China

Dear Client, We are sending you a Special Report prepared by my colleague Matt Gertken, associate vice president of our Geopolitical Strategy team. This report focuses on the upcoming 19th Party congress and discusses its implications on China’s economic and political outlook, as well as its impact on financial markets. I trust you will find this report insightful. Best regards, Yan Wang, Senior Vice President China Investment Strategy Highlights The Communist Party will hold its nineteenth National Congress on Oct. 18. This is the "midterm election" for President Xi Jinping, whose political capital will be replenished; Recent Chinese leaders have a greater impact in their second term than their first; Base case: Xi consolidates power while preserving a balance on the Politburo Standing Committee; Stay long Chinese equities versus emerging market peers. Feature China's Communist Party will hold the nineteenth National Party Congress on October 18-25. This is a critical "midterm" leadership reshuffle that will also mark the halfway point of General Secretary Xi Jinping's term in office. Investors around the world will watch closely to see what insight can be gained about the political trajectory of the world's second-largest economy. This report serves as a "primer" for readers to understand the party congress and its investment takeaways. Why Is The Party Congress Important? Because it rotates China's political leaders! Chart 1So Long To The 18th Central Committee In a political system without popular representation, the rotation of personnel according to promotion and retirement is the only way to rejuvenate the policy process. The average rate of turnover on the Communist Party's Central Committee at each five-year congress has been 62%, which is a remarkably high rate (Chart 1). It reveals an underrated dynamism in Chinese politics. This leadership rotation also allows the top leader (Xi Jinping) to consolidate power by putting his supporters into key positions. This in turn alters the policymaking environment and the way in which China formulates policies and responds to external events. China has a "parallel" political system in which the ruling Communist Party operates alongside (and above) the state. Xi Jinping is "General Secretary" of the party, president of the People's Republic of China, and (not least) chairman of the Central Military Commission. The party maintains supremacy by independently controlling the state and the army. Since fall 2016, Xi has been dubbed the "core" of the Communist Party, putting him on a par with previous core leaders Mao Zedong, Deng Xiaoping and Jiang Zemin.1 The party's nearly 90 million members convene large congresses of about 2,000 members every five years to select the membership of the key decision-making bodies (Diagram 1), a practice known as "intra-party democracy."2 The key body is the Central Committee, which consists of about 200 full members and another 100-some alternative members. The Central Committee then "elects" the General Secretary, Political Bureau (a.k.a. "Politburo," the top 25 or so leaders) and Politburo Standing Committee (the "PSC," the top five-to-nine leaders) - though in reality the Politburo and the PSC are chosen through intense negotiations among the incumbent PSC and former leaders. Diagram 1National Party Congress Of The Communist Party Of China The handful of men on the PSC are the chief decision-makers in China, often in league with the broader Politburo (and former PSC members who exercise some power through the back door). Most of the key personnel decisions will have been made before the Central Committee votes.3 Hence the current top leaders have a chance to put their loyalists and supporters in key positions, potentially improving the implementation of their agenda. The outgoing eighteenth Central Committee will meet for its last session on October 11, and then the nineteenth party congress will meet on October 18 to elect a new Central Committee. It will in turn ratify the new Politburo and PSC. At the beginning of the party congress, Xi Jinping will deliver a keynote political report on the state of the party and nation, reviewing the progress of the past five years and mapping out a vision for the next five. The party congress will also amend the Communist Party constitution.4 By the end of the week, the members of the new PSC will step out to meet the press together for the first time. Only later will the party's key decisions be incorporated by the state, i.e. China's central government, including key personnel appointments and policy initiatives. This will occur when the legislature, the National People's Congress ("NPC," not to be confused with party congress), convenes at its annual "Two Sessions" in early March 2018. Chart 2Bold Action Can Follow Midterm Congresses Any NPC session following a five-year party congress carries more weight than usual not only because it approves of the party congress's leadership decisions but also because it kicks off major new policy initiatives. For instance, Premier Zhu Rongji was appointed to launch the "assault stage" of President Jiang Zemin's reforms of state-owned enterprise at the NPC in March 1998 (Chart 2). Similarly, Hu Jintao's Premier Wen Jiabao launched extensive administrative reforms at the NPC meeting in early 2008.5 How does a "midterm" party congress differ from others? Typically, in even-numbered years, the top two leaders change over, as with Xi Jinping and Premier Li Keqiang in 2012. These transitions are highly significant as they mark a leadership succession, a transfer of power to a new general secretary in a heavily centralized, authoritarian system that does not have a codified succession process. By contrast, in odd-numbered years like 2017, the Communist Party promotes, demotes, and retires a large number of other top leaders. Thus Xi Jinping's place is assured, and Li Keqiang's place is probably assured as well, but most likely the other five members of the PSC will be gone.6 This year's transition is also significant because the total turnover on the Central Committee is expected to be higher than usual (perhaps 70%) as a result of President Xi's aggressive anti-corruption campaign and other factors (see Chart 1 above).7 Leaders often spend the bulk of their first five years consolidating power and the second five years pushing forward their true policy agenda. Even President Hu Jintao, who failed to see his preferred social safety-net policies fully implemented, had a vastly more influential second term than first term in office: the 2007-12 period saw the 4 trillion RMB stimulus package to thwart the Global Recession. Moreover, Chinese leaders do not normally become "lame ducks" toward the end of their last term: Deng Xiaoping recommitted the country to pro-market reforms in 1992, after having stepped down as general secretary, while Jiang Zemin reached the height of his power at the end of his term in 2002, when he chose to hang onto the position of top military leader for two extra years. Many observers suspect that Xi Jinping will hold onto power beyond 2022. Bottom Line: The National Party Congress coincides with a sweeping rotation of the Chinese political elites, which is a critical way of ensuring that China, unlike a monarchy or personalized "dictatorship," has an orderly way of updating its policy-makers and (hopefully) policies. Midterm reshuffles allow top leaders to promote supporters and re-energize the implementation of their policy agenda. The past two Chinese leaders were more consequential in their second term than their first. How Is The Nineteenth Congress Unique? Chart 3Xi Jinping's Generation Taking Command The most important change this year is the passing of a generation.8 China's political elites are classified into "leadership generations," with Mao Zedong symbolizing the first generation, Deng Xiaoping the second, Jiang Zemin the third, Hu Jintao the fourth, and Xi Jinping the fifth generation. The current reshuffle will see the following generational trends: The End of the Jiang Zemin Era: The key figures retiring on the PSC are those who were born before 1950 and put in place by Jiang Zemin. Thus in a very real sense, Jiang Zemin's influence is coming to a close (Chart 3).9 This generational shift is likely to force the retirement of 11 of the 25-member Politburo, and five of the seven PSC members (Table 1), as well as other major figures, such as the long-serving central bank Governor Zhou Xiaochuan. Table 1Chinese Leaders Set To Retire On Politburo And Politburo Standing Committee Jiang-era leaders are defined by certain characteristics that are now fading. As Chart 4 demonstrates, these leaders came of age in the early, idealistic days of the Revolution, leading them to have a conservative streak in ideological matters. Yet they are well-known pragmatists in economic matters. They studied engineering and natural sciences in answer to the call for the young to develop the country's heavy industry. They tended to hail from capitalist-leaning coastal provinces, and often gained first-hand experience operating China's state-owned enterprises. This last point became especially important when they pioneered pro-market corporate reforms in the 1990s. By contrast, fewer of them served as government ministers on the State Council (China's cabinet) than subsequent generations. Chart 4Leadership Characteristics Of The Politburo Standing Committee The Middle of the Hu Jintao Era: The passing of Jiang's cohort will necessarily give his successor Hu Jintao's cohort a boost in relative influence at the top levels. Hu's generation is marked by leaders who studied the "soft sciences" (like law and economics). Several of them (including Hu and Premier Wen Jiabao) have links with the politically liberal wing of the party. They have far less experience in the military or state-owned business, but are more likely to have governing experience in the central government and especially the provinces (Chart 4 above). This includes the interior provinces from which they often hail. They are thus highly attuned to the problem of maintaining social stability, arguably to the neglect of economic dynamism. Hu Jintao's influence may be underrated. Xi's administration has shown important continuities with Hu's, and Hu's followers are well positioned in the Central Committee, the Politburo, and the provincial governments (though not the current PSC). If Xi does not take decisive moves to replace some of Hu's acolytes on the PSC at the coming party congress, then Hu's men will likely outnumber Xi's on the PSC as they graduate up the ladder from the Politburo.10 A strong showing by Hu's faction could affect China's policy priorities, given that Xi showed different preferences from Hu in the first few years of his rule (Table 2). However, the factions do not maintain consistent policy platforms. The bottom line is that Hu's faction could act as more or less of a constraint on Xi regardless of what policies the latter pursues. Table 2Fiscal Priorities Of Recent Chinese Presidents The True Beginning of the Xi Jinping Era: Xi's generation has yet to reveal its full character - the demographics of the new Central Committee will help determine it. So far it is a continuation of the trends above: more likely than not to come from interior than coastal provinces, to have studied the humanities, to have governed in the provinces or central ministries, and to lack military or business experience (Chart 4 above). The coming reshuffle could initiate a change in some of these trends, given some of Xi's revealed preferences, but that will not become clear until this fall.11 Xi is not stereotypical when it comes to China's political cycles: he consolidated power rapidly in his first term.12 The question, then, is whether Xi can continue to accrue power at the party congress, or whether his second term will become complicated by an infusion of Hu Jintao supporters into top party posts. Thus the success of Hu's supporters (particularly on the PSC) is the critical moving part that could determine the political constraints on Xi Jinping from 2017-22. Will Xi be able to arrange a favorable power-sharing agreement? Or will he go further and try to remove this political constraint entirely, even at the risk of political instability? The above points raise two critical questions: Will Chinese politics become more institutionalized? Investors should expect China to maintain a stridently informal political system. Rules and norms can and will be bent, but key principles will be upheld. In other words, the goal posts can be moved, but not too far. Going beyond certain limits would be destabilizing for China's political, institutional, and factional balances, and so far Xi has exhibited poise and the desire to maintain stability that is characteristic of post-1978 Chinese leaders.13 We think there is a low probability that Xi will overthrow all the norms of leadership selection and overturn the balance of power on the Politburo and PSC. If he does, it will raise alarms that he is setting up a new "cult of personality" like Mao, which could cause domestic economic and market instability. Rather, we expect him to modify the rules to maintain control of the PSC without excluding Hu Jintao's faction from power. Will Xi initiate the succession process for 2022? Some commentators suspect that Xi will use the party congress to pave the way for him to cling to power beyond 2022. Clearly Xi could retain the top military post and stay within recent precedent. But any hints at altering recent succession patterns, despite the fact that they are informal, are dangerous for investors in the long run because they raise deep uncertainty about the range of possibilities and political conflicts that could occur upon the actual change of power in 2022. Nevertheless, bear in mind the following points: The question of succession will not be resolved this October. If Xi plans to hang on beyond 2022, then he will continue amassing power and positioning loyalists over the next five years so that he will have full institutional support at the critical moment in 2022 - like Jiang Zemin did when he chose to hang onto the military chairmanship from 2002-04. Thus while Xi may lay some groundwork that makes political observers uneasy, the question will not be resolved either way this fall. Xi's tenure will be an ongoing topic for investors to monitor. Xi is already set to be the most powerful Chinese leader well into the 2020s. Xi's anti-corruption campaign is remarkable evidence of his strength as a ruler. Significantly, this campaign has focused on rooting out Jiang Zemin's influence. Yet Jiang stepped down way back in 2004! In other words, Jiang wielded massive influence between 2004 and 2017. Indeed, Xi's boldest move this year so far was to remove Sun Zhengcai, a Jiang acolyte. It stands to reason that, even if Hu Jintao's faction pulls off a relative victory this year, Xi Jinping's faction will likely be well positioned for a victory in 2022. And if Hu loses out this year, Xi's followers will be better positioned in 2027, as well as 2022. In short, market participants are unlikely to be able to tell the difference this October between (1) Xi getting a boost of political capital for his second term and (2) Xi getting such a big boost that he is on track to overstay his second term.14 Xi might intend to become a dictator and cling to power for longer, but all the market will know for certain is that he has maintained control of the PSC and his general policy framework will be more or less continuous, which is likely a relief in the near term. Finally, investors may not initially care if Xi seizes additional power at the expense of party norms and the succession process. A-shares sold off, but H-shares rallied, when Jiang Zemin decided not to step down entirely in 2002 (Chart 5). Russian stocks and the RUB/USD only fleetingly sold off when Vladimir Putin made clear his intention to return to the presidency yet again in 2011 (Chart 6). Chart 5Foreign Investors Cheered Jiang's Clinging To Power Chart 6Russian Investors Cheered Putin's Second Presidency While it is impossible to know whether markets will cheer any signs of "Papa Xi" doing away with term limits, it is bad for China's governance in the long run if Xi does not clearly begin grooming a successor with this fall's promotions. An heir-apparent for 2022 would reduce the risks of disruptive power-struggle and would impose a personal deadline on Xi Jinping's reform agenda. That is, a deadline above and beyond the 2020 deadline in the 13th Five Year Plan and the 2021 deadline for the 100th anniversary of the Communist Party's founding. That reform agenda, in turn, is essential for improving China's long-term productivity.15 Bottom Line: The Chinese political system is informal, which means that rules and norms can be bent without altering the underlying principles of balance among the key factions and stability of the regime and society as a whole. Our baseline scenario is a market-positive one: that Xi Jinping will win a victory at the party congress, but that he will not overthrow Hu Jintao's followers and abandon the "collective leadership" model, since that would destroy the overall balance of power and heighten domestic political risks. If Xi loses out to the Hu faction, then we would expect Chinese and China-exposed risk assets to sell off, at least initially. If Xi romps to total victory, excluding Hu's clique from power, we would fade any market rally. Such a development would heighten political risks for the foreseeable future. Investment Conclusions The prospect of a Xi-dominated, yet stable, PSC in China is promising because it suggests that China will have at least a marginally improved policy framework for managing the immense challenges it faces. On the economic front, the loss of the demographic dividend threatens to make China old before it gets rich (Chart 7). Xi will need a unified party, as well as loyal supporters in key posts, if he is to re-energize his productivity-enhancing reforms. On the socio-political front, China's intensifying focus on domestic security is symbolized by draconian media censorship ahead of the party congress and, more broadly, a faster rate of spending on public security than national defense in recent years (Chart 8). Such trends suggest that policy makers are concerned about public support. Income inequality and regional disparities are burning issues in an authoritarian country with a larger and more connected middle class and an incipient civil rights movement. Chart 7Rising Participation Boosted Euro Area Labor Force Growth China's Demographic Challenge Chart 8Social Stability A Major Concern In China In terms of the likely economic and market response, we have highlighted in the past that larger macro-economic trends tend to swamp any effects of China's five-year party congresses. There is no observable correlation between these events and the deviations of China's nominal GDP, credit, or fixed investment from long-term averages going back to 1992 (Chart 9). Chart 9No Clear Policy Impact From Past Party Congresses Moreover, China only has two midterm party congresses to compare to today's party congress, and both occurred in the thick of global financial crises (1997, 2007). This makes it difficult to draw firm conclusions about any impact on Chinese risk assets. A-shares were mostly flat after the 1997 congress but fell after 2007, while H-shares broadly fell after both meetings, as one might expect given the crises raging around them (Chart 10 A&B). Chart 10AChinese Stocks Were Flat Or Down ... Chart 10B... After Past Midterm Party Congresses H-shares, being highly responsive to global financial market turmoil, fell relative to emerging market (EM) equities as well in 1997 and 2007. A-shares were more insulated and outperformed EM stocks during the 1997 crisis, though not in the 2007 crisis (Chart 11 A&B). What is clear - for Chinese domestic investors - is that A-shares outperformed H-shares after the party congresses in 1997 and 2007 (Chart 12). Chart 11AChinese Stocks Sold Off In Relative Terms... Chart 11B...Except A-Shares During The Asian Crisis Chart 12A-Shares Outperformed H-Shares After Midterm Congresses This fall, it would not be surprising to see Chinese and global risk-on attitudes prevail in the immediate aftermath of China's party congress: in the broadest sense, the meeting represents a political recapitalization for the Xi administration. Moreover, the backdrop is positive: global and Chinese growth are on a synchronized upswing, Chinese industrial profits have improved, the Fed is on hold, and China's growth risks and capital outflow pressures have diminished.16 This suggests a marginal positive impact for H-shares as well as A-shares. However, Chinese stocks are no longer trading at a discount relative to peers. Moreover, BCA's Geopolitical Strategy believes that the Xi administration's reform reboot will likely bring tougher financial and environmental regulation that will slow credit growth and cut into corporate profits.17 It also seems likely that 2018 will see the dollar stage a comeback as inflation recovers and the Fed resumes hiking rates.18 For all these reasons, we recommend staying long Chinese stocks relative to EM, on the basis that China's reform efforts will be positive for China's productivity outlook but negative for commodities and EM in 2018. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Mao's successor Hua Guofeng, and Xi's predecessor Hu Jintao, are the two leaders who did not obtain "core" status. 2 The current norms developed mostly in the 1980s and have evolved since. The list of candidates is mostly pre-arranged by the top leaders. The party congress then votes on which candidates to include, leaving a remainder of about 10% who do not take seats in the Central Committee. 3 Nevertheless, the Central Committee could produce a few surprises. It is almost inevitable that a few major personalities will fail to get promoted into key positions, while others will be catapulted to higher places. There will also be some tea leaves to read about the share of negative votes or abstentions and the implications for different candidates. 4 The political report is filled with arcane Communist Party jargon but is very important. It is a consensus document that takes multiple committees a year or more to draft, though Xi Jinping will give the finishing touches. It will cover a comprehensive range of policies and will be scrutinized closely by experts for slight changes of terminology, emphasis, or omission. Key things to watch for are whether Xi adds or removes entire sections; whether he alters developmental goals outlined in previous administrations; and whether he inserts new concepts or revises party ideology to make way for contentious reforms. As for the party's constitution, the main question of any change is whether Xi's leadership philosophy is incorporated into the Communist Party's guiding thought, and if so, whether Xi's name is explicitly attached to it. The latter in particular would be a sign that Xi's political capital within the party is massive. For additional commentary, please see Alice Miller, "How To Read Xi Jinping's 19th Party Congress Political Report," China Leadership Monitor 53 (2017), available at www.hoover.org. 5 For the "assault stage" of reform, see Robert Lawrence Kuhn, The Man Who Changed China: The Life And Legacy Of Jiang Zemin (NY: Crown, 2004). Jiang had first targeted SOE reform in 1996 in a speech, he launched the policy itself at the party congress in September 1997, and the state began to implement it at the NPC in March 1998. For Hu Jintao's and Wen Jiabao's administrative reforms after the seventeenth party congress, see Willy Wo Lap Lam, "Beijing Unveils Plan For Super Ministries," China Brief, Jamestown Foundation, February 4, 2008. These reforms, which were only part of the overall agenda after the congress, included restructuring the State Council, empowering the National Development and Reform Commission, and setting up "Super-Ministries" to streamline cabinet-level functions. 6 Rumor has it that Xi will keep his anti-corruption chief, Wang Qishan, on the PSC beyond the 69-year mandatory retirement age, and that he could even replace Premier Li Keqiang. We do not expect either to happen, but both are well within the realm of political possibility - particularly retaining Wang. 7 For this estimate, please see Cheng Li, Chinese Politics In The Xi Jinping Era: Reassessing Collective Leadership (Washington, D.C.: Brookings, 2016), chapter 9. 8 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 9 Traces of Jiang's power will persist here and there, especially if Wang Qishan remains on the PSC, but the overall effect will be a diminishment of this powerful leadership cohort. Symbolically, just as Deng Xiaoping's death loomed over the fifteenth party congress in 1997, Jiang's impending death will loom over the nineteenth party congress today. 10 Indeed judging solely by the cyclical rotation of Chinese leaders according to generation and faction, Hu Jintao's acolytes are favored to outnumber Jiang Zemin's and Xi Jinping's in the 2017 reshuffle. Please see BCA Geopolitical Strategy, "China: Two Factions, One Party," dated September 2012, available at gps.bcaresearch.com. However, Xi's effectiveness and good luck since coming to power lead us to believe that he will secure his followers on the PSC and Politburo this year: please see BCA Geopolitical Strategy Strategic Outlook 2017, "We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 11 For example, Xi Jinping's recent promotions have re-emphasized SOE managers and his policies have supported large "state champion" SOEs. Please see Cheng Li and Lucy Xu, "The rise of state-owned enterprise executives in China's provincial leadership," Brookings, February 22, 2017, available at www.brookings.edu. 12 He came to the top office at a time of significant public dissatisfaction (2012), which meant that he received a kind of "mandate" to make big changes. His faction dominated the PSC, and his sweeping anti-corruption campaign purged the party and state of formidable rivals. In the fall of 2016 he clinched his status as the "core" of the party. 13 As to specific rules, no one should be surprised if they are altered. Take the age limit, which is hotly debated: Jiang Zemin introduced a hard age limit into the PSC in 1997, specifically in a way that prevented the promotion of a heavy-hitting politician, Qiao Shi, while allowing Jiang to continue in power. Now, assume Xi alters the rules to preserve Wang Qishan: this would not necessarily mean that Xi plans to overstay his term limits, though some observers will take it that way. For market participants, the important point is that slight tweaks to informal rules are unlikely to have a big market impact. Consider that Wang has overseen a massive crackdown on corruption, helping clean up the party's image, and is known to be competent in financial regulation as well. If he is retained, will the market really protest? We doubt it. Having said that, we expect him to retire according to the existing rule of thumb. 14 The exception to this statement is if Xi reforms Communist Party political institutions, as some commentators suspect he might, in order to allow the Central Committee to elect the Politburo and PSC directly from its members, thus expanding "intra-party democracy" while also giving Xi a higher likelihood of staying in power. Please see Bo Zhiyue, "Commentary: Sweeping Reforms Expected At Party Congress, But Will Xi Jinping Get All He Wants?" Channel News Asia, August 20, 2017, available at www.channelnewsasia.com. 15 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. Please also see BCA China Investment Strategy, "Understanding China's Master Plan," dated November 20, 2013, available at cis.bcaresearch.com. 16 Please see BCA China Investment Strategy Weekly Reports, "China: Earnings Scorecard And Market Tea Leaves," dated September 7, 2017, and "Monitoring Chinese Capital Outflows And The RMB Internationalization Process," dated August 24, 2017, available at cis.bcaresearch.com. 17 Please see BCA China Investment Strategy Weekly Report, "A Closer Look At Chinese Equity Valuations," dated August 31, 2017, available at cis.bcaresearch.com. For the reform agenda, please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 18 Please see BCA Global Investment Strategy Weekly Report, "Central Bank Showdown," dated September 8, 2017, available at gis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights The Communist Party will hold its nineteenth National Congress on Oct. 18. This is the "midterm election" for President Xi Jinping, whose political capital will be replenished; Recent Chinese leaders have a greater impact in their second term than their first; Base case: Xi consolidates power while preserving a balance on the Politburo Standing Committee; Stay long Chinese equities versus emerging market peers. Feature China's Communist Party will hold the nineteenth National Party Congress on October 18-25. This is a critical "midterm" leadership reshuffle that will also mark the halfway point of General Secretary Xi Jinping's term in office. Investors around the world will watch closely to see what insight can be gained about the political trajectory of the world's second-largest economy. This report serves as a "primer" for readers to understand the party congress and its investment takeaways. Why Is The Party Congress Important? Because it rotates China's political leaders! Chart 1So Long To The 18th Central Committee In a political system without popular representation, the rotation of personnel according to promotion and retirement is the only way to rejuvenate the policy process. The average rate of turnover on the Communist Party's Central Committee at each five-year congress has been 62%, which is a remarkably high rate (Chart 1). It reveals an underrated dynamism in Chinese politics. This leadership rotation also allows the top leader (Xi Jinping) to consolidate power by putting his supporters into key positions. This in turn alters the policymaking environment and the way in which China formulates policies and responds to external events. China has a "parallel" political system in which the ruling Communist Party operates alongside (and above) the state. Xi Jinping is "General Secretary" of the party, president of the People's Republic of China, and (not least) chairman of the Central Military Commission. The party maintains supremacy by independently controlling the state and the army. Since fall 2016, Xi has been dubbed the "core" of the Communist Party, putting him on a par with previous core leaders Mao Zedong, Deng Xiaoping and Jiang Zemin.1 The party's nearly 90 million members convene large congresses of about 2,000 members every five years to select the membership of the key decision-making bodies (Diagram 1), a practice known as "intra-party democracy."2 The key body is the Central Committee, which consists of about 200 full members and another 100-some alternative members. The Central Committee then "elects" the General Secretary, Political Bureau (a.k.a. "Politburo," the top 25 or so leaders) and Politburo Standing Committee (the "PSC," the top five-to-nine leaders) - though in reality the Politburo and the PSC are chosen through intense negotiations among the incumbent PSC and former leaders. Diagram 1National Party Congress Of The Communist Party Of China The handful of men on the PSC are the chief decision-makers in China, often in league with the broader Politburo (and former PSC members who exercise some power through the back door). Most of the key personnel decisions will have been made before the Central Committee votes.3 Hence the current top leaders have a chance to put their loyalists and supporters in key positions, potentially improving the implementation of their agenda. The outgoing eighteenth Central Committee will meet for its last session on October 11, and then the nineteenth party congress will meet on October 18 to elect a new Central Committee. It will in turn ratify the new Politburo and PSC. At the beginning of the party congress, Xi Jinping will deliver a keynote political report on the state of the party and nation, reviewing the progress of the past five years and mapping out a vision for the next five. The party congress will also amend the Communist Party constitution.4 By the end of the week, the members of the new PSC will step out to meet the press together for the first time. Only later will the party's key decisions be incorporated by the state, i.e. China's central government, including key personnel appointments and policy initiatives. This will occur when the legislature, the National People's Congress ("NPC," not to be confused with party congress), convenes at its annual "Two Sessions" in early March 2018. Chart 2Bold Action Can Follow Midterm Congresses Any NPC session following a five-year party congress carries more weight than usual not only because it approves of the party congress's leadership decisions but also because it kicks off major new policy initiatives. For instance, Premier Zhu Rongji was appointed to launch the "assault stage" of President Jiang Zemin's reforms of state-owned enterprise at the NPC in March 1998 (Chart 2). Similarly, Hu Jintao's Premier Wen Jiabao launched extensive administrative reforms at the NPC meeting in early 2008.5 How does a "midterm" party congress differ from others? Typically, in even-numbered years, the top two leaders change over, as with Xi Jinping and Premier Li Keqiang in 2012. These transitions are highly significant as they mark a leadership succession, a transfer of power to a new general secretary in a heavily centralized, authoritarian system that does not have a codified succession process. By contrast, in odd-numbered years like 2017, the Communist Party promotes, demotes, and retires a large number of other top leaders. Thus Xi Jinping's place is assured, and Li Keqiang's place is probably assured as well, but most likely the other five members of the PSC will be gone.6 This year's transition is also significant because the total turnover on the Central Committee is expected to be higher than usual (perhaps 70%) as a result of President Xi's aggressive anti-corruption campaign and other factors (see Chart 1 above).7 Leaders often spend the bulk of their first five years consolidating power and the second five years pushing forward their true policy agenda. Even President Hu Jintao, who failed to see his preferred social safety-net policies fully implemented, had a vastly more influential second term than first term in office: the 2007-12 period saw the 4 trillion RMB stimulus package to thwart the Global Recession. Moreover, Chinese leaders do not normally become "lame ducks" toward the end of their last term: Deng Xiaoping recommitted the country to pro-market reforms in 1992, after having stepped down as general secretary, while Jiang Zemin reached the height of his power at the end of his term in 2002, when he chose to hang onto the position of top military leader for two extra years. Many observers suspect that Xi Jinping will hold onto power beyond 2022. Bottom Line: The National Party Congress coincides with a sweeping rotation of the Chinese political elites, which is a critical way of ensuring that China, unlike a monarchy or personalized "dictatorship," has an orderly way of updating its policy-makers and (hopefully) policies. Midterm reshuffles allow top leaders to promote supporters and re-energize the implementation of their policy agenda. The past two Chinese leaders were more consequential in their second term than their first. How Is The Nineteenth Congress Unique? Chart 3Xi Jinping's Generation Taking Command The most important change this year is the passing of a generation.8 China's political elites are classified into "leadership generations," with Mao Zedong symbolizing the first generation, Deng Xiaoping the second, Jiang Zemin the third, Hu Jintao the fourth, and Xi Jinping the fifth generation. The current reshuffle will see the following generational trends: The End of the Jiang Zemin Era: The key figures retiring on the PSC are those who were born before 1950 and put in place by Jiang Zemin. Thus in a very real sense, Jiang Zemin's influence is coming to a close (Chart 3).9 This generational shift is likely to force the retirement of 11 of the 25-member Politburo, and five of the seven PSC members (Table 1), as well as other major figures, such as the long-serving central bank Governor Zhou Xiaochuan. Table 1Chinese Leaders Set To Retire On Politburo And Politburo Standing Committee Jiang-era leaders are defined by certain characteristics that are now fading. As Chart 4 demonstrates, these leaders came of age in the early, idealistic days of the Revolution, leading them to have a conservative streak in ideological matters. Yet they are well-known pragmatists in economic matters. They studied engineering and natural sciences in answer to the call for the young to develop the country's heavy industry. They tended to hail from capitalist-leaning coastal provinces, and often gained first-hand experience operating China's state-owned enterprises. This last point became especially important when they pioneered pro-market corporate reforms in the 1990s. By contrast, fewer of them served as government ministers on the State Council (China's cabinet) than subsequent generations. Chart 4Leadership Characteristics Of The Politburo Standing Committee The Middle of the Hu Jintao Era: The passing of Jiang's cohort will necessarily give his successor Hu Jintao's cohort a boost in relative influence at the top levels. Hu's generation is marked by leaders who studied the "soft sciences" (like law and economics). Several of them (including Hu and Premier Wen Jiabao) have links with the politically liberal wing of the party. They have far less experience in the military or state-owned business, but are more likely to have governing experience in the central government and especially the provinces (Chart 4 above). This includes the interior provinces from which they often hail. They are thus highly attuned to the problem of maintaining social stability, arguably to the neglect of economic dynamism. Hu Jintao's influence may be underrated. Xi's administration has shown important continuities with Hu's, and Hu's followers are well positioned in the Central Committee, the Politburo, and the provincial governments (though not the current PSC). If Xi does not take decisive moves to replace some of Hu's acolytes on the PSC at the coming party congress, then Hu's men will likely outnumber Xi's on the PSC as they graduate up the ladder from the Politburo.10 A strong showing by Hu's faction could affect China's policy priorities, given that Xi showed different preferences from Hu in the first few years of his rule (Table 2). However, the factions do not maintain consistent policy platforms. The bottom line is that Hu's faction could act as more or less of a constraint on Xi regardless of what policies the latter pursues. Table 2Fiscal Priorities Of Recent Chinese Presidents The True Beginning of the Xi Jinping Era: Xi's generation has yet to reveal its full character - the demographics of the new Central Committee will help determine it. So far it is a continuation of the trends above: more likely than not to come from interior than coastal provinces, to have studied the humanities, to have governed in the provinces or central ministries, and to lack military or business experience (Chart 4 above). The coming reshuffle could initiate a change in some of these trends, given some of Xi's revealed preferences, but that will not become clear until this fall.11 Xi is not stereotypical when it comes to China's political cycles: he consolidated power rapidly in his first term.12 The question, then, is whether Xi can continue to accrue power at the party congress, or whether his second term will become complicated by an infusion of Hu Jintao supporters into top party posts. Thus the success of Hu's supporters (particularly on the PSC) is the critical moving part that could determine the political constraints on Xi Jinping from 2017-22. Will Xi be able to arrange a favorable power-sharing agreement? Or will he go further and try to remove this political constraint entirely, even at the risk of political instability? The above points raise two critical questions: Will Chinese politics become more institutionalized? Investors should expect China to maintain a stridently informal political system. Rules and norms can and will be bent, but key principles will be upheld. In other words, the goal posts can be moved, but not too far. Going beyond certain limits would be destabilizing for China's political, institutional, and factional balances, and so far Xi has exhibited poise and the desire to maintain stability that is characteristic of post-1978 Chinese leaders.13 We think there is a low probability that Xi will overthrow all the norms of leadership selection and overturn the balance of power on the Politburo and PSC. If he does, it will raise alarms that he is setting up a new "cult of personality" like Mao, which could cause domestic economic and market instability. Rather, we expect him to modify the rules to maintain control of the PSC without excluding Hu Jintao's faction from power. Will Xi initiate the succession process for 2022? Some commentators suspect that Xi will use the party congress to pave the way for him to cling to power beyond 2022. Clearly Xi could retain the top military post and stay within recent precedent. But any hints at altering recent succession patterns, despite the fact that they are informal, are dangerous for investors in the long run because they raise deep uncertainty about the range of possibilities and political conflicts that could occur upon the actual change of power in 2022. Nevertheless, bear in mind the following points: The question of succession will not be resolved this October. If Xi plans to hang on beyond 2022, then he will continue amassing power and positioning loyalists over the next five years so that he will have full institutional support at the critical moment in 2022 - like Jiang Zemin did when he chose to hang onto the military chairmanship from 2002-04. Thus while Xi may lay some groundwork that makes political observers uneasy, the question will not be resolved either way this fall. Xi's tenure will be an ongoing topic for investors to monitor. Xi is already set to be the most powerful Chinese leader well into the 2020s. Xi's anti-corruption campaign is remarkable evidence of his strength as a ruler. Significantly, this campaign has focused on rooting out Jiang Zemin's influence. Yet Jiang stepped down way back in 2004! In other words, Jiang wielded massive influence between 2004 and 2017. Indeed, Xi's boldest move this year so far was to remove Sun Zhengcai, a Jiang acolyte. It stands to reason that, even if Hu Jintao's faction pulls off a relative victory this year, Xi Jinping's faction will likely be well positioned for a victory in 2022. And if Hu loses out this year, Xi's followers will be better positioned in 2027, as well as 2022. In short, market participants are unlikely to be able to tell the difference this October between (1) Xi getting a boost of political capital for his second term and (2) Xi getting such a big boost that he is on track to overstay his second term.14 Xi might intend to become a dictator and cling to power for longer, but all the market will know for certain is that he has maintained control of the PSC and his general policy framework will be more or less continuous, which is likely a relief in the near term. Finally, investors may not initially care if Xi seizes additional power at the expense of party norms and the succession process. A-shares sold off, but H-shares rallied, when Jiang Zemin decided not to step down entirely in 2002 (Chart 5). Russian stocks and the RUB/USD only fleetingly sold off when Vladimir Putin made clear his intention to return to the presidency yet again in 2011 (Chart 6). Chart 5Foreign Investors Cheered Jiang's Clinging To Power Chart 6Russian Investors Cheered Putin's Second Presidency While it is impossible to know whether markets will cheer any signs of "Papa Xi" doing away with term limits, it is bad for China's governance in the long run if Xi does not clearly begin grooming a successor with this fall's promotions. An heir-apparent for 2022 would reduce the risks of disruptive power-struggle and would impose a personal deadline on Xi Jinping's reform agenda. That is, a deadline above and beyond the 2020 deadline in the 13th Five Year Plan and the 2021 deadline for the 100th anniversary of the Communist Party's founding. That reform agenda, in turn, is essential for improving China's long-term productivity.15 Bottom Line: The Chinese political system is informal, which means that rules and norms can be bent without altering the underlying principles of balance among the key factions and stability of the regime and society as a whole. Our baseline scenario is a market-positive one: that Xi Jinping will win a victory at the party congress, but that he will not overthrow Hu Jintao's followers and abandon the "collective leadership" model, since that would destroy the overall balance of power and heighten domestic political risks. If Xi loses out to the Hu faction, then we would expect Chinese and China-exposed risk assets to sell off, at least initially. If Xi romps to total victory, excluding Hu's clique from power, we would fade any market rally. Such a development would heighten political risks for the foreseeable future. Investment Conclusions The prospect of a Xi-dominated, yet stable, PSC in China is promising because it suggests that China will have at least a marginally improved policy framework for managing the immense challenges it faces. On the economic front, the loss of the demographic dividend threatens to make China old before it gets rich (Chart 7). Xi will need a unified party, as well as loyal supporters in key posts, if he is to re-energize his productivity-enhancing reforms. On the socio-political front, China's intensifying focus on domestic security is symbolized by draconian media censorship ahead of the party congress and, more broadly, a faster rate of spending on public security than national defense in recent years (Chart 8). Such trends suggest that policy makers are concerned about public support. Income inequality and regional disparities are burning issues in an authoritarian country with a larger and more connected middle class and an incipient civil rights movement. Chart 7Rising Participation Boosted Euro Area Labor Force Growth China's Demographic Challenge Chart 8Social Stability A Major Concern In China In terms of the likely economic and market response, we have highlighted in the past that larger macro-economic trends tend to swamp any effects of China's five-year party congresses. There is no observable correlation between these events and the deviations of China's nominal GDP, credit, or fixed investment from long-term averages going back to 1992 (Chart 9). Chart 9No Clear Policy Impact From Past Party Congresses Moreover, China only has two midterm party congresses to compare to today's party congress, and both occurred in the thick of global financial crises (1997, 2007). This makes it difficult to draw firm conclusions about any impact on Chinese risk assets. A-shares were mostly flat after the 1997 congress but fell after 2007, while H-shares broadly fell after both meetings, as one might expect given the crises raging around them (Chart 10 A&B). Chart 10AChinese Stocks Were Flat Or Down ... Chart 10B... After Past Midterm Party Congresses H-shares, being highly responsive to global financial market turmoil, fell relative to emerging market (EM) equities as well in 1997 and 2007. A-shares were more insulated and outperformed EM stocks during the 1997 crisis, though not in the 2007 crisis (Chart 11 A&B). What is clear - for Chinese domestic investors - is that A-shares outperformed H-shares after the party congresses in 1997 and 2007 (Chart 12). Chart 11AChinese Stocks Sold Off In Relative Terms... Chart 11B...Except A-Shares During The Asian Crisis Chart 12A-Shares Outperformed H-Shares After Midterm Congresses This fall, it would not be surprising to see Chinese and global risk-on attitudes prevail in the immediate aftermath of China's party congress: in the broadest sense, the meeting represents a political recapitalization for the Xi administration. Moreover, the backdrop is positive: global and Chinese growth are on a synchronized upswing, Chinese industrial profits have improved, the Fed is on hold, and China's growth risks and capital outflow pressures have diminished.16 This suggests a marginal positive impact for H-shares as well as A-shares. However, Chinese stocks are no longer trading at a discount relative to peers. Moreover, BCA's Geopolitical Strategy believes that the Xi administration's reform reboot will likely bring tougher financial and environmental regulation that will slow credit growth and cut into corporate profits.17 It also seems likely that 2018 will see the dollar stage a comeback as inflation recovers and the Fed resumes hiking rates.18 For all these reasons, we recommend staying long Chinese stocks relative to EM, on the basis that China's reform efforts will be positive for China's productivity outlook but negative for commodities and EM in 2018. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Mao's successor Hua Guofeng, and Xi's predecessor Hu Jintao, are the two leaders who did not obtain "core" status. 2 The current norms developed mostly in the 1980s and have evolved since. The list of candidates is mostly pre-arranged by the top leaders. The party congress then votes on which candidates to include, leaving a remainder of about 10% who do not take seats in the Central Committee. 3 Nevertheless, the Central Committee could produce a few surprises. It is almost inevitable that a few major personalities will fail to get promoted into key positions, while others will be catapulted to higher places. There will also be some tea leaves to read about the share of negative votes or abstentions and the implications for different candidates. 4 The political report is filled with arcane Communist Party jargon but is very important. It is a consensus document that takes multiple committees a year or more to draft, though Xi Jinping will give the finishing touches. It will cover a comprehensive range of policies and will be scrutinized closely by experts for slight changes of terminology, emphasis, or omission. Key things to watch for are whether Xi adds or removes entire sections; whether he alters developmental goals outlined in previous administrations; and whether he inserts new concepts or revises party ideology to make way for contentious reforms. As for the party's constitution, the main question of any change is whether Xi's leadership philosophy is incorporated into the Communist Party's guiding thought, and if so, whether Xi's name is explicitly attached to it. The latter in particular would be a sign that Xi's political capital within the party is massive. For additional commentary, please see Alice Miller, "How To Read Xi Jinping's 19th Party Congress Political Report," China Leadership Monitor 53 (2017), available at www.hoover.org. 5 For the "assault stage" of reform, see Robert Lawrence Kuhn, The Man Who Changed China: The Life And Legacy Of Jiang Zemin (NY: Crown, 2004). Jiang had first targeted SOE reform in 1996 in a speech, he launched the policy itself at the party congress in September 1997, and the state began to implement it at the NPC in March 1998. For Hu Jintao's and Wen Jiabao's administrative reforms after the seventeenth party congress, see Willy Wo Lap Lam, "Beijing Unveils Plan For Super Ministries," China Brief, Jamestown Foundation, February 4, 2008. These reforms, which were only part of the overall agenda after the congress, included restructuring the State Council, empowering the National Development and Reform Commission, and setting up "Super-Ministries" to streamline cabinet-level functions. 6 Rumor has it that Xi will keep his anti-corruption chief, Wang Qishan, on the PSC beyond the 69-year mandatory retirement age, and that he could even replace Premier Li Keqiang. We do not expect either to happen, but both are well within the realm of political possibility - particularly retaining Wang. 7 For this estimate, please see Cheng Li, Chinese Politics In The Xi Jinping Era: Reassessing Collective Leadership (Washington, D.C.: Brookings, 2016), chapter 9. 8 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 9 Traces of Jiang's power will persist here and there, especially if Wang Qishan remains on the PSC, but the overall effect will be a diminishment of this powerful leadership cohort. Symbolically, just as Deng Xiaoping's death loomed over the fifteenth party congress in 1997, Jiang's impending death will loom over the nineteenth party congress today. 10 Indeed judging solely by the cyclical rotation of Chinese leaders according to generation and faction, Hu Jintao's acolytes are favored to outnumber Jiang Zemin's and Xi Jinping's in the 2017 reshuffle. Please see BCA Geopolitical Strategy, "China: Two Factions, One Party," dated September 2012, available at gps.bcaresearch.com. However, Xi's effectiveness and good luck since coming to power lead us to believe that he will secure his followers on the PSC and Politburo this year: please see BCA Geopolitical Strategy Strategic Outlook 2017, "We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 11 For example, Xi Jinping's recent promotions have re-emphasized SOE managers and his policies have supported large "state champion" SOEs. Please see Cheng Li and Lucy Xu, "The rise of state-owned enterprise executives in China's provincial leadership," Brookings, February 22, 2017, available at www.brookings.edu. 12 He came to the top office at a time of significant public dissatisfaction (2012), which meant that he received a kind of "mandate" to make big changes. His faction dominated the PSC, and his sweeping anti-corruption campaign purged the party and state of formidable rivals. In the fall of 2016 he clinched his status as the "core" of the party. 13 As to specific rules, no one should be surprised if they are altered. Take the age limit, which is hotly debated: Jiang Zemin introduced a hard age limit into the PSC in 1997, specifically in a way that prevented the promotion of a heavy-hitting politician, Qiao Shi, while allowing Jiang to continue in power. Now, assume Xi alters the rules to preserve Wang Qishan: this would not necessarily mean that Xi plans to overstay his term limits, though some observers will take it that way. For market participants, the important point is that slight tweaks to informal rules are unlikely to have a big market impact. Consider that Wang has overseen a massive crackdown on corruption, helping clean up the party's image, and is known to be competent in financial regulation as well. If he is retained, will the market really protest? We doubt it. Having said that, we expect him to retire according to the existing rule of thumb. 14 The exception to this statement is if Xi reforms Communist Party political institutions, as some commentators suspect he might, in order to allow the Central Committee to elect the Politburo and PSC directly from its members, thus expanding "intra-party democracy" while also giving Xi a higher likelihood of staying in power. Please see Bo Zhiyue, "Commentary: Sweeping Reforms Expected At Party Congress, But Will Xi Jinping Get All He Wants?" Channel News Asia, August 20, 2017, available at www.channelnewsasia.com. 15 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. Please also see BCA China Investment Strategy, "Understanding China's Master Plan," dated November 20, 2013, available at cis.bcaresearch.com. 16 Please see BCA China Investment Strategy Weekly Reports, "China: Earnings Scorecard And Market Tea Leaves," dated September 7, 2017, and "Monitoring Chinese Capital Outflows And The RMB Internationalization Process," dated August 24, 2017, available at cis.bcaresearch.com. 17 Please see BCA China Investment Strategy Weekly Report, "A Closer Look At Chinese Equity Valuations," dated August 31, 2017, available at cis.bcaresearch.com. For the reform agenda, please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 18 Please see BCA Global Investment Strategy Weekly Report, "Central Bank Showdown," dated September 8, 2017, available at gis.bcaresearch.com.

Highlights We estimate total Belt & Road Initiative (BRI) investment will rise from US$120 billion this year to about US$170 billion in 2020. The size of BRI investments is about 47 times smaller than China's annual gross fixed capital formation (GFCF). Therefore, a slump in domestic capital spending in China will fully offset the increase in demand for industrial goods and commodities as a result of BRI projects. Pakistan, Kazakhstan and Ghana will benefit the most among major frontier markets from BRI. Investors should consider buying these bourses in sell-off. On a positive note, BRI leads to improved global capital allocation, allows China to export its excess construction and heavy industry capacity, and boosts recipient countries' demand for Chinese exports. Feature China's 'Belt and Road' Initiative (BRI) is on an accelerating path (Chart I-1), with total investment expected to rise from US$120 billion to about US$170 billion over the next three years. Chart I-1Accelerating BRI Investment From China The BRI has been one of the central government's main priorities since late 2013. The primary objectives of the BRI are: To export China's excess capacity in heavy industries and construction to other countries - i.e., build infrastructure in other countries; To expand the country's international influence via a grand plan of funding investments into the 69 countries along the Belt and the Road (B&R) (Chart I-2); To build transportation and communication networks as well as energy supply to facilitate trade and provide China access to other regions, especially Europe and Africa; To facilitate the internationalization of the RMB; To speed up the development of China's poor (and sometimes restive) central and western regions, namely by turning them into economic hubs between coastal China and the BRI countries in the rest of Asia; To boost China's strategic position in central, south, and southeast Asia through security linkages arising from BRI cooperation, as well as from assets (like ports) that could provide military as well as commercial uses in the long run. From a cyclical investment perspective, the pertinent questions for investors are: How big is the current scale of BRI investment, and where is the funding coming from? Will rising BRI investment be able to offset the negative impact from a potential slowdown in Chinese capex spending? Which frontier markets will benefit most from Chinese BRI investment? Chart I-2The Belt And Road Program China's BRI: Scale And Funding Scale China has been implementing its strategic BRI since 2013. To date it has invested in 69 B&R countries through two major approaches: infrastructure project contracts and outward direct investment (ODI). The first approach - investment through projects - is the main mechanism of BRI implementation. BRI projects center on infrastructure development in recipient countries, encompassing construction of transportation (railways, highways, subways, and bridges), energy (power plants and pipelines) and telecommunication infrastructure. The cumulative size of the signed contracts with B&R countries over the past three years is US$383 billion, of which US$182 billion of projects are already completed. However, the value of newly signed contracts in a year does not equal the actual project investment occurred in that year, as generally these contracts will take several years to be implemented and completed. Table I-1 shows our projection of Chinese BRI project investment over the years of 2017-2020, which will reach US$168 billion in 2020. This projection is based on two assumptions: an average three-year investing and implementation period for BRI projects from the date of signing the contract to the commercial operation date (COD) of the project, and an average annual growth rate of 10% for the total value of the annual newly signed contracts over the next three years. Table I-1Projection Of Chinese BRI Project Investment Over The Years 2017-2020 The basis for the first assumption is that the majority of the completed BRI projects were by and large finished within three years, and most of the existing and future BRI projects are also expected to be completed within a three-year period.1 The second assumption of the 10% future growth rate is reasonable, given the 13.5% average annual growth rate for the past two years, but from a low base. These large-scale infrastructure projects were led mainly by Chinese state-owned enterprises (SOEs), and often in the form of BOTs (Build-Operate Transfers), Design-Build-Operate (DBOs), BOOT (Build-Own-Operate-Transfers), BOO (Build-Own-Operate) and other types of Public-Private Partnerships (PPPs). After a Chinese SOE successfully wins a bid on an infrastructure project in a hosting country, the company will typically seek financing from a Chinese source to fund the project, and then execute construction of the project. After the completion of the project, depending on the terms pre-specified in the contract, the company will operate the project for a number of years, which will generate revenues as returns for the company. The second approach - investing into the recipient countries through ODI - is insignificant, with an amount of US$14.5 billion last year. This was only 12% of BRI project investment, and only 8.5% of China's total ODI. Chinese ODI has so far been mainly focused on tertiary industries, particularly in developed countries that can educate China in technology, management, innovation and branding. Besides, most of the Chinese ODI has been in the form of cross-border M&A purchases by Chinese firms, with only a small portion of the ODI targeted at green-field projects, which do not lead to an increase in demand for commodities and capital goods. Therefore, in this report we will only focus on the analysis of project investment as a proxy of Chinese BRI investment, as opposed to ODI. The focal point of this analysis is to gauge the demand outlook for commodities and capital goods originating from BRI. The Sources Of Chinese Funding The projected US$120 billion to US$170 billion BRI investment every year seems affordable for China. This is small in comparison to about US$3-3.5 trillion of new money origination, or about US$3 trillion of bank and shadow-bank credit (excluding borrowing by central and local governments) annually in the past two years. The financing sources for China's BRI investment include China's two policy banks (China Development Bank and the Export-Import Bank of China), two newly established funding sources (Silk Road Fund and Asia Infrastructure Investment Bank), Chinese commercial banks, and other financial institutions/funds. Table I-2 shows our estimate of the breakdown of BRI funding in 2016. Table I-2BRI Funding Sources In 2016 China Development Bank (CDB): As the country's largest development bank, the CDB has total assets of US$2.1 trillion, translating into more than US$350 billion of potential BRI projects over the next 10 years, which could well result in US$35 billion in funding annually from the CDB. The Export-Import Bank of China (EXIM): The EXIM holds an outstanding balance of over 1,000 BRI projects, and has also set up a special lending scheme worth US$19.5 billion over the next three years. This will increase EXIM's BRI lending from last year's US$5 billion to at least US$6.5 billion per year. Silk Road Fund (SRF): The Chinese government launched the SRF in late 2014 with initial funding of US$40 billion to directly support the BRI mission. This year, Chinese President Xi Jinping pledged a funding boost to the SRF with an extra 100 billion yuan (US$15 billion). Therefore, SRF funding to BRI projects over the next three years will be higher than the US$6 billion recorded last year. The Asian Infrastructure Investment Bank (AIIB): The AIIB was established in October 2014 and started lending in January 2016. It only invested US$1.7 billion in loans for nine BRI projects last year. The BRI funding from the AIIB is set to accelerate as the number of member countries has significantly expanded from an original 57 to 80 currently. Chinese commercial banks: Chinese domestic commercial banks, the largest source of BRI funding, have been driving BRI investment momentum. Chinese commercial banks currently fund about 62% of BRI investment and the main financiers are Bank of China (BoC) and Industrial & Commercial Bank of China (ICBC). After lending about US$60 billion over the past two years, the BOC plans to provide US$40 billion this year. The ICBC has 412 BRI projects in its pipeline, involving a total investment of US$337 billion over the next 10 years, which will likely result in an annual US$34 billion in BRI investment. The China Construction Bank (CCB) also has over 180 BRI projects in its pipeline, worth a total investment of US$90 billion over the next five to 10 years. Only three commercial banks will likely fund US$80 billion of BRI projects over the next three years. A few more words about the currency used in BRI funding. The U.S. dollar and Chinese RMB will be the two main currencies employed in BRI funding. Chinese companies can get loans denominated either in RMBs or in USDs from domestic commercial banks/policy banks/special funds/multilateral international banks to buy machinery and equipment (ME) from China. For some PPP projects that involve non-Chinese companies or governments (i.e. those of recipient countries), the local presence can use either USD loans or their central bank's Chinese RMB reserves from the currency swap deal made with China's central bank. China has long looked to recycle its large current account surpluses by pursuing investments in hard assets (land, commodities, infrastructure, etc.) across the world, to mitigate its structural habit of building up large foreign exchange reserves that are mostly invested in low-interest-bearing American government securities. Risky but profitable BRI infrastructure projects are a continuation of this trend. China had so far signed bilateral currency swap agreements worth an aggregate of more than 1 trillion yuan (US$150 billion) with 22 countries or regions along the B&R. The establishment of cross-border RMB payment, clearing and settlement has been gaining momentum, and the use of RMB has been expanding gradually in global trade and investment, notwithstanding inevitable setbacks. Bottom Line: We estimate total BRI investment with Chinese financing will rise from US$120 billion this year to about US$170 billion in 2020, and Chinese financial institutions will be capable of funding it. Can BRI Offset A Slowdown In China's Capex? From a global investors' perspective, a pertinent question around the BRI program is whether the BRI-funded capital spending can offset the potential slowdown in China's domestic investment expenditure. This is essential to gauge the demand outlook for industrial commodities and capital goods worldwide. Our short answer is not likely. Table I-3 reveals that in 2016, gross fixed capital formation (GFCF) in China was estimated by the National Bureau of Statistics to be at RMB 32 trillion, or $4.8 trillion. Table I-3China's GFCF* Vs. China's BRI Investment Expenditures Meantime, China-funded BRI investment expenditure amounted to US$102 billion in 2016. In a nutshell, last year GFCF in China was about 47 times larger than BRI investment expenditures. The question is how much of a drop in mainland GFCF would need to take place to offset the projected BRI investment. The latter will likely amount to US$139 billion in 2018, US$153 billion in 2019 and US$168 billion in 2020. Provided estimated sizes of Chinese GFCF in 2017 are RMB 33.5 trillion (US$4.9 trillion), it would take only 0.4% contraction in GFCF in 2018, 0.3% in 2019 and 2020 to completely offset the rise in BRI-related investment expenditure (Table 3). Chart I-3Record Low Credit Growth... We derive these results by comparing the expected absolute change in BRI capital spending expenditures with the size of China's GFCF. The expected increases in BRI in 2018, 2019 and 2020 are US$20 billion, US$14 billion and US$15 billion. Given the starting point of GFCF in 2017 was US$4.9 trillion, it will take only about 0.4% of decline in $4.9 trillion to offset the $20 billion rise in BRI. In the same way, we estimated that it would take only an annual 0.3% contraction in nominal GFCF in China to completely offset the rise in BRI capital spending in both 2019 and 2020. To be sure, we are not certain that the GFCF will contract in each of the next three years. Yet, odds of such shrinkage in one of these years are substantial. As always, investors face uncertainty, and they need to make assessments. Is an annual 0.4% decline in China's GFCF likely in 2018? In our opinion, it is quite likely, based on our money and credit growth, as illustrated in Chart I-3. Importantly, interest rates in China continue to drift higher. A higher cost of borrowing and regulatory tightening on banks and shadow banking will lead to a meaningful deterioration in China's credit origination. The latter will weigh on investment expenditures. The basis is that the overwhelming portion of GFCF is funded by credit to public and private debtors, and aggregate credit growth has already relapsed. Chart I-4 and Chart I-5 demonstrate that money and credit impulses lead several high-frequency economic variables that tend to correlate with capital expenditure cycles. Chart I-4Negative Money Credit Impulses Point To... Chart I-5...Slowing Capital Expenditure Therefore, we conclude that meaningful weakness in the GFCF is quite likely in 2018, and that it will spill out to 2019 if the government does not counteract it with major stimulus. By and large, odds are that a slump in domestic capital spending in China offset the rise in BRI-related capital expenditures. BCA's Emerging Markets Strategy service has written substantively on motives surrounding China's capital spending and how it is set to slow, and we will not cover these topics. Some reasons why investment spending is bound to slow include: considerable credit excesses/high indebtedness of companies; misallocation of capital and resultant weak cash flow position of companies; non-performing assets on banks' and other creditors' balance sheets and their weak liquidity position. To be sure, investors often ask whether or not material weakness in mainland growth will lead the authorities to stimulate. Odds are they will. Yet, before the slowdown becomes visible in economic numbers, financial markets will likely sell-off. In brief, policymakers are currently tightening and will be late to reverse their policies. Finally, should one compare the entire GFCF, or only part of it? There is a dearth of data to analyze various types of capital spending. In a nutshell, Chart I-6 reveals that installation accounts for roughly 70% of investment, while purchases of equipment account for the remaining 18%. Therefore, we guess the composition of BRI projects will be similar to structure of investment spending in China, and hence it makes sense to use overall GFCF as a comparative benchmark. In addition, the GFCF data is a better measure for Chinese capital spending over Chinese fixed asset investment (FAI) data, as the FAI number includes land values, which have risen significantly over the years and already account for about half of the FAI (Chart I-7). Chart I-6Chinese Fixed Investment Structure Chart I-7GFCF Is A Better Measure Than FAI Bottom Line: While it is hard to forecast and time exact dynamics over the next several years, odds are that the next 12-24 months will turn out to be a period of a slump in China's capital spending. This will more than offset the increase in demand for industrial goods and commodities as a result of BRI projects. Implication For Frontier Markets The BRI, which currently covers 69 countries, will keep expanding its coverage for the foreseeable future. Insofar as it is a way for China to create new markets for its exports, Beijing has no reason to exclude any country. In practice, however, certain countries will receive greater dedication, for the simple reason that their development fits into China's political, military and strategic interests as well as economic interests. As most of the investments are infrastructure-focused, aiming to improve transportation, energy and telecommunication connectivity as well as special economic zones, the recipient countries, especially underdeveloped frontier markets, will benefit considerably from China's BRI. Table I-4 shows that Pakistan, Kazakhstan and Ghana will benefit the most among major frontier markets, as the planned BRI investment in those countries amounts to a significant amount of their GDP. Chart I-8 also shows that, in terms of current account deficit coverage by the Chinese BRI funding, the three countries that stand to benefit most are also Pakistan, Kazakhstan and Ghana. Table I-1The B&R Countries That Benefit From ##br##China's BRI Investment (Ranged From High-To-Low) Chart I-8Chinese BRI Funding's Impact On ##br##External Account Of B&R Countries Of these, clearly Pakistan and Kazakhstan have the advantage of attracting China's strategic as well as economic interest: Kazakhstan offers China greater access into Central Asia and broader Eurasia; Pakistan is a large-population market that offers a means of accessing the Indian Ocean without the geopolitical complications of Southeast and East Asia. These states also neighbor China's restive Xinjiang, where Beijing hopes economic development can discourage separatist and terrorist activities. Pakistan Pakistan is a key prospect for China's exports in of itself, and in the long run offers a maritime waystation and an energy transit hub separate from China's other supply lines. For China, it is a critical alternative to Myanmar and the Malacca Strait. In April 2015, China announced a remarkable US$46.4 billion CPEC (China-Pakistan Economic Corridor) investment plan in Pakistan, equal to 16.4% of Pakistani GDP. It is expected to be implemented over five years. In particular, the planned US$33.2 billion energy investment will increase Pakistan's existing power capacity by 70% from 2017 to 2023. On the whole, China's CPEC plan will be significantly positive to economic development in Pakistan in the long run, but in the near term it is still not enough to boost the nation's competitiveness (Chart I-9A, top panel). Chart I-9AOur Calls Have Been Correct Chart I-9BTop 3 Frontier Markets Benefiting Most ##br##From Chinese BRI Investment Also, as about 40% of the investment has already been invested over the previous two years, odds are that China's CPEC investment will go slower and smaller this year and over the next few years. BCA's Frontier Markets Strategy service's recent tactical bearish call on Pakistani stocks has been correct, with a 25% decline in the MSCI Pakistan Index in U.S. dollar terms since our recommendation in March (Chart I-9B, top panel).2 We remain tactically cautious for now. Kazakhstan Kazakhstan is a key transit corridor for Chinese goods to enter Europe and the Middle East. In June 2017, Chinese and Kazakh enterprises and financial institutions signed at least 24 deals worth more than US$8 billion. China's BRI investment in Kazakhstan facilitated the country's accelerated economic growth (Chart I-9A, middle panel). BCA's Frontier Markets Strategy service reiterates its positive view on Kazakhstan equities because of a recuperating economy, considerable fiscal stimulus and rising Chinese BRI investment (Chart I-9B, middle panel).3 Ghana Ghana is not strategic for China (it is a minor supplier of oil). Instead, it illustrates the fact that BRI is not always relevant to China's strategic or geopolitical interests. Sometimes it is simply about China's need to invest its surplus U.S. liquidity into hard assets around the world. Of course, Ghana itself will benefit considerably from the committed US$19 billion BRI investment, which was announced only a few months ago. This is a huge amount for the country, equaling 45% of Ghana's 2016 GDP. This massive fresh investment will boost Ghana's economic growth in both the near and long term (Chart I-9A, bottom panel). BCA's Frontier Markets Strategy service upgraded its stance on the Ghanaian equity market from negative to neutral in absolute terms at the end of July, and we also recommended overweighting the bourse relative to the broader MSCI EM universe (Chart I-9B, bottom panel).4 Our positive view on Ghana remains unchanged for now and we are looking to establish a long position in the absolute terms in this bourse amid a potential EM-wide sell-off. Other Macro Ramifications Industrial goods and commodities/materials are vulnerable. BRI will not change the fact that a potential relapse in capital spending in China will lead to diminishing growth in commodities demand. If there is a massive slowdown in property market like China experienced in 2015, which is very likely due to lingering excesses, Chinese commodity and industrial goods demand could even contract (Chart I-10). Notably, mainland's imports of base metals have been flat since 2010, and imports of capital goods shank in 2015 even though GDP and GFCF growth were positive (Chart I-11). The point is that there could be another cyclical contraction in Chinese imports of commodities and industrial goods, even if headline GDP and GFCF do not contract. Chart I-10Chinese Capital Goods Imports Could Contract Again Chart I-11Imports Of Metals Could Slow Further As China accounts for 50% of global demand of industrial metals and it imports about US$ 589 billion of industrial goods and materials annually, either decelerating growth or outright demand contraction will be negative news for global commodities markets and industrial goods producers. China's Exports Have A Brighter Outlook China's machinery and equipment (ME) exports account for 47% of total exports, and 9% of its GDP (Table I-5). The BRI investment will boost Chinese ME exports directly through large infrastructure projects. Table I-5Structure Of Chinese Exports (2016) Meantime, robust income growth in the recipient countries will boost their demand for household goods (Chart I-12). China has a very strong competitive advantage in white and consumer goods production, especially in low-price segments that are popular in developing economies. Therefore, not only is China exporting its excess construction and heavy industry capacity, but the BRI is also boosting recipient countries' demand for Chinese household and other goods exports. Adding up dozens of countries like Ghana can result in a meaningful augmentation in China's customer base. Notably, Chinese total exports have exhibited signs of improvement as Chinese ME exports and exports to the major B&R countries have contributed to a rising share of total Chinese exports since 2015 (Chart I-13). Chart I-12BRI Will Lift Chinese Exports Of ##br##Capital And Consumer Goods Chart I-13Signs Of Improvement In Chinese Exports ##br##Due To Rising BRI Investment BRI Leads To Improved Global Capital Allocation BRI is one of a very few global initiatives that improves the quality of global capital allocation. Therefore, it is bullish for global growth from a structural perspective. By shifting capital spending from a country that has already invested a lot in the past 20 years (China) to the ones that have been massively underinvested, BRI boosts the marginal productivity of capital. One billion dollars invested in the underinvested recipient countries will generate more benefits than the same amount invested in China. Risks To BRI Projects Notable deterioration in the health of Chinese banks may meaningfully curtail BRI funding, as Chinese non-policy banks will likely need to provide 60% of BRI projects' funding. Political stability/changes in destination countries: As most infrastructure projects have been authorized by the top government and need their cooperation, any changes in the recipient countries' governments or regimes may slow down or deter BRI projects. China already has a checkered past with developing countries where it has invested heavily. This is because of its employment of Chinese instead of local labor, its pursuit of flagship projects seen as benefiting elites rather than commoners, its allegedly corrupt ties with ruling parties, and perceived exploitation of natural resources to the neglect of the home nation. As China's involvement grows, local politics will be more difficult to manage, requiring China to suffer occasional losses due to political reversals or to defend its assets through aggressive economic sanctions, or even expeditionary force. For now, as there are no clear signs that any these risks are imminent, we remain positive on the further implementation of China's BRI program. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 China has long been known to use three-year periods - as distinct from its better known "five year plans" - for major domestic initiatives. In 2016, the National Development and Reform Commission re-emphasized three-year planning periods for "continuous, rolling" implementation. 2 Please see BCA's Frontier Markets Strategy Special Report "Pakistani Stocks: A Top Is At Hand", published March 13, 2017. Available at fms.bcaresearch.com. 3 Please see BCA's Frontier Markets Strategy Special Report "Kazakhstan: A Touch Less Dependent On Oil Prices", published March 28, 2017. Available at fms.bcaresearch.com. 4 Please see BCA's Frontier Markets Strategy Special Report "Ghana: Sailing On Chinese Winds", published July 31, 2017. Available at fms.bcaresearch.com.

Feature The Brazilian economy is finally improving following a devastating depression of about 3 years, where real GDP dropped by a whopping 7.4%. Does the current economic revival warrant a bullish stance on its financial markets? If the global risk-on trade persists among EM risk assets and commodities and there are no domestic political blunders in Brazil, the country's financial markets will continue to rally as economic growth improves. If the EM and commodities rallies wane and an EM risk-off cycle develops, Brazilian risk assets will sell off, regardless of domestic economic recovery. Provided economies around the world have become interconnected, it is often difficult to separate global economic and financial market impact from domestic economic dynamics. Yet, it is possible to do so in Brazil in the latest cycle. Chart I-1 demonstrates that the Brazilian real bottomed with iron ore prices on December 21, 2015 - not with the bottom in the Brazilian economy in early Q1 2017 (Chart I-1, bottom panel). In turn, the currency's rally amid the collapse in domestic demand has led to a material drop in inflation and allowed the central bank to cut interest rates aggressively. The exchange rate is the main variable driving financial markets in many developing countries, including Brazil. In these countries, it is the exchange rate that causes swings in interest rate expectations, not the other way around. Furthermore, other important variables that led to the bottom in iron ore prices and the BRL were the Chinese manufacturing PMI and money growth, both of which bottomed in the second half of 2015 (Chart I-2). Chart 1BRL Correlates With Commodities ##br##Not Domestic Demand Chart 2Chinese Data Led##br## The Bottom In BRL In short, economic recovery arrived much later in Brazil, and so far it has been exceptionally tame and tentative (Chart I-3). Brazil's domestic demand performance has in no way justified the rally in its financial markets since January 2016. If anything, it is the opposite: the domestic economic recovery emerged too late, and has been extremely subdued compared with the sizable gains in share prices. For example, banks' EPS bottomed only in May 2017, while their share prices troughed in January 2016 (Chart I-4). Similarly, Brazil's fiscal outlook and debt profile has continued to deteriorate, even though the country's sovereign spreads have tightened substantially (Chart I-5). Chart 3Brazil: Economic Recovery Is Exceptionally Tame Chart 4Brazil: Bank Share Prices And EPS Chart 5Brazil's Fiscal And Debt Profiles Have Deteriorated Hence, one can safely argue that economic growth and domestic fundamentals were not the basis behind why Brazilian financial markets found a bottom and rallied starting January 2016. Rather, the critical driving force has been commodities prices, China, the U.S. dollar and global risk appetite. This is consistent with the defining features of bull and bear markets: In a bull market, liquidity lifts all boats, and all flaws are overlooked or discharged while minor positives are magnified by the market. In a bear market, even marginal negatives are overblown, and the market punishes severely for minor missteps. In short, global risk assets have been in a genuine bull market since early 2016, and that has overridden Brazil's poor domestic fundamentals. Going forward, we recommend avoiding Brazilian risk assets - not because we do not expect an economic recovery in Brazil to progress, but because our view on China's impact on commodities and the potential U.S. dollar rebound will curb overall risk appetite toward EM. We discussed this EM/China/commodities outlook at length in last week's report.1 Timing a shift in financial market regimes is always a difficult task, but our sense is that a top in EM risk assets will likely occur between now and the end of October, as China's Communist party Congress reiterates its focus on containing financial risk and leverage, as well as the authorities' marginal tolerance for slightly slower growth. Furthermore, our broad money (M3) impulse for China suggests an imminent relapse in Goldman Sach's current economic activity indicator for the mainland economy (Chart I-6). Our assumption is that commodities prices will drop due to potential weakness in China, and that the U.S. dollar and U.S. bond yields are oversold and will recover, respectively. Altogether, these views warrant a cautious stance on EM currencies. The real has historically been correlated with commodities prices, and this positive correlation will likely continue. As and when the Brazilian currency resumes its depreciation, the risk-on trade in Brazilian equities and credit markets will end. As for Brazilian financial markets, a few relationships are worth highlighting: Since early this year, iron ore prices have been inversely correlated with Chinese money market rates (Chart I-7). A possible explanation is that iron ore and other commodities prices trading on Chinese exchanges have been driven by meaningful speculative buying that negatively correlates with borrowing costs on the mainland. Chart 6China's Growth Is Set To Slow Chart 7Iron Ore Prices Are Vulnerable Given the latest relapse in Brazil's nominal GDP growth, the pace of amelioration in private banks' NPL and NPL provisions could stall (Chart I-8). In turn, Brazilian banks' share prices seem to move inversely with the rate of change in private banks' NPL and NPL provisions (Chart I-9A & Chart I-9B). If these relationships hold, we might be close to a peak in Brazilian bank share prices. Chart 8Brazil: Is The Improvement In NPL Cycle Over? Chart 9ABrazil: NPL Cycles and Bank Stocks Chart 9BBrazil: Provisions Cycles And Bank Stocks Finally, the pace of economic recovery will likely disappoint because the Brazilian economy is facing numerous headwinds: High borrowing costs - the real prime lending rate is 12.5% and the policy rate in the real terms is 6.8%, while public banks' lending rates are set to rise due to the TJLP reform that will remove the government budget's subsidy for borrowers. With 50% of outstanding credit being earmarked credit (previously subsidized by the government and provided by public banks), the impact on economic activity will be non-trivial; Lower government spending, as 2018 government expenditure growth cannot exceed the 2017 June headline inflation rate of 3%. Besides, the fiscal balance is so disastrous that risks to taxes are to the upside, not downside. Furthermore, the recently augmented 2017 year-end fiscal primary deficit target of BRL 159 billion is smaller than the deficit of BRL 182 billion for the past 12 months. This entails government spending cuts are likely this year, which will weigh on growth. The Brazilian exchange rate is not cheap. The nation needs a cheaper currency to reflate its economy. Lingering political uncertainty amid the corruption scandals and upcoming presidential elections in fall 2018 will continue to weigh on capital spending and employment, which have not yet recovered. Bottom Line: Our overarching negative view on EM, China and commodities heralds staying cautious on Brazil's financial markets despite the early signs of domestic economic recovery. 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 Weekly Report, titled "Copper Versus Money/Credit In China - Which One Is Right?", dated September 6,. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Chinese monetary conditions have tightened on the margin, but have remained fairly stimulative compared with previous years, likely the key reason why overall growth has remained reasonably robust. Listed Chinese firms reported strong and broad based H1 earnings growth. The profit recovery is of fundamental importance to the Chinese economy, and the positive feedback between profits and business activity has further to run. Collectively the markets are likely flashing further upside in China’s growth cycle. At a minimum, there is no sign of an imminent downturn. The macro backdrop of economic and market fundamentals are conducive for higher equity prices in general, and Chinese equities in particular. Feature Recent manufacturing PMIs from a number of major countries confirm that the global economy is on a synchronized upturn. As an increasingly important driving force of the world economy, how China's growth outlook pans out matters materially. On this front, the most recent news has been encouraging. Chinese manufacturing PMIs, both official and private, accelerated in August and remained above the expansion/contraction threshold. Meanwhile, earnings of Chinese-listed companies in the first half of the year increased strongly from a year earlier across all major sectors, with both stronger sales and higher margins, confirming that the Chinese profit cycle upturn is firmly in place. This should further support business activity, especially among private enterprises. In addition, some market signals from global assets that are traditionally sensitive to Chinese growth trends have been fairly strong of late, likely signaling further upside in the Chinese business cycle. All of this is conducive for higher prices for Chinese equities, and paints a bullish backdrop for global risk assets. A Closer Look At The PMI The stronger-than-expected August Chinese PMI numbers set a firmer tone for the economic data to be released in the coming weeks. They also herald that economic growth in the third quarter will likely remain comfortably above the government's target, setting an ideal political environment for the country's top leadership going into the 19th Communist Party Congress in October. The policy setting will likely be maintained at status quo, and downside risks remain low. It is important to note that the recent rise in PMI has occurred in tandem with a continued decline in Chinese broad money growth, suggesting the improvement in Chinese industrial activity has little to do with money and credit stimuli (Chart 1). Some analysts have been preoccupied with inventing some obscure measures of "credit impulse" to guestimate China's near-term growth outlook, which in our view is misguided.1 Instead, China's growth improvement since last year has to a larger extent been due to marked easing in monetary conditions - a combination of lower real rates and a cheaper trade-weighted RMB. In this vein, Chinese monetary conditions have begun to tighten on margin, but have remained fairly stimulative compared with previous years. This is likely the key reason why overall growth has remained reasonably robust, despite falling monetary aggregates. It is particularly noteworthy that the trends of new orders and finished products inventory have diverged of late. New orders have stayed at close to multi-year highs, while inventory PMI has remained well below 50 since 2012, and has relapsed anew in recent months, leading to a significant rise in the new orders-to-inventory ratio (Chart 2). In other words, manufacturers remain decisively in a destocking mood, despite the improvement in new orders. Looking forward, this should supercharge production should new orders remain strong, and create a buffer for manufacturing activity should orders roll over. Chart 1Chinese PMI: Monetary Conditions ##br##Matter More Than Money Supply Chart 2Manufacturers Remain Decisively ##br##In Destocking Mood Another important development is that there appears to be some regained pricing power among service providers, which historically has been a leading indicator for manufacturers' producer prices (PPI), as shown in Chart 3. It appears that PPI may continue to downshift toward year end and regain some strength early next year. PPI has been a key signpost for China's reflation trend, and matters materially for manufacturers' profit margins and the real cost of funding. Any sign of PPI improvement will likely be viewed as a positive development from a market perspective. The market relevance of the PMI survey is that it often leads net earnings revisions of listed Chinese companies by bottom-up analysts (Chart 4). If history is any guide, net earnings revisions will likely improve further, notwithstanding earnings of listed companies have already recovered strongly in the first half of the year. Chart 3Early Signs Of PPI Bottoming? Chart 4PMI Leads Net Earnings Revisions Earnings Reality Check Chart 5A Sharp Profit Upturn By now, all listed firms in Chinese domestic stock exchanges have released financial statements for the first half of the year. Our calculations show that total earnings increased by 18% year-over-year for all listed firms, or 36% if banks and petroleum firms are excluded - both sharply higher compared with a year earlier. This is largely in line with the profit upturn reported by the national statistics agency2 (Chart 5, top panel). A few observations can be made: First, the sharp increase in earnings is due to a combination of rising sales and improving margins, underscoring a marked ease in deflationary pressures and a significant pickup in business activity in nominal terms. (Chart 5, bottom two panels). It is noteworthy that revenue growth stagnated for several consecutive years before the strong recovery since mid-last year. Similarly, profit margins dropped to close to record low levels between 2012 and mid-2016, and have since largely recovered. Profit margins, however, do not yet look overly excessive from a historical perspective. Second, the improvement in earnings is broad-based, as shown in Table 1. Materials producers and energy concerns have experienced a massive profit boom, particularly steelmakers. With the only notable exception being utilities, largely thermal power plants, whose profit margins have been squeezed by rising coal costs, most other sectors have also booked healthy profit gains. This means the profit upturn has been driven by improvement in the broader economy rather than specific government policies that benefit select industries. Finally, the banking sector has also experienced a pickup in earnings growth, especially among large state-controlled banks. More importantly, asset quality of bank loans has also improved, albeit marginally. Our calculation shows that non-performing loans (NPL) and "special-mention-loans," which banks place closer scrutiny on as borrowers face higher risks of default, have both begun to decline (Chart 6). This should not be surprising, given the corporate sector's rising profits. Leaders in the current profit recovery are mining companies, materials producers and some industrial firms, all of which have been regarded as major trouble spots in banks' loan books.3 It may be premature to declare the peak of China's NPL problem, but the profit improvement has certainly helped banks mend their balance sheets. Table 1Earnings Scorecard Chart 6Marginal Improvement##br## In Banks' Asset Quality In short, we maintain the view that profit recovery is of fundamental importance to the Chinese economy, a key pillar in our positive stance on China's cyclical outlook.4 Rising profits restore entrepreneurial confidence, boost private-sector capital spending, ease balance sheet stress of asset-heavy enterprises and de-escalate banking sector risk. It is certainly unrealistic to expect profit growth to perpetually accelerate, but there are no signs of a sudden contraction in profits anytime soon. We expect the positive feedback loop between profits and business activity has further to run. Reading Market Tea Leaves Stronger Chinese growth is also reflected in asset prices well beyond its borders. Some asset classes that are traditionally highly sensitive to Chinese growth cycles have been showing remarkable strength of late. Metals prices have been firm across the board. The London Metal Exchange Index has historically been a reliable leading indicator of China's business cycle (Chart 7). Stock prices of metals producers in major producing countries have significantly outperformed their respective benchmarks, likely pointing to an imminent upturn in China's leading economic indicator (Chart 8) The Baltic Dry Index, the benchmark for bulk shipping rates that is largely driven by Chinese materials demand, has stayed elevated, probably a sign that China's bulk commodities intake has remained fairly robust (Chart 9) Turning to the Chinese equity market, real estate developers have been among the star performers in the Chinese equity universe so far this year - historically, the relative performance of Chinese developers has been an excellent leading indicator for home sales, which in turn drives real estate investment (Chart 10). Chart 7Metals Point To Further Upside##br## In Chinese Business Cycle... Chart 8...So Do Metal Producers Chart 9Baltic And Chinese Commodity Imports Chart 10Developers' Relative Performance ##br##Leads Home Sales Collectively the markets are likely flashing further upside in China's growth cycle. At a minimum, there is no sign of an imminent downturn. Currently, global equity markets, including those in the Greater China region, are clouded by the escalating geopolitical risk over the Korean Peninsula, where the near term outlook remains volatile and unpredictable.5 Barring an extreme scenario, the macro backdrop of economic and market fundamentals are conducive for higher equity prices in general, and Chinese equities in particular. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report "A Chinese Slowdown: How Much Downside?" dated June 8, 2017, and Special Report, "Focusing On Chinese Money Supply", dated July 27, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "A Closer Look At Chinese Equity Valuations", dated August 31, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report, "Stress-Testing Chinese Banks", dated July 27, 2016, available at cis.bcaresearch.com. 4 Please see China Investment Weekly Report, "China: The 2017 Outlook, And The Trump Wildcard", dated January 12, 2017, and "China Outlook: A Mid-Year Revisit", dated July 13, 2017, available at cis.bcaresearch.com. 5 Please see China Investment Strategy Weekly Report, "China's Geopolitical Pressure Points: Knowns, Unknowns And A Hedge", dated August 17, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Beijing's continued focus on reducing excess industrial capacity in the lead-up to the 19th National Congress of the Communist Party will keep iron ore and steel markets buoyant for the balance of the year. The trajectory of prices further out the curve will, however, depend greatly on how quickly China's reflationary policies wane next year. Energy: Overweight. U.S. gasoline inventories could fall by 7-10mm barrels in the first week following the storm (data to be reported today by the EIA), and another 5-10mm barrels (or more) over the next month, depending on how long it takes to restart all of the refineries knocked offline by Hurricane Harvey, according to estimates in BCA Research's Energy Sector Strategy. Current gasoline inventories sit about 20 million barrels above the 2011-2015 average, which, based on our calculations, could be completely evaporated within a month, materially changing the U.S. gasoline market and related crack spreads.1 Base Metals: Neutral. Following our analysis last month, we are recommending a tactical short Dec/17 COMEX copper position at tonight's close, expecting the market to correct in line with the fundamentals we highlighted.2 Precious Metals: Neutral. We remain long gold as a strategic portfolio hedge. The metal will be supported by low real interest rates and safe-haven demand. The position was recommended May 4, 2017, and is up 8.7%. Ags/Softs: Underweight. Another bumper crop is being priced into corn this year. Expectations for higher corn yields this year - ranging from 166.9 bushels/acre (bpa) to 169.2 bpa vs. 169.5 bpa expected by the USDA - will keep prices under pressure. We remain bearish.3 Feature In reaction to Chinese economic and environmental policies, iron ore and steel each rallied by ~78% in 2016. While steel continued its ascent in 2017 - gaining a further ~20% in the year-to-date (ytd), iron ore broke away from this trend and plummeted by more than 40% between mid-February and mid-June (Chart of the Week). Chart of the WeekSteel And Iron Ore Diverged Earlier This Year Although iron ore has since reversed its path and regained most of the loss, the divergence between steel and the ore from which it is produced comes down to a difference in fundamentals. Increased supplies of iron ore at a time of healthy inventories were bearish in H1. On the other hand, closures of both steel capacity as well as coal capacity kept the steel market tight. While China's supply-side policies have been the force behind the strength in both to date, Chinese demand - which accounts for ~50% of global iron ore and steel consumption, and steel production - will take center stage next year. The speed at which China's reflationary policies wane will determine the long-term trajectory of steel and iron ore markets. Granted while there are some early signs of a potential slowdown in China's economy, we do not expect this to hit metals generally in the near term. As Beijing continues its focus on reducing excess capacity in the steel sector, and as policymakers prepare for the 19th National Congress later this year, we expect steel and iron ore to remain buoyant in H2. China's Steel Production Paradox Eliminating Excess Steel Capacity At The Forefront Of Reform Agenda... The National Development and Reform Commission (NDRC) - China's top economic planning authority - has made clear that reducing overcapacity is at the forefront of its reform priorities. More concretely, Beijing aims to cut steel capacity by up to 100-150mm MT over the five-year period between 2016 and 2020. It has already made progress towards that end - shuttering a reported 65mm MT last year - and is on track to meet its targeted 50mm MT of steel capacity cuts by the end of 2017. Additionally, in January the central government announced its intention to eliminate all steel capacity from intermediate frequency furnaces (IFF) by the end of June 2017. So it is no surprise that steel has been performing so well. However, this narrative is inconsistent with Chinese data. ...Yet Chinese Production Is At All-Time Highs Steel production from China this year has been soaring, growing by more than 5% year-on-year (yoy) in the first seven months of 2017. In fact, latest production data from July came in at 74mm MT, marking a more than 10% yoy increase, and an all-time record high for monthly production (Chart 2). And since ~50% of global steel is produced in China, this has translated into strong global steel production figures in 2017. Production grew by 4.75% yoy in the first seven months of 2017, the most since 2011 and almost five times as much as the five-year average yoy increase for that period. In fact, the China Iron and Steel Association recently announced that the strength in steel prices does not reflect underlying fundamentals and is instead due to speculation and a misunderstanding of the market impact of China's policies. In an effort to deter speculation, China's commodity exchanges implemented several restrictions in August, including increasing margins on futures contracts and limiting positions (Chart 3).4 Chart 2Record Steel Production##BR##Amid Chinese Capacity Cuts Chart 3Pure Speculation Or Not?##BR##Beijing Cracking Down On Market Speculation It Comes Down To The Nature Of IFFs This paradox of record high production at a time of capacity closures comes down to the nature of IFF capacity that was shutdown. While for the most part, old, outdated and unproductive facilities were targeted for closure last year, the shift in focus towards IFFs had a different effect on the market in 2017. IFFs use scrap steel, rather than iron ore, as a raw material, which is melted through an induction furnace to produce low-quality steel. Because this steel fails to meet government specifications for high-quality steel, it is considered "illegal" and, although it is used to satisfy steel demand, it is not included in official production data. Thus, efforts to shut-down these producers are not evident in China's production figures. However, IFF steelmaking capacity is estimated to be 80-120mm MT a year, and accounts for ~10% of steel production capacity in China. In terms of output, this substandard steel accounts for almost 4% of Chinese production. Thus, traditional steelmaking facilities have been required to fill the supply void caused by IFF closures, raising the official production figures. Steel Exports Take A U-Turn As "Illegal" Capacity Is Shuttered Moreover, Chinese exports have reversed their trend and are on the decline. Steel exports registered a ~30% yoy fall in the first seven months of this year (Chart 4). This is further evidence that the capacity closures have had a real impact on actual steel production, and that domestic consumers have turned to steel that is typically exported, in order to fulfill their demand for the metal. Furthermore, as authorities crack down on IFFs, demand for scrap steel - the main raw material in IFFs - has declined. Amid waning demand, scrap steel prices fell by 9% in H1 before regaining almost 6% in July. This follows a ~70% rally last year (Chart 5). Chart 4Exports Are Down As##BR##Capacity Is Shutdown Chart 5Scrap Steel Rally Takes A Break##BR##As Demand From IFFs Eliminated Coking Coal Cost Push As part of its environmental protection plans, China's policymakers announced plans to replace 800mm MT of outdated coal mining capacity with 500mm MT of "advanced" capacity by 2020. Last year, coal-mining capacity closures exceeded the 250mm MT target, reversing the slump in coal prices and leading an almost 225% rally in coke futures. Coking coal, or metallurgical coal, is a key ingredient in the steelmaking process. Although coke dipped since its December high, it has rallied by 34% in the past two months. Thus, Chinese steel mills are now producing in an environment of higher input costs, which will translate to higher prices for the finished good. China's Capacity Closures Likely Peaked Given that China has set June 30, 2017 as the target for eliminating induction furnace-based steelmaking, we do not expect IFF shutdowns to continue impacting the steel market. Additionally, while excess steel capacity is conventionally estimated to be 325-350mm MT in China, the Peterson Institute for International Economics (PIIE) argues that this estimate does not account for the need for a certain amount of excess capacity. Instead, they cite 130mm MT as a more reasonable figure of Chinese excess steel capacity. According to PIIE estimates, this means that by the end of the year, China will have eliminated almost all of its excess capacity, and will be very close to the quantity of capacity closures it aims to achieve by 2020. Consequently, we do not expect shutdowns to continue driving up steel prices. However, plans to halve blast-furnace production at Northern China mills to reduce pollution during the winter will weigh on near term Chinese production and the steel market. Bottom Line: Chinese authorities are closing in on their targeted capacity shutdowns. We do not expect this reduction in capacity to continue impacting steel markets in the long term. Near-term supply dynamics will be driven by efforts to reduce winter pollution. IFF Closures Spur Demand For Iron Ore Chart 6Mid-Year China Inventories At Record High With the elimination of IFFs, which take in scrap steel as the main input, we expect greater demand for iron ore from traditional steel mills as they work toward filling the supply gap left by the loss of the so-called illegal steel. While steel prices have been on a consistent uptrend since 2016, iron ore - which usually moves in tandem with steel - diverged from its main demand market earlier this year, before resuming its rally in Q2. The deviation earlier this year was due to increased supplies from Australia and Brazil amid record levels of Chinese inventories (Chart 6). This has reversed, and iron ore has resumed its climb. Stronger demand for iron ore is consistent with import data, which shows that China has been hungry for Australian and Brazilian iron ore. However, since the average iron ore production cost in China - estimated at more than 60 USD/MT, or roughly three (3) times the cost of iron-ore production in Brazil and Australia - is greater than in other regions, many Chinese mines go offline during periods of low prices. By the same token, elevated prices tempt high-cost Chinese producers back online, increasing global supply. Bottom Line: Since the closure of induction furnaces has shored up demand for iron ore, pulling prices up with it, we do not anticipate further drops in prices. However, if prices remain elevated, increased production from China amid well stocked global markets will keep a tight lid on iron ore prices. Chinese Appetite Will Determine Long-Run Market Performance While steel and iron ore are currently well supported, their near term strength is in large part due to China's reflation policies which have revived demand. Given that it is a sensitive political year, we do not foresee downturns in the Chinese economy this year. Authorities will want to go into the 19th National Congress of the Communist Party in mid-October with solid economic data as a backdrop. However, waning Chinese growth would be a long-run negative for the markets (Chart 7). Specifically, official government data indicate: 1. There are early warning signs that the property market in China may be losing momentum. New floor space started, and new floor space completed contracted in July, while growth in floor space under construction and floor space sold have been easing. Furthermore, while total real estate investment has been growing at an average monthly rate of almost 9% yoy since the beginning of the year, July figures show a marked slowdown, at less than 5% yoy growth. We would not be surprised to see the property market winding down as China begins to tighten its real estate policies. 2. Chinese automobile production has slowed significantly from all-time highs recorded at the end of last year. The monthly average 4% yoy growth in the five months to July is a significant deceleration from the 10% yoy average witnessed during the same period last year. 3. However, infrastructure investment has been strong, recording its all-time high in June, and a 20% yoy increase in July. With the National Congress scheduled in October, we do not expect a slowdown in infrastructure spending this year. In addition, August manufacturing PMI data in China came in above expectations, and registered a slight increase from the previous month (Chart 8). The index has remained relatively stable since the beginning of the year, after gaining strength last year. Chart 7Despite Signs Of Fizzling,##BR##Slowdown Not Expected In 2017 Chart 8Accomodative Policies Will##BR##Keep Near Term Demand Solid Bottom Line: Although we expect China's appetite for steel will begin to wane as the economy unravels from its reflationary policies, steel demand will remain strong in 2017. Chinese authorities will want to ensure solid growth in the run-up to the National Congress scheduled for mid-October. Thus, the near-term focus will remain on supply, and the impact of its reforms on ferrous metals. Post-Harvey Rebuilding Will Spur Steel Demand Hurricane Harvey is expected to impact steel markets in three main ways: 30-35% of all U.S. steel imports come through Port Houston. However, the port resumed operations as of September 1 and there is no longer a threat posed on steel imports. The disruption in freight service resulting from Harvey is expected to temporarily push up trucking rates in the next few weeks. This will give U.S. steel firms, which have long been suffering from cheaper Chinese imports, an advantage and opportunity to fill the demand void which will be bullish for U.S. steel. Harvey will have a longer-run positive impact on steel markets through the demand that will be generated from the infrastructure rebuilding process. Still, increased demand for steel will be partially mitigated by a rise in scrap steel supply, in the aftermath of destruction. While it is still too early to measure the extent of damage and the impact of the rebuilding process on steel markets, estimates from the storm's damage run as high as USD 120 billion. Texas's governor estimated the damage to be much greater - between USD 150-180 billion. This compares to USD 110 billion from Hurricane Katrina, the most devastating storm to hit the U.S. prior to Harvey. Bottom Line: While it is still too early to determine the full extent of destruction, the infrastructure rebuilding phase will spur demand for steel. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see BCA Research's Energy Sector Strategy Weekly Report "Upgrading Refining Sector As Harvey Clears Out Inventories," published September 6, 2017 It is available at nrg.bcaresearch.com. 2 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Copper's Getting Out Ahead Of Fundamentals, Correction Likely," published August 24, 2017. It is available at ces.bcaresearch.com. 3 Please see "GRAINS - Corn lower as U.S. yield forecasts rise; soy, wheat climb," published by reuters.com on September 1, 2017. 4 Please see "Shanghai exchange urges steel investors to act rationally, hikes fees" published by reuters.com on August 11, 2017. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights Industrial metals prices are signaling that China's business conditions are presently robust, but they lag the credit and money measures. The most reliable leading (forward looking) indicators of Chinese business cycle have been money and credit. Presently, all money and credit indicators forecast an imminent slowdown in the industrial sectors and a relapse in base metals prices. A new trade: short copper / long Chilean peso. Inflation in Hungary will surge. Continue betting on yield curve steepening in Hungary and stay short HUF versus PLN. Feature Copper and industrial metals prices continue to signal strong growth in China, while the majority of the country's money and credit measures forecast an imminent growth slump. Which one is correct, and which one should investors heed to when formulating their investment strategy? Chart I-1 demonstrates that our broad money measure (M3) and private and public credit impulses for China both lead copper and industrial metals prices by about nine months. Based on the historical track record, odds are that investors will be better off following these money and credit indicators rather than heeding the bullish message from copper and other industrial commodities. While copper prices are coincident with the business cycle, money and credit impulses lead not only the real economy but also industrial metals prices. Copper Copper prices have surged of late (Chart I-2), seriously challenging our negative view on Chinese capital spending, commodities and EM. In fact, the rally in industrial metals has not been confined to copper but has been broad-based, and is, at first blush, suggestive of continued strength in global and Chinese industrial cycle. Chart I-1China's Money/Credit Leads Industrial Metals Prices Chart I-2Traders Are Very Bullish On Copper: A Contrarian Signal? Consistently, China's manufacturing PMI has picked up over the past three months, as has the overall EM PMI ex-China (Chart I-3). China's aggregate imports of copper products, unwrought copper, copper ore and concentrate as well as copper scrap have been contracting since May, and interestingly, they have historically often been negatively correlated with copper prices (Chart I-4). Hence, little insight can be drawn from Chinese imports of copper, as these purchases do not correlate with the mainland's business cycle. Chart I-3China/EM PMIs Have Risen Chart I-4Chinese Copper Imports And ##br##Copper Prices: Negative Correlation? On the contrary, Chinese imports of copper typically rise when copper prices fall and its industrial sector is decelerating. The reason: Chinese importers time their commodities purchases when prices slump, and do not chase prices higher. In short, when attempting to predict the sustainability of Chinese economic activity, there is little to be gained in examining Chinese copper imports. Bottom Line: Industrial metals prices are signaling that China's business conditions are presently robust, but they lag the credit and money measures discussed below. Leading Indicators: Money And Credit In our experience, the best leading indicators of the Chinese business cycle have been money and credit growth, more specifically, their impulses. The latter is the change in money/credit growth, or the second derivative of outstanding money/credit. In fact, money/credit impulses lead both the leading economic indicator and the well-known Li Keqiang index (Chart I-5). The latter two are often used by analysts and investors to gauge the direction of the Chinese economy. In recent months, we have done extensive work to properly measure money and credit. This has led us to the realization that China's official M2 and total social financing have not reflected the true dynamics in money creation and leverage formation over the past two years. In particular, M2 has over the years become a less all-encompassing money measure, as the size of commercial banks' liabilities that are not counted as part of M2 has exploded in recent years. So, the gap between M2 and other measures of money and credit has in the recent years widened as depicted on the top panel of Chart I-6. Chart I-5China: Money/Credit Leads ##br##Leading Economic Indicators Chart I-6China: Money/Credit Growth Have Fallen To New Lows The bottom panel of Chart I-6 demonstrates official M2, our version of broad money M3 (calculated using commercial banks' liabilities), credit-money (computed based on banks' balance sheet assets) and aggregate of private and public credit. All these measures have slowed to new lows. The most reasonable and all-inclusive measures from the four, in our view, is our measure of broad money M3 and private and public credit. As such, this is what we use to gauge the Chinese business cycle outlook. Chart I-7A and Chart I-7B demonstrate that the impulses of both M3 and private and public credit lead various business cycle and financial variables such as nominal GDP, manufacturing PMI, total imports, imports of capital goods, the freight index and producer prices as well as industrial profits. Chart I-7AChina: Money And Credit Impulses ##br##Entail Business Cycle Slowdown (II) Chart I-7BChina: Money And Credit Impulses ##br##Entail Business Cycle Slowdown (I) Regardless of which money and credit measure we use, and regardless of their past track record, all of them currently suggest that China's business cycle is about to experience a considerable slump. Besides, money and credit impulses typically lead copper and industrial metals prices by about nine months, as shown in Chart I-1. These are the primary fundamental reasons why we are reluctant to alter our negative view on China's industrial cycle. Bottom Line: The most reliable leading indicators of the mainland business cycle have been money and credit. All money and credit indicators presently forecast an imminent slowdown in the industrial sectors. Financial markets are typically forward looking, and they change their direction before business cycles actually turn. Hence, from an investment strategy perspective, it makes sense to heed messages from leading indicators. Other Big Picture Considerations We have for several years argued that the rampant build-up in China's debt and credit excesses is unsustainable, and when credit growth normalizes/slows the economy will undergo a marked deceleration. Chart I-8Rising Interest Rates Herald A Further ##br##Slowdown In Money/Credit Growth Have these excesses been partially unwound, and has credit growth normalized? Not at all - the credit excesses have gotten larger. In fact, corporate and household debt and shadow banking credit have expanded enormously in the past two years. Even after the recent deceleration, broad money and credit continue growing at around 10% from a year ago (Chart I-6, bottom panel on page 5). Importantly, borrowing costs in China have recently resumed their upward move (Chart I-8, top panel) and rising interest rates will further dampen already slowed money and credit growth (Chart I-8, bottom panel) and thereby economic activity. In brief, from a big-picture standpoint, China's leverage situation has worsened, and interest rates are rising. While growth momentum is currently strong, financial markets leveraged to China's growth have already rallied a lot, and investor sentiment is quite bullish, as illustrated in Chart I-2 on page 2 in the case of copper. This makes the investment risk-reward profile of EM risk assets and commodities poor. Finally, some readers might wonder why we have been spending so much time focusing on China versus other developing economies. The basis is that China is now a major pillar of the global economy, and its cyclical economic trend materially influences those of many EM and DM countries. In short, every other developing country is too small to affect EM financial markets. But China does affect financial market dynamics in many other parts of the EM world. So, to gauge overall trends in EM financial markets, China and other global variables matter, yet individual developing countries do not. For the majority of emerging economies in Asia, Latin America and Africa, China is the dominant external force, similar to how the U.S. is for many of its trading partners. Similarly, Chinese interest rates are as important as borrowing costs in the U.S. Therefore, developments in Chinese interest rates, money/credit and economic activity are of paramount significance to many emerging markets. In particular, China's money as well as private and public credit impulses lead both EM and DM export shipments to China by about nine months (Chart I-9A and Chart I-9B). These developing nations' exports to China make up a meaningful part of their respective economies. In addition, industrial metals prices are by and large driven by China's capital spending, and hence affect commodities-producing countries. Chart I-9AExports To China Correlate ##br##With China's Money/Credit Chart I-9BExports To China Correlate ##br##With China's Money/Credit Bottom Line: In 2015 and 2016, China resorted to its standard playbook: money and credit origination, boosting capital spending and overall growth. In particular, China's broad money M3 and private and public credit both have surged by RMB 46 trillion in the past two years alone. Consequently, the excesses have become larger. That said, President Xi Jinping's ongoing campaign to control financial risks - and consequential tightening of monetary/liquidity conditions - entails considerable growth deceleration ahead. Risks Of Relying On Money And Credit There are a number of risks involved in relying on measures of money and credit. We discussed the velocity of money, the money multiplier and productivity in our last report1, and will only touch on these briefly this week: An economy can accelerate with sluggish or slowing money growth if the velocity of money rises materially. However, there is no basis to expect the velocity of money to rise in China now, given it has been declining for the past 10 years. Money and credit growth can recover quickly, despite rising interest rates, if the money multiplier spikes. However, the money multiplier is already extremely elevated in China, and the odds are low that it will surge further. This is especially true amid rising interest rates and the ongoing regulatory crackdown on off-balance sheet assets of banks and shadow banking. Real economic output can improve if productivity growth notably accelerates. Money growth and velocity of money will define nominal output, yet productivity will boost real output. However, it is unrealistic to expect productivity to improve meaningfully in China when structural reforms have not been widely implemented. Chart I-10China's Exports To The U.S. And EU Are ##br##Small Compared With Credit Origination Finally, some argue that robust exports to the U.S. and Europe can boost mainland growth, even if domestic demand slips. We disagree. China's combined annual exports to the U.S. and EU currently make up only US$ 0.77 trillion (6.6% of GDP). On the other hand, the amount of new private and public debt origination has amounted to US$ 3 trillion (25% of GDP) in the past 12 months (Chart I-10). Bottom Line: Given money and credit growth have already slumped, our negative outlook for China's capital spending and imports will be wrong if the 1) velocity of money rises considerably, 2) the money multiplier shoots up, or 3) productivity growth accelerates materially. If any one of these were to occur, relying on money growth to forecast economic growth will prove futile. That said, assumptions about a substantial increase in either the velocity of money, the money multiplier or productivity from current levels would be highly conjectural, speculative and unreasonable. Some Market Observations: The U.S. Dollar And Oil The Greenback Chart 11 demonstrates that the U.S. dollar sits on its three-year moving average. A three-year moving average sometimes marks the borderline between structural bull and bear markets, as demonstrated in the case of the S&P 500 in the bottom panel of Chart I-11. Hence, the U.S. dollar is flirting with a structural bear market. Indeed, if the greenback slides further, it would signify a breakdown into a structural bear market. That said, if the broad trade-weighted U.S. dollar finds a bottom here, a meaningful rebound will ensue. Interestingly, the U.S. dollar has plunged even though U.S. real rates have not declined much (Chart I-12). The overwhelming portion of the drop in U.S. bond yields since early this year has been due to inflation expectations. Chart I-11Will The Greenback Find ##br##Support At Current Levels? Chart I-12U.S. TIPS Yields Have Not Dropped A Lot Typically, stable real rates amid falling inflation expectations are neutral-to-positive for an exchange rate. This has not been the case with the dollar this year. Pessimism within the fixed income and currency markets on U.S. growth is overdone. U.S. domestic demand is strong, the labor market is tight and global disinflationary forces that have suppressed U.S. inflation are alive and rampant in other parts of the world as well. Hence, there is no basis why the U.S. dollar should be punished more than other currencies because of secular global disinflation. Odds are that the euro has seen its lows in this cycle, and any selloff will not take it anywhere close its 2015-16 lows. Nevertheless, the outlook for EM currencies is meaningfully negative. The basis is that we believe EM business cycle amelioration is not sustainable - a growth slump in China, as discussed above, lower commodities prices and the hangover from the preceding credit booms in a number of countries will cap EM growth and weigh on their currency values. Bottom Line: Our take is that the dollar has been hammered too fast too far. Unless the U.S. dollar is in a structural bear market, odds are it will likely find floor here. Oil The current bear market in oil prices is tracking the 1980s bear market in crude reasonably well (Chart I-13). Based on this profile, oil prices will relapse further. We are reiterating our trade recommendation from March 8, 2017: short the spot oil price / long the Russian ruble. While both are correlated, the ruble offers 7.8% carry and will have less downside than crude. Hence, by being long the ruble, traders are being paid to short oil (Chart I-14). Stay with this position. Chart I-13Oil Is Tracking Its 1980s Bear Market Chart I-14Maintain Short Oil / Long Ruble Position A New Trade: Short Copper / Long CLP This week we recommend replicating the above oil trading strategy in the copper market. We believe shorting copper and going long a copper-related currency such as the Chilean peso offers an attractive risk-reward profile. The rationale to short copper is the potential relapse in China's growth (Chart I-1 on page 1) and elevated bullish sentiment on copper as shown in Chart I-2 on page 2. To hedge the timing risk and earn some carry, it makes sense to complement the short copper position with a long leg in a currency exposed to industrial metals/copper prices that is not vulnerable due to domestic reasons, i.e., beside copper price effect. Such a currency is the Chilean peso, in our view. The country's macro fundamentals are fine: domestic demand seems to be bottoming out and inflation is under control (Chart I-15). The primary risk to this exchange rate is copper prices. Chart I-16 depicts the total return of the combined return of a short copper and long CLP position accounting for the carry. The CLP has lagged the recent surge in copper prices and this trade offers a good entry point. Chart I-15Signs Of Bottom In The Chilean Economy Chart I-16A New Trade: Long Chilean Peso / Short Copper Bottom Line: Short copper and go long the Chilean peso. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Hungary: Inflation Is Set To Surge The dovish tone following the National Bank of Hungary's (NBH) most recent monetary policy meeting has reinforced the notion that more unconventional policy tools are likely to be forthcoming. In our view, the NBH is displeased about the recent currency strength and is presently laying the groundwork for pegging/depreciating the currency. This reinforces our view that inflation is set to surge. We have been recommending a short HUF / long PLN trade since September 28, 2016 on the basis that the NBH will remain dovish far longer than the National Bank of Poland (NBP) in the face of rising genuine inflationary pressures in both economies2 (Chart II-1). Also, the NBH has much less appetite for tolerating currency appreciation than the NBP. In turn, the NBP will hike interest rates and allow the zloty to appreciate. The latest rhetoric from the NBH reinforces our conviction, and today we are reiterating our short HUF / long PLN trade. Furthermore, relative to the forint, the zloty is still cheap based on relative real effective exchange rates, calculated using unit labor costs (Chart II-2). Chart II-1Relative Swap Rates Justify Higher PLN/HUF Chart II-2Zloty Is Cheap Versus Forint When a central bank favors extremely low interest rates and a cheap currency amid an economy that is operating above full employment and a labor market that is extremely tight, inflation is set to surge. This is exactly what is happening in Hungary. The NBH has been downplaying the tight labor market, noting that so far there has been little impact on inflation. We see a major problem with this argument. Inflation is a lagging indicator; to gauge where inflation will be headed in the coming six to 12 months, one has to monitor forward-looking indicators such as labor market dynamics and money/credit conditions. Presently, the majority of these indicators point toward much higher inflation in the coming months: The labor market is definitely tight - labor shortages are widespread, the unemployment rate is making historical lows and the participation rate is high (Chart II-3). Both wages and unit labor cost growth are surging (Chart II-4). Chart II-3Labor Market Is Super Tight In Hungary Chart II-4Hungary: Labor Costs Are Surging While private credit growth is meager, money supply is booming at a double-digit rate (Chart II-5). Such a gap between money and credit is probably due to loan write-offs. In brief, new loan origination is much stronger than implied by private credit growth, which is being affected by loan write-offs. Besides, government spending growth is currently above 20%, and banks have been funding the government by increasing their holdings of government bonds. This has also boosted money supply and is ultimately inflationary. All in all, odds are that the NBH will allow inflation to run away. As a result, long-dated local bond yields will spike, while short-term yields will be anchored by the NBH's dovish policy. We have been recommending betting on the yield curve steepening in Hungary: receive 1-year / pay 10-year swap rates. This trade remains intact (Chart II-6). Chart II-5Money Growth Is Booming Chart II-6The Yield Curve Will Steepen Further Bottom Line: Stay short the HUF versus the PLN. Maintain a bet on yield curve steepening in Hungary: receive 1-year / pay 10-year swap rates. For other fixed-income and currency as well as equity positions in central Europe and elsewhere in the EM universe, please refer to pages 19-20. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report, titled "Making Sense Of The EM Business Cycle", dated August 30, 2017, link available on page 21. 2 Please refer to the Emerging Markets Strategy Weekly Report, titled "Central European Strategy: Two Currency Trades," dated September 28, 2016 and Emerging Markets Strategy Special Report, titled "Central Europe: Beware Of An Inflation Outbreak," dated June 21, 2017, links available on page 21. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Feature Shrugging Off The Political Noise All the political noise of August (White House resignations, Charlottesville, North Korean missile launches, the looming U.S. debt ceiling) could do no more than trigger a minor market wobble: at the worst point, global equities were off only 2% from their all-time high. The reason is that global cyclical growth remains strong, earnings are accelerating, and central banks have no immediate need to turn hawkish. In such an environment, risk assets should continue to outperform over the next 12 months. The political risks will not disappear (and will no doubt produce further hair-raising moments), but they are unlikely to have a decisive impact on markets. BCA's geopolitical strategists think eventually there will be a diplomatic solution to the North Korean situation - albeit only after a significant further rise in tension forces the two sides to the negotiating table.1 It is hard to imagine the debt ceiling not being raised, since Republicans control both houses of Congress and the White House, and they would be blamed for any disruption caused by a failure to raise it. Recent personnel changes in the White House have left - for now - a more pragmatic "Goldman Sachs clique" in charge. We believe there is still a reasonable likelihood of tax cuts, not least since the Republicans are on track to lose a lot of seats in next year's mid-term elections unless they can boost the administration's popularity (Chart 1). Recent growth data has been decent. U.S. Q2 GDP growth was revised up to 3% QoQ annualized, and the regional Fed NowCasts point to 1.9-3.4% growth in Q3. If anything, growth momentum in the euro area (2.4% in Q2) and Japan (4%) is even better. Corporate earnings growth continues to accelerate too, with S&P 500 EPS growth in the second quarter coming in at 10% YoY, compared to a forecast of just 6% before the results season started. BCA's models suggest that, in all regions, earnings growth is likely to continue to accelerate for a couple more quarters (Chart 2). Chart 1Republicans Need A Popularity Boost Chart 2Earnings Continue To Accelerate The outlook for the dollar remains the key to asset allocation. The market currently assumes that the dollar will weaken further, as U.S. inflation stays low and the Fed, therefore, stays on hold. Futures markets currently price only a 38% probability of a Fed hike in December, and only 25 BP of hikes over the next 12 months. If markets are right, this scenario would be positive for emerging market equities and commodity currencies, and would mean that long-term rates would be likely to stay low, around current levels. But we think that assumption is wrong. Diffusion indexes for core inflation have begun to pick up (Chart 3). The tight labor market should start to push up wages, dollar deprecation is already coming through in the form of rising import prices, and some transitory factors (pre-election drugs price rises, for example) will fall out of the data soon. The Fed is clearly nervous that it has fallen behind the curve, especially since financial conditions have recently eased significantly (Chart 4). A moderate stabilization of inflation by December would be enough to push the Fed to hike again - and to reiterate its plan to raise rates three times next year. Chart 3Inflation To Pick Up? Chart 4Financial Condition: Easy In The U.S., Tight In Europe Meanwhile, long-term interest rates in developed economies look too low given growth prospects (Chart 5). As inflation picks up, the Fed talks more hawkishly, and the dollar begins to appreciate again, rates are likely to move up in the U.S. and in the euro zone. Our view, then, is that the Fed will tighten faster than the market expects, long-term rates will rise and the dollar will appreciate. Equities might wobble initially as they price in the tighter monetary policy but, as long as growth continues to be strong, should outperform bonds on a 12-month basis. Our scenario would be positive for euro zone and Japanese equities, but somewhat negative for EM equities. Equities: We prefer DM equities over EM. Emerging equities have been boosted over the past 12 months by the weaker dollar and Chinese reflation. With the dollar likely to appreciate (for the reasons argued above), and a slowdown in Chinese money supply growth pointing to slower growth in that economy (Chart 6), we think EM equities will struggle over coming quarters. Meanwhile, there is little sign that domestic growth momentum is improving in emerging economies (Chart 7). Within DM, our underlying preference is for euro zone and Japanese equities. Our quants model now points to an underweight for the U.S. We haven't implemented this yet because 1) of our view that the USD will strengthen, and 2) we prefer not to make too frequent changes to recommendations. We will review this in our next Quarterly. Chart 5Rates Lag Behind Global Growth Chart 6Slowing Chinese Money Growth Is A Risk For EM Chart 7EM Domestic Growth Anemic Text below Fixed Income: BCA's model of fair value for the 10-year U.S. Treasury yield (the model incorporates the Global Manufacturing PMI and USD bullish sentiment) points to 2.6%, almost 50 BP above the current level (Chart 8). We therefore expect G7 government bonds to produce a negative return over the next 12 months, as inflation expectations rise and monetary policy continues to "normalize". We still find some attraction in spread product, especially in the U.S. (Chart 9). While spreads are quite low compared to history, U.S. high-yield spreads remain 119 BP above historic lows, while euro area ones are only 65 BP above. Chart 8U.S. Rate Fair Value Is Around 2.6% Chart 9Credit Spreads Not At Record Lows Currencies: The euro has likely overshot. Long speculative positions are close to record levels (Chart 10) and the currency has returned to its Purchasing Power Parity level against the USD (Chart 11). An announcement of a "dovish" tapering of asset purchases by ECB President Draghi in September could persuade the market that the ECB will continue to be much more cautious about tightening than the Fed. The yen is also likely to weaken against the US dollar as global rates rise, since the BoJ will not change its yield curve control policy despite the better recent growth numbers, given how far inflation is still from its target. Chart 10There Are A Lot Of Euro Bulls Chart 11Euro Is No Longer Undervalued Commodities: Our forecast that a drawdown in crude inventories will push the WTI price back up is slowing coming about. U.S. crude inventories have fallen by 25.3 million barrels since the start of the year. The after-effects of Hurricane Harvey might affect the data for a while but, as long as global demand holds up, the crude oil price should rise further, with WTI moving over $55 a barrel by year-end. Metals prices have moved largely sideways year to date, and future movements depend mostly on the outlook for Chinese growth, which may begin to slow. In particular, the recent run-up in copper prices (which have risen by 20% since early June) seems unsustainable. The bullish sentiment was mostly due to short-term supply/demand imbalances caused by labor disruptions at some major mines. However, Chinese copper demand, especially for construction, is likely to weaken over coming months.2 Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see Geopolitical Strategy Weekly Report "Can Pyongyang Derail The Bull Market," dated 16 August 2017, available at gps.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report "Copper's Getting Out Ahead Of Fundamentals, Correction Likely," dated 24 August 2017, available at ces.bcaresearch.com Recommended Asset Allocation

Highlights A broad survey on various valuation ratios suggests that Chinese investable equities' exceptional cheapness in the past several years has essentially vanished. Valuation is no longer a compelling reason for staying positive. Multiples of Chinese equities have been rerated in the past two years. This asset class is currently trading at a slight premium over its historical norms as well as other emerging markets, but it is still at discounts to developed bourses and the all-country-world averages. Remain bullish on Chinese investable equities due to our positive stance on the cyclical outlook of economy and profits. Feature Chinese industrial profits increased by 16.5% in July from a year ago, as released early this week. This is a mild deceleration compared with the 19.1% pace a month earlier, which the authorities attributed to temporary factory shutdowns due to extreme summer heat. Irrespective, the latest profit numbers confirm that the economy is passing its peak growth rate in this mini cycle upturn, but overall business activity remain fairly robust. Looking forward, we see limited downside in China's cyclical growth outlook, as discussed in various recent reports.1 Chinese equities have also experienced a mini melt-up in recent weeks. So far this year, Chinese investable stocks, measured by the MSCI China Free index, have rallied by almost 40% in dollar-terms, significantly outpacing all major global and EM benchmarks. Importantly, the total return index of Chinese investable stocks, price appreciation and dividend income combined has recently broken above a long-term resistance, reaching an all-time high (Chart 1). While the strong performance of Chinese equities has validated our positive stance on China's growth and profit profile, the sharp rally in prices also raises a red flag on potential froth and complacency. A closer look at the valuation picture of Chinese equities is well warranted. Conventional Valuation Indicators At the onset, conventional valuation indicators for the broad Chinese investable equity universe currently do not look demanding compared with historical norms (Chart 1, bottom panel). Our composite valuation indicator, which combines several conventional yardsticks such as trailing and forward price-to-earnings, price-to-book, price-to-cash and dividend yield, has crawled out of the "undervalued" extreme that lasted for several years, but it is not yet overvalued. Most conventional valuation indicators are currently roughly in line with their respective long-term averages (Chart 2). Chart 1Chinese Investable Stocks Are No Longer ##br##Exceptionally Cheap Chart 2Most Valuation Indicators ##br##Are Back To Historical Means Compared with other emerging bourses, Chinese investable equities have also been re-rated. In fact, Chinese equities' outperformance against the EM benchmark since mid-last year has been entirely driven by relative multiples expansion (Chart 3). Our relative composite valuation indicator suggests Chinese investable equities are trading at a moderate premium over the EM benchmark, after a few years of deep discount. Most valuation indicators of Chinese equities are slightly higher than the EM benchmark, but are still significantly lower than their peers in the developed market (Chart 4). Chart 3Chinese Equities Have Been Rerated ##br##Against EM Chart 4Chinese Equities Are Trading At Premium##br## Against EM, But Not DM Weight-Adjusted Valuation Indicators A major issue of conducting historical and cross-country comparisons of valuation indicators is the ever-changing constituents in the indexes. The benchmark to evaluate P/B ratios of tech companies should be categorically different from those of banks, as should the price-to-cash ratios for retailers and utility firms. A simple lump-sum aggregate of a conventional valuation indicator ignores the different sector weights among different markets, which could be misleading. This is particularly important for China, as its juvenile equity universe is constantly evolving and rapidly changing (Chart 5). The largest sector by weight in the Chinese investable market in the past 10 years has shifted from telecom to energy to banks, with the baton more recently being passed to information technology. Currently, IT firms account for over 40% of the MSCI China Free index, up from less than 10% three years ago, while banks have dropped from a peak of 44% to 25% currently. The shifting sector weights within the Chinese equity universe also reflect the rapidly changing structure of the underlying Chinese economy. Chart 5Chinese Investable Equities Sector Breakdown One way to deal with this issue is some sort of "controlled weight" valuation indicator by holding sector weights constant. Chart 6 shows the simple averages of various valuation ratios of the 10 Global Industry Classification Standard (GICS) sectors.2 With the exception of dividend yield, the equal-weighted valuation indicators are more expensive than their respective market weight-based versions, according to our calculation. This means that some smaller-weight sectors are more dearly valued compared with the large weights, particularly banks. However, none of the valuation ratios appear extreme in a historical context. How do Chinese equities compare with other markets? Table 1 summarizes equal-sector-weight valuation indicators. Overall, Chinese equities are trading at a slight premium over emerging markets, but are still at 10-20% discounts to developed bourses and the all-country-world averages. Table 1 Cyclically-Adjusted P/E Ratios The Cyclically Adjusted Price Earnings (CAPE) multiple (also known as the Shiller P/E) compares the equity price to the earnings in a full business cycle extended over many years, rather than just one random year. Typically, CAPEs are calculated by dividing the equity price by the 10-year average of real earnings, which smooths out the business cycle and theoretically better captures what equity investors are paying for companies' long term earning streams. Chart 7 shows that CAPEs are well above 20 times for the U.S. and Japanese markets, and around 16 times for U.K. and euro area stocks - all have experienced some multiples expansion since the global financial crisis. In China's case, the CAPE for investable equities has been hovering at around 10 times, near a record low and significantly below the level of the other major indexes. In fact, the CAPE of investable Chinese shares has barely stopped falling amid the rally in prices. Chart 6Average Versus Market-Weight Valuation Ratios Chart 7Cyclically Adjusted P/E: A Global Comparison Investment Conclusions Taken together, the valuation picture of Chinese investable stocks has become mixed, as its total return index has reached an all-time high. This asset class is no longer obviously undervalued compared with both historical norms and its EM peers. Some viewed Chinese equities' exceptional cheapness in the past several years as a "value-trap," which has proven to be a costly mistake and has been discredited. Now the "easy trade" is over, and valuation is no longer a compelling reason for staying positive on Chinese equities. On the other hand, a broad survey on various valuation ratios does yet not conjure up images of an overly extended market, both compared with historical averages and other global benchmarks, particularly DM bourses. Lack of valuation froth means Chinese investable shares are not yet subject to the pull of mean reversion. Cyclically, we remain optimistic on China's growth and earnings outlook, which should continue to push up stock prices. Valuation indicators are never good timing tools, but they should be closely monitored going forward to assess the risk-return tradeoff of holding Chinese equities. We will dig deeper into domestic A shares in an upcoming report. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Monitoring Chinese Capital Outflows And The RMB Internationalization Process", dated August 24, 2017, available at cis.bcaresearch.com. 2 Includes Consumer Discretionary, Consumer Staples, Energy, Financials, Health Care, Industrials, Information Technology, Materials, Telecommunication Services and Utilities. Real Estate is included in Financials, due to its limited data availability as a stand-alone GICS sector. Cyclical Investment Stance Equity Sector Recommendations

Highlights Hurricane Harvey will prove a bigger market-mover than North Korea's latest missile test; The worst flood in Houston's history will improve U.S. policymaking and remove domestic risks; North Korea justifies hedging against violent incidents, but actors are constrained from full-scale war; Insights from our travels in Asia suggest that U.S.-China cooperation is still meaningful. China's reform reboot faces constraints; Abenomics is not done yet. Feature As we go to press, two crises are developing. The one that has rattled the markets - and that we focus on in this Weekly Report - is the North Korean missile launch. However, we think the more investment-relevant one is the slow-moving Hurricane Harvey, which is about to inundate Houston - a metropolitan area with nearly 7 million people - with more rain. We cannot predict the ultimate impact on the economy of the developing natural disaster, but we do know that Houston is experiencing the greatest flood in its history. The scale of human suffering is likely being massively underestimated at present. Comparisons with Hurricane Katrina are not without merit, but Houston has a population about five times that of New Orleans. Investors may rightly ask, so what? The stock market actually rallied at the height of Hurricane Katrina and one would struggle to pick its date on a chart of the S&P 500. The impact on the economy and markets is likely to be tepid in the near term once again. The significance of Hurricane Harvey is its likely impact on politics. First, there is now no chance that the debt ceiling will be breached. We discussed the low odds last week and we reiterate them here. Second, odds are that a government shutdown is unlikely as well. It is unfathomable to shut down the government during an emergency. Imagine if the Federal Emergency Management Agency (FEMA) had to cease operations. Wall or no wall on the Mexican border, Republicans in Congress and the White House will fund the government. More than that, Americans suffering in a Red State that voted for President Trump could be the catalyst that Republicans need to put their intra-party differences aside and start working with vigor on legislation, including tax reform. We could even contemplate legislative action on a bipartisan infrastructure plan, although the ability of U.S. policymakers to put aside grief and focus back on partisan bickering never ceases to amaze. The bottom line for us is that in six months' time, when investors look back on late August 2017, it will be Hurricane Harvey that is cited as having been market-relevant in the long term, not North Korea's n-th missile launch. That said, North Korea remains relevant. It has launched an avowed ballistic missile over Japan for the first time (as opposed to a space launch vehicle, which it has done in 1998 and 2009). The launch originated near Pyongyang, a warning to the U.S. that any strikes against launch sites would be complex (involving civilians) and tantamount to an attack on the capital and a declaration of war. The United States and its allies will be forced to respond to this brinkmanship by trying harder to establish that the military option is indeed credible despite the well-known constraints (the decimation of Seoul). Therefore more market volatility will ensue in the coming months and year. We do not rule out major violent incidents, though full-scale war still seems highly unlikely due to hard constraints on the various actors. (Please see "Appendix" for our updated checklist on whether the U.S. will attack.) While we do not expect either Pyongyang or Hurricane Harvey to derail the bull market, we recognize that valuations are stretched, volatility is low, and the market may be looking for a reason to sell off significantly. In this report, we discuss insights on North Korea and other key issues gleaned from our recent travels abroad. BCA's Geopolitical Strategy went on the road this summer for five weeks. We visited the American Midwest, Australia, New Zealand, Singapore, Taiwan, China, Japan, South Korea and the U.K. There we had the pleasure of speaking with clients across the asset management industry. Each region had its own set of specific questions and concerns, as well as insights. Over the next two weeks, we plan to share these with our entire client base. Going on the road is critical for investment strategists. It is an opportunity to stress-test and sharpen one's view through interaction with sophisticated investors. Meeting clients also ensures that you are asking the right questions. We are happy to report that our three main questions - how stimulative will U.S. tax reform be; is China willing to deleverage; and is Italy a potential source of global risk-off - are indeed on all of our clients' minds. This does not mean that everyone came to the same conclusions that we did, but at least we know that we are looking for the same answers. Sino-American Split Is Overstated Investors are no longer as quick to dismiss one of our central geopolitical theses: that the U.S. and China are on a path likely to end in the "Thucydides Trap."1 However, one of our clients was not so sure that U.S.-China relations are deteriorating as rapidly as they appear to be. He observed a pattern in bilateral trade that suggested to him that the two countries are working together, under the table, to keep relations from collapsing despite the unprecedented challenges posed by the post-2008 global political and economic environment. He began with the simple point that the U.S.'s rising trade protectionism against Chinese steel in recent years actually made it easier for President Xi to take aim at overcapacity problems in the steel sector in China. After U.S. steel imports from China collapsed, from 20% of total in 2008 to 3% in 2016, China was able to embark on a long-delayed purge of excess steel capacity, shutting down a reported 87mmt over the past year and a half (Chart 1). China moved up the steel product value chain partly as a result of U.S. actions.2 China also appears to have responded promptly to U.S. complaints about agricultural imports. In late 2016, amid a heated and protectionist presidential campaign, the U.S. government threatened to impose tariffs on China's grain exports and demanded that subsidies be removed so that U.S. companies could compete on a level playing field in China's domestic market. Corn prices were at a nine-year low; Beijing was giving rebates to domestic corn exporters and had amassed large corn inventories. Within a few months, in March 2017, China launched the agricultural side of its supply-side reforms. It removed the supports for corn, allowing prices to plummet and making way for lower Chinese supply and thus more U.S. imports (Chart 2). Chart 1U.S. And China Attack Chinese Steel Capacity Chart 2China's Supply-Side Agriculture Reforms Most recently, the client emphasized, China launched one of its periodic crackdowns on intellectual property violations.3 Enforcement was observable in China's mainstream online services, which largely lost the ability to stream content for which they lacked the rights.4 As with steel, China has a self-interest in these reforms, especially as it generates its own intellectual property. But it cannot have detracted from China's urgency that the U.S. announced a formal investigation in early August to determine whether China's intellectual property violations deserve punitive actions.5 It is as if China anticipated the U.S.'s moves coming out of the U.S.-China Comprehensive Economic Dialogue in July. In these and many other cases, a pattern seems to emerge: U.S. trade grievances boil up, U.S. authorities threaten punitive actions, China responds to the threat by vowing retaliation and pushing through supply-side reforms that are already in its interest. The process appears to be a win-win, however precarious. The client also suggested that the U.S. may be offering to become more constructive toward certain Chinese initiatives. For instance, China is pressing forward on the long-delayed launch of an oil futures contract on the Shanghai International Energy Exchange in the second half of 2017. This new benchmark would ostensibly rival Brent and West Texas Intermediate contracts and be settled in RMB instead of USD. To our client, China's moving forward with this scheme, immediately after top-level trade negotiations with the U.S., seemed to reveal the U.S.'s tacit support for RMB internationalization. Certainly the U.S. nodded at the IMF including the RMB in its special drawing rights basket.6 Presumably, then, the U.S. and China have not entirely lost the ability to deal with each other on sensitive issues in an atmosphere fraught with distrust. Moreover, both sides can attempt to roll with the punches. China can blame the difficulties of necessary internal reforms on U.S. protectionism, while U.S. protectionist impulses can be mitigated via China's internal reforms. This dynamic could become the silver lining in Sino-American relations in 2018, a year in which Xi will have the best opportunity to push reforms while Trump may be most eager to take protectionist actions ahead of the midterm election. A silver lining to a black cloud, of course. Bottom Line: Risks to Sino-American relations remain serious, but the two sides still retain some ability to manage tensions. The question is how much ability? Our own view has been that 2017 would largely be a year of Trump issuing "a shot across the bow" and then negotiating. Concrete, aggressive action would be more likely to occur in 2018. This remains our baseline case. But silent coordination of the kind described above could perhaps improve trade relations enough to satisfy Trump in 2018 and delay a Sino-U.S. confrontation. China has long dealt with protectionist threats from the U.S. by conceding various reforms and policy adjustments, especially by increasing U.S. imports. The U.S. has long accepted such a response. We doubt that this tactic will be enough in this day and age, but maybe so. North Korea Could Cause A Recession What about U.S.-China cooperation on North Korea? It appears as if coordination has improved in the face of a potential conflict. At the peak of tensions this summer, China has offered to implement sanctions, cutting off some trade and joint ventures, while the U.S. has given reassurances about U.S. military intentions in the event of a conflict.7 However, judging by conversations with clients on the mainland, a large gap still exists between U.S. and Chinese perceptions. In particular, Chinese clients pushed back against any implication that China is responsible for reining in North Korea's bad behavior. They highlighted China's emphasis on national autonomy, the idea that every country should be left alone to address its own problems in its own jurisdiction. Otherwise countries should resolve differences through diplomacy and dialogue, conducted as equals. The threat or use of force always makes things worse. The current North Korean situation is, from this perspective, America's fault. The North Koreans pursue nuclear-tipped ballistic missiles in order to deter a U.S. attack, having seen what happened to other nuclear aspirants like Iraq, Syria, and most recently Libya.8 In short, China sympathizes with its formal ally North Korea. It demands peaceful negotiations and denounces the threat of regime change. And it does not believe U.S. officials when they renounce regime change as an option, as Secretary of State Rex Tillerson has recently done. "No one will believe that," one of our clients said, and least of all North Korea. (Quite reasonably, we would add.) This argument reinforces our view that China will not impose crippling sanctions on the North, even if it tries to pressure Pyongyang back to the negotiating table. Since the North cannot be expected to give up its nuclear weapons, the negotiations themselves will be limited from the outset. The U.S. essentially has to accept the status quo, possibly even the perpetual threat of a North Korean nuclear strike. This, in turn, increases the probability that the Trump administration will be disappointed with the outcome. Which is precisely why we expect the U.S. not only to bulk up its military alliance in the region but also to impose more "secondary sanctions" and trade tariffs on China. Sino-American tensions will get harder and harder to manage. While we can foresee skirmishes and violent incidents, we think the probability of a full-scale Second Korean War is low. Diplomacy is not exhausted, the U.S. alliance with regional powers remains intact, and, most importantly, North Korea has not committed an act of war (or acted as if it is about to, which would prompt U.S. preemption). Regarding the big picture, some of our clients are not so sanguine. One of them pointed out recent academic research arguing that armed conflict, as a cause of death in the human population, has declined. The number of violent deaths per 100,000 people has fallen from historic levels in the hundreds down to an average of 60 in the twentieth century, which includes two world wars, and down to the single digits in the post-WWII era (Chart 3). The client asks: Is this drop in war deaths sustainable? The implication is that the level of deaths has nowhere to go but up. Chart 3Human Deaths By War Have Collapsed In Post-WWII Era The client coupled this thought with another bearish theory. It is widely known that recessions are normally preceded by large financial or economic imbalances. Today many investors are encouraged by the apparent lack of any such imbalance. They read this as saying, "let the good times roll." Our client viewed it another way, suggesting that the imbalance that will cause the next major recession will be non-financial and non-economic, e.g. ecological, epidemiological, geopolitical, etc. Chart 4Global Conflicts Increasing In Frequency The client was not specifically hinting at a North Korean conflagration, though probably not ruling it out either. He was mostly concerned with the historic drop in deaths by conflict and how it might be reversed in the near future. Unfortunately this bleak suggestion that war might make a secular comeback is not incompatible with our view that geopolitical multipolarity goes hand in hand with a higher incidence of internationalized conflicts (Chart 4), which could be exacerbated by a decline in global trade. On the other hand, the fall in deaths is a product of a range of political, economic, social and scientific advances, and may not be reversed through geopolitical tensions alone. Bottom Line: The U.S. and China remain far apart in their perceptions of who is to blame for North Korea and what is to be done. China will not take responsibility for "solving" the problem as the U.S. demands. This reinforces our view that North Korean tensions have not yet peaked and remain market-relevant. We ultimately believe that a peaceful solution will prevail, but getting from here (tensions) to there (a negotiated settlement) entails further risks. China Will Try To Reform, But Won't Touch The Property Bubble "They've got to do something about the corporate leverage." This was the conclusion of a client who agreed with our view that President Xi Jinping will likely accelerate his reform agenda after the nineteenth National Party Congress this fall, and that deleveraging is the key indicator (Chart 5). Some clients in China - specifically banks - confirmed that they were under pressure from tightening financial regulation and as a result were both slowing the pace of lending and becoming more scrutinizing of borrowers' creditworthiness. Borrowing rates have ticked up (Chart 6). Chart 5High Time For Some Belt-Tightening Chart 6Chinese Cost Of Capital Ticks Up Clients also suggested that Chinese leaders would soon re-emphasize the country's transition away from GDP targets as a measure of successful governance and economic stewardship. When the Xi administration came to power, it sought to de-emphasize GDP targets and introduced new and alternative targets - such as urban and rural income per capita, labor productivity, corruption, air pollution - into its assessments of economic progress. But the administration was forced to return to GDP targets amid growth fears in 2015, prompting Premier Li Keqiang to promise "at least" 6.5% growth for the next five years. Now the attempt to elevate qualitative measures of governance looks set to resume. Xi held two meetings of the Central Leading Group for Deepening Overall Reform this summer, in which he noticeably prioritized "green growth" rather than plain old growth, and pushed for replicating and applying more broadly the pilot reforms that have been implemented since his reform agenda was first laid out in 2013. In mid-July, at the National Financial Work Conference, Xi called for local officials to be held accountable for local government debt - even beyond their term in office. And in late July, Yang Weimin, a key economic policymaker who reports to Xi, said, "we won't allow the leverage ratio to rise for the sake of maintaining growth."9 The implication is that GDP growth will be allowed to fall as the government attempts to make progress on difficult reform initiatives. Chart 7Bonds More Important In China Several clients also expressed confidence that China would resume economic "opening up" before long. It is well known that, over the past year, Beijing has sought to attract FDI by promising to implement a nationwide "negative list" and removing certain sub-sectors from that list, in a bid to counter recent weak FDI inflows and ongoing capital outflow pressure. Beijing has also taken steps to deepen its financial sector, such as by expanding and regularizing its bond markets (Chart 7) in preparation for opening the Hong Kong-Shanghai "bond connect," which will allow foreign investors to buy Chinese bonds and, we think, generate strong demand. To add to this list, clients stressed that China is beginning to think about what happens after it lifts the capital controls put in place last year to halt outflows. A number of institutions are interested in expanding their overseas portfolios when they get the "all clear." We would expect the re-opening to come after the central government completes a round of reforming, recapitalizing, and restructuring banks and SOEs, which could push the timing well into 2018 or 2019. But clients are clearly chomping at the bit - which may suggest that they anticipate capital controls to be lifted sooner rather than later. One important reform item that we were told not to expect is the imposition of a nationwide property tax. Chinese authorities delayed the implementation of the tax in 2016 due to the desire to reflate the property market. Presumably they will return to this initiative now that the economy has recovered: it makes long-term sense to give local governments a more stable source of revenue and to suck some air out of the property bubble gradually so that it does not burst (Chart 8). However, clients are skeptical about any reforms that could harshly suppress real estate prices due to the heavy concentration of household wealth in the property sector (Chart 9). Chart 8Provinces To Be Weaned Off Of Land Sales? Chart 9Chinese Wealth Stored In Housing If the property bubble should be popped, people's life savings would vanish into thin air and there would be chaos in the streets. A client in Hong Kong remarked that the Chinese public will pretty much accept anything as long as property prices continue to rise. Since everyone agrees that social stability is the critical aim of the ruling party, it stands to reason that reforms will not be allowed to threaten the property sector, at least not directly. If the property sector prevents serious attempts at deleveraging, then the environmental agenda will become all the more significant as the focus of the Xi administration in its second five-year term. The administration began by increasing central government spending for environmental regulation more than for any other category of spending (Table 1). And Xi's statements in July, previewing the National Party Congress, emphasized fighting pollution as one of three chief focal points (the others were controlling systemic risks and fighting poverty). Table 1Fiscal Priorities Of Recent Chinese Presidents In recent months, central inspectors have fanned out across the country to conduct local pollution inspections ahead of end-of-year deadlines. These have fueled market speculation about deep curbs coming to industrial overcapacity, causing the prices of certain commodities that China produces, like aluminum, to surge (Chart 10). These commodity prices have likely already seen the biggest moves - given China's sharp slowdown in 2014 and reflation in 2015-16 - but they are still sensitive to the policy mix in China, i.e. the relative amounts of capacity cuts and deleveraging that take place. Chart 10Supply-Side Reform Has Boosted Metals Bottom Line: Clients across the Asia-Pacific region were focused on the question of Chinese structural reforms. We got the sense that there was much skepticism over whether they would indeed be growth-constraining. But when pushed, clients focused on real estate prices as the one threshold policymakers would not dare to cross in China. What About Japan? A Visit With Mr. K One of our most esteemed clients is a seasoned Japanese global investor who shall go by the moniker of "Mr. K" in the following dialogue (and for future reference). Mr. K opened the dialogue with us by asking us for our view of Japan. Mr. K: What is your view on my country, on Japan? GPS: We tend to think that the current reflationary policy will continue. The Tokyo metropolitan elections did not sound the death knell for Prime Minister Shinzo Abe (Chart 11). The BoJ has become more, not less, dovish, and is not likely to follow other central banks in tightening policy anytime soon. Abe retains control of both houses of the Diet and can increase government spending to boost the economy. And the LDP will continue reflation even if Abe falls. Mr. K: This may be true, reflation will continue. However, the Japanese economy is reaching a plateau after five years of Abenomics. The recent strong GDP numbers were not well-received because consumers feel the stagnation (Chart 12). Global demand, and Chinese demand, have provided a positive backdrop for Japanese manufacturers, but the domestic outlook is not wildly optimistic. Chart 11Abe No Longer In Free-Fall Chart 12Japanese Feel Stagnant Despite Strong Growth With economic policy, the key phrase is "TINA," There Is No Alternative. There is no alternative to Abe at the moment. If you look back at the Democratic Party of Japan's support in 2011 under Prime Minister Yoshihiko Noda, it was a real contender. Today, it is far from rivaling the LDP (Chart 13). The voting population is, apparently, comfortable. It is true that if Abe leaves, it will not make much of a difference, as long as the LDP remains in power. The younger generations do not seem troubled by the current state of affairs. They are well-trained to endure economic stagnation. There is a sense that those who stand out feel uncomfortable. College graduates looking for jobs are very conservative. While with Generation X there was always the expectation that tomorrow would be a brighter day, Generation Millennial has come not only to accept stagnation, but even to like the stability of flat growth. GPS: Isn't this kind of stagnation a good thing? Isn't it a case of Japan being in a "Goldilocks" phase? Mr. K: Stability and stagnation can be good for markets. First, the macro environment is decent. Corporations have large cash balances, external demand is strong, wage demand is subdued, and the exchange rate is weak. However, risk-taking is not prized, whether in the education system or the media. Public discourse tends to discourage high-risk investments. And risk-takers have not been properly rewarded over the past two decades in Japan (Chart 14), so confidence and risk-appetite are weak. Also, deflation is hard to defeat. The "100 Yen Shop" (dollar store) retail model is a good example. The goods are all cheap, but as long as you can bring more people in, you can make a profit. This is almost all deflationary. Moreover, the Japanese have nothing to spend on! They no longer need new cars, or big computers; they just need mobile phones, maybe a Nintendo Switch, etc. Second, as to the financial markets, greater deregulation is necessary to attract non-Japanese capital flows. Maybe then valuations will normalize (Chart 15). It is essential to see if leading companies continue to gain global competitiveness, in anything from Internet services to gaming. Watch valuations and watch cash flow. Chart 13Opposition Still Can't Touch Ruling LDP Chart 14Risk-Takers Punished In Japan Chart 15Japanese Valuations Still Low The key firms are not necessarily the keiretsu, but secondary or new manufacturers that are driving growth. Small caps are more leveraged to foreign exchange, whereas neither the Japanese domestic economy nor the value of the yen matter much to large multinationals anymore. To capitalize on the internal economy you want to be long small caps. Or better yet, long semi-large caps: those companies equivalent to the U.S. companies that make the difference between the S&P 500 and the S&P 600. These are some of the best plays in Japan because they are domestic-oriented and sensitive to the weaker yen. This will provide a tailwind for stocks elsewhere. Local property markets also offer a very good return over the risk-free rate. GPS: What do you make of our view that Abe will push reflationary policy ahead of his efforts to revise the constitution? Given that he needs a strong economy to pass the popular referendum? Mr. K: It is harder to increase fiscal spending in Japan than one might think. However, the North Korean threat is not going anywhere. And the media love "tensions." GPS: So it seems like you are positive about the markets in Japan, but are not yet sold on Abenomics? Mr. K: I suppose the lesson is, if it isn't too cold, stay on the ski slopes. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 For this term, please see Graham Allison, "The Thucydides Trap: Are The U.S. And China Headed For War?" The Atlantic, September 24, 2015, as well as Allison's new book, Destined For War: Can America and China Escape Thucydides's Trap? (New York: Houghton Mifflin Harcourt, 2017). 2 Please see BCA China Investment Strategy Weekly Report, "China-U.S. Trade Relations: The Big Picture," dated November 17, 2016, available at cis.bcaresearch.com. 3 Please see BCA China Investment Strategy Weekly Report, "China's Geopolitical Pressure Points: Knowns, Unknowns And A Hedge," dated August 17, 2017, available at cis.bcaresearch.com. 4 Please see "China cracks down on distribution of illegal publications," Xinhua, July 25, 2017, available at news.xinhuanet.com. China also highlighted the BRICS countries' joint efforts at enforcing intellectual property as it prepared to host the BRICS conference in Xiamen, Fujian in September. Please see Ministry of Commerce, "Ministry Of Commerce Holds Press Conference on 2017 BRICS Trade Ministers' Meeting," August 4, 2017, available at english.mofcom.gov.cn. 5 Please see the Office of the United States Trade Representative, "USTR Announces Initiation of Section 301 Investigation of China," August 2017, available at ustr.gov. 6 Other examples of U.S. cooperation with Chinese initiatives include the U.S. sending a small delegation to take part in the One Belt One Road (OBOR) conference in May. 7 In particular, Chairman of the Joint Chiefs of Staff Dunsford visited China, met with the Central Military Commission, and vowed to improve military-to-military relations. 8 Or a country like Ukraine, which agreed to give up its nuclear arsenal as soon as it became independent in 1994, only to see its territory carved up by global powers 20 years later (13 years after it emptied its missile silos). 9 Please see Sidney Leng, "China shifts gear from growth to debt cuts in race against rising tide of red ink," South China Morning Post, July 27, 2017, available at www.scmp.com. Appendix Table 2Will The U.S. Attack North Korea? Geopolitical Calendar