China

Dear Client, This Special Report is the full transcript and slides of a keynote presentation I recently gave to the Sovereign Investor Institute in London titled: 'The Biggest Risks To The Global Economy Are…' The short presentation pulls together several concepts and observations which identify the ‘weak links’ in the global economy. Therefore, the presentation should serve as a useful summary of the global economy’s current vulnerabilities. The report then explains how each of the risks translates into a European investment context. I hope you find it insightful. Best regards, Dhaval Joshi, Chief European Investment Strategist Image Feature Full Transcript And Slides Image Good morning Thank you for inviting me to give today’s keynote presentation under the title: ‘The Biggest Risks To The Global Economy Are…’ (Slide 1). I will not discuss all the risks out there, but the four risks that I will present are the ones that I think are the most significant. And the biggest of these four risks I will leave to the end. So let’s begin. Risk 1 is China’s Credit Cycle (Slide 2). You can see this very clearly in this slide (Slide 3) which shows the short-term accelerations and decelerations in credit within the world’s three largest economies – Europe, the United States, and China. In essence, it is showing how much new credit was created in the last six months compared with the preceding six months. Was it more credit creation or was it less, and how much more or less? Everything is in dollars to allow a fair comparison. Image Image Now look at the red line. The red line is China. Just ten years ago, China’s credit cycle was irrelevant. It simply didn’t matter. But after the GFC, China’s short-term credit expansions and contractions suddenly became as large as those in Europe and the U.S. More recently, China’s cycle is dwarfing the others, so now it is the European and the U.S. credit cycles that are irrelevant! This means that whenever China’s short-term credit cycle turns down, as it did in late 2015, early 2017, and 2018, the global economy feels a chill. The point is that this short-term cycle is a near-perfect oscillator. Down-oscillations will occur every eighteen months or so, and any of them has the potential to turn nasty. Though we are currently in an up-oscillation, the next down-oscillation is due later this year. And I predict that it will pose a big risk to the global economy. Risk 2 is Trade Imbalances (Slide 4). This slide (Slide 5) has a mischievous title ‘Where President Trump Is Right About Europe’. The red line shows where the president is absolutely right: Europe is running a massive – a record-high – trade surplus with the United States. It is an undeniable fact. But the president is wrong about the underlying cause. The underlying cause is not unfair trade practices or tariffs, the underlying cause is the other line, the blue line, which shows the divergent monetary policies of the ECB and the Fed. Image Image The trade imbalance and monetary policy divergence are moving together tick for tick, and the transmission mechanism is of course the exchange rate. The divergent monetary policies have depressed the euro, and a depressed euro obviously makes German cars cheaper for American consumers. That is the reason that the president is seeing so many BMWs driving down Fifth Avenue! My point is that these record-high imbalances are being used to justify economic nationalism – retaliatory tariffs, restricted trade, and potentially all-out trade wars. Alternatively, this chart suggests that the imbalances would correct with large-scale movements of exchange rates. But to me, either of these options poses a big risk to the global economy. Risk 3 Is Technological Disruption (Slide 6). To understand why, I want to introduce you to a concept known as Moravec’s Paradox (Slide 7). A professor of robotics, Hans Moravec, noticed something odd. He realized that things that we find very hard are actually very easy for AI. Things like complex mathematics, speaking multiple languages, or advance pattern recognition. Typically, as few people have these skills, they are well-paid skills. Image Image Whereas things that we find very easy are incredibly difficult for AI. Things like human movement and recognizing, and responding to, emotional signals. Typically, as everybody has these skills, they are low-paid skills.  Moravec’s Paradox means that the current wave of technological progress is much more disruptive than previous waves. The steam engine destroyed low-paid jobs, forcing workers up the income ladder. But the current wave of technology, led by AI, is destroying well-paid jobs forcing workers down the income ladder. Image You can see it in the data. While job creation in most major economies is on the face of it very strong, just look at what type of jobs are being created (Slide 8). Food delivery, bar work, care work and social work. Now you’ll agree that this is not highly paid work with career prospects!  In essence, the current wave of technology is revealing a huge misallocation of capital. You might have invested huge amounts of time and money in say, becoming a linguist. Only to find that AI can translate languages much better than you – and your employment opportunities are limited to lower-income work. Well that misallocation of capital is very disruptive.  In my opinion, it’s one of the main reasons why even though economies are growing and unemployment is very low, people don’t feel good. Making them susceptible to simplistic fixes such as ‘take back control’ and economic nationalism. My point is that the current wave of AI-led job disruption has much further to run, and the populist backlash will remain a big risk to the global economy. But now I want to turn to what I believe is the biggest risk of all. Risk 4 Is Higher Bond Yields (Slide 9). Most people believe that economic downturns cause financial market downturns. But the truth is the complete opposite: the causality almost always runs the other way! In the vast majority of cases, it is financial market imbalances and mispricing that cause economic downturns and crises. Take the last three economic downturns – in 2001, in 2008 and in 2011. They all had their roots in financial mispricing – the dot com bubble, the U.S. mortgage market, and euro area sovereign debt. Likewise for the Great Depression in the 30s, Japan’s recession in the early 90s. I could go on. You get the point… What is the financial vulnerability today that could cause an economic downturn? (Slide 10) The answer is that the very rich valuation of equities and other risk-assets is highly sensitive to bond yields. Which means that substantially higher bond yields pose a very big risk to the global economy. Image Image You see, at very low bond yields, the bond price can no longer go up much but it can go down massively (Slide 11). The latest advances in financial theory now conclusively show that this unattractive ‘negative’ asymmetry is what defines ‘risk’ for investors. The crucial point is that at low bond yields, bonds become as risky, or more risky, than equities (Slide 12). And this necessarily means that equities no longer need to deliver a superior return, a risk-premium, over the low bond yield (Slide 13). As bond yields decline this means equity valuations get an exponential boost because both components of the equity’s required return – the risk-free component and the risk-premium component – are collapsing simultaneously (Slide 14). Image Image Image Image But if bond yields rise substantially, the process would go into vicious reverse and equity valuations would fall off a cliff. Other risk-assets too, and bear in mind that if we include real estate – as we should – global risk-assets are worth $400 trillion, five times the size of the global economy!   Our research shows that the point of vulnerability is if the global 10-year bond yield approaches 2 percent, which is about 50 basis points above where it stands right now. And that, to me, is by far the biggest risk to the global economy. Image So to summarise, the biggest risks to the global economy are: China’s credit cycle; trade imbalances and technological disruption and their associated populist backlash; and the biggest risk is higher bond yields (Slide 15). In the near future I think alarm bells should start to ring if China’s credit cycle has tipped into a down-oscillation and/or the global 10-year bond yield is 50 bps higher. Don’t worry, the alarm bells are not ringing right now but they might be later this year. Finally, given the title you gave me, this presentation has necessarily focussed on the key risks. But I don’t want you to get too negative. I also have another presentation called ‘The Biggest Positives For The Global Economy Are…’ And for balance, I hope you invite me to present that next time! Thank you. How Do The Risks Translate Into A European Investment Context? Risk 1: China’s Credit Cycle, is highly relevant to European investors, for two reasons. First, the European economy is very open, meaning that exports make a substantial contribution to GDP growth. This is especially true in Europe’s engine economy, Germany, but it is also important for other major economies like Sweden. And it is evidenced in large trade surpluses as, for example, illustrated in Slide 5. Therefore, whenever China’s credit cycle enters a down-oscillation, as it did last year, Germany cannot escape the nasty chill coming through its all-important net export channel. Second, the European equity market is over-exposed to global growth sensitive sectors and companies – specifically, Industrials, Materials, and Financials. These sectors tend to have a very high operational gearing to global growth. Meaning that a small change in global growth has a disproportionate effect on these companies’ profits and share price performance. The upshot is that in a credit cycle up-oscillation, Europe’s global-growth sensitive stock markets and sectors benefit from a sharp burst of outperformance. The opposite applies in a credit cycle down-oscillation. It follows that if China’s credit cycle is due to tip into a down-oscillation later this year, it would be time to close our successful relative overweighting to European equities and to the global growth sensitive cyclical sectors. Risk 2: Trade Imbalances, is also highly relevant to European investors, for the obvious reason that European economies – especially Germany – are running huge trade surpluses. This puts these economies squarely in the cross-hairs of a retaliatory salvo involving tariffs, trade barriers, or worse, an all-out trade war. Clearly, Europe’s ‘exporting champions’ are the most vulnerable to this risk. The issue is important for the exchange rate too. We showed conclusively that Europe’s trade imbalance is the consequence of the depressed euro. It follows that another way to correct this imbalance is via a stronger euro. In this sense, the fundamentals imply euro upside from here. Risk 3: Technological Disruption, manifests through disruption in the jobs market, the lack of feel good, and the ensuing backlash leading to populism and nationalism. This is particularly relevant to Europe because its collection of nations, each with its own political processes, provides more scope for a political tail-event. A lull in the major political-event cycle is a good thing for Europe. In this regard, the upcoming EU parliamentary elections is not a big risk given the EU parliament’s inability, by itself, to drive policy. The risk increases approaching a meaningful political event, and this includes the date of Brexit. Therefore, this risk is likely to rise somewhat towards the end of the year. Risk 4: Higher Bond Yields, is clearly very relevant to Europe because many of the core euro area bond yields are at their lower bound. This means that the negative asymmetry of returns has its maximum impact on, for example, German bunds. It follows that German bunds are a sell in the near-term. Nevertheless, the upside to yields is ultimately limited given the aforementioned vulnerability of risk-asset valuations to higher bond yields. Therefore, the better long-term strategy is to short German bunds relative to U.S. T-bonds. Finally, a 50 basis points rise in 10-year yields from current levels would be a trigger to flip to underweight European equities.  Fractal Trading System* Crude oil is at a technical reversal level. The best way to play this is on a hedged basis versus metals: short WTI, long LMEX. Set the profit target at 5 percent with a symmetrical stop-loss. In other trades, we are pleased to report long AUD/CNY achieved its profit target at which it was closed. This leaves five open positions. 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. Short WTI / Long LMEX Short WTI / Long LMEX 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 Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart I-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations   Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights BCA’s China Investment Strategy team recommended that investors upgrade Chinese stocks to overweight (both investable and domestic) in a Special Alert last week. Investors had a legitimate macro fundamental basis to go overweight Chinese stocks as of February 15, but we hesitated to shift our stance due to several still-present risks and out of concern that the sheer magnitude of the spike in credit could cause a regulatory response that would constrain credit growth in future months. The March credit data has confirmed that Chinese policymakers have chosen to prioritize growth for now, but we are unconvinced that a shift back to controlling leverage is out of the question over the coming year. Investors should continue to monitor this and several other risks noted below. Despite having already rallied significantly this year, Chinese investable and domestic stocks have the potential to earn double-digit relative returns (12-15%) in an optimistic scenario in US$ terms versus global stocks over the coming year. Conservatively, we expect high single-digit relative returns (6-8%). Feature BCA’s China Investment Strategy team recommended that investors upgrade Chinese stocks to overweight (both investable and domestic) in a Special Alert last week.1 In this week’s report we address several issues concerning the outlook for the economy and for Chinese stocks in a Q&A format where we answer the questions of a hypothetical, representative investor. In particular, we will discuss how much relative equity upside investors can expect over the coming year, whether the recent pace of credit growth significantly increases the chance of another credit overshoot, and when investors should expect to see a pickup in actual economic activity. Q: First, a question about timing. Why did it take so long to recommend upgrading Chinese stocks? Haven’t Chinese equities been forecasting an economic recovery for several months? A: Prior to the release of the January total social financing data on February 15, investors had no legitimate macro fundamental basis to go overweight Chinese stocks and were instead responding to a relatively less important factor for the economy – the Sino/U.S. trade war. We placed Chinese stocks on upgrade watch in late-February, and waited for confirmation that the spike in credit was not a one-off surge to be reversed by policymakers dead set against “flood irrigation-style” stimulus. As investors are surely aware, no two economic or financial market cycles are exactly alike. This is particularly true in the case of China; its economy experienced a major structural shift a decade ago, and economic and financial market oscillations since then have been highly disparate. As part of our ongoing search to identify tools that reliably predict the Chinese economy, we presented detailed evidence in a November 2017 Special Report2 that suggested monetary conditions, money, and credit growth have been among the most reliable predictors of Chinese “investment-relevant economic activity” (Chart 1). Chinese activity, in turn, has reliably led investable equity earnings growth, and we have therefore followed this framework closely when judging the economic outlook and the attendant implications for investment strategy. Chart 1Monetary Conditions, Money, And Credit Growth Reliably Lead Chinese Economic Activity Monetary Conditions, Money, And Credit Growth Reliably Lead Chinese Economic Activity Monetary Conditions, Money, And Credit Growth Reliably Lead Chinese Economic Activity Given that financial markets typically lead turning points in economic activity, many market participants have incorrectly suggested that the bottom in Chinese stocks in late-October reflected prescient expectations of a durable re-acceleration in Chinese credit growth. Rather, a detailed examination of the events of the past year highlights that the opposite is true: global investors, the most influential “buyer” of Chinese investable stocks, materially lagged or ignored important developments in leading economic indicators and focused instead on a relatively less important factor for the economy – the Sino/U.S. trade war. Two important pieces of evidence support this point: We prominently discussed the risk that a trade war would pose to China’s economy in the first-half of 2018,3 but we underscored numerous times that this risk was on top of an ongoing and much more concerning slowdown in leading indicators for China’s industrial sector. By June of last year our leading indicator for the Li Keqiang index had been in a downtrend for 16 months straight (Chart 2), and yet investors only sold Chinese investable stocks once President Trump began imposing tariffs against Chinese exports to the U.S. We placed Chinese stocks on downgrade watch at the end of March 2018,4 well in advance of the selloff versus global stocks, and deftly triggered the downgrade on June 20.5 Relative to the global benchmark, November 2018 represented the largest month of relative performance for Chinese investable stocks. At that time, there was zero credible evidence to suggest that a credit upturn was underway; in fact, money and credit growth weakened on a sequential basis for most of Q4. It is true that monetary policy eased significantly following the imposition of U.S. tariffs in June, but given the extent of the decline in interbank rates, this would have led to a bottom in relative performance in July or August if investors were willing to assume that China’s monetary transmission mechanism would work without impairment. November 2nd marks the clear inflection point for Chinese investable stocks and our BCA Market-Based China Growth Indicator (Chart 3), and in our view this proves beyond a doubt that investors have been solely focused on trade: on that day, news broke that President Trump wanted to make a deal with Xi Jinping at the G20 meeting in Argentina later that month, and had instructed aides to begin “drafting terms”.6 Chart 2Until Tariffs Arrived, Investors Completely Ignored The Decline In Leading Indicators Until Tariffs Arrived, Investors Completely Ignored The Decline In Leading Indicators Until Tariffs Arrived, Investors Completely Ignored The Decline In Leading Indicators Chart 3It Was News Of A Trade Deal That Caused A Bottom In China-Related Assets It Was News Of A Trade Deal That Caused A Bottom In China-Related Assets It Was News Of A Trade Deal That Caused A Bottom In China-Related Assets   Besides recommending a tactical overweight stance on December 5,7 we generally failed to forecast and position for a meaningful détante in the trade war, and we acknowledge that this contributed to a period of missed potential outperformance. But our research suggests that a trade deal would have been irrelevant had the drivers of China’s relevant economic activity continued to deteriorate, and investors had no concrete signs to suggest otherwise prior to the release of the January total social financing data on February 15 (Chart 4). We conservatively forecast high single-digit relative returns versus global stocks, on the order of 6-8%. There is even more upside potential in an optimistic scenario. Chart 4Before February 15, There was No Basis To Confidently Project An Upturn In Credit Before February 15, There was No Basis To Confidently Project An Upturn In Credit Before February 15, There was No Basis To Confidently Project An Upturn In Credit Starting on February 15, investors did have a legitimate macro fundamental basis to go overweight Chinese stocks. We responded to the January data by placing Chinese stocks on upgrade watch,8 but we hesitated to move to an outright cyclical overweight at that time due to several still-present risks (discussed below) and out of concern that the sheer magnitude of the spike in credit could cause a regulatory response, discreet or otherwise, that would constrain credit growth in future months. The public spat between Premier Li Keqiang and the PBOC over whether the January credit spike represented “flood irrigation-style” stimulus and the disappointing February credit data were both emblematic of these concerns, but ultimately the March credit data has confirmed that a significant credit expansion is underway. This has indeed raised the odds of a major credit overshoot, although we reiterate below why policymakers are likely to remain reluctant to allow one to occur. Q: Chinese investable stocks have already rallied 22% year-to-date in US$ terms; domestic stocks are up 37%. How much further upside can investors realistically expect? A: In an optimistic scenario, Chinese investable and domestic stocks have the potential to earn double-digit relative returns (12-15%) in US$ terms versus global stocks over the coming year. Conservatively, we expect high single-digit relative returns (6-8%). Chart 5 presents our earnings recession model for the MSCI China index. The recent improvement in credit, forward earnings momentum, and the new export orders component of the official manufacturing PMI have already caused the model probability to peak. The dotted line shows that the odds of a contraction in earnings over the coming year are set to fall very sharply if credit even just continues on a moderate expansion path, and assuming that the current values of the remaining model predictors stay constant. Chart 6 shows that while there has been an earnings “response” to the ongoing economic slowdown in China, the response has so far been less intense than what might be expected. While this raises a near-term risk for Chinese stocks if Q1 & Q2 earnings disappoint (see below), it also implies that the level of 12-month trailing earnings may not trend lower over the coming year. Chart 5The Odds Of An Earnings Decline Over The Next Year Have Peaked And Will Fall Further The Odds Of An Earnings Decline Over The Next Year Have Peaked And Will Fall Further The Odds Of An Earnings Decline Over The Next Year Have Peaked And Will Fall Further Chart 6The 'Response' Of Earnings To A Slowing Economy Has Been Less Intense Than Expected The 'Response' Of Earnings To A Slowing Economy Has Been Less Intense Than Expected The 'Response' Of Earnings To A Slowing Economy Has Been Less Intense Than Expected   If Chinese earnings are largely stable over the next year, we think it is reasonable to expect that investable Chinese stock prices will re-approach or fully return to their early-2018 high. We noted in our March 27 Weekly Report that China’s potential to command a higher multiple than global stocks is probably capped barring a major structural improvement in earnings growth,9 but Chart 7 highlights that Chinese stocks were still cheaper than their global counterparts at their peak early last year. Chart 7Even At Their 2018 High, Chinese Stocks Were Cheaper Than Global Stocks Even At Their 2018 High, Chinese Stocks Were Cheaper Than Global Stocks Even At Their 2018 High, Chinese Stocks Were Cheaper Than Global Stocks It is true that the multiple expansion that occurred for Chinese stocks in 2016 and 2017 was quite large, but in our view this was due to the index addition and growth of technology companies with potential structural growth stories (such as the “BAT” stocks) rather than due to a significant decline in the risk premium assigned to Chinese stocks. These firms are still present in the investable index, and we have no reason to believe that investors over the coming year will perceive their structural earnings potential to be any different than was the case early last year, which suggests that a forward P/E ratio of 14 to 14½ is again achievable. Domestic equities do not directly benefit from the “BAT effect”, but their realized earnings growth has been somewhat superior than the investable index over the past few years. In effect, we have no strong reasons to argue against a return of both domestic and investable forward multiples back to levels seen in early-2018. Chart 8 highlights that a return to these levels would imply a relative price return of about 12% for investable stocks and 14-15% for domestic stocks, in US$ terms. Several risks (highlighted below) underscore the possibility that Chinese stocks will trend higher but not fully return to their early-2018 levels over the coming year. Given this, we conservatively forecast high single-digit relative returns versus global stocks, on the order of 6-8%. As a final point, for investors focused on A-shares, we should note that our domestic equity call is based on the MSCI China A Onshore index, not the CSI 300 or the FTSE/Xinhua A50 index. While the former very closely tracks the latter two, Chart 9 highlights that the CSI 300 and the A50 have rebounded closer to their early-2018 highs than the MSCI China A Onshore index, suggesting that there is somewhat less upside potential for the former than the latter. Chart 8There Is Meaningful Further Upside Potential For Chinese Stocks Vs. Global There Is Meaningful Further Upside Potential For Chinese Stocks Vs. Global There Is Meaningful Further Upside Potential For Chinese Stocks Vs. Global Chart 9A-Shares: Favor MSCI Indexes Over The CSI300 And The A50 A-Shares: Favor MSCI Indexes Over The CSI300 And The A50 A-Shares: Favor MSCI Indexes Over The CSI300 And The A50   Q: What specific trades would you recommend as a result of your change in stance towards Chinese stocks? A: We are making five changes to our trade book, four of which are directly linked to our upgrade recommendation. In addition, we are closing another trade related to iron ore, given that prices have risen to a multi-year high. We are opening the following new trades in response to our recommendation to upgrade Chinese stocks: Open long MSCI China Index / short MSCI All Country World Index (US$) Open long MSCI China A Onshore Index / short MSCI All Country World Index (US$) Open long MSCI China Growth Index / short MSCI All Country World Index (US$) Regarding the latter trade, we noted in a previous report that value stocks have been responsible for more of the rally in China’s investable market versus the global average than their growth peers, and Chart 10 highlights that a long China growth / short broad market trade is strongly correlated with China’s relative performance trend versus global stocks. This means that a long MSCI China Growth Index / short MSCI All Country World Index trade represents a higher octane version of our long MSCI China Index position, which we offer as a riskier trade for investors seeking maximum upside potential in response to a cyclical recovery in China’s economy. Chart 10China Growth: A High Octane Version Of The MSCI China Index China Growth: A High Octane Version Of The MSCI China Index China Growth: A High Octane Version Of The MSCI China Index In addition to these new trades, we are closing the following two existing positions in our trade book: Long MSCI China Low-Beta Sectors / short MSCI China trade, initiated on June 27, 2018 and closed at a modest loss of 0.7% Long September 2019 iron ore futures / short September 2019 steel rebar futures trade initiated on October 17, 2018 and closed at a substantial gain of 22% We initiated our low-beta sectors position soon after we downgraded Chinese stocks in June of last year, which acted as a defensive trade for investors to play while waiting out a selloff in Chinese relative performance. The profit from the trade peaked at approximately 11% in early-October, but has since given back most of its gains. Lastly, we are closing our iron ore / steel rebar pair trade to lock in a healthy profit from the position. An improvement in Chinese economic growth would typically be bullish for iron ore prices, but they have recently surged to a multi-year high in response to supply restrictions. This implies that stronger demand over the coming 6-12 months may not necessarily be positive for prices if it is accompanied by easier supply-side conditions. Q: What are the risks facing Chinese relative equity performance over the coming year? A: A collapse in the trade talks or an underwhelming deal, a lagged and series decline in earnings per share, a sharp slowdown in credit growth after a trade deal is signed, and a meaningful lag between the upturn in credit and an improvement in Chinese “hard data”. There are four non-trivial risks to a bullish relative stance towards Chinese stocks over the coming year. In general, these scenarios pose a risk to the magnitude of an uptrend in Chinese relative performance, but in some cases could prevent Chinese relative performance from trending higher over the coming year (and thus bear monitoring). There are still four non-trivial risks to a bullish relative stance towards Chinese stocks over the coming year. The trade deal between the U.S. and China falls through or substantially underwhelms. Despite signs continuing to point to the likelihood of a deal, a meaningful breakdown in trade talks or an underwhelming deal clearly have the potential to derail an uptrend in Chinese relative performance given that global investors have (incorrectly) treated the conflict as the primary risk factor facing the Chinese economy. A full resumption of the trade war would definitely cause Chinese stocks to actively underperform until evidence presented itself that the inevitable policy response is stabilizing economic activity. An underwhelming deal would probably weigh on the magnitude of China’s outperformance, but would probably not constitute a threat on its own to an uptrend in relative performance unless the “deal” did not result in a significant removal of tariffs (which, to us, is the point of China participating in the negotiations in the first place). Chinese earnings per share decline significantly from current levels. We noted in Chart 6 on page 6 that the earnings “response” to the ongoing economic slowdown in China has been less intense than we expected. Our earnings recession model suggests that the odds of a contraction in earnings over the coming 12 months has fallen meaningfully, but that does not rule out further near-term weakness stemming from the slowdown in activity that has already occurred. Chart 11Any Further Weakness In EPS Growth Should Be Temporary Any Further Weakness In EPS Growth Should Be Temporary Any Further Weakness In EPS Growth Should Be Temporary We noted earlier that Chinese economic and financial market oscillations have been highly disparate since 2010 (when the economy experienced a clear structural shift), and as such we are unable to confidently predict the magnitude of a decline in EPS in response to a given amount of weakness in China’s old economy. For now, the meaningful uptick in net earnings revisions as well as the stabilization in forward EPS momentum (Chart 11) suggests that any further weakness in EPS growth will be temporary, but a larger or more prolonged decline should be acknowledged as a serious risk to our stance. Chinese credit growth slows meaningfully after a U.S./China trade deal is signed. To the extent that Chinese policymakers are still serious about preventing significant further leveraging, it is possible that the recent pace of credit growth will slow following the signing of a trade deal. This could occur because of a shift to tighter monetary policy, or due to the use of informal “administrative controls” to limit the pace of further lending. Chart 12 highlights that the pace of credit growth in the first quarter, if sustained, would actually imply a credit overshoot; our recommendation to upgrade Chinese stocks was based on the assumption of a moderate credit expansion, and thus we would not be surprised (or worried) if the pace of credit growth slows somewhat. However, a more meaningful slowdown, particularly if coupled with signals from policymakers that a much slower pace of growth is desired, could pose a risk to our stance. A recovery in China’s “hard data”, i.e. its coincident activity measures, meaningfully lags the pickup in credit growth. The March credit data has made us sufficiently confident that a rebound in Chinese investment-relevant economic activity is forthcoming, but it is difficult to pinpoint exactly when the data will bottom and whether further near-term weakness is likely. On the latter point, we noted in our April 3 Weekly Report that coincident economic activity sharply converged in January and February with our leading indicator for China’s economy (shown in Chart 1 on page 2), as most if not all of the previously beneficial tariff front-running effect washed out of the data.10 This implies that future changes in activity measures are now more likely to reflect actual changes in underlying economic circumstances, but a lagged response may still occur and could weigh on investor sentiment towards Chinese stocks over the coming few months. Q: What is your best estimate as to when investors can expect to see a pickup in China’s “hard” economic data? A: China’s activity data is likely to bottom between now and the middle of the year, implying that activity will pickup in 2H2019. Chart 13 presents an average correlation profile of our BCA Li Keqiang leading indicator and its main credit component (adjusted total social financing, “TSF”, as a share of GDP) with four activity measures: 1) the Bloomberg Li Keqiang index, 2) nominal manufacturing output, 3) nominal total import growth in US$, and 4) nominal total import growth in RMB. Values to the left of the zero line show that the leading indicator / TSF as a share of GDP tend to lead the four activity measures, with the x-axis values showing by how many months. Chart 12Q1 Credit Growth, If Sustained, Would Lead To An Overshoot Q1 Credit Growth, If Sustained, Would Lead To An Overshoot Q1 Credit Growth, If Sustained, Would Lead To An Overshoot Chart 13Our Indicators Tend To Lead Actual Economic Activity By 4-6 Months Our Indicators Tend To Lead Actual Economic Activity By 4-6 Months Our Indicators Tend To Lead Actual Economic Activity By 4-6 Months China’s activity data is likely to bottom between now and the middle of the year. The chart suggests that our predictors tend to lead actual economic activity by 4-6 months on average, depending on the predictor and the activity measure in question. Our LKI leading indicator technically bottomed in June of last year, although the rise has since been narrowly-based and it has retreated since October. TSF as a share of GDP clearly bottomed in December, which implies that China’s activity data is likely to bottom between now and the middle of the year. This is consistent with our view that the global economy will improve in the second half of the year, as well as our recommendation to overweight Chinese stocks on a cyclical basis. The risk, as noted above, is that investors react negatively to any further weakness in China’s measures of economic activity before they durably bottom. Q: Final question – In your list of potential risks facing Chinese relative equity performance, you cited the issue of whether policymakers are serious about preventing significant further leveraging. It seems as if they are stepping away from that. Will they, and is this fundamentally justified? A: For now, Chinese policymakers have chosen to prioritize growth, out of fear that the economy will decelerate significantly and possibly spiral out of control. But we are unconvinced that a shift back to controlling leverage is out of the question over the coming year. Policymakers have good economic reasons to try and shift China’s economy away from extremely high rates of investment towards more consumption, and they are likely to see the act of restraining credit growth as furthering this goal. Arguably, this is one of the most important questions facing global investors over both cyclical and secular time horizons, and it is likely to feature prominently in our research over the coming year. The question of the sustainable growth rate of China’s debt is a controversial one, even among BCA strategists. While it is by no means a conclusive answer, we tackled the question in our October 31 Weekly Report,11 and came down on the side that China’s policymakers have good economic reasons to try and shift China’s economy away from extremely high rates of investment towards more consumption. To the extent that attempts to restrain credit growth further this goal, our sense is that it is more wisdom than folly. We noted three key points in our October report: First, while there is a strong empirical cross-country relationship between average rates of investment over the past half-century and the level of real per capita GDP today, that relationship also shows that China’s current rate of investment is nearly off the scale and thus probably cannot be sustained. Second, in 2014, based on the definition of the data from the Penn World Table (GDP share of gross capital formation at current purchasing power parity), China had maintained its investment share above 30% for 12 years. At first blush, there appears to be some precedent suggesting that China’s outsized investment run can go on for longer: among the 80 countries with data available since 1950, 14 of them have experienced a longer continuous run of investment as a share of GDP. However, Chart 14 shows that most of these concurrent experiences occurred in the 1960s and 1970s, when global exports as a share of GDP were rising from a very low base. This implies that historical examples of outsized investment runs have largely reflected export-driven catch-up stories, which bodes poorly for China’s ability to continue to invest at its recent massive scale given that global exports to GDP appear to have peaked. Chart 14High And Sustained Rates Of Investment Have Been Driven By Exports High And Sustained Rates Of Investment Have Been Driven By Exports High And Sustained Rates Of Investment Have Been Driven By Exports Third, the historical relationship between investment and real per capita GDP captures the potential gains of profitable and rational investment (the accumulation of a “useful” stock of capital). But an unfortunate reality facing savers is that while one can certainly choose to save or invest, one cannot necessarily choose the accompanying rate of return. If China invests heavily at very low or negative rates of return, the idea that continued heavy investment will lead China out of the middle-income trap is very likely wrong. On the third point, there is good evidence to suggest that the marginal gains from investment in China have been falling. The private sector debt-to-GDP ratio features prominently in the case against profitable investment in China: despite a massive rise in investment and debt from 2002-2007, the ratio barely rose, because this debt was used to accumulate capital that verifiably delivered nominal GDP growth (Chart 15). Yet following 2010 the ratio rose sharply, implying that the returns from the investment that has taken place over the past decade have been (at least so far) considerably lower than those of the prior decade. Also, we noted in our August 29 Special Report that state-owned enterprises (SOEs) have accounted for a sizeable portion of the private sector leveraging that occurred after 2010,12 and that the marginal net return on borrowed funds for SOEs has become negative (Chart 16). A gap between the cost/return on borrowed funds strongly implies that the investment channeled through SOEs over the past several years does not represent, on balance, the accumulation of useful capital. Chart 15A Rise In Debt-To-GDP Inherently Implies That Investment Is Increasingly Unproductive A Rise In Debt-To-GDP Inherently Implies That Investment Is Increasingly Unproductive A Rise In Debt-To-GDP Inherently Implies That Investment Is Increasingly Unproductive Chart 16Strong Evidence Against Productive SOE Investment Strong Evidence Against Productive SOE Investment Strong Evidence Against Productive SOE Investment We believe that Chinese policymakers now understand the risks posed with extremely high and prolonged rates of investment. Whereas most modern central banks characterize their monetary policy decisions within the context of a trade-off between growth and inflation, Chinese policymakers now appear to face a trade-off between growth and leveraging. For now, they have chosen growth, out of fear that the economy will decelerate significantly and possibly spiral out of control. But we are unconvinced that a shift back to controlling leverage is out of the question over the coming year, particularly after a trade deal has been signed with the U.S. As noted above, this is a non-trivial risk to our recommendation to overweight Chinese stocks over the coming year, and thus bears monitoring To be continued!   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1 Please see China Investment Strategy Special Alert, “Upgade Chinese Stocks To Overweight”, dated April 12, 2019, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Special Report, “The Data Lab: Testing The Predictability Of China’s Business Cycle”, dated November 30, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Reports, “The Question That Won’t Go Away”, dated April 18, 2018, “China: A Low-Conviction Overweight”, dated May 2, 2018, “The Three Pillars Of China’s Economy”, dated May 16, 2018, and “A Shaky Ladder”, dated June 13, 2018, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report, “Chinese Stocks: Trade Frictions Make For A Tenuous Overweight”, dated March 28, 2018, available at cis.bcaresearch.com. 5 Please see China Investment Strategy Special Report, “Downgrade Chinese Stocks To Neutral”, dated June 20, 2018, available at cis.bcaresearch.com. 6 Please see “Trump Said To Ask Cabinet To Draft Possible Trade Deal With Xi”, Bloomberg News, November 2, 2018. 7 Please see China Investment Strategy Weekly Report, “2019 Key Views: Four Themes For China In The Coming Year”, dated December 5, 2018, available at cis.bcaresearch.com. 8 Please see China Investment Strategy Weekly Report, “Dealing With A (Largely) False Narrative”, dated February 27, 2019, available at cis.bcaresearch.com. 9 Please see China Investment Strategy Weekly Report, “Ready, Aim, But Don’t Fire (Yet)”, dated March 27, 2019, available at cis.bcaresearch.com. 10 Please see China Investment Strategy Weekly Report, “China Macro and Market Review”, dated April 3, 2019, available at cis.bcaresearch.com. 11 Please see China Investment Strategy Weekly Report, “Is China Making A Policy Mistake?”, dated October 31, 2018, available at cis.bcaresearch.com. 12 Please see China Investment Strategy Special Report “Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging”, dated August 29, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

We noted in our December 5 Weekly Report that a tactical overweight stance towards Chinese stocks (either the domestic or investable market) within a global equity portfolio was probably warranted over the following few months, but that the conditions for a cyclical overweight stance (6-12 months) were not yet present.1 More recently, we noted that an improvement in several economic indicators suggested that a strong March credit number could create these conditions, and tip the scales in favor of an upgrade recommendation for Chinese stocks over the coming year.2 Chart 1Leading Indicators Are Now Convincingly Bullish For Chinese Stocks Leading Indicators Are Now Convincingly Bullish For Chinese Stocks Leading Indicators Are Now Convincingly Bullish For Chinese Stocks Chart 1 shows that today’s credit release has caused a meaningful improvement in the credit component of our leading indicator for the Chinese economy. Overall growth in the money supply remains weak, but monetary conditions are easy and have clearly helped support a rebound in credit growth. All told, today’s data has made us sufficiently confident in the Chinese macroeconomic outlook to recommend a cyclical (6-12 month) overweight towards Chinese stocks (both investable and domestic) versus the global benchmark. Several questions concerning both the outlook for the economy and for Chinese stocks remain, and we will review these issues at length in next week’s report. In particular, we will discuss how much relative equity upside investors can expect over the coming year, whether the recent pace of credit growth significantly increases the chance of another credit overshoot, and when investors should expect to see a pickup in actual economic activity. Stay tuned!   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com     1 Please see China Investment Strategy Weekly Report “2019 Key Views: Four Themes For China In The Coming Year”, dated December 5, 2018, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report “China Macro And Market Review”, dated April 3, 2019, available at cis.bcaresearch.com.

Highlights Evidence continues to mount that the Chinese economy is in a bottoming process. This suggests the path of least resistance for the RMB is up. Meanwhile, as the U.S. and China move closer to a trade deal, any geopolitical risk premium in the RMB will slowly erode. The ultimate catalyst for CNY longs will be depreciation in the U.S. dollar, which we believe is slowly underway. The ECB is turning more dovish at a time when euro area growth is hitting a nadir. This will be bullish for the euro beyond the near term. Our limit buy on the pound was triggered at 1.30. Target 1.45 with stops at 1.25. With the Aussie dollar close to the epicenter of Chinese stimulus, data down under is increasingly stabilizing. We are closing our short AUD/NOK position for a small profit. Feature Chart I-1The Chinese Yuan Is Pro-cyclical The Chinese Yuan Is Pro-cyclical The Chinese Yuan Is Pro-cyclical In addition to the dovish shift by global central banks, most investors are rightly fixated on China at this juncture in the economic cycle.  For one, it has been mostly responsible for the mini cycles in the global economy since 2014. And with improvements in both Chinese credit and manufacturing data in recent months, the consensus is drawing closer to the fact that we may be entering a reflationary window. Looking at risk assets, MSCI China is up 25% from its lows, while the S&P 500 is up 20%. Commodity prices are also rising, with crude oil hitting a new calendar-year high this week. The corollary is that if the improvement in Chinese data proves sustainable, it will propel these asset markets to fresh highs. The evolution of the cycle has important implications for the yuan exchange rate, because the RMB has been trading like a pro-cyclical currency in recent years. The USD/CNY has been moving tick for tick with emerging market equities, Asian currencies, and even some commodity prices (Chart I-1). Ever since its liberalization over a decade ago, the RMB may finally be behaving like a free-floating exchange rate. Therefore, a simple evaluation of how relative prices between China and the rest of the world evolve will be valuable input for the fair value of the RMB exchange rate. Reading the tea leaves from Chinese credit data can be daunting, but we agree with the assessment of our China Investment Strategy team that while the credit impulse has clearly bottomed,1 the magnitude of the rise is unlikely to be what we saw in 2015-2016. That said, a higher credit-to-GDP ratio also requires a smaller increase in credit growth to have an outsized effect on GDP. As such, monitoring what is happening with hard data in the economy concurrently – in particular, green shoots – could add valuable evidence to the reflation theme. A Repeat Of 2016? Cycle bottoms can be protracted and volatile, but also V-shaped. So it is useful when economic data is at a nadir to pay attention to any green shoots emerging, because by the time the last piece of pertinent economic data has turned around, it may well be too late to call the cycle. Admittedly, most measures of Chinese (and global) growth remain weak. But there have been notable improvements in recent months that suggest economic velocity may be picking up: Production of electricity and steel, all inputs into the overall manufacturing value chain, are inflecting higher. Intuitively, these tend to lead overall industrial production. Overall industrial production remains weak, but the production of electricity and steel, all inputs into the overall manufacturing value chain, are inflecting higher. Intuitively, these tend to lead overall industrial production (Chart I-2). Electricity production for the month of February grew 5% after grinding to a halt in 2015-2016. Production of steel also rose by 7%. If these advance any further, they will begin to exceed Q4 GDP growth, indicating a renewed mini-cycle. Chart I-2A Revival In Industrial Activity A Revival In Industrial Activity A Revival In Industrial Activity Chart I-3Metal Prices Are Sniffing A Rebound Metal Prices Are Sniffing A Rebound Metal Prices Are Sniffing A Rebound   In recent weeks, both steel and iron ore prices have been soaring. Many commentators have attributed these increases to supply bottlenecks and/or seasonal demand. However, it is evident from both the manufacturing data and the trend in prices that demand is also playing a role (Chart I-3). Overall residential property sales remain soft, but evidence from tier-1 and even tier-2 cities is signalling that this may be behind us, given robust sales. Over the longer term, the ebb and flow of property sales has tended to be in sync across city tiers. A revival in the property market will support construction activity and investment. House prices have been rising to the tune of 10% year-on-year, and real estate stocks in China may be sniffing an eventual pick-up in property volumes (Chart I-4). Over the last 20 years or so, Chinese credit growth has been a reliable indicator for car sales with a lead of about six months. Government expenditures were already inflecting higher ahead of last month’s China National People’s Congress (NPC). Again, this suggests stimulus this time around may be more fiscal than monetary (Chart I-5). In addition to the recent VAT cut for manufacturing firms from 16% to 13%, a string of policy easing measures will begin to accrue, including a cut to social security contributions effective May 1st, and perhaps a pickup in infrastructure spending. Already, real estate infrastructure spending growth is perking up, with that in the mining sector soaring to multi-year highs. Chart I-4Real Estate Volumes Could Pick Up Real Estate Volumes Could Pick Up Real Estate Volumes Could Pick Up Chart I-5The Fiscal Spigots Are Opening The Fiscal Spigots Are Opening The Fiscal Spigots Are Opening Finally, Chinese retail sales including those of durable goods remain very weak. Car sales are deflating at the fastest pace in over two decades. But the latest VAT cut by the government is being passed through to consumers, with an increasing number of car manufactures cutting retail prices. Chart I-6Car Sales Typically Have V-Shaped Recoveries Car Sales Typically Have V-Shaped Recoveries Car Sales Typically Have V-Shaped Recoveries   Over the last 20 years or so, Chinese credit growth has been a reliable indicator for car sales with a lead of about six months (Chart I-6). The indicator right now suggests we could witness a coiled-spring rebound in Chinese car sales over the next few months. Bottom Line: Both Chinese stocks and commodity prices have been suggesting a bottoming process in the domestic economy for a while now. Incoming data is beginning to corroborate this view. This has important implications for both the Chinese yuan and other global assets. Capital Flows Improving domestic and external conditions will likely offset any renewed pressure on the Chinese yuan from capital outflows. Our China Investment Strategy team reckons that even after adjusting for cross-border RMB settlements and illicit capital outflows, there is less evidence of capital flight today than there was in 2015-2016.2  Chart I-7Offshore Markets Don't See RMB Weakness Offshore Markets Don't See RMB Weakness Offshore Markets Don't See RMB Weakness Typically, offshore markets have had a good track record of anticipating depreciation in the yuan. Back in 2014, offshore markets started pricing in a rising USD/CNY rate, and maintained that view all the way through to 2018, when the yuan eventually bottomed. Right now, no such depreciation is being priced in (Chart I-7). The reason offshore markets in Hong Kong and elsewhere can be prescient is because more often than not, they are the destination for illicit flows out of China. For example, one of the often-rumored ways Chinese money has left the country is through junkets, key operators in Macau casinos.3 These junkets bankroll their Chinese clients in Macau while collecting any debts in China allowing for illicit capital outflows. This was particularly rampant ahead of the Chinese 2015-2016 corruption clampdown, when Macau casino equities were surging while equity prices in China remained subdued. Historically, both equity markets tend to move together, since over 70% of visitors to Macau come from China (Chart I-8). Right now, both the Chinese MSCI index and Macau casino stocks are rising in tandem, suggesting gains are more related to fundamentals than hot money outflows. Chart I-8Macau Casinos: A Good Proxy For Chinese Spending Macau Casinos: A Good Proxy For Chinese Spending Macau Casinos: A Good Proxy For Chinese Spending A surge in illicit capital outflows could also be part of the reason for an explosion in sight deposits in Hong Kong ahead of the 2015-2016 clampdown (Chart I-9). Admittedly, most of these deposits were and still are due to cross-border RMB settlements, but it is also possible that part of these constituted hot money outflows. With these sight deposits rising at a more reasonable pace, it suggests little evidence of capital flight. Chart I-9The Chinese Government Has Clamped Down On Illicit Flows The Chinese Government Has Clamped Down On Illicit Flows The Chinese Government Has Clamped Down On Illicit Flows Trade Truce A trade truce between the U.S. and China will be the final catalyst for a stronger yuan. The news flow so far has been positive, with both U.S. President Donald Trump and Chinese President Xi Jinping publicly acknowledging they are closer to a deal. Even well-known China hawk Peter Navarro, head of the U.S. National Trade Council, has admitted that the two sides are in the final stages of talks. But with a still-ballooning U.S. trade deficit with China, Trump will want to take home a win (Chart I-10). Chart I-10Trump Needs To Take A Win Back To America Trump Needs To Take A Win Back To America Trump Needs To Take A Win Back To America Concessions on the Chinese side so far seem reasonable, allowing us to speculate that there is a rising probability of a deal. They have agreed to increase agriculture and energy imports from the U.S. by about $1 trillion over the next six years, announced a cut on import tariffs, revised their Patent Law to improve protection of intellectual property, and provided a clear timeline for when foreign caps will be removed in sectors such as autos and financial services. These seem like very reasonable concessions that will allow Trump to go home and declare victory. Trade wars are usually synonymous with recessions. As such, there are acute political constraints inching both sides towards an agreement. For President Trump, a deteriorating U.S. manufacturing sector in the midwestern battleground states is a thorn in his side. For President Xi, rising unemployment is a key constraint. On the currency front, the details of any agreement are still unknown, but should Chinese economic fundamentals start to genuinely improve, it will put upward pressure under rates – and ergo the yuan (Chart I-11). A gradually rising yuan exchange rate will further assuage any doubts or concerns that Trump may have. Bottom Line: Our fundamental models show the yuan as undervalued by about 3%. This means China could allow its currency to gradually appreciate towards fair value, with little impact on the domestic economy or even exports. Given some green shoots in incoming economic data, little risk of capital flight, and the rising likelihood of a trade deal between the U.S. and China, our bias is that the path of least resistance for the Chinese RMB is up (Chart I-12). Chart I-11Rising Chinese Rates Will Favor The Yuan Rising Chinese Rates Will Favor The Yuan Rising Chinese Rates Will Favor The Yuan Chart I-12The RMB Is Not Expensive The RMB Is Not Expensive The RMB Is Not Expensive     Another Dovish Shift By The ECB In another dovish twist, the European Central Bank kept monetary policy unchanged following this week’s meeting, while highlighting that it might be on hold for longer. Unsurprisingly, incoming data has been weak of late, which the ECB (like other central banks) blamed on the external environment. It did fall short of speculation that it will introduce a tiered system for its marginal deposit facility, which would have alleviated some cash flow pressures for euro area banks. Our bias is for the new Targeted Long Term Refinancing Operation (TLTRO III – in other words, cheap loans), to remain a better policy tool than a tiered central bank deposit system. In the case of a TLTRO, the ECB can effortlessly decentralize monetary policy, since liquidity gravitates towards the countries that need it the most. While a tiered system can allow a bank to offer higher rates and attract deposits, there is no guarantee that these deposits will find their way into new loans. It is also likely to benefit countries with the most excess liquidity. In the case of a TLTRO, the ECB can effortlessly decentralize monetary policy. Beyond any short-term volatility in the euro, we think the ECB’s dovish shift could be paradoxically bullish. If a central bank eases financing conditions at a time when growth is hitting a nadir, it is tough to argue that it is bearish for the currency. Meanwhile, fiscal policy is also set to be loosened. Swedish new orders-to-inventories lead euro area growth by about five months, and the recent bounce could be a harbinger of positive euro area data surprises ahead (Chart I-13). Chart I-13Euro Area Growth Will Recover Euro Area Growth Will Recover Euro Area Growth Will Recover Bottom Line: European rates are further below equilibrium compared to the U.S., and the ECB’s dovish shift will help lift the euro area’s growth potential. Meanwhile, investors are currently too pessimistic on euro area growth prospects. Our bias is that the euro is close to a floor. House Keeping Our buy-stop on the British pound was triggered at 1.30. We recommend placing stops at 1.25, with an initial target of 1.45. As we argued last week,4 the odds of a hard Brexit continue to fall, with U.K. Prime Minister Theresa May explicitly saying this week that the path for the U.K. going forward is either a deal with the EU or with no Brexit at all. As we go to press, EU leaders have granted the U.K. an extension until the end of October, with a review in June. Chart I-14What Next For The Pound? What Next For The Pound? What Next For The Pound? Back when the referendum was held in June 2016, even the pro-Brexit Tories, a minority in the party, promised continued access to the Common Market. Fast forward to today and there are simply not enough committed Brexiters in Westminster to deliver a hard exit. Given that the can has been kicked down the road, markets are likely to turn their focus on incoming economic data. On that front, economic surprises in the U.K. relative to both the U.S. and euro area are soaring (Chart I-14). Elsewhere, we are also taking profits on our short AUD/NOK position. Since 2015, the market has been significantly dovish on Australia, in part due to a more accelerated downturn in house prices and a marked slowdown in China. The reality is that the downturn in Australia has allowed some cleansing of sorts and has brought it far along the adjustment path relative to its potential. Any potential growth pickup in China will light a fire under the Aussie dollar, which is a risk to this position. Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see China Investment Strategy Special Report, titled “China: Stimulating Amid The Trade Talks,” dated February 20, 2019, available at fes.bcaresearch.com 2 Please see China Investment Strategy Special Report, titled “Monitoring Chinese Capital Outflows,” dated March 20, 2019, available at fes.bcaresearch.com 3 Farah Master, “Factbox: How Macau's casino junket system works,” Reuters, October 21, 2011. 4 Please see Foreign Exchange Strategy Weekly Report, titled “Not Out Of The Woods Yet,” dated April 5, 2019, available at bca.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. have been mostly positive: In March, 196K nonfarm jobs were created, surprising to the upside; unemployment rate stayed low at 3.8%, though average hourly earnings growth fell to 3.2% year-on-year. The factory orders in February contracted by 0.5% month-on-month. More importantly, headline consumer price inflation in March rose to 1.9% year-on-year, however this was mostly lifted by rising energy prices. Core inflation excluding food and energy dropped by 10 basis points to 2%. JOLTs job openings unexpectedly fell to 7.1 million in February, from 7.6 million. However, initial jobless claims fell to 196K. After a 3-month lull, producer prices are inflecting higher at a pace of 2.2% year-on-year for the month of March. DXY index fell by 0.44% this week. Global risk assets are on the rise this week. Meanwhile, the Fed minutes highlighted that members are in no rush to raise rates. Stalling interest rate differentials will be a headwind for the dollar.  Report Links: Not Out Of The Woods Yet - April 5, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 Into A Transition Phase - March 8, 2019 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been positive: The Sentix Investor Confidence index continues to inflect higher, coming in at -0.3 from -2.2.  German industrial production grew by 0.7% month-on-month in February. Trade balances improved across the euro area. In France, the trade deficit fell to €-4.0B in February. In Germany, the trade surplus increased to €18.7B. Italian retail sales increased by 0.9% year-on-year in February. On the inflation front, consumer price inflation in Germany and France both stayed at 1.3% year-on-year in March. EUR/USD rose by 0.57% this week. On Wednesday, the ECB has decided to leave policy unchanged as expected. Mario Draghi also highlighted more uncertainties and downside risks to the euro area amid the ongoing trade disputes. While the global trade war might add volatility to the pro-cyclical euro, easier financial conditions should eventually backstop growth. Report Links: Into A Transition Phase - March 8, 2019 A Contrarian Bet On The Euro - March 1, 2019 Balance Of Payments Across The G10 - February 15, 2019 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been negative: Preliminary cash earnings fell by 0.8% year-on-year in February, the only decline since mid-2017. Household confidence continues to tick lower, coming in at 40.5 in March. The trade balance in February came in at a surplus of ¥489.2B. Capex is rolling over. Machinery orders fell by 5.5% year-on-year in February. Machine tool orders remain extremely weak, at -28.5% year-on-year for the month of March. Lastly, the foreign investment in Japanese stocks increased to ¥1,463.7B. USD/JPY fell by 0.46% this week. In its April regional outlook, the BoJ downgraded most of the prefectures in Japan, with only Hokkaido that had an upgrade in the aftermath of the earthquake. As domestic deflationary pressures intensify, this will favor the yen.  This also raises the probability the government defers the consumption tax hike. Report Links: Tug OF War, With Gold As Umpire - March 29, 2019 A Trader’s Guide To The Yen - March 15, 2019 Balance Of Payments Across The G10 - February 15, 2019 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. have been strong: In February, manufacturing production increased by 0.6% year-on-year; industrial production also increased by 0.1% year-on-year, both surprising to the upside. Both were deflating in January. The goods trade balance in February fell to £-14.1B, however the total trade balance came in at a smaller deficit of £4.86B. Monthly GDP also came in higher at 2% year-on-year in February. House prices gains have pared the increase of previous years, but the Halifax house price index still increased by 2.6% year-on-year for the month of March.  GBP/USD rose by 0.41% this week. Theresa May got an extension for Brexit to October 31. Meanwhile, U.K. data have been stronger than consensus recently. We are long GBP/USD from 1.30, with a 0.6% profit. Report Links: Not Out Of The Woods Yet - April 5, 2019 A Trader’s Guide To The Yen - March 15, 2019 Balance Of Payments Across The G10 - February 15, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have continued to improve: Investment lending for homes in February grew by 2.6%. Home loans in February increased by 2% month-on-month, surprising to the upside. Westpac consumer confidence came in at 100.7 in April, increasing by 1.9%.  AUD/USD surged by 0.64% this week. The RBA Deputy Governor Guy Debelle hinted that a wait-and-see approach for interest rates seemed like the appropriate path, signaling that policy will continue to be accommodative. Meanwhile, the Australian dollar is probably anticipating better upcoming data from China, as it is Australia’s largest trading partner. If the world’s second largest economy can turn around, the Aussie dollar is likely to grind higher. Report Links: Not Out Of The Woods Yet - April 5, 2019 Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 There was little data out of New Zealand this week: The food price index came in at 0.5% month-on-month in March, shy of the estimate of 1.3%. NZD/USD plunged after rising by 0.5% initially this week, returning flat. Incoming data in New Zealand is likely to lag its commodity currency counterparts pushing the kiwi relatively lower. Our long AUD/NZD position is now 0.7% in the money since entry last Friday. Report Links: Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been negative: On the labor market front, the participation rate in March fell slightly to 65.7%; 7,200 jobs were lost, underperforming the estimated creation of 1,000 jobs; unemployment rate was unchanged at 5.8%. On the housing market front, starts in March increased by 192.5K year-on-year, underperforming the expected 196.5K; building permits dropped by 5.7% month-on-month in February. USD/CAD rebounded quickly after falling by 0.7% earlier this week, offsetting the loss. While the dovish shift by the BoC and looser fiscal policy, together with rising oil prices are likely to be growth tailwinds, the data disappointment coming from the housing market and overall economy limit upside in the CAD. Report Links: A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 There was scant data in Switzerland this week: The foreign currency reserves came in at 756B CHF in March. Unemployment rate in March was unchanged at 2.4%, in line with expectations. USD/CHF appreciated by 0.44% this week. With the euro area economy slowly recovering, the franc is likely to underperform as risk appetite rises. We are long EUR/CHF for a 0.1% profit. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Waiting For A Real Deal - December 7, 2018 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been strong, with inflation grinding higher: Headline consumer price inflation increased to 2.9% year-on-year in March; core inflation also rose to 2.7% year-on-year, both surprising to the upside. Producer price index grew by 5.2% year-on-year in March, outperforming expectations. USD/NOK depreciated by 1.16% this week. The improving domestic economy, rising oil prices, and the tick up in inflation are all the reasons why we favor the Norwegian krone. We are playing the NOK via a few pairs, notably long NOK/SEK and short AUD/NOK, which are currently 3.11% and 0.75% in the money, respectively. Report Links: A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been mixed: Industrial production fell to 0.7% year-on-year in February, lower than the previous reading of 3%. New manufacturing orders contracted by 2.8% year-on-year in February. However, the leading manufacturing new orders to inventory ratio is rising suggesting we might be near a bottom. Consumer price inflation came in higher at 1.9% year-on-year in March. USD/SEK fell by 0.21% this week. We remain bullish on the Swedish krona due to its cheap valuation and the imminent pickup in the euro area economy. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades