at -2%, the lowest in 20 years (Chart II-2, bottom panel). Given the genuine need for rate normalization in Hungary and the central bank's readiness to do so, we are adjusting our strategy: We are taking profits of 72 basis points on our Hungarian yield curve steepening trade that we initiated on June 21, 2017. Hungary's yield curve is already the steepest yield curve in Europe. The slope of the 10/1-year yield curve is 320 basis points in Hungary, versus 200 in Poland, 100 in the Czech Republic and 105 in Germany. We are closing our long PLN / short HUF trade with a 7.7% gain since its initiation on September 28, 2016 (Chart II-4). The cross rate is close to an all-time high and will likely reverse. Chart II-4Book Profits On Long PLN / Short HUF Book Profits On Long PLN / Short HUF Book Profits On Long PLN / Short HUF A new trade: We recommend paying 3-year swap rates in Hungary and receiving 3-year swap rates in the euro area (Chart II-5). Chart II-5A New Trade: Pay Hungarian / Receive Euro Area 3-year Swap Rates A New Trade: Pay Hungarian / Receive Euro Area 3-year Swap Rates A New Trade: Pay Hungarian / Receive Euro Area 3-year Swap Rates First, not only is final domestic demand in Hungary much more robust than in the euro area, but Hungary's output gap is positive while the euro area's is still negative (Chart II-6,top and middle panel). This foreshadows a widening gap in inflation between Hungary and the euro area (Chart II-6, bottom panel). As this transpires, policy rate expectations will rise faster and by more in Hungary than in the euro area. Chart II-6Hungarian Economy Will Overheat Faster Than Euro Area's Hungarian Economy Will Overheat Faster Than Euro Area's Hungarian Economy Will Overheat Faster Than Euro Area's Second, ultra-accommodative monetary policy in Hungary has served its purpose and has generated an overflow of liquidity. In effect, with broad money supply in Hungary now growing considerably faster than in the euro area, the NBH will likely tighten its policy at a faster pace and by more than the ECB (Chart II-7). This warrants a widening 3-year swap rate differential between Hungary and the euro area. Chart II-7Hungary Vs. Euro Area: Money Growth And Swap Rates Hungary Vs. Euro Area: Money Growth And Swap Rates Hungary Vs. Euro Area: Money Growth And Swap Rates Third, as global trade continues to slump, affecting German manufacturing, the European Central Bank will be fast to reiterate its readiness to keep policy accommodative longer than expected. This could push back expectations of the first ECB rate hike. Finally, Italy remains a risk and European banks are exposed to weakening developing countries. With euro area bank share prices plunging close to their 2008 and 2012 lows, the ECB will be both slow and cautious in signaling rate normalization in the immediate future. While Hungary is a very open economy and will feel the pinch from a slowdown in European manufacturing, its currency may depreciate further against the euro as it typically does amid global risk-off periods. A cheap currency will reduce the NBH's worries about the pass-through of a global slowdown and disinflation into its domestic economy. In short, given that both economies have different inflationary backdrops, Hungarian interest rate expectations will increasingly diverge from those of the euro area. As such, fixed-income investors should bet on a rising 3-year swap rate differential between Hungary and the euro area. Our Other Positions In Central European Markets Within the fixed income and currency space: Stay overweight CE3 within EM dedicated fixed-income portfolios. Predicated on our view that the epicenter of the ongoing global growth slowdown is China, emerging Asian and commodity leveraged markets are at much bigger risk than their Central European counterparts. Consistent with this theme, stay short IDR versus PLN. Book profits of 109 basis points on the following trade initiated on July 26, 2017: Pay Czech / receive Polish 10-year swap rates (Chart II-8). In line with our expectations,4 the Czech National Bank has been responding to rising domestic inflationary pressures and has been tightening monetary policy faster than the National Bank of Poland. There now remains little upside in Czech rates relative to Polish ones, so we are booking profits. Chart II-8Book Profits On Pay Czech / Receive Polish 10-year Swap Rates Book Profits On Pay Czech / Receive Polish 10-year Swap Rates Book Profits On Pay Czech / Receive Polish 10-year Swap Rates Stay long CZK against the EUR. Widening growth and inflation gaps between the Czech Republic and the euro area justify higher rates and a stronger currency in the former relative to the latter. Regarding the equity space: Stay long CE3 banks / short euro area banks. CE3 banks are less leveraged and have a higher return on assets than euro area banks. Continue overweighting CE3 within EM dedicated equity portfolios. CE3 stocks have staged a double bottom relative to their emerging market peers, both in common and local currency terms (Chart II-9). Given emerging markets are saddled with credit excesses, unresolved economic imbalances and looming currency weakness, central Europe is likely to continue outperforming. Chart II-9CE3 Equities Will Outperform EM CE3 Equities Will Outperform EM CE3 Equities Will Outperform EM A summary of all our trades and asset allocations can be found on page 14 and 15. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please see Emerging Markets Strategy/Geopolitical Strategy Special Report, "The Philippines: Duterte's Money Illusion," dated April 25, 2018, available at ems.bcaresearch.com 2 Please see Emerging Markets Strategy Special Report "Central Europe: Beware Of An Inflation Outbreak," dated June 21, 2017, available at ems.bcaresearch.com. 3 http://www.mnb.hu/en/monetary-policy/the-monetary-council/press-releases/2018/press-release-on-the-monetary-council-meeting-of-18-september-2018 4 Please see Emerging Markets Strategy Weekly Report "Follow The Money, Not The Crowd," dated July 26, 2017, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Our presiding macroeconomic theme for central Europe - which we first elaborated on in a Special Report titled, Central Europe: Beware Of An Inflation Outbreak1 - has been as follows: An accommodative policy stance in the context of strong growth and tight labor markets warrants higher inflation. Our proxy for labor shortages - calculated as the number of job vacancies divided by the number of unemployed looking for a job - is continuing to surge across all central European countries as well as in Germany. This foreshadows higher wage growth ahead (Chart II-1). Tight Labor Markets Means Higher Wage Growth Tight Labor Markets Means Higher Wage Growth Furthermore, monetary policy in central European countries remains accommodative - policy rates are negative in real (inflation-adjusted) terms. Consistently, private credit (bank loan) growth and domestic demand remain robust. Today, we appraise and modify our investment strategy across all central European markets in general and Hungary in particular, where a policy shift is in the making. Hungary: Moving Away From Ultra-Accommodative Monetary Policy? Last month, the NBH (National Bank of Hungary) modified its monetary policy statement to include a new paragraph explaining that the council is prepared for the gradual normalization of monetary policy, depending on the outlook for inflation.2 Given our view that inflation in Hungary will continue to rise, the NBH is likely to move away from ultra-accommodative monetary policy sooner rather than later. Besides mounting inflationary pressures, several factors lead us to believe that the NBH is more comfortable normalizing policy today than in the past: First, after seven years of deleveraging, private credit is finally on the rise, and money supply growth is booming (Chart II-2, top and middle panel). Hungary: Easy Monetary Conditions Will Lift Inflation Hungary: Easy Monetary Conditions Will Lift Inflation Second, capital expenditures are recovering and business confidence is making new highs (Chart II-3, top and middle panel). Furthermore, construction is firing on all cylinders (Chart II-3, bottom panel). Hungary: Capex Is Robust Hungary: Capex Is Robust Lastly, core consumer inflation is rising and the real deposit rates is at -2%, the lowest in 20 years (Chart II-2, bottom panel). Given the genuine need for rate normalization in Hungary and the central bank's readiness to do so, we are adjusting our strategy: We are taking profits of 72 basis points on our Hungarian yield curve steepening trade that we initiated on June 21, 2017. Hungary's yield curve is already the steepest yield curve in Europe. The slope of the 10/1-year yield curve is 320 basis points in Hungary, versus 200 in Poland, 100 in the Czech Republic and 105 in Germany. We are closing our long PLN / short HUF trade with a 7.7% gain since its initiation on September 28, 2016 (Chart II-4). The cross rate is close to an all-time high and will likely reverse. Book Profits On Long PLN / Short HUF Book Profits On Long PLN / Short HUF A new trade: We recommend paying 3-year swap rates in Hungary and receiving 3-year swap rates in the euro area (Chart II-5). A New Trade: Pay Hungarian / Receive Euro Area 3-year Swap Rates A New Trade: Pay Hungarian / Receive Euro Area 3-year Swap Rates First, not only is final domestic demand in Hungary much more robust than in the euro area, but Hungary's output gap is positive while the euro area's is still negative (Chart II-6,top and middle panel). This foreshadows a widening gap in inflation between Hungary and the euro area (Chart II-6, bottom panel). As this transpires, policy rate expectations will rise faster and by more in Hungary than in the euro area. Hungarian Economy Will Overheat Faster Than Euro Area's Hungarian Economy Will Overheat Faster Than Euro Area's Second, ultra-accommodative monetary policy in Hungary has served its purpose and has generated an overflow of liquidity. In effect, with broad money supply in Hungary now growing considerably faster than in the euro area, the NBH will likely tighten its policy at a faster pace and by more than the ECB (Chart II-7). This warrants a widening 3-year swap rate differential between Hungary and the euro area. Hungary Vs. Euro Area: Money Growth And Swap Rates Hungary Vs. Euro Area: Money Growth And Swap Rates Third, as global trade continues to slump, affecting German manufacturing, the European Central Bank will be fast to reiterate its readiness to keep policy accommodative longer than expected. This could push back expectations of the first ECB rate hike. Finally, Italy remains a risk and European banks are exposed to weakening developing countries. With euro area bank share prices plunging close to their 2008 and 2012 lows, the ECB will be both slow and cautious in signaling rate normalization in the immediate future. While Hungary is a very open economy and will feel the pinch from a slowdown in European manufacturing, its currency may depreciate further against the euro as it typically does amid global risk-off periods. A cheap currency will reduce the NBH's worries about the pass-through of a global slowdown and disinflation into its domestic economy. In short, given that both economies have different inflationary backdrops, Hungarian interest rate expectations will increasingly diverge from those of the euro area. As such, fixed-income investors should bet on a rising 3-year swap rate differential between Hungary and the euro area. Our Other Positions In Central European Markets Within the fixed income and currency space: Stay overweight CE3 within EM dedicated fixed-income portfolios. Predicated on our view that the epicenter of the ongoing global growth slowdown is China, emerging Asian and commodity leveraged markets are at much bigger risk than their Central European counterparts. Consistent with this theme, stay short IDR versus PLN. Book profits of 109 basis points on the following trade initiated on July 26, 2017: Pay Czech / receive Polish 10-year swap rates (Chart II-8). In line with our expectations,3 the Czech National Bank has been responding to rising domestic inflationary pressures and has been tightening monetary policy faster than the National Bank of Poland. There now remains little upside in Czech rates relative to Polish ones, so we are booking profits. Book Profits On Pay Czech / Receive Polish 10-year Swap Rates Book Profits On Pay Czech / Receive Polish 10-year Swap Rates Stay long CZK against the EUR. Widening growth and inflation gaps between the Czech Republic and the euro area justify higher rates and a stronger currency in the former relative to the latter. Regarding the equity space: Stay long CE3 banks / short euro area banks. CE3 banks are less leveraged and have a higher return on assets than euro area banks. Continue overweighting CE3 within EM dedicated equity portfolios. CE3 stocks have staged a double bottom relative to their emerging market peers, both in common and local currency terms (Chart II-9). Given emerging markets are saddled with credit excesses, unresolved economic imbalances and looming currency weakness, central Europe is likely to continue outperforming. CE3 Equities Will Outperform EM CE3 Equities Will Outperform EM A summary of all our trades and asset allocations can be found on page 14 and 15. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com     1 Please see Emerging Markets Strategy Special Report "Central Europe: Beware Of An Inflation Outbreak," dated June 21, 2017, available at ems.bcaresearch.com. 2http://www.mnb.hu/en/monetary-policy/the-monetary-council/press-releases/2018/press-release-on-the-monetary-council-meeting-of-18-september-2018 3 Please see Emerging Markets Strategy Weekly Report "Follow The Money, Not The Crowd," dated July 26, 2017, available at ems.bcaresearch.com

Our presiding macroeconomic theme for central Europe - which we first elaborated on in a Special Report titled, Central Europe: Beware Of An Inflation Outbreak2 - has been as follows: An accommodative policy stance in the context of strong growth and tight labor markets warrants higher inflation. Tight Labor Markets Means Higher Wage Growth Tight Labor Markets Means Higher Wage Growth Our proxy for labor shortages - calculated as the number of job vacancies divided by the number of unemployed looking for a job - is continuing to surge across all central European countries as well as in Germany. This foreshadows higher wage growth ahead (Chart II-1). Furthermore, monetary policy in central European countries remains accommodative - policy rates are negative in real (inflation-adjusted) terms. Consistently, private credit (bank loan) growth and domestic demand remain robust. Today, we appraise and modify our investment strategy across all central European markets in general and Hungary in particular, where a policy shift is in the making. Hungary: Moving Away From Ultra-Accommodative Monetary Policy? Last month, the NBH (National Bank of Hungary) modified its monetary policy statement to include a new paragraph explaining that the council is prepared for the gradual normalization of monetary policy, depending on the outlook for inflation.3 Given our view that inflation in Hungary will continue to rise, the NBH is likely to move away from ultra-accommodative monetary policy sooner rather than later. Besides mounting inflationary pressures, several factors lead us to believe that the NBH is more comfortable normalizing policy today than in the past: First, after seven years of deleveraging, private credit is finally on the rise, and money supply growth is booming (Chart II-2, top and middle panel). Second, capital expenditures are recovering and business confidence is making new highs (Chart II-3, top and middle panel). Furthermore, construction is firing on all cylinders (Chart II-3, bottom panel). Hungary: Easy Monetary Conditions Will Lift Inflation Hungary: Easy Monetary Conditions Will Lift Inflation Hungary: Capex Is Robust Hungary: Capex Is Robust   Lastly, core consumer inflation is rising and the real deposit rates is at -2%, the lowest in 20 years (Chart II-2, bottom panel). Given the genuine need for rate normalization in Hungary and the central bank's readiness to do so, we are adjusting our strategy: We are taking profits of 72 basis points on our Hungarian yield curve steepening trade that we initiated on June 21, 2017. Hungary's yield curve is already the steepest yield curve in Europe. The slope of the 10/1-year yield curve is 320 basis points in Hungary, versus 200 in Poland, 100 in the Czech Republic and 105 in Germany. We are closing our long PLN / short HUF trade with a 7.7% gain since its initiation on September 28, 2016 (Chart II-4). The cross rate is close to an all-time high and will likely reverse. A new trade: We recommend paying 3-year swap rates in Hungary and receiving 3-year swap rates in the euro area (Chart II-5). Book Profits On Long PLN / Short HUF Book Profits On Long PLN / Short HUF A New Trade: Pay Hungarian / Receive Euro Area 3-year Swap Rates A New Trade: Pay Hungarian / Receive Euro Area 3-year Swap Rates   First, not only is final domestic demand in Hungary much more robust than in the euro area, but Hungary's output gap is positive while the euro area's is still negative (Chart II-6, top and middle panel). This foreshadows a widening gap in inflation between Hungary and the euro area (Chart II-6, bottom panel). As this transpires, policy rate expectations will rise faster and by more in Hungary than in the euro area. Second, ultra-accommodative monetary policy in Hungary has served its purpose and has generated an overflow of liquidity. In effect, with broad money supply in Hungary now growing considerably faster than in the euro area, the NBH will likely tighten its policy at a faster pace and by more than the ECB (Chart II-7). This warrants a widening 3-year swap rate differential between Hungary and the euro area. Hungarian Economy Will Overheat Faster Than Euro Area's Hungarian Economy Will Overheat Faster Than Euro Area's Hungary Vs. Euro Area: Money Growth And Swap Rates Hungary Vs. Euro Area: Money Growth And Swap Rates Third, as global trade continues to slump, affecting German manufacturing, the European Central Bank will be fast to reiterate its readiness to keep policy accommodative longer than expected. This could push back expectations of the first ECB rate hike. Finally, Italy remains a risk and European banks are exposed to weakening developing countries. With euro area bank share prices plunging close to their 2008 and 2012 lows, the ECB will be both slow and cautious in signaling rate normalization in the immediate future. While Hungary is a very open economy and will feel the pinch from a slowdown in European manufacturing, its currency may depreciate further against the euro as it typically does amid global risk-off periods. A cheap currency will reduce the NBH's worries about the pass-through of a global slowdown and disinflation into its domestic economy. In short, given that both economies have different inflationary backdrops, Hungarian interest rate expectations will increasingly diverge from those of the euro area. As such, fixed-income investors should bet on a rising 3-year swap rate differential between Hungary and the euro area. Our Other Positions In Central European Markets Within the fixed income and currency space: Stay overweight CE3 within EM dedicated fixed-income portfolios. Predicated on our view that the epicenter of the ongoing global growth slowdown is China, emerging Asian and commodity leveraged markets are at much bigger risk than their Central European counterparts. Consistent with this theme, stay short IDR versus PLN. Book profits of 109 basis points on the following trade initiated on July 26, 2017: Pay Czech / receive Polish 10-year swap rates (Chart II-8). In line with our expectations,4 the Czech National Bank has been responding to rising domestic inflationary pressures and has been tightening monetary policy faster than the National Bank of Poland. There now remains little upside in Czech rates relative to Polish ones, so we are booking profits. Stay long CZK against the EUR. Widening growth and inflation gaps between the Czech Republic and the euro area justify higher rates and a stronger currency in the former relative to the latter. Regarding the equity space: Stay long CE3 banks / short euro area banks. CE3 banks are less leveraged and have a higher return on assets than euro area banks. Continue overweighting CE3 within EM dedicated equity portfolios. CE3 stocks have staged a double bottom relative to their emerging market peers, both in common and local currency terms (Chart II-9). Given emerging markets are saddled with credit excesses, unresolved economic imbalances and looming currency weakness, central Europe is likely to continue outperforming. Book Profits On Pay Czech / Receive Polish 10-year Swap Rates Book Profits On Pay Czech / Receive Polish 10-year Swap Rates CE3 Equities Will Outperform EM CE3 Equities Will Outperform EM   A summary of all our trades and asset allocations can be found on page 14 and 15. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Footnotes 2 Please see Emerging Markets Strategy Special Report "Central Europe: Beware Of An Inflation Outbreak," dated June 21, 2017, available at ems.bcaresearch.com. 3http://www.mnb.hu/en/monetary-policy/the-monetary-council/press-releases/2018/press-release-on-the-monetary-council-meeting-of-18-september-2018 4 Please see Emerging Markets Strategy Weekly Report "Follow The Money, Not The Crowd," dated July 26, 2017, available at ems.bcaresearch.com  

We published a Special Alert report titled Turkey: Book Profits On Shorts yesterday. The link is available on page 18. This report is Part 2 of an overview of the cyclical profiles of emerging market (EM) economies. This all-in-charts presentation illustrates the business cycle conditions of various developing economies. 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 were covered in Part 1, published last week (the link to it is available on page 18). Chart I-1 bca.ems_wr_2018_08_16_s1_c1 bca.ems_wr_2018_08_16_s1_c1 Malaysia: Keep Underweight For Now As... Malaysia: Keep Underweight For Now As... CHART 2 CHART 2 Malaysia: Keep Underweight For Now As... CHART 3 CHART 3 Malaysia: Keep Underweight For Now As... CHART 4 CHART 4 ...Bank Shares Have Significant Downside ...Bank Shares Have Significant Downside CHART 5 CHART 5 ...Bank Shares Have Significant Downside CHART 6 CHART 6 ...Bank Shares Have Significant Downside CHART 7 CHART 7 Indonesia: Underweight Equities & Bonds Indonesia: Underweight Equities & Bonds CHART 8 CHART 8 Indonesia: Underweight Equities & Bonds CHART 9 CHART 9 Indonesia: Underweight Equities & Bonds CHART 10 CHART 10 Indonesia: Underweight Equities & Bonds CHART 11 CHART 11 Indonesia: The Sell-Off Is Not Over Yet Indonesia: The Sell-Off Is Not Over Yet As Banks' NPL Provisions Rise, Bank Stocks Could Fall CHART 12 As Banks' NPL Provisions Rise, Bank Stocks Could Fall CHART 12 Indonesia: The Sell-Off Is Not Over Yet CHART 14 CHART 14 Indonesia: The Sell-Off Is Not Over Yet CHART 16 CHART 16 Indonesia: The Sell-Off Is Not Over Yet CHART 13 CHART 13 Thailand: Stay Overweight Thailand: Stay Overweight CHART 19 CHART 19 Thailand: Stay Overweight CHART 17 CHART 17 Thailand: Stay Overweight CHART 20 CHART 20 Thailand: Better Positioned To Weather The EM Storm Thailand: Better Positioned ##br##To Weather The EM Storm CHART 15 CHART 15 Thailand: Better Positioned ##br##To Weather The EM Storm CHART 21 CHART 21 Thailand: Better Positioned ##br##To Weather The EM Storm CHART 18 CHART 18 Thailand: Better Positioned ##br##To Weather The EM Storm CHART 22 CHART 22 Philippines: Inflation Breakout Philippines: Inflation Breakout CHART 28 CHART 28 Philippines: Inflation Breakout CHART 27 CHART 27 Philippines: Inflation Breakout CHART 26 CHART 26 Philippines: Neutral On Equities Due To Oversold Conditions Philippines: Neutral On Equities ##br##Due To Oversold Conditions CHART 25 CHART 25 Philippines: Neutral On Equities ##br##Due To Oversold Conditions CHART 24 CHART 24 Philippines: Neutral On Equities ##br##Due To Oversold Conditions CHART 23 CHART 23 Central Europe: Labor Shortages & Wage Inflation Central Europe: Labor Shortages & Wage Inflation CHART 29 CHART 29 Central Europe: Labor Shortages & Wage Inflation CHART 30 CHART 30 Central Europe: Robust Growth - Overweight Central Europe: Robust Growth - Overweight CHART 31 CHART 31 Central Europe: Robust Growth - Overweight CHART 32 CHART 32 Central Europe: Robust Growth - Overweight CHART 33 CHART 33 Chile: Robust Growth - Overweight Equities Chile: Robust Growth - Overweight Equities CHART 34 CHART 34 Chile: Robust Growth - Overweight Equities CHART 35 CHART 35 Chile: No Inflationary Pressures Chile: No Inflationary Pressures CHART 36 CHART 36 Chile: No Inflationary Pressures CHART 37 CHART 37 Chile: No Inflationary Pressures CHART 38 CHART 38 Chile: No Inflationary Pressures CHART 39 CHART 39 Colombia: Currency Will Be A Release Valve Colombia: Currency Will Be A Release Valve CHART 40 CHART 40 Colombia: Currency Will Be A Release Valve CHART 41 CHART 41 Colombia: Currency Will Be A Release Valve CHART 42 CHART 42 Colombia: Currency Will Be A Release Valve CHART 43 CHART 43 Colombia: Credit Growth Remains A Headwind For Economy - Neutral Colombia: Credit Growth Remains ##br##A Headwind For Economy - Neutral CHART 44 CHART 44 Colombia: Credit Growth Remains ##br##A Headwind For Economy - Neutral CHART 45 CHART 45 Colombia: Credit Growth Remains ##br##A Headwind For Economy - Neutral bca.ems_wr_2018_08_16_s1_c46 bca.ems_wr_2018_08_16_s1_c46 Peru: Vulnerable To External Developments Peru: Vulnerable To External Developments CHART 47 CHART 47 Peru: Vulnerable To External Developments CHART 48 CHART 48 Peru: Vulnerable To External Developments CHART 49 CHART 49 Peru: Vulnerable To External Developments CHART 50 CHART 50 Peruvian Equities - Underweight Peruvian Equities - Underweight CHART 51 CHART 51 Peruvian Equities - Underweight CHART 52 CHART 52 Peruvian Equities - Underweight CHART 53 CHART 53

Highlights Stay tactically long the SEK. Our preferred expression is long SEK/GBP. Stay tactically short the NOK. Our preferred expression is long AUD/NOK. Take profits in the underweight to Poland... ...and open a tactical countertrend position: long Poland's Warsaw General Index, short Italy's MIB. A coalition of populists governing Italy might ruffle some feathers in Brussels, but the main risk appears to be contained. Both The League and 5 Star Movement have dropped calls for a referendum on Italy's membership of the monetary union. Feature Italy And The U.K. Compete For Political Risk The European political lens is once again focussed on Italy as the two anti-establishment parties - The League and 5 Star Movement - negotiate to form a government. A coalition of populists governing Italy might ruffle some feathers in Brussels, but the main risk appears to be contained. Both parties have dropped calls for a referendum on Italy's membership of the monetary union, and have instead turned their fire on the EU's fiscal rules, specifically the 3 per cent limit on budget deficits. Chart of the WeekThe SEK Is Due A Tactical Rebound The SEK Is Due A Tactical Rebound The SEK Is Due A Tactical Rebound The populist demand for some fiscal relaxation is actually smart economics. When the private sector is paying down debt - as it is in Italy - private sector demand shrinks. To prevent a recession, the government must step in to borrow and spend the paid-down debt. And what seems to be fiscal largesse does not lead to crowding out, inflation, or surging interest rates. This means that as long as Italian populists correctly push back on the EU's draconian fiscal rules rather than the monetary union per se, the market is right to regard Italian politics as a drama, rather than an existential risk to the euro (Chart I-2). Chart I-2The Market Remains Unconcerned ##br##About Euro Break-Up Risk The Market Remains Unconcerned About Euro Break-Up Risk The Market Remains Unconcerned About Euro Break-Up Risk Maybe the European political lens should be focussed instead on Britain. The Conservative party remains as bitterly divided as ever on its vision for the U.K.'s future trading and customs relationships with the EU and the rest of the world. Paralysed and frightened by this division, Theresa May is delaying the legislative passage of three crucial bills - the EU Withdrawal Bill, the Trade Bill, and the Customs Bill. When these bills eventually reach a vote in the House of Commons later this year, any one of them could result in a humiliating defeat for May - and, quite likely, resignations from the government. Meanwhile, as the government kicks the issue into the long grass, firms are holding fire on long-term spending commitments in the U.K. and rechannelling the investment to elsewhere in Europe. Buy SEKs, Avoid NOKs For all the recent swings in the euro versus the dollar and pound, the trade-weighted euro has remained a paragon of relative stability (Chart I-3). This is because the moves versus the dollar and pound have largely cancelled out (Chart I-4). Earlier this year, euro weakness versus the pound coincided with strength versus the dollar; more recently, euro weakness versus the dollar has coincided with strength versus the pound. Chart I-3The Trade-Weighted Euro Has ##br##Remained Relatively Stable... The Trade-Weighted Euro Has Remained Relatively Stable... The Trade-Weighted Euro Has Remained Relatively Stable... Chart I-4...Because Moves Versus The Dollar And The ##br##Pound Have Largely Cancelled Out ...Because Moves Versus The Dollar And The Pound Have Largely Cancelled Out ...Because Moves Versus The Dollar And The Pound Have Largely Cancelled Out Interestingly, the driver of the trade-weighted euro remains the same as it has been for the past fifteen years - it is simply the euro area's long bond yield shortfall versus the U.K. and U.S. (Chart I-5). With the ECB already at the realistic limit of ultra-loose policy, the path for policy rate expectations cannot go meaningfully lower. This means that the trade-weighted euro has some long-term support given that the BoE and/or the Fed have tightening expectations that could be priced out, while the ECB effectively doesn't. Chart I-5The Trade Weighted Euro Is A Function Of The Euro Area's ##br##Long Bond Yield Shortfall Versus The U.K. And U.S. The Trade Weighted Euro Is A Function Of The Euro Area's Long Bond Yield Shortfall Versus The U.K. And U.S. The Trade Weighted Euro Is A Function Of The Euro Area's Long Bond Yield Shortfall Versus The U.K. And U.S. Put another way, for the trade-weighted euro to drift significantly lower, relative surprises in the economic, financial and political news have to be significantly worse in the euro area than in both the U.K. and the U.S. We think this configuration is unlikely. Nevertheless, the more interesting tactical opportunities lie elsewhere: the Swedish krona and the Norwegian krone. Recent tweaks to monetary policy frameworks in Sweden and Norway are responsible, at least partly, for technically exaggerated moves in their currencies which are likely to reverse. In the case of Sweden, the inflation target is unchanged at 2 per cent but the Riksbank introduced a variation band of 1-3 per cent, because "monetary policy is not able to steer inflation in detail." Given that Sweden's inflation rate is now close to 2 per cent, the market interpreted this tweak as very dovish - because it permits the continuation of ultra-accommodative policy. The upshot was that the SEK sold off. But our tried and tested indicator of excessive groupthink suggests that the currency may have overreacted (Chart of the Week). Hence, the tactical opportunity is to stay long the SEK, and our preferred expression is long SEK/GBP. In the case of Norway, a Royal Decree on Monetary Policy lowered the Norges Bank inflation target from 2.5 to 2.0 per cent. This followed years of failure to achieve the higher target. The market interpreted this change as hawkish, as it created the scope for tighter - or at least, less loose - policy than was previously expected. The upshot was that the NOK rallied. But again, the market reaction shows evidence of a technical overreaction (Chart I-6). Hence, the tactical opportunity is to stay short the NOK, and our preferred expression is long AUD/NOK. Chart I-6Our Preferred Expression Of Short NOK Is Versus The AUD Our Preferred Expression Of Short NOK Is Versus The AUD Our Preferred Expression Of Short NOK Is Versus The AUD Financial Markets Are Not Complicated, But They Are Complex The words 'complicated' and 'complex' appear to be interchangeable, but their meanings are quite distinct. The distinction is important because financial markets are not complicated, but they are complex. Something that is complicated is the sum of a large number of separate parts or processes. For example, making a car is complicated. But predicting the performance of financial markets over the medium term - say, a year or longer - is uncomplicated. The philosophy of Investment Reductionism teaches us that investment strategy is not made up of many separate parts or processes. It reduces to just three things: Predicting the evolution of the global economy. Predicting central bank reaction functions. Predicting tail-events: political, economic and financial. For example, this week's lesson in Investment Reductionism is to illustrate that the medium term decision to allocate between emerging market equities and the Eurostoxx600 largely reduces to the prospects for global metal prices (Chart I-7). Chart I-7EM Versus Eurostoxx600 = Metal Prices EM Versus Eurostoxx600 = Metal Prices EM Versus Eurostoxx600 = Metal Prices By contrast, something that is complex is not the sum of its parts, because the parts interact in unpredictable ways. Complexity characterizes the behaviour of financial markets over the short term - say, up to around six months. Therefore, the best way to model the behaviour of any investment over the very short term is to think of it as a complex adaptive system. A complex adaptive system is a system with a large number of mutually interacting agents, which can learn from their interactions and thereby adapt their subsequent behaviour. Examples include traffic flows, crowds in stadiums, and of course financial markets. A crucial property of all such systems is they possess an endogenous tipping point of instability, at which the behaviour undergoes a 'phase-shift'. This is the essence of how we identify likely short-term trend reversals in any investment such as the SEK and the NOK. This week's final trade recommendation uses this idea once again. Poland's equity market has underperformed recently in line with the general underperformance of the emerging market basket - and our underweight in the Warsaw General Index versus the Eurostoxx600 is handsomely in profit. However, looking at the market as a complex adaptive system, the extent of Poland's underperformance is overdone (Chart I-8). Chart I-8The Extent Of Poland's Underperformance Is Overdone The Extent Of Poland's Underperformance Is Overdone The Extent Of Poland's Underperformance Is Overdone Hence we are taking profit on our underweight in Poland and putting on a short-term countertrend position: long Poland's Warsaw General Index, short Italy's MIB. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* As discussed in the main body of the report, this week's new trade recommendation is a pair-trade: long Poland's Warsaw General Index, short Italy's MIB. The profit target is 5% with a symmetrical stop loss. Our preferred expression of long SEK is versus the GBP which is already in profit since initiation. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 Long SEK Long SEK The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations