China

Feature It has been a Geopolitical Strategy tradition, since our launch in 2012, to include our best and worst forecasts of the year in our end-of-year Strategic Outlook monthly reports.1 Since we have switched over to a weekly publication schedule, we are making this section of our Outlook an individual report.2 It will also be the final publication of the year, provided that there is no global conflagration worthy of a missive between now and January 10, when we return to our regular publication schedule. The Worst Calls Of 2017 A forecasting mistake is wasted if one learns nothing from the error. Alternatively, it is an opportunity to arm oneself with wisdom for the next fight. This is why we take our mistakes seriously and why we begin this report card with the zingers. Overall, we are satisfied with our performance in 2017, as the successes below will testify. However, we made one serious error and two ancillary ones. Short Emerging Markets Continuing to recommend an overweight DM / underweight EM stance was the major failure this year (Chart 1). More specifically, we penned several bearish reports on the politics of Brazil, South Africa, and Turkey throughout the year to support our view.3 What did we learn from our mistake? The main driving forces behind EM risk assets in 2017 have been U.S. TIPS yields and the greenback (Chart 2). Weak inflation data and policy disappointments as the pro-growth, populist economic policy of the Trump Administration stalled mid-year supported the EM carry trade throughout the year. The post-election dollar rally dissipated, while Chinese fiscal and credit stimulus carried over into 2017 and buoyed demand for EM exports. Chart 1The Worst Call Of 2017: Long DM / Short EM The Worst Call Of 2017: Long DM / Short EM The Worst Call Of 2017: Long DM / Short EM Chart 2How Long Can The EM Carry Trade Survive? How Long Can The EM Carry Trade Survive? How Long Can The EM Carry Trade Survive? Our bearish call was based on EM macroeconomic and political fundamentals. On one hand, our fundamental analysis was genuinely wrong. Emerging markets were buoyed by Chinese stimulus and a broad-based DM recovery. On the other hand, our fundamental analysis was irrelevant, as the global "search-for-yield" overwhelmed all other factors. Chart 3The Dollar Ought ##br##To Rebound The Dollar Ought To Rebound The Dollar Ought To Rebound Chart 4Chinese Monetary Conditions Point##br## To Slowing Industrial Activity Chinese Monetary Conditions Point To Slowing Industrial Activity Chinese Monetary Conditions Point To Slowing Industrial Activity Going forward, it is difficult to see this combination of factors emerge anew. First, the U.S. economy is set to outperform the rest of the world in 2018, particularly with the stimulative tax cut finally on the books, which should be dollar bullish (Chart 3). Second, downside risks to the Chinese economy are multiplying (Chart 4) as policymakers crack down on the shadow financial sector and real estate (Chart 5). BCA's Foreign Exchange Strategy has shown that EM currencies are already flagging risks to global growth. Their "carry canary indicator" - EM currencies vs. the JPY - is forecasting a sharp deceleration in global growth within the next two quarters (Chart 6). Chart 5Chinese Growth ##br##Slowing Down? Chinese Growth Slowing Down? Chinese Growth Slowing Down? Chart 6After Carry Trades Lose Momentum,##br## Global IP Weakens After Carry Trades Lose Momentum, Global IP Weakens After Carry Trades Lose Momentum, Global IP Weakens That said, we have learned our lesson. We are closing all of our short EM positions and awaiting January credit numbers from China. If our view on Chinese financial sector reforms is correct, these figures should disappoint. If they do not, the EM party can continue. "Trump, Day One: Let The Trade War Begin" In our defense, the title of our first Weekly Report of the year belied the nuanced analysis within.4 We argued that the Trump administration would begin its relationship with China with a "symbolic punitive measure," but that it would then "seek high-level negotiations toward a framework for the administration's relations with China over the next four years." This was largely the script followed by the White House. We also warned clients that it would be the "lead up to the 2018 or 2020 elections" that truly revealed President Trump's protectionist side. Nonetheless, we were overly bearish about trade protectionism throughout 2017. First, President Trump did not name China a currency manipulator. Second, the border adjustment tax (BAT), which we thought had a 55% chance of being included in tax reform, really was dead-on-arrival. Third, the "Mar-A-Lago Summit" consensus lasted through the summer, buoying companies with relative exposure to China relative to the S&P 500 (Chart 7).5 Chart 7Second Worst Call Of 2017:##br## Alarmism On Protectionism Second Worst Call Of 2017: Alarmism On Protectionism Second Worst Call Of 2017: Alarmism On Protectionism Why did we get the Trump White House wrong on protectionism? There are three possibilities: Constraints error: We strayed too far from our constraints-based model by focusing too much on preferences of the Trump Administration. While we are correct that the White House lacks constraints when it comes to trade, tensions with North Korea this year - which we forecast correctly - were a constraint on an overly punitive trade policy against China. Preferences error: We got the Trump administration preferences wrong. Trade protectionism is the wool that Candidate Trump pulled over his voters' eyes. He is in fact an establishment Republican - a pluto-populist - with no intention of actually enacting protectionist policies. Timing error: We were too early. Year 2018 will see fireworks. Unfortunately for our clients, we have no idea which error we committed. But Trump's national security speech on Dec. 18 maintained the protectionist threat, and there are several key deadlines coming up that should reveal which way the winds are blowing: New Year: Trump will have to decide on January 12 and February 3 whether to impose tariffs on solar panels and washing machines, respectively, under Section 201 of the U.S. Trade Act of 1974. This ruling will have implications for other trade items. End of Q1: NAFTA negotiations have been extended through the end of Q1 2018. As we recently posited, the abrogation of NAFTA by the White House is a 50-50 probability.6 The question is whether the Trump administration follows this up with separate bilateral talks with Canada and Mexico, or whether it moves beyond NAFTA to clash directly with the WTO instead.7 The U.K. Election (Although We Got Brexit Right!) Our forecasting record of U.K. elections is abysmal. We predicted that Theresa May would preserve her majority in the House of Commons, although in our defense we also noted that the risks were clearly skewed to the downside given the movement of the U.K. median voter to the left.8 We are now 0 for 2, having also incorrectly called the 2015 general election (we expected the Tories to fail to reach the majority in that election).9 On the other hand, we correctly sounded the alarm on Brexit, noting that the probability was much closer to 50% than what the market was pricing at the time.10 What gives? The mix of U.K.'s first-past-the-post system and the country's unique party distribution makes forecasting elections difficult. Because the Tories are essentially the only right-of-center party in England, they tend to outperform their polls and win constituencies with a low-plurality of votes. As such, in 2017, we ignored the strong Labour momentum in the polls, expecting that it would stall. It did not (Chart 8). That said, our job is not to call elections, but to generate alpha by focusing on the difference between what the market is pricing in and what we believe will happen. If elections are a catalyst for market performance - as was the case with the French one this year - we track them closely in a series of publications and adjust our probabilities as new data comes in. For U.K. assets this year, by contrast, getting the Brexit process right was far more relevant than the general election. Our high conviction view that the EU would not be punitive, that the U.K. would accept all conditions, and that the May administration would essentially stick to the "hard Brexit" strategy it defined in January ended up being correct.11 This allowed us to call the GBP bottom versus the USD in January (Chart 9). Chart 8Third Worst Call Of 2018: The U.K. Election Third Worst Call Of 2018: The U.K. Election Third Worst Call Of 2018: The U.K. Election Chart 9But We Got Brexit - And Cable! - Right But We Got Brexit - And Cable! - Right But We Got Brexit - And Cable! - Right What did we learn from our final error? Stop trying to forecast U.K. elections! The Best Calls Of 2017 The best overall call in 2017 was to tell clients to buy the S&P 500 in April and never look back. Our "Buy In May And Enjoy Your Day!" missive on April 26 was preceded by our analysis of global geopolitical risks and opportunities.12 In these, we concluded that "Political Risks Are Overstated In 2017" and "Understated In 2018."13 As such, the combination of strong risk asset performance and low volatility did not surprise us. It was our forecast (Chart 10). U.S. Politics: Tax Cuts & Impeachment Not only did we forecast that President Trump would manage to successfully pass tax reform in 2017, but we also correctly called the GOP's fiscal profligacy.14 We get little recognition for the latter in conversations with clients and colleagues, but it was a highly contentious call, especially after seven years of austere rhetoric from the fiscal conservatives supposedly running the Republican Party. We were also correct that impeachment fears and the ongoing Mueller Investigation would have little impact on U.S. assets.15 Chart 11 shows that the U.S. dollar and S&P 500 barely moved with each Trump-related scandal (Table 1). Chart 10The Best Call Of 2017: Getting The Market Right The Best Call Of 2017: Getting The Market Right The Best Call Of 2017: Getting The Market Right Chart 11No Real Impact From Trump Imbroglio BCA Geopolitical Strategy 2017 Report Card BCA Geopolitical Strategy 2017 Report Card By correctly identifying the ongoing "Trump Put" in the market, we were able to remain bullish on U.S. equities throughout the year and avoid calling any pullbacks. Table 1An Eventful Year 1 Of The Trump Presidency BCA Geopolitical Strategy 2017 Report Card BCA Geopolitical Strategy 2017 Report Card Europe (All Of It) Our performance forecasting European politics and markets has been stellar this year. Instead of reviewing each call, the list below simply summarizes each report: "After Brexit, N-Exit?" - Although technically a call made in 2016, our view that Brexit would cause a surge in support for the EU was a view for 2017.16 Several anti-establishment populists failed to perform in line with their 2015-2016 polling, particularly Geert Wilders in the Netherlands. "Will Marine Le Pen Win?" - We definitely answered this question in the negative, going back to November 2016.17 This allowed us to recommend clients go long the euro vs. the U.S. dollar (Chart 12). Moreover, we argued that regardless of who won the election, the next French government would embark on structural reforms.18 As a play on our bullish view of France, we recommended that clients overweight French industrials vs. German ones (Chart 13). "Europe's Divine Comedy: Italy In Purgatorio" - We correctly assessed that Italian Euroskpetics would migrate towards the center on the question of the euro. However, we missed recommending the epic rally in Italian equities and bonds that should have naturally flowed from our political view.19 "Fade Catalan Risks" - Based on our 2014 net assessment, we concluded that the Catalan independence drive would be largely irrelevant for the markets.20 This proved to be correct this year. "Can Turkey Restart The Immigration Crisis?" - Earlier in the year, clients became nervous about a potential diplomatic breakdown between the EU and Turkey leading to a renewal of the immigration crisis.21 We reiterated our long-held view that the immigration crisis did not end because of Turkish intervention, but because of tighter European enforcement. Throughout the year, we were proven right, with Europeans becoming more and more focused on interdiction. Chart 12Second Best Call Of 2017: The Euro... Second Best Call Of 2017: The Euro... Second Best Call Of 2017: The Euro... Chart 13...And France In Particular ...And France In Particular ...And France In Particular China: Policy-Induced Financial Tightening Throughout 2016-17, in the lead-up to China's nineteenth National Party Congress, we argued that the stability imperative would ensure an accommodative-but-not-too-accommodative policy stance.22 In particular, we highlighted the ongoing impetus for anti-pollution controls.23 This forecast broadly proved to be correct, as the government maintained stimulus yet simultaneously surprised the markets with financial and environmental regulatory crackdowns throughout the year. Once these regulatory campaigns took off, we argued that they would remain tentative, since the truly tough policies would have to wait until after the party congress. At that point, Xi Jinping could re-launch his structural reform agenda, primarily by intensifying financial sector tightening.24 Over the course of the year, this political analysis began to be revealed in the data, with broad money (M3) figures suggesting that money growth decelerated sharply in 2017 (Chart 14). In addition, we correctly called several moves by President Xi Jinping at the party congress.25 Chart 14Third Best Call Of 2017:##br## Chinese Reforms? (We Will See In 2018!) Third Best Call Of 2017: Chinese Reforms? (We Will See In 2018!) Third Best Call Of 2017: Chinese Reforms? (We Will See In 2018!) Our view that Chinese policymakers will restart reforms after the party congress is now becoming more widely accepted, given Xi's party congress speech Oct. 18 and the news from the December Politburo meeting.26 Where we differ from the market is in arguing that Beijing's bite will be worse than its bark. We are concerned that there is considerable risk to the downside and that stimulus will come much later than investors think this time around. Our China view was largely correct in 2017, but the real market significance will be felt in 2018. There are still several questions outstanding, including whether the crackdown on the financial sector will be as growth-constraining as we think. As such, this is a key view that will carry over into 2018. Thankfully, we should know whether we are right or wrong by the March National People's Congress session and the data releases shortly thereafter. North Korea - Both A Tail Risk And An Overstated Risk We correctly identified North Korea as a key 2017 geopolitical risk in our Strategic Outlook and began signaling that it was no longer a "red herring" as early as April 2016.27 In April 2017, we told clients to prepare for safe haven flows due to the likelihood that tensions would increase as the U.S. established a "credible threat" of war, a playbook that the Obama administration most recently used against Iran.28 While we flagged North Korea as a risk that would move the markets, we also signaled precisely when the risk became overstated. In September, we told clients that U.S. Treasury yields would rise from their lows that month as investors realized that the North Korean regime was constrained by its paltry military capability.29 At the same time, we gave President Trump an A+ for his performance establishing a credible threat, a bet that worked not only on Pyongyang, but also on Beijing. Since this summer, China has begun to ratchet up economic pressure against North Korea (Chart 15). Chart 15Fourth Best Call Of 2017: North Korea Fourth Best Call Of 2017: North Korea Fourth Best Call Of 2017: North Korea Middle East And Oil Prices BCA Research scored a big win this year with our energy call. It would be unfair for us to take credit for that view. Our Commodity & Energy Strategy as well as our Energy Sector Strategy deserve all the credit.30 Nonetheless, we helped our commodity teams make the right calls by: Correctly forecasting that Saudi-Iranian and Russo-Turkish tensions would de-escalate, allowing OPEC and Russia to maintain the production-cut agreement;31 Emphasizing risks to Iraqi production as tensions shifted from the Islamic State to the Kurdish Regional Government; Highlighting the likely continued decline, but not sharp cut-off, of Venezuelan production, due to the regime's ability to cling to power even as the conditions of production worsened.32 In addition, we were correct to fade various concerns regarding renewed tensions in Qatar, Yemen, and Lebanon throughout the year. Despite the media narrative that the Middle East has become a cauldron of instability anew, our long-held view that all the players involved are constrained by domestic and material constraints has remained cogent. In particular, our view that Saudi Arabia would engage in serious social reforms bore fruit in 2017, with several moves by the ruling regime to evolve the country away from feudal monarchy.33 Going forward, a major risk to our view is the Trump administration policy towards Iran, our top Black Swan risk for 2018. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Ekaterina Shtrevensky, Research Assistant ekaterinas@bcaresearch.com 1 Due to the high volume of footnotes in this report, we have decided to include them at the end of the document. For a review of our past Strategic Outlooks, please visit gps.bcaresearch.com. 2 For the rest of our 2018 Outlook, please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, and "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy, "Turkey: Military Adventurism And Capital Controls," dated December 7, 2016, "South Africa: Back To Reality," dated April 5, 2017, "Brazil: Politics Giveth And Politics Taketh Away," dated May 24, 2017, "South Africa: Crisis Of Expectations," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "G19," dated July 12, 2017, available at gps.bcaresearch.com. 6 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. 7 The outcome at the WTO Buenos Aires summit last week offered a possible way out of confrontation between the Trump administration and the WTO. It featured Europe and Japan taking a tougher line on trade violations, namely China, to respond to the Trump administration grievances that, unaddressed, could escalate into a full-fledged Trump-WTO clash. 8 Please see BCA Geopolitical Strategy Weekly Report, "How Long Can The 'Trump Put' Last?" dated June 14, 2017 and "U.K. Election: The Median Voter Has Spoken," dated June 9, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "U.K. Election Preview," dated February 26, 2015, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me?' World?" dated January 25, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017 and "Political Risks Are Understated In 2017," dated April 12, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, "The French Revolution," dated February 3, 2017 and "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014 and "Why So Serious?" dated October 11, 2017, available at gps.bcaresearch.com. 21 Please see BCA Geopolitical Strategy Weekly Report, "Five Questions On Europe," dated March 22, 2017, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation)," dated July 13, 2016, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 24 Please see BCA Geopolitical Strategy We," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 25 We argued in our 2017 Strategic Outlook that while Xi's faction would gain a majority on the Politburo Standing Committee, he would maintain a reasonable balance and refrain from excluding opposing factions from power. We expected that factional struggle would flare back up into the open (as with the ouster of Sun Zhengcai), and that Xi would retire anti-corruption chief Wang Qishan, but not that Xi would avoid promoting a successor for 2022 to the Politburo Standing Committee. 26 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 27 Please see BCA Geopolitical Strategy "North Korea: A Red Herring No More?" in Monthly Report, "Partem Mirabilis," dated April 13, 2016 and "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 28 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 29 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 30 If you are an investor with even a passing interest in commodities and oil, you must review the work of our colleagues Robert Ryan and Matt Conlan. 31 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com. 32 Please see BCA Geopolitical Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 33 Please see BCA Geopolitical Strategy Special Report, "The Middle East: Separating The Signal From The Noise," dated November 15, 2017, available at gps.bcaresearch.com.

Highlights The financial system / banks cannot and do not lend out or intermediate national or households "savings". In any economy, new money/new purchasing power is originated by commercial banks "out of thin air". The term "savings" in macroeconomics denotes an increase in the economy's capital stock, not deposits at the banks. The Chinese banking system has enormous amount of deposits because banks have created them "out of nothing" not because households save a lot. Hence, the narrative that justifies China's money, credit and property market excesses by high national and household "savings" is incorrect. The maneuvering room for China is diminishing as inflationary pressures are rising, productivity is slowing and speculative leverage is high. Feature An Unprecedented Credit And Money Boom In China An Unprecedented Credit And Money Boom In China The debate on China's macro outlook continues to linger both within and outside BCA. The focal point of the debate centers on the role of national "savings" in China in spurring credit origination and debt formation. Many of my colleagues at BCA and the majority of commentators outside BCA argue that China's high "savings" rate, or so-called "excess savings", has been an important contributor to its exponential credit and money growth. Contrary to this narrative, we within BCA's Emerging Markets Strategy team maintain that the dramatic surge in credit and money in China has been the result of speculative behavior by banks and debtors. As such, the boom in money and credit growth has produced large imbalances and excesses, if not outright bubbles (Chart I-1). Every financial bubble in history has had its justifications. Last decade, the common narrative about U.S. real estate was that nationwide, U.S. house prices had historically never deflated in nominal terms. In the late 1990s, the tech bubble was vindicated by the "new productivity" era. In the meantime, in the 1980s in Japan and the mid-1990s in Hong Kong, sky high property prices were rationalized by limited amounts of land, given that these are islands. Despite these validations, all of these bubbles ultimately burst. We feel that vindicating China's enormous credit, money and property market excesses - which are all interrelated - by the nation's high "savings" is another attempt to endorse overextended and unsustainable macro imbalances. This report is a continuation of our series discussing these issues in great depth.1 The objective of this piece is to illuminate on the confusion between national "savings" and credit / deposits / money. Intuitively, many investors and commentators use the term "savings" to refer to bank deposits. Yet, in macroeconomics, national and household "savings" are not about deposits or money in the banking system at all. The term "savings" in macroeconomics denotes an increase in the economy's capital stock. Therefore, the financial system in general, and banks in particular, cannot and do not lend out or intermediate national or households "savings." The Chinese banking system has enormous amount of deposits because banks have created them "out of nothing" not because households save a lot. In an economy where banks exist, "savings" and financing are very different things. Commercial banks (hereafter referred to as banks) provide financing by expanding their balance sheets - creating deposits "out of thin air" as and when they originate loans. We previously elaborated on this money creation process,2 but given its importance to the topic of this report, we revisit it here. Banks Create New Purchasing Power "Out Of Thin Air" When a bank originates a loan, it simultaneously creates a deposit, or new money. Importantly, this does not represent a transfer of an existing deposit to the new borrower. This is a new deposit - new purchasing power - that did not previously exist (Figure 1). The True Meaning Of China's Great 'Savings' Wall The True Meaning Of China's Great 'Savings' Wall The borrower can immediately use this new deposit to purchase goods and services or buy assets. At the same time, all owners of existing deposits at the bank still have their deposits too, and can use them as, when, and how they prefer. Thereby, the bank has created new purchasing power "out of nothing" when it originated a loan. Traditional macroeconomic theory presumes that for a person or company to invest in productive capacity, another person/unit must save. This assumption is true for a barter economy with no banks and money - where some entities produce but do not consume, so that others can acquire their output (goods) and in turn use them as investment. Nevertheless, in an economy with banks, one does not need to save in the form of a deposit in a bank in order for the latter to lend money to another entity. When a bank grants a loan or acquires an asset, it simultaneously creates new deposit/money - which is de facto new purchasing power originated by the bank "out of thin air." We use the terms deposit and money interchangeably because broad money supply is computed as the sum of all deposits in the commercial banks. Let's consider an example of how a bank loan leads to new income creation. A company borrows from a bank to build a bridge, it then pays its suppliers and contractors for their work. As a result, the suppliers and contractors, and consequently their employees and shareholders, earn income. Without this loan, the bridge would not have been built, and the suppliers, their employees and business owners would not have received income. In short, the loan comes first, then the investment - and only after the investment is carried out do employees and business owners earn income. Thereafter, they can consume, acquire assets and save in forms of bank deposits. Critically, this income is realized because the bank originated a loan / new purchasing power "out of nothing." Chart I-2 illustrates that the Chinese banking system has created RMB 140 trillion of broad money/deposits since January 2009. This is equivalent to US$21 trillion at today's exchange rate. This is twice as much as aggregate broad money - equivalent to $10.5 trillion - generated by commercial and central banks in the U.S., the euro area and Japan combined since early 2009 - even amid their respective QE programs. Helicopter Money In China Helicopter Money In China The unprecedented new purchasing power of Chinese companies and households has been primarily due to this enormous balance sheet expansion by mainland commercial banks (Chart I-3). China: Commercial Banks Assets And Money Multiplier China: Commercial Banks Assets And Money Multiplier Bank Versus Financial Intermediaries Banks perform a unique function in the economy and financial system. There are considerable differences between a bank lending money or buying assets and a non-bank doing the same. This is unfortunately not reflected in mainstream economic theory and macro models. Unlike banks, non-banks - such as pension funds, insurance companies, households, businesses and all other non-bank entities - do not create new money/new purchasing power when they grant a loan or acquire an asset. The act of lending by non-banks simply constitutes a transfer of an existing deposit from a creditor to a borrower. Banks are not intermediaries of deposits into loans as the Loanable Funds Theory (LFT) alleges. They create deposits themselves by making loans and acquiring assets. The LFT, nonetheless, applies to non-bank lenders - the latter are indeed financial intermediaries, i.e., they channel existing deposits into loans or other assets. The institutional and legal differences that make commercial banks unique and allow them to create money are discussed in detail in "How Do Banks Create Money, and Why Can Other Firms Not Do the Same?," Werner (2014b).3 The theory of fractional banking is not applicable to modern banking as well.4 It is the theory of money creation by banks that we subscribe to and present here that accurately describes the process of money creation. Bottom Line: Banks differ vastly from non-bank financial institutions, and are unique in their ability to create money/new purchasing power by originating loans or acquiring assets. Money Versus Credit Remarkably, there is also an important analytical distinction between credit/leverage and money. New money matters when one is attempting to gauge the (nominal) growth outlook because it represents new purchasing power. New money can only be originated by banks, including the central bank. Central banks can create broad money in circulation (i.e. beyond central bank reserves) when they buy financial assets from or lend to non-bank entities. Doing so creates a deposit in the commercial banking system. China: Money Versus Credit/Debt China: Money Versus Credit/Debt By contrast, the degree of credit/leverage is critical when evaluating the risk of financial distress in both the economy and the financial system. Credit can be extended not only by banks but also by non-banks. Hence, lending or buying corporate bonds by non-banks creates leverage/credit but not new money. The banking system is the only one capable of originating new money, and in turn, new purchasing power. In China, the outstanding stock of total non-financial debt (private plus public) is close to the amount of money supply (Chart I-4). Even though non-bank credit growth has risen in importance since 2010, it seems that without banks' money creation, non-bank credit would not have expanded. On another note, household propensity to save alters the velocity of money, not the amount of money in the banking system. A decision by a household to spend more rather than save does not change the amount of deposits in the banking system. As an example, a person who gets paid $1000 might spend $800 of her income and decide to save the remaining $200. The amount of deposits in the banking system does not change; $800 will be transferred to another bank account as she pays for her purchases, while the remaining $200 stays in her existing bank account. Hence, there is no change in the amount of deposits and money supply in the banking system in this scenario. On the whole, the amount of deposits, and hence, broad money supply, in any banking system is equal to the cumulative net money creation by banks and the central bank over the course of their history. This has nothing to do with household and national "savings." The Chinese banking system has enormous amount of deposits because banks have created them "out of nothing" not because households save a lot. Interestingly, changes in household propensity to save are reflected not in money supply but in the velocity of money. When households or companies decide to spend their deposits, the velocity of money rises. Conversely, when households and companies decide to save (retain) their deposits, the velocity of money drops. Bottom Line: Money is distinct from credit and leverage. Changes in the propensity to save alter the velocity of money, but not the amount of deposits/money supply in the banking system. True Meaning Of "Savings" In Macroeconomics What is the true meaning of "savings"5 in macroeconomics, given the amount of deposits in the banking system has no bearing on "savings?" The confusion between national "savings" and deposit/money creation is dealt with nicely by Fabian Lindner. Having modelled it, Lindner6 argues: "... the aggregate economy's saving is equal to the newly produced tangible assets and inventories. That total saving is equal to just the increase in tangible assets ... (because) all changes in net financial assets in the economy add up to zero... Thus, for every economic agent increasing her net financial assets, there is a corresponding decrease in net financial assets of all other economic agents in the economy. Put in more general terms: An economic agent can only save financially if other agents dis-save financially by the same amount... That is why in the entire economy (that is the world economy or a closed economy) only the increase in tangible assets, thus investment, is saving (emphasis is added). Thus, saving and investment are equivalent in the aggregate... The equivalence of investment and saving however does not mean - as claimed by LFT - that household saving (or the sum of household and government saving) is equal to total saving and thus to investment. No matter how high one group's financial saving is, the financial dis-saving of the rest of the economy has to be just as high. The only thing remaining is the creation of tangible assets." (Lindner 2015) In another paper,7 Lindner asserts: "Investment is the production of any non-financial asset in an economy and thus is always directly and unambiguously savings: it increases the economy's net worth... The economy as a whole cannot change its net financial wealth since it always equals zero. The aggregate economy can only save in the form of non-financial assets...The only way an economy can save is by increasing its non-financial wealth, i.e., its physical capital stock." (Lindner 2012) Bottom Line: For a country to raise its domestic "savings" rate, it needs to build its capital stock by using domestically produced investment goods and raw materials. Thereby, domestic "savings" have nothing to do with the absolute level or changes in amount of deposits/money in the banking system. China's Great Wall Of "Savings" China has been investing tremendous amounts for many years, and its capital stock has been mushrooming (Chart I-5, top panel). Yet, the incremental capital-to-output ratio (ICOR) has surged and, its inverse, the output-to-capital ratio has plunged since 2010 (Chart I-5, middle and bottom panels). These developments signify deteriorating efficiency in the Chinese economy and worsening capital allocation. They also entail that companies might have difficulties servicing their debt. When its export machine faltered in 2008 due to the Global Financial Crisis, China offset it by boosting its domestic investments. These investments - incremental additions to the nation's capital stock - defined by macroeconomics as domestic "savings"- offset the decline in external "savings." As such, the composition of national "savings" has changed dramatically since 2008: the share of external "savings" (net exports) have declined while the share of domestic "savings" has risen (Chart I-6). China: Capital Stocks Has Surged China: Capital Stocks Has Surged China: Domestic And External 'Savings' China: Domestic And External 'Savings' In China, the augmentation of its capital stock and, hence, its domestic "savings," have been largely financed by loans from Chinese banks. This may sound like nonsense, but only because we are using the term "savings" in a way used in macroeconomics. Yet, new purchasing power originated by the banking system is not in and of itself a sufficient condition to generate domestic "savings." The sufficient condition for having high domestic "savings" is the ability to produce domestic capital goods and raw materials that go into investment. If a country does not build its capacity to produce capital goods and raw materials, it would need to rely on imports - in other words it has to acquire foreign "savings" to invest. Encouraging domestic "savings" entails enhancing capacity to produce goods that are used in capital spending like raw materials, chemicals, steel, cement, machinery, and various equipment and instruments. This is what China has done exceptionally well over the past 20 years. The following points illustrate how China achieved very high "savings" and investment rates (Chart I-7): China devalued its currency in January 1994 by 32% and relied on a cheap currency to produce large trade surpluses (Chart I-8). It used the foreign currency proceeds to purchase foreign technologies and equipment to boost its capital stock. Savings And Investment Ratios Savings And Investment Ratios It also attracted FDI to build its productive capacity both for consumer goods as well as capital goods. FDI inflows surged since China's acceptance into the WTO in 2001. China: The 1994 Currency Devaluation Started New Era China: The 1994 Currency Devaluation Started New Era   Since 2009, however, China has been relying on new purchasing power created by banks to expand its industrial capacity to produce commodities, raw materials, industrial equipment and machinery. Meanwhile, mainland banks have been originating new loans, and hence deposits/money - new purchasing power - to finance real estate development and infrastructure construction, utilizing these domestically produced raw materials and machinery. This has allowed China to sustain high levels of domestic "savings." On the whole, China indeed has had "excess savings" as its economy has been suffering from excess industrial capacity. Initially, China invested to create such excess capacity. Then, its banking system originated enormous amount of money/new purchasing power to support and keep zombie companies alive in these industries with excess capacity. The banking system is still involved in this function up until today. While this is a reasonable economic policy in the short run, it is not a good growth strategy in the long term. The problem is that easy money and credit support inefficient enterprises and encourage unproductive investment. As a result, productivity growth will slow and potential growth will decelerate considerably. Bottom Line: The countries that produce a lot of goods and services for domestic investment are said to have high domestic "savings." By definition, the more excess industrial capacity a country has, the more "excess savings" that economy will carry. Yet, uncontrolled money/credit origination to support zombie enterprises in over-capacity sectors entails inefficient allocation of capital that necessarily slows productivity growth and hence economic growth potential in the long term. Limits On Money Creation A natural question that arise from all this is what are the limits on money creation? We list some of major ones here, but these issues have been addressed in our previous three reports,8 and we will address them again in forthcoming reports. Inflation and/or deprecation pressures on the currency that could lead to monetary tightening; Bank regulation and various regulatory ratios; Shareholders of banks - who are highly leveraged to non-performing assets/loans - might order reduced lending; Removing the implicit government "put" that encourage irresponsible borrowing and lending. Inflationary pressures are presently rising and more entrenched in China now than at any time in the past decade or so (Chart I-9). In the context of negative real interest rates (Chart I-10) and barring major growth slowdown, the authorities are unlikely to stimulate anytime soon. Beware Of Rising Inflation In China... Beware Of Rising Inflation In China... ...Making Interest Rates Negative ...Making Interest Rates Negative   Negative real local interest rates undermine Chinese households' willingness to hold the currency. China's foreign exchange reserves at $3 trillion, while high, are equal only to 10% broad money (M3) and 14% of official M2. This signifies how much money the banking system has created. At the moment, mainland banking regulations are being tightened. This as well as liquidity tightening by the People's Bank of China and the government's anti-corruption crackdown that is moving into the financial industry will further dampen money creation and leverage expansion. This triple tightening amid lingering money and credit excesses constitutes the main rationale behind our negative stance on China's growth and China-related plays in global financial markets. Policy tightening is especially dangerous amid the existing credit, money and property market imbalances and excesses. Downgrade Chinese Stocks From Overweight To Neutral Downgrade Chinese Investable Stocks From Overweight To Neutral Downgrade Chinese Investable Stocks From Overweight To Neutral The Chinese MSCI Investable equity index - which unlike H-shares includes mega-cap tech companies - has rallied massively and outperformed the EM benchmark (Chart I-11). Relative performance is overbought, and we recommend dedicated EM equity portfolios downgrade their allocation from overweight to neutral. Our overweight position was initiated on November 26, 2014, and has generated an 18.5% gain. The freed-up capital should be allocated proportionally to our remaining overweights, which are Taiwan, Thailand, Korean tech stocks, Russia and central Europe. We are contemplating upgrading Chile. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Reports from October 26, 2016, November 23, 2016 and January 18, 2017; available on ems.bcaresearch.com 2 Please refer to the Emerging Markets Strategy Special Report titled "Misconceptions About China's Credit Excesses," dated October 16, 2016, available on available on ems.bcaresearch.com 3 Werner, R. (2014b), "How Do Banks Create Money, and Why Can Other Firms Not Do the Same?", International Review of Financial Analysis, 36, 71-77. 4 Werner, R. (2014a), "Can banks individually create money out of nothing? -- The theories and the empirical evidence", International Review of Financial Analysis, 36, 1-19. 5 We use "savings" in parenthesis because as this term does not really mean households' and companies' and governments' financial assets or deposits at the banks. "Savings" signifies the amount of goods and services produced but not consumed by an economy. 6 Lindner, F. (2015), "Did Scarce Global Savings Finance the US Real Estate Bubble? The Global Saving Glut thesis from a stock flow Consistent Perspective", Macroeconomic Policy Institute, Working Paper 155, July 2015. 7 Lindner, F. (2012), "Savings does not finance Investment: Accounting as an indispensable guide to economic theory", Macroeconomic Policy Institute, Working Paper 100, October 2012. 8 Please refer to the Emerging Markets Strategy Special Reports from October 26, 2016, November 23, 2016 and January 18, 2017; available on ems.bcaresearch.com  

Highlights The financial system / banks cannot and do not lend out or intermediate national or households "savings". In any economy, new money/new purchasing power is originated by commercial banks "out of thin air". The term "savings" in macroeconomics denotes an increase in the economy's capital stock, not deposits at the banks. The Chinese banking system has enormous amount of deposits because banks have created them "out of nothing" not because households save a lot. Hence, the narrative that justifies China's money, credit and property market excesses by high national and household "savings" is incorrect. The maneuvering room for China is diminishing as inflationary pressures are rising, productivity is slowing and speculative leverage is high. Feature The debate on China's macro outlook continues to linger both within and outside BCA. The focal point of the debate centers on the role of national "savings" in China in spurring credit origination and debt formation. Many of my colleagues at BCA and the majority of commentators outside BCA argue that China's high "savings" rate, or so-called "excess savings", has been an important contributor to its exponential credit and money growth. Contrary to this narrative, we within BCA's Emerging Markets Strategy team maintain that the dramatic surge in credit and money in China has been the result of speculative behavior by banks and debtors. As such, the boom in money and credit growth has produced large imbalances and excesses, if not outright bubbles (Chart I-1). Chart I-1An Unprecedented Credit ##br##And Money Boom In China An Unprecedented Credit And Money Boom In China An Unprecedented Credit And Money Boom In China Every financial bubble in history has had its justifications. Last decade, the common narrative about U.S. real estate was that nationwide, U.S. house prices had historically never deflated in nominal terms. In the late 1990s, the tech bubble was vindicated by the "new productivity" era. In the meantime, in the 1980s in Japan and the mid-1990s in Hong Kong, sky high property prices were rationalized by limited amounts of land, given that these are islands. Despite these validations, all of these bubbles ultimately burst. We feel that vindicating China's enormous credit, money and property market excesses - which are all interrelated - by the nation's high "savings" is another attempt to endorse overextended and unsustainable macro imbalances. This report is a continuation of our series discussing these issues in great depth.1 The objective of this piece is to illuminate on the confusion between national "savings" and credit / deposits / money. Intuitively, many investors and commentators use the term "savings" to refer to bank deposits. Yet, in macroeconomics, national and household "savings" are not about deposits or money in the banking system at all. The term "savings" in macroeconomics denotes an increase in the economy's capital stock. Therefore, the financial system in general, and banks in particular, cannot and do not lend out or intermediate national or households "savings." The Chinese banking system has enormous amount of deposits because banks have created them "out of nothing" not because households save a lot. In an economy where banks exist, "savings" and financing are very different things. Commercial banks (hereafter referred to as banks) provide financing by expanding their balance sheets - creating deposits "out of thin air" as and when they originate loans. We previously elaborated on this money creation process,2 but given its importance to the topic of this report, we revisit it here. Banks Create New Purchasing Power "Out Of Thin Air" When a bank originates a loan, it simultaneously creates a deposit, or new money. Importantly, this does not represent a transfer of an existing deposit to the new borrower. This is a new deposit - new purchasing power - that did not previously exist (Figure 1). Figure I-1Credit / Money Creation Process The True Meaning Of China's Great 'Savings' Wall The True Meaning Of China's Great 'Savings' Wall The borrower can immediately use this new deposit to purchase goods and services or buy assets. At the same time, all owners of existing deposits at the bank still have their deposits too, and can use them as, when, and how they prefer. Thereby, the bank has created new purchasing power "out of nothing" when it originated a loan. Traditional macroeconomic theory presumes that for a person or company to invest in productive capacity, another person/unit must save. This assumption is true for a barter economy with no banks and money - where some entities produce but do not consume, so that others can acquire their output (goods) and in turn use them as investment. Nevertheless, in an economy with banks, one does not need to save in the form of a deposit in a bank in order for the latter to lend money to another entity. When a bank grants a loan or acquires an asset, it simultaneously creates new deposit/money - which is de facto new purchasing power originated by the bank "out of thin air." We use the terms deposit and money interchangeably because broad money supply is computed as the sum of all deposits in the commercial banks. Let's consider an example of how a bank loan leads to new income creation. A company borrows from a bank to build a bridge, it then pays its suppliers and contractors for their work. As a result, the suppliers and contractors, and consequently their employees and shareholders, earn income. Without this loan, the bridge would not have been built, and the suppliers, their employees and business owners would not have received income. In short, the loan comes first, then the investment - and only after the investment is carried out do employees and business owners earn income. Thereafter, they can consume, acquire assets and save in forms of bank deposits. Critically, this income is realized because the bank originated a loan / new purchasing power "out of nothing." Chart I-2 illustrates that the Chinese banking system has created RMB 140 trillion of broad money/deposits since January 2009. This is equivalent to US$21 trillion at today's exchange rate. This is twice as much as aggregate broad money - equivalent to $10.5 trillion - generated by commercial and central banks in the U.S., the euro area and Japan combined since early 2009 - even amid their respective QE programs. Chart I-2Helicopter Money In China Helicopter Money In China Helicopter Money In China The unprecedented new purchasing power of Chinese companies and households has been primarily due to this enormous balance sheet expansion by mainland commercial banks (Chart I-3). Chart I-3China: Commercial Banks ##br##Assets And Money Multiplier China: Commercial Banks Assets And Money Multiplier China: Commercial Banks Assets And Money Multiplier Bank Versus Financial Intermediaries Banks perform a unique function in the economy and financial system. There are considerable differences between a bank lending money or buying assets and a non-bank doing the same. This is unfortunately not reflected in mainstream economic theory and macro models. Unlike banks, non-banks - such as pension funds, insurance companies, households, businesses and all other non-bank entities - do not create new money/new purchasing power when they grant a loan or acquire an asset. The act of lending by non-banks simply constitutes a transfer of an existing deposit from a creditor to a borrower. Banks are not intermediaries of deposits into loans as the Loanable Funds Theory (LFT) alleges. They create deposits themselves by making loans and acquiring assets. The LFT, nonetheless, applies to non-bank lenders - the latter are indeed financial intermediaries, i.e., they channel existing deposits into loans or other assets. The institutional and legal differences that make commercial banks unique and allow them to create money are discussed in detail in "How Do Banks Create Money, and Why Can Other Firms Not Do the Same?," Werner (2014b).3 The theory of fractional banking is not applicable to modern banking as well.4 It is the theory of money creation by banks that we subscribe to and present here that accurately describes the process of money creation. Bottom Line: Banks differ vastly from non-bank financial institutions, and are unique in their ability to create money/new purchasing power by originating loans or acquiring assets. Money Versus Credit Remarkably, there is also an important analytical distinction between credit/leverage and money. New money matters when one is attempting to gauge the (nominal) growth outlook because it represents new purchasing power. New money can only be originated by banks, including the central bank. Central banks can create broad money in circulation (i.e. beyond central bank reserves) when they buy financial assets from or lend to non-bank entities. Doing so creates a deposit in the commercial banking system. By contrast, the degree of credit/leverage is critical when evaluating the risk of financial distress in both the economy and the financial system. Credit can be extended not only by banks but also by non-banks. Hence, lending or buying corporate bonds by non-banks creates leverage/credit but not new money. The banking system is the only one capable of originating new money, and in turn, new purchasing power. In China, the outstanding stock of total non-financial debt (private plus public) is close to the amount of money supply (Chart I-4). Even though non-bank credit growth has risen in importance since 2010, it seems that without banks' money creation, non-bank credit would not have expanded. Chart I-4China: Money Versus Credit/Debt China: Money Versus Credit/Debt China: Money Versus Credit/Debt On another note, household propensity to save alters the velocity of money, not the amount of money in the banking system. A decision by a household to spend more rather than save does not change the amount of deposits in the banking system. As an example, a person who gets paid $1000 might spend $800 of her income and decide to save the remaining $200. The amount of deposits in the banking system does not change; $800 will be transferred to another bank account as she pays for her purchases, while the remaining $200 stays in her existing bank account. Hence, there is no change in the amount of deposits and money supply in the banking system in this scenario. On the whole, the amount of deposits, and hence, broad money supply, in any banking system is equal to the cumulative net money creation by banks and the central bank over the course of their history. This has nothing to do with household and national "savings." The Chinese banking system has enormous amount of deposits because banks have created them "out of nothing" not because households save a lot. Interestingly, changes in household propensity to save are reflected not in money supply but in the velocity of money. When households or companies decide to spend their deposits, the velocity of money rises. Conversely, when households and companies decide to save (retain) their deposits, the velocity of money drops. Bottom Line: Money is distinct from credit and leverage. Changes in the propensity to save alter the velocity of money, but not the amount of deposits/money supply in the banking system. True Meaning Of "Savings" In Macroeconomics What is the true meaning of "savings"5 in macroeconomics, given the amount of deposits in the banking system has no bearing on "savings?" The confusion between national "savings" and deposit/money creation is dealt with nicely by Fabian Lindner. Having modelled it, Lindner6 argues: "... the aggregate economy's saving is equal to the newly produced tangible assets and inventories. That total saving is equal to just the increase in tangible assets ... (because) all changes in net financial assets in the economy add up to zero... Thus, for every economic agent increasing her net financial assets, there is a corresponding decrease in net financial assets of all other economic agents in the economy. Put in more general terms: An economic agent can only save financially if other agents dis-save financially by the same amount... That is why in the entire economy (that is the world economy or a closed economy) only the increase in tangible assets, thus investment, is saving (emphasis is added). Thus, saving and investment are equivalent in the aggregate... The equivalence of investment and saving however does not mean - as claimed by LFT - that household saving (or the sum of household and government saving) is equal to total saving and thus to investment. No matter how high one group's financial saving is, the financial dis-saving of the rest of the economy has to be just as high. The only thing remaining is the creation of tangible assets." (Lindner 2015) In another paper,7 Lindner asserts: "Investment is the production of any non-financial asset in an economy and thus is always directly and unambiguously savings: it increases the economy's net worth... The economy as a whole cannot change its net financial wealth since it always equals zero. The aggregate economy can only save in the form of non-financial assets...The only way an economy can save is by increasing its non-financial wealth, i.e., its physical capital stock." (Lindner 2012) Bottom Line: For a country to raise its domestic "savings" rate, it needs to build its capital stock by using domestically produced investment goods and raw materials. Thereby, domestic "savings" have nothing to do with the absolute level or changes in amount of deposits/money in the banking system. China's Great Wall Of "Savings" China has been investing tremendous amounts for many years, and its capital stock has been mushrooming (Chart I-5, top panel). Yet, the incremental capital-to-output ratio (ICOR) has surged and, its inverse, the output-to-capital ratio has plunged since 2010 (Chart I-5, middle and bottom panels). These developments signify deteriorating efficiency in the Chinese economy and worsening capital allocation. They also entail that companies might have difficulties servicing their debt. When its export machine faltered in 2008 due to the Global Financial Crisis, China offset it by boosting its domestic investments. These investments - incremental additions to the nation's capital stock - defined by macroeconomics as domestic "savings"- offset the decline in external "savings." As such, the composition of national "savings" has changed dramatically since 2008: the share of external "savings" (net exports) have declined while the share of domestic "savings" has risen (Chart I-6). Chart I-5China: Capital Stocks Has Surged China: Capital Stocks Has Surged China: Capital Stocks Has Surged Chart I-6China: Domestic And External 'Savings' China: Domestic And External 'Savings' China: Domestic And External 'Savings' In China, the augmentation of its capital stock and, hence, its domestic "savings," have been largely financed by loans from Chinese banks. This may sound like nonsense, but only because we are using the term "savings" in a way used in macroeconomics. Yet, new purchasing power originated by the banking system is not in and of itself a sufficient condition to generate domestic "savings." The sufficient condition for having high domestic "savings" is the ability to produce domestic capital goods and raw materials that go into investment. If a country does not build its capacity to produce capital goods and raw materials, it would need to rely on imports - in other words it has to acquire foreign "savings" to invest. Encouraging domestic "savings" entails enhancing capacity to produce goods that are used in capital spending like raw materials, chemicals, steel, cement, machinery, and various equipment and instruments. This is what China has done exceptionally well over the past 20 years. The following points illustrate how China achieved very high "savings" and investment rates (Chart I-7): China devalued its currency in January 1994 by 32% and relied on a cheap currency to produce large trade surpluses (Chart I-8). It used the foreign currency proceeds to purchase foreign technologies and equipment to boost its capital stock. Chart I-7Savings And Investment Ratios Savings And Investment Ratios Savings And Investment Ratios Chart I-8China: The 1994 Currency ##br##Devaluation Started New Era China: The 1994 Currency Devaluation Started New Era China: The 1994 Currency Devaluation Started New Era It also attracted FDI to build its productive capacity both for consumer goods as well as capital goods. FDI inflows surged since China's acceptance into the WTO in 2001. Since 2009, however, China has been relying on new purchasing power created by banks to expand its industrial capacity to produce commodities, raw materials, industrial equipment and machinery. Meanwhile, mainland banks have been originating new loans, and hence deposits/money - new purchasing power - to finance real estate development and infrastructure construction, utilizing these domestically produced raw materials and machinery. This has allowed China to sustain high levels of domestic "savings." On the whole, China indeed has had "excess savings" as its economy has been suffering from excess industrial capacity. Initially, China invested to create such excess capacity. Then, its banking system originated enormous amount of money/new purchasing power to support and keep zombie companies alive in these industries with excess capacity. The banking system is still involved in this function up until today. While this is a reasonable economic policy in the short run, it is not a good growth strategy in the long term. The problem is that easy money and credit support inefficient enterprises and encourage unproductive investment. As a result, productivity growth will slow and potential growth will decelerate considerably. Bottom Line: The countries that produce a lot of goods and services for domestic investment are said to have high domestic "savings." By definition, the more excess industrial capacity a country has, the more "excess savings" that economy will carry. Yet, uncontrolled money/credit origination to support zombie enterprises in over-capacity sectors entails inefficient allocation of capital that necessarily slows productivity growth and hence economic growth potential in the long term. Limits On Money Creation A natural question that arise from all this is what are the limits on money creation? We list some of major ones here, but these issues have been addressed in our previous three reports,8 and we will address them again in forthcoming reports. Inflation and/or deprecation pressures on the currency that could lead to monetary tightening; Bank regulation and various regulatory ratios; Shareholders of banks - who are highly leveraged to non-performing assets/loans - might order reduced lending; Removing the implicit government "put" that encourage irresponsible borrowing and lending. Inflationary pressures are presently rising and more entrenched in China now than at any time in the past decade or so (Chart I-9). In the context of negative real interest rates (Chart I-10) and barring major growth slowdown, the authorities are unlikely to stimulate anytime soon. Chart I-9Beware Of Rising Inflation In China... Beware Of Rising Inflation In China... Beware Of Rising Inflation In China... Chart I-10...Making Interest Rates Negative ...Making Interest Rates Negative ...Making Interest Rates Negative Negative real local interest rates undermine Chinese households' willingness to hold the currency. China's foreign exchange reserves at $3 trillion, while high, are equal only to 10% broad money (M3) and 14% of official M2. This signifies how much money the banking system has created. At the moment, mainland banking regulations are being tightened. This as well as liquidity tightening by the People's Bank of China and the government's anti-corruption crackdown that is moving into the financial industry will further dampen money creation and leverage expansion. This triple tightening amid lingering money and credit excesses constitutes the main rationale behind our negative stance on China's growth and China-related plays in global financial markets. Policy tightening is especially dangerous amid the existing credit, money and property market imbalances and excesses. Downgrade Chinese Stocks From Overweight To Neutral The Chinese MSCI Investable equity index - which unlike H-shares includes mega-cap tech companies - has rallied massively and outperformed the EM benchmark (Chart I-11). Chart I-11Downgrade Chinese Investable Stocks ##br##From Overweight To Neutral Downgrade Chinese Investable Stocks From Overweight To Neutral Downgrade Chinese Investable Stocks From Overweight To Neutral Relative performance is overbought, and we recommend dedicated EM equity portfolios downgrade their allocation from overweight to neutral. Our overweight position was initiated on November 26, 2014, and has generated an 18.5% gain. The freed-up capital should be allocated proportionally to our remaining overweights, which are Taiwan, Thailand, Korean tech stocks, Russia and central Europe. We are contemplating upgrading Chile. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Reports from October 26, 2016, November 23, 2016 and January 18, 2017; available on ems.bcaresearch.com 2 Please refer to the Emerging Markets Strategy Special Report titled "Misconceptions About China's Credit Excesses," dated October 16, 2016, available on available on ems.bcaresearch.com 3 Werner, R. (2014b), "How Do Banks Create Money, and Why Can Other Firms Not Do the Same?", International Review of Financial Analysis, 36, 71-77. 4 Werner, R. (2014a), "Can banks individually create money out of nothing? -- The theories and the empirical evidence", International Review of Financial Analysis, 36, 1-19. 5 We use "savings" in parenthesis because as this term does not really mean households' and companies' and governments' financial assets or deposits at the banks. "Savings" signifies the amount of goods and services produced but not consumed by an economy. 6 Lindner, F. (2015), "Did Scarce Global Savings Finance the US Real Estate Bubble? The Global Saving Glut thesis from a stock flow Consistent Perspective", Macroeconomic Policy Institute, Working Paper 155, July 2015. 7 Lindner, F. (2012), "Savings does not finance Investment: Accounting as an indispensable guide to economic theory", Macroeconomic Policy Institute, Working Paper 100, October 2012. 8 Please refer to the Emerging Markets Strategy Special Reports from October 26, 2016, November 23, 2016 and January 18, 2017; available on ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Feature It has been a Geopolitical Strategy tradition, since our launch in 2012, to include our best and worst forecasts of the year in our end-of-year Strategic Outlook monthly reports.1 Since we have switched over to a weekly publication schedule, we are making this section of our Outlook an individual report.2 It will also be the final publication of the year, provided that there is no global conflagration worthy of a missive between now and January 10, when we return to our regular publication schedule. The Worst Calls Of 2017 A forecasting mistake is wasted if one learns nothing from the error. Alternatively, it is an opportunity to arm oneself with wisdom for the next fight. This is why we take our mistakes seriously and why we begin this report card with the zingers. Overall, we are satisfied with our performance in 2017, as the successes below will testify. However, we made one serious error and two ancillary ones. Short Emerging Markets Continuing to recommend an overweight DM / underweight EM stance was the major failure this year (Chart 1). More specifically, we penned several bearish reports on the politics of Brazil, South Africa, and Turkey throughout the year to support our view.3 What did we learn from our mistake? The main driving forces behind EM risk assets in 2017 have been U.S. TIPS yields and the greenback (Chart 2). Weak inflation data and policy disappointments as the pro-growth, populist economic policy of the Trump Administration stalled mid-year supported the EM carry trade throughout the year. The post-election dollar rally dissipated, while Chinese fiscal and credit stimulus carried over into 2017 and buoyed demand for EM exports. Chart 1The Worst Call Of 2017: Long DM / Short EM The Worst Call Of 2017: Long DM / Short EM The Worst Call Of 2017: Long DM / Short EM Chart 2How Long Can The EM Carry Trade Survive? How Long Can The EM Carry Trade Survive? How Long Can The EM Carry Trade Survive? Our bearish call was based on EM macroeconomic and political fundamentals. On one hand, our fundamental analysis was genuinely wrong. Emerging markets were buoyed by Chinese stimulus and a broad-based DM recovery. On the other hand, our fundamental analysis was irrelevant, as the global "search-for-yield" overwhelmed all other factors. Chart 3The Dollar Ought ##br##To Rebound The Dollar Ought To Rebound The Dollar Ought To Rebound Chart 4Chinese Monetary Conditions Point##br## To Slowing Industrial Activity Chinese Monetary Conditions Point To Slowing Industrial Activity Chinese Monetary Conditions Point To Slowing Industrial Activity Going forward, it is difficult to see this combination of factors emerge anew. First, the U.S. economy is set to outperform the rest of the world in 2018, particularly with the stimulative tax cut finally on the books, which should be dollar bullish (Chart 3). Second, downside risks to the Chinese economy are multiplying (Chart 4) as policymakers crack down on the shadow financial sector and real estate (Chart 5). BCA's Foreign Exchange Strategy has shown that EM currencies are already flagging risks to global growth. Their "carry canary indicator" - EM currencies vs. the JPY - is forecasting a sharp deceleration in global growth within the next two quarters (Chart 6). Chart 5Chinese Growth ##br##Slowing Down? Chinese Growth Slowing Down? Chinese Growth Slowing Down? Chart 6After Carry Trades Lose Momentum,##br## Global IP Weakens After Carry Trades Lose Momentum, Global IP Weakens After Carry Trades Lose Momentum, Global IP Weakens That said, we have learned our lesson. We are closing all of our short EM positions and awaiting January credit numbers from China. If our view on Chinese financial sector reforms is correct, these figures should disappoint. If they do not, the EM party can continue. "Trump, Day One: Let The Trade War Begin" In our defense, the title of our first Weekly Report of the year belied the nuanced analysis within.4 We argued that the Trump administration would begin its relationship with China with a "symbolic punitive measure," but that it would then "seek high-level negotiations toward a framework for the administration's relations with China over the next four years." This was largely the script followed by the White House. We also warned clients that it would be the "lead up to the 2018 or 2020 elections" that truly revealed President Trump's protectionist side. Nonetheless, we were overly bearish about trade protectionism throughout 2017. First, President Trump did not name China a currency manipulator. Second, the border adjustment tax (BAT), which we thought had a 55% chance of being included in tax reform, really was dead-on-arrival. Third, the "Mar-A-Lago Summit" consensus lasted through the summer, buoying companies with relative exposure to China relative to the S&P 500 (Chart 7).5 Chart 7Second Worst Call Of 2017:##br## Alarmism On Protectionism Second Worst Call Of 2017: Alarmism On Protectionism Second Worst Call Of 2017: Alarmism On Protectionism Why did we get the Trump White House wrong on protectionism? There are three possibilities: Constraints error: We strayed too far from our constraints-based model by focusing too much on preferences of the Trump Administration. While we are correct that the White House lacks constraints when it comes to trade, tensions with North Korea this year - which we forecast correctly - were a constraint on an overly punitive trade policy against China. Preferences error: We got the Trump administration preferences wrong. Trade protectionism is the wool that Candidate Trump pulled over his voters' eyes. He is in fact an establishment Republican - a pluto-populist - with no intention of actually enacting protectionist policies. Timing error: We were too early. Year 2018 will see fireworks. Unfortunately for our clients, we have no idea which error we committed. But Trump's national security speech on Dec. 18 maintained the protectionist threat, and there are several key deadlines coming up that should reveal which way the winds are blowing: New Year: Trump will have to decide on January 12 and February 3 whether to impose tariffs on solar panels and washing machines, respectively, under Section 201 of the U.S. Trade Act of 1974. This ruling will have implications for other trade items. End of Q1: NAFTA negotiations have been extended through the end of Q1 2018. As we recently posited, the abrogation of NAFTA by the White House is a 50-50 probability.6 The question is whether the Trump administration follows this up with separate bilateral talks with Canada and Mexico, or whether it moves beyond NAFTA to clash directly with the WTO instead.7 The U.K. Election (Although We Got Brexit Right!) Our forecasting record of U.K. elections is abysmal. We predicted that Theresa May would preserve her majority in the House of Commons, although in our defense we also noted that the risks were clearly skewed to the downside given the movement of the U.K. median voter to the left.8 We are now 0 for 2, having also incorrectly called the 2015 general election (we expected the Tories to fail to reach the majority in that election).9 On the other hand, we correctly sounded the alarm on Brexit, noting that the probability was much closer to 50% than what the market was pricing at the time.10 What gives? The mix of U.K.'s first-past-the-post system and the country's unique party distribution makes forecasting elections difficult. Because the Tories are essentially the only right-of-center party in England, they tend to outperform their polls and win constituencies with a low-plurality of votes. As such, in 2017, we ignored the strong Labour momentum in the polls, expecting that it would stall. It did not (Chart 8). That said, our job is not to call elections, but to generate alpha by focusing on the difference between what the market is pricing in and what we believe will happen. If elections are a catalyst for market performance - as was the case with the French one this year - we track them closely in a series of publications and adjust our probabilities as new data comes in. For U.K. assets this year, by contrast, getting the Brexit process right was far more relevant than the general election. Our high conviction view that the EU would not be punitive, that the U.K. would accept all conditions, and that the May administration would essentially stick to the "hard Brexit" strategy it defined in January ended up being correct.11 This allowed us to call the GBP bottom versus the USD in January (Chart 9). Chart 8Third Worst Call Of 2018: The U.K. Election Third Worst Call Of 2018: The U.K. Election Third Worst Call Of 2018: The U.K. Election Chart 9But We Got Brexit - And Cable! - Right But We Got Brexit - And Cable! - Right But We Got Brexit - And Cable! - Right What did we learn from our final error? Stop trying to forecast U.K. elections! The Best Calls Of 2017 The best overall call in 2017 was to tell clients to buy the S&P 500 in April and never look back. Our "Buy In May And Enjoy Your Day!" missive on April 26 was preceded by our analysis of global geopolitical risks and opportunities.12 In these, we concluded that "Political Risks Are Overstated In 2017" and "Understated In 2018."13 As such, the combination of strong risk asset performance and low volatility did not surprise us. It was our forecast (Chart 10). U.S. Politics: Tax Cuts & Impeachment Not only did we forecast that President Trump would manage to successfully pass tax reform in 2017, but we also correctly called the GOP's fiscal profligacy.14 We get little recognition for the latter in conversations with clients and colleagues, but it was a highly contentious call, especially after seven years of austere rhetoric from the fiscal conservatives supposedly running the Republican Party. We were also correct that impeachment fears and the ongoing Mueller Investigation would have little impact on U.S. assets.15 Chart 11 shows that the U.S. dollar and S&P 500 barely moved with each Trump-related scandal (Table 1). Chart 10The Best Call Of 2017: Getting The Market Right The Best Call Of 2017: Getting The Market Right The Best Call Of 2017: Getting The Market Right Chart 11No Real Impact From Trump Imbroglio BCA Geopolitical Strategy 2017 Report Card BCA Geopolitical Strategy 2017 Report Card By correctly identifying the ongoing "Trump Put" in the market, we were able to remain bullish on U.S. equities throughout the year and avoid calling any pullbacks. Table 1An Eventful Year 1 Of The Trump Presidency BCA Geopolitical Strategy 2017 Report Card BCA Geopolitical Strategy 2017 Report Card Europe (All Of It) Our performance forecasting European politics and markets has been stellar this year. Instead of reviewing each call, the list below simply summarizes each report: "After Brexit, N-Exit?" - Although technically a call made in 2016, our view that Brexit would cause a surge in support for the EU was a view for 2017.16 Several anti-establishment populists failed to perform in line with their 2015-2016 polling, particularly Geert Wilders in the Netherlands. "Will Marine Le Pen Win?" - We definitely answered this question in the negative, going back to November 2016.17 This allowed us to recommend clients go long the euro vs. the U.S. dollar (Chart 12). Moreover, we argued that regardless of who won the election, the next French government would embark on structural reforms.18 As a play on our bullish view of France, we recommended that clients overweight French industrials vs. German ones (Chart 13). "Europe's Divine Comedy: Italy In Purgatorio" - We correctly assessed that Italian Euroskpetics would migrate towards the center on the question of the euro. However, we missed recommending the epic rally in Italian equities and bonds that should have naturally flowed from our political view.19 "Fade Catalan Risks" - Based on our 2014 net assessment, we concluded that the Catalan independence drive would be largely irrelevant for the markets.20 This proved to be correct this year. "Can Turkey Restart The Immigration Crisis?" - Earlier in the year, clients became nervous about a potential diplomatic breakdown between the EU and Turkey leading to a renewal of the immigration crisis.21 We reiterated our long-held view that the immigration crisis did not end because of Turkish intervention, but because of tighter European enforcement. Throughout the year, we were proven right, with Europeans becoming more and more focused on interdiction. Chart 12Second Best Call Of 2017: The Euro... Second Best Call Of 2017: The Euro... Second Best Call Of 2017: The Euro... Chart 13...And France In Particular ...And France In Particular ...And France In Particular China: Policy-Induced Financial Tightening Throughout 2016-17, in the lead-up to China's nineteenth National Party Congress, we argued that the stability imperative would ensure an accommodative-but-not-too-accommodative policy stance.22 In particular, we highlighted the ongoing impetus for anti-pollution controls.23 This forecast broadly proved to be correct, as the government maintained stimulus yet simultaneously surprised the markets with financial and environmental regulatory crackdowns throughout the year. Once these regulatory campaigns took off, we argued that they would remain tentative, since the truly tough policies would have to wait until after the party congress. At that point, Xi Jinping could re-launch his structural reform agenda, primarily by intensifying financial sector tightening.24 Over the course of the year, this political analysis began to be revealed in the data, with broad money (M3) figures suggesting that money growth decelerated sharply in 2017 (Chart 14). In addition, we correctly called several moves by President Xi Jinping at the party congress.25 Chart 14Third Best Call Of 2017:##br## Chinese Reforms? (We Will See In 2018!) Third Best Call Of 2017: Chinese Reforms? (We Will See In 2018!) Third Best Call Of 2017: Chinese Reforms? (We Will See In 2018!) Our view that Chinese policymakers will restart reforms after the party congress is now becoming more widely accepted, given Xi's party congress speech Oct. 18 and the news from the December Politburo meeting.26 Where we differ from the market is in arguing that Beijing's bite will be worse than its bark. We are concerned that there is considerable risk to the downside and that stimulus will come much later than investors think this time around. Our China view was largely correct in 2017, but the real market significance will be felt in 2018. There are still several questions outstanding, including whether the crackdown on the financial sector will be as growth-constraining as we think. As such, this is a key view that will carry over into 2018. Thankfully, we should know whether we are right or wrong by the March National People's Congress session and the data releases shortly thereafter. North Korea - Both A Tail Risk And An Overstated Risk We correctly identified North Korea as a key 2017 geopolitical risk in our Strategic Outlook and began signaling that it was no longer a "red herring" as early as April 2016.27 In April 2017, we told clients to prepare for safe haven flows due to the likelihood that tensions would increase as the U.S. established a "credible threat" of war, a playbook that the Obama administration most recently used against Iran.28 While we flagged North Korea as a risk that would move the markets, we also signaled precisely when the risk became overstated. In September, we told clients that U.S. Treasury yields would rise from their lows that month as investors realized that the North Korean regime was constrained by its paltry military capability.29 At the same time, we gave President Trump an A+ for his performance establishing a credible threat, a bet that worked not only on Pyongyang, but also on Beijing. Since this summer, China has begun to ratchet up economic pressure against North Korea (Chart 15). Chart 15Fourth Best Call Of 2017: North Korea Fourth Best Call Of 2017: North Korea Fourth Best Call Of 2017: North Korea Middle East And Oil Prices BCA Research scored a big win this year with our energy call. It would be unfair for us to take credit for that view. Our Commodity & Energy Strategy as well as our Energy Sector Strategy deserve all the credit.30 Nonetheless, we helped our commodity teams make the right calls by: Correctly forecasting that Saudi-Iranian and Russo-Turkish tensions would de-escalate, allowing OPEC and Russia to maintain the production-cut agreement;31 Emphasizing risks to Iraqi production as tensions shifted from the Islamic State to the Kurdish Regional Government; Highlighting the likely continued decline, but not sharp cut-off, of Venezuelan production, due to the regime's ability to cling to power even as the conditions of production worsened.32 In addition, we were correct to fade various concerns regarding renewed tensions in Qatar, Yemen, and Lebanon throughout the year. Despite the media narrative that the Middle East has become a cauldron of instability anew, our long-held view that all the players involved are constrained by domestic and material constraints has remained cogent. In particular, our view that Saudi Arabia would engage in serious social reforms bore fruit in 2017, with several moves by the ruling regime to evolve the country away from feudal monarchy.33 Going forward, a major risk to our view is the Trump administration policy towards Iran, our top Black Swan risk for 2018. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Ekaterina Shtrevensky, Research Assistant ekaterinas@bcaresearch.com 1 Due to the high volume of footnotes in this report, we have decided to include them at the end of the document. For a review of our past Strategic Outlooks, please visit gps.bcaresearch.com. 2 For the rest of our 2018 Outlook, please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, and "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy, "Turkey: Military Adventurism And Capital Controls," dated December 7, 2016, "South Africa: Back To Reality," dated April 5, 2017, "Brazil: Politics Giveth And Politics Taketh Away," dated May 24, 2017, "South Africa: Crisis Of Expectations," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "G19," dated July 12, 2017, available at gps.bcaresearch.com. 6 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. 7 The outcome at the WTO Buenos Aires summit last week offered a possible way out of confrontation between the Trump administration and the WTO. It featured Europe and Japan taking a tougher line on trade violations, namely China, to respond to the Trump administration grievances that, unaddressed, could escalate into a full-fledged Trump-WTO clash. 8 Please see BCA Geopolitical Strategy Weekly Report, "How Long Can The 'Trump Put' Last?" dated June 14, 2017 and "U.K. Election: The Median Voter Has Spoken," dated June 9, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "U.K. Election Preview," dated February 26, 2015, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me?' World?" dated January 25, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017 and "Political Risks Are Understated In 2017," dated April 12, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, "The French Revolution," dated February 3, 2017 and "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014 and "Why So Serious?" dated October 11, 2017, available at gps.bcaresearch.com. 21 Please see BCA Geopolitical Strategy Weekly Report, "Five Questions On Europe," dated March 22, 2017, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation)," dated July 13, 2016, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 24 Please see BCA Geopolitical Strategy We," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 25 We argued in our 2017 Strategic Outlook that while Xi's faction would gain a majority on the Politburo Standing Committee, he would maintain a reasonable balance and refrain from excluding opposing factions from power. We expected that factional struggle would flare back up into the open (as with the ouster of Sun Zhengcai), and that Xi would retire anti-corruption chief Wang Qishan, but not that Xi would avoid promoting a successor for 2022 to the Politburo Standing Committee. 26 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 27 Please see BCA Geopolitical Strategy "North Korea: A Red Herring No More?" in Monthly Report, "Partem Mirabilis," dated April 13, 2016 and "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 28 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 29 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 30 If you are an investor with even a passing interest in commodities and oil, you must review the work of our colleagues Robert Ryan and Matt Conlan. 31 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com. 32 Please see BCA Geopolitical Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 33 Please see BCA Geopolitical Strategy Special Report, "The Middle East: Separating The Signal From The Noise," dated November 15, 2017, available at gps.bcaresearch.com.

Highlights The dollar has decoupled from interest rate differentials, being hurt by buoyant global growth. For the dollar to weaken more in 2018, global growth will have to accelerate further from current lofty rates. The tightening in Chinese policy along with the poor performance of EM carry trades point to a slight slowdown, not an acceleration. A pick up in volatility would magnify the underperformance of EM carry trades, and thus, tighten global liquidity conditions. This will help the dollar, but could help the yen even more. Buy NOK/SEK. Feature This past Wednesday, the Federal Reserve increased its growth forecast through 2020. It also cut expectations for the U.S. unemployment rate in 2018 and 2019 to 3.9%, and finally it increased its interest rate forecast to 3.1% by 2020. Yet, the U.S. dollar weakened substantially. Even if we acknowledge that interest rate markets are skeptical that the Fed will be able to fulfill its promises, the U.S. dollar has also decoupled itself from market interest rates. While rate spreads between the U.S. and the rest of the world point to a higher USD, the dollar is in fact gaining no traction (Chart I-1). We think global growth has been the key to this conundrum. Global Growth Steals The Limelight Interest rate differentials are the most common driver of exchange rates, but sometimes, growth dynamics also play a role. Currently, strong global growth stands firmly in the driver's seat, explaining why the dollar is weakening. Generally, when non-U.S. activity improves, the dollar underperforms (Chart I-2). Chart I-1Dollar And Rates Spot The Disconnect Dollar And Rates Spot The Disconnect Dollar And Rates Spot The Disconnect Chart I-2The Dollar Doesn't Like Strong Global Growth The Dollar Doesn't Like Strong Global Growth The Dollar Doesn't Like Strong Global Growth The reason is straightforward, and has two main elements. First, the U.S. is a low-beta economy. When global growth accelerates, the U.S. does not benefit as much as Europe. The IMF estimates that a 1% gyration in EM activity affects euro area growth three times as much as it impacts the U.S. Not only is EM activity a key source of variance in the global industrial cycle, it has also been the key factor behind this upswing. Second, money tends to flow out of the U.S. when global growth accelerates. Since non-U.S. economies are more levered to the global industrial cycle than the U.S., so is their profit growth. Additionally, an accelerating global economy is associated with a rise in central bank foreign exchange reserves outside of the U.S. as global trade expands. This creates generous liquidity conditions in the rest of the world, which further favors economic growth and asset price expansion. Money flows where higher returns are to be found. In recent quarters, global reserves have indeed expanded, highlighting this easing in global liquidity conditions (Chart I-3). To bet on the U.S. dollar weakening is to bet on this set of conditions continuing. This is the wager market participants are currently making. Investors are very short the U.S. dollar index and very long the euro, the CAD, the AUD, gold and oil (Chart I-4). This suggests that even a mild slowdown in global growth would indeed be a surprise - one that would cause the dollar to move back toward levels implied by interest rate differentials (Chart I-5). Chart I-3Buoyant Growth Equals Reserves Accumulation Equals Strong EM Currencies Buoyant Growth Equals Reserves Accumulation Equals Strong EM Currencies Buoyant Growth Equals Reserves Accumulation Equals Strong EM Currencies Chart I-4Investors Are Short The Dollar Long Growth Investors Are Short The Dollar Long Growth Investors Are Short The Dollar Long Growth Chart I-5Dollar Is Cheap Relative To Rates Dollar Is Cheap Relative To Rates Dollar Is Cheap Relative To Rates Bottom Line: A key factor behind the dollar's weakness in 2017 has been the positive global growth surprise. This helps explain why the dollar has been much weaker than interest rate differentials would otherwise suggest. Since the dollar is trading at such a discount to interest rate differentials, for the greenback to weaken further global growth needs to continue to accelerate. Based on positioning, the surprise for investors would be if global industrial activity decelerates. Risks To Global Growth Chart I-6China Helped Australia China Helped Australia China Helped Australia The acceleration in global growth needed for the dollar to sell off more is unlikely to emerge. To the contrary, growing evidence indicates that a mild slowdown is likely to hit global industrial activity next year. One of the key pillars for global growth, China, is turning the corner. China has played an essential role in explaining the strong growth of many economies in 2017. The link for EM or commodity producers like Australia to Chinese growth is relatively self-evident. For example, the value of Australian exports received a strong fillip when Chinese industrial activity surged in 2016 and 2017. As such, the recent rollover in the Li Keqiang index - a key gauge of China's secondary sector - points to a reversal in Chinese growth (Chart I-6). Chinese activity also has important implications for the performance of growth in the euro area relative to the U.S. As Chart I-7 highlights, when Chinese monetary conditions ease or when the Chinese marginal propensity to save - as approximated by the gap between the growth rate of M2 and M1 - decreases, the Eurozone's economy accelerates relative to the U.S. Currently, Chinese monetary conditions are tightening and the marginal propensity to save is rising, highlighting that European growth will decelerate relative to the U.S. Chart I-7AChina Also Matters For The Distribution Of Growth Between Europe And The U.S. (I) China Also Matters For The Distribution Of Growth Between Europe And The U.S. (I) China Also Matters For The Distribution Of Growth Between Europe And The U.S. (I) Chart I-7BChina Also Matters For The Distribution Of Growth Between Europe And The U.S. (II) China Also Matters For The Distribution Of Growth Between Europe And The U.S. (II) China Also Matters For The Distribution Of Growth Between Europe And The U.S. (II) The outlook for Chinese growth suggests that the recent reversal in industrial activity could run a bit deeper. Arthur Budaghyan, who leads BCA's Emerging Markets Strategy service, has highlighted that Chinese broad money growth is decelerating, and that the Chinese fiscal impulse is slowing. This is normally associated with falling Chinese imports, which is China's direct footprint on the global economic cycle and global trade (Chart I-8). Moreover, Chinese borrowing costs are rising and the real estate sector is already showing signs of slowing. The amount of new floor space sold is now contracting, which often precedes serious decelerations in new house prices (Chart I-9, top panel). Thus, Chinese construction is likely to contribute less to global growth and to demand for commodities in the coming year than in the past two years. Chart I-8Slowing Chinese Money Is A ##br##Headwind For Global Activity bca.fes_wr_2017_12_15_s1_c8 bca.fes_wr_2017_12_15_s1_c8 Chart I-9Excess Investment Is A Real Problem China Fixed Capital Formation To Slow in 2018 Excess Investment Is A Real Problem China Fixed Capital Formation To Slow in 2018 Excess Investment Is A Real Problem China Fixed Capital Formation To Slow in 2018 Meanwhile, China has overinvested in its capital stock when compared with other EM economies at similar stages of development (Chart I-9, bottom panel). Therefore, the risk that capex will slow in response to policy tightening is high. This would further weigh on Chinese imports. Various Chinese leading economic indicators have also rolled over sharply. This portends a further fall in the Li Keqiang index (Chart I-10) and also gives more credence to our view that China's industrial activity and imports will slow in 2018. As BCA's Geopolitical Strategy team has argued, the willingness of the Chinese authorities to implement reforms and control credit growth next year will only solidify this negative impulse.1 It is not just Chinese variables that are deteriorating, but other key leading indicators of the global industrial cycle seem to be picking up on this impulse (Chart I-11). The recent deceleration in global money growth also confirms this insight (Chart I-12). Chart I-10Chinese Monetary Conditions ##br##Point To Slowing Industrial Activity Chinese Monetary Conditions Point To Slowing Industrial Activity Chinese Monetary Conditions Point To Slowing Industrial Activity Chart I-11Global Growth Gauges Corroborate ##br## Chinese Indicators Global Growth Gauges Corroborate Chinese Indicators Global Growth Gauges Corroborate Chinese Indicators Chart I-12Where Global Money Growth Goes, ##br##So Does Activity Where Global Money Growth Goes, So Does Activity Where Global Money Growth Goes, So Does Activity Most importantly, the performance of our EM Carry Canaries - how key EM carry currencies are performing against the quintessential funding currency, the yen, corroborates this picture. EM carry trades' total returns have sharply rolled over, a signal that has always led to a slowdown in global industrial activity for the past 20 years (Chart I-13). We argued two weeks ago that EM carry trades are beginning to weaken because of the negative impulse emanating from China. We also stressed that the relationship between EM carry trades and global industrial activity is strengthened by the role carry trades play in disseminating and enhancing global liquidity.2 Strongly performing EM carry trades are a symptom of liquidity making its way across the globe, leading to supportive conditions for risk assets and growth. On the other hand, an underperformance in EM carry trades is an early signal that liquidity is on the wane, pointing to an upcoming downturn in risk taking and economic activity. Going forward, there is a growing likelihood that policy within developed markets will amplify the weakness in EM carry trades that currently reflects mostly changing growth dynamics in China. Global volatility has been extremely muted in 2017, which normally helps carry trades perform well. However, as Chart I-14 illustrates, volatility tends to experience upside when U.S. inflation picks up. This is because as inflation picks up, not only does the Fed increase rates, which tightens global liquidity conditions and hampers risk taking, but the path for future growth also becomes trickier to discount, requiring higher volatility in the process. BCA expects U.S. inflation to pick up significantly in 2018. The rise in the growth of the velocity of money in the U.S. is one of the clearest indications of that risk (Chart I-15). Chart I-13EM Carry Trades Are Confirming These Trends EM Carry Trades Are Confirming These Trends EM Carry Trades Are Confirming These Trends Chart I-14Global Vol Will Rise With Inflation Global Vol Will Rise With Inflation Global Vol Will Rise With Inflation Chart I-15U.S. Core Inflation Has Upside U.S. Core Inflation Has Upside U.S. Core Inflation Has Upside The tax repatriation included in the U.S. Tax Cuts and Jobs Act represents an additional risk for global aggregate volatility. When U.S. entities repatriate dollars back home, this curtails the supply of USD collateral available in the offshore market. As a result, dollar funding becomes scarcer, creating widening pressures on USD cross-currency basis swap spreads (Chart I-16, top panel).3 The introduction in January of rules by the BIS for banks to hold greater collateral against OTC transactions will further exacerbate this potential dollar squeeze in the swap market, increasing the risk that the U.S. tax bill will result in wider USD basis-swap spreads. Historically, wider swap spreads haven been associated with rising volatility, a logical consequence of more expensive funding (Chart I-16, bottom panel). This rise in volatility is likely to aggravate the weakness in EM carry trades. This will amplify the risks to global liquidity. As this process unfolds, global growth will begin to slow, precisely at the time when investors are not positioned for it. Bottom Line: Global growth is being hit by the beginning of a slowdown in Chinese industrial activity. This slowdown does not constitute a crisis, nor a repeat of the 2015 period of elevated risks for China. However, it does nonetheless create a headwind for global industrial activity that is already being picked up by key reliable gauges of global growth. Moreover, EM carry trades, which have been an extremely reliable leading indicators of global growth, are already corroborating this picture. Since volatility is set to increase in 2018 as U.S. inflation picks up and U.S. tax repatriation dries global dollar funding, the downside in EM carry trades has further to go which will result in tighter global liquidity conditions, in turn increasing the probability that global growth will disappoint. Global Growth, U.S. Policy, And The Dollar We began this report by highlighting that since the dollar is now trading at a substantial discount to interest rate differentials, betting on a weaker dollar is akin to betting on additional strengthening in global growth. However, the factors highlighted above argue against an acceleration in global growth, especially in global industrial activity. Moreover, global growth is set to decelerate while the Fed is hiking rates - a scenario reminiscent of the late 1990s. In fact, the gap between growth indicators and the Fed's policy setting has in the past been a useful tool in pinpointing dollar bull and bear markets (Chart I-17). Chart I-16Tax Repatriation Leads To Wider ##br## Swap Spreads And Greater Volatility Tax Repatriation Leads To Wider Swap Spreads And Greater Volatility Tax Repatriation Leads To Wider Swap Spreads And Greater Volatility Chart I-17A USD-Positive ##br##Dichotomy A USD-Positive Dichotomy A USD-Positive Dichotomy Thus, we continue to follow the scenario we elaborated on in early September:4 The dollar will end the year having generated positive but uninspiring returns during the fourth quarter. It will only gather steam in Q1 2018, once U.S. inflation picks up significantly. This rebound in U.S. core inflation will help the Fed fulfill its promise to increase rates three times next year. It will also create a non-negligible headwind to global growth by pushing volatility higher, hurting global carry trades and global liquidity conditions in the process. At this point, any move in DXY to 93 should be used to build bullish bets on the dollar. Conversely, moves in EUR/USD to 1.18 should be used to sell the USD. We remain short commodity currencies and our portfolio is especially negative on the AUD. Finally, we have professed a negative view on the JPY on the basis of higher U.S. rates. While higher U.S. rates may continue to lift USD/JPY, the window to be short the JPY is likely closing. If volatility does pick up on the back of the risks highlighted in this report, the yen could buck the dollar's strength and rally. We thus remain short NZD/JPY to protect against this eventuality, and we will look to close our long USD/JPY position around the New Year. Bottom Line: As global growth is set to slow somewhat, the Fed is redoubling on its hawkish rhetoric. Since the dollar is trading at a discount to interest rate differentials and is being sold by speculators, this raises the risk that the USD will experience a significant rally in the first half of 2018. Any move in the DXY to 93 should be used to build significant long positions in the USD, whether through the index or by shorting EUR/USD, or by betting on further AUD weakness. The yen could benefit in this environment. An Uncorrelated Trade: Long NOK/SEK It is always important to find potentially uncorrelated trades within a portfolio, as it increases diversification benefits. The FX space is no exception to this rule. Such an opportunity seems to be emerging in the European currency space: buying Nokkie/Stokkie. NOK/SEK currently trades at a large 8% discount to purchasing power parity. More sophisticated models incorporating productivity differentials and terms-of-trade shocks also show that the krone is cheap relative to its neighbor (Chart I-18). Moreover, the IMF expects the Norwegian current account to stand at 5.5% of GDP for 2017, while Sweden's will be a more modest 3.9% of GDP. This gap is anticipated to be maintained in 2018. In terms of catalysts for a rally in NOK/SEK, Sweden's relative economic outperformance that has been so vital to this cross's weakness is ebbing. Norwegian real GDP and industrial production growth are both accelerating relative to Sweden's. This trend looks set to endure as the Norwegian leading economic indicator is displaying a similar profile (Chart I-19). Confirming this picture, the Norwegian economic surprise index is turning up from exceptionally depressed levels when compared to Sweden's. Historically, this tends to translate into a stronger NOK. Yesterday's comments by Norges Bank Governor Oystein Olsen pointing to a first hike in late 2018 are helping catalyze the pricing of these dynamics in the cross's price. Financial markets are telling a similar story. Norwegian equities have been outperforming their Swedish counterparts since the middle of 2017. Moreover, Norwegian nominal and real yields are rallying relative to Sweden, which normally puts upward pressure on NOK/SEK (Chart I-20). Chart I-18NOK/SEK Is Cheap NOK/SEK Is Cheap NOK/SEK Is Cheap Chart I-19Growth Momentum Moving In Favor Of Norway Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth Chart I-20Relative Yields Point To Higher NOK/SEK Relative Yields Point To Higher NOK/SEK Relative Yields Point To Higher NOK/SEK While a slowdown in global growth is a risk when holding a commodity currency like the NOK, NOK/SEK offers a healthy level of cushion against this eventuality. Overwhelmed by domestic fundamentals, NOK/SEK has decoupled from its historical relationship with EM equities, EM spreads, oil and global growth. Thus, this cross is not as levered to the global economic cycle as it normally is. In fact, BCA's view that oil prices have upside, especially relative to EM asset prices, points toward a higher NOK/SEK (Chart I-21). Finally, from a technical perspective, NOK/SEK looks interesting. The pair's 40-week rate-of-change measure is hitting oversold levels. More tellingly, NOK/SEK is forming an inverted head-and-shoulder pattern exactly as its 13-week rate of change loses downward momentum (Chart I-22). Chart I-21Liking Oil Relative To EM Stocks ##br##Is The Same Thing As Being Long NOK/SEK Liking Oil Relative To EM Stocks Is The Same Thing As Being Long NOK/SEK Liking Oil Relative To EM Stocks Is The Same Thing As Being Long NOK/SEK Chart I-22Favorable Technical ##br##Set Up Favorable Technical Set Up Favorable Technical Set Up Thus, we are buying NOK/SEK this week, with an entry point at 1.0163, a stop at 0.998, and an initial target at 1.08. Bottom Line: Buying NOK/SEK at current levels makes sense. Not only is it an uncorrelated trade with the dollar, but the pair is also cheap. Moreover, economic momentum, which was overwhelmingly in favor of the SEK, is now rolling in favor of the NOK, a message confirmed by financial market indicators. NOK/SEK is trading at cheap levels relative to global economic and financial variables, suggesting a cushion to negative shocks is in the price. Instead, NOK/SEK should benefit if oil prices outperform EM assets, a view held by BCA. Finally, the trade looks attractive from a technical perspective. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Geopolitical Strategy Special Reports, titled "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017, and "China: Party Congress Ends... So What?" dated November 1, 2017, available at gps.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "Canaries In The Coal Mine Alert: EM/JPY Carry Trades," dated December 1, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report, titled "It's Not My Cross To Bear," dated October 27, 2017, available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report, titled "Conflicting Forces For The Dollar," dated September 8, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 U.S. data has been mixed: Core CPI grew by 1.7% annually, lower than the expected 1.8%; Producer prices were strong annually at 3.1%, above the expected 2.9%; while the core measure also produced strong results of 2.4%, above the expected 2.3%; Retail sales were also quite positives, beating expectations by a wide margin. This week, in line with expectations, the Fed hiked rates to 1.25 - 1.5%. The FMOC also upgraded its growth forecasts while still penciling in three rate hikes for next year. However, Treasurys rallied and the DXY dropped 0.6%, showing that markets believe the Fed is potentially making a hawkish error inflation continues to underperform. We do agree with the Fed and we expect inflation be in the process of bottoming. Report Links: Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 The Xs And The Currency Market - November 24, 2017 It's Not My Cross To Bear - October 27, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 European data was generally positive: German ZEW Current Situation increased to 89.3 while economic sentiment declined to 17.4; European PMIs were very strong, with the manufacturing and services indices coming in at 60.6 and 58, respectively, both increasing and beating expectations. German inflation stayed steady and in line with expectations at 1.8%; French CPI underperformed expectations, growing at 1.2% annually; Italian inflation was in line with consensus at 1.1%; European growth is currently stellar, and markets have priced in this reality. The ECB agrees, and it has upgraded its growth and inflation forecasts up to 2020. Yet, even under the new set of forecasts, inflation fails to hit the ECB's target. With the end of the asset purchases program anticipated for the September 2018, the first hike could materialize in the second quarter of 2019, suggesting EONIA rates possess some genuine but limited upside from current levels. However, most importantly, we think that EONIA pricing will still lag the U.S. OIS going forward, putting downward pressure on EUR/USD. Report Links: The Xs And The Currency Market - November 24, 2017 Temporary Short-Term Rates - November 10, 2017 Market Update - October 27, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data has been mixed in Japan: Nikkei Manufacturing PMI outperformed expectations, coming in at 53.8. Machinery orders yearly growth also outperformed expectations, coming in at 5%. Moreover, gross domestic product growth also outperformed, coming in at 2.5% in the third quarter. This was a significant improvement from the 1.4% growth number registered in Q2. However labor cash earnings growth underperformed expectations, coming in at 0.6%, suggesting still muted inflation pressures. Finally, housing starts growth surprised to the downside, coming in at -4.8%. After rising throughout the week, USD/JPY collapsed following the FOMC rate decision, as U.S. Treasuries rallied. Overall we continue to be bullish on the yen against risk-on currencies like the NZD and the AUD, as tightening Chinese financial conditions should set the stage for a temporary slowdown in global growth. Report Links: Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 The Xs And The Currency Market - November 24, 2017 Temporary Short-Term Rates - November 10, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been positive: Markit Manufacturing PMI outperformed expectations, coming in at 58.2. This number also increased from the October reading. Construction PMI also outperformed expectations, coming in at 53.1, and also increasing from the previous month's number. Headline inflation also outperformed expectations, with a reading of 3.1%. Nevertheless, core inflation came in according to expectations at 2.7% Finally, the trade balance also outperformed expectations on the month of October, coming in at -1.405 Billion pounds. The BOE's MPC left policy rates unchanged at 0.5%. Overall, we believe that in the short term, the ability of the BoE to continue to hike is limited, given that consumption remains sluggish and leading indicators of house prices still flag some frailty. Furthermore, the uncertainty surrounding Brexit continues to make the BoE more cautious than otherwise. Report Links: The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Australian data was mixed: House prices contracted at a quarterly pace by 0.2%, less than the expected 0.5%; NAB Business Confidence went down from 9 to 6; NAB Business Conditions went down from 21 to 12; Westpac consumer confidence went up to 3.6% from -1.7%; However, employment increased by 61,600, beating expectations of 18,000, with full-time employment increasing by 41,900, outperforming part-time employment of 19,700; The AUD rallied on these data releases. Furthermore, faltering U.S. inflation and upbeat Chinese data fed into the AUD's rally. The Australian economy is still mired in substantial slack, and the RBA is likely to stay easy, putting a lid on AUD upside. Report Links: The Xs And The Currency Market - November 24, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been negative: Seasonally-adjusted building permits contracted by 9.6% in October. Furthermore, the terms of trade index, continued to fall in the third quarters, coming in at 0.7%. This number also surprised to the downside. Manufacturing sales grew by 0.3% in the third quarter, a slowdown from the 1% growth witnessed in Q2. Finally, the ANZ Business Confidence measure fell to -39.3, the lowest level in more than 9 years. The NZD/USD has rallied by roughly 3% in the past week. This mostly reflects weakness on the part of the USD yesterday following the FOMC interest rate decision as NZD is flat against the AUD on the weak. Overall, the long term outlook for NZD/USD, NZD/EUR, and NZD/JPY is negative, as decreased immigration and the addition of an employment mandate for the RBNZ, will structurally lower rates in New Zealand. However, NZD still possesses upside against the AUD. Report Links: The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Last week, the BoC left its policy rate unchanged at 1%. The Bank is delaying hiking as inflation and growth have slowed. The BoC also want to appraise the impact of its previous two interest rate hikes as well as the brewing risks surrounding NAFTA negotiations. That being said, inflation still is around 40 bps higher than it was in June. Employment data remains stellar, and the tightening labor market is pointing to a pickup in wages. Additionally, oil could offer additional upside as supply continues to be curtailed by Saudi Arabia and Russia. The CAD is likely to perform well next year, particularly against the SEK and the AUD. However, upside against the U.S. dollar will be limited. Report Links: The Xs And The Currency Market - November 24, 2017 Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been mixed: Headline inflation surprised to the downside, coming in at 0.8%. However it increased from 0.7% on the previous month. The unemployment rate came in below expectations, at 3%. Additionally, the SNB kept its -0.75% deposit rate unchanged. Furthermore, it continued to signal that it will stay active in the foreign exchange markets. Indeed, the SNB stated that although the overvaluation of the franc has decreased "the franc remains highly valued". On a more positive note, however, the SNB revised its inflation forecast for its coming quarters, suggesting an overshoot may even happen and be tolerated as this inflation upgrade mainly reflected the appreciation of oil and the depreciation of the franc. We continues to believe that the SNB will keep its ultra-dovish monetary policy in place as long as core inflation remains very low and the Swiss franc stays overvalued on a PPP basis. These negatives for the franc could get occasionally interrupted when volatility re-emerges global markets. Report Links: The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been mixed: Core inflation surprised to the downside, coming in at 1.1%. This number also declined from last week's number of 1.2%. Retail Sales growth also underperformed expectations, coming in at -0.2%. However this number improved from last month's 0.8% contraction. However manufacturing output outperformed expectations, coming in at 0.7%. However this number slowed down from last month's 2.8% growth. The Norges Bank kept rates unchanged at 0.5% at its latest monetary policy meeting. Overall, this release was less dovish than markets expected as the Norge Bank brought forward to late 2018 it expectations for a first hike. Essentially, despite a weak batch of data this week, the Norwegian economy is heeling, and is not experiencing the same debilitating deflationary pressures as has been experienced by other countries in Europe. Our favored way to play these improvements in the Norwegian economy, along with the change of tone at the Norges Bank helm is to buy NOK/SEK And short EUR/NOK. Report Links: The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Swedish data has recently taken a stronger turn: Industrial production increased by 6% annually, higher than the previous 2.7% growth rate; Manufacturing new orders increased by 3.8% annually; Inflation popped up to 1.9%, higher than the previous 1.7%, and outperforming the expected 1.7%. While inflation has picked back up, last quarter's disappointing GDP numbers still raises important question marks. The risks are still skewed toward the current Riksbank leadership maintaining a dovish stance, despite an economy that hardly needs it. This risk will only grow if our EM canaries are correct and global industrial activity turns around, a phenomenon that will impact Swedish growth and inflation negatively. Report Links: The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Global growth will remain strong in 2018, but the composition of that growth will shift in favour of the U.S. The surprise results of the Alabama Senate election are unlikely to scuttle the Republicans' tax plans. We expect a bill to be finalized by the end of the year. The Fed is poised to raise rates four times next year, two more hikes than the market is pricing in. The dollar should stage a modest rebound in 2018. China's economy will decelerate over the coming months, but merely from an above-trend pace. Near-term concerns about Chinese debt levels are overblown. Stay cyclically overweight global risk assets at least for the next six months. Feature Tax Cut Or Not, U.S. Growth Is Likely To Stay Strong In 2018 We expect global growth to remain strong in 2018. However, the composition of that growth is likely to shift back towards the United States. The weakening of the dollar this year should boost net exports, while dwindling spare capacity and faster wage growth should spur business investment and consumer spending. A looser fiscal policy will also help buoy the U.S. economy, but as we have discussed in recent reports, the contribution to growth from lower tax rates is likely to be fairly modest.1 We estimate that the final bill will lift real GDP growth by about 0.2%-0.3% in 2018 and 2019. The effects will diminish thereafter, eventually turning negative as larger budget deficits crowd out the savings that are necessary to finance private-sector investment. Democrat Doug Jones' surprise victory in the Alabama Senate election has thrown a wrench into the legislative process. Outgoing Senator Bob Corker voted against the original bill. If the reconciled House and Senate bill is not passed by the time Jones is seated in January, the Republicans may not have enough votes to get it through the chamber. Our geopolitical strategists expect the bill to pass by the end of the year, but this will likely require that Congressional Republicans acquiesce to Senator Collins' demand that Congress adopt legislation to help health insurers deal with the proposed abolition of the individual mandate. It may also require that Republican dealmakers ditch their last-minute effort to cut the marginal personal tax rate to 37% (the House version of the bill penciled in a top rate of 39.6%, while the Senate version envisioned a rate of 38.5%). The Fed Keeps On Hiking The Federal Reserve hiked rates again this week, taking the fed funds target range up to 1.25%-1.50%. The Fed's determination to tighten monetary policy at a time when inflation is still below target has many investors fretting. We are not particularly concerned. Inflation is a highly lagging indicator. The New York Fed's Underlying Inflation Gauge, which includes various forward-looking inflation components such as producer prices and the ISM prices paid index, has accelerated to a cycle high of 3.0% (Chart 1). The unemployment rate is likely to fall to 3.5% by the end of next year. This would leave it more than one full point below NAIRU and 0.4 points below the median dot in the Summary Of Economic Projections released on Wednesday. Auxiliary measures of labor market slack, such as the U-6 rate and the share of the working-age population that is out of the labor force but wants a job, have also fallen back to pre-recession levels (Chart 2). Chart 1U.S. Inflationary Pressures Starting To Brew U.S. Inflationary Pressures Starting To Brew U.S. Inflationary Pressures Starting To Brew Chart 2Labor Market Slack Has Largely Vanished Labor Market Slack Has Largely Vanished Labor Market Slack Has Largely Vanished If U.S. growth surprises on the upside next year, as we expect, the Fed is likely to raise rates four times in 2018. This is roughly two more hikes than the market is currently pricing in. We recommended shorting the December 2018 fed funds futures contract on September 7th. The trade is up 48 basis points since then, but we think there is still scope for further gains. Modestly Slower Growth Elsewhere Outside the U.S., growth is likely to come down a notch in 2018. Japanese growth should cool somewhat from the heady pace of 2.7% seen over the past two quarters. Euro area growth is also likely to tick lower, as the impact of a stronger euro begins to bite. Financial conditions in the U.S. have loosened significantly relative to those in the euro area since the start of 2017. If history is any guide, this will cause euro area inflation to rise less than U.S. inflation over the coming year (Chart 3). This, in turn, will keep the ECB's forward guidance on the dovish side. This week's ECB meeting reinforced the message that the central bank is unlikely to raise rates at least until the summer of 2019. Chart 3Diverging Financial Conditions Will Have Inflationary Consequences Diverging Financial Conditions Will Have Inflationary Consequences Diverging Financial Conditions Will Have Inflationary Consequences Chart 4 shows that the euro has strengthened more against the dollar since the beginning of this year than can be accounted for by changes in interest rate expectations. We expect EUR/USD to fall back to 1.11 by the end of 2018. Chart 4AEUR/USD Has Strengthened More Than What One Would Have Expected Based On Changes In Interest Rate Differentials EUR/USD Has Strengthened More Than What One Would Have Expected Based On Changes In Interest Rate Differentials EUR/USD Has Strengthened More Than What One Would Have Expected Based On Changes In Interest Rate Differentials Chart 4BEUR/USD Has Strengthened More Than What One Would Have Expected Based On Changes In Interest Rate Differentials EUR/USD Has Strengthened More Than What One Would Have Expected Based On Changes In Interest Rate Differentials EUR/USD Has Strengthened More Than What One Would Have Expected Based On Changes In Interest Rate Differentials The Chinese Wildcard The biggest question mark over growth surrounds China. Real-time measures of industrial activity such as electricity generation, freight traffic, and excavator sales have slowed since the start of the year (Chart 5). The Caixin manufacturing PMI has also dipped, signaling weaker growth prospects among the country's small-to-medium sized private enterprises. Monetary conditions have tightened (Chart 6). How worried should investors be? So far, there is no reason to panic. Growth has weakened, but from an above-trend pace. Nominal GDP growth reached 11.2% year-over-year in Q3 2017, up from 6.4% in Q4 2015. Producer price inflation rose to 6.9% in October before backing off to 5.8% in November. Some cooling in the economy was both inevitable and desirable (Chart 7). Chart 5Growth Has Ticked Down ##br##Modestly In China Growth Has Ticked Down Modestly In China Growth Has Ticked Down Modestly In China Chart 6Monetary Conditions Have##br## Tightened In China Monetary Conditions Have Tightened In China Monetary Conditions Have Tightened In China Chart 7Chinese Growth Has Merely Weakened##br## From An Above-Trend Pace Chinese Growth Has Merely Weakened From An Above-Trend Pace Chinese Growth Has Merely Weakened From An Above-Trend Pace A more ominous slowdown cannot be ruled out, but that would require a substantial policy error. Such errors have occurred in the past. In 2015, the government undertook measures to reduce credit growth and cool the property market just as the global manufacturing sector was entering a recession on the heels of a sudden decline in energy sector capex. The Chinese authorities amplified the problem by trying to tippy-toe over the question of whether to devalue the currency, even as other EM currencies were sinking. This led to large capital outflows, thereby exacerbating the tightening in Chinese financial conditions. The circumstances today are quite different from 2015. While the authorities have clearly stepped up the pace of reforms following the Party Congress, the global and domestic backdrop is a lot more favorable. Global growth is much stronger. The yuan is also a lot cheaper - down 8.8% in real trade-weighted terms since its peak in 2015 (Chart 8). Chart 8The Yuan Has Cheapened Since 2015 The Yuan Has Cheapened Since 2015 The Yuan Has Cheapened Since 2015 Domestic demand remains on a firm footing. The service sector PMI ticked up further in November, an important development considering that China's service sector is now larger than its manufacturing sector (Chart 9). Alibaba reported sales of over U.S. $25 billion on its platform on "Singles Day" last month, up 39% from last year, and greater than U.S. online sales on Black Friday and Cyber Monday combined. The Chinese government is unlikely to take measures that allow growth to fall significantly below trend. Indeed, if anything, the recent evidence suggests that the authorities are tentatively easing their foot off the brake. Bond yields and credit spreads have come off their recent highs. New loans to the real economy clocked in at RMB 1.12 trillion in November, well above consensus estimates of RMB 800 billion. While the year-over-year change in M2 growth remains close to historic lows, the three-month change has hooked up (Chart 10). Chart 9It's Not All About Manufacturing In China It's Not All About Manufacturing In China It's Not All About Manufacturing In China Chart 10China: Money Growth Starting To Accelerate China: Money Growth Starting To Accelerate China: Money Growth Starting To Accelerate Higher core inflation has pushed real deposit rates into negative territory, making it increasingly painful for households to hold cash. This should cause the velocity of money to speed up, allowing nominal GDP growth to exceed money growth. Don't Bet On A Chinese Debt Crisis... Yet What about the longer-term debt issues haunting China? Here, there is both good and bad news. The bad news is that China's need to keep piling on debt may be an even more vexing problem than typically assumed. Pundits often claim that the government simply needs to bite the bullet and take the painful measures that are necessary to curb debt growth. The problem with this argument is that it sidesteps the question of what will offset the loss in spending from slower debt accumulation. Chinese households are massive net savers (Chart 11). As a matter of arithmetic, these savings must either be transformed into domestic investment or exported abroad via a current account surplus. China used to emphasize the latter. Its current account surplus reached 10% of GDP in 2007, mainly due to a widening trade surplus. It would be economically and politically impossible to pursue such a beggar-thy-neighbour strategy today. Economically, China is simply too big. Its economy has more than doubled relative to the rest of the world over the past decade (Chart 12). Politically, no major economy these days is prepared to tolerate a massive trade deficit with China - certainly not the U.S. Chart 11Mattresses Are ##br##Thicker In China Mattresses Are Thicker In China Mattresses Are Thicker In China Chart 12China's Size Limits Its Ability To Export Its ##br##Way Out Of Its Problems China's Size Limits Its Ability To Export Its Way Out Of Its Problems China's Size Limits Its Ability To Export Its Way Out Of Its Problems This means that China must now recycle excess savings internally. One way that Chinese households have done this is by purchasing real estate. In many respects, the Chinese property market has served as a piggy bank of sorts for much of the population. Large amounts of savings have also been placed into bank deposits and, increasingly, so-called wealth management products. These funds have then been used to satisfy the borrowing needs of local governments and business enterprises. It is no surprise that credit growth in China began to accelerate in 2009, just as the current account surplus was starting to narrow (Chart 13). In practice, the distinction between fiscal and corporate spending in China is rather blurry. Chart 14 shows China's official general government budget deficit as well as an augmented version constructed by the IMF which includes various off-balance sheet expenses. The former stands at a reasonably slim 3.7% of GDP, while the latter weighs in at a hefty 12.6% of GDP. Chart 13Credit Growth Took Off As ##br##Current Account Surplus Shrunk Credit Growth Took Off As Current Account Surplus Shrunk Credit Growth Took Off As Current Account Surplus Shrunk Chart 14China's "Secret" ##br##Budget Deficit Will China Spoil The Party? Will China Spoil The Party? A large chunk of these off-balance sheet items consist of losses incurred by China's state-owned enterprises. In many respects, these companies are the equivalent of Japan's fabled "bridges to nowhere": They exist to prop up demand in an economy where there is too much savings. Rather than making the economy more efficient, the risk is that structural reforms, if undertaken too rapidly, will simply depress growth. The most misallocated resource is a worker who wants a job but cannot find one. The troubling implication is that deleveraging may be difficult to achieve without causing significant economic distress. On The Bright Side... Fortunately, a number of factors mitigate the risks of a Chinese debt crisis. As Japan's experience shows, as long as a country has ample domestic savings and borrows primarily in its own currency, debt can increase to levels that many people might have thought impossible. Moreover, most of China's debt mountain consists of loans made by state-owned banks to SOEs and local governments. These loans often carry implicit guarantees from the central government. While this exacerbates the moral hazard problem, it does limit the potential of "leveraged losses" to lead to a massive credit crunch of the sort experienced during the Global Financial Crisis. China also has reasonably good long-term growth prospects. Output-per-worker is only a quarter of U.S. levels. Likewise, capital-per-worker is a fraction of what it is among advanced economies (Chart 15). Even with its bleak demographics, China would need to grow by around 6% per year over the coming decade if it were to remain on course to catch up to South Korea in output-per-worker by 2050 (Chart 16). Chart 15China Has More Catching Up To Do (1) Will China Spoil The Party? Will China Spoil The Party? Chart 16China Has More Catching Up To Do (2) China Has More Catching Up To Do China Has More Catching Up To Do Given China's well-educated labor force, it is likely that productivity levels will continue to converge with richer economies in the years ahead (Chart 17). Rapid growth, in turn, will allow China to outgrow some its debt and overcapacity problems more easily than would be the case for slower growing economies. Chart 17A Well-Educated Labor Force Bodes Well For China's Development Will China Spoil The Party? Will China Spoil The Party? Lastly, not all credit creation in China represents the intermediation of savings into productive investment. A lot of it is simply driven by speculative activities that contribute little to growth. Curbing the ability of individuals and companies to use extreme amounts of leverage to supercharge financial returns would enhance economic stability. To its credit, the government is actively addressing this issue. The bottom line is that Chinese growth is likely to slow modestly next year, but not by enough to imperil the global economy. Investors should remain cyclically overweight global equities and other risk assets at least for the next six months. Peter Berezin, Chief Global Strategist peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "When To Get Out," dated December 8, 2017; and Weekly Report, "Fiscal Follies," dated November 17, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The stellar performance in metals over the past year resulted from a combination of favorable demand- and supply-side developments, propelled along, as always, by China's outsized effect on fundamentals. On the demand side, robust global growth is keeping metals consumption strong. On the supply side, environmental reforms in China and the shuttering of mills - as well as supply-side shocks in individual markets - continues to bolster prices. A weak U.S. dollar - which lost 6% of its value in broad trade-weighted terms - further supports these bullish conditions for metal markets. We expect China's winter supply cuts to dominate 1Q18 market fundamentals. As we move toward mid-year, we expect a soft and controlled slowdown in China, brought about by the Communist Party's goals of reducing industrial pollution and pivoting toward consumer-led growth. Although this will moderate demand from the world's top metal consumer, strong growth from the rest of the world will neutralize the impact of this slowdown. Energy: Overweight. Pipeline cracks in the critical Forties system in the North Sea highlight the unplanned-outage risk to oil prices we flagged in recent reports. We remain long Brent and WTI $55/bbl vs. $60/bbl call spreads in 2018, which are up an average of 47%, respectively, since they were recommended in September and October 2017. Base Metals: Neutral. Following a strong 1Q18, a moderate slowdown in China will be offset by growth in the rest of the world (see below). Precious Metals: Neutral. We continue to recommend gold as a strategic portfolio hedge, even though we expect as many as three additional Fed rate hikes next year. Ags/Softs: Underweight. The U.S. undersecretary for trade and foreign agricultural affairs warned farmers this week they "need to have a backup plan in the event the U.S. exits the North American Free Trade Agreement," in an interview with agriculture.com's Successful Farming. No specifics were offered. Canada and Mexico - the U.S.'s NAFTA partners - are expected to account for $21 billon and $19 billion of exports, respectively, based on USDA estimates for FY 2018. These exports largely offset imports of $22 billion and $23 billion, respectively, from both countries. The U.S. runs an ag trade surplus of ~ $23.5 billion annually. Feature Metals had another extraordinary year in 2017. The LME base metal index rallied more than 20% year-to-date (ytd) bringing the index up more than 50% since it bottomed in mid-January 2016 (Chart Of The Week). Chart of the WeekA Great Year For Metals A Great Year For Metals A Great Year For Metals Steel, zinc, copper, and aluminum led the gains. In fact, of the metals we track, iron ore is the only one in negative territory - having lost almost 8% ytd. Nonetheless, it has been on the uptrend recently - gaining ~ 24% since it bottomed at the end of October. Capacity reductions in China, where policymakers mandated inefficient and highly polluting mills and smelters in steel- and aluminum-producing provinces be taken offline, continue to affect the supply side in those metals most. As China churns out less of these commodities, competition for the more limited supply will pull prices for them higher. Nevertheless, a stronger USD - brought about by a more hawkish Fed - likely will cap significant upside gains, and prevent a repeat of this year's exceptional performance. Strong Global Demand Will Neutralize China Slowdown The Chinese economy is beginning to show signs of a slowdown. The Li Keqiang Index - a proxy for China's economic activity - has rolled over. Furthermore, the manufacturing PMI has plateaued following last year's rapid ascent (Chart 2). This deceleration is also evident in China's infrastructure data. Annual growth in infrastructure spending in the first three quarters of the year are below the four-year average. And, although spending grew 15.9% year-on-year (yoy) in the first 10 months of this year, the rate of growth is slower than the four-year average of 19.6% (Chart 3). Chart 2A China Slowdown Is In The Cards... A China Slowdown Is In The Cards... A China Slowdown Is In The Cards... Chart 3...Threatening A Pull Back In Metals Demand ...Threatening A Pull Back In Metals Demand ...Threatening A Pull Back In Metals Demand That said, it is important to point out that this is due to a significant decline in utilities spending growth, which accounts for ~ 20% of infrastructure investments. Investment in utilities grew a mere 2.3% in the first ten months of the year, in contrast with the average 15.7% yoy increase of the previous four years. In any case, the slowdown in China's reflation reflects President Xi Jinping's resolve to shift gears and emphasize quality over quantity in future growth strategies. Now that Xi has consolidated his power, we expect policymakers to build on the momentum from the National Communist Party Congress, and be more effective in implementing reforms going forward. As such, Beijing should be more willing to tolerate slower growth than it has in the past. Nonetheless, we do not anticipate a significant slowdown. More likely than not, policymakers will resort to fiscal stimulus if the economy is faced with notable risks. Consequently, a hard landing in China is not our base case scenario. In any case, strong global demand will neutralize a slowdown in China's metal consumption in 2018. Despite a deceleration in China, the IMF expects global growth to pick up in 2018 (Table 1). The Global PMI is at its highest level since early 2011, supported by strong readings in the Euro Area and the U.S. (Chart 4). In all likelihood, conditions for global metal demand will remain favorable in 2018. Table 1IMF Economic Forecasts China's Supply Cuts Will Tighten Metals In 1Q18; Global Demand Offsets 2H18 Slowdown In China China's Supply Cuts Will Tighten Metals In 1Q18; Global Demand Offsets 2H18 Slowdown In China Chart 4Strong Global Demand Will Neutralize##BR##Impact Of China Slowdown Strong Global Demand Will Neutralize Impact Of China Slowdown Strong Global Demand Will Neutralize Impact Of China Slowdown China Real Estate Will Slow; Major Downturn Not Expected Chart 5Slowing Real Estate Investment Is A Mild Risk Slowing Real Estate Investment Is A Mild Risk Slowing Real Estate Investment Is A Mild Risk We do not foresee significant risks to China's real estate market, which is the big driver of base-metals demand in that economy. Total real estate investment is up 7.8% in the first 10 months of the year - the strongest growth for the period since 2014 (Chart 5). Even so, it is important to note the slowdown in that sector. After growing 9% yoy in 1Q17, growth rates fell to 8% and 7% in 2Q and 3Q17, respectively. In fact, growth in October, the latest month for which data are available, came in at 5.6% yoy - significantly slower than the average monthly yoy rate of 8% in the first nine months of the year. The slowdown in floor-space-started is more pronounced. The area of floor space started grew 5% in the first 10 months of the year, down from an 8% expansion in the same period in 2016. October data showed a yoy as well as month-on-month contraction - 4.2% for the former, and 12.1% for the latter. This is the second yoy contraction in 2017, with July experiencing a 4.9% reduction in floor area started. Similarly, quarterly data shows a significant slowdown from almost 12% yoy growth rates registered in 4Q16 and 1Q17 to the mere 0.4% yoy growth in 3Q17. In addition, the growth rate in commodity building floor-space-under-construction has slowed down to 3.1% yoy in the first 10 months of 2017, down from almost 5% for the same period in the previous two years. Although the data are a reflection of Xi's resolve to tighten control of the real estate market, we do not expect a major downturn that will weigh on metal demand. As BCA Research's China Investment Strategy desk notes, strong demand in the real estate sector, coupled with declining inventories, will prevent a major slowdown in construction activity, even in face of tighter policies.1 A Stronger Dollar Moderates Upside Price Pressures In our modeling of the LME Base Metal Index, we find that currency movements are important determinants of the evolution of metals prices. More specifically, the U.S. dollar is inversely related to the LME base metal index. While U.S. inflation has remained stubbornly low, we expect inflation to start its ascent sometime before mid-2018, allowing the Fed to proceed with its rate-hiking cycle. Given our view that too few hikes are currently priced in for 2018, there remains some upside to the USD. Thus, while dollar weakness has been supportive for metal prices in 2017, a stronger dollar will be a headwind in 2018. A Look At The Fundamentals In terms of supply/demand dynamics in individual metal markets, idiosyncrasies in their current states, and variations in how China's environmental reforms manifest themselves will mean the different metals will follow different trajectories next year. Muted Consumption Mitigated Impact Of Supply Disruptions In Copper Copper production had a bumpy 2017, rocked by sporadic supply disruptions in some of the world's top mines.2 This led to a contraction in world refined production ex-China, which was offset by an increase in Chinese output (Chart 6). Although Chinese refined copper output grew a healthy 6% yoy in the first three quarters, this was nonetheless a slowdown from the 8% yoy expansion for the same period in 2016. Even so, increased Chinese copper production more than offset declines from other top producers. Refined copper production in the rest of the world contracted by 1.5% in the first three quarters, bringing world production growth to 1.3% - significantly slower than the average 2.6% yoy increase witnessed in the same period in the previous two years. The supply-side impact on the overall market was mitigated by a slowdown in consumption. Chinese consumption, which accounts for 50% of global refined copper demand, remained largely unchanged in the first three quarters of the year compared to last year. This follows a yoy increase of ~ 8% in Chinese demand vs. the same period in 2016. Demand from the rest of the world contracted by 0.6% yoy, down from a 2.5% yoy expansion in the same period last year. So, despite supply disruptions, the copper market remained balanced - registering a 20k MT surplus in the first three quarters of this year, following a 230k MT deficit in the same period in 2016. Recently, there is news of capacity cuts in Anhui province - where China's second-largest copper smelter will be eliminating 20 to 30% of its capacity during the winter.3 If the copper market is the next victim of China's environmental reforms, global balances may be pushed to a deficit. Although copper remains well stocked at the major warehouses, an adoption of these winter cuts by other copper producing provinces would weaken refined copper supply and support prices (Chart 7). Chart 6Copper Rallied On Back Of Supply-Side Fears Copper Rallied On Back Of Supply-Side Fears Copper Rallied On Back Of Supply-Side Fears Chart 7Copper Warehouses Are Well Stocked Copper Warehouses Are Well Stocked Copper Warehouses Are Well Stocked Steel Prices Will Remain Elevated Throughout Q1 China's steel sector has undergone significant reforms this year. In addition to the 100-150 mm MT of capacity cuts to be implemented between 2016 and 2020, Beijing has also eliminated steel produced by intermediate frequency furnaces (IFF).4 Even so, Chinese steel production - paradoxically - is at record highs. This comes down to the nature of IFFs, which are illegal and thus not reflected in official crude steel production data. However, growth in steel products - which reflect output from both official as well as illegal steel mills - has been flat (Chart 8). In addition, China's steel exports have come down significantly since last year, reflecting a domestic shortage in the steel industry. November data shows a 34% yoy contraction, and exports for the first 11 months of the year are down more than 30% from the same period last year. We expect Chinese steel production to remain anemic until the end of 1Q18, as mandated winter capacity cuts cap production in major steel-producing provinces. The near-term cutback in production will keep steel prices elevated. The spread between steel and iron ore prices during this period will remain wide as lower steel production translates into muted demand for the ore. This is also consistent with China's inventory data which shows that after falling since August, iron ore stocks have been building up since mid-October - in conjunction with the start of winter steel-capacity cuts. Indonesian Nickel Exports Bearish In Long Run, Not So Much In Near Term Ever since Indonesia's ban on nickel ore exports in 2014, worldwide production has been on the downtrend. In the previous two years, shrinking supply from China - which makes up about a quarter of global output - was the culprit of reduced world output, offsetting increases from the rest of the globe, and causing global production to contract by 0.2% and 0.5%, respectively (Chart 9). Chart 8Falling Exports And Flat Steel Products##BR##Output Reflect Closures In Steel Falling Exports And Flat Steel Products Output Reflect Closures In Steel Falling Exports And Flat Steel Products Output Reflect Closures In Steel Chart 9Deficit And Inventory##BR##Drawdowns Dominate Nickel... Deficit And Inventory Drawdowns Dominate Nickel... Deficit And Inventory Drawdowns Dominate Nickel... However, at 2.5%, the contraction in global output is significantly larger for the first three quarters of this year. What is noteworthy is that it is caused by shrinking production both from China - down ~ 7.5% - as well as from the rest of the world, where output is down ~ 1%. Nevertheless, a decline in demand from China - which accounts for almost half of global consumption - has softened the impact of withering production. Chinese demand for semi refined nickel shrunk 22% in the first three quarters of the year, more than offsetting the 9% growth in demand from the rest of the world. However, there has been a recovery in global demand since June. A 15% yoy growth in the third quarter from consumers ex-China drove a 5% yoy gain in global growth. Despite weak demand in 1H17, the nickel market recorded a deficit in the first three quarters of the year. In fact, nickel has been in deficit for the past two years. Going forward, Indonesia's gradual lifting of the export ban will prop up production. In fact, global yoy production growth has been in the green since June. However, while Indonesian ores are slowly returning to the global market, they remain a fraction of their pre-ban levels. Thus, prices will likely remain under upside pressure in the near term. Record Deficit And Significant Inventory Drawdowns Dominate Aluminum... Aluminum has been in deficit for the past three years. In fact, at 100k MT, the deficit in the first three quarters of 2017 is the largest on record for that period. This is reflected in LME inventory data which has been experiencing drawdowns since April 2014 - Falling from more than 5mm MT to ~ 1mm MT (Chart 10). Strong growth from Chinese producers - which account for more than half the world's primary production - kept global output growth strong, despite a decline from other top producers. However, falling Chinese production in August and September compounded the fall in output from the rest of the world, leading to a 3.5% yoy decline for those two months. In fact, September's Chinese output data marks the lowest production figure since February 2016. On the demand side, global consumption is up 6.2% yoy in the first seven months of 2017, reflecting a general uptrend in both Chinese consumption and, to a lesser extent, a greater appetite for the metal from the rest of the world. However, there has been some weakness from China recently. Chinese demand contracted by 2.9% and 9.6% yoy in August and September. While an 8.2% yoy increase in consumption from the rest of the world offset the August weakness from China, global demand shrunk by 5.8% in September. As with steel, supply-side reforms will dominate and keep aluminum prices elevated in the near term. ... Along With Zinc Demand Global zinc production has been more or less flat this year. The 2.7% decline from Chinese producers, which supply 46% of global zinc slab, was offset by a 2.4% increase in production from the rest of the world. On the demand side, although Chinese consumption - which accounts for almost half of global zinc slab demand - has been flat, strength from the rest of the world supported global demand, which is up 2.3% yoy for the first three quarters of the year (Chart 11). Chart 10...As Well As Aluminum... ...As Well As Aluminum... ...As Well As Aluminum... Chart 11...And Zinc ...And Zinc ...And Zinc Static supply coupled with increased demand has led the zinc market to a deficit of 500k MT - a record for the first three quarters of 2017. The deficit has continued to eat up zinc stocks, which have been in free-fall, since early 2013.   Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see BCA Research's China Investment Strategy Weekly Report titled "Chinese Real Estate: Which Way Will The Wind Blow?," dated September 28, 2017, available at cis.bcaresearch.com. 2 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "Copper's Getting Out Ahead Of Fundamentals, Correction Likely," dated August 24, 2017, available at ces.bcaresearch.com. 3 Please see "Chinese Copper Smelter Halts Capacity to Ease Winter Pollution," published on December 7, 2017, available at Bloomberg.com. 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "Slow-Down in China's Reflation Will Temper Steel, Iron Ore in 2018,' dated September 7, 2017, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades China's Supply Cuts Will Tighten Metals In 1Q18; Global Demand Offsets 2H18 Slowdown In China China's Supply Cuts Will Tighten Metals In 1Q18; Global Demand Offsets 2H18 Slowdown In China Commodity Prices and Plays Reference Table China's Supply Cuts Will Tighten Metals In 1Q18; Global Demand Offsets 2H18 Slowdown In China China's Supply Cuts Will Tighten Metals In 1Q18; Global Demand Offsets 2H18 Slowdown In China Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights Investors should expect little policy initiative out of the U.S. Congress after tax cuts; Polarization is likely to rise substantively in 2018, gridlocking Congress; Chinese policymakers are experimenting with growth-constraining reforms; Global growth has peaked; underweight emerging markets in 2018; Go long energy stocks relative to metal and mining equities. Feature Last week we published Part I of our 2018 Key Views.1 In it, we presented our five "Black Swans" for 2018: Lame Duck Trump: President Trump realizes his time in the White House is going to be short and seeks relevance abroad. He finds it in jingoism towards Iran - throwing the Middle East into chaos - and protectionism against China. A Coup In North Korea: Chinese economic pressure overshoots its mark and throws Pyongyang into a crisis. Kim Jong-un is replaced, but markets struggle to ascertain whether the successor is a moderate or a hawk. Prime Minister Jeremy Corbyn: Markets cheer the higher probability of "Bremain" and then remember that Corbyn is a genuine socialist. Italian Election Troubles: Markets are fully pricing in the sanguine scenario of "much ado about nothing," which is our view as well. But is there really anything to cheer in Italy? If not, then why is the Italian market the best performing in all of DM? Bloodbath In Latin America: Emerging markets stall next year as Chinese policymakers tighten financial regulations. As the tide pulls back, Mexico and Brazil are caught swimming naked. These are not our core views. As black swans, they are low-probability events that may disturb markets in 2018. Our core view remains that geopolitical risks were overstated in 2017 and will be understated in 2018 (Charts 1 & 2). Most importantly, U.S. politics will be a tailwind to global growth while Chinese politics will be a headwind to global growth. While the overall effect may be neutral, the combination will be bullish for the U.S. dollar and bearish for emerging markets.2 Chart 12018 Will See Risks Dominate... 2018 Will See Risks Dominate... 2018 Will See Risks Dominate... Chart 2...As Global Growth Concerns Reemerge ...As Global Growth Concerns Reemerge ...As Global Growth Concerns Reemerge This week, we turn to the three questions that we believe will define the year for investors: Is A Civil War Coming To America? Is The Ghost Of Deng Xiaoping Haunting China? Will Geopolitical Risk Shift To The Middle East? Is A Civil War Coming To America? On a recent visit to Boston and New York we were caught off guard by how alarmed several large institutional clients were about the risk of severe social unrest in the U.S. We share this concern about the level of polarization in the U.S. and expect social instability to rise over the coming years (Chart 3).3 When roughly 40% of both Democrats and Republicans believe that their political competitors pose a "threat to the nation's well-being," we have entered a new paradigm (Chart 4). Chart 3Inequality Fuels Political Polarization Inequality Fuels Political Polarization Inequality Fuels Political Polarization Chart 4"A Threat To The Nation's Well-Being?" Really?! Three Questions For 2018 Three Questions For 2018 Where we differ from some of our clients is in assessing the likely trigger for the unrest and its investment implications over the next 12 months. If the Democrats take the House of Representatives in the November 6 midterm election, as is our low-conviction view at this early point, then we would expect them eventually to impeach President Trump in 2019.4 Even then, it is not clear that the Senate would have the necessary 67 votes to convict Trump of the articles of impeachment (whatever they prove to be) and hence remove him from power. Republicans are likely to increase their majority in the Senate, even if they lose the House, because more Democratic senators are up for re-election in 2018. Therefore well over a dozen Republican senators would have to vote to remove a Republican president from power. For that to happen, Trump's popularity with Republican voters would have to go into a free fall, diving well below 60% (Chart 5). Meanwhile, we do not buy the argument that hordes of gun-wielding "deplorables" would descend upon the liberal coasts in case of impeachment. There may well be significant acts of domestic terrorism, particularly in the wake of any removal of Trump from office, but they would likely be isolated and unable to galvanize broader support. Our clients should remember, however, that ultra-right-wing militant groups are not the only perpetrators of domestic terrorism.5 Any acts of violence or social unrest are likely to draw press coverage and analytical hyperbole. But our left-leaning clients in the Northeast are likely overstating the sincerity of support for President Trump. President Trump won 44.9% of the Republican primary votes, but he averaged only 35% of the vote in the early days when the races were the most competitive. Given that only 25% of Americans identify as Republicans (Chart 6), it is fair to say that only about a third of that figure - 8%-10% of all U.S. voters - are Trump loyalists. Many conservative voters simply wanted change and were willing to give an outsider a chance (much as their liberal counterparts did in 2008!). Of that small percentage of genuine Trump fans, it is highly unlikely that a large share would seriously contemplate taking arms against the state in order to keep their leader in power against the constitutional impeachment process. Especially given that President Trump would be replaced by a genuine conservative, Vice President Mike Pence.6 Chart 5We Are A Long Way Away##BR##From Trump's Demise Three Questions For 2018 Three Questions For 2018 Chart 6Party Identifications##BR##Are Shrinking Party Identifications Are Shrinking Party Identifications Are Shrinking As such, we believe that it is premature to speak of a total breakdown of social order in America. It is notable that such a conversation is taking place, but other forms of polarization and social unrest are far more likely to be relevant at the moment. In terms of policy, we would expect gridlock in Congress if Democrats take the House and begin focusing on impeachment. In fact, gridlock may already be upon us, as we see little agreement between the Trump administration, its loyalists in Congress, and establishment Republican Senators like Dan Sullivan (R, Alaska), Cory Gardner (R, Colorado), Joni Ernst (R, Iowa), Susan Collins (R, Maine), Ben Sasse (R, Nebraska), and Thom Tillis (R, North Carolina). These six Senators are all facing reelection in 2020 and are likely to evolve into Democrats-in-all-but-name. If President Trump's overall popularity continues to decline, we would not be surprised if one or two (starting with Collins) even take the dramatic step of leaving the Republican Party for the 2020 election. Essentially, establishment Republicans will become effective Democrats ahead of the midterms. Post-midterm election, with Democrats potentially taking over the House, the legislative process will grind to a complete halt. Government shutdowns, debt ceiling fights, failure of proactive policymaking to deal with crises and natural disasters, will all rise in probability. As President Trump faces greater constraints in Congress, we can see him becoming increasingly reliant on his executive authority to create policy. He would not be unique in this way, as President Obama did the same. While Trump's executive policy will be pro-business, unlike Obama's, uncertainty will rise regardless. The business community will not be able to take White House policies seriously amidst impeachment and a potential Democratic wave-election in 2020. Whatever executive orders Trump signs into power over the next three years, chances are that they will be immediately reversed in 2020. What about the markets? The Mueller investigation and heightened level of polarization could create drawdowns in equity markets throughout the year. However, impeachment proceedings are not likely to begin in 2018 and have never carried more weight with investors than market fundamentals (Chart 7).7 True, the Watergate scandal under President Richard Nixon triggered a spike in volatility and a fall in equities. However, the scandal alone did not cause the correction, rather it was a combination of factors, including the second devaluation of the dollar, rapid increases in price inflation, massive insurance fraud, recession, and a global oil shock.8 Chart 7AFundamentals, Not Impeachment,##BR##Drive Markets Fundamentals, Not Impeachment, Drive Markets Fundamentals, Not Impeachment, Drive Markets Chart 7BFundamentals, Not Impeachment,##BR##Drive Markets Fundamentals, Not Impeachment, Drive Markets Fundamentals, Not Impeachment, Drive Markets What about the impact on the U.S. dollar? Does Trump-related political instability threaten the dollar's status as the chief global reserve currency and a major financial safe haven? The data suggest not. We put together a list of events in 2017 that could be categorized as "unorthodox, Trump-related, political risk" (Table 1). We specifically left out geopolitical events, such as the North Korean nuclear crisis, so as not to dilute our dataset's focus on domestic intrigue. As Chart 8 illustrates, the U.S. dollar rose slightly, on average, a week after each event relative to its average weekly return prior to the crisis. While this may not be a resounding vote of confidence for the greenback (gold performed better), there is no evidence that investors are betting on a paradigm shift away from the dollar as the global reserve currency. Table 1An Eventful Year 1 Of Trump Presidency Three Questions For 2018 Three Questions For 2018 Chart 8Trump Is Not A U.S. Dollar Paradigm Shift Three Questions For 2018 Three Questions For 2018 If investors should not worry about investment-relevant social strife in the U.S. in 2018, then when should they worry? Well, if Trump is actually removed from office, a first in U.S. history, at a time of extreme polarization, and in a country with easy access to arms and at least a strain of domestic terrorism, then 2019-20 will at least be a time for concern. Even without Trump's removal, we worry about unrest beyond 2018. We expect the ideological pendulum to shift to the left by the 2020 election. If our sister service - BCA's Global Investment Strategy - is correct, then a recession is likely to begin in late 2019.9 A combination of low popularity, market turbulence, and economic recession would doom Trump's chances of returning to the White House. But they would also be toxic for the candidacy of a moderate Democrat and would possibly propel a left-wing candidate to the presidency. Four years under a left-wing, socially progressive firebrand may be too much for many far-right voters to tolerate. Given America's demographic trends (Chart 9), these voters will realize that the writing is on the wall, that the window of opportunity to lock in their preferred policies has been firmly shut. The international context teaches us that disenchanted groups contemplate "exit" when the strategy of "voice" no longer works. How this will look in the U.S. is unclear at this point. Bottom Line: Investors should continue to fade impeachment-related, and Mueller investigation-related, pullbacks in the markets or the U.S. dollar in 2018. Our fears of U.S. social instability are mostly for the medium and long term. Fundamentals drive the markets and U.S. fundamentals remain solid for now. As our colleague Peter Berezin has pointed out, there is no imminent risk of a U.S. recession (Chart 10) and the cyclical picture remains bright (Chart 11).10 Chart 9A Changing America A Changing America A Changing America Chart 10No Imminent Risk Of A U.S. Recession No Imminent Risk Of A U.S. Recession No Imminent Risk Of A U.S. Recession Chart 11U.S. Cyclical Picture Is Bright U.S. Cyclical Picture Is Bright U.S. Cyclical Picture Is Bright Where BCA's Geopolitical Strategy diverges from the BCA House View, however, is in terms of the global growth picture. While we recognize that there are no imminent risks of a global recession, we do believe that the policy trajectory in China is being obfuscated by positive global economic projections. To this risk we now turn. Is The Ghost Of Deng Xiaoping Haunting China? Our view that Chinese President Xi Jinping would reboot his reform agenda after the nineteenth National Party Congress this October is beginning to bear fruit. Investors are starting to realize that the policy tightening of 2017 was not a one-off event but a harbinger of what to expect in 2018. China's economic activity is slowing down and the policy outlook is getting less accommodative (Chart 12).11 To be clear, we never bought into the 2013 Third Plenum "reform" hype, which sought to resurrect the ghost of Deng Xiaoping and his decision to open China's economy at the Third Plenum in 1978.12 Nor will we buy into any similar hype around the upcoming Third Plenum in 2018. Instead, we focus on policymaker constraints. And it seems to us that the constraints to reform in China have fallen since 2013. The severity of China's financial and economic imbalances, the positive external economic backdrop, the desire to avoid confrontation with Trump, and the Xi administration's advantageous moment in the Chinese domestic political cycle, all suggest to us that Xi will be driven to accelerate his agenda in 2018. Broadly, this agenda consists of revitalizing the Communist Party regime at home and elevating China's national power and prestige abroad. More specifically it entails: Re-centralizing power after a perceived lack of leadership from roughly 2004-12; Improving governance, to rebuild the legitimacy and popular support of the single-party state, namely by fighting corruption; Restructuring the economy to phase out the existing growth model, which relies excessively on resource-intensive investment while suppressing private consumption (Chart 13). Chart 12China's Economic Prospects Are Dimming China's Economic Prospects Are Dimming China's Economic Prospects Are Dimming Chart 13Excess Investment Is A Real Problem Excess Investment Is A Real Problem Excess Investment Is A Real Problem The October party congress showed that this framework remains intact.13 First, Xi was elevated to Mao Zedong's status in the party constitution, which makes it much riskier for vested interests to flout his policies. Second, he declared the creation of a "National Supervision Commission," which will expand the anti-corruption campaign from the Communist Party to the administrative bureaucracy at all levels. Third, he recommitted to his economic agenda of improving the quality of economic growth at the expense of its pace and capital intensity. What does this mean for the economy in 2018? We expect government policy to become a headwind, after having been a tailwind in 2016-17. As Xi and the top-decision-making Politburo officially stated on December 9, the coming year will be a "crucial year" for advancing the most difficult aspects of the agenda: Financial risk: Financial regulation will continue to tighten, not only on banks and shadow lenders but also on the property sector, which Chinese officials claim will see a new "long-term regulatory mechanism" begin to be enacted (perhaps a nationwide property tax) (Chart 14). Local governments will face greater central discipline over bad investments, excessive debt, and corruption. The new leadership of the People's Bank of China, and of the just-created "Financial Stability and Development Commission," will attempt to establish their credibility in the face of banks that will be clamoring for less readily available liquidity.14 Green industrial restructuring: State-owned enterprises (SOEs) will continue to face stricter environmental regulations and cuts to overcapacity. This is in addition to tighter financial conditions, SOE restructuring initiatives, and an anti-corruption campaign that puts top managers under the microscope. SOEs that have not been identified as national champions, or otherwise as leading firms, will get squeezed.15 What are the market implications? First and foremost, the status quo in China is shifting, which is at least marginally negative for China's GDP growth, fixed investment, capital spending, import volumes, and resource-intensity. Real GDP should fall to around 6%, if not below, rather than today's 7%, while the Li Keqiang index should fall beneath the 2013-14 average rate of 7.3%. Second, a smooth and seamless conclusion of the 2016-17 upcycle cannot be assumed. The government's heightened effectiveness in economic policy will stem in part from an increase in political risk: the expansion of the anti-corruption campaign and Xi Jinping's personal power.16 The linking of anti-corruption probes with general policy enforcement means that any lack of compliance could result in top officials being ostracized, imprisoned, or even executed. Xi's measures will have sharper teeth than the market currently expects. Local economic actors (small banks, shadow lenders, local governments, provincial SOEs) will behave more cautiously. This will create negative growth surprises not currently being predicted by leading economic indicators (Chart 15). Chart 14Property Tightening##BR##Continues Property Tightening Continues Property Tightening Continues Chart 15Our Composite LKI Indicator Suggests##BR##A Benign Slowdown In Growth Our Composite LKI Indicator Suggests A Benign Slowdown In Growth Our Composite LKI Indicator Suggests A Benign Slowdown In Growth Chinese economic policy uncertainty, credit default swaps, and equity volatility should trend upward, as investors become accustomed to sectors disrupted by government scrutiny and a government with a higher tolerance for economic pain (Chart 16). How should investors play this scenario? Despite the volatility, we still expect Chinese equities, particularly H-shares, to outperform the EM benchmark, assuming the economy does not spiral out of control and cause a global rout. Reforms will improve China's long-term potential even as they weigh on EM exports, currencies, corporate profits and share prices. On a sectoral basis, BCA's China Investment Strategy has shown that China's health care, tech, and consumer staples sectors (and arguably energy) all outperformed China's other sectors in the wake of the party congress, as one would expect of a reinvigorated reform agenda (Chart 17). These sectors should continue to outperform. Going long the MSCI Environmental, Social, and Governance (ESG) Leaders index, relative to the broad market, is one way to bet on more sustainable growth.17 Chart 16Stability Continues##BR##After Party Congress? Stability Continues After Party Congress? Stability Continues After Party Congress? Chart 17China's Reforms Will Create##BR##Some Winners And Losers China's Reforms Will Create Some Winners And Losers China's Reforms Will Create Some Winners And Losers More broadly, investors should prefer DM over EM equities, since emerging markets (especially Latin America) will suffer from a slower-growing and less commodity-hungry China (Chart 18). Within the commodities complex, investors should expect crosswinds, with energy diverging upward from base metals that are weighed down by China.18 Chart 18Who Is Exposed To China? Three Questions For 2018 Three Questions For 2018 What are the risks to this view? How and when will we find out if we are wrong? Chart 19All Signs Pointing To Headwinds Ahead All Signs Pointing To Headwinds Ahead All Signs Pointing To Headwinds Ahead First, the best leading indicators of China's economy are indicators of money and credit, as BCA's Emerging Markets Strategy and China Investment Strategy have shown.19 The credit and broad money (M3) impulses have finally begun to tick back up after a deep dip, suggesting that in six-to-nine months the economy, which has only just begun to slow, will receive some necessary relief (Chart 19). The question is how much relief? Strong spikes in these impulses, or in the monetary conditions index or housing prices, would indicate that stimulus is still taking precedence over reform. Second, our checklist for a reform reboot, which we have maintained since April and is so far on track, offers some critical political signposts for H1 2018 (Table 2).20 For instance, if China is serious about deleveraging, then authorities will restrain bank lending at the beginning of the year. A sharp increase in credit growth in Q1 would greatly undermine our thesis (while likely encouraging exuberance globally).21 Also, in March, the National People's Congress (NPC), China's rubber-stamp parliament, will hold its annual meeting. NPC sessions can serve to launch new reform initiatives (as in 1998 and 2008) or new stimulus efforts (as in 2009 and 2016). This year's legislative session is more important than usual because it will formally launch Xi Jinping's second term. The event should provide more detail on at least a few concrete reform initiatives. If the only solid takeaways are short-term growth measures and more infrastructure investment, then the status quo will prevail. Table 2China Reform Checklist Three Questions For 2018 Three Questions For 2018 By the end of May, an assessment of the concrete NPC initiatives and the post-NPC economic data should indicate whether China's threshold for economic pain has truly gone up. If not, then any reforms that the Xi administration takes will have limited effect. It is important to note that our view does not hinge on China's refraining from stimulus altogether. We do not expect Beijing to self-impose a recession. Rather, we expect stimulus to be of a smaller magnitude than in 2015-16. We also expect the complexion of fiscal spending to continue to become less capital intensive as it is directed toward building a social safety net (Chart 20). Massive old-style stimulus should only return if the economy starts to collapse, or closer to the sensitive 2020-21 economic targets timed to coincide with the anniversary of the Communist Party.22 Chart 20China's Fiscal Spending Is Becoming Less Capital Intensive Three Questions For 2018 Three Questions For 2018 Bottom Line: The Xi administration has identified financial instability, environmental degradation, and poverty as persistent threats to the regime and is moving to address them. The consequences are, on the whole, likely to be negative for growth in the short term but positive in the long term. We expect China to see greater volatility but to benefit from better long-term prospects. Meanwhile China-exposed, commodity-reliant EMs will suffer negative side-effects. Will Geopolitical Risk Shift To The Middle East? The U.S. geopolitical "pivot to Asia" has been a central theme of our service since its launch in 2012.23 The decision to geopolitically deleverage from the Middle East and shift to Asia was undertaken by the Obama administration (Chart 21). Not because President Obama was a dove with no stomach to fight it out in the Middle East, but because the U.S. defense and intelligence establishment sees containing China as America's premier twenty-first century challenge. Chart 21U.S. Has Deleveraged From The Middle East U.S. Has Deleveraged From The Middle East U.S. Has Deleveraged From The Middle East The grand strategy of containing China has underpinned several crucial decisions by the U.S. since 2011. First, the U.S. has become a lot more aggressive about challenging China's military expansion in the South China Sea. Second, the U.S. has begun to reposition military hardware into East Asia. Third, Washington concluded a nuclear deal with Tehran in 2015 - referred to as the Joint Comprehensive Plan of Action (JCPA) - in order to extricate itself from the Middle East and focus on China.24 President Trump, however, while maintaining the pivot, has re-focused his rhetoric back on the Middle East. The decision to move the U.S. embassy to Jerusalem, while largely accepting a fait accompli, is an unorthodox move that suggests that this administration's threshold for accepting chaos in the Middle East is a lot lower. Our concern is that the Trump administration may set its sights on Iran next. President Trump appears to believe that the U.S. can contain China, coerce North Korea into nuclear negotiations, and reverse Iranian gains in the Middle East at the same time. In our view, he cannot. The U.S. military is stretched, public war weariness remains a political constraint, regional allies are weak, and without ground-troop commitments to the Middle East Trump is unlikely to change the balance of power against Iran. All that the abrogation of the JCPA would do is provoke Iran, which could lash out across the Middle East, particularly in Iraq where Tehran-supported Shia militias remain entrenched. Investors should carefully watch whether Trump approves another six-month waiver for the Iran Freedom and Counter-Proliferation Act (IFCA) of 2012. This act imposes sanctions against all entities - whether U.S., Iranian, or others - doing business with the country (Table 3). In essence, IFCA is the congressional act that imposed sanctions against Iran. The original 2015 nuclear deal did not abrogate IFCA. Instead, Obama simply waived its provisions every six months, as provided under the original act. Table 3U.S. Sanctions Have Global Reach Three Questions For 2018 Three Questions For 2018 BCA's Commodity & Energy Strategy remains overweight oil. As our energy strategists point out, the last two years have been remarkably benign regarding unplanned production outages. Iran, Libya, and Nigeria all returned production to near-full potential, adding over 1.5 million b/d of supply back to the world markets (Chart 22). This supply increase is unlikely to repeat itself in 2018, particularly as geopolitical risks are likely to return in Iraq, Libya, and Nigeria, and already have in Venezuela (Chart 23). Chart 22Unplanned Production Outages Are At The Lowest Level In Years Three Questions For 2018 Three Questions For 2018 Nigeria is on the map once again with the Niger Delta Avengers vowing to renew hostilities with the government. Nigeria's production has been recovering since pipeline saboteurs knocked it down to 1.4 million b/d in the period from May 2016 to June 2017, but rising tensions could threaten output anew. And Venezuela remains in a state of near-collapse.25 Iraq is key, and three risks loom large. First, as we have pointed out since early 2016, the destruction of the Islamic State is exposing fault lines between the Kurds - who have benefited the most from the vacuum created by the Islamic State's defeat - and their Arab neighbors.26 Second, remnants of the Islamic State may turn into saboteurs since their dream of controlling a Caliphate is dead. Third, investors need to watch renewed tensions between the U.S. and Iran. Shia-Sunni tensions could reignite if Tehran decides to retaliate against any re-imposition of economic sanctions by Washington. Not only could Tehran retaliate against Sunnis in Iraq, throwing the country into another civil war, but it could even go back to its favorite tactic from 2011: threatening to close the Straits of Hormuz. Another critical issue to consider is how the rest of the world would respond to the re-imposition of sanctions against Iran. Under IFCA, the Trump administration would be able to sanction any bank, shipping, or energy company that does business with the country, including companies belonging to European and Asian allies. If the administration pursued such policy, however, we would expect a major break between the U.S. and Europe. It took Obama four years of cajoling, threatening, and strategizing to convince Europe, China, India, Russia, and Asian allies to impose sanctions against Iran. For many economies this was a tough decision given reliance on Iran for energy supplies. A move by the U.S. to re-open the front against Iran, with no evidence that Tehran has failed to uphold the nuclear deal itself, would throw U.S. alliances into a flux. The implications of such a decision could therefore go beyond merely increasing the geopolitical risk premium. Chart 23Iraq, Libya, And Venezuela Are##BR##At Risk Of Production Disruptions In 2018 Iraq, Libya, And Venezuela Are At Risk Of Production Disruptions In 2018 Iraq, Libya, And Venezuela Are At Risk Of Production Disruptions In 2018 Chart 24Buy Energy,##BR##Short Metals Buy Energy, Short Metals Buy Energy, Short Metals Bottom Line: BCA's Commodity & Energy Strategy has set the average oil price forecast at $67 per barrel for 2018.27 We believe that the upside risk to this view is considerable. As a way to parlay our relatively bearish view on the Chinese economy with the bullish oil view of our commodity colleagues, we would recommend that our clients go long global energy stocks relative to metal and mining equities (Chart 24). 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 Special Report, "2018 Key Views, Part I: Five Black Swans," dated December 6, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 5 On June 14, James Hodkinson, a left-wing activist, attacked Republican members of Congress while practicing baseball for the annual Congressional Baseball Game for Charity. 6 A very sophisticated client in New York asked us whether we believed that National Guard units, who are staffed from the neighborhoods they would have to pacify in case of unrest, would remain loyal to the federal government in case of impeachment-related unrest. Our high-conviction view is that they would. First, the U.S. has a highly professionalized military with a strong history of robust civil-military relations. Second, if the Alabama National Guard remained loyal to President Kennedy in the 1963 University of Alabama integration protests - the so-called "Stand in the Schoolhouse Door" incident - then we certainly would expect "Red State" National Guard units to remain loyal to their chain-of-command in 2017. That said, the very fact that we do not consider the premise of the question to be ludicrous suggests that we are in a genuine paradigm shift. 7 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 8 The "Saturday Night Massacre," which escalated the crisis in the White House, occurred in October, the same month that OPEC launched an oil embargo and caused the oil shock. The U.S. economy was already sliding into recession, which technically began in November. 9 Please see BCA Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," dated June 16, 2017, available at gis.bcaresearch.com. 10 Please see BCA Global Investment Strategy Weekly Report, "When To Get Out," dated December 8, 2017, available at gis.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, and Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Monthly Report, "Reflections On China's Reforms," in "The Great Risk Rotation - December 2013," dated December 11, 2013, and Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Xi Jinping: Chairman Of Everything," dated October 25, 2017, available at gps.bcaresearch.com. 16 For instance, the decision to stack the country's chief bank regulator (the CBRC) with some of the country's toughest anti-corruption officials is significant and will bode ill not only for corrupt regulators but also for banks that have benefited from cozy relationships with them. This is not a neutral development with regard to bank lending. Please see BCA Geopolitical Strategy Weekly Report, "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017, available at gps.bcaresearch.com. 17 Please see BCA China Investment Strategy Weekly Report, "Messages From The Market, Post-Party Congress," dated November 16, 2017, available at cis.bcaresearch.com. 18 Note that these eco-reforms will reduce supply, which could offset - at least in part - the lower demand from within China. Please see BCA Commodity & Energy Strategy Weekly Report, "Shifting Gears In China: The Impact On Base Metals," dated November 9, 2017, available at ces.bcaresearch.com. The status of China's supply-side reforms suggests that steel, coking coal, and iron ore prices are most likely to decline from current levels; please see BCA Emerging Markets Strategy Special Report, "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017, available at ems.bcaresearch.com. 19 Please see BCA Emerging Markets Strategy Special Report, "Ms. Mea Challenges The EMS View," dated October 19, 2017, available at ems.bcaresearch.com, and China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle," dated November 30, 2017, available at cis.bcaresearch.com. 20 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 21 It is primarily credit excesses that a reform-oriented government would seek to rein in, while fiscal spending may have to increase to try to compensate for slower credit growth. 22 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, and "Brewing Tensions In The South China Sea: Implications," dated June 13, 2012, available at gps.bcaresearch.com. 24 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 25 Please see BCA Geopolitical Strategy and Energy Sector Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 26 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 27 Please see BCA Commodity & Energy Strategy, "Key Themes For Energy Markets In 2018," dated December 7, 2017, available at ces.bcaresearch.com.

Highlights Investors should expect little policy initiative out of the U.S. Congress after tax cuts; Polarization is likely to rise substantively in 2018, gridlocking Congress; Chinese policymakers are experimenting with growth-constraining reforms; Global growth has peaked; underweight emerging markets in 2018; Go long energy stocks relative to metal and mining equities. Feature Last week we published Part I of our 2018 Key Views.1 In it, we presented our five "Black Swans" for 2018: Lame Duck Trump: President Trump realizes his time in the White House is going to be short and seeks relevance abroad. He finds it in jingoism towards Iran - throwing the Middle East into chaos - and protectionism against China. A Coup In North Korea: Chinese economic pressure overshoots its mark and throws Pyongyang into a crisis. Kim Jong-un is replaced, but markets struggle to ascertain whether the successor is a moderate or a hawk. Prime Minister Jeremy Corbyn: Markets cheer the higher probability of "Bremain" and then remember that Corbyn is a genuine socialist. Italian Election Troubles: Markets are fully pricing in the sanguine scenario of "much ado about nothing," which is our view as well. But is there really anything to cheer in Italy? If not, then why is the Italian market the best performing in all of DM? Bloodbath In Latin America: Emerging markets stall next year as Chinese policymakers tighten financial regulations. As the tide pulls back, Mexico and Brazil are caught swimming naked. These are not our core views. As black swans, they are low-probability events that may disturb markets in 2018. Our core view remains that geopolitical risks were overstated in 2017 and will be understated in 2018 (Charts 1 & 2). Most importantly, U.S. politics will be a tailwind to global growth while Chinese politics will be a headwind to global growth. While the overall effect may be neutral, the combination will be bullish for the U.S. dollar and bearish for emerging markets.2 Chart 12018 Will See Risks Dominate... 2018 Will See Risks Dominate... 2018 Will See Risks Dominate... Chart 2...As Global Growth Concerns Reemerge ...As Global Growth Concerns Reemerge ...As Global Growth Concerns Reemerge This week, we turn to the three questions that we believe will define the year for investors: Is A Civil War Coming To America? Is The Ghost Of Deng Xiaoping Haunting China? Will Geopolitical Risk Shift To The Middle East? Is A Civil War Coming To America? On a recent visit to Boston and New York we were caught off guard by how alarmed several large institutional clients were about the risk of severe social unrest in the U.S. We share this concern about the level of polarization in the U.S. and expect social instability to rise over the coming years (Chart 3).3 When roughly 40% of both Democrats and Republicans believe that their political competitors pose a "threat to the nation's well-being," we have entered a new paradigm (Chart 4). Chart 3Inequality Fuels Political Polarization Inequality Fuels Political Polarization Inequality Fuels Political Polarization Chart 4"A Threat To The Nation's Well-Being?" Really?! Three Questions For 2018 Three Questions For 2018 Where we differ from some of our clients is in assessing the likely trigger for the unrest and its investment implications over the next 12 months. If the Democrats take the House of Representatives in the November 6 midterm election, as is our low-conviction view at this early point, then we would expect them eventually to impeach President Trump in 2019.4 Even then, it is not clear that the Senate would have the necessary 67 votes to convict Trump of the articles of impeachment (whatever they prove to be) and hence remove him from power. Republicans are likely to increase their majority in the Senate, even if they lose the House, because more Democratic senators are up for re-election in 2018. Therefore well over a dozen Republican senators would have to vote to remove a Republican president from power. For that to happen, Trump's popularity with Republican voters would have to go into a free fall, diving well below 60% (Chart 5). Meanwhile, we do not buy the argument that hordes of gun-wielding "deplorables" would descend upon the liberal coasts in case of impeachment. There may well be significant acts of domestic terrorism, particularly in the wake of any removal of Trump from office, but they would likely be isolated and unable to galvanize broader support. Our clients should remember, however, that ultra-right-wing militant groups are not the only perpetrators of domestic terrorism.5 Any acts of violence or social unrest are likely to draw press coverage and analytical hyperbole. But our left-leaning clients in the Northeast are likely overstating the sincerity of support for President Trump. President Trump won 44.9% of the Republican primary votes, but he averaged only 35% of the vote in the early days when the races were the most competitive. Given that only 25% of Americans identify as Republicans (Chart 6), it is fair to say that only about a third of that figure - 8%-10% of all U.S. voters - are Trump loyalists. Many conservative voters simply wanted change and were willing to give an outsider a chance (much as their liberal counterparts did in 2008!). Of that small percentage of genuine Trump fans, it is highly unlikely that a large share would seriously contemplate taking arms against the state in order to keep their leader in power against the constitutional impeachment process. Especially given that President Trump would be replaced by a genuine conservative, Vice President Mike Pence.6 Chart 5We Are A Long Way Away##BR##From Trump's Demise Three Questions For 2018 Three Questions For 2018 Chart 6Party Identifications##BR##Are Shrinking Party Identifications Are Shrinking Party Identifications Are Shrinking As such, we believe that it is premature to speak of a total breakdown of social order in America. It is notable that such a conversation is taking place, but other forms of polarization and social unrest are far more likely to be relevant at the moment. In terms of policy, we would expect gridlock in Congress if Democrats take the House and begin focusing on impeachment. In fact, gridlock may already be upon us, as we see little agreement between the Trump administration, its loyalists in Congress, and establishment Republican Senators like Dan Sullivan (R, Alaska), Cory Gardner (R, Colorado), Joni Ernst (R, Iowa), Susan Collins (R, Maine), Ben Sasse (R, Nebraska), and Thom Tillis (R, North Carolina). These six Senators are all facing reelection in 2020 and are likely to evolve into Democrats-in-all-but-name. If President Trump's overall popularity continues to decline, we would not be surprised if one or two (starting with Collins) even take the dramatic step of leaving the Republican Party for the 2020 election. Essentially, establishment Republicans will become effective Democrats ahead of the midterms. Post-midterm election, with Democrats potentially taking over the House, the legislative process will grind to a complete halt. Government shutdowns, debt ceiling fights, failure of proactive policymaking to deal with crises and natural disasters, will all rise in probability. As President Trump faces greater constraints in Congress, we can see him becoming increasingly reliant on his executive authority to create policy. He would not be unique in this way, as President Obama did the same. While Trump's executive policy will be pro-business, unlike Obama's, uncertainty will rise regardless. The business community will not be able to take White House policies seriously amidst impeachment and a potential Democratic wave-election in 2020. Whatever executive orders Trump signs into power over the next three years, chances are that they will be immediately reversed in 2020. What about the markets? The Mueller investigation and heightened level of polarization could create drawdowns in equity markets throughout the year. However, impeachment proceedings are not likely to begin in 2018 and have never carried more weight with investors than market fundamentals (Chart 7).7 True, the Watergate scandal under President Richard Nixon triggered a spike in volatility and a fall in equities. However, the scandal alone did not cause the correction, rather it was a combination of factors, including the second devaluation of the dollar, rapid increases in price inflation, massive insurance fraud, recession, and a global oil shock.8 Chart 7AFundamentals, Not Impeachment,##BR##Drive Markets Fundamentals, Not Impeachment, Drive Markets Fundamentals, Not Impeachment, Drive Markets Chart 7BFundamentals, Not Impeachment,##BR##Drive Markets Fundamentals, Not Impeachment, Drive Markets Fundamentals, Not Impeachment, Drive Markets What about the impact on the U.S. dollar? Does Trump-related political instability threaten the dollar's status as the chief global reserve currency and a major financial safe haven? The data suggest not. We put together a list of events in 2017 that could be categorized as "unorthodox, Trump-related, political risk" (Table 1). We specifically left out geopolitical events, such as the North Korean nuclear crisis, so as not to dilute our dataset's focus on domestic intrigue. As Chart 8 illustrates, the U.S. dollar rose slightly, on average, a week after each event relative to its average weekly return prior to the crisis. While this may not be a resounding vote of confidence for the greenback (gold performed better), there is no evidence that investors are betting on a paradigm shift away from the dollar as the global reserve currency. Table 1An Eventful Year 1 Of Trump Presidency Three Questions For 2018 Three Questions For 2018 Chart 8Trump Is Not A U.S. Dollar Paradigm Shift Three Questions For 2018 Three Questions For 2018 If investors should not worry about investment-relevant social strife in the U.S. in 2018, then when should they worry? Well, if Trump is actually removed from office, a first in U.S. history, at a time of extreme polarization, and in a country with easy access to arms and at least a strain of domestic terrorism, then 2019-20 will at least be a time for concern. Even without Trump's removal, we worry about unrest beyond 2018. We expect the ideological pendulum to shift to the left by the 2020 election. If our sister service - BCA's Global Investment Strategy - is correct, then a recession is likely to begin in late 2019.9 A combination of low popularity, market turbulence, and economic recession would doom Trump's chances of returning to the White House. But they would also be toxic for the candidacy of a moderate Democrat and would possibly propel a left-wing candidate to the presidency. Four years under a left-wing, socially progressive firebrand may be too much for many far-right voters to tolerate. Given America's demographic trends (Chart 9), these voters will realize that the writing is on the wall, that the window of opportunity to lock in their preferred policies has been firmly shut. The international context teaches us that disenchanted groups contemplate "exit" when the strategy of "voice" no longer works. How this will look in the U.S. is unclear at this point. Bottom Line: Investors should continue to fade impeachment-related, and Mueller investigation-related, pullbacks in the markets or the U.S. dollar in 2018. Our fears of U.S. social instability are mostly for the medium and long term. Fundamentals drive the markets and U.S. fundamentals remain solid for now. As our colleague Peter Berezin has pointed out, there is no imminent risk of a U.S. recession (Chart 10) and the cyclical picture remains bright (Chart 11).10 Chart 9A Changing America A Changing America A Changing America Chart 10No Imminent Risk Of A U.S. Recession No Imminent Risk Of A U.S. Recession No Imminent Risk Of A U.S. Recession Chart 11U.S. Cyclical Picture Is Bright U.S. Cyclical Picture Is Bright U.S. Cyclical Picture Is Bright Where BCA's Geopolitical Strategy diverges from the BCA House View, however, is in terms of the global growth picture. While we recognize that there are no imminent risks of a global recession, we do believe that the policy trajectory in China is being obfuscated by positive global economic projections. To this risk we now turn. Is The Ghost Of Deng Xiaoping Haunting China? Our view that Chinese President Xi Jinping would reboot his reform agenda after the nineteenth National Party Congress this October is beginning to bear fruit. Investors are starting to realize that the policy tightening of 2017 was not a one-off event but a harbinger of what to expect in 2018. China's economic activity is slowing down and the policy outlook is getting less accommodative (Chart 12).11 To be clear, we never bought into the 2013 Third Plenum "reform" hype, which sought to resurrect the ghost of Deng Xiaoping and his decision to open China's economy at the Third Plenum in 1978.12 Nor will we buy into any similar hype around the upcoming Third Plenum in 2018. Instead, we focus on policymaker constraints. And it seems to us that the constraints to reform in China have fallen since 2013. The severity of China's financial and economic imbalances, the positive external economic backdrop, the desire to avoid confrontation with Trump, and the Xi administration's advantageous moment in the Chinese domestic political cycle, all suggest to us that Xi will be driven to accelerate his agenda in 2018. Broadly, this agenda consists of revitalizing the Communist Party regime at home and elevating China's national power and prestige abroad. More specifically it entails: Re-centralizing power after a perceived lack of leadership from roughly 2004-12; Improving governance, to rebuild the legitimacy and popular support of the single-party state, namely by fighting corruption; Restructuring the economy to phase out the existing growth model, which relies excessively on resource-intensive investment while suppressing private consumption (Chart 13). Chart 12China's Economic Prospects Are Dimming China's Economic Prospects Are Dimming China's Economic Prospects Are Dimming Chart 13Excess Investment Is A Real Problem Excess Investment Is A Real Problem Excess Investment Is A Real Problem The October party congress showed that this framework remains intact.13 First, Xi was elevated to Mao Zedong's status in the party constitution, which makes it much riskier for vested interests to flout his policies. Second, he declared the creation of a "National Supervision Commission," which will expand the anti-corruption campaign from the Communist Party to the administrative bureaucracy at all levels. Third, he recommitted to his economic agenda of improving the quality of economic growth at the expense of its pace and capital intensity. What does this mean for the economy in 2018? We expect government policy to become a headwind, after having been a tailwind in 2016-17. As Xi and the top-decision-making Politburo officially stated on December 9, the coming year will be a "crucial year" for advancing the most difficult aspects of the agenda: Financial risk: Financial regulation will continue to tighten, not only on banks and shadow lenders but also on the property sector, which Chinese officials claim will see a new "long-term regulatory mechanism" begin to be enacted (perhaps a nationwide property tax) (Chart 14). Local governments will face greater central discipline over bad investments, excessive debt, and corruption. The new leadership of the People's Bank of China, and of the just-created "Financial Stability and Development Commission," will attempt to establish their credibility in the face of banks that will be clamoring for less readily available liquidity.14 Green industrial restructuring: State-owned enterprises (SOEs) will continue to face stricter environmental regulations and cuts to overcapacity. This is in addition to tighter financial conditions, SOE restructuring initiatives, and an anti-corruption campaign that puts top managers under the microscope. SOEs that have not been identified as national champions, or otherwise as leading firms, will get squeezed.15 What are the market implications? First and foremost, the status quo in China is shifting, which is at least marginally negative for China's GDP growth, fixed investment, capital spending, import volumes, and resource-intensity. Real GDP should fall to around 6%, if not below, rather than today's 7%, while the Li Keqiang index should fall beneath the 2013-14 average rate of 7.3%. Second, a smooth and seamless conclusion of the 2016-17 upcycle cannot be assumed. The government's heightened effectiveness in economic policy will stem in part from an increase in political risk: the expansion of the anti-corruption campaign and Xi Jinping's personal power.16 The linking of anti-corruption probes with general policy enforcement means that any lack of compliance could result in top officials being ostracized, imprisoned, or even executed. Xi's measures will have sharper teeth than the market currently expects. Local economic actors (small banks, shadow lenders, local governments, provincial SOEs) will behave more cautiously. This will create negative growth surprises not currently being predicted by leading economic indicators (Chart 15). Chart 14Property Tightening##BR##Continues Property Tightening Continues Property Tightening Continues Chart 15Our Composite LKI Indicator Suggests##BR##A Benign Slowdown In Growth Our Composite LKI Indicator Suggests A Benign Slowdown In Growth Our Composite LKI Indicator Suggests A Benign Slowdown In Growth Chinese economic policy uncertainty, credit default swaps, and equity volatility should trend upward, as investors become accustomed to sectors disrupted by government scrutiny and a government with a higher tolerance for economic pain (Chart 16). How should investors play this scenario? Despite the volatility, we still expect Chinese equities, particularly H-shares, to outperform the EM benchmark, assuming the economy does not spiral out of control and cause a global rout. Reforms will improve China's long-term potential even as they weigh on EM exports, currencies, corporate profits and share prices. On a sectoral basis, BCA's China Investment Strategy has shown that China's health care, tech, and consumer staples sectors (and arguably energy) all outperformed China's other sectors in the wake of the party congress, as one would expect of a reinvigorated reform agenda (Chart 17). These sectors should continue to outperform. Going long the MSCI Environmental, Social, and Governance (ESG) Leaders index, relative to the broad market, is one way to bet on more sustainable growth.17 Chart 16Stability Continues##BR##After Party Congress? Stability Continues After Party Congress? Stability Continues After Party Congress? Chart 17China's Reforms Will Create##BR##Some Winners And Losers China's Reforms Will Create Some Winners And Losers China's Reforms Will Create Some Winners And Losers More broadly, investors should prefer DM over EM equities, since emerging markets (especially Latin America) will suffer from a slower-growing and less commodity-hungry China (Chart 18). Within the commodities complex, investors should expect crosswinds, with energy diverging upward from base metals that are weighed down by China.18 Chart 18Who Is Exposed To China? Three Questions For 2018 Three Questions For 2018 What are the risks to this view? How and when will we find out if we are wrong? Chart 19All Signs Pointing To Headwinds Ahead All Signs Pointing To Headwinds Ahead All Signs Pointing To Headwinds Ahead First, the best leading indicators of China's economy are indicators of money and credit, as BCA's Emerging Markets Strategy and China Investment Strategy have shown.19 The credit and broad money (M3) impulses have finally begun to tick back up after a deep dip, suggesting that in six-to-nine months the economy, which has only just begun to slow, will receive some necessary relief (Chart 19). The question is how much relief? Strong spikes in these impulses, or in the monetary conditions index or housing prices, would indicate that stimulus is still taking precedence over reform. Second, our checklist for a reform reboot, which we have maintained since April and is so far on track, offers some critical political signposts for H1 2018 (Table 2).20 For instance, if China is serious about deleveraging, then authorities will restrain bank lending at the beginning of the year. A sharp increase in credit growth in Q1 would greatly undermine our thesis (while likely encouraging exuberance globally).21 Also, in March, the National People's Congress (NPC), China's rubber-stamp parliament, will hold its annual meeting. NPC sessions can serve to launch new reform initiatives (as in 1998 and 2008) or new stimulus efforts (as in 2009 and 2016). This year's legislative session is more important than usual because it will formally launch Xi Jinping's second term. The event should provide more detail on at least a few concrete reform initiatives. If the only solid takeaways are short-term growth measures and more infrastructure investment, then the status quo will prevail. Table 2China Reform Checklist Three Questions For 2018 Three Questions For 2018 By the end of May, an assessment of the concrete NPC initiatives and the post-NPC economic data should indicate whether China's threshold for economic pain has truly gone up. If not, then any reforms that the Xi administration takes will have limited effect. It is important to note that our view does not hinge on China's refraining from stimulus altogether. We do not expect Beijing to self-impose a recession. Rather, we expect stimulus to be of a smaller magnitude than in 2015-16. We also expect the complexion of fiscal spending to continue to become less capital intensive as it is directed toward building a social safety net (Chart 20). Massive old-style stimulus should only return if the economy starts to collapse, or closer to the sensitive 2020-21 economic targets timed to coincide with the anniversary of the Communist Party.22 Chart 20China's Fiscal Spending Is Becoming Less Capital Intensive Three Questions For 2018 Three Questions For 2018 Bottom Line: The Xi administration has identified financial instability, environmental degradation, and poverty as persistent threats to the regime and is moving to address them. The consequences are, on the whole, likely to be negative for growth in the short term but positive in the long term. We expect China to see greater volatility but to benefit from better long-term prospects. Meanwhile China-exposed, commodity-reliant EMs will suffer negative side-effects. Will Geopolitical Risk Shift To The Middle East? The U.S. geopolitical "pivot to Asia" has been a central theme of our service since its launch in 2012.23 The decision to geopolitically deleverage from the Middle East and shift to Asia was undertaken by the Obama administration (Chart 21). Not because President Obama was a dove with no stomach to fight it out in the Middle East, but because the U.S. defense and intelligence establishment sees containing China as America's premier twenty-first century challenge. Chart 21U.S. Has Deleveraged From The Middle East U.S. Has Deleveraged From The Middle East U.S. Has Deleveraged From The Middle East The grand strategy of containing China has underpinned several crucial decisions by the U.S. since 2011. First, the U.S. has become a lot more aggressive about challenging China's military expansion in the South China Sea. Second, the U.S. has begun to reposition military hardware into East Asia. Third, Washington concluded a nuclear deal with Tehran in 2015 - referred to as the Joint Comprehensive Plan of Action (JCPA) - in order to extricate itself from the Middle East and focus on China.24 President Trump, however, while maintaining the pivot, has re-focused his rhetoric back on the Middle East. The decision to move the U.S. embassy to Jerusalem, while largely accepting a fait accompli, is an unorthodox move that suggests that this administration's threshold for accepting chaos in the Middle East is a lot lower. Our concern is that the Trump administration may set its sights on Iran next. President Trump appears to believe that the U.S. can contain China, coerce North Korea into nuclear negotiations, and reverse Iranian gains in the Middle East at the same time. In our view, he cannot. The U.S. military is stretched, public war weariness remains a political constraint, regional allies are weak, and without ground-troop commitments to the Middle East Trump is unlikely to change the balance of power against Iran. All that the abrogation of the JCPA would do is provoke Iran, which could lash out across the Middle East, particularly in Iraq where Tehran-supported Shia militias remain entrenched. Investors should carefully watch whether Trump approves another six-month waiver for the Iran Freedom and Counter-Proliferation Act (IFCA) of 2012. This act imposes sanctions against all entities - whether U.S., Iranian, or others - doing business with the country (Table 3). In essence, IFCA is the congressional act that imposed sanctions against Iran. The original 2015 nuclear deal did not abrogate IFCA. Instead, Obama simply waived its provisions every six months, as provided under the original act. Table 3U.S. Sanctions Have Global Reach Three Questions For 2018 Three Questions For 2018 BCA's Commodity & Energy Strategy remains overweight oil. As our energy strategists point out, the last two years have been remarkably benign regarding unplanned production outages. Iran, Libya, and Nigeria all returned production to near-full potential, adding over 1.5 million b/d of supply back to the world markets (Chart 22). This supply increase is unlikely to repeat itself in 2018, particularly as geopolitical risks are likely to return in Iraq, Libya, and Nigeria, and already have in Venezuela (Chart 23). Chart 22Unplanned Production Outages Are At The Lowest Level In Years Three Questions For 2018 Three Questions For 2018 Nigeria is on the map once again with the Niger Delta Avengers vowing to renew hostilities with the government. Nigeria's production has been recovering since pipeline saboteurs knocked it down to 1.4 million b/d in the period from May 2016 to June 2017, but rising tensions could threaten output anew. And Venezuela remains in a state of near-collapse.25 Iraq is key, and three risks loom large. First, as we have pointed out since early 2016, the destruction of the Islamic State is exposing fault lines between the Kurds - who have benefited the most from the vacuum created by the Islamic State's defeat - and their Arab neighbors.26 Second, remnants of the Islamic State may turn into saboteurs since their dream of controlling a Caliphate is dead. Third, investors need to watch renewed tensions between the U.S. and Iran. Shia-Sunni tensions could reignite if Tehran decides to retaliate against any re-imposition of economic sanctions by Washington. Not only could Tehran retaliate against Sunnis in Iraq, throwing the country into another civil war, but it could even go back to its favorite tactic from 2011: threatening to close the Straits of Hormuz. Another critical issue to consider is how the rest of the world would respond to the re-imposition of sanctions against Iran. Under IFCA, the Trump administration would be able to sanction any bank, shipping, or energy company that does business with the country, including companies belonging to European and Asian allies. If the administration pursued such policy, however, we would expect a major break between the U.S. and Europe. It took Obama four years of cajoling, threatening, and strategizing to convince Europe, China, India, Russia, and Asian allies to impose sanctions against Iran. For many economies this was a tough decision given reliance on Iran for energy supplies. A move by the U.S. to re-open the front against Iran, with no evidence that Tehran has failed to uphold the nuclear deal itself, would throw U.S. alliances into a flux. The implications of such a decision could therefore go beyond merely increasing the geopolitical risk premium. Chart 23Iraq, Libya, And Venezuela Are##BR##At Risk Of Production Disruptions In 2018 Iraq, Libya, And Venezuela Are At Risk Of Production Disruptions In 2018 Iraq, Libya, And Venezuela Are At Risk Of Production Disruptions In 2018 Chart 24Buy Energy,##BR##Short Metals Buy Energy, Short Metals Buy Energy, Short Metals Bottom Line: BCA's Commodity & Energy Strategy has set the average oil price forecast at $67 per barrel for 2018.27 We believe that the upside risk to this view is considerable. As a way to parlay our relatively bearish view on the Chinese economy with the bullish oil view of our commodity colleagues, we would recommend that our clients go long global energy stocks relative to metal and mining equities (Chart 24). 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 Special Report, "2018 Key Views, Part I: Five Black Swans," dated December 6, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 5 On June 14, James Hodkinson, a left-wing activist, attacked Republican members of Congress while practicing baseball for the annual Congressional Baseball Game for Charity. 6 A very sophisticated client in New York asked us whether we believed that National Guard units, who are staffed from the neighborhoods they would have to pacify in case of unrest, would remain loyal to the federal government in case of impeachment-related unrest. Our high-conviction view is that they would. First, the U.S. has a highly professionalized military with a strong history of robust civil-military relations. Second, if the Alabama National Guard remained loyal to President Kennedy in the 1963 University of Alabama integration protests - the so-called "Stand in the Schoolhouse Door" incident - then we certainly would expect "Red State" National Guard units to remain loyal to their chain-of-command in 2017. That said, the very fact that we do not consider the premise of the question to be ludicrous suggests that we are in a genuine paradigm shift. 7 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 8 The "Saturday Night Massacre," which escalated the crisis in the White House, occurred in October, the same month that OPEC launched an oil embargo and caused the oil shock. The U.S. economy was already sliding into recession, which technically began in November. 9 Please see BCA Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," dated June 16, 2017, available at gis.bcaresearch.com. 10 Please see BCA Global Investment Strategy Weekly Report, "When To Get Out," dated December 8, 2017, available at gis.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, and Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Monthly Report, "Reflections On China's Reforms," in "The Great Risk Rotation - December 2013," dated December 11, 2013, and Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Xi Jinping: Chairman Of Everything," dated October 25, 2017, available at gps.bcaresearch.com. 16 For instance, the decision to stack the country's chief bank regulator (the CBRC) with some of the country's toughest anti-corruption officials is significant and will bode ill not only for corrupt regulators but also for banks that have benefited from cozy relationships with them. This is not a neutral development with regard to bank lending. Please see BCA Geopolitical Strategy Weekly Report, "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017, available at gps.bcaresearch.com. 17 Please see BCA China Investment Strategy Weekly Report, "Messages From The Market, Post-Party Congress," dated November 16, 2017, available at cis.bcaresearch.com. 18 Note that these eco-reforms will reduce supply, which could offset - at least in part - the lower demand from within China. Please see BCA Commodity & Energy Strategy Weekly Report, "Shifting Gears In China: The Impact On Base Metals," dated November 9, 2017, available at ces.bcaresearch.com. The status of China's supply-side reforms suggests that steel, coking coal, and iron ore prices are most likely to decline from current levels; please see BCA Emerging Markets Strategy Special Report, "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017, available at ems.bcaresearch.com. 19 Please see BCA Emerging Markets Strategy Special Report, "Ms. Mea Challenges The EMS View," dated October 19, 2017, available at ems.bcaresearch.com, and China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle," dated November 30, 2017, available at cis.bcaresearch.com. 20 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 21 It is primarily credit excesses that a reform-oriented government would seek to rein in, while fiscal spending may have to increase to try to compensate for slower credit growth. 22 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, and "Brewing Tensions In The South China Sea: Implications," dated June 13, 2012, available at gps.bcaresearch.com. 24 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 25 Please see BCA Geopolitical Strategy and Energy Sector Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 26 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 27 Please see BCA Commodity & Energy Strategy, "Key Themes For Energy Markets In 2018," dated December 7, 2017, available at ces.bcaresearch.com.

Highlights The growth momentum of China's recent mini-cycle has peaked, but the ongoing slowdown is likely to continue to remain benign in nature. A return to 2015-like conditions is not the most likely outcome over the coming year. Chinese policymakers are likely to increase their focus on reform efforts next year, but the pace will have to be modulated to avoid a repeat of the significant slowdown that occurred in 2014/2015. The risk of a policy mistake is a key theme to watch for 2018. Chinese ex-tech stocks have room to re-rate next year in a benign slowdown scenario. Investors should stay overweight Chinese investable equities vs EM and global stocks. Feature BCA recently published its special year end Outlook report for 2018,1 which described the macro themes that are likely to drive global financial markets over the coming year. In this week's China Investment Strategy report we expand on the Outlook, by reviewing our three key themes for China over the coming year. Key Theme # 1: A Benign End To China's Recent Mini-Cycle We presented our case that the cyclical slowdown of the Chinese economy will likely be benign in our October 12 Weekly Report. Chart 1 presents a stylized view of the Chinese economy over the past three years that was published in that report, which illustrated our framework of how cyclical growth conditions have evolved over this "mini-cycle". It also highlighted three possible scenarios for the coming 6-12 months, and noted that our bet was on scenario 2: A re-acceleration of the economy and a continuation of the V-shaped rebound profile A benign, controlled deceleration and settling of growth into the "stable" growth range, and An uncontrolled and sharp deceleration in the economy that threatens a return to the conditions that prevailed in early-2015 (or worse) Chart 1A Stylized View Of China's Recent "Mini-Cycle" Three Themes For China In The Coming Year Three Themes For China In The Coming Year Since we presented this framework, incoming evidence has been consistent with our call. Chart 2 shows that the Li Keqiang index has now decisively rolled over, but that economic conditions remain well away from their mid-2015 lows. We sketched out the basis for our benign slowdown view in our October 12 piece, but we followed up more formally in a two-part report that addressed the main factors arguing against a return to 2015-like conditions.2 Our view is grounded in the perspective that economic conditions in 2015 were not "normal", and we showed in these reports how a sharp slowdown in the economy was caused by an extremely weak external demand environment and overly tight monetary policy. On the trade front, Chart 3 highlights how Chinese export growth is likely to moderate over the coming several months, which argues against the re-acceleration scenario described above. Since mid-2011, Chinese export growth has lagged what most economic indicators would have predicted, and we noted in part I of our 2015 vs today comparison that this can be traced largely to two factors: a decline in global import intensity and, to a lesser extent, a decline in China's export "market share". Chart 2An Economic Slowdown In China##br## Is Now Underway An Economic Slowdown In China Is Now Underway An Economic Slowdown In China Is Now Underway Chart 3Chinese Export Growth Likely To##br## Converge To Global IP Growth Chinese Export Growth Likely To Converge To Global IP Growth Chinese Export Growth Likely To Converge To Global IP Growth Our analysis in that report suggested that China's 2018 export growth will converge to that of global industrial production, which implies a modest deceleration in the months ahead. Still, export growth of +4% would be a far cry from the significant contraction of exports that occurred in late-2015 / early-2016, which is consistent with a benign growth slowdown. On the monetary policy front, we showed how a monetary conditions approach captured the tightness of China's policy stance from 2012 to early-2015, which led to a material decline in China's industrial sector (Chart 4). Our Special Report last week further supported the view that monetary conditions matter enormously for China's economy; out of 40 macro data series that we tested to reliably predict the Chinese business cycle, only measures of money & credit passed our criteria.3 An aggregate indicator of these 6 series has a similar profile to the Bloomberg Monetary Conditions Index that we have shown in the past (Chart 4, panel 2), and neither suggests that a sharp further slowdown in China's economy is imminent. We will be watching these indicators closely in 2018 for signs of a more aggressive decline than we currently expect. Recently, some investors have pointed to a sharp rise in China's corporate bond yields as a sign that the monetary policy stance is, in fact, tighter than a standard monetary conditions approach would imply. Indeed, China's 5-year AA corporate bond yield has risen 230 bps since late-October 2016, from 3.6% to 5.9%, with most of this rise having occurred due to a rise in government bond yields. Corporate bond spreads have also risen, but relative to spreads on similarly-rated U.S. credit, the rise appears to reflect a rebound from extremely low levels late last year and is not (yet) symptomatic of major concerns over defaults (Chart 5). Chart 4The Ongoing Slowdown Is Likely ##br##To Be Benign The Ongoing Slowdown Is Likely To Be Benign The Ongoing Slowdown Is Likely To Be Benign Chart 5China's Corporate Bond Spreads ##br##Do Not Yet Look Onerous China's Corporate Bond Spreads Do Not Yet Look Onerous China's Corporate Bond Spreads Do Not Yet Look Onerous We are not complacent of the potential risk posed by rising corporate bond yields, and a further significant rise in 2018 could change our view that a benign economic slowdown is the most likely outcome. But for now, the fact that the stock of corporate bond issuance accounts for only 10% of ex-equity social financing suggests that the rise in yields this year is not likely to have an outsized impact on the economy in 2018, beyond the impact that monetary tightening has had on overall average interest rates (which, for now, is material but has not returned rates back to their 2015 levels). Chart 6The Rise In CPI Will Likely Soon Peak The Rise In CPI Will Likely Soon Peak The Rise In CPI Will Likely Soon Peak Finally, the 85 bps rise in Chinese core consumer price inflation that has occurred over the past year has also fed investor concerns that monetary policy will become even tighter next year. To us, this risk is probably overblown, given that demand-driven inflation lags growth (which has clearly peaked). Chart 6 shows the year-over-year change in Chinese core CPI vs that of the Li Keqiang index, and clearly suggests that the acceleration in core prices is likely to soon abate. Poor communication from the PBOC means that it is not clear how prominently core inflation features into the central bank's reaction function, but given that tighter monetary conditions have already caused a peak in both house prices and growth momentum, we doubt that policymakers will see the recent rise in consumer prices as a basis to aggressively tighten further. Bottom Line: The growth momentum of China's recent mini-cycle has peaked, but a return to 2015-like conditions is not the most likely outcome over the coming year. Key Theme # 2: Monitoring The Pace Of Renewed Structural Reforms We have written several reports concerning China's 19th Communist Party Congress over the past three months, both in the lead-up to the event and as a post-mortem.4 The Congress was significant because it likely heralds stepped-up reform efforts in 2018 and beyond. By "reforms", our Geopolitical Strategy team specifically means deleveraging in the financial sector accompanied by a more intense anti-corruption campaign focused on the shadow-banking sector, as well as ongoing restructuring in the industrial sector. Table 1 presents our geopolitical team's assessment of the likely reform scenarios and probabilities over the coming year. It should be clearly noted that the "reform reboot" scenario as described in Table 1 is likely negative for emerging market equities and other plays on China's industrial sector (such as industrial metals). Table 1Post-Party Congress Scenarios And Probabilities Three Themes For China In The Coming Year Three Themes For China In The Coming Year We agree that the "status quo" scenario of no significant reforms is highly unlikely given that President Xi has succeeded in amassing tremendous political capital and that he has an agenda for reform. But the intensity of reforms pursued over the coming year will have to be closely monitored by policymakers, to avoid a repeat of the significant slowdown that occurred in 2014/2015. As such, the view of BCA's China Investment Strategy service is that the reform efforts over the coming year will be structured at a pace that is sufficient to avoid a meaningful deceleration in China's industrial sector and is conducive to the outperformance of Chinese ex-technology stocks. However, the potential for a brisk pace of reforms to cause a more acute decline in industrial activity in 2018 is a risk to our view that China's ongoing economic slowdown is likely to be benign and controlled. We presented our framework for monitoring this risk in our November 16 Weekly Report,5 specifically our BCA China Reform Monitor (Chart 7). The monitor is calculated as an equally-weighted average of four "winner" sectors that outperformed the investable benchmark in the month following the Party Congress relative to an equally-weighted average of the remaining seven sectors. Significant underperformance of "loser" sectors could become a headwind for broad MSCI China outperformance (especially ex-tech), and we will be watching in 2018 for signs that our monitor is rising largely due to outright declines in the denominator. Chart 7Our Reform Monitor Will Help Us Judge ##br##Whether The Pace Of Reforms Becomes Too Burdensome Our Reform Monitor Will Help Us Judge Whether The Pace Of Reforms Becomes Too Burdensome Our Reform Monitor Will Help Us Judge Whether The Pace Of Reforms Becomes Too Burdensome For now, there is no indication that reform risk is affecting the performance of the MSCI China index. Panel 2 of Chart 7 highlights that recent movements in our Reform Monitor have been driven by the "winner" sectors, with the recent selloff largely reflecting a modest correction in global technology stocks sparked by the passage of the U.S. Senate's tax reform plan.6 But we will be watching the monitor closely in 2018, and will adjust it as needed in reaction to additional reform announcements over the coming months. Finally, next year's reform announcements will be highly significant not just because of the "what", but also the "how". It is difficult to see how China's leadership can aggressively pare back heavy-polluting industry and deleverage the financial sector without destabilizing the economy in the near term, but their goal to significantly raise China's per capita GDP and escape the "middle income trap" over the long-term is equally nebulous. We have noted in previous reports that a country's income level is fundamentally determined by its productivity, which is in turn determined by the level and sophistication of its capital stock. Chart 8 shows a clear positive correlation between a country's per capita output, a measure of productivity, and its per capita capital stock. In general, industrialized countries enjoy much higher levels of per capita capital stock than developing economies, leading to much higher productivity, income, and living standards. Therefore, the process of industrialization is fundamentally a process of accumulation of capital stock through investment. As shown in Chart 9, despite some remarkable achievements, the productivity level of the average Chinese worker is still just a fraction of the level in more advanced countries. Conventional economics would suggest that if China wishes to keep progressing on the productivity and income ladder, that it should remain on the path of growing the capital stock through savings and investment. If, however, it abandons its current growth model and "rebalances" towards a consumption-driven one, the risk that the country will stagnate and fail to advance beyond the "middle income trap" looms large. Chart 8Productivity Is Positively Correlated ##br##With Capital Stock Three Themes For China In The Coming Year Three Themes For China In The Coming Year Chart 9China's Catchup Process ##br## Has A Lot Further To Run Three Themes For China In The Coming Year Three Themes For China In The Coming Year Chart 10 makes this point from a different perspective. At root, China's leadership is describing the desire to rapidly transition towards an economy with a much higher level of tertiary industry (services) as a share of GDP, but the U.S. experience suggests that this is a long process that is not investment-oriented. The chart shows the evolution of U.S. investment in private services excluding real estate as a share of total private fixed assets since 1947, when the U.S. had only a slightly higher level of real per capita GDP than China today. It has taken almost 70 years for the share of private services ex real estate to rise by 16 percentage points in the U.S., and it has yet to account for the majority of private fixed investment.7 Services activity/investment also typically requires a highly educated workforce as an input, and rate of China's post-secondary educational attainment appears to be too low to fit the bill (Chart 11). In short, crucial details about China's reform plan should hopefully emerge in 2018, which are likely to have both near-term and multi-year implications. Bottom Line: Chinese policymakers are likely to increase their focus on reform efforts next year, but the pace will have to be modulated to avoid a repeat of the significant slowdown that occurred in 2014/2015. The risk of a policy mistake is a key theme to watch for 2018. Chart 10China Cannot Easily Replace 'Hard' Investment China Cannot Easily Replace 'Hard' Investment China Cannot Easily Replace 'Hard' Investment Chart 11China's Workforce Is Not Well Equipped To Transition To Services Three Themes For China In The Coming Year Three Themes For China In The Coming Year Key Theme # 3: The Relative Re-Rating Of Chinese Investable Ex-Tech Stocks Over the past several years, this publication argued strongly that the valuation discount applied to Chinese equities was unjustified. For the investable benchmark, the past two years of material outperformance vs emerging market and global stocks has removed a significant portion of this discount, and we noted in our August 31 Weekly Report that Chinese equities are no longer "exceptionally cheap".8 However, a good portion of this revaluation has been isolated to the tech sector. Chart 12 shows that while the 12-month forward P/E ratio for Chinese tech stocks is 70% higher than the global average, ex-tech shares still trade at a 37% relative discount. Chart 13 echoes this conclusion by showing the ex-tech price-to-book ratio for every country in MSCI's All Country World index; by this metric China's ex-tech cheapness currently ranks in the 85th percentile, behind only Israel, Colombia, Italy, Jordan, Korea, Russia, and Greece. Chart 12China: Expensive Tech, Extremely Cheap Ex-Tech China: Expensive Tech, Extremely Cheap Ex-Tech China: Expensive Tech, Extremely Cheap Ex-Tech Chart 13China's Ex-Tech P/B Ratio Among The Lowest In The World Three Themes For China In The Coming Year Three Themes For China In The Coming Year Charts 12 and 13 are weighted simply by the remaining market capitalization in each country's market after excluding the technology sector, meaning that the deep discount applied to Chinese banks wields a disproportionate influence (financials would make up 40% of China's MSCI ex-tech "index", if one officially existed). Although we agree that the magnitude of the rise in debt over the past several years warrants somewhat of a P/B discount, we would argue that the risk is more earnings and dilution-related rather than solvency-related. It is highly unlikely that the Chinese government would allow large banks to fail outright in the event of a serious financial crisis, but the potential for a rise in provisioning and significant new capital raising suggests that the risk premium for these stocks should be somewhat higher than what would otherwise be normal. Chart 14China's Banks Can Re-Rate ##br##In A Benign Slowdown Scenario China's Banks Can Re-Rate In A Benign Slowdown Scenario China's Banks Can Re-Rate In A Benign Slowdown Scenario Still, either the Chinese bank risk premium is excessive, or the banking sectors of several major DM countries are significantly overvalued. For example, Chinese investable banks trade at a P/B ratio of 0.8, but Canadian, Australian, and Swedish banks trade at an average P/B ratio of 1.7. If the concern over credit excesses is the source of the higher risk premium applied to Chinese banks, Chart 14 suggests that there is a major inconsistency in pricing; an equally-weighted average of Canadian, Australian, and Swedish private sector debt-to-GDP is higher than that of China's, at 214% vs 211% as of Q2 this year. Our bet is the former: In a world where outsized returns are scarce and U.S. equities are overvalued, a benign growth deceleration and a modulated pace of reforms favor a lessening of the substantial valuation discount currently applied to China's investable ex-tech stocks. Barring a more pronounced slowdown in China's economy than we currently expect, investors should stay overweight the MSCI China investable index in 2018, within both an emerging markets and global equity portfolio. Bottom Line: Chinese ex-tech stocks have room to re-rate in a benign slowdown scenario. Investors should stay overweight Chinese investable stocks in 2018. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see BCA Special Report, "2018 Outlook - Policy And The Markets: On A Collision Course," dated November 20, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Reports "China's Economy - 2015 Vs Today (Part I): Trade", dated October 26, 2017, and "China's Economy - 2015 Vs Today (Part II): Monetary Policy", dated November 9, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle", dated November 30, 2017, available at cis.bcaresearch.com. 4 Please see China Investment Strategy and Geopolitical Strategy Special Reports, "China's Nineteenth Party Congress: A Primer", dated September 14, 2017, "How To Read Xi Jinping's Party Congress Speech", dated October 18, 2017, and BCA Special Report "China: Party Congress Ends ... So What?", dated November 2, 2017, available at cis.bcaresearch.com. 5 Please see China Investment Strategy Weekly Report, "Messages From The Market, Post-Party Congress", dated November 16, 2017, available at cis.bcaresearch.com. 6 The Senate bill that was passed this week unexpectedly retained 20% alternative minimum tax (AMT) for corporations, which would disproportionately impact U.S. technology companies. Indications currently suggest that the final tax cut bill to be approved by both houses of Congress will repeal the AMT. 7 In 2016, real estate investment accounted for roughly 29% of total private investment in fixed assets, and the sum of primary and secondary industry (agriculture, mining, utilities, construction, and manufacturing) accounted for about 28%. 8 Please see China Investment Strategy Weekly Report, "A Closer Look At Chinese Equity Valuations", dated August 31, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations