China

Highlights We have been cautious on asset allocation on a tactical (3-month) horizon for two months. The backdrop has deteriorated enough that we believe that caution is now warranted beyond a tactical horizon. Trim exposure to global stocks to benchmark and place the proceeds in cash on a cyclical (6-12 month) horizon. Government bonds remain at underweight. Our growth and earnings indicators are not flashing any warning signs. Indeed, while economic growth is peaking at the global level, it remains impressive in the U.S. Nonetheless, given the advanced stage of the economic cycle and the fact that a lot of good news is discounted in risk assets, we believe that it is better to be early and leave some money on the table than to be late. There are several risks that loom large enough to justify caution. First, the clash between monetary policy and the markets that we have been expecting is drawing closer. The FOMC may soon be forced to more aggressively tighten the monetary screws. The ECB signaled that it will push ahead with tapering. Perhaps even more important are escalating trade tensions, which could turn into a full-scale trade war with possible military implications. China has eased monetary policy slightly, but the broad thrust of past policy tightening will continue to weigh on growth. The RMB may be used to partially shield the economy from rising tariffs. Global bonds remain vulnerable. In the U.S., rate expectations in 2019 and beyond are still well below the path implied by a "gradual" tightening pace. In the Eurozone, there is also room for the discounted path of interest rates beyond the next year to move higher. Lighten up on both U.S. IG and HY corporate bonds, placing the proceeds at the short-end of the Treasury and Municipal bond curves. Duration should be kept short. We would consider upgrading if there is a meaningful correction in risk assets. More likely, however, we will shift to an outright bearish stance later this year or in early 2019 in anticipation of a global recession in 2020. Diverging growth momentum, along with the ongoing trade row, will continue to place upward pressure on the dollar. Shift to an overweight position in U.S. equities versus the other major markets on an unhedged basis. The risk of an oil price spike to the upside is rising. Feature The time to reduce risk-asset exposure on a cyclical horizon has arrived. Escalating risks and our assessment that equities and corporate bonds offered a poor risk/reward balance caused us to trim our tactical (3-month) allocation to risk assets to neutral two months ago. We left the 6-12 month cyclical view at overweight, because we expected to shed our near-term caution once the global slowdown ran its course, geopolitical risk calmed down a little, and EM assets stabilized. Nonetheless, the backdrop for global financial markets has deteriorated enough that we believe that caution is now warranted beyond a tactical horizon. It is not that there have been drastic changes in any particular area. Indeed, while profit growth is peaking at the global level, 12-month forward earnings continue to rise smartly in the major markets (Chart I-1). In the U.S., our corporate pricing power indicator is still climbing, forward earnings estimates have "gone vertical", and the net earnings revisions ratio is elevated (Chart I-2). The negative impact of this year's dollar strength on corporate profits will be trounced by robust sales activity. The U.S. economy is firing on all cylinders and growth appears likely to remain well above-trend in the second half of the year. Chart I-1Forward EPS Estimates Still Rising Forward EPS Estimates Still Rising Forward EPS Estimates Still Rising Chart I-2Some Mixed Signals For Stocks Some Mixed Signals For Stocks Some Mixed Signals For Stocks This economic and profit backdrop might make the timing of our downgrade seem odd at first glance. Nevertheless, valuations and the advanced stage of the economic and profit cycle mean that it is prudent to focus on capital preservation and be quicker to take profits than would be the case early in the cycle. BCA has recommended above-benchmark allocations to equities and corporate bonds for most of the time since mid-2009. There are several risks that loom large enough to justify taking some money off the table. One of our main themes for the year, set out in the 2018 BCA Outlook, is that markets are on a collision course with policy. This is particularly the case in the U.S. Real interest rates and monetary conditions still appear to be supportive by historical norms, but this cycle has been anything but normal and the level of real interest rates that constitute "neutral" today is highly uncertain. The fact that broad money growth has slowed in absolute terms and relative to nominal GDP is a worrying sign (Chart I-3). Dollar-based global liquidity is waning based on our proxy measure, which is particularly ominous for EM assets (bottom panel). Chart I-3Liquidity Conditions Are Deteriorating Liquidity Conditions Are Deteriorating Liquidity Conditions Are Deteriorating Moreover, our Equity Scorecard remained at 'two' in June, which is below a level that is consistent with positive excess returns in the equity market (please see the Overview section of the May 2018 Bank Credit Analyst). Our U.S. Willingness-to-Pay indicator reveals that investment flows are no longer favoring stocks over bonds in the U.S. (Chart I-2). Perhaps even more importantly for the near term are the escalating trade tensions, which could turn into a full trade war with possible military implications (see below). These and other risks suggest to us that the period of "prudent caution" may extend well into the 6-12 month cyclical horizon. For those investors not already at neutral on equities and corporate bonds, we recommend trimming exposure and placing the proceeds in cash rather than bonds. Fixed-income remains at underweight. There are risks on both sides for government bonds, but we believe that it is more likely that yields rise than fall. Trade Woes: Not Yet At Peak Pessimism The Trump Administration upped the ante in June by announcing plans to impose tariffs on another $200 billion of Chinese exports to the U.S., as well as to restrict Chinese investment in the U.S. We would expect China to retaliate if this is implemented but, at that point, China's proportionate response would cover more goods than the entire range of U.S. imports. Retaliation will therefore have to occur elsewhere. Tariffs are bad enough, but our geopolitical team flags the risk that trade tensions spill over into the South China Sea and other areas of strategic disagreement. The South China Sea or Taiwan could produce market-moving "black swan" geopolitical events this year or next.1 The Trump Administration has also launched an investigation into the auto industry, and has threatened to tear up the North American Free Trade Agreement (NAFTA). Congress will likely push hard to save the agreement because it is important for so many U.S. companies, especially those with supply chains that criss-cross the borders with Canada and Mexico. Still, Trump has the option of triggering the six-month withdrawal period as a negotiating tactic to increase the pressure on the two trading partners. This would really rattle equity markets. Many believe that Trump will back away from his aggressive negotiating tactics if the U.S. stock market begins to feel pain. We would not bet on that. The President's popularity is high, and has not been overly correlated with the stock market. Moreover, blue collar workers, Trump's main support base, do not own many stocks. The implication is that the President will be willing to take risks with the equity market in order to score points with his base heading into the mid-term elections. The bottom line is that we do not believe that investors have seen "peak pessimism" on the trade front. A trade war would result in a lot of stranded capital, forcing investors to mark down the value of the companies in their portfolios. Can Trump Reduce The Trade Gap? One of the Administration's stated goals is to reduce the U.S. trade deficit. It is certainly fair to ask China to pay for the intellectual property it takes from other countries. Broadly speaking, rectifying unfair trade practices is always a good idea. However, erecting a higher tariff wall alone is unlikely to either shrink the trade gap or boost U.S. economic growth, especially given that other countries are retaliating in kind. During the 2016 election campaign, then-candidate Trump proposed a 35% and 45% across-the-board tariff on Mexican and Chinese imports, respectively. We estimated at the time that, with full retaliation, this policy would reduce U.S. real GDP by 1.2% over two years, not including any knock-on effects to global business confidence.2 Cancelling NAFTA would be much worse. The bottom line is that nobody wins a trade war. Moreover, the trade deficit is more likely to swell than deflate in the coming years, irrespective of U.S. trade policy action. The flip side of the U.S. external deficit is an excess of domestic investment over domestic savings. The latter is set to shrivel given the pending federal budget deficit blowout and the fact that the household savings rate continues to decline and is close to all-time lows. This, together with an expected acceleration in business capital spending, pretty much guarantees that the U.S. external deficit will swell in the next few years. This month's Special Report, beginning on page 18, discusses the consequences of the deteriorating long-term fiscal outlook and the associated "twin deficits" problem. We conclude that a market riot point will be required to change current trends. But even if disaster is avoided for a few more years, the dollar will ultimately be a casualty. In the near term, however, trade friction and the decoupling of U.S. from global growth should continue to support the dollar. We highlighted the divergence in growth momentum in last month's Overview. Fiscal policy is pumping up the U.S. economy, while trade woes are souring confidence abroad. Coincident and leading economic indicators confirm that the divergence will continue for at least the near term (Chart I-4). Policy Puts We do not believe that the current 'soft patch' in the Eurozone and Japanese economies will turn into anything worse over the next year. We are much more concerned with the Chinese economy. May data on industrial production, retail sales, and fixed asset investment all disappointed. Property prices in tier 1 cities are down year-over-year. Our leading indicator for the Li Keqiang index, a widely followed measure of economic activity, is in a clear downtrend (Chart I-5). Chart I-4Growth Divergence To Continue Growth Divergence To Continue Growth Divergence To Continue Chart I-5China's Growth Slowdown China's Growth Slowdown China's Growth Slowdown The authorities will likely provide fresh stimulus if the trade war intensifies. Indeed, recent statements from the Ministry of Finance suggest that planned fiscal spending for the year will be accelerated/brought forward, and the PBOC has already made a targeted cut to the reserve requirement ratio and reduced the relending rate for small company loans. Chart I-6U.S. Small Business Is Ecstatic U.S. Small Business Is Ecstatic U.S. Small Business Is Ecstatic However, the bar for a fresh round of material policy stimulus is higher today than it was in the past; elevated debt levels, excess capacity in some parts of the industrial sector, and worries about pollution all limit the extent to which the authorities can respond with monetary or fiscal stimulus. The most effective way for China to retaliate to rising U.S. tariffs is to weaken the RMB, but this too could be quite disruptive for financial markets and, thus, provides another reason for global investors to scale back on risk. Similarly, the bar is also rising in terms of the Fed's willingness to come to the rescue. Policymakers have signaled that they will not mind an overshoot of the inflation target. Nonetheless, the facts that core PCE inflation is closing in on 2% and that unemployment rate is well below the Fed's estimate of full employment, mean that the FOMC will be slower to jump to stock market's defense were there to be a market swoon. Small business owners are particularly bullish at the moment because of Trump's regulatory, fiscal and tax policies. The NFIB survey revealed that confidence soared to the second highest level in the survey's 45-year history (Chart I-6). Expansion plans are also the most robust in survey history. With the output gap effectively closed, increasing pressure on resource utilization should translate into faster wage gains and higher inflation. This was also quite apparent in the latest NFIB survey. Reports of higher compensation hit an all-time high as firms struggle to find qualified workers, and a growing proportion of small businesses plan to increase selling prices. Despite the signs of a very tight labor market, the FOMC's inconsistent macro projection remained in place in June. Policymakers expect continued above-trend growth for 2018-2020, but they forecast a flat jobless rate and core inflation at 3.5% and 2.1%, respectively. If the Fed is right on growth, then the overshoot of inflation will surely be larger than officials are currently expecting. Risk assets will come under downward pressure when the Fed is forced to shift into a higher gear and actively target slower economic growth. We expect the Fed to hike more aggressively next year than is discounted, and lift the consensus 'dot' for the neutral Fed funds rate from the current 2¾-3% range. Bonds remain vulnerable to this shift because rate expectations in 2019 and beyond are still well below the path implied by a "gradual" quarter-point-per-meeting tightening pace (Chart I-7). Chart I-7Market Expectations For Fed Funds Are Below A ''Gradual'' Pace Market Expectations For Fed Funds Are Below A ''Gradual'' Pace Market Expectations For Fed Funds Are Below A ''Gradual'' Pace At a minimum, rising inflation pressures have narrowed the Fed's room to maneuver, which means that the "Fed Put" is less of a market support. Italy Backs Away From The Brink Last month we flagged Italy as a reason to avoid risk in financial markets, but we are less concerned today. We believe that Italy will eventually cause more volatility in global financial markets, but for the short-term it appears that this risk has faded. The reason is that the M5S-Lega coalition has already punted on three of its most populist promises: wholesale change to retirement reforms, a flat tax of 15%, and universal basic income. The back-of-the-envelope cost of these three proposals is €100bn, which would easily blow out Italy's budget deficit to 7% of GDP. There was also no mention of issuing government IOUs that would create a sort of "parallel currency" in the country. If this is wrong and there is another blowout in Italian government spreads, investors should fade any resulting contagion to the peripheral countries. Greece, Portugal, Ireland and Spain - the hardest-hit economies in 2010 - have undertaken significant fiscal adjustment and, unlike Italy, have closed a lot of the competitiveness gap relative to Germany. Spread widening in these countries related to troubles in Italy should be considered a buying opportunity.3 ECB: Tapering To Continue The ECB looked through the recent Italian political turmoil and struck a confident tone in the June press conference. President Draghi described the first quarter cooling of the euro area economy as a soft patch driven mainly by external demand. We agree with the ECB President; in last month's Overview we highlighted several factors that had provided extra lift to the Eurozone economy last year. These tailwinds are now fading, but we believe that growth is simply returning to a more sustainable, but still above-trend, pace. That said, rising trade tensions are a wildcard to the economic outlook, especially because of Europe's elevated trade sensitivity. Draghi provided greater clarity on the outlook for asset purchases and interest rates. The pace of monthly purchases will slow from the current €30bn to €15bn in the final three months of year and then come to a complete end (Chart I-8). On interest rates, the ECB expects rates to remain at current levels "at least through the summer of 2019". This means that September 2019 could be the earliest timing for the ECB to deliver the first rate hike. Chart I-8ECB Balance Sheet Will Soon Stop Growing ECB Balance Sheet Will Soon Stop Growing ECB Balance Sheet Will Soon Stop Growing We agree with this assessment on the timing of the first rate increase. It will likely take that long for inflation to move into the 1½-2% range, and for long-term inflation expectations to surpass 2%. These thresholds are consistent with the ECB's previous rate hike cycles. Still, there is room for the discounted path of interest rates beyond the next year to move higher as Eurozone economic slack is absorbed. The number of months to the first rate hike discounted in the market has also moved too far out (24 months). Thus, we expect that bunds will contribute to upward pressure on global yields. Bond investors should be underweight the Eurozone within global fixed income portfolios. In contrast, we recommend overweight positions in U.K. gilts because market expectations for the Bank of England (BoE) are too hawkish. Investors should fade the central bank's assertion that policymakers now have a lower interest rate threshold for beginning to shrink the balance sheet. The knee-jerk rally in the pound and gilt selloff in June will not last. First, the OECD's leading economic indicator remains in a downtrend, warning that the U.K. economy faces downside risks (Chart I-9). Second, Brexit uncertainty will only increase into the March 2019 deadline. Prime Minister May managed to win a key parliamentary vote on the Withdrawal Bill in late June, but the Tories will face more tests ahead, including a vote on the Trade and Customs Bill. The fault lines between the hard and soft Brexiteers within the Tory party could bring an early end to May's government. Either May could be replaced with a hard Brexit prime minister, such as Brexit Secretary David Davis, or the U.K. could face a new general election. The latter implies the prospect of a Labour-led government. Admittedly, this will ensure a soft Brexit, but Jeremy Corbyn would almost surely herald far-left economic policies that will dampen business sentiment. As a result, we believe that the BoE is sidelined for the remainder of the year, which will keep a lid on gilt yields and sterling. Corporate Bonds: Poor Value And Rising Leverage Our newfound caution for equities on a 6-12 month investment horizon carries over to the corporate bond space. Corporate balance sheets have been deteriorating since 2015 Q1 based on our Corporate Health Monitor (CHM). The first quarter's improvement in the CHM simply reflected the tax cuts and thus does not represent a change in trend (Chart I-10). Chart I-9Fade BoE Hawkish Talk Fade BoE Hawkish Talk Fade BoE Hawkish Talk Chart I-10Q1 Improvement In Corporate ##br##Health To Reverse Q1 Improvement In Corporate Health To Reverse Q1 Improvement In Corporate Health To Reverse The improvement was concentrated in the components of the Monitor that use after-tax cash flows, and as such they were influenced by the sharp decline in the corporate tax rate. Profit margins, for example, increased from 25.8% to 26.4% on an after-tax basis in Q1 (Chart I-10, panel 2), but would have fallen to 25.5% if the effective corporate tax rate had remained the same as in 2017 Q4. As the effective corporate tax rate levels-off around its new lower level (bottom panel), last quarter's improvement in the Corporate Health Monitor will start to unwind. More importantly, the corporate sector has been leveraging aggressively, as we highlighted in our special reports that analysed company-level data from the U.S. and the Eurozone.4 We highlighted that investors and rating agencies are not too concerned about leverage at the moment, but that will change when growth slows. Interest- and debt-coverage ratios are likely to plunge to new historic lows (Charts I-11A and I-11B). Chart I-11ACorporate Leverage Will Come ##br##Back To Haunt Bondholders Corporate Leverage Will Come Back To Haunt Corporate Leverage Will Come Back To Haunt Chart I-11BCorporate Leverage Will Come ##br##Back To Haunt Bondholders Corporate Leverage Will Come Back To Haunt Corporate Leverage Will Come Back To Haunt Both U.S. investment grade (IG) and high-yield (HY) corporates are expensive, but not at an extreme, based on the 12-month breakeven spread.5 However, both IG and HY are actually extremely overvalued once we adjust for gross leverage (Chart I-12). Chart I-12U.S. Leverage - Adjusted ##br##Corporate Bond Valuation U.S. Leverage - Adjusted Corporate Bond Valuation U.S. Leverage - Adjusted Corporate Bond Valuation We have highlighted several other indicators to watch to time the exit from corporate bonds. These include long-term inflation expectations (when the 10-year TIPS inflation breakeven reaches the 2.3-2.5% range), bank lending standards for C&I loans, the slope of the yield curve, and real short-term interest rates or monetary conditions. While monetary conditions have tightened, the overall message from these indicators as a group is that it is still somewhat early to expect rising corporate defaults and sustained spread widening. That said, we have also emphasized that it is very late in the credit cycle and return expectations are quite low. Excess returns historically have been modest when the U.S. 3-month/10-year yield curve slope has been in the 0-50 basis point range. Similar to our logic behind trimming our equity exposure, the expected excess return from corporate bonds no longer justifies the risk. We recommend lightening up on both U.S. IG and HY corporate bonds, moving to benchmark and placing the proceeds at the short-end of the Treasury and Municipal bond curves. Duration should be kept short. Also downgrade EM hard currency sovereign and corporate debt to maximum underweight. We are already underweight on Eurozone corporates within European fixed-income portfolios due to the pending end to the ECB QE program. Conclusions The political situation in Italy and tensions vis-à-vis North Korea appear to be less of a potential landmine for investors, at least for the next year. Nonetheless, the risks have not diminished overall - they have simply rotated into other areas such as international trade. It is also worrying that the FOMC will have to become more aggressive in toning down the labor market. What makes the asset allocation decision especially difficult is that the economic and earnings backdrop in the U.S. is currently constructive for risk assets. Nonetheless, recessions and bear markets are always difficult to spot in real time. Given the advanced stage of the economic cycle and the fact that a lot of good news is discounted in risk assets, we believe that it is better to be early and leave some money on the table than to be late and go over the cliff. This does not mean that we will recommend a neutral allocation to risk assets for the remainder of the economic expansion. We would consider upgrading if there is a meaningful correction in equity and corporate bond prices at a time when our growth indicators remain positive. More likely, however, we will shift to an outright bearish stance on risk assets later this year or in early 2019 in anticipation of global recession in 2020. The divergence in growth momentum between the U.S. and the rest of the major economies, along with the ongoing trade row, will continue to place upward pressure on the dollar. We envision the following pecking order from weakest to strongest currency versus the greenback: dollar bloc and EM commodity currencies, non-commodity sensitive EM currencies, the euro and yen. The Canadian dollar is an exception; we are bullish versus the U.S. dollar beyond a short-term horizon due to expected Bank of Canada rate hikes. Tightening financial conditions are likely to culminate in a crisis in one or more EM countries; as a share of GDP, exports and international reserves, U.S. dollar debt is at levels not seen in over 15 years. Slowing Chinese growth and trade tensions just add to the risk in this space. The recent upturn in base metal prices will likely reverse if we are correct on the Chinese growth outlook. Oil is a different story, despite our bullish dollar view. OPEC 2.0 - the oil-producer coalition led by Saudi Arabia and Russia - agreed in June to raise oil output by 1 million bpd. The coalition aims to increase production to compensate for an over-compliance of previous deals to trim output, as well as production losses due to lack of investment and maintenance (Chart I-13). The bulk of the losses reflect the free-fall in Venezuela's output. Our oil experts believe that OPEC 2.0 does not have much spare capacity to lift output. Meanwhile, the trend decline in production by non-OPEC 2.0 states is being magnified by unplanned outages in places like Nigeria, Libya and Canada. While U.S. shale producers can be expected to grow their output, infrastructure constraints - chiefly insufficient pipeline capacity to take all of the crude that can be produced in the Permian Basin to market - will continue to limit growth in the short-term. In the face of robust demand, the risk to oil prices thus remains to the upside. A stronger dollar will somewhat undermine the profits of U.S. multinationals. U.S. equities also appear a little expensive versus Europe and Japan based on our composite valuation indicators (Chart I-14). Nonetheless, the sector composition of the U.S. stock market is more defensive than it is elsewhere and relative economic growth will favor the U.S. market. On balance, we no longer believe that euro area and Japanese equities will outperform the U.S. in local currency terms. Overweight the U.S. market on an unhedged basis. Chart I-13Oil Production Outlook Oil Production Outlook Oil Production Outlook Chart I-14Composite Equity Valuation Indicators Composite Equity Valuation Indicators Composite Equity Valuation Indicators Consistent with our shift in broad asset allocation this month, we have adjusted our global equity sector allocation to be more defensive. Materials and Industrials were downgraded to underweight, while Healthcare and Telecoms were upgraded (Consumer Staples was already overweight). Financials was downgraded to benchmark because the flattening term structure is expected to pressure net interest margins. Mark McClellan Senior Vice President The Bank Credit Analyst June 28, 2018 Next Report: July 26, 2018 1 Please see Geopolitical Strategy Special Reports, "The South China Sea: Smooth Sailing?," March 28, 2017 and "Taiwan Is A Potential Black Swan," March 30, 2018, available at gps.bcaresearch.com. 2 Please see The Bank Credit Analyst Overview, dated December 2016, Box I-1. 3 Please see Geopolitical Strategy Special Report, "Mediterranean Europe: Contagion Risk Or Bear Trap?," June 13, 2018, available at gps.bcaresearch.com. 4 Please see The Bank Credit Analyst, March 2018 and June 2018, available at bca.bcaresearch.com. 5 The breakeven spread is the amount of spread widening that would have to occur over 12 months for corporates to underperform Treasurys. We focus on the breakeven spread to adjust for changes in the average duration of the index over time. II. U.S. Fiscal Policy: An Unprecedented Macro Experiment Congress is conducting a major economic experiment that has never been attempted in the U.S. outside of wartime; substantial fiscal stimulus when the economy is already at full employment. The budget deficit is on track to surpass 6% of GDP in a few years. It would likely peak above 8% in the case of a recession. The alarming long-term U.S. fiscal outlook is well known, but it has just become far worse. The combination of rising life expectancy and a decline in the ratio of taxpayers to retirees will place growing financial strains on the Social Security and Medicare systems. The federal government will be spilling far more red ink over the next decade than during any economic expansion phase since the 1940s. The debt/GDP ratio could surpass the previous peak set during WWII within 12 years. Shockingly large budget deficits in the past have sparked some attempt in Congress to limit the damage. Unfortunately, there will be little appetite to tighten the fiscal purse strings for the next decade. Voters have shifted to the left and politicians are following along. Factors that explain the political shift include disappointing income growth, income inequality, and rising political clout for Millennials, Hispanics and the elderly. Fiscal conservatism is out of fashion and this is unlikely to change over the next decade, no matter which party is in power. This means that a market riot will be required to shake voters and the political establishment into making the tough decisions necessary. While the U.S. is not at imminent risk of a market riot over the deteriorating fiscal trends, there are costs: in the long-term, the dollar will be weaker, borrowing rates will be higher and living standards will be lower than otherwise would be the case. Profligacy: (Noun) Unconstrained by convention or morality. Congress is conducting a major economic experiment that has never been attempted before in the U.S. outside of wartime; substantial fiscal stimulus at a time when the economy is already at full employment. Investors are celebrating the growth-positive aspects of the new fiscal tailwind at the moment, but it may wind up generating a party that is followed by a hangover as the Fed is forced to lean hard against the resulting inflationary pressures. Moreover, even in the absence of a recession, the federal government will likely be spilling far more red ink than during any economic expansion since the 1940s (Chart II-1). What are the long-term implications of this macro experiment? Will the U.S. continue to easily fund large and sustained budget deficits? Chart II-1U.S. Deficits Will Be Extremely Large For A Non-Recessionary Period U.S. Deficits Will Be Extremely Large For A Non-Recessionary Period U.S. Deficits Will Be Extremely Large For A Non-Recessionary Period Historically, shockingly large budget deficits sparked some attempt by Congress to limit the damage. Unfortunately, we argue in this Special Report that there will be little appetite to tighten the fiscal purse strings for the next decade. Voters have shifted to the left and politicians are following along. While the U.S. is not at imminent risk of a market riot over the deteriorating fiscal trends, the dollar will be weaker, borrowing rates will be higher and living standards will be lower than otherwise would be the case. On The Bright Side The Trump tax cuts, the immediate expensing of capital spending and a lighter regulatory touch have stirred animal spirits in the U.S. The Administration's trade policies are a source of concern, but CEO confidence is generally high. The NFIB survey highlights that small business owners are almost euphoric regarding the outlook. The IMF estimates that the tax cuts and less restrictive spending caps will provide a direct fiscal thrust of 0.8% in 2018 and 0.9% in 2019 (Chart II-2). The overall impact on the economy over the next 12-18 months could be larger to the extent that business leaders follow through on their newfound bullishness and ramp up capital spending. Chart II-2Lots Of Fiscal Stimulus In 2018 And 2019 July 2018 July 2018 Fiscal policy is a clear positive for stocks and other risk assets in the near term, as long as inflation is slow to respond. In addition to the near-term boost, there will be longer-term benefits from the 2017 tax act. Various provisions of the act affect the long-run productive potential of the U.S. economy, by promoting increases in investment and labor supply. Corporate tax cuts and the full expensing of business capital outlays should permanently increase the nation's capital stock relative to what it otherwise would be, leading to a slightly faster trend pace of productivity growth. Similarly, lower income taxes are projected to encourage more people to enter the workforce or to work longer hours. The CBO estimates that the tax act will boost the level of potential real GDP by 0.9% by the middle of the next decade. This may not sound like much, but it translates into almost a million extra jobs. The supply-side benefits of the 2017 tax act are therefore meaningful. Unfortunately, given the lack of offsetting spending cuts, it comes at the cost of a dramatically worse medium- and long-term outlook for government debt. The CBO estimates that the recent changes in fiscal policy will cumulatively add $1.7 trillion to the federal government's debt pile, relative to the previous baseline (Chart II-3). The annual deficit is projected to surpass $1 trillion in 2020, and peak as a share of GDP at 5.4% in 2022. Federal government debt held by the private sector will rise from 76% this year to 96% in 2028 in this scenario. Chart II-3Comparing To The Reagan Era Comparing To The Reagan Era Comparing To The Reagan Era The budget situation begins to look better after 2020 in the CBO's baseline forecast because a raft of "temporary provisions" are assumed to sunset as per current law, including some of the personal tax cuts and deductions included in the 2017 tax package. As is usually the case, the vast majority of these provisions are likely to be extended. The CBO performed an alternative scenario in which it extends the temporary provisions and grows the spending caps at the rate of inflation after 2020. In this more realistic scenario, the deficit reaches 7% of GDP by 2028 and the federal debt-to-GDP ratio hits 105% (Chart II-3). Moreover, there will undoubtedly be a recession sometime in the next five years. Even a mild downturn, on par with the early 1990s, could inflate the budget deficit to 8% or more of GDP. The Demographic Time Bomb Chart II-4The Withering Support Ratio The Withering Support Ratio The Withering Support Ratio The pressure that the aging population will place on federal coffers over the medium term is well known, but it is worth reviewing in light of Washington's new attitude toward deficit financing. The combination of rising life expectancy and a decline in the ratio of taxpayers to retirees will place growing financial strains on the Social Security and Medicare systems. In 1970, there were 5.4 people between the ages of 20 and 64 for every person 65 or older. That ratio has since dropped to 4 and will be down to 2.6 within the next 20 years (Chart II-4). Spending on entitlements (Social Security, Medicare, Medicaid, Income Security and government pensions) is on an unsustainable trajectory (Charts II-5 and II-6). In fiscal 2017, these programs absorbed 76% of federal revenues and the CBO estimates that this will rise to almost 100% by 2028, absent any change in law. If we also include net interest costs, total mandatory spending1 is projected to exceed total federal government revenues as early as next year, meaning that deficit financing will be required for all discretionary spending. Chart II-5Entitlements Will Explode ##br##Mandatory Spending Entitlements Will Explode Mandatory Spending Entitlements Will Explode Mandatory Spending Chart II-6All Discretionary Spending ##br##To Be Deficit Financed? All Discretionary Spending To Be Deficit Financed? All Discretionary Spending To Be Deficit Financed? The CBO last published a multi-decade outlook in 2017 (Chart II-7). The Federal debt/GDP ratio was projected to reach 150% by 2047. If we adjust this for the new (higher) starting point in 2028 provided by the CBO's alternative scenario, the debt/GDP ratio would top 164% in 2047. Chart II-7An Unsustainable Debt Accumulation An Unsustainable Debt Accumulation An Unsustainable Debt Accumulation To put this into perspective, the demands of WWII swelled the federal debt/GDP ratio to 106% in 1946, the highest on record going back to the early 1700s (Chart II-8). The debt ratio could rocket past that level before 2030, even in the absence of a recession. Chart II-8U.S. Debt In Historical Context U.S. Debt In Historical Context U.S. Debt In Historical Context These extremely long-term projections are only meant to be suggestive. A lot of things can happen in the coming years that could make the trajectory better or even worse. But the point is that current levels of taxation are insufficient to fund entitlements in their current form in the long run. Chart II-9 shows that outlays as a share of GDP have persistently exceeded revenues since the mid-1970s, except for a brief period during the Clinton Administration. The gap is set to widen over the coming decade. Something will have to give. Chart II-9U.S. Outlays And Revenues U.S. Outlays And Revenues U.S. Outlays And Revenues Forget Starving The Beast "Starve the Beast" refers to the idea that the size of government can be restrained through a low-tax regime that spurs growth and pressures Congress to cut spending and control the budget deficit. It has been the mantra of Republicans since the Reagan era. The 1981 Reagan tax cuts included an across-the-board reduction in marginal tax rates, taking the top rate down from 70% to 50%. Corporate taxes were slashed by $150 billion over a 5-year period and tax rates were indexed for inflation, among other changes. It was not surprising that the budget deficit subsequently ballooned. Outrage grew among fiscal conservatives, but Congress spent the next few years passing laws to reverse the loss of revenues, rather than aggressively attacking the spending side. Today, Congressional fiscal hawks are in retreat and the Republican Party under President Donald Trump is not as fiscally conservative as it once was. This trend reflects the pull toward the center of the economic policy spectrum in response to a shift to the left among voters. BCA's political strategists have highlighted that this is the "median voter theory" (MVT) in action.2 The MVT posits that parties and politicians will approximate the policy choices of the median voter in order to win an election or stay in power. Every U.S. presidential election involves candidates making a mad dash to the most popularly appealing positions. President Trump exhibited this process when he ran in the Republican primary on a platform of increased infrastructure spending and zero cuts to "entitlement" spending. The Great Financial Crisis, disappointingly slow growth, stagnating middle class incomes and the widening income distribution have resulted in a leftward shift among voters on economic issues. Adding to the shift is the rising political clout of the Millennial generation, which generally favors more government involvement in the economy and will become the major voting block as it ages in the 2020s. There also are important changes underway in the ethnic composition of the electorate. The rising proportion of Hispanic voters will on balance favor the Democrats, according to voting trends (Chart II-10). A previous Special Report by Peter Berezin, BCA's Chief Global Strategist, predicted that Texas will become a swing state in as little as a decade and a solid Democrat state by 2030.3 Chart II-10The Proportion Of Minority Voters Set To Grow The Proportion Of Minority Voters Set To Grow The Proportion Of Minority Voters Set To Grow President Trump's shift to the left on economic policy helped him to out-flank Clinton in the election, particularly in the Rust Belt, where his protectionist and anti-austerity message resonated. Even his anti-immigration appeal is mostly based on economic reasoning - i.e. jobs, rather than cultural factors. Trump has admitted that he is not all that concerned about taking the country deeper into hock. The Republican rank-and-file has generally gone along with Trump's agenda because he has delivered traditional Republican tax cuts and continues to rate highly among his supporters (his approval is around 90% among Republicans). Fiscal hawks within the GOP have been forced to the sidelines while Trump and moderate Republicans have passed bipartisan spending increases with Democratic assistance. Where's The Outrage? Chart II-11Entitlements Are Popular* July 2018 July 2018 The implication is that, unlike the Reagan years, we do not expect there will be a strong political force capable of leading a fight against budget deficits. After a decade of disappointing income growth, voters are in no mood for tax hikes. On the spending side, health care and pensions are still politically untouchable. A recent study by the Pew Research Center confirms that only a very small percentage of Americans of either political stripe would agree with cuts to spending on education, Medicare, Social Security, defense, infrastructure, veterans or anti-terrorism efforts (Chart II-11). It is therefore no surprise that a populist such as Trump has promised to defend entitlement programs. Moreover, the graying of America will make it increasingly difficult for politicians to tame the entitlement beast. An aging population might generally favor the GOP, but it will also solidify opposition towards cutting Medicare and Social Security. As for defense, U.S. military spending was 3.3% of GDP and almost 15% of total spending in 2017 (Chart II-12). Congress recently lifted the spending cap for defense expenditures, but it is still projected to fall as a share of total government spending and GDP in the coming years. It is conceivable that Congress could eventually trim the defense budget even faster, but spending is already low by historical standards and it is hard to see any future Congress gutting the military at a time when the global challenge from China and Russia is rising. Indeed, given the geopolitical atmosphere of great power competition, defense spending is more likely to rise. Chart II-12What's Left To Cut? What's Left To Cut? What's Left To Cut? So, what is left to cut? If entitlements and defense are off the table, that leaves non-defense discretionary spending as the sacrificial lamb. This category includes spending by the Departments of Agriculture, Education, Energy, Homeland Security, Health and Human Services, Justice, State and Veteran Affairs. Such spending has already declined sharply during the past several decades (Chart II-12). Non-defense discretionary spending amounted to $610 billion in 2017, which is only 15.3% of total federal spending. To put this into perspective, cutting every last cent of non-defense discretionary spending by 2022 would still leave a budget deficit of about 2½% of GDP. And it would be political suicide. The Departments of Education, Health and Human Services, Homeland Security, Justice and Veterans Affairs account for more than half of non-defense discretionary spending. But these programs are very popular among voters. And, at only 1.3% of total spending, eliminating all foreign aid won't make much difference. Either President Trump or Vice-President Mike Pence will be the GOP presidential candidate in 2020. Pence could be more fiscally conservative than Trump, but Congress is unlikely to remain GOP-controlled through 2024. Similarly, it is difficult to see the Democrats making more than a token effort to rein in the deficit if the party is in charge after 2020. Perhaps they will raise taxes on the rich and push the corporate rate back up a bit, but voters will probably not favor a full reversal of the Trump tax cuts. Democrats will not tackle entitlements either. In other words, we can forget about "starving the beast" as a viable option no matter which party is in power. There will be little appetite for fiscal austerity in the U.S. through to the mid-2020s at a minimum. International Comparison This all places the U.S. out of sync with other major industrialized countries, where structural budget deficits have been tamed in most cases and are expected to remain so according to the IMF's latest projections (Chart II-13). The U.S. cyclically-adjusted budget deficit is projected to be almost 7% of GDP in 2019, by far the highest among other industrialized countries except for Norway. Spain and Italy are expected to have relatively small structural deficits of 2½% and 0.8%, respectively, next year. Greece is running a small structural surplus! Including all levels of government, the IMF estimates that the U.S. general government gross debt/GDP ratio is projected to be well above that of the U.K., France, Germany, Spain and Portugal in 2023 (Chart II-14). It is expected to be on par with Italy at that time, although the newly-installed populist government there is likely to negotiate a loosening of the fiscal rules with Brussels, leading to higher debt levels than the IMF currently expects. The implication is that the U.S. government appears destined to become one of the most indebted in the developed world. Chart II-13U.S. Budget Deficit Stands Out July 2018 July 2018 Chart II-14International Debt Comparison July 2018 July 2018 The Fiscal Tipping Point Investors are not yet worried about the path of U.S. fiscal policy; the yield curve is quite flat, CDS spreads on U.S. Treasurys have not moved and the dollar is still overvalued by most traditional measures. The challenge is timing when a fiscally-induced crisis might occur. A warning bell does not ring when government debt or deficits reach certain levels. Fiscal trends generally do not suddenly spiral out of control - it is a gradual and insidious process reflected in multi-year deficits and slowly accumulating debt burdens. Eventually, a tipping point is reached where the only solution is drastic policy shifts or in extreme cases, default. Along the way, there are a number of signs that fiscal trends are entering dangerous territory. The relevance of the various signs will be different for each country, reflecting, among other things, the depth and structure of the financial system, the soundness of the economy, the dependence on foreign capital, and the asset preferences of domestic investors. Some key signs of building fiscal stress are given in Box II-1. None of the factors in Box II-1 appear to be a threat at the moment for the U.S. Moreover, comparisons with other countries that have hit the debt wall in the past are not that helpful because the U.S. is a special case. It has a huge economy and has political and military clout. The dollar is the world's main reserve currency and the country is able to borrow in its own currency. This suggests that the U.S. will be able to "get away with" its borrowing habit for longer than other countries have in the past. At the same time, financial markets are fickle and, even with hindsight, it not always clear why investors switch from acceptance to bearishness about a particular state of affairs. BOX II-1 Traditional Signs Of An Approaching Debt Crisis Government deficits absorb a rising share of net private savings, leaving little for new investment. Interest payments account for an increasingly large share of government revenues, squeezing out discretionary spending and requiring tough budget action merely to stop the deficit from rising. The government exhausts its ability to raise tax burdens. Traditional sources of debt finance dry up, requiring alternative funding strategies. Fears of inflation and/or default lead to a rising risk premium on interest rates and/ or a falling exchange rate. Political shifts occur as governments get blamed for eroding living standards, high taxes, and continued pressure to cut spending. The Costs Of Fiscal Profligacy Even if the U.S. is not near a fiscal tipping point, this does not mean that massive debt accumulation is costless: Interest Costs: Spending 3% of GDP on servicing the federal government's debt load over the next decade is not a disaster. Nonetheless, it does reduce the tax dollars available to fund entitlements or investing in infrastructure. Counter-Cyclical Fiscal Policy: Lawmakers would have less flexibility to use tax and spending policies to respond to unexpected events, such as natural disasters or recessions. As noted above, a recession in 2020 could generate a federal deficit of more than 8% of GDP. In that case, Congress may feel constrained in supporting the economy with even temporary fiscal stimulus. National Savings: Because government borrowing reduces national savings, then either capital spending must assume a smaller share of the economy or the U.S. must borrow more from abroad. Most likely it will be some combination of both. Crowding Out: If global savings are not in plentiful supply, then the additional U.S. debt issuance will place upward pressure on domestic interest rates and thereby "crowd out" business capital spending. This would reduce the nation's capital stock, leading to lower growth in productivity and living standards than would otherwise be the case. The CBO estimates that the positive impact on the capital stock from the changes to the corporate tax structure will overwhelm the negative impact from higher interest rates over the next decade. Nonetheless, the crowding out effect may dominate over a longer-time horizon. Academic studies suggest that every percentage point rise in the government's debt-to-GDP ratio adds 2-3 basis points to the equilibrium level of bond yields. If this is correct, then a rise in the U.S. ratio of 25 percentage points over the next decade in the CBO's baseline would lift equilibrium long-term bond yields by a meaningful 50-75 basis points. Much depends, however, on global savings backdrop at the time. External Trade Gap: If global savings are plentiful, then it may not take much of a rise in U.S. interest rates to attract the necessary foreign inflows to fund both the higher U.S. federal deficit and the private sector's borrowing requirements. Of course, this implies a larger current account deficit and a faster accumulation of foreign IO Us. Twin Deficits The U.S. has run a current account deficit for most of the past 40 years, which has cumulated into a rising stock of foreign-owned debt. The Net International Investment Position (NIIP) is the difference between the stock of foreign assets held by U.S. residents and the stock of U.S. assets held by foreign investors. The NIIP has fallen increasingly into the red over the past few decades, reaching 40% of GDP today (Chart II-15). The current account deficit was 2.4% at the end of 2017, matching the post-Lehman average. Nonetheless, this deficit is set to worsen as increased domestic demand related to the fiscal stimulus is partly satisfied via higher imports. Chart II-15Scenarios For The U.S. Net International Investment Position Scenarios For The U.S. Net International Investment Position Scenarios For The U.S. Net International Investment Position We estimate that a two percentage point rise in the budget deficit relative to the baseline could add a percentage point or more to the current account deficit, taking it up close to 4% of GDP. Upward pressure on the external deficit will also be accentuated in the next few years to the extent that the U.S. business sector ramps up capital spending. The implication is that the NIIP will fall deeper into negative territory at an even faster pace. A 2% current account deficit would be roughly consistent with stabilization in the NIIP/GDP ratio. But a 4% deficit would cause the NIIP to deteriorate to almost 80% of GDP by 2040 (Chart II-15). The sustainability of the U.S. twin deficits has been an area of intense debate among academics and market practitioners for many years. The U.S. has been able to get away with the twin deficits for so long in part because of the dollar's status as the world's premier reserve currency. The critical role of the dollar in international transactions underpins global demand for the currency. This has allowed the U.S. to issue most of its debt obligations in U.S. dollars, forcing the currency risk onto foreign investors. The worry is that foreign investors will at some point begin to question the desirability of an oversized exposure to U.S. assets within their global portfolios. We argued in our April 2018 Special Report 4 that the U.S. situation is not that dire that the U.S. dollar and Treasury bond prices are about to fall off a cliff because of sudden concerns about the unsustainability of the current account deficit. Even though the NIIP/GDP ratio will continue to deteriorate in the coming years, it does not appear that the U.S. is close to the point where foreign investors would begin to seriously question America's ability or willingness to service its debt. That said, the "twin deficits" and the downward trend in U.S. productivity relative to the rest of the world will ensure that the underlying long-term trend in the dollar will remain down (Chart II-16).5 Chart II-16Structural Drivers Of The U.S. Dollar Structural Drivers Of the U.S. Dollar Structural Drivers Of the U.S. Dollar Conclusions The long-term U.S. fiscal outlook was dire even before the Great Recession and the associated shift to the political left in America. Fiscal conservatism is out of fashion and this is unlikely to change before the mid-2020s, no matter which party is in power. This means that a market riot will be required to shake voters and the political establishment into making the tough decisions. Given demographic trends, it appears more likely that taxes will rise than entitlements cut. We do not foresee a crisis occurring in the next few years. Nonetheless, arguing that the U.S. fiscal situation is sustainable for the foreseeable future does not mean that it is desirable. There will be costs associated with current fiscal trends, even on a relatively short 5-10 year horizon. Interest costs will mushroom, potentially crowding out government spending in other areas. U.S. government debt has already been downgraded by S&P to AA+ in 2013, and the other two main rating agencies are likely to follow suit during the next recession as the deficit balloons to 8% or more. Investors may begin to demand a risk premium in order to entice them to continually raise their exposure to U.S. government bonds in their portfolios. Taxes will eventually have to rise to service the government debt, and some capital spending will be crowded out, both of which will undermine the economy's growth potential. Finally, the dollar will also be weaker than it otherwise would be in the long-term, representing an erosion in America's standard of living because everything imported is more expensive. Could Japan offer a roadmap for the U.S.? The Bank of Japan has effectively monetized 43% of the JGB market and has control over yields, at least out to the 10-year maturity. Moreover, Japan has enjoyed a "free lunch" so far because monetization has not resulted in inflation. The reason that Japan has enjoyed a free lunch is that it has suffered from a chronic lack of demand and excess savings in the private sector. The government has persistently run a deficit and fiscally stimulated the economy in order to offset insufficient demand in the private sector. The Bank of Japan purchased bonds and drove short-term interest rates down to zero. These policies have made very slow progress in eradicating lingering deflationary economic forces. However, if animal spirits in the business sector perk up, then inflation could make a comeback unless the policy stimulus is dialed down in a timely manner. In other words, the BoJ-financed fiscal "free lunch" should disappear at some point. The U.S. is in a very different situation. There is no lack of aggregate demand or excessive savings in the private sector. The economy is at full employment, and thus persistent budget deficits should turn into inflation much more quickly than was the case in Japan. In other words, the U.S. is unlikely to enjoy much of a "free lunch", whether the Fed monetizes the debt or not. Mark McClellan Senior Vice President The Bank Credit Analyst 1 Mandatory spending refers to entitlements; that is, government expenditure programs that are required by current law. These include Social Security, Medicare, Medicaid, government pensions and other smaller programs. 2 Please see Geopolitical Strategy Monthly Report, "Introducing The Median Voter Theory," June 8, 2016, available at gps.bcaresearch.com. 3 Please see The Bank Credit Analyst, "America's Fiscal Fortune: Leave Your Wallet On The Way Out," June 2011, available at bca.bcaresearch.com. 4 Please see The Bank Credit Analyst Special Report, "U.S. Twin Deficits: Is The Dollar Doomed?," April, 2018, available at bca.bcaresearch.com. 5 In the near term, fiscal stimulus and increased business capital spending will likely boost the dollar. But this effect on the dollar will reverse in the long-term. III. Indicators And Reference Charts The divergence between the U.S. corporate earnings data and our equity-related indicators continued in June. Forward earnings estimates continue to climb at an impressive pace. The U.S. net revisions ratio pulled back a little, but remains well above the zero line. Moreover, positive earnings surprises continue to trounce negative surprises. That said, the earnings upgrades are partly due to the Trump tax cuts, which are still being reflected in analysts' estimates. Second, some of our indicators are warning that there are clouds on the horizon. Our Monetary Indicator has fallen to levels that are low by historical standards, which is a negative sign for risk assets. This partly reflects the slowdown in growth in the monetary aggregates (see the Overview section). Our Equity Technical Indicator is threatening to dip below the zero line, which would be a clear 'sell' signal. Our Equity Valuation Indicator is flirting with our threshold of overvaluation, at +1 standard deviations. This is not bearish on its own, but valuation does provide information on the downside risks when the correction finally occurs. Our Willingness-to-Pay (WTP) indicator for the U.S. has rolled over, although this hasn't yet occurred for Japan and the Eurozone. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. This indicator suggests that flows into the U.S. stock market are waning. Finally, our Revealed Preference Indicator (RPI) for stocks remained on a 'sell' signal in June. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. These indicators are not aligned at the moment, further supporting the view that caution is warranted. The U.S. 10-year Treasury is slightly on the inexpensive side and our Composite Technical Indicator suggests that the bond has still not worked off oversold conditions. This suggests that the consolidation period has further to run, although we still expect yields to move higher over the remainder of the year. The dollar is expensive on a PPP basis, but is not yet overbought. The long-term outlook for the dollar is down, but it has more upside in the next 6-12 months. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-10U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

NOTE: There will be a few minor scheduling changes to BCA's China Investment Strategy service in July. We will publishing next week's report and the report scheduled on July 25 one day late, on Thursday, July 5 and 26, respectively. There will also be no report on Wednesday, July 18 due to our regular summer break. Highlights In response to the sharp spike in the risk of a full-blown U.S./China trade war, many market participants have concluded that significant fiscal and/or monetary policy stimulus is forthcoming. But for now, a depreciation in the RMB is the only clear and significant policy response to the imposition of U.S. import tariffs that we can currently observe, and we would still classify it as just a remedial measure. While a falling RMB will improve the financial position of China's exporters, it also increases the risk that the U.S. will follow through with the worst of their threats. Despite two conceivable upside scenarios for the equity market, we recommend a neutral stance towards Chinese stocks within a global equity portfolio and currently view the risks as largely to the downside. We are closing our long China / short Taiwan trade for a considerable profit, and recommend that investors go long low-beta sectors within the MSCI China index. Feature Chart 1A Decisive Technical Breakdown In ##br##Ex-Tech Stocks Vs Global A Decisive Technical Breakdown In Ex-Tech Stocks Vs Global A Decisive Technical Breakdown In Ex-Tech Stocks Vs Global In a Special Alert last week, we recommended that investors downgrade Chinese ex-tech stocks versus their global peers to neutral from overweight,1 after having placed them on downgrade watch at the end of March.2 Our recommendation was made in response to the ongoing slowdown in China's industrial sector, a significant escalation in the imposition of import tariffs between the U.S. and China, and an unfavorable shift in the risk/reward balance of global risky asset prices.3 It was also timely, as Chinese ex-tech stock prices have now decisively broken below their 200-day moving average (Chart 1). Following our shift in stance, the question facing BCA's China team, as well as global investors, is straightforward: Now what? Stimulus Watch The answer to this question among many market participants is that fiscal and/or monetary policy stimulus is forthcoming. We have no doubt that China will announce some remedial or compensatory measures in response to protectionist action from the U.S. Indeed, recent statements from the Ministry of Finance (MOF) suggest that planned fiscal spending for the year will be accelerated/brought forward, and the PBOC has already made a targeted cut to the reserve requirement ratio and reduced the relending rate for small company loans. However, we have argued that the bar for a fresh round of material stimulus is higher today than it was in the past, and we continue to hold this view. Elevated debt levels, excess capacity in some parts of the industrial sector, and worries about pollution all limit the extent to which the authorities can respond with the usual barrage of infrastructure spending and increased bank lending. The economy likely needs to feel more pain before policymakers come to its aid with enough magnitude to potentially spark another upswing in economic activity. Below we outline a few perspectives on the potential for stimulus, and how investors can gauge whether policymakers are deploying enough stimulus to materially impact China's economic outlook: Fiscal Stimulus The MOF's statement reflects the first fiscal policy action that China would likely take to combat any economic weakness, which is to speed up spending that has already been approved but was planned to occur later in the year. But from the perspective of whether a policy action is likely to materially boost economic activity, frontloading pre-approved spending would qualify, at best, as a remedial measure. In our view, tracking China's budgetary government finance data represents the best method for investors to determine whether policymakers are truly stimulating via the fiscal channel. While it is true that China's shadow budget deficit is much larger than the official data show (Chart 2), there is a crucial aspect of China's recent mini-cycle that is not well understood by many investors: almost all of the expansion of China's fiscal stance from 2014-16 was from on-budget rather than off-budget spending. Given that China has been trying to limit off-budget spending as part of its structural reform program, our sense is that this time won't be different if China decides that significant fiscal stimulus is required. This is good news for investors, given that on-budget spending is easier to observe in real-time, and Chart 3 presents two simple measures that we are using to monitor China's fiscal stance, alongside their year-over-year changes: on-budget expenditure and the on-budget balance, both as a % of GDP. Based on these measures there are no signs yet that the fiscal stance is easing (in fact, the opposite has occurred over the past year), but we will watching Chart 3 closely over the coming months for any indication of a change. Chart 2China's Shadow Budget Deficit Is Large... Now What? Now What? Chart 3...But If China Stimulates It Will Likely Be On-Budget ...But If China Stimulates It Will Likely Be On-Budget ...But If China Stimulates It Will Likely Be On-Budget Monetary Stimulus In our judgement, the recent cut to the reserve requirement ratio is not likely to be effective at stimulating the domestic economy. Investors should note that the initial reaction of many market participants to the April 17 reserve requirement ratio cut of 1% was that it represented a shift in the PBOC's policy stance towards easing, which ultimately proved to be a false narrative. Chart 4 shows China's 3-month interbank repo rate (China's de-facto policy rate which leads average lending rates), and highlights the timing of two specific events: March 28, when news broke that the PBOC would extend the deadline for the implementation of new regulatory standards for asset management products, and April 17, when the PBOC announced its targeted reserve requirement ratio cut. The chart makes it clear that the decline in the repo rate was in response to the deadline extension rather than the repo rate cut. This is entirely consistent with the findings of our February 22 Special Report,4 particularly the fact that 75% of the monetary tightening that has occurred since late-2016 has been regulatory in nature. We have previously argued that the dip in the repo rate in response to the deadline extension would probably be temporary,5 and Chart 4 shows that the rate has indeed increased over that past two months. In short, there is no evidence that the April 17 reserve ratio cut had any measurable effect on the stance of monetary policy in China. Given this, there are two key points for investors. The first is that small cuts to the reserve requirement ratio should be viewed, at best, as remedial measures that may help blunt the impact of shock to the export sector, but they are unlikely to alter the downward trajectory of the "old economy" (the portion of China's economy that is most relevant to global investors). The second is that if cuts to the reserve requirement ratio or any other monetary policy action stimulates the provision of credit via easier lending standards (rather than by reducing the cost of borrowing), their effect should result in a pickup in broad measures of credit growth rather than a reduction in interest rates. Chart 5 highlights that, for now, no such pickup has occurred; adjusted total social financing, which excludes equity issuance but includes municipal bonds, remains in a downtrend. This series, along with its impulse equivalent, are both included in the BCA Li Keqiang Leading Indicator which is at the core of our efforts to monitor the cyclical condition of China's business cycle. Chart 4No Evidence That April RRR Cut Eased Interest Rates No Evidence That April RRR Cut Eased Interest Rates No Evidence That April RRR Cut Eased Interest Rates Chart 5No Evidence That April RRR Cut Eased Lending Standards No Evidence That April RRR Cut Eased Lending Standards No Evidence That April RRR Cut Eased Lending Standards The Exchange Rate BCA's Geopolitical Strategy team has recently argued that China is likely to retaliate to a potential tariff imposition by weakening CNY/USD. This would have the effect of improving the competitiveness of exports priced in RMB, or would bolster the revenue of exporters selling goods priced in U.S. dollars (by way of receiving more RMB after converting the dollars received). Evidence has emerged over the past week to suggest that the PBOC is indeed allowing China's currency to depreciate against the U.S. dollar. Chart 6 shows the actual CNY/USD exchange rate alongside the value that would be predicted based on its relationship with the dollar over the year prior to its early-April peak. The chart suggests that the decline in CNY/USD appears to have, until very recently, reflected the strength in the U.S. dollar. However, the chart shows that CNY/USD has fallen over the past few days by magnitude in excess of what would be expected given movements in the U.S. dollar, implying that the very recent weakness is likely policy-driven. Chart 6The PBOC Is Letting CNY/USD Depreciate The PBOC Is Letting CNY/USD Depreciate The PBOC Is Letting CNY/USD Depreciate We agree that depreciating the currency versus the U.S. dollar will improve the financial condition of domestic exporters, but we would also caution investors against looking at a deep depreciation in CNY/USD in an encouraging light. We have noted in previous reports that such a development would be a clear sign of an outright, full-scale trade war between the U.S. and China, and in this context currency deprecation should still be classified as just a remedial measure (i.e. it is unlikely to lead to a renewed upswing in Chinese economic activity). Bottom Line: A depreciation in the RMB is the only clear and significant policy response to the imposition of U.S. import tariffs that we can currently observe, and we would still classify it as just a remedial measure. While a falling RMB will improve the financial position of China's exporters, it may also invite even further protectionist action from the U.S. Investment Recommendations Our recommendation to cut Chinese ex-tech stocks to neutral means that investors should be looking both for upside and downside risks when judging when to make their next allocation shift. For now, our discussion above underscores that we view the risks largely to the downside. The scenario that would cause us to further downgrade Chinese stocks to underweight within a global equity portfolio is not difficult to imagine: the worst outcome in the U.S. / China trade dispute materializes, the global economy slows meaningfully, and the inertia from the ongoing structural reform program causes Chinese policymakers to limit their stimulus to compensatory, remedial measures until a painful slowdown emerges in the domestic economy. We are not yet past the "point of no return" on the way to this outcome, but the events of the past two weeks have clearly moved us further along the path. Conversely, there are two scenarios that we can envision that could cause us to upgrade Chinese stocks back to overweight: Chart 7Keep Monitoring Floor Space Sold Keep Monitoring Floor Space Sold Keep Monitoring Floor Space Sold A protectionist exchange occurs between China and the U.S. but fails to devolve to the most damaging outcome. China's remedial measures are successful at easing the pain from tariffs on domestic producers, and the economic outlook stabilizes. In this scenario the most acute risk would be removed, but the gradual underlying downtrend in China's "old economy" would be intact. In this case we would be more comfortable upgrading Chinese stocks if there was an additional reflationary tailwind, such as a boost from fiscal spending or some reversal of the monetary tightening that has occurred since late-2016. But a significant, exogenous acceleration in economic activity from some other sector of China's economy would also fit the bill, and we have argued in past reports that housing appears to be the best candidate. Chart 7 highlights that residential sales volume may now be in a gradual uptrend, which could translate into stronger construction in the months ahead. The second scenario that would cause us to upgrade Chinese stocks is straightforward: Chinese policymakers determine that the risks to growth from an export shock are unacceptably large given the existing slowdown in the industrial sector, and decide to temporarily reverse course on the structural reform path by opting for "big bang" fiscal and/or monetary stimulus. A significant and highly investment-relevant mini-cycle upswing occurred in China the last time that the authorities strongly prioritized growth, and we will watching closely for real indications of a shift in attitude in this direction. For now our judgement is that policymakers have a higher pain threshold than in the past, suggesting that this is outcome is not yet probable. Related to our decision to downgrade Chinese ex-tech stocks to neutral within a global equity portfolio, we have three updates to our trade book: We are closing our long MSCI China / short MSCI Taiwan position and upgrading our Taiwanese cyclical stance to neutral: Despite being massively overweight technology stocks, Chart 8 highlights that Taiwan is a comparatively low-beta equity market versus China. Our trade has generated a 21% return since we initiated it in February 2017, and we believe it is time to book profits. Given Taiwan's small size it is actually possible that its economy and/or equity market will suffer disproportionately if the worst U.S. / China trade outcome materializes, which could cause us to revisit the trade. But for now our judgement is that a neutral position is warranted. We are sticking with our long China onshore corporate bond trade: We would certainly expect credit spreads on Chinese corporate bonds to flare in response to a deteriorating economic outlook, but we highlighted in our June 13 Weekly Report how high the bar is for investors to lose money on these bonds.6 In short, China's corporate bond market already offers a margin of safety given its high yield and a comparatively short duration, and we do not see recent developments on the trade front as a sufficiently compelling reason to exit the trade. We are initiating a new trade - within the MSCI China index, long low-beta sectors / short benchmark: Chart 9 presents the relative US$ stock price return of a portfolio of low-beta level 1 GICS sectors within the MSCI China index, relative to the index itself. Our methodology in calculating the portfolio is the same as that employed in the A-share factor analysis that we presented in our June 13 report; namely it is a value-weighted portfolio of sectors with below-median rolling 1-year market beta.7 The chart shows that the portfolio has outperformed over time, but sold off quite substantially last year as the high-flying tech sector boosted the performance of the overall index. The relative performance trend for low-beta has recently strengthened and crossed above its 200-day moving average, which we regard as a supportive technical signal to initiate the trade. Chart 8Taiwan's Equity Market Is Low Beta Vs China's Taiwan's Equity Market Is Low Beta Vs China's Taiwan's Equity Market Is Low Beta Vs China's Chart 9Go Long Low-Beta Sectors Vs The Broad Market Go Long Low-Beta Sectors Vs The Broad Market Go Long Low-Beta Sectors Vs The Broad Market Bottom Line: Despite two potential upside scenarios, we recommend a neutral stance towards Chinese stocks within a global equity portfolio and currently view the risks as largely to the downside. We are closing our long China / short Taiwan for a considerable profit, and recommend that investors go long low-beta sectors within the MSCI China index. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Pease see China Investment Strategy Special Alert "Downgrade Chinese Stocks To Neutral", dated June 20, 2018, available at gis.bcaresearch.com. 2 Please see China Investment Strategy Special Report, "Chinese Stocks: Trade Frictions Make For A Tenuous Overweight," dated March 28, 2018, available at cis.bcaresearch.com. 3 Pease see Global Investment Strategy Special Report "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral", dated June 19, 2018, available at gis.bcaresearch.com. 4 Pease see China Investment Strategy Special Report "Seven Questions About Chinese Monetary Policy", dated February 22, 2018, available at cis.bcaresearch.com. 5 Pease see China Investment Strategy Weekly Report "China: A Low-Conviction Overweight", dated May 2, 2018, available at cis.bcaresearch.com. 6 Pease see China Investment Strategy Weekly Report "A Shaky Ladder", dated June 13, 2018, available at cis.bcaresearch.com. 7 The current sector weights of the portfolio are: 26% telecom services, 24% industrials, 19% health care, 16% utilities, and 14% consumer staples. Cyclical Investment Stance Equity Sector Recommendations

While copper prices remain comfortably within the $2.90 to $3.30/lb range they've occupied this year, the rising threat of a Sino - U.S. trade war spilling into the global trading system, along with slowing credit and monetary stimulus in China, will continue to roil copper markets. Refined copper prices - like most commodities - are highly sensitive to the level of world copper demand and EM imports, particularly out of Asia, which are closely tied to income. EM income growth is expected to remain strong; however, a global trade war, or a significant slowing in trade that reduces investment in EM markets and stymies income growth will be bearish for copper prices. Highlights Energy: Overweight. Going into tomorrow's OPEC 2.0 meeting in Vienna, the Kingdom of Saudi Arabia (KSA) and Russia apparently were divided on how much crude oil production needed to be restored to the market. Increases of as little as 300k to 600k b/d and as much as 1.5mm b/d are flying around the market in the lead-up to the meeting.1 Meanwhile, China threatened to impose tariffs on oil imports from the U.S. if President Trump goes ahead with additional tariffs. The increased Sino - American acrimony on trade issues raises the likelihood China will significantly increase oil imports from Iran, in our estimation, which will exacerbate tensions even further. Base Metals: Neutral. Copper treatment and refining charges (TC/RCs) soared at the end of last week following the closure of India's largest smelter. The Metal Bulletin TC/RC index went to an average of $85/MT at the end of last week, up from $82.25/MT. The pricing service also reported China's primary copper-smelting capacity is lower in June due to environmental constraints. Precious Metals: Neutral. Gold prices dropped below $1,300/oz following the FOMC meeting last week, as Fed officials - e.g., Dallas Fed President Robert Kaplan - nodded toward a fourth rate hike this year, even though his base case remained at three. Ags/Softs: Underweight. Grains and beans are down as much as 10% in the past week, on the back of additional tariffs announced by the Trump administration - 10% on $200 billion worth of Chinese imports. The new tariffs were a retaliatory move by the administration, and represent an escalation of tit-for-tat measures by both sides. Feature Chart of the WeekMajor Drivers of Copper Prices Still Supportive Major Drivers of Copper Prices Still Supportive Major Drivers of Copper Prices Still Supportive Rising EM incomes and expanding world trade volumes, particularly EM imports, have supported base metals prices for the past two years. This was partly aided by expansionary fiscal and monetary policy in China, the world's largest base-metals market, in 2016, which reversed overly restrictive monetary and fiscal policy in the two years prior. For the most part, these supportive underpinnings are still in place for EM commodity growth over the next two years (Chart of the Week). However, their stability increasingly is being threatened by rising Sino - American trade tensions, and the limited room for credit and fiscal expansion in China.2 Global Copper Demand And Trade In its most recent update of global growth, the World Bank is expecting the rate of growth globally to level off this year and next. However, the Bank expects income growth in EM and developing economies - the growth engines of commodity demand - to go from 4.3% last year to 4.5% this year, and 4.7% next year. EM growth will be dominated by South Asia (Chart 2).3 EM GDP growth is of particular importance to commodity markets, since this constitutes the bulk of commodity demand growth generally, particularly in base metals and oil. For the largest EM economies, the income elasticity of demand for copper is 0.70, meaning a 1% increase in income leads to a 0.70% increase in copper consumption. The Bank notes, "The seven largest emerging markets (EM7) accounted for almost all the increase in global consumption of metals, and two-thirds of the increase in energy consumption" over the past 20 years.4 In what the Bank refers to as Low Income Countries (LICs) - a grouping of smaller economies loaded with commodity producers - GDP is expected to grow 6% p.a. on average over the 2018 - 2020 period. Chart 2World Bank Expects Solid EM Growth Trade Wars, China Credit Policy Will Roil Global Copper Markets Trade Wars, China Credit Policy Will Roil Global Copper Markets EM GDP growth fuels copper demand. Since 2000, a 1% increase in global copper consumption ex-China translates into an almost 2% increase in high-grade refined copper prices, based on results of our modeling. When we replace ex-China demand with China, we see a 1% increase in China's consumption translates into a 0.75% increase in high-grade copper prices over the 2000 - 2018 interval. China's growth is expected to slow going forward, in the wake of a managed slowdown, and due to the fact that, as its economy evolves, more of its growth will come from services and consumer demand, which are less commodity intensive. GDP growth also fuels trade, and vice versa. The Bank estimates the income elasticity of trade averaged 1.5% from 2000 - 07, and 1.2% from 2010 - 17, meaning a 1% increase in income has led to a roughly 1.4% growth in trade over this period. In our modeling, we've found a 1% increase in EM trade volumes translates into a 1.3% increase in high-grade copper prices, an elasticity in line with post-GFC trade growth. The other key variable in our modeling is the broad trade-weighted USD, which remains a highly important variable for copper prices. In both our global copper-demand and EM import volume models for copper prices, the level of the USD is an important explanatory variable - a 1% increase (decrease) in the USD TWIB translates into ~ 3% decrease (increase) in copper prices since 2000 in our estimates.5 Tight Credit Conditions In China Can Weigh On Copper ... We've been expecting China's managed slowdown in 2H18 to be offset by strong global demand, which, all else equal, would keep copper demand fairly stable.6 While we still do not expect a hard landing in China, the slowdown we've been expecting is showing up in weaker industrial production prints, disappointing retail sales in May, and most significantly, regulatory and liquidity tightening weighing on money and credit. Chinese demand makes up ~ 50% of global metal consumption, these markets would be especially vulnerable in the case of a significant slowdown. The fear of a more serious slump is founded on tighter financial conditions restricting capital spending, and GDP growth. Granger causality tests to determine the direction of causation between Chinese monetary variables and copper prices point to causality running from de-trended levels of all four measures of money and credit to copper prices (Table 1).7 Table 1Chinese Credit And Copper Prices: Evidence Of Causality Trade Wars, China Credit Policy Will Roil Global Copper Markets Trade Wars, China Credit Policy Will Roil Global Copper Markets Furthermore, y/y changes in copper prices are more highly correlated with monetary variables expressed in terms of de-trended levels, than with those same variables expressed as y/y growth rates, or impulses (Chart 3). Across the four credit and money measures, this expression yields an average correlation coefficient of 0.56, compared with 0.38 and 0.37 when expressed as y/y growth rates and impulses as a percent of GDP, respectively. Our modeling also indicates that it generally takes two to three quarters for the full effect of a change in China's credit conditions to be transmitted to copper markets. When we restrict the sample size to the period from 2010 to now we get similar results to our longer intervals (Chart 4). However monetary variables are more highly correlated with copper prices in the shorter sample. Chart 3Chinese Credit Leads Copper Prices By 3 Quarters... Trade Wars, China Credit Policy Will Roil Global Copper Markets Trade Wars, China Credit Policy Will Roil Global Copper Markets Chart 4...A Slightly Longer Lead Time Since 2010 Trade Wars, China Credit Policy Will Roil Global Copper Markets Trade Wars, China Credit Policy Will Roil Global Copper Markets Correlations in the period since 2010 average 0.61, 0.57, and 0.45 for the de-trended levels, y/y growth rates, and impulses, respectively. This can be put down to the fact that China's role as a demand market for copper has been steadily growing over this period. Given that between 2000 and 2017, China's share of global copper demand swelled from 12% to 50%, it is only natural that the impact of its domestic economy on global copper prices also increased (Chart 5). Furthermore, the time lag between Chinese monetary variables and copper markets in the more recent sample increased slightly, with money and credit variables leading prices by 9-10 months, compared to 6-8 months in the full sample. Chart 5China's Growing Role In Copper Markets Trade Wars, China Credit Policy Will Roil Global Copper Markets Trade Wars, China Credit Policy Will Roil Global Copper Markets Bottom Line: De-trended Chinese money and credit variables statistically cause, and are correlated with, y/y changes in copper prices. While these relationships have generally strengthened with China's growing role in the demand side of global copper markets, rolling correlations highlight that there are also extended periods of weak correlations, suggesting fundamental factors can overwhelm the impact of China's credit environment on global copper markets, as has been the case for the past two years. ...But Other Factors Can Take Over In estimating the effect of China's money and credit conditions on copper markets, we find that the relationship can be dominated by supply - demand fundamentals, and overall global macro conditions. More specifically, we find that in periods where DM equity markets outperform EM equity markets, the coefficients in our models with y/y copper prices as the dependent variable are on average 13% lower than the full sample period (Chart 6). Similarly, in periods where EM outperforms DM, the models' credit coefficients are on average 15% higher than the full sample period.8 Our modeling indicates the pre-2005 period as well as the post-2015 intervals as periods during which strong copper demand from growing DM economies weakened the long-term relationship between Chinese money and credit variables and copper prices. Given our expectation that DM demand will remain supportive, this will, to some extent, offset the negative implications of the deteriorating credit environment in China on copper demand and prices. Similarly, in periods characterized by backwardated copper markets, the magnitude of the impact of Chinese money and credit variables on copper prices is on average 35% lower than the full sample (Chart 7). On the other hand, when the copper market is in contango, the magnitude of the impact of Chinese financial variables is on average 13% higher than the full sample period. This highlights the importance of physical fundamentals, and the fact that in cases where they deviate from the direction of the Chinese credit environment - such as during a supply shock - the physical fundamentals weaken historical correlation relationships. Chart 6Credit-Copper Relationship Weakens When DM Outperforms EM ... Trade Wars, China Credit Policy Will Roil Global Copper Markets Trade Wars, China Credit Policy Will Roil Global Copper Markets Chart 7... And When Markets Are Backwardated Trade Wars, China Credit Policy Will Roil Global Copper Markets Trade Wars, China Credit Policy Will Roil Global Copper Markets To rank the top explanatory financial variables in terms of their effect on the evolution of copper prices, we estimated regression models with monetary variables, along with the broad trade-weighted U.S. dollar, and world excluding China copper demand as independent variables (Table 2). Table 2USD Usually Dominates Copper's Evolution Trade Wars, China Credit Policy Will Roil Global Copper Markets Trade Wars, China Credit Policy Will Roil Global Copper Markets The results, which can be interpreted as the y/y percentage point (pp) change in copper prices from a one y/y pp increase in each of the three explanatory variables, indicate that Chinese credit has a similar effect as a one y/y pp increase in world excluding China copper demand, a not-unexpected result, given the rest of the world accounts for 50% of demand. On the other hand, the USD has an outsized effect on the copper market. In our modeling, we've found that, in general, a one pp increase (decrease) in the broad trade-weighted USD translates into a one pp change in copper prices, using y/y models.9 Will Copper Vs. USD Correlations Return To Equilibrium? Our House view calls for a stronger USD going forward. Despite our expectation that DM demand will remain supportive, absent supply-side shocks, a stronger USD along with deteriorating credit conditions in China will weigh on copper prices.10 Ongoing trade disputes will only further bear down on the copper market. Stronger EM GDP growth and the associated increase in copper consumption and trade volumes will offset the strong-USD effects, but a trade war would undermine this support. A caveat to this conclusion is that while credit growth has been generally restrained, the Chinese government - fearful that its policy measures to date are spiraling out of control - may partially reverse its efforts and attempt some easing.11 Bottom Line: The impact of Chinese credit conditions on copper prices is weakened in periods where DM stock prices outperform EM, and when the copper forward curve is backwardated. In terms of the relative magnitude of the effect of China's credit conditions, we find that it has a similar sized effect as the rest of the world's copper demand on the red metal's price, while the USD has a relatively larger effect. This implies that a stronger USD, coupled with tighter financial conditions in China, will compete with expanding EM GDPs and trade growth going forward. Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 OPEC 2.0 is the name we've coined for the oil producer coalition lead by KSA and Russia. In November 2016, the coalition agreed to remove 1.8mm b/d of production. We estimate actual production cuts amount to 1.2mm b/d, while as much a 1.5mm b/d of production has been lost to depletion and a lack of maintenance drilling (e.g., infill and other forms of enhanced oil recovery). 2 Our colleague Peter Berezin, writing in this week's Global Investment Strategy, noting slowing industrial production, retail sales and fixed-asset investment, observes, China's "policy response has been fairly muted." Further, unlike 2015, when China stimulated its economy and lifted EM generally, this go-round, there is less room to maneuver owing to high debt levels and overcapacity. Please see BCA Research Global Investment Strategy Special Report "Three Policy Puts Go Kaput: Downgrade Global risk Assets To Neutral," dated June 20, 2018, available at gis.bcaresearch.com. 3 Please see "The Role of Major Emerging Markets in Global Commodity Demand" in the Bank's Global Economic Prospects, June 2018, beginning on p. 61. 4 The Bank's EM7 are Brazil, China, India, Indonesia, Mexico, the Russian Federation, and Turkey. They account for ~ 25% of global GDP, and some 60% of global metals consumption. The income elasticities of aluminum and zinc demand for this group are 0.80 and 0.30, respectively. Please see Table SF1.1 on p. 70 of the Bank's June report. 5 The R2 statistic measuring the goodness of fit between actual copper prices and the modeled prices is 94% for the copper-consumption model, and 96% for the EM trade model over the 2000 - 2018 interval. The USD TWIB was used as an explanatory variable in both models. 6 Please see BCA Research Commodity & Energy Strategy Weekly Report "China's Managed Slowdown Will Dampen Base Metals Demand," dated March 29, 2018, available at ces.bcaresearch.com. 7 Given that in levels, the money and credit variables display a deterministic upward trend, we removed the trend from the data in order to isolate the fluctuations around this trend. This de-trended series is what is significant to copper demand, and thus the evolution of copper prices. 8 We use a threshold OLS model to estimate the y/y model coefficients. The average change in the value of the coefficient is based on the coefficients in the models' outputs of the four money and credit measures. 9 The R2 statistics measuring the goodness of fit between actual y/y changes and those estimated in our models were ~63% in all four models. 10 We discussed this at length last week in BCA Research Commodity & Energy Strategy Weekly Report "Correlations Vs. USD Weaken," dated June 14, 2018, available at ces.bcaresearch.com. 11 Some preliminary signs of potential easing include (1) the PBOC's most recent monetary policy decision in which it did not follow the US Fed's interest rate decision by hiking rates, as it generally does, and (2) a reduction in the reserve requirement ratio. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Insert table images here Trades Closed in Trade Wars, China Credit Policy Will Roil Global Copper Markets Trade Wars, China Credit Policy Will Roil Global Copper Markets

Highlights China's crude oil inventories - both strategic and commercial - have skyrocketed in recent years. This has entirely offset the decline in OECD commercial crude oil inventories. China's crude oil import growth is likely to average mid-single digit territory over the coming 18-24 months with risks of falling toward zero for several months. This is in sharp contrast to the average double-digit growth rate that prevailed during 2015-2017. Chinese crude oil inventories will rise much more slowly and a period of modest de-stocking in commercial crude inventories in China cannot be ruled out. Chinese crude oil final consumption growth is tempering alongside slowing growth in almost all major petroleum products demand. Both transportation and industrial consumption growth of petroleum products is showing considerable weakness. The investment implication is that Chinese oil demand and especially imports of crude oil will likely be much less supportive of oil prices in the coming two years than they have been in recent years.1 Feature The common narrative in the global investment community of late attributes the oil price rally since 2016 to the decline in OECD crude oil inventories. Yet, the OECD countries do not include China and many other developing nations. This report looks to shed light on China's impact on the oil market with respect to demand, output and inventories. The most revealing part of our assessment is that China's crude oil inventories have skyrocketed in recent years, which in turn have offset the decline in OECD commercial crude oil inventories. The top panel of Chart I-1 illustrates that when China's crude oil inventories are added to the OECD measure, the aggregate of global crude inventories is currently still near a record high. Chinese crude oil inventories have surged from 470 million barrels in 2014 to more than 1 billion barrels presently (Chart I-1, bottom panel). In brief, China has been importing much more oil than it has been consuming since the middle of 2014, when crude prices began to collapse (Chart I-2). In other words, the massive inventory accumulation has been a major force behind the double-digit growth in China's crude imports. Chart I-1Be Aware Of High Chinese Crude Oil Inventories Be Aware Of High Chinese Crude Oil Inventories Be Aware Of High Chinese Crude Oil Inventories Chart I-2China: Importing More Oil Than Consuming China: Importing More Oil Than Consuming China: Importing More Oil Than Consuming The key question for investors is: Will China maintain strong crude oil imports growth going forward? Having examined China's demand, output, and inventory dynamics, we conclude that the recent deceleration in Chinese crude oil import growth (to 5-6%) has been driven by legitimate fundamentals. Crude import growth is likely to average mid-single digit territory over the coming 18-24 months with risks of falling toward zero for several months. This is in sharp contrast to the average double-digit growth rate that prevailed during 2015-2017 (Chart I-3).2 Chart I-3Chinese Oil Imports Growth: ##br##No More Double Digits Chinese Oil Imports Growth: No More Double Digits Chinese Oil Imports Growth: No More Double Digits This suggests that China will be much less supportive of global oil prices in the coming year or two than it has been in recent years, a fact that may also weigh more generally on global investor sentiment towards China. A Clearer Picture Of Global Oil Inventories In Chart I-1, our calculation showed a massive buildup of China's crude oil inventories over the past three years, reaching a record high of 1,030 million barrels as of May 2018. Below we answer four questions about China's inventories: Why are China's oil inventories significant for investors? How did we calculate a timely monthly oil inventory estimate for China? How can investors judge the validity of our approach? What is the outlook for strategic and commercial inventory accumulation over the coming year? Why are China's oil inventories significant for investors? The following suggest that without China's oil inventory build-up, oil prices would not have rallied as much as they have over the past two years. In other words, China has been a major force pushing oil prices higher: Mainly due to the significant inventory buildup, the increase in Chinese oil imports has been bigger than the increase in global oil production in both 2016 and 2017, which are clearly different from previous years (Chart I-4, top panel). The 490 million-barrel increase in Chinese crude oil inventories over 2015-2017 alone mopped up 35% global oil production increase. While OECD commercial crude oil reserves have declined 275 million barrels from their July 2016 peak to May 2018, Chinese crude inventories have actually risen by 380 million barrels over the same period. As of May 2018, Chinese crude oil inventory levels had already risen to 36% of OECD total commercial crude oil inventories (Chart I-4, bottom panel). How did we calculate a timely monthly oil inventory estimate for China? Our Chinese crude oil inventory proxy was constructed based on the crude oil flow diagram shown in Chart I-5. Chart I-4China Has Been A Major Force For Oil Price Rally China Has Been A Major Force For Oil Price Rally China Has Been A Major Force For Oil Price Rally Chart I-5How We Derived Our Chinese Crude Oil Inventory Proxy? China's Crude Oil Inventories: A Slippery Slope China's Crude Oil Inventories: A Slippery Slope Total crude oil supply in China equals to the sum of crude oil net imports and domestic crude oil production. The crude oil available for demand is either for final consumption without any transformation, which in general only accounts for about 1-2% of total supply, or used in refineries to be transformed into petroleum products. The latter typically accounts for over 90% of total supply. The remaining unused crude oil is stored as either Strategic Petroleum Reserves (SPR) or Commercial Petroleum Reserves (CPR). Therefore, by deducting the crude oil consumed in the refining process from the total supply of crude oil, we derived the flow of inventory - the level of changes of inventory.3 By using the cumulative value of the flow inventory data, we were able to derive the stock of inventory. Here we assume the initial inventory in 2006 was zero. This assumption is reasonable as the first fill of the SPR was in 2007 and the stock of CPR was extremely low compared to current levels. Hence, any error in this calculation is reasonably minute. Chart I-2 on page 2 clearly shows that crude oil supply growth is much faster than the growth of domestic crude oil consumption, resulting in rising domestic crude oil inventories. In the meantime, Chart I-6 illustrates that most of the increase in China's crude oil imports have indeed been due to the massive build-up in domestic crude oil inventories - not growth in final demand. Chart I-6Significant Inventory Buildup Has Driven Up ##br##Chinese Crude Oil Imports Significant Inventory Buildup Has Driven Up Chinese Crude Oil Imports Significant Inventory Buildup Has Driven Up Chinese Crude Oil Imports Regarding the data, there is a technical question to clarify: Does the NBS data of crude oil consumed in the refining process cover all Chinese refineries? We believe so. The data always cover both state-owned refineries and large and medium non-state-owned refineries. The only question is whether the crude oil used in small refineries - which have capacity of 2 million tons per year or lower - are accounted for in the NBS data on the amount crude oil refined. According to NBS, the data is collected from refineries with annual main business income of RMB20 million and above. In China, all refineries have much higher revenue than RMB20 million. Even for a small refinery with capacity of 2 million tons per year, its annual main business income is considerably above this threshold. For example, at the end of 2013, there were 49 local refining enterprises in Shandong province, with total main business income of RMB 336 billion. This means on average one refining company in Shandong can generate about RMB 7 billion - significantly higher than the RMB20 million threshold. Investors should note that Shandong province has the most local refineries and owns the largest local refining capacity in China among all provinces. Since 2015 the government has also implemented supply reforms in the oil refinery sector, having shut down or upgraded outdated refining facilities with capacity of 2 million tons per year or lower. Therefore, the amount of crude oil used in the small refineries that is not captured by NBS statistics, if any, is insignificant. In addition, increasingly stringent environmental policies, intensifying domestic competition and rising requirements for higher-quality petroleum products have all forced many small refineries out of business. In brief, our level of conviction in our crude oil inventory estimate for China is high. How can investors judge the validity of our approach? Official Chinese oil inventory data does exist: the NBS publishes a yearly series of annual changes in domestic crude oil inventories. But the significance of our inventory estimate is that it is available with far greater frequency and timeliness than the official data, and a simple comparison of our proxy with the official data for crude oil inventories shows similar size and variations (Chart I-7). Hence, our inventory calculation provides investors with a timely monthly estimate of Chinese oil inventories that is consistent with official data. Chart I-7Validity Check: Our Inventory ##br##Proxy Vs. NBS Data Validity Check: Our Inventory Proxy Vs. NBS Data Validity Check: Our Inventory Proxy Vs. NBS Data What is the outlook for strategic and commercial inventory accumulation over the coming year? As of this past May, China had 290 million barrels of SPR and 740 million barrels of CPR. Looking forward, the pace of SPR accumulation will be significantly slower than the previous several years. Back in 2004, the government planned three phases of SPR construction. The first phase has long been completed, and was filled in before 2010. The completion of construction of the second phase of SPR was delayed from 2015 to last year. So far, the government has released little information about the third phase of SPR construction. Total capacity from the first two phases is 40 million tons: 12 million tons from the first phase and 28 million tons from the second phase. The NBS last December released Chinese crude oil SPR inventory data, which was at 37.73 million tons (277 million barrels) as of June 2017. We believe the second phase of the SPR was completed in the past 10 months, and that there is not much free SPR space left at the moment. The third phase has the same capacity (28 million tons, or about 200 million barrels) as the second phase. Given that in both first and second phases it has taken more than two years to select and construct the SPR sites, the fill of the third phase of the SPR will unlikely occur within the next two years. The CPR has been rising much faster than the SPR due to low oil prices and the government's policy of allowing local refineries to import crude oil starting in 2015. In the past three years, CPR accumulation accounted for about 80% of China's total crude oil inventory increase. This makes sense, as commercial crude oil users have much larger physical reserve space than the SPR. Also, both commercial users and the government would have taken advantage of previously low oil prices to import as much as they could during the past several years. This is in line with China's strategy of building commodities inventories when prices drop. Back in 2009-2010, when oil prices were low, China also significantly boosted its purchases of crude oil overseas to build up domestic crude oil inventories. As China will continue with its domestic refinery capacity expansion, we still expect further accumulation in the country's CPR, albeit at a much slower pace. That said, a brief period of modest de-stocking in commercial inventories of crude oil cannot be ruled out either. Current Chinese crude oil inventories (CPR and SPR combined) are no longer low (Chart I-8). They are equivalent to 123 days of crude oil net imports - much higher than the 90 days the IEA requires OECD countries to hold. Chart I-8Chinese Crude Oil Inventories: No Longer Low Chinese Crude Oil Inventories: No Longer Low Chinese Crude Oil Inventories: No Longer Low With Brent oil prices rising above $75 per barrel and elevated domestic crude oil inventories, both government and commercial users will likely slow their purchases of overseas oil for inventory accumulation. Tightening credit supply also will hinder companies' ability and willingness to finance more inventory accumulation. This might cause even a brief period of de-stocking in commercial inventories of crude oil. Bottom Line: After a massive buildup over the past three years, further inventory accumulation for both the SPR and CPR will slow considerably and in fact a period of modest de-stocking in commercial crude inventories in China cannot be ruled out. As a result, Chinese oil imports will converge to the pace of final demand growth. Tempering Final Oil Demand Growth In addition to our view that Chinese oil inventory accumulation will slow significantly and even could halt for several months, China's final oil demand growth is also trending lower (Chart I-9). As China's economic structure has been shifting from exports and investments to consumer spending, its energy intensity has declined. Petroleum products consumption within industry (mining, manufacturing and electricity generation) posted the biggest decline on record in the past decade, while consumption in transport service and residential posted the largest gains (Chart I-10, top panel). In 2016, the transport service and residential sectors (car driving and cooking and heating) together accounted for 83% of the increase in Chinese total petroleum products consumption (Chart I-10, bottom panel). Chart I-9Slowing China's Oil Consumption Growth Slowing China's Oil Consumption Growth Slowing China's Oil Consumption Growth Chart I-10Drivers Of Chinese Oil Consumption Growth China's Crude Oil Inventories: A Slippery Slope China's Crude Oil Inventories: A Slippery Slope In terms of types of petroleum products, this economic shift has translated into higher growth in gasoline, kerosene and LPG consumption, and lower growth in diesel fuel and fuel oil consumption. Gasoline and kerosene are mainly consumed as fuel for passenger cars and airplanes, respectively. LPG is also widely used for residential heating and cooking fuel. By comparison, diesel fuel and fuel oil are more used in the industrial process, even though diesel is also a major fuel for commercial trucks and special vehicles. As a result, gasoline, kerosene and LPG have experienced a rising share of total Chinese petroleum consumption, while diesel and fuel oil and other products have drifted lower (Chart I-11). Looking forward, we still expect positive growth in Chinese petroleum products consumption, but expect it to fall from 4-5% to 3-4% over the next two years. Chinese car sales growth will remain weak at 1-2% in the coming years as rising car ownership, advanced public transportation and high frequency of traffic jams temper car sales growth (Chart I-12). Chart I-11Chinese Oil Products As Share Of Total ##br##Oil Consumption: Gains And Losses China's Crude Oil Inventories: A Slippery Slope China's Crude Oil Inventories: A Slippery Slope Chart I-12Weak Car Sales Growth Weak Car Sales Growth Weak Car Sales Growth Some government policies are discouraging residents from owning a car. For example, Beijing car buyers are required to obtain a license plate through a random draw before they can actually drive their car. The odds of obtaining a plate in Beijing as of this past February stood at an astonishingly low 1 in 1,907 - twice as low as the end of last year (1 in 800) and the lowest since the license plate lottery was introduced in January 2011. In Shanghai and Shenzhen, it costs more than $14,000 to get a new car license plate, and the success rate of bidding keeps declining. Meanwhile, the authorities' priority is to move to ecologically friendly vehicles. The government has been using sale tax discounts to promote sales of small-engine cars with engines up to 1.6L from 2008 to 2017. As a result, among existing cars and new car sales, passenger cars with capacity under 1.6L account for over 55% of total cars (Chart I-13). The government also encourages new energy vehicle (NEV) sales through direct cash subsidies, tax subsidies and easier access to a new car plate. With the government's support, we expect NEV sales growth to remain high (Chart I-14). NEV sales reached 770 thousand units last year, and accumulated sales will rise to 5 million units by 2020. Chart I-13Government Promotes ##br##Ecologically Friendly Vehicles Government Promotes Ecologically Friendly Vehicles Government Promotes Ecologically Friendly Vehicles Chart I-14Strong Growth of New Energy ##br##Vehicle Sales Will Continue Strong Growth Of New Energy Vehicle Sales Will Continue Strong Growth Of New Energy Vehicle Sales Will Continue In addition, the government is aiming to improve the average passenger car's fuel efficiency from 6.7L/100KM to 5L/100KM in 2020 and further to 4L/100KM in 2025. This means a 25% reduction in fuel consumption for driving 100KM over the next two years, and another 20% reduction from 2020 to 2025. Fuel efficiency improvement has been limited in the past several years as gas-guzzling SUVs have dominated sales. The government could increase its policy enforcement to facilitate the improvement in fuel efficiency over the next 12-18 months as we move closer to 2020. China has also started promoting ethanol consumption in transportation fuel to substitute gasoline to some extent. The industrial sector will continue to slow, which will lead to lower diesel and fuel oil demand. Bottom Line: Chinese organic oil demand growth is on a weakening path. Improving Chinese Crude Oil Production After accounting for inventory accumulation and underlying demand growth, production is the final aspect to consider when analyzing China's impact on the market for oil. The big contraction in Chinese crude oil production - a 6.9% drop in 2016 and a 4.1% decline last year - has contributed to 33% and 22% of Chinese net imports growth in 2016 and 2017, respectively (Chart I-15). Chart I-15Chinese Crude Oil Production ##br##Will Likely Improve Chinese Crude Oil Production Will Likely Improve Chinese Crude Oil Production Will Likely Improve Aging fields and oil prices below break-even production costs are the main culprits behind shrinking output. We expect Chinese crude oil output to recover over the next 12-18 months. As China has a crude oil production target of a minimum of 200 million tons in 2020, the country has to boost its output by 4.4% over the next two years. Odds are high that Chinese crude oil output may at least stop falling this year. Petro China has produced 1.38 million tons of crude oil in Xinjiang in the past two years and plans to raise its output from the region to 6 million tons, in accordance with the country's 13th five-year development plan (2016-2020). Rising oil prices may help recover some production losses. In 2016, some high-cost and low-efficiency production in the Shengli oilfield was shut down. In that year, the Xinjiang oilfield also cut 700 thousand tons of production. Oil majors such as PetroChina and CNOOC are ramping up their upstream exploration efforts. Bottom Line: Chinese crude oil output is likely to recover over the next 12-18 months. Investment Conclusions The major investment implication from the above analysis is that Chinese oil demand and imports will be much less supportive for global oil prices in the coming two years than they have been in recent years. Chart I-16Crude Oil: Still Near-Record ##br##High Speculative Positions Crude Oil: Still Near-Record High Speculative Positions Crude Oil: Still Near-Record High Speculative Positions From the perspective of BCA's China Investment Strategy service, this reality may weigh on global investor sentiment towards China given the prominence that many market participants place on China's commodity demand when judging its contribution to global economic activity. BCA's China team downgraded Chinese ex-tech stocks versus their global peers to neutral from overweight in yesterday's Special Alert,4 and our conclusions in this report support that recommendation. From the perspective of BCA's Emerging Markets Strategy service, the "China factor" has probably not been well discounted in the current price of oil, as both net speculative positions and open interest in crude oil recently rose to their highest levels since at least 2000 (Chart I-16). Hence, the Emerging Markets Strategy team believes the risk-reward for oil prices is poor. In comparison, a lot of positive news that has already occurred and is widely known by investors - i.e. OPEC production rationing, U.S. newly re-imposed sanctions on Iran and a further decline in Venezuelan crude oil output - has likely already been fully discounted in current oil prices. In addition, emerging market (EM) ex-China crude oil demand is facing strong headwinds, given that oil prices in many emerging countries in local currency terms have risen substantially and in some cases to new highs (Chart I-17A and Chart I-17B ). Besides, as many of these countries have removed fuel subsidies, local prices will continue to move in tandem with world oil prices. Chart I-17AOil Demand Growth In EM Ex-China: ##br##Facing Strong Headwinds Oil Demand Growth in EM ex-China: Facing Strong Headwinds Oil Demand Growth in EM ex-China: Facing Strong Headwinds Chart I-17BOil Demand Growth In EM Ex-China: ##br##Facing Strong Headwinds Oil Demand Growth in EM ex-China: Facing Strong Headwinds Oil Demand Growth in EM ex-China: Facing Strong Headwinds The combination of both high local currency oil prices and fuel subsidies removals entails that consumers in many developing countries are already feeling the pain from higher oil prices, and their demand will slow. EM ex-China accounts for 45.3% of global oil consumption. Hence, weakness in EM demand from EM ex-China will not be inconsequential for oil prices. Ellen JingYuan He, Associate Vice President Frontier Markets Strategy EllenJ@bcaresearch.com 1 This view differs from BCA's Commodities and Energy Strategy team's view on oil that is bullish. 2 Our research suggests that China's net exports of petroleum products will likely continue to rise strongly and require even more crude oil imports. However, the increase of Chinese crude oil imports for rising net petroleum products will not affect total global crude oil demand as its final oil products will just be consumed outside of China. Hence, it is about shifts in market share of refineries not oil final demand. 3 This is also adjusted for final consumption of crude oil without refining. This use of crude oil account for only 1-2% of total crude oil supply (output plus net imports). 4 Please see China Investment Strategy Special Alert "Downgrade Chinese Stocks To Neutral," dated June 20, 2018, available on cis.bcaresearch.com

Three macro "policy puts" are in jeopardy of disappearing or, at the very least, being repriced. Fed Put: Rising inflation has made the Fed more reluctant to back off from rate hikes at the first hint of slower growth or falling asset prices. China Put: Worries about high debt levels, overcapacity, and pollution all mean that the bar for fresh Chinese stimulus is higher than in the past. Draghi Put: Bailing out Italy was a no-brainer in 2012 when the country was the victim of contagion from the Greek crisis. But now that Italy is the source of the disease, the rationale for intervention has weakened. These factors, along with additional risks such as mounting protectionism, warrant a more cautious 12-month stance towards global equities and other risk assets. The fact that valuations are stretched across most asset classes only adds to our concern. A neutral stance does not imply that we expect markets to move sideways. On the contrary, volatility is likely to increase over the balance of the year, with the next big move for global equities probably being to the downside. Buckle Up One of BCA's key ongoing themes is that policy and markets are on a collision course. We are starting to see this impending crash play out across the world. Higher Inflation Is Tying The Fed's Hands A slowdown in global growth caused the Fed to abort its tightening plans for 12 months starting in December 2015. Global growth is faltering again, but this time around the Fed is less eager to hit the pause button. In contrast to 2015, the U.S. economy has run out of spare capacity. The unemployment rate fell to a 48-year low of 3.75% in May. For the first time in the history of the Bureau of Labor Statistics' Job Openings and Labor Turnover Survey (JOLTS), there are more job vacancies than unemployed workers (Chart 1). Average hourly earnings surprised on the upside in May, while the Employment Cost Index for private-sector workers - the cleanest and most reliable measure of U.S. wage growth - rose at a robust 4% annualized pace in the first quarter. Labor market surveys, which generally lead wage growth by three-to-six months, are pointing to a further acceleration in wages (Chart 2). Chart 1There Are Now More ##br##Vacancies Than Jobseekers There Are Now More Vacancies Than Jobseekers There Are Now More Vacancies Than Jobseekers Chart 2U.S. Wage Growth Is Set To Accelerate U.S. Wage Growth Is Set To Accelerate U.S. Wage Growth Is Set To Accelerate The Dollar Rally Can Keep Going Rising wages will put more income into workers' pockets, who will then spend it. Stronger demand can be partly satisfied by imports, but it will take a change in relative prices for that to happen. U.S. imports account for only 16% of GDP. Unless the prices of foreign-made goods decline in relation to the prices of domestically-produced goods, the bulk of any additional household income will be spent on goods produced in the U.S. This means that the dollar needs to strengthen. The Fed's broad trade-weighted dollar index is up 8% since the start of February. While we are not as bullish on the dollar as we were a few months ago, we still believe that the path of least resistance for the greenback is up. Our long DXY trade recommendation has gained 12.1% inclusive of carry since we initiated it. We are raising the target price from 96 to 98. A stronger dollar can help deflect some additional spending towards imports, but this won't be enough to fully cool the economy. Services, which generally cannot be imported, account for nearly two-thirds of GDP. Since it takes time to shift resources from goods-producing sectors to service sectors, any rising aggregate demand will boost service prices. Outside of housing, service-sector inflation is already running at 2.4%, a number that is likely to rise further over the coming year (Chart 3). This will keep the Fed on edge. Hard Times For Emerging Markets The combination of rising U.S. rates and a stronger dollar is bad news for emerging markets. Eighty percent of EM foreign-currency debt is denominated in dollars. Outside of China, EM dollar debt is now back to late-1990s levels both as a share of GDP and exports (Chart 4). Chart 3Faster Wage Growth Will Push ##br##Up Service Inflation Faster Wage Growth Will Push Up Service Inflation Faster Wage Growth Will Push Up Service Inflation Chart 4EM Dollar Debt Back To Late-1990s Levels EM Dollar Debt Back To Late-1990s Levels EM Dollar Debt Back To Late-1990s Levels The wave of EM local-currency debt issued in recent years only complicates matters. If EM central banks raise rates to defend their currencies, this could imperil economic growth and make it difficult for local-currency borrowers to pay back their loans. Rather than hiking rates, some EM central banks may simply choose to inflate away debt. Consider the case of Brazil. Ninety percent of Brazilian sovereign debt is denominated in reais. The Brazilian government won't default on its debt per se. However, if push comes to shove, Brazil's central bank can always step in to buy government bonds, effectively monetizing the fiscal deficit. The specter of trade wars only adds to the risks facing emerging markets. A larger U.S. budget deficit will drain national savings, leading to a bigger trade deficit. Rather than blaming his own macroeconomic policies, President Trump will blame America's trading partners. Global trade has already been flatlining for over a decade (Chart 5). Trump's trade agenda will further undermine the global trading system. Emerging markets will bear the brunt of that development. Chart 5Global Trade Has Crested Global Trade Has Crested Global Trade Has Crested Chinese Stimulus To The Rescue? When emerging markets last succumbed to pressure in 2015, China saved the day by stepping in with massive new stimulus. Fiscal spending and credit growth accelerated to over 15% year-over-year. The government's actions boosted demand for all sorts of industrial commodities. Today, Chinese growth is slowing again. May data on industrial production, retail sales, and fixed asset investment all disappointed. Property prices in tier 1 cities are down year-over-year. Our leading indicator for the Li Keqiang index, a widely followed measure of economic activity, is in a clear downtrend (Chart 6). So far, the policy response has been fairly muted. Reserve requirements have been cut and some administrative controls loosened, but the combined credit and fiscal impulse has plunged (Chart 7). Onshore and offshore corporate bond yields have increased to multi-year highs. Bank lending rates are rising, while loan approvals are dropping (Chart 8). Chart 6Chinese Growth Is Slowing Anew Chinese Growth Is Slowing Anew Chinese Growth Is Slowing Anew Chart 7China: Policy Response To Slowdown ##br##Has Been Muted So Far China: Policy Response To Slowdown Has Been Muted So Far China: Policy Response To Slowdown Has Been Muted So Far Chart 8China: Credit Tightening China: Credit Tightening China: Credit Tightening We have no doubt that China will stimulate again if the economy appears to be heading for a deep slowdown. However, the bar for a fresh round of stimulus is higher today than it was in the past. Elevated debt levels, excess capacity in some parts of the industrial sector, and worries about pollution all limit the extent to which the authorities can respond with the usual barrage of infrastructure spending and increased bank lending. The economy needs to feel more pain before policymakers come to its aid. Draghi's Dilemma The Italian economy was showing signs of weakness even before bond yields exploded higher. Domestic demand slowed to a mere 0.3% qoq in Q1. The PMIs, consumer confidence, and the Bank of Italy's Ita-Coin cyclical indicator all decelerated (Chart 9). Italy would benefit from a more competitive cost structure, but the political will to undertake the sort of reforms Germany implemented in the late 1990s, and that Spain implemented after the Great Recession, has been sorely lacking (Chart 10). Unwilling to take tough actions to improve competitiveness, the Five Star-Lega coalition government has proposed loosening fiscal policy to support demand. Chart 9Italy's Economy Is Weakening... Again Italy's Economy Is Weakening... Again Italy's Economy Is Weakening... Again Chart 10Italy: More Work Needs To Be Done On ##br##The Labor Competitiveness Front Italy: More Work Needs To Be Done On The Labor Competitiveness Front Italy: More Work Needs To Be Done On The Labor Competitiveness Front Italy's shift towards populism is arriving at the same time that the ECB is looking to wind down its asset purchase program. This means that a key buyer of Italian debt is stepping back just when it may be needed the most. Getting the ECB to bail out Italy will not be as straightforward this time around. Recall that Mario Draghi and Jean-Claude Trichet penned a letter to the Italian government in 2011 outlining a series of reforms they wanted to see enacted as a condition of ongoing ECB support. The contents of the letter were so explosive that they precipitated the resignation of then-PM Silvio Berlusconi when they were leaked to the public. One of the reforms that Mario Draghi demanded - and the subsequent government led by Mario Monti ultimately undertook - was the extension of the retirement age. Italy's current government has explicitly promised to reverse that decision much to the consternation of the ECB and the European Commission. It was one thing for Mario Draghi to promise to do "whatever it takes" to protect Italy when the country was the victim of contagion from the Greek crisis. But now that Italy is the source of the disease, the rationale for intervention has weakened. Investment Conclusions The outlook for global risk assets is likely to be more challenging over the coming months. With that in mind, we are downgrading our 12-month recommendation on global equities and credit from overweight to neutral. A neutral stance does not imply that we expect markets to move sideways. On the contrary, volatility is likely to increase again over the balance of the year, with the next big move for global equities probably being to the downside. Although Treasurys could rally in the near term, higher U.S. inflation will push bond yields up over a 12-month horizon. Given that yields are positively correlated across international bond markets, rising U.S. yields will put upward pressure on yields in the rest of the world. As such, we recommend shifting equity allocations towards cash rather than long-duration bonds. We would also reduce credit exposure. Within the commodity complex, the backdrop for crude remains more favorable than for economically-sensitive metals. Investors should underweight EM equities, credit, and currencies relative to their developed market peers. The Fed needs to tighten U.S. financial conditions to prevent the economy from overheating. Chart 11 shows that EM equities almost always fall when that is happening. Chart 11Tighter U.S. Financial Conditions Do Not Bode Well For EM Stocks Tighter U.S. Financial Conditions Do Not Bode Well For EM Stocks Tighter U.S. Financial Conditions Do Not Bode Well For EM Stocks A stronger dollar will hurt the profits of U.S. multinationals. That said, the sector composition of the U.S. stock market is a bit more defensive than it is elsewhere. On balance, we no longer have a strong view that euro area and Japanese equities will outperform the U.S. in local-currency terms, and hence we are closing our trade recommendation to this effect for a loss of 5.4%. If macro developments evolve as we expect, we will shift to an outright bearish stance on risk assets later this year or in early 2019 in anticipation of a global recession in 2020. That said, we would consider moving our 12-month recommendation temporarily back to overweight if global equities were to sell off by more than 15% over the next few months or the policy environment becomes markedly more market friendly. But at current prices, the risk-reward trade-off no longer justifies a high degree of bullishness. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Feature In a Global Investment Strategy service Special Report sent to all BCA clients yesterday,1 we recommended downgrading global equities to neutral (from overweight) over the coming year. For BCA's China Investment Strategy service, the most immediate implication of this change in recommendation is that an overweight stance towards Chinese stocks within a global portfolio is no longer justified. Consequently, we are closing two open positions in our trade book: 1) long MSCI China ex-technology / short MSCI All Country World ex-technology, and 2) long MSCI China value / short MSCI All Country World value. The rationale behind our downgrade of global equities is rooted in the view that there has been an unfavorable shift in the risk/reward balance for risky assets. A potential slowdown in global growth, fueled by protectionist action in the U.S. and dollar-driven weakness in emerging markets, could be met by intransigent policy, particularly in the U.S. In this scenario, financial markets would be set up for a collision course with global policymakers, which could precipitate a material selloff in risky asset prices before a sufficiently large policy response could be deployed. In the case of China, we have argued many times over the past several months that a slowdown in its industrial sector raised the risk of eventual underperformance of ex-tech "old economy" stocks versus their global peers. Chart 1 highlights that our leading indicator for the Li Keqiang index suggests that the index itself is set to decelerate further over the coming months, and we have highlighted that this poor domestic growth momentum means that fiscal or monetary stimulus will likely be required if China suffers a sudden export shock. This week's sharp escalation of protectionist action between the U.S. and China clearly raises the risk of such a shock. In addition, we showed in a January Special Report that China has become a high-beta equity market versus the global benchmark (in common currency terms) over the past few years,2 and Chart 2 shows that this is true even for ex-tech stock prices. In our judgement, the combination of an ongoing slowdown in China's industrial sector, a significant escalation in the imposition of import tariffs between the U.S. and China, and an unfavorable shift in the risk/reward balance of global risky asset prices is a compelling reason to reduce pro-cyclical exposure to China. Chart 1China's Old Economy Will Continue To Slow China's Old Economy Will Continue To Slow China's Old Economy Will Continue To Slow Chart 2Chinese Stocks Are High Beta, Even Excluding Technology Chinese Stocks Are High Beta, Even Excluding Technology Chinese Stocks Are High Beta, Even Excluding Technology Bottom Line: We are closing two pro-cyclical positions in our trade book, and recommend that investors downgrade Chinese stocks to neutral within a global equity portfolio. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Pease see Global Investment Strategy Special Report "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral", dated June 19, 2018, available at gis.bcaresearch.com. 2 Pease see China Investment Strategy Special Report "China: No Longer A Low-Beta Market", dated January 11, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights BCA's Geopolitical Power Index (GPI) confirms that we live in a multipolar world; Most of President Trump's policies are designed to strike out against this structural reality; Trade war with China is real and presents the premier geopolitical risk in 2018; President Trump's aggression towards G7 allies boils down to greater NAFTA risk; We remain bullish USD, bearish EM, maintain our short U.S. China-exposed equities and closing all our "bullish" NAFTA trades; Remain short GBP/USD, Theresa May's days appear numbered. Feature "We're going to win so much, you're going to be so sick and tired of winning." Candidate Donald Trump, May 26, 2016 In 2013, BCA's Geopolitical Strategy introduced the concept of multipolarity into our financial lexicon.1 Multipolarity is a term in political science that denotes when the number of states powerful enough to pursue an independent and globally relevant foreign policy is greater than one (unipolarity) or two (bipolarity). At the time, the evidence that U.S. global hegemony was in retreat was plentiful, but the idea of a U.S. decline was still far from consensus. By late 2016, however, President Donald Trump was overtly campaigning on it. His campaign slogan, "Make America Great Again," promised to reverse the process by striking out at the perceived causes of the decline: globalization, unchecked illegal immigration, and the ineffective foreign policy of the D.C. establishment. How can we quantitatively prove that the world is multipolar? We recently enhanced the classic National Capability Index (NCI) with our own measure, the Geopolitical Power Index (GPI). The original index, created for the Correlates of War project in 1963, had grown outdated. Its reliance on "military personnel" and "iron and steel production" harkened back to the late nineteenth century and overstated the power of China (Chart 1). Chart 1The National Capability Index Overstates China's Power The National Capability Index Overstates China's Power The National Capability Index Overstates China's Power Our own index avoids these pitfalls, while retaining the parsimony of the NCI, by focusing on six key factors: Population: We adapted the original population measure by penalizing countries with large dependency ratios. Yes, having a vast population matters, but having too many dependents (the elderly and youth) can strain resources otherwise available for global power projection. Global Economic Relevance: The original index failed to capture a country's relevance for the global economy. Designed at the height of the Cold War, the NCI did not foresee today's globalized future. As such, we modified the original index by introducing a measure that captures a country's contribution to global final demand. The more an economy imports, the greater its bargaining power in terms of trade and vis-à-vis its geopolitical rivals. Arms Exports: Having a large army is no longer as relevant now that wars have become a high-tech affair. To capture that reality, we replaced the NCI's focus on the number of soldiers with arms exports as a share of the global defense industry. We retained the original three variables that measure primary energy consumption, GDP, and overall military expenditure. Chart 2 shows the updated data. As expected, the U.S. is in decline, having lost nearly a third of its quantitatively measured geopolitical power since 1998. Over the same period, China has gone from having just 30% of U.S. geopolitical power to over 80%. Other countries, like Russia, India, Turkey, Iran, and Pakistan, have also seen an increase in geopolitical power over the same period, confirming their roles as regional powers (Chart 3). Chart 2BCA's Geopolitical Power Index Illustrates A Multipolar World BCA's Geopolitical Power Index Illustrates A Multipolar World BCA's Geopolitical Power Index Illustrates A Multipolar World Chart 3China Was Not The Only EM To Rise Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? President Trump was elected with the mandate of changing the trajectory of American power and getting the country back on a "winning" path. Investors can perceive nearly all the moves by the administration - from protectionist actions against China and traditional allies, to applying a "Maximum Pressure" doctrine against North Korea and Iran - as a fight against the structural decline of U.S. power. Isn't President Trump "tilting at windmills"? Fighting a vain battle against imaginary adversaries? Yes. The decline of the U.S. is a product of classic imperial overstretch combined with the natural lifecycle of any global hegemon. U.S. policymakers have made decisions that have hastened the decline, but the overarching American geopolitical trajectory would have been negative regardless: Global peace brought prosperity which strengthened Emerging Markets (EM), particularly China, relative to the U.S. That said, Trump is not as crazy as the media often imply. Chaos is not necessarily bad for a domestically driven economy secured by two oceans. The U.S. tends to outperform the rest of the world - economically, financially, and geopolitically - amid turbulence. Our own updated GPI shows that both World Wars were massively favorable for U.S. hegemony (Chart 4), although this time around the chaos is mostly self-inflicted. Chart 4America Profits From Chaos America Profits From Chaos America Profits From Chaos Similarly, Trump's economic populism at home is buoying sentiment and assuaging the negative consequences - real or imagined - of his protectionism. Meanwhile, the threat of tariffs is souring the mood abroad. This policy mix is causing U.S. assets to outperform (Chart 5). Most importantly, the U.S. dollar is now up 2.7% since the beginning of the year, putting pressure on EM assets. When combined with continued counter-cyclical structural reforms in China, we maintain that the overall macro and geopolitical context remains bearish for global risk assets. This is not the first time that an American president has deployed both an aggressive trade policy and an aggressive foreign policy. The difference, this time around, is that the world is multipolar. A defining feature of multipolarity is that it is less predictable and more likely to produce inter-state conflict (Chart 6). As more countries matter - geopolitically, economically, financially - the number of "veto players" rises, making stable equilibria more difficult to produce. As such, bullying as a negotiating tactic worked when used by Presidents Nixon, Reagan, Bush Jr., and Clinton, but may not work today. Investors should therefore prepare for a long period of uncertainty this summer as the world responds to a U.S. administration focused on "winning." Chart 5U.S. Assets Outperform U.S. Assets Outperform U.S. Assets Outperform Chart 6Multipolarity Produces Uncertainty Multipolarity Produces Uncertainty Multipolarity Produces Uncertainty Bottom Line: There is a clear logic behind President Trump's foreign and trade policy. He is trying to reverse a decline in U.S. hegemony. The problem is that his policy decisions are unlikely to address the structural causes of America's decline. What is much more likely is that his policy will cause the rest of the world to react in unpredictable ways. The U.S. may benefit, but that is not a forgone conclusion. Investors should position themselves for a volatile summer. Below we review three key issues, two negative and one positive. The U.S. Vs. China: The Trade War Is Real The Trump administration has announced that it will go ahead with tariffs on $50 billion worth of Chinese imports in retaliation for forced technology transfer and intellectual property theft under Section 301 of the 1974 Trade Act. The tariffs will come in two tranches beginning on July 6. China will respond proportionately, based on both its statements and its response to the steel and aluminum tariffs (Chart 7). If the two sides stop here, then perhaps the trade war can be delayed. But Trump is already saying he will impose tariffs on a further $200 billion worth of goods. At that point, if Beijing re-retaliates, China's proportionate response will cover more goods than the entire range of U.S. imports (Chart 8). Retaliation will have to occur elsewhere. Chart 7Trump's Steel/Aluminum Tariffs Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? Chart 8Trump's Tariffs On China Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? We would expect the CNY/USD to weaken as negotiations fail. We would also expect tensions to continue spilling over into the South China Sea and other areas of strategic disagreement.2 The South China Sea or Taiwan could produce market-moving "black swan" geopolitical events this year or next.3 Chart 9Downside Risks Continue Downside Risks Continue Downside Risks Continue It is critical to distinguish between the U.S. trade conflict with China and the one with the G7. In the latter case, the U.S. political establishment will push against the Trump administration, encouraging him to compromise. With China, however, Congress is becoming the aggressor and we certainly do not expect the Defense Department or the intelligence community to play the peacemaker with Beijing. In particular, members of Congress are trying to cancel Trump's ZTE deal while expanding the powers of the Committee on Foreign Investment in the United States (CFIUS) to restrict Chinese investments.4 These congressional factors underscore our theme that U.S.-China tensions are structural and secular.5 Would China stimulate its economy to negate the effects of tariffs? We see nothing yet on the policy side to warrant a change in our fundamental view, which holds that any stimulus will be limited due to the agenda of containing systemic financial risk. Credit growth remains weak and fiscal spending has not yet perked up (Chart 9), portending weak Chinese imports and negative outcomes for EM. The risk to Chinese growth remains to the downside this year (and likely next year) as the government continues with the reforms. Critically, stimulus is not the only possible Chinese response to trade war. A trade war with the United States will provide Xi with a "foreign devil" on whom he can blame the pain of structural reforms. As such, it is entirely possible that Beijing doubles-down on reforms in light of an aggressive U.S. Bottom Line: The U.S.-China trade war is beginning and will cause additional market volatility and, potentially, a "black swan" event, especially ahead of the U.S. midterm elections. We do not expect 2015-style economic stimulus from Beijing. Stay long U.S. small caps relative to large caps; short U.S. China-exposed equities; and remain short EM equities relative to DM. The U.S. Vs. The G6: This Is About NAFTA There was little rhyme or reason to President Trump's smackdown of traditional U.S. allies at the G7 summit in Quebec. As our colleague Peter Berezin recently pointed out, the U.S. is throwing stones while living in a glass house.6 While the overall level of tariff barriers within developed countries is low, the U.S. actually stands at the top end of the spectrum (Chart 10). The decision to launch an investigation into whether automobile imports "threaten to impair the national security" of the U.S. - under Section 232 of the Trade Expansion Act of 1962 - falls into the same rubric of empty threats. The U.S. has had a 25% tariff on imported light trucks since 1964, a decision that likely caused its car companies to become addicted to domestic pickup truck demand to the detriment of global competitiveness. Meanwhile, only 15% of U.S. autos shipped to the EU were subject to the infamous European 10% surcharge on auto imports. This is because U.S. autos containing European parts are exempt from the tariff. Many foreign auto manufacturers have already adjusted to the U.S. market, setting up manufacturing inside the country (Chart 11). Tariffs would hurt luxury brands like BMW, Daimler, Volvo, and Jaguar.7 As such, we doubt the investment-relevance of Trump's threat against autos. Either way, the investigation is unlikely to be completed until the tail-end of Q1 2019. Chart 10Tariffs: Who Is Robbing The U.S.? Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? Chart 11Car Imports? What Imports? Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? Instead, investors should take Trump's aggressive comments from the G7 in the context of the ongoing NAFTA negotiations and the closing window for a deal. President Trump wants to get a NAFTA deal ahead of the U.S. midterms in November and prior to the new Mexican Congress being inaugurated on September 1.8 This means that a deal has to be concluded by late July, or early August, giving the "old" Mexican Congress enough time to ratify it before the new president - likely Andrés Manuel López Obrador - comes to power on December 1. This would conceivably give the U.S. Congress enough time to ratify a deal by December, assuming Republicans can remove some procedural hurdles before then. The rising probability of no resolution before the U.S. midterm election will increase the risk that Trump will trigger Article 2205 and announce the U.S.'s withdrawal. Trump has always had the option of triggering the six-month withdrawal period as a negotiating tactic to increase the pressure on Canada and Mexico. Withdrawing might fire up the base, while major concessions from Canada or Mexico might be presented as "victories" to voters. Anything short of these binary outcomes is useless to Trump on November 6. Therefore, if Canada and Mexico do not relent in the next month or two, the odds of Trump triggering Article 2205 will shoot up. The key is that Trump faces limited legal or economic constraints in withdrawing: Legal Constraints: Not only can Trump unilaterally withdraw from the agreement, triggering the six-month exit period, but Congress is unlikely to stop him. Announcing withdrawal automatically nullifies much of the 1993 NAFTA Implementation Act.9 Some provisions of NAFTA under this act may continue to be implemented, but the bulk would cease to have effect, and the White House could refuse to enforce the rest. Economic Constraints: The U.S. economy has far less exposure to Canada and Mexico than vice- versa (Chart 12). Certain states and industries would be heavily affected - ironically, the U.S. auto industry would be most severely impacted (Chart 13) - and they would lobby aggressively to save the agreement. But with the American economy hyper-charged with stimulus, the drag from leaving NAFTA is not prohibitive to Trump. Voters will feel any pocketbook consequences about three months late i.e., after the election. Chart 12U.S. Economy:##br## Largely Unaffected By NAFTA U.S. Economy: Largely Unaffected By NAFTA U.S. Economy: Largely Unaffected By NAFTA Chart 13NAFTA Has Made U.S. Auto ##br##Manufacturing More Competitive Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? The potential saving grace for Canada is the Canada-U.S. Free Trade Agreement (CUSFTA), which took effect in 1989 and was incorporated into NAFTA. The U.S. and Canada agreed through an exchange of letters to suspend CUSFTA's operation when NAFTA took effect, but the suspension only lasts as long as NAFTA is in effect. However, reinstating CUSFTA is not straightforward. The NAFTA Implementation Act suspends some aspects of the CUSFTA and amends others (for instance, on customs fees), so there will not be an easy transition from NAFTA to a fully operational CUSFTA.10 Trump may well walk away from both CUSFTA and NAFTA in the same proclamation, or he could walk away from NAFTA while leaving CUSFTA in limbo. The latter would mitigate the negative impact on Canada, but it would still see rising tariffs, customs fees, and rising policy uncertainty. Bottom Line: We originally assigned a high probability to the abrogation of NAFTA.11 Subsequently, we lowered the probability due to positive comments from the White House and Trump's negotiating team. This was a mistake. As we initially posited, there are few constraints to abrogating NAFTA, particularly if President Trump intends to renegotiate the deal later, or conclude two separate bilateral deals that effectively maintain the same trade relationship. We are closing our trade favoring an equally-weighted basket of CAD/EUR and MXN/EUR. We are also closing our trade favoring Mexican local government bonds relative to EM. North Korea: A Geopolitical Opportunity, Not A Risk Not every move by the Trump administration is increasing geopolitical volatility. Trump's Maximum Pressure doctrine may have elevated risks on the Korean Peninsula in 2017, but it ultimately worked. The media is missing the big picture on the Singapore Summit. Diplomacy is on track and geopolitical risk - namely the risk of war on the peninsula - is fading. It is false to claim that President Trump got nothing in return for the summit. Since November 28, North Korea has moderated its belligerent threats, ceased conducting missile tests, released three U.S. political prisoners, and largely blocked off access to the Punggye-ri nuclear testing site. Now, North Korean leader Kim Jong-un has held the summit with Trump, reaffirmed his longstanding promise of "complete denuclearization," reaffirmed the peace-seeking April 2018 Panmunjom Declaration with South Korea, and pledged to dismantle a ballistic missile testing site and continue negotiations. In response, President Trump has given security guarantees to the North Korean regime and has pledged to discontinue U.S.-South Korea military drills for the duration of the negotiations. Trump has not yet eased economic sanctions and his administration has ruled out troop withdrawals from South Korea for now. There is much diplomatic work to be done. But the summit was undoubtedly a positive sign, dialogue is continuing at lower levels, and Kim is expected to visit the White House in the near future. Table 1 shows that the Singapore Summit is substantial when compared with major U.S.-North Korea agreements and inter-Korean summits - and it is unprecedented in that it was agreed between American and North Korean leaders. Table 1How The Singapore Summit Stacks Up To Previous Pacts With North Korea Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? Because Trump demonstrated a credible military threat, and China enforced sanctions, the foundation is firmer than that of President Barack Obama's April 2012 agreement to provide food aid in payment for a cessation of nuclear and missile activity. It is much more similar to that of President Clinton and the "Agreed Framework" of 1994, which lasted until 2002, despite many serious failures on both the U.S. and North Korean sides. We should also bear in mind that it was originally U.S. Congress, not North Korea, which undermined the 1994 agreement. Aside from removing war risk, Korean diplomacy is of limited global significance. It marginally improves the outlook for South Korean industrials, energy, telecoms, and consumer staples relative to their EM peers (Chart 14). In the long run it should also be positive for the KRW. Chart 14Winners And Losers Of Inter-Korean Engagement Winners And Losers Of Inter-Korean Engagement Winners And Losers Of Inter-Korean Engagement We maintain that a U.S.-China trade war will not be prevented because of a Korean deal. But we do not expect China to spoil the negotiations. Geopolitically, China benefits from reducing the basis for U.S. forces to be stationed in South Korea. Bottom Line: Go long a "peace dividend" basket of South Korean equity sectors (industrials, energy, consumer staples, and telecoms) and short South Korean "loser" sectors (financials, IT, consumer discretionary, and health care), both relative to their EM peers. Stick to our Korean 2-year/10-year sovereign bond curve steepener trade. Brexit Update: A New Election Is Now In Play Prime Minister Theresa May is fending off a revolt within her Conservative Party this week that could set the course for a new election this year. May reneged on a "compromise" with soft-Brexit/Bremain Tory backbenchers on an amendment that would have given the House of Commons a meaningful vote on the final U.K.-EU Brexit deal. According to the press, the compromise was killed by her own Brexit Secretary, David Davis. There is a fundamental problem with Brexit. The current path towards a hard Brexit, pushed on May by hard-Brexit members of her cabinet and articulated in her January 2017 speech, is incompatible with her party's preferences. According to their pre-referendum preferences, a majority of Tory MPs identified with the Bremain campaign ahead of the referendum (Chart 15). That would suggest that a vast majority prefer a soft Brexit today, if not staying in the EU. We would go further. The current trajectory is incompatible with the democratic preferences of the U.K. public. First, polls are showing rising opposition to Brexit (Chart 16). Second, most voters who chose to vote for Brexit in 2016 did so under the assumption that the Conservative Party would pursue a soft Brexit, including continued membership in the Common Market. Boris Johnson, the most prominent supporter of Brexit ahead of the vote and now the foreign minister, famously stated right after the referendum that "there will continue to be free trade and access to the single market."12 Chart 15Westminster MPs Support Bremain! Are You "Sick Of Winning" Yet? Are You "Sick Of Winning" Yet? Chart 16Bremain On The Rise Bremain On The Rise Bremain On The Rise So what happens now? We expect the government to be defeated on the crucial amendment giving Westminster the right to vote on the final EU-U.K. deal. If that happens, PM May could be replaced by a hard-Brexit prime minister, most likely Davis. Given the lack of support for an actual hard-Brexit outcome - both in Westminster and among the public - we believe that a new election remains likely by March 2019. Bottom Line: Political risk remains elevated in the U.K. A new election could resolve this risk, but the potential for a Jeremy Corbyn-led Labour Party to win the election could add additional political risk to U.K. assets. We remain short GBP/USD. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Monthly Report, "The Great Risk Rotation," dated December 11, 2013; and "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Pyongyang's Pivot To America," dated June 8, 2018, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Taiwan Is A Potential Black Swan," dated March 30, 2018, available at gps.bcaresearch.com. 4 The Senate has passed a version of the National Defense Authorization Act with a rider that would boost CFIUS and maintain stringent restrictions on ZTE's business with the U.S. These restrictions have crippled the company but would have been removed under the Trump administration's snap deal in June. The White House claims it will remove the rider when the House and Senate hold a conference to resolve differences between their versions of the defense bill, but it is not clear that the White House will succeed. Congress could test Trump's veto. If Trump does not veto he will break a personal promise to Xi Jinping and escalate the trade war further than perhaps even he intended. 5 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 6 Please see BCA Global Investment Strategy Weekly Report, "Piggy Bank No More? Trump And The Dollar's Reserve Currency Status," dated June 15, 2018, available at gis.bcaresearch.com. 7 We do not include Porsche in this list as we would gladly pay the 25% tariff on top of its current price. 8 Mexican elections for both president and Congress will take place on July 1, but the new Congress will sit on September 1 while the new president will take office on December 1. 9 Please see Lori Wallach, "Presidential Authority to Terminate NAFTA Without Congressional Approval," Public Citizen's Global Trade Watch, November 13, 2017, available at www.citizen.org. 10 The National Customs Brokers and Forwarders Association of America, "Issues Surrounding US Withdrawal From NAFTA," available from GHY International at www.ghy.com. See also Dan Ciuriak, "What if the United States Walks Away From NAFTA?" C. D. Howe Institute Intelligence Memos, dated November 27, 2017, available at www.cdhowe.org. 11 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 12 Please see "U.K. will retain access to the EU single market: Brexit leader Johnson," Reuters, dated June 26, 2016, available at uk.reuters.com. Geopolitical Calendar

Three macro "policy puts" are in jeopardy of disappearing or, at the very least, being repriced. Fed Put: Rising inflation has made the Fed more reluctant to back off from rate hikes at the first hint of slower growth or falling asset prices. China Put: Worries about high debt levels, overcapacity, and pollution all mean that the bar for fresh Chinese stimulus is higher than in the past. Draghi Put: Bailing out Italy was a no-brainer in 2012 when the country was the victim of contagion from the Greek crisis. But now that Italy is the source of the disease, the rationale for intervention has weakened. These factors, along with additional risks such as mounting protectionism, warrant a more cautious 12-month stance towards global equities and other risk assets. The fact that valuations are stretched across most asset classes only adds to our concern. A neutral stance does not imply that we expect markets to move sideways. On the contrary, volatility is likely to increase over the balance of the year, with the next big move for global equities probably being to the downside. Buckle Up One of BCA's key ongoing themes is that policy and markets are on a collision course. We are starting to see this impending crash play out across the world. Higher Inflation Is Tying The Fed's Hands A slowdown in global growth caused the Fed to abort its tightening plans for 12 months starting in December 2015. Global growth is faltering again, but this time around the Fed is less eager to hit the pause button. In contrast to 2015, the U.S. economy has run out of spare capacity. The unemployment rate fell to a 48-year low of 3.75% in May. For the first time in the history of the Bureau of Labor Statistics' Job Openings and Labor Turnover Survey (JOLTS), there are more job vacancies than unemployed workers (Chart 1). Average hourly earnings surprised on the upside in May, while the Employment Cost Index for private-sector workers - the cleanest and most reliable measure of U.S. wage growth - rose at a robust 4% annualized pace in the first quarter. Labor market surveys, which generally lead wage growth by three-to-six months, are pointing to a further acceleration in wages (Chart 2). Chart 1There Are Now More ##br##Vacancies Than Jobseekers There Are Now More Vacancies Than Jobseekers There Are Now More Vacancies Than Jobseekers Chart 2U.S. Wage Growth Is Set To Accelerate U.S. Wage Growth Is Set To Accelerate U.S. Wage Growth Is Set To Accelerate The Dollar Rally Can Keep Going Rising wages will put more income into workers' pockets, who will then spend it. Stronger demand can be partly satisfied by imports, but it will take a change in relative prices for that to happen. U.S. imports account for only 16% of GDP. Unless the prices of foreign-made goods decline in relation to the prices of domestically-produced goods, the bulk of any additional household income will be spent on goods produced in the U.S. This means that the dollar needs to strengthen. The Fed's broad trade-weighted dollar index is up 8% since the start of February. While we are not as bullish on the dollar as we were a few months ago, we still believe that the path of least resistance for the greenback is up. Our long DXY trade recommendation has gained 12.1% inclusive of carry since we initiated it. We are raising the target price from 96 to 98. A stronger dollar can help deflect some additional spending towards imports, but this won't be enough to fully cool the economy. Services, which generally cannot be imported, account for nearly two-thirds of GDP. Since it takes time to shift resources from goods-producing sectors to service sectors, any rising aggregate demand will boost service prices. Outside of housing, service-sector inflation is already running at 2.4%, a number that is likely to rise further over the coming year (Chart 3). This will keep the Fed on edge. Hard Times For Emerging Markets The combination of rising U.S. rates and a stronger dollar is bad news for emerging markets. Eighty percent of EM foreign-currency debt is denominated in dollars. Outside of China, EM dollar debt is now back to late-1990s levels both as a share of GDP and exports (Chart 4). Chart 3Faster Wage Growth Will ##br##Push Up Service Inflation Faster Wage Growth Will Push Up Service Inflation Faster Wage Growth Will Push Up Service Inflation Chart 4EM Dollar Debt Back To Late-1990s Levels EM Dollar Debt Back To Late-1990s Levels EM Dollar Debt Back To Late-1990s Levels The wave of EM local-currency debt issued in recent years only complicates matters. If EM central banks raise rates to defend their currencies, this could imperil economic growth and make it difficult for local-currency borrowers to pay back their loans. Rather than hiking rates, some EM central banks may simply choose to inflate away debt. Consider the case of Brazil. Ninety percent of Brazilian sovereign debt is denominated in reais. The Brazilian government won't default on its debt per se. However, if push comes to shove, Brazil's central bank can always step in to buy government bonds, effectively monetizing the fiscal deficit. The specter of trade wars only adds to the risks facing emerging markets. A larger U.S. budget deficit will drain national savings, leading to a bigger trade deficit. Rather than blaming his own macroeconomic policies, President Trump will blame America's trading partners. Global trade has already been flatlining for over a decade (Chart 5). Trump's trade agenda will further undermine the global trading system. Emerging markets will bear the brunt of that development. Chart 5Global Trade Has Crested Global Trade Has Crested Global Trade Has Crested Chinese Stimulus To The Rescue? When emerging markets last succumbed to pressure in 2015, China saved the day by stepping in with massive new stimulus. Fiscal spending and credit growth accelerated to over 15% year-over-year. The government's actions boosted demand for all sorts of industrial commodities. Today, Chinese growth is slowing again. May data on industrial production, retail sales, and fixed asset investment all disappointed. Property prices in tier 1 cities are down year-over-year. Our leading indicator for the Li Keqiang index, a widely followed measure of economic activity, is in a clear downtrend (Chart 6). So far, the policy response has been fairly muted. Reserve requirements have been cut and some administrative controls loosened, but the combined credit and fiscal impulse has plunged (Chart 7). Onshore and offshore corporate bond yields have increased to multi-year highs. Bank lending rates are rising, while loan approvals are dropping (Chart 8). Chart 6Chinese Growth Is Slowing Anew Chinese Growth Is Slowing Anew Chinese Growth Is Slowing Anew Chart 7China: Policy Response To Slowdown ##br##Has Been Muted So Far China: Policy Response To Slowdown Has Been Muted So Far China: Policy Response To Slowdown Has Been Muted So Far Chart 8China: Credit Tightening China: Credit Tightening China: Credit Tightening We have no doubt that China will stimulate again if the economy appears to be heading for a deep slowdown. However, the bar for a fresh round of stimulus is higher today than it was in the past. Elevated debt levels, excess capacity in some parts of the industrial sector, and worries about pollution all limit the extent to which the authorities can respond with the usual barrage of infrastructure spending and increased bank lending. The economy needs to feel more pain before policymakers come to its aid. Draghi's Dilemma The Italian economy was showing signs of weakness even before bond yields exploded higher. Domestic demand slowed to a mere 0.3% qoq in Q1. The PMIs, consumer confidence, and the Bank of Italy's Ita-Coin cyclical indicator all decelerated (Chart 9). Italy would benefit from a more competitive cost structure, but the political will to undertake the sort of reforms Germany implemented in the late 1990s, and that Spain implemented after the Great Recession, has been sorely lacking (Chart 10). Unwilling to take tough actions to improve competitiveness, the Five Star-Lega coalition government has proposed loosening fiscal policy to support demand. Chart 9Italy's Economy Is Weakening... Again Italy's Economy Is Weakening... Again Italy's Economy Is Weakening... Again Chart 10Italy: More Work Needs To Be Done On ##br##The Labor Competitiveness Front Italy: More Work Needs To Be Done On The Labor Competitiveness Front Italy: More Work Needs To Be Done On The Labor Competitiveness Front Italy's shift towards populism is arriving at the same time that the ECB is looking to wind down its asset purchase program. This means that a key buyer of Italian debt is stepping back just when it may be needed the most. Getting the ECB to bail out Italy will not be as straightforward this time around. Recall that Mario Draghi and Jean-Claude Trichet penned a letter to the Italian government in 2011 outlining a series of reforms they wanted to see enacted as a condition of ongoing ECB support. The contents of the letter were so explosive that they precipitated the resignation of then-PM Silvio Berlusconi when they were leaked to the public. One of the reforms that Mario Draghi demanded - and the subsequent government led by Mario Monti ultimately undertook - was the extension of the retirement age. Italy's current government has explicitly promised to reverse that decision much to the consternation of the ECB and the European Commission. It was one thing for Mario Draghi to promise to do "whatever it takes" to protect Italy when the country was the victim of contagion from the Greek crisis. But now that Italy is the source of the disease, the rationale for intervention has weakened. Investment Conclusions The outlook for global risk assets is likely to be more challenging over the coming months. With that in mind, we are downgrading our 12-month recommendation on global equities and credit from overweight to neutral. A neutral stance does not imply that we expect markets to move sideways. On the contrary, volatility is likely to increase again over the balance of the year, with the next big move for global equities probably being to the downside. Although Treasurys could rally in the near term, higher U.S. inflation will push bond yields up over a 12-month horizon. Given that yields are positively correlated across international bond markets, rising U.S. yields will put upward pressure on yields in the rest of the world. As such, we recommend shifting equity allocations towards cash rather than long-duration bonds. We would also reduce credit exposure. Within the commodity complex, the backdrop for crude remains more favorable than for economically-sensitive metals. Investors should underweight EM equities, credit, and currencies relative to their developed market peers. The Fed needs to tighten U.S. financial conditions to prevent the economy from overheating. Chart 11 shows that EM equities almost always fall when that is happening. Chart 11Tighter U.S. Financial Conditions Do Not Bode Well For EM Stocks Tighter U.S. Financial Conditions Do Not Bode Well For EM Stocks Tighter U.S. Financial Conditions Do Not Bode Well For EM Stocks A stronger dollar will hurt the profits of U.S. multinationals. That said, the sector composition of the U.S. stock market is a bit more defensive than it is elsewhere. On balance, we no longer have a strong view that euro area and Japanese equities will outperform the U.S. in local-currency terms, and hence we are closing our trade recommendation to this effect for a loss of 5.4%. If macro developments evolve as we expect, we will shift to an outright bearish stance on risk assets later this year or in early 2019 in anticipation of a global recession in 2020. That said, we would consider moving our 12-month recommendation temporarily back to overweight if global equities were to sell off by more than 15% over the next few months or the policy environment becomes markedly more market friendly. But at current prices, the risk-reward trade-off no longer justifies a high degree of bullishness. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com

Highlights As widely expected, the Fed raised the policy rate by 25bps last week. The central bank is also forecasting an additional rate hike for 2018, but one less for 2020. The labor market typically continues to improve after the economy reaches full employment, wage inflation begins to accelerate after the economy achieves full employment, while prices rise only gradually. Gold and Treasuries were the big winners and the dollar was the big loser in previous trade spats. Feature The dollar rose 1%, but gold, the S&P 500, and U.S. Treasury yields sunk last week amid a busy calendar of U.S. economic data and the Fed's new forecasts. The stats and the FOMC projections confirmed that the U.S. economy is already at full employment and that the market is underpricing the number of Fed hikes planned for this year. Meanwhile, U.S. President Trump's meeting with North Korea leader Kim Jong Un provided some relief on the geopolitical front, but there is still uncertainty on trade over impending tariffs on China. Chart 1Watch The 2.3% To 2.5% Level##BR##On TIPS Breakevens Watch The 2.3% To 2.5% Level On TIPS Breakevens Watch The 2.3% To 2.5% Level On TIPS Breakevens BCA's base case remains that U.S. equities will not be subject to an over-aggressive Fed until mid-2019 and that increasing bond yields are not a threat. That said, the timing is uncertain and depends importantly on how inflation and inflation expectations shift in the coming months. Inflation is only gradually moving higher at the moment and the Fed is willing to tolerate an overshoot of the 2% target. However, some inflation hawks at the Fed are worried given that the economy is already at full employment and expected to accelerate this year. The uptrend in inflation could suddenly become steeper in this macro environment. Alarm bells will ring when inflation hits 2.5% and the central bank will switch from normalizing policy to targeting slower growth, putting risk assets under pressure. We are also on the watch for a rise in the 10-year TIPS breakeven rate above 2.3% as a signal that the FOMC will become more aggressive in leaning against above-trend growth and a falling unemployment rate (Chart 1). That would be an important signal to trim exposure to risk assets. Although Trump's meeting with Kim lowered geopolitical risk, BCA's strategists note that the secular decline in U.S.-China ties and the "apex of globalization"1 are more relevant subjects than what happens on the Korean peninsula. While North Korea may still stir up concern, we recommend that investors monitor U.S.-China trade tensions, the East and South China Seas, and Taiwan. Elsewhere, U.S.-Iran tensions are the key understated geopolitical risk to markets. Moreover, BCA's Geopolitical Strategy service expects that trade-related uncertainty will persist at least until the U.S. mid-term elections in November.2 Two More In '18 As widely expected, the Fed raised the policy rate by 25bps last week. The central bank is also forecasting an additional rate hike for 2018, but one less for 2020 (Chart 2). Chart 2FOMC And Market Mostly##BR##Aligned On Economy And Rates FOMC And Market Mostly Aligned On Economy And Rates FOMC And Market Mostly Aligned On Economy And Rates Instead of three, the Fed now expects to deliver a total of four rate hikes in 2018. For 2019, the Fed continues to project a further three rate hikes. And for 2020, the Fed now believes only one rate hike will be warranted, down from two hikes in its previous forecast. What this means is that the Fed has simply brought forward one rate hike from 2020 to 2018. It left its median projection for the level of the Fed funds rate in 2020 unchanged at 3.375%. Moreover, the Fed kept its estimate of the neutral rate unchanged at 2.875%. In other words, the Fed is forecasting a marginally faster pace to rate hikes, but it has not changed its outlook for the full extent of the tightening cycle. This minor change to the policy outlook should not disrupt financial markets. Prior to last week's FOMC meeting, Fed funds futures were already pricing a 50% probability of a fourth rate hike this year. The bigger question is whether more upward adjustments to the interest rate outlook lie ahead. On this front, there are inconsistencies in the Fed's economic projections. In terms of the long-run steady state, the Fed believes the potential growth rate of the economy is 1.8% and NAIRU is 4.5%. Yet the Fed is forecasting real GDP growth of 2.4% and 2.0% (i.e. above-trend) for 2019 and 2020, respectively, but expects both the jobless rate and core inflation to remain steady at 3.5% and 2.1%, respectively. Above-trend growth should imply a further decline in the unemployment rate. And a jobless rate that's well below NAIRU should imply an acceleration in inflation. In turn, this should mean a higher path for interest rates. But rather than higher interest rates, the inconsistency in the Fed's economic forecasts can also be resolved in other ways. First, the Fed could simply be too optimistic on growth. If growth is weaker, then unemployment and inflation forecasts could be proven right. Second, the Fed's estimates of trend growth and NAIRU may be incorrect. If trend growth is higher and NAIRU is lower, the pressures on resource utilization and inflation will be less. Bottom Line: The tweaks to the Fed's interest rate projections are too small to have a material impact on financial market pricing. However, there is a risk that the inconsistencies in the Fed's economic forecasts will be resolved with more hawkishness in 2019. This could then prove problematic for global risk assets, depending on the evolution of inflation. Are We There Yet? The U.S. economy reached full employment in Q1 2017. The unemployment rate crossed below the Fed's measure of NAIRU in March 2017, a whopping 93 months after the start of the current expansion. Chart 3 shows that in the long expansions3 in the 1980s and 1990s, the economy reached full employment sooner; 54 months in the 1980s and 72 months in the 1990s expansion. After the economy attained full employment in the 1980s and 1990s, an average of another 27 months passed before the unemployment rate troughed. This means that the trough will occur in mid-2019 and our view is that the rate will bottom at around 3.5% in mid-2019.4 Moreover, the 1980s' economic recovery lasted another 34 months once the economy hit full employment and another 47 months once full employment was breached in the 1990s. If this historical pattern holds, then the next recession will begin in late 2020. This date is consistent with our prior work5 on the start date of the next downturn. Chart 3The Economy At Full Employment In Long Cycles The Economy At Full Employment In Long Cycles The Economy At Full Employment In Long Cycles The labor market typically continues to improve after the economy reaches full employment. Initial claims for unemployment insurance, as a share of the labor force, move lower for another two years, on average, after labor market slack disappears (Chart 4, panel 2). The monthly non-farm payrolls job count follows a similar pattern and it does not turn negative for another four years (panel 3). The Conference Board's jobs easy/hard to get shows that the labor market is hotter than in the previous long expansions (panel 4). The conclusion is that the labor market will continue to tighten for another year or so, consistent with our outlook. Wage inflation begins to accelerate after the economy achieves full employment. Chart 5 shows increases in the average hourly earnings (AHE), the Employment Cost Index (ECI), and compensation per hour after the unemployment rate fell below NAIRU in the 1980s and 1990s. However, unit labor costs (ULCs) did not accelerate in those years until well after the economy hit full employment. Many of these measures of wage inflation are also on the upswing today. However, none of the indicators are rising as quickly as they did in the 1980s and 1990s (See Appendix Table 1 for more details on performance of labor market, wage and inflation metrics after the economy reaches full employment). Inflation initially remained tame even after labor market slack was taken up in the previous two long expansions. Chart 6 shows that neither headline nor core CPI accelerated sharply after the economy arrived at full employment in the '80s and '90s. However, headline CPI inflation began rising not long after full employment was reached. It took a little longer for core inflation to perk up. Moreover, inflation tends to peak as the unemployment rate troughs. This occurs, on average, about three years after the unemployment rate crosses below NAIRU. Chart 4The Labor Market When##BR##The Economy Is At Full Employment The Labor Market When The Economy Is At Full Employment The Labor Market When The Economy Is At Full Employment Chart 5Wages And Compensation When##BR##The Economy Is At Full Employment Wages And Compensation When The Economy Is At Full Employment Wages And Compensation When The Economy Is At Full Employment Chart 6Inflation When The Economy##BR##Is At Full Employment Inflation When The Economy Is At Full Employment Inflation When The Economy Is At Full Employment Bottom Line: The U.S. economy has been at full employment since early 2017, but investors should be patient if they expect a marked acceleration in inflation. Inflation is already at the Fed's target and BCA expects two more rate hikes this year and at least three more increases in 2019 as inflation moves closer to 2.5%. Stay underweight duration. The labor market is as tight as it was at this point of the previous two long expansions. Moreover, the trends in inflation and wages are similar, although from a lower level. That said, while inflation is more muted today, interest rates are much, much lower, and the Fed does not want a major overshoot. If we follow the same path as the previous two long expansions, then inflation will rise only gradually, and the next recession is a ways off. But watch for an acceleration in ULC, because in the average of the last two long expansions, an acceleration in ULC coincided with an acceleration in core CPI inflation. That would cause the Fed to become more aggressive. Trump's Focus On China The U.S. is an old hand at trade wars and economic conflicts, with an endgame of dollar depreciation and compromises on trade.6 Since 1970 there have been seven major trade disputes involving tariffs, including the one that began in March of this year. Some were brief and several of those periods overlapped. Moreover, many other factors affected investment returns, including recessions, wars, major terrorist attacks, and financial crises. As a result, these periodic trade tiffs make it difficult to discern the implications for the financial markets. During episodes of trade-related uncertainty, stocks underperform Treasuries, the dollar falls both pre- and post-dispute, and gold performs much better both during and after. Treasuries are the most consistent performer, and this asset class beat stocks during five of the six periods. Meanwhile, the dollar fell during 5 of the 6 trade spats (Table 1). Chart 7 shows the performance of a wider set of U.S. financial assets before, during, and after trade tensions erupt. Table 1U.S. Stocks, Treasuries, The Dollar, Gold And Trade Disputes The Economy At Full Employment The Economy At Full Employment Chart 7U.S. Financial Assets And Trade Spats U.S. Financial Assets And Trade Spats U.S. Financial Assets And Trade Spats We begin our discussion of trade spats and their implication for financial markets in the early 1970s. In August 1971, with the dollar steeply overvalued, President Richard Nixon abandoned the gold standard and imposed a 10% surcharge on all dutiable imports. The purpose of the tariff was to force the U.S. allies to appreciate their currencies against the dollar. Some appreciation occurred as a result of the Smithsonian Agreement, but the effects were short-lived. The U.S. could not afford to alienate its allies amid the Cold War and removed the restrictions four months later. Table 1 shows that S&P 500 increased by nearly 40% in the year prior to the 1971 trade spat, but the economy was recovering from the 1969-70 recession. Equities easily beat Treasuries (+17%), the dollar declined by 3%, and gold jumped by 22%. However, during late 1971, the S&P 500 underperformed Treasuries, the dollar dropped by 5%, and gold was little changed. In the 12 months after the trade issue was resolved, U.S. stocks beat bonds, the dollar continued to move lower, and gold surged. This occurred as inflation ramped up. In a trade dispute episode during the 1980s, then President Reagan and a Democrat-leaning Congress became concerned with trade deficits and a sharply rising dollar. The Plaza Accord in 1985 consisted of a German and Japanese promise, once again, to appreciate their currencies. From 1985-89, a U.S.-Japan trade war was waged over Japan's growing share of the U.S. market and certain unfair trade practices affecting goods such as cars, semiconductors, and electronics (Chart 8). The combination of yen appreciation, voluntary export restraints and tariffs, resulted in compromises, and in the early 1990s the U.S. removed Japan from its list of targets. Chart 8The U.S.-Japan Trade Spat In The 1980s The U.S.-Japan Trade Spat In The 1980s The U.S.-Japan Trade Spat In The 1980s During the 1985-89 dispute, the U.S. stock market crashed, economic growth surged, inflationary pressures mounted, and the Fed hiked rates. Nevertheless, stocks crushed bonds as the dollar tumbled by 40% and gold soared by 30% (Table 1). Note that gold fell in the year before the trade dispute began and in the year after it ended. In the late 1990s, a series of trade disputes erupted between the U.S. and the European Union, most significantly on a tax device that allowed companies reduced taxes on profits derived from export sales. The EU won its case against the U.S. at the WTO and the U.S. eventually repealed the offending provisions in its tax code. At the same time, from 1999-2001, the U.S. contested EU policies on banana imports. Then in March 2002, President George W. Bush imposed steel tariffs affecting Europe, but these were subsequently reversed in December 2003 in the face of retaliatory threats. Trade tension in the late 1990s and early 2000s developed alongside the tech boom, the 2001 recession and recovery, and the first Gulf War. The 10-year Treasury outperformed the S&P 500 as Bush's steel tariffs were in effect, but the early part of this period coincided with the accounting scandals that buffeted U.S. equity markets. The U.S. dollar dropped nearly 25%, although the Fed cut rates in 2002 and 2003. Gold climbed 34% in this period, outpacing both stocks and bonds. President Trump's trade positions are reminiscent of both Nixon's and Reagan's policies and his trade team includes a notable veteran of the U.S.-Japan trade war, U.S. Trade Representative Robert Lighthizer. The focus, however, is not entirely the same. True, there is still a fixation on privileged manufacturing industries like steel and autos, both in the Section 232 actions on steel and aluminum and in the NAFTA renegotiation. But there is today a heightened focus on China's abuses of the international trade system, in particular its technology theft and intellectual property violations (the Section 301 actions). For investors, the critical issue is to separate the two areas of focus. The U.S. grievances with Europe, NAFTA, and Japan will cause more volatility this year and beyond, but are ultimately more manageable than those with China. U.S.-China trade tensions are caught up in a Great Power rivalry that will likely persist throughout this century, making trade tensions a permanent feature of the relationship going forward.7 China's rapid military growth and technological acquisition threaten U.S. global dominance. China will view any imposition of tariffs by the U.S., or demands for dramatic RMB appreciation, as a strategic attempt to derail China's rise. Moreover, while Congress will not attack President Trump for retreating from the trade war with the allies, it will attack President Trump for compromising on China. Recent U.S. elections have swung on Rust Belt Midwestern states that resent America's deindustrialization. In 2020, Democrats will attempt to reclaim their credibility as defenders of American workers and "fair trade," especially against China. President Trump stole their thunder with his protectionist platform. There is unlikely to be a "trade dove," and especially not a "China dove," in the White House from 2020-24. Bottom Line: The U.S. has historically used punitive trade measures to force its allied trading partners to appreciate their currencies versus the dollar. It has also sought to protect politically sensitive industries. Today, however, the trade war with China is inextricably tied to a strategic conflict that will play out over decades. Trump will likely impose Section 301 tariffs on China after June 15 and any deal to avoid confrontation will merely delay the decision on tariffs until after November's mid-term elections. Investors should recall that bonds beat stocks, the dollar fell, and gold rose during previous periods of trade tension. We also note that shifts in correlations between key U.S. asset classes tend to occur as trade spats begin and end, especially in the past 30 years (Chart 9). Moreover, gold usually continues to climb and the dollar falters even after these disputes are resolved. Chart 9U.S. Asset Class Correlations During Trade Disputes U.S. Asset Class Correlations During Trade Disputes U.S. Asset Class Correlations During Trade Disputes John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Research's Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014. Available at gps.bcaresearch.com. 2 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump's Demands On China," published April 4, 2018. Available at gps.bcaresearch.com. 3 Please see BCA Research's Bank Credit Analyst Monthly Report, published March 2017. Available at bca.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Tightening Up", published May 14, 2018. Available at usis.bcaresearch.com. 5 Please see BCA Research's Global Investment Strategy Weekly Report, "Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000," published March 30 2018. Available at gis.bcaresearch.com. 6 Please see BCA Research's Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," published April 12, 2017. Available at gps.bcaresearch.com. 7 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," published March 14, 2018. Available at gps.bcaresearch.com. Appendix Appendix Table 1Key Labor Market And Inflation Indicators At Full Employment The Economy At Full Employment The Economy At Full Employment

Highlights Major and drawn-out financial market downturns usually occur in phases and often resemble a domino effect. There have been a number of noteworthy divergences in the EM space of late. They are probably part of a domino effect - some tiles have begun to drop, but other tiles down the chain still remain standing. The selloff in EM risk assets will broaden and intensify. A defensive positioning is warranted. India's relative equity performance has by and large been undermined by rising oil prices. A potential roll-over in crude prices will aid the Indian bourse's relative performance versus its EM peers. The South African rand remains on shaky foundation; stay short. Feature There have been a number of noteworthy divergences in financial markets of late, in particular between emerging markets (EM) and commodities, as well as between Chinese investable stocks trading outside the mainland and equity prices listed domestically. In our view, these divergences are part of a domino effect - some tiles have begun to drop, but other tiles down the chain still remain standing. In dominos, tiles do not all fall simultaneously. They fall one by one, and there is a time lag between the first domino and the last-standing domino to drop. Also, unlike in natural sciences, time lags and speed in economics and finance vary with each experiment - because they are contingent on complex human psychology and behavior, not on well defined natural phenomena such as gravity or motions of objects. Hence, they are impossible to forecast with much precision. A Message From Our Risky Versus Safe-Haven Currency Ratio Although U.S. share prices have lately been firm, EM stocks have broken below their 200-day moving average (Chart I-1, top panel). So has our risky versus safe-haven currencies ratio 1 (Chart I-1, bottom panel). Indeed, while having held up at its 200-day moving average several times in the past two years, the ratio has recently decisively broken below this technical support line. This indicator correlates extremely well with EM share prices, and its message is presently unambiguous: The rally in EM is over, and a bear market has likely commenced. Crucially, this ratio measures commodities currencies versus the average of the Japanese yen and Swiss franc - two defensive currencies - not against the U.S. dollar. Hence, it is not impacted by the greenback's trend. Given that all six risky currencies used in the numerator of this ratio - AUD, CAD, NZD, BRL, ZAR and CLP - are commodity currencies, it is not surprising that the ratio also correlates with commodities prices. In this context, it currently suggests the outlook for both industrial metals and oil is troublesome (Chart I-2). Chart I-1Beware Of These Breakdowns Beware Of These Breakdowns Beware Of These Breakdowns Chart I-2A Red Flag For Commodities Prices bca.ems_wr_2018_06_14_s1_c2 bca.ems_wr_2018_06_14_s1_c2 The common denominator that links all these financial variables is global growth. The risky versus safe-haven currencies ratio typically leads world trade cycles by several months, and it currently points to a notable slowdown in global export volumes (Chart I-3). Chart I-3Global Export Growth Is Set To Slow bca.ems_wr_2018_06_14_s1_c3 bca.ems_wr_2018_06_14_s1_c3 Further, commodities prices have exhibited a rare decoupling from the U.S. dollar. It is very unlikely that this divergence can be sustained for much longer. Our bias is that global trade will slow as China/EM demand weakens despite robust U.S. growth. Growth dynamics shifting in favor of the U.S. entails that the greenback will continue to appreciate. Consistently, EM/China growth disappointments and U.S. dollar's persisting strength suggest that commodities will reverse their current trend sooner rather than later. A relapse in commodities prices will reinforce EM currency depreciation, triggering more outflows from EM equities and fixed-income markets. Decoupling Or A Time Lag? Chart I-4Domino Effect In 2007-08 Domino Effect In 2007-08 Domino Effect In 2007-08 Major and drawn-out financial market downturns usually occur in phases and often resemble a domino effect. The EM crises in 1997-98 did not occur simultaneously across all EM countries. It began in July 1997 with Thailand, then it spread to Korea, Malaysia and Indonesia and finally, to the rest of Asia. In August 1998, Russian financial markets collapsed triggering the LTCM debacle. The last leg of this crisis appeared in Brazil and culminated in the real's devaluation in January 1999. Similarly, the U.S. financial/credit crisis commenced with the selloff in sub-prime securities in March 2007. Following that, corporate spreads began widening and bank share prices rolled over in June 2007. In the meantime, the S&P 500 and EM stocks peaked on October 9 and 29, 2007, respectively. Despite all of these developments, commodities prices and EM currencies continued rallying until summer of 2008 and then quickly collapsed in the second half of that year (Chart I-4). Finally the Lehman crash took place on September 29 of 2008. That marked the apogee of the crisis, causing a complete unravelling of financial markets and the global economy, and lasting until March of 2009. It seems some sort of domino effect is now taking hold of the EM universe. Initially, it started with Turkey and Argentina. Then, it spread to Indonesia, India and Brazil. The currency weakness across the wider EM universe has already led to EM credit spread widening. Yet, there are a few EM financial markets, particularly Chinese, Korean and Taiwanese, that are still holding up relatively well. Moreover, U.S. share prices and high-yield credit spreads have done quite well too. How should investors interpret these divergences? Our view has been, and remains, that EM risk assets will do poorly regardless of the direction of the S&P 500. In fact, an escalation in EM turmoil and a slowdown in developing economies are among the main risks to American share prices themselves. The primary link from EM financial markets to the S&P 500 is via the exchange rate - a strong dollar along with an EM/China growth slump will weigh on American multinationals' profits. The following three questions are presently vital for investors: 1. Can EM and U.S. risk assets de-couple from each other, and has a sustainable divergence happened in the past? Although short-term moves in U.S. and EM equity indexes often appear correlated, from a big-picture perspective there have been considerable divergences. The overall EM stock index is now at the same level it was in 2007 (Chart I-5). Meanwhile, the S&P 500 index is a hair below its all-time high. Chart I-5EM Share Prices And The S&P 500: A Long-Term Perspective EM Share Prices And The S&P 500: A Long-Term Perspective EM Share Prices And The S&P 500: A Long-Term Perspective The same is true for many EM currencies and the S&P 500. A substantial decoupling did occur in the not-so-distant past: EM currencies depreciated from 2011 to early 2016, while U.S. share prices rallied strongly from late 2011 until 2015 (Chart I-6). With respect to U.S. credit spreads, Chart I-7 illustrates that EM and U.S. credit spreads have had a much higher correlation than their respective equity indexes. During the 1997-'98 EM crises and the 2014 -'15 EM turmoil, U.S. high-yield corporate spreads widened. In brief, there has historically been little decoupling between U.S. and EM credit markets. Hence, the U.S. high-yield credit market's latest resilience in the face of widening in EM credit spreads is historically exceptional. Chart I-6EM Currencies And The S&P 500 EM Currencies And The S&P 500 EM Currencies And The S&P 500 Chart I-7EM Sovereign And U.S. Corporate Credit Spreads: A Long-Term Perspective EM Sovereign And U.S. Corporate Credit Spreads: A Long-Term Perspective EM Sovereign And U.S. Corporate Credit Spreads: A Long-Term Perspective As EM currencies continue to depreciate versus the U.S. dollar, EM sovereign and corporate credit spreads will widen. Given their past high correlation with U.S. credit markets, odds point to widening corporate credit spreads in the U.S. On the whole, if EM risk assets continue to sell off, which is our baseline scenario, the S&P 500 and U.S. credit markets could defy gravity for a while, but not forever. At some point, risks stemming from EM turbulence will cause a selloff in American stocks and corporate bonds. It is impossible to know when and by how much U.S. stocks will suffer. Our bias is that a U.S. equity selloff will likely be on par with the 2015-'16 episode. 2. Can North Asian equity markets such as China, Korea and Taiwan remain relatively resilient if the turbulence in other EM countries continues? Based on history, they can, but only for a short period of time. There have been a few episodes when emerging Asian and Latin American stocks de-coupled: In 1997-'98, the home-grown Asian crisis devastated regional markets, but Latin American stocks continued to rally until mid-1998 - at which point they began plummeting (Chart I-8, top panel). In 2007-'08, emerging Asian equities started tumbling along with the S&P 500 in late 2007, but Latin American bourses fared well until the middle of 2008 due to surging commodities prices (Chart I-8, middle panel). Finally, the bottom panel of Chart I-8 illustrates that in early 2015, Asian stocks performed well, supported by the inflating Chinese equity bubble. Meanwhile, Latin American stocks plunged. In all of these episodes, the de-coupling between Asia and Latin America proved to be unsustainable, and the markets that showed initial resilience eventually re-coupled to the downside. Regarding Asia's business cycle conditions, the slowdown is already taking place and will likely intensify. Leading indicators of exports and manufacturing such as Korea's manufacturing shipments-to-inventory ratio and Taiwan's semiconductor shipments-to-inventory ratio herald further deceleration in their respective export sectors (Chart I-9). Chart I-8Asian And Latin American Equities: ##br##Unsustainable Divergences Asian And Latin American Equities: Unsustainable Divergences Asian And Latin American Equities: Unsustainable Divergences Chart I-9Asia's Export Slowdown Is In Making Asia's Export Slowdown Is In Making Asia's Export Slowdown Is In Making 3. Is there any other notable financial market decoupling that investors should be aware of? Chart I-10China: A Decoupling In Various Equity Segments China: A Decoupling In Various Equity Segments China: A Decoupling In Various Equity Segments Since early this year, there has been substantial decoupling between Chinese investable stocks and the onshore A-share market. First, the overall A-share index has dropped since early this year, but the MSCI Investable Chinese stock index has so far been resilient (Chart I-10). Second, while it might be tempting to explain this decoupling by discrepancies in the sectors' weights in these indexes, this has not been the case this time around. The fact remains that there has been considerable divergence between share prices of the same sectors. For example, onshore and offshore equity prices have diverged for the following sectors: real estate stocks, materials, industrials, technology, utilities and consumer discretionary (Chart I-11A and Chart I-11B). Only defensive sectors such as consumer staples and health care have done well in both universes. Share prices of financials and telecoms have dropped in both the onshore and offshore markets. Chart I-11AChinese Equity Sectors: Puzzling Decoupling Chinese Equity Sectors: Puzzling Decoupling Chinese Equity Sectors: Puzzling Decoupling Chart I-11BChinese Equity Sectors: Puzzling Decoupling Chinese Equity Sectors: Puzzling Decoupling Chinese Equity Sectors: Puzzling Decoupling Finally, a similar performance gap has appeared between Chinese small cap stocks trading onshore and in Hong Kong (Chart I-12). Chart I-12China's Small-Cap Stocks: A Perplexing Gap China's Small-Cap Stocks: A Perplexing Gap China's Small-Cap Stocks: A Perplexing Gap How do we explain these divergences? Our bias is that local investors in China are much more concerned about the mainland growth outlook than foreign investors. This is the opposite of what occurred in 2015. Back then, international investors were somewhat cautious on China - commodities prices and other China-related global financial market plays were in a bear market. Meanwhile, local investors were caught up in a full-fledged equity mania that ended with a crash. Given our downbeat outlook on China's capital spending and related plays in financial markets, we reckon that domestic investors in China will be proven right in the months ahead, while the international investment community will be left flat-footed. Importantly, there has been an unexplainable mismatch between monetary/credit tightening in China and complacency among international investors about the outlook for the mainland economy. Specifically, the cost of borrowing has gone up, and credit standards have tightened. Chart I-13 illustrates that both onshore and offshore corporate bond yields have risen to new cycle highs, Chinese banks' lending rates are rising, while banks' loan approvals are dropping. Consistently, money and credit growth have plunged. Importantly, this is occurring in an economy with immense credit excesses. Nevertheless, commodities prices have so far defied such a pronounced deceleration in money and credit aggregates in China (Chart I-14). Chart I-13China: Ongoing Credit Tightening China: Ongoing Credit Tightening China: Ongoing Credit Tightening Chart I-14China's Money/Credit And Commodities Prices China's Money/Credit And Commodities Prices China's Money/Credit And Commodities Prices All in all, we interpret these divergences by varying lead and lags rather than as a fundamental breakdown in the relationship between money/credit and the real economy. We continue to expect tightening liquidity and credit to escalate the growth slowdown in China. As a result, there continues to be considerable downside risks for Chinese investable stocks and commodities prices. Bottom Line: The dominos have begun to fall. We continue to recommend a defensive strategy and an underweight position in EM equities, credit and currencies versus their U.S./DM peers. High-yield local currency bonds that are a de-facto bet on the underlying currencies are vulnerable too. For investors willing to go short, it is not too late to short EM stocks and currencies. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Average of cad, aud, nzd, brl, clp & zar total return (including carry) indices relative to average of jpy & chf total returns. India's Equity Underperformance: Blame It On Oil Indian stocks have been underperforming their EM counterparts. Rising oil prices have created a toxic macro mix for India, triggering the equity underperformance (Chart II-1): Rising crude prices have led to widening current account and trade deficits. Oil price swings are often instrumental to trends in India's current account balance (Chart II-2). The deterioration in the nation's external accounts has been behind the rupee's poor performance. Chart II-1Higher Crude Oil Prices Hurt Indian Stocks Higher Crude Oil Prices Hurt Indian Stocks Higher Crude Oil Prices Hurt Indian Stocks Chart II-2Crude Oil And Current Account Deficit Crude Oil And Current Account Deficit Crude Oil And Current Account Deficit Given that India is a major oil importer, falling commodities prices - especially crude oil - will benefit India's stock market. The recent surge in oil prices has also reinforced inflation dynamics in India (Chart II-3). Chart II-3Higher Crude Oil Boosts Inflation Higher Crude Oil Boosts Inflation Higher Crude Oil Boosts Inflation The basis for the high correlation between core consumer price inflation (excluding energy and food) and oil prices is due to the fact that core inflation includes components that are heavily influenced by fluctuations in oil prices. For instance, the transportation and communication component of inflation is very sensitive to changes in oil prices. This component accounts for 18% of core consumer price index. Further, the personal care and effects component also correlates with crude oil. Personal care goods use petroleum products as an important input in their production process. This component accounts for 8% of core consumer price index. Together these components account for a non-trivial 26% of core consumer price index, and will likely subside as oil prices fall. On the inflation front, we highlighted in our April 19 Weekly Report that risks to inflation are tilted to the upside due to strong consumer and government spending in an otherwise under-invested economy.1 Domestic demand has been accelerating, providing tailwinds for higher inflation (Chart II-4). Higher inflation and currency weakness has led to a considerable rise in both government and corporates local currency bond yields (Chart II-5). Chart II-4Domestic Economy Is Strong Domestic Economy Is Strong Domestic Economy Is Strong Chart II-5Rising Borrowing Rates Rising Borrowing Rates Rising Borrowing Rates Given the very high equity valuations, share prices in India are especially sensitive to rising local borrowing costs. All in all, India's relative equity performance has by and large been undermined by rising oil prices. BCA's Emerging Markets Strategy team believes the risk-reward for oil prices is skewed to the downside due to the expected deterioration in EM/China oil demand, investors' extremely high net long positions in crude and appreciating dollar.2 That is why we are still reluctant to downgrade Indian stocks within the EM equity universe. It is vital to emphasize, however, that our overweight call is relevant to dedicated EM equity portfolios. We have been, and remain, negative on Indian share prices in absolute U.S. dollar terms. Bottom Line: Odds are that commodities prices will drop meaningfully in the months ahead and that will support India's relative equity performance versus the EM benchmark. EM dedicated investors should keep an overweight stance on Indian equities for now. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "Country Perspectives: India And Turkey," dated April 19, 2018, link available on page 21. 2 The Emerging Markets Strategy team's view on oil differs from BCA's house view which remains bullish. The South African Rand Remains On Shaky Foundations Although the rand has not been among the worse hit EM currencies, investors should remain cautious on it. The currency presently finds itself resting on very shaky foundations, raising odds of substantial depreciation for the remainder of the year: First, South Africa's external funding has solely been driven by portfolio inflows, leaving the exchange rate highly exposed to potential portfolio outflows. As illustrated in Chart III-1, net portfolio inflows reached all-time highs while net FDIs reached all-time lows at the end of 2017 (the latest available statistics). Meanwhile, foreign ownership of domestic bonds has reached new highs (Chart III-2). The total return in dollar terms on South Africa's local currency bond index1 has failed to break above its previous highs and has relapsed (Chart III-3). It seems this asset class has entered a new bear market. Further decline in the total return of bonds will spur more selling or hedging of currency risks by international bond investors. Chart III-1South Africa: Highly Exposed To Portfolio Flows South Africa: Highly Exposed To Portfolio Flows South Africa: Highly Exposed To Portfolio Flows Chart III-2Foreign Holdings Of South African Local Bonds Is Elevated Foreign Holdings Of South African Local Bonds Is Elevated Foreign Holdings Of South African Local Bonds Is Elevated Chart III-3South African Bonds Were Unable To Break Out South African Bonds Were Unable To Break Out South African Bonds Were Unable To Break Out Second, the country's trade balance is set to deteriorate. Despite continued episodes of currency weakness throughout last decade, there has been little to no import substitution in South Africa. Consequently, a reviving domestic demand will prompt higher imports. That, and a potential relapse in export (raw materials) prices, will lead to a widening trade balance. Chart III-4The Rand Is Not Cheap The Rand Is Not Cheap The Rand Is Not Cheap Finally, the rand is not cheap; its valuation is neutral (Chart III-4). When an exchange rate is close to its fair value, it can either appreciate or depreciate. In short, the rand's valuation is not extreme enough to be a major factor in driving the market right now. Bottom Line: Currency traders should stay short the ZAR versus both the USD and the MXN. Relative trade balance dynamics and valuations continue to play in favor of the Mexican peso relative to the South African rand. Predicated by our negative view on the rand, we recommend EM dedicated equity and fixed-income investors to maintain an underweight allocation to South Africa. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 JP Morgan GBI-EM Global Diversified Emerging Markets Government Bond Index for South Africa. Equity Recommendations Fixed-Income, Credit And Currency Recommendations