China & EM Asia

Highlights Our constraints-based methodology does not rely on human intelligence or the "rumor mill" to analyze political risks; Yet insights from our travels across the U.S., including inside the Beltway, offer interesting background information and a sense of the general pulse; Anecdotal information suggests that Trump is not "normalizing" in office; that U.S.-China relations will get worse before they get better; and that Trump will walk away from the 2015 Iranian nuclear deal. Stick to our current trades: energy over industrial metals; South Korean bull steepener; long DXY; long DM equities versus EM; long JPY/EUR; short Chinese tech stocks and U.S. S&P500 China-exposed stocks. Feature With the third inter-Korean summit demonstrating our view that "diplomacy is on track,"1 we remind investors of the key geopolitical risks we have been emphasizing - souring U.S.-China relations and rising geopolitical risks over Iran's role in the Middle East.2 We at BCA's Geopolitical Strategy do not base our analysis on information from human "intelligence" sources. No private enterprise can obtain the volume of intelligence that would make the sample statistically significant. Private political analysts relying on such intelligence are at best using flawed reasoning devoid of an analytical framework, and at worst are hucksters. Government intelligence agencies obviously collect a wide swath of not only human but also electronic and signals intelligence. Their sample can be statistically significant. However, the cost of such an effort is prohibitive to the private sector. Nonetheless, we may use human intelligence for background information, insight into how to improve our framework, and to take the subjective pulse of any particular situation. The latter is sometimes the most useful. It is not what a policymaker says that matters so much as how they say it, or the fact that they mention the subject at all. Given that we live in an era of political paradigm shifts, and that "charismatic leadership" is rising in influence relative to more predictable, established institutions and systems,3 we have decided to do something we have not done in the past: share some insights from our recent trips to Washington, DC and elsewhere in the U.S. Caveat emptor: the rumor mill is often wildly misleading, which is why we do not base our research on it. Exhibit A: Donald Trump's tax cuts, which our constraints-based methodology enabled us to predict in spite of the prognostications of in-the-know people throughout the year.4 Trump Is Not Normalizing U.S. domestic politics is the top concern of investors, policymakers, and policy wonks almost everywhere we go. It routinely ranks above concerns about Russia, China, the Middle East, or emerging markets (EM). We frequently heard that the U.S. is entering a period of political turmoil worse than anything since President Richard Nixon and the Watergate scandal. Some old Washington hands even claim that the Trump era will cause even greater uncertainty than the Nixon era did because Congress is allegedly less willing to keep the president in check. Economic policy uncertainty, based on newspaper word count, is at least comparable today to the tumultuous 1973-74 period, which culminated with Nixon's resignation in August 1974, and is trending upward (Chart 1). Chart 1Trump Uncertainty Approaching Nixon Levels? Inside The Beltway Inside The Beltway Of course, there is a big difference between Trump's and Nixon's context: today the economy is not going through a recession but rip-roaring ahead, charged with Trump's tax cuts and a bipartisan spending splurge. And the nation is not in the midst of a large-scale and deeply divisive war (not yet, anyway). There is little chance of major new legislation this year, yet deregulation, particularly financial deregulation, will continue to pad corporate earnings and grease the wheels of the economy. The booming economy is lifting Trump's approval ratings, which are trying to converge to the average of previous presidents at this stage in their terms (Chart 2). This development poses the single biggest risk to the unanimous opinion in DC that Republicans face a "Blue Wave" (Democratic Party sweep) in the midterm elections on November 6. However, a key support of the "Blue Wave" theory is that Republicans are split among themselves - and no one in the Washington swamp will deny it. Pro-business, establishment Republicans have never trusted Trump. They are retiring in droves rather than face up to either populist challengers in the Republican primary elections this summer or enthusiastic "anti-Trump" Democrats and independents in the general election (Chart 3).5 Chart 2Is Trump's Stimulus Bump Over? Inside The Beltway Inside The Beltway Chart 3GOP Retirements Are Unprecedented Inside The Beltway Inside The Beltway Trump is expected to ignite a constitutional crisis by firing Special Counsel Robert Mueller, the man leading the investigation into the Trump campaign's alleged collusion with Russia. Republicans are widely against firing Mueller, but they are not united in legislating against it, leaving Trump unconstrained. Senate Majority Leader Mitch McConnell (R, KY) says he will not allow consideration on the Senate floor of a bill approved by the Senate Judiciary Committee that would protect Mueller from firing.6 If Trump fires Mueller, Democrats expect a political earthquake. Some think that mass protests, and mass counter-protests encouraged by Trump himself, will culminate in violence. (We would expect protests to be mostly limited to activists, but obviously violent incidents are probable at mass rallies with opposing sides.) The Democrats are widely expected to take the House of Representatives; most observers are on the fence about the Senate. The House is enough to impeach Trump, which is widely expected to occur, by hook or by crook. But the impact on the country's political polarization will be much worse if there is impeachment without "smoking gun" evidence against Trump's person. Nixon, recall, refused to hand over evidence (the Watergate tapes) under a court order. When he handed some tapes over, they emitted a suspicious buzzing sound at critical points in the recording. Public opinion turned against him, prompting his party to abandon ship. He resigned because the loss of party support made him unlikely to survive impeachment. By contrast, there is not yet any comparable missing or doctored evidence in Trump's case, nor any sinkhole in Republican opinion that would presage a 67-vote conviction in the Senate (Chart 4). Chart 4Trump Not Yet In Nixon's Shoes Inside The Beltway Inside The Beltway Still, clouds are on the horizon. When people raise concerns about geopolitical issues - the U.S.-Russia confrontation, or the potential for a trade war with China - their starting point is uncertainty about President Donald Trump and his administration's policies. The United States is seen as the chief source of political risk in the world. Bottom Line: People in the Beltway who were once willing to believe that Trump would learn on the job and become "normalized" in office now seem to be shifting to the view that he is truly an unorthodox, and potentially reckless, president. The New (Aggressive) Consensus On China China is in the air like never before in D.C. In policy circles, the striking thing is the near unanimity of the disenchantment with China. Republicans are angry with China over trade and national security. Democrats are not to be outdone, having long been angry with China over trade, and also labor issues and human rights violations. It seems that everyone in the government and bureaucracy, liberal or conservative, is either demanding a tougher policy on China or resigned to its inevitability. American officials flatly reject the view that the Trump administration is instigating a conflict with China that destabilizes the world economy. Rather they insist that China has already instigated the conflict and caused destabilizing global imbalances through its mercantilist policies. They firmly believe that the U.S. can and should disrupt the status quo in order to change China's behavior, but that no one wants a trade war. They believe that the U.S. can be aggressive without causing things to spiral out of control. This could be a problem, as we detect a similar hardening of sentiment in China. On our travels there, the attitude was one of defiance toward Trump and Washington. We have received assurances that Beijing will not simply fold, no matter how much pain is incurred from trade measures. Of course, it is in China's interest to bluster in order to deter the U.S. from tariffs. But Chinese policymakers may be ready to sustain greater damage than Washington or the investment community expects. Tech companies are particularly out of the loop with Washington. They are said to have been unprepared for the president's actions upon receiving the Section 301 investigation results. They may also be underestimating the product list that the U.S. Trade Representative has drawn up pursuant to Section 301.7 Even products on that list that are not imported directly from China could have their trade disrupted. While China is demanding that the U.S. ease restrictions on high-tech exports, to reduce the trade imbalance (Chart 5), the U.S. believes that export controls allow for plenty of waivers and exceptions. They do not see export controls as a major risk. Chart 5U.S. Deficit Due To Security Concerns Inside The Beltway Inside The Beltway Rather, they see rising U.S. restrictions on Chinese investment in the U.S. as the real risk. The U.S. wants reciprocity in investment as well as trade. The emphasis lies on fair and equal access, which will require massive compromises from China, given its practice of walling off "strategic" sectors (including aviation, energy, electricity, shipping, and communications) from foreign interests. China's recent pledges to allow foreigners majority stakes in financial companies may not be enough to pacify the U.S. negotiators, especially if the promises hinge on long-term implementation. Treasury Secretary Steve Mnuchin will cause a stir when he releases his guidelines for investment restrictions, as expected by May 21 under the president's declaration on the Section 301 probe (Table 1).8 Both the House of Representatives and Senate are expected, within a couple of months, to pass the Foreign Investment Risk Review Modernization Act, proposed by Senator John Cornyn (R, TX) and Representative Robert Pittenger (R, NC). This bill would grant greater powers to the secretive Committee on Foreign Investment in the United States (CFIUS) in conducting investigations into foreign investment deals with national security ramifications. Under the new law CFIUS will be able to review proposed investment deals on grounds that go beyond a strict reading of national security. They will now include economic security, and potential sectoral impacts as well as individual corporate impacts, and previously neglected issues like intellectual property.9 Trump is unlikely to veto the bill, as previous presidents have done when laws cracking down on China have passed Congress, given his desire to shake up the China relationship. Table 1Protectionism: Upcoming Dates To Watch Inside The Beltway Inside The Beltway Will CFIUS enforcement truly intensify? Treasury's actions may preempt the bill, and CFIUS has already been subjecting China to greater scrutiny for years (Chart 6). Moreover, American presidents have always canceled investment deals if CFIUS advised against them.10 Presumably broadening CFIUS's powers will result in a wider range of deals struck down. The government already stopped Broadcom, a Singaporean company, from taking over the U.S. firm Qualcomm, in March, for reasons that have more to do with R&D and competitiveness (economic security) than with any military applications of its technologies (national security). Separately, U.S. policy elites are starting to turn their sights toward China's global propaganda and psychological operations. The scandal over the Communist Party's subversive institutional and political influence in Australia has heightened concerns in other Western, especially Anglo-Saxon, countries.11 This is a new trend that will have bigger implications going forward in Western civil society and the business community, with state efforts to create firewalls against Chinese state intrusion exacerbating political and trade tensions. Australians have the most favorable view of China in the West, and on the whole they continue to see China in a positive light. However, this view will likely sour this year. The recent attempt by Prime Minister Malcolm Turnbull to pass legislation guarding against Communist Party interference in Australian politics has already led to a series of diplomatic incidents, including tensions over the South China Sea and Pacific Islands. These can get worse in the near future. Consistently, over 40% of Australians view China as "likely" to become a military threat over the next 20 years (Chart 7), and this number will worsen if attempts to safeguard democratic institutions from state-backed influence operations cause China to retaliate with punitive measures toward Australia. China is offering some concessions to counteract the new, aggressive consensus in Washington. Enforcing UN sanctions against North Korea was the big turn. But it is also allowing the RMB to appreciate against the USD (Chart 8), which is an issue close to Trump's heart. The change in temperature in Washington can be measured by the fact that these concessions seem to be taken for granted while the discussion moves onto other demands like trade and investment reciprocity. Chart 6U.S. To Restrict Chinese Investment U.S. To Restrict Chinese Investment U.S. To Restrict Chinese Investment Chart 7Australian Fears About China To Rise Inside The Beltway Inside The Beltway Chart 8Is This Enough To Stay Trump's Hand On Tariffs? Is This Enough To Stay Trump's Hand On Tariffs? Is This Enough To Stay Trump's Hand On Tariffs? Simultaneously, China is courting Europe. European policymakers say that they share U.S. concerns about China's trade practices but wish to resolve disputes through the World Trade Organization and reject unilateral American actions or aggressive punitive measures that could harm global stability. Meanwhile China hopes that American policy toward Iran and the Middle East will alienate the Europeans while distracting Washington from formulating a coherent pivot to Asia. Bottom Line: Investors are underestimating the potential for a full-blown trade war. Policymakers - in China as well as the U.S. - have greater appetite for confrontation. Iran: Reversing Obama's Legacy The financial news media continue to underrate the importance of geopolitical risk tied to Iran this year (Chart 9). Our sense is that the Trump administration, when in doubt, is still biased towards reversing Obama-era policy on any given issue. Iranian nuclear deal of 2015 appears to be no exception. Chart 9Iranian Geopolitical Risk About to Shoot Up Iranian Geopolitical Risk About to Shoot Up Iranian Geopolitical Risk About to Shoot Up Signs have emerged for months that Trump is likely to refuse to waive Iranian sanctions (Table 2) when the renewal comes due on May 12. He has fired his national security adviser and secretary of state, as well as lesser officials, in preference for Iran hawks.12 French President Emmanuel Macron, having tried to convince Trump to retain the deal on his recent state visit to Washington, is apparently convinced Trump will scrap it.13 Table 2U.S. Sanctions Have Global Reach Inside The Beltway Inside The Beltway Moreover, discussions of Iran mark the one exception to the hardening consensus on China. A number of people we spoke with were not convinced that the Trump administration will truly devote the main thrust of its foreign policy to countering China. Some believed U.S. voters did not have the stomach for a trade fight that would affect their pocketbooks. Others believed that the Trump administration would simply revert to a more traditional Republican foreign policy, accepting a "quick win" on China trade while pursuing a confrontational military posture in the Persian Gulf. Still others believed that Trump has unique reasons, such as political weakness at home and the desire to be respected abroad, for wanting to be in lock-step with Israeli Prime Minister Benjamin Netanyahu and Crown Prince Mohammad bin Salman against Iran. All agreed that while a shift to China makes strategic sense, it may not overrule Republican policy preferences or inertia. The stakes are high. Allowing sanctions to snap back into place would affect a substantial portion of the one million barrels per day of oil that Iran has brought onto global markets since sanctions were eased in January 2016 (Chart 10). Chart 10Re-Imposing Iranian Sanctions Threatens Oil Supply And Middle East Stability Re-Imposing Iranian Sanctions Threatens Oil Supply And Middle East Stability Re-Imposing Iranian Sanctions Threatens Oil Supply And Middle East Stability As BCA's Commodity & Energy Strategy notes, global oil supply is tight and the critical driver - emerging market demand - remains strong. Meanwhile the "OPEC 2.0" cartel plans to extend production cuts throughout 2018 and likely into 2019, further draining global inventories. Inventories are now on track to fall beneath their 2010-14 average level by next year. In this context, the geopolitical risk premium will add to upside oil price risks this year. Our commodity strategists still expect oil prices to average $70-$74 per barrel this year (WTI and Brent respectively), but they can see it shooting above $80 per barrel on occasion, and warn that even small supply disruptions (whether from Iran, Venezuela, Libya, or elsewhere) could send prices even higher (Chart 11).14 Chart 11Oil Prices Can Make Runs Into /Barrel Range Oil Prices Can Make Runs Into $80/Barrel Range Oil Prices Can Make Runs Into $80/Barrel Range If the U.S. re-imposes sanctions on Iran, we doubt that the full one million barrels per day of post-sanctions Iranian production will be taken offline. Global compliance with sanctions will be ineffective this time around. The Trump administration's sanctions will not have the legitimacy or buy-in that the Obama administration's sanctions did. Trump may even intend to impose the sanctions for domestic political consumption while giving Europe, Japan, and others a free pass. Still, the geopolitical and production impact will be significant. As for oil, price overshoots are even more likely when one considers Venezuela, where our oil analysts estimate that state collapse will remove around 500,000 barrel per day from last year's average by the end of this year.15 Bottom Line: We continue to expect energy commodities to outperform metals in an environment where energy prices benefit from a rising geopolitical risk premium, while metals could suffer from ongoing risks to Chinese growth. Investment Conclusions Independently of the above anecdotes, Geopolitical Strategy has laid out a case urging clients to sell in May and go away.16 Last year we were confident recommending that clients forget this old adage because we had clarity on the geopolitical risks and their constraints. This year, with both China and Iran, we lack that clarity. The U.S.'s European allies could perhaps convince Trump to maintain the 2015 Iranian nuclear agreement, and Trump could perhaps accept China's concessions (such as they are) to get a "quick win" on the trade front before the midterm elections. But we have no basis for assessing that he will do either with any degree of conviction. How long will it take to resolve the raft of outstanding U.S.-Iran and U.S.-China tensions? Our uncertainty here gives us a high conviction view that this summer will be turbulent. Geopolitical tensions will likely get worse before they get better. We would reiterate our recommendation that clients be long DXY and hold a "geopolitical protector portfolio" of Swiss bonds and gold. We remain long developed market equities relative to emerging markets and long JPY/EUR. We are also maintaining our shorts on Chinese tech stocks and U.S. stocks exposed to China. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Strategic Outlook, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "Will Trump Fail The Midterm?" dated April 18, 2018, available at gps.bcaresearch.com. 6 Please see Jordain Carney, "McConnell: Senate won't take up Mueller protection bill," April 17, 2018, available at thehill.com. 7 Please see U.S. Trade Representative, "Under Section 301 Action, USTR Releases Proposed Tariff List on Chinese Products," and "USTR Robert Lighthizer Statement on the President's Additional Section 301 Action," dated April 3 and April 5, 2018, available at ustr.gov. 8 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. 9 Please see Senator Jon Cornyn, "S.2098 - Foreign Investment Risk Review Modernization Act of 2017," dated Nov. 8, 2017, available at www.congress.gov. For the argument behind the bill, see Cornyn and Dianne Feinstein, "FIRRMA Act will give Committee on Foreign Investment a needed update," The Hill, dated March 21, 2018, available at thehill.com. 10 Please see Wilson Sonsini Goodrich & Rosati, "CFIUS In 2017: A Momentous Year," 2018, available at www.wsgr.com. 11 Australian Senator Sam Dastyari (Labor Party) resigned on December 11, 2017 after it was exposed that he accepted cash donations from a Chinese property developer that he used to repay his own debts. He had also supported China's position in the South China Sea. The scandal prompted revelations of a range of Chinese state-linked political donations. Prime Minister Malcolm Turnbull has introduced legislation banning foreign political donations and forcing lobbyists for foreign countries to register. 12 Mike Pompeo replaced Rex Tillerson as Secretary of State, John Bolton replaced H.R. McMaster as National Security Adviser, and Chief of Staff John Kelly has been sidelined; Bolton has appointed Mira Ricardel as his deputy, who has been said to clash with Secretary of Defense James Mattis in trying to staff the Pentagon with Trump loyalists. Please see Niall Stanage, "The Memo: Nationalists gain upper hand in Trump's White House," The Hill, April 25, 2018, available at thehill.com. 13 Macron has presented a framework that German Chancellor Angela Merkel and U.K. Prime Minister Theresa May have accepted that would call for improvements to outstanding issues with Iran while keeping the 2015 deal intact. Macron has also spoken with Iranian President Hassan Rouhani about retaining the deal while addressing the Trump administration's grievances. 14 Please see BCA Commodity & Energy Strategy Weekly Report, "Tighter Balances Make Oil Price Excursions To $80/bbl Likely," dated April 19, 2018, available at ces.bcaresearch.com. 15 Please see footnote 14, and BCA Geopolitical Strategy and Energy Sector Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Weekly Report, "Expect Volatility ... Of Volatility," dated April 11, 2018, available at gps.bcaresearch.com. Geopolitical Calendar

Highlights The Philippines is seeing a genuine inflation outbreak. The Duterte administration's policies favor "growth at all costs." "Charter change," or constitutional revision, will stoke political polarization, erode governance, and feed inflation. We are neutral on Philippine stocks and bonds within EM benchmarks for now but are placing the country on downgrade watch. Feature Chart 1Markets Sold On Duterte Election Markets Sold On Duterte Election Markets Sold On Duterte Election It has been nearly two years since Rodrigo "Roddy" Duterte - the Philippines' populist and anti-establishment president - was elected. On May 11, 2016, two days after the vote, BCA's Geopolitical Strategy and Emerging Markets Strategy published a joint report arguing that Duterte would "take the shine off" the economic structural reforms that had taken place under the outgoing administration of President Benigno Aquino.1 We downgraded the bourse from overweight to neutral within the EM universe. Financial markets have largely vindicated this view. Philippine stocks peaked against EM stocks three days before Duterte's inauguration and have continued to underperform since then. The Philippine peso has also suffered, both in real effective terms and relative to the weakening U.S. dollar (Chart 1). Is it time to buy then? No. Duterte's policies will continue to erode the country's governance and macro fundamentals, overheating the economy and subtracting from investment returns. Of course, the country is well insulated from any China or commodity shock, and this is an important advantage over other EMs in the medium term. Also, equity and currency valuations have improved relative to other EMs. Hence we recommend clients remain neutral Philippine stocks, currency, and credit versus the EM benchmark for now, and use any meaningful outperformance to downgrade the country to underweight within aggregate EM portfolios. An Inflation Outbreak One of the most reliable definitions of a populist leader is one who pursues nominal, as opposed to real, GDP growth. While policymakers can stimulate nominal growth through various policies, real growth over the long run depends on productivity and labor force growth, which are much harder to control. The only way policymakers can affect real growth is by undertaking structural reforms - which are often painful and unpopular in the short run. By contrast, faster nominal growth as a result of higher inflation can create the "money illusion" among the populace and bring political rewards, at least for a time.2 Higher nominal growth might initially please the public, but when inflation escalates it will reduce living standards. Moreover, an inflation outbreak will eventually necessitate major policy tightening and a growth downturn to reverse inflation. A comparison of a range of populist political leaders with orthodox (non-populist) leaders across Latin America, Central Europe, and Central Asia demonstrates that populists really do tend to achieve higher nominal growth relative to non-populists in the first two years of their rule (Chart 2). This finding has served BCA's Geopolitical Strategy well in predicting that U.S. President Donald Trump would blow out the federal budget through tax cuts and government spending in pursuit of faster growth.3 With stimulus taking effect while the output gap is closed, inflationary pressures are likely to rise higher than they otherwise would have done over the next 12-to-24 months.4 Chart 2Populists Pursue Nominal GDP Growth The Philippines: Duterte's Money Illusion The Philippines: Duterte's Money Illusion President Duterte of the Philippines also appears to fit this rubric. Like Donald Trump, he combines foul-mouthed eccentricity and personal risk-taking with a policy agenda of tax cuts, fiscal spending, and deregulation (Table 1).5 Yet unlike Trump, his infrastructure program - which is desperately needed in the Philippines, a laggard in this respect - is up and running, producing a large increase in capital expenditures and imports. The gap between nominal and real GDP growth - i.e. the inflation rate - looks likely to rise further. Table 1Duterte's Agenda Consists Of Drug War, Tax Cuts, And Big Spending The Philippines: Duterte's Money Illusion The Philippines: Duterte's Money Illusion Signs of an inflation outbreak are already evident. Chart 3 shows that both core and headline inflation measures are now rising sharply and have crossed the Bangko Sentral ng Pilipinas's (BSP) 3% inflation target by a wide margin, even rising above the 2%-4% target band. Further, local currency yields are rapidly ascending while the currency has been plunging against the weak U.S. dollar. These indicators suggest that the inflation outbreak that BCA's Emerging Markets Strategy warned investors about in October has now come to pass.6 The official explanation for the inflation spike this year is Duterte's tax reform bill, which took effect January 1 (and is the first of several such bills). The bill cuts taxes for households and raises excise taxes on a range of goods - from electricity, petroleum products, coal, and mining to sugary drinks and tobacco.7 The central bank has cited this law and its ramifications (including transportation costs and wage demands) as reasons for the inflation overshoot to be temporary. Yet Duterte's growth agenda and the BSP's simulative policies have created an environment ripe for inflationary pressures to build, namely by encouraging banks to expand their balance sheets and money supply (Chart 4). This has led to excessive strength in domestic demand. Chart 3An Inflation Outbreak An Inflation Outbreak An Inflation Outbreak Chart 4Stimulative Policies Stimulative Policies Stimulative Policies Further signs of a genuine inflation outbreak include: Twin deficits: both the current account and fiscal balances are negative in the Philippines, a significant development over the past two years (Chart 5). Further, the trade balance now stands at a nearly two-decade low of 9.5% of GDP (Chart 6). Worryingly, the current account has fallen into deficit despite the fact that remittances from Filipinos living abroad, which account for 9% of GDP, have been robust (Chart 6, bottom panel). Oil prices are surprising to the upside as global inventories drain and the geopolitical risk premium rises. This puts additional pressure on the current account balance and adds to inflationary pressures. Chart 5The Philippines Now Has Twin Deficits The Philippines Now Has Twin Deficits The Philippines Now Has Twin Deficits Chart 6Trade Deficit Worsens; Remittances The Saving Grace Trade Deficit Worsens Despite Remittances Trade Deficit Worsens Despite Remittances The Philippines' import bill is growing briskly, especially that of consumer goods (Chart 7, top panel). Meanwhile, overall export volumes and revenues of non-electronic/manufacturing exports are contracting (Chart 7, second panel). This is a sign that the Philippine economy is losing competiveness. Indeed, the third panel of Chart 7 shows that the country's global export market share is deteriorating. Wages are rising across many sectors (Chart 8). The imposition of excise taxes on electricity and fuel has prompted a wave of demands for higher wages from labor groups and provincial wage boards. Duterte is also said to be preparing a nationwide minimum wage law (to increase regional wages vis-à-vis the capital Manila) and an end to temporary employment contracts, which cover about 25% of the nation's workers and pay wages that are 33% lower on average. As wage growth outpaces productivity gains, unit labor costs are rising, eating into listed non-financial companies' profit margins (Chart 9). Chart 7Domestic Demand Surges While Competitiveness Falls Domestic Demand Surges While Competitiveness Falls Domestic Demand Surges While Competitiveness Falls Chart 8Wage Growth Is Strong Wage Growth Is Strong Wage Growth Is Strong On the fiscal front, the Duterte administration is pushing badly needed spending increases in infrastructure, health, and education. The investments amount to $42 billion over six years, or roughly 2% of GDP per year in new fiscal spending.8 While these investments will be beneficial in the long run as they augment both the hard and soft infrastructure of the nation, their size and timing needs to be modulated in real time to prevent them from creating excessive inflationary pressures in the short and medium run. This is difficult and the administration is likely to err on the side of higher spending that feeds inflation. Further, the administration's tax reform plan is unlikely to raise enough revenue to cover all the new spending. The first tax reform bill to pass through Congress cuts household tax rates for most brackets (with rates to fall further in 2023) and raises the threshold to qualify for income tax, thereby narrowing the tax base to 17% of the population. The value added tax (VAT) will also have its threshold increased. Corporate taxes will be cut next. Revenue shortfalls will add to the budget deficit. Loosening fiscal policy will foster higher inflation and will continue weighing on the currency. Despite the upside inflation surprise, the central bank has kept the policy rate at the record low level of 3% where it has been since 2014. It also cut reserve requirements in March, injecting liquidity into the system. Deputy Governor Diwa Guinigundo says that an inflation reading within the target band at the May 10 monetary policy meeting will increase the likelihood that no rate hikes will occur this year.9 The central bank explicitly views this year's high inflation as a passing phenomenon tied to the excise taxes. It may also have stayed its hand due to signs of waning momentum in certain segments of the economy such as autos and property construction, which are weakening (Chart 10). Chart 9Higher Labor Costs Eat Firm Margins Higher Labor Costs Eat Firm Margins Higher Labor Costs Eat Firm Margins Chart 10Central Bank Not Worried About Overheating Economy Is Not Invincible Economy Is Not Invincible But in light of the fiscal and credit trends outlined above, and given that the Philippine economy is domestically driven and insulated from the slowdown in global growth, we do not expect domestic growth to fall very far. Overall, the central bank has maintained accommodative monetary policy for too long and tolerated an inflation outbreak. At this stage, central bank independence thus becomes a critical question. The current governor, Nestor Espenilla, is a tough enforcer against financial crimes who may be willing to do what it takes to rein in inflation: his comments have been a mixture of hawkish and dovish. But he is also a Duterte appointee, and thus perhaps unwilling to counter a popular, and forceful, president. It is too soon to say that the BSP will fail in its duties, but it does have a reputation for dovishness that it has reinforced this year.10 This analysis points to a policy of "growth at all costs." Odds are that growth will remain fast, that the inflation outbreak will continue, and that the BSP has fallen behind the curve. Bottom Line: The Philippines is witnessing an inflation outbreak that is likely to continue. Credit growth is booming, fiscal policy is loose, and the central bank is behind the curve. This policy setup is negative for the currency and for stock prices and local bonds in the absolute. Cha-Cha: What Does It Mean? In the long run, Duterte's authoritarian leanings will weigh on the country's performance. Governance has declined since he took office, primarily because of his rampant war against drugs. The Drug War has officially led to the deaths of 6,542 people since July 1, 2016, according to the Philippine Drug Enforcement Agency.11 Human rights groups believe the actual tally is twice as high. Yet even if we exclude "political stability and absence of violence" from the Philippines' governance indicators, the country's score has declined under Duterte and is worse than that of its neighbors (Chart 11). And this score does not yet account for the fact that Duterte has imposed martial law on the southern island of Mindanao and is using his popularity (56% net approval, Chart 12) and supermajority in Congress (89% of seats in the House and 74% in the Senate) to push a constitutional rewrite that would give him even more extensive powers.12 Chart 11Even Excluding The Drug War, Philippine Governance Is Bad And Getting Worse The Philippines: Duterte's Money Illusion The Philippines: Duterte's Money Illusion Chart 12Duterte Is Popular (But Not That Popular) The Philippines: Duterte's Money Illusion The Philippines: Duterte's Money Illusion Like previous administrations, the Duterte administration wants to revise the 1987 Philippine constitution. There are three current proposals, each of which would change the government from a "unitary" to a "federal" system.13 Manila would remain the capital but the provinces would be incorporated into states or regions that would have their own governments and greater autonomy. The proposals differ in detail, but if and when congressmen and senators reconstitute themselves into a Constituent Assembly to rewrite the charter, they will have complete freedom, i.e. will not be limited to the specifics of these proposals. A popular referendum will be necessary to approve the results and could occur as early as May 13, 2019, when Senate elections will be held, or the summer afterwards.14 "Charter change" or Cha-cha is a perennial preoccupation in the country with three main drivers (Table 2). First, successive Philippine presidents try to revise the constitution so that they can stay in power longer than the single, six-year term limit. Second, provincial political forces seek to change the constitution to decentralize power. Third, economic reformers and business interests seek to remove protectionist articles embedded in the constitution, particularly limitations on private and foreign investment. Table 2History Of Cha-Cha In The Philippines The Philippines: Duterte's Money Illusion The Philippines: Duterte's Money Illusion In general, Manila is seen as a distant and unresponsive capital ruling over an extremely diverse and disparate archipelago. The centralized system is prone to corruption due to the pyramid-like patronage structure descending from a handful of elite, Manila-based, families at the top. Meanwhile the provinces lack autonomy and economic development. While the capital region only contains 13% of the population, it accounts for 38% of GDP. The central government has trouble raising resources - as indicated by a low tax revenue share of GDP compared to neighbors (Chart 13). It is at times incapable of providing essential services like security and infrastructure, particularly in far-flung provinces like Mindanao or parts of the Visayas where poverty, under-development, natural disasters, and militancy reign. The chief goal of those who want a federal system is to decentralize power in order to strengthen the provinces. They argue that reversing the role of central and regional fiscal powers will improve government effectiveness overall by bringing the government closer to the people it governs. Today, the central government controls about 93.7% of the revenues and 82.7% of the spending while local governments control about 6.3% and 17.3% respectively (Chart 14). Chart 13The Philippine Government Is Underfunded And Weak The Philippines: Duterte's Money Illusion The Philippines: Duterte's Money Illusion Chart 14The Philippine Government Is Heavily Centralized The Philippines: Duterte's Money Illusion The Philippines: Duterte's Money Illusion Under a federal system these roles would reverse. Local governments would gain greater powers to tax and spend within their jurisdictions, while also improving tax collection. This would enable them to improve public services while still providing the federal government with resources to pursue national goals. Better funded and more autonomous local governments would presumably be more responsive to public demands within their jurisdictions. This is especially the case given the country's population and geography, with 101 million people spread out over more than 7,000 islands. The result - say the proponents - would be better governance all around, including greater economic development across the regions. From this point of view, over the long run, Cha-cha appears to be a pro-market outcome. In particular, the proposed changes will probably include greater openness to foreign direct investment (FDI), easing restrictions on land ownership, utilization, and resource exploitation that have long been difficult to remove because of their constitutional status (a vestige of anti-colonial sentiment). The Philippines falls markedly behind its peers in attracting FDI (Chart 15). This change would likely have a positive impact on FDI and productivity, as the Philippines has long suffered from its closed, protectionist, and heavily regulated model.15 Chart 15The Problem With Constitutional Restrictions On Foreign Investment The Philippines: Duterte's Money Illusion The Philippines: Duterte's Money Illusion However, Cha-cha's opponents argue that the net effect will be negative for the business community and financial markets because of the drastic shift in the status quo. They argue that the 1987 constitution provides ample authority for decentralization but that Congress has refused to pass implementing legislation due to vested interests. As opposed to reforming the Local Government Code and other laws on the books, a total change of the government system would be controversial, expensive, and prone to expanding bureaucracy (as it would replicate the current national government institutions for each state/region in the new federal system). It would also be self-interested. Cha-cha would give Duterte additional powers to oversee the chaotic transition, and likely give him new powers in the aftermath as a result of the provisions themselves.16 Weighing both sides, we expect that charter change will require a massive political struggle and a long transition period in which economic uncertainty will spike. It will also give Duterte more arbitrary power and weaken central institutions and legal frameworks designed to keep him in check. While he insists that he will step down in 2022 according to existing term limits, Cha-cha could remove the constitutional limit on his time in office or allow him to resume as prime minister indefinitely. He would also have extensive powers of appointment and dismissal affecting the judiciary and other checks and balances. Is creeping authoritarianism market-negative? Not necessarily. Authoritarian governments in some cases have greater ability to make difficult, unpopular decisions that benefit national interests in the long run - including on macroeconomic policy. Singapore, Taiwan, and China are famous regional examples. Nevertheless, the Philippines is not Singapore or China - it is not a weak or non-existent democracy with a strong central government, but rather a strong democracy with a weak central government. It will not be easy for Duterte to seize ever-greater control if he should attempt to. He will eventually meet resistance from "people power" - mass protests from civil society such as those that overthrew dictator Ferdinand Marcos in 1986 and President Joseph Estrada in 2001. Such a movement may not develop in the short run, given his popularity, but the distance from here to there will involve political instability and a deterioration of monetary and fiscal management. To illustrate this process, consider the Philippines' record in the "Polity IV" dataset, which is a political science tool that provides a standardized measure of the quality of democracy in different regimes across the world.17 A time series of the Philippines' Polity scores illustrates the drastic collapse of governance under Marcos (Chart 16), who imposed martial law from 1972-81 and plunged the country into a morass of oppression, dysfunction, and corruption. This ended with the first People Power Revolution in 1986 and the promulgation of the 1987 constitution. Since then, Polity scores have improved markedly. Today the Philippines scores an eight, within the range of western democracies. The democratic era has been a boon for investors who have seen the Philippines improve its macroeconomic and business environment over this period. But Duterte is a Marcos-like figure who could reverse this process even if he does not drag the country all the way down into the worst conditions of the 1970s-80s. Could Duterte succeed in charter change where his post-Marcos predecessors have failed? Yes. He has a lot of political capital and is well situated to push for dramatic change. He is an anti-establishment political outsider - the first Philippine president from the deep south - elected amidst a wave of disenchantment over persistent, endemic problems like poverty, corruption, lawlessness, and lack of development. He has high public approval ratings and a supermajority in Congress (Chart 17). It is too early in the game to give firm probabilities on whether the constitutional changes will pass the necessary popular referendum in spring or summer 2019, but it is perfectly possible for Duterte to succeed judging by his standing today. Chart 16The Marcos Dictatorship Was Inflationary The Marcos Dictatorship Was Inflationary The Marcos Dictatorship Was Inflationary Chart 17Duterte's Legislative Supermajority The Philippines: Duterte's Money Illusion The Philippines: Duterte's Money Illusion What will be the economic effects? Aside from policy uncertainty, decentralization will be good for growth and inflation. Local leaders will have more tax money to spend and less central discipline. Pent-up demand for development in the provinces will be unleashed, with local political leaders likely to encourage credit expansion. In the context outlined above this change means higher inflation. Inflation rates in the provinces should start to climb toward those of the capital region, while those of the capital region would have no reason to fall amid the flurry of new activity. Hence investors interested in the Philippines must monitor the long and rocky road of charter change. They should look to see if the Congress and Senate do indeed merge into a Constituent Assembly (the quickest yet most controversial way of revising the constitution because it is the least constrained); what proposals look to be codified in the drafting of the constitution and assembly debates; if Duterte retains his popularity throughout the constitutional process; and whether the public is supportive of the proposals.18 Our rule of thumb is that a constitutional process focused on decentralization and removal of protectionist provisions would be market-positive in principle. However, if authoritarian provisions creep into the final text, they may reveal the market-negative priorities and a lack of constraints on policymakers in Manila. Bottom Line: Philippine governance will continue to decay under the Duterte administration. Revisions to the constitution will have pro-market aspects, and net FDI will probably continue to rise. But these positive aspects will be overweighed by the politically polarizing and destabilizing process of charter change itself. Moreover, decentralization will feed into the current credit boom and inflationary backdrop and could produce excesses. The U.S.-China Crossfire The Philippines is a strategically located island chain that frames the South China Sea (Diagram 1). It has been caught in great power struggles for centuries. The rising U.S. colonial power displaced the remnants of the established Spanish colonial power there in 1898; the rising Japanese empire displaced the established U.S. in 1941, only to be defeated by the U.S. and its allies in 1944. Diagram 1The South China Sea: Still A Risk The Philippines: Duterte's Money Illusion The Philippines: Duterte's Money Illusion Now China is the rising power in Asia and is applying pressure on America's visiting forces. The Philippines is again caught in the middle. It relies on the U.S. more than China economically and strategically, but China is rapidly catching up, as is clear in trade data (Chart 18). And China's newfound naval assertiveness must be taken seriously. Indeed, Duterte claims that Chinese President Xi Jinping threatened him with war if his country crossed China's red line in the South China Sea.19 Chart 18China Rivals U.S. In The Philippines China Rivals U.S. In The Philippines China Rivals U.S. In The Philippines Geopolitical risk has fallen since Duterte's election as a result of his pledge to improve relations with China and distance his country from the United States. This was a sharp reversal of Philippine policy. From 2010-16, the Aquino administration engaged in aggressive strategic balancing against China. The country was threatened by China's militarization of the Spratly Islands in the South China Sea and encroachment into Philippine maritime space and territory. The pro-American direction of Aquino's policy culminated in the signing of the Enhanced Defense Cooperation Agreement (EDCA), which granted the American military the right, for ten years, to rotate back into Philippine bases. In July 2016, the Permanent Court of Arbitration ruled in favor of the Philippines, against China, in a landmark case of international law. It held that the South China Sea "islands" were not islands at all and that China could not base territorial or maritime claims off them.20 This strategic balancing brought tensions with China to a near boiling point. However, the pot was taken off the fire when the Philippine public elected the outspokenly anti-American, pro-Chinese, and communist-sympathizing Duterte. Duterte immediately set about courting Chinese investment, calling for bilateral China-Philippine solutions in the South China Sea (such as joint energy development), and denouncing President Barack Obama, the West, and various international legal bodies.21 As a result, China has largely dropped its pressure tactics against the Philippines. It has been investing more in the country over time (Chart 19) and has recently proposed a range of new projects worth a headline value of $26 billion. In the short run, Duterte's policy is positive because it enables the country to extract economic and security benefits from both the U.S. and China. China has reduced its coercive tactics, while the U.S. under President Trump has taken an easy-going attitude both toward Duterte's human rights violations and his pro-China (and pro-Russia) leanings. Duterte, for his part, has not tried to nullify the 2014 military pact with the U.S., but rather reversed his claim that he would sever ties with the U.S. by asking for American counter-insurgency support during the 2017 Siege of Marawi. Eventually, however, the emerging U.S.-China "Cold War" could force Duterte to make unpopular choices that violate economic relations with China or security protections from the U.S. The Philippine public is largely pro-American and suspicious of China.22 Thus, if Duterte pushes his foreign policy too far, he will provoke a backlash. This could take the form of a revolt against Chinese investments in the economy - as Chinese companies will be eager to take advantage of greater FDI access, especially under constitutional reform. Or it could take the form of a revolt against Chinese encroachments in the South China Sea, which are bound to recur.23 Alternatively, if the Philippines takes China's side, the U.S. could threaten to cut off market access, remittances, or (less likely) military support. A rupture in U.S. or China relations could spark or feed into domestic opposition to Duterte over political or constitutional issues or trigger a tense U.S.-China diplomatic standoff with economic ramifications. This is something to monitor in case a conflict emerges such as that which occurred in 2012-14 at the height of Philippine-China tensions, or in South Korea in 2015-16. In both cases, China imposed discrete economic sanctions against American allies as a result of foreign policy moves they took in stride with the United States (Chart 20). Chart 19Chinese Investment Will Rise Under Duterte Chinese Investment Is Growing Over Time Chinese Investment Is Growing Over Time Chart 20China Imposes Sanctions In Geopolitical Spats China Imposes Sanctions In Geopolitical Spats China Imposes Sanctions In Geopolitical Spats Bottom Line: Geopolitical risks have abated over the past two years and should remain contained for the next few years, as China wishes to reward Duterte and his foreign policy. However, relations between the U.S. and China are getting worse, which puts the Philippines in the middle of the crossfire. The South China Sea remains a fundamental, not superficial, source of tension. Investment Conclusions Chart 21Stocks And Bonds Will Underperform 21. Stocks And Bonds Will Underperform 21. Stocks And Bonds Will Underperform This scenario is negative for financial markets and will cause stocks to fall and local bonds yields to rise in absolute terms (Chart 21). Philippine equities remain very expensive. At this point only policy tightening by the BSP can control inflation, but that, even if it were to occur (unlikely in our opinion), will be negative for growth and financial markets in the short-to-medium term. Relative to other EMs, Philippine financial markets have underperformed considerably for the past few years, and thus might experience a relative rebound. If so, it will not be due to Philippine fundamentals but to the fact that in other EMs, fundamentals are deteriorating and financial markets selling off. These markets have had a good run in the past two years and are vulnerable to the downside. In this context, it matters that the Philippines is not a major commodity exporter and not highly vulnerable to a Chinese growth slowdown. Oversold conditions relative to EM peers and lower commodity prices could allow the Philippine bourse and currency to outperform those peers for a time. We thus maintain neutral allocation on Philippine stocks and bonds within EM benchmarks for now but are placing it on downgrade watch. On the political side, President Duterte is making investments in the country that will improve the supply side, but his policies will feed inflation in the short term and erode governance in the long term. His push to reshape the political and governmental system will increase political risk at a rare moment when geopolitical risks have somewhat abated. The latter are significant, but latent, and could flare up significantly in the long run due to U.S.-China conflicts. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Ayman Kawtharani, Associate Editor Emerging Markets Strategy ayman@bcaresearch.com 1 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 2The "money illusion" is a concept in macroeconomics coined by economist Irving Fisher, who wrote a book of the same title in 1928, to describe the failure of economic actors to perceive fluctuations in the value of any unit of money. In other words, people tend to pay more attention to nominal than to real changes in money or prices. The concept is valid today, albeit subject to academic debate over its precise workings. 3 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, and Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 4 Please see BCA Emerging Markets Strategy Weekly Report, "EM: Perched On An Icy Cliff," dated March 29, 2018, and "Two Tectonic Macro Shifts," dated January 31, 2018, available at ems.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Monthly Report, "Transformative Vs. Transactional Leadership," dated September 14, 2016, available at gps.bcaresearch.com. 6 Please see "The Philippines: An Overheating Economy Requires Policy Tightening" in BCA Emerging Markets Strategy Weekly Report, "Is The Dollar Expensive, And Are EM Currencies Cheap?" dated October 11, 2017, available at ems.bcaresearch.com. 7 Please see Office of the Presidential Spokesperson, "A Guide To T.R.A.I.N. Tax Reform for Acceleration and Inclusion (Republic Act No. 10963," dated January 2018, available at www.pcoo.gov.ph, and Department of Finance, "The Tax Reform For Acceleration And Inclusion (TRAIN) Act," dated December 27, 2017, available at www.dof.gov.ph. 8 Please see the Philippine Department of Finance, "The Comprehensive Tax Reform Program: Package One: Tax Reform For Acceleration And Inclusion (TRAIN)," January 2018, available at www.dof.gov.ph. 9 At its March policy meeting the BSP decided to keep interest rates on hold despite a March inflation reading of 4.3%, above the top of the target range of 4%. For Guinigundo's comments about the May 10 meeting, please see "Philippines c. bank says monetary policy still data-driven, may hold rates," April 20, 2018, available at www.reuters.com. 10 The BSP has reportedly only surprised markets four times out of 84 scheduled monetary policy meetings over the past ten years. Please see Siegfrid Alegado, "Life Is Getting Harder For Philippine Central Bank Watchers," dated March 21, 2018, available at www.bloomberg.com. 11 Please see Rambo Talabong, "Duterte gov't tally: At least 4,000 suspects killed in drug war," dated April 5, 2018, available at www.rappler.com. 12 Duterte's personal popularity is overstated. He was elected in a landslide, but only received 39% of the popular vote. The Pulse Asia quarterly polls suggest his popularity and "trust" ratings have ranged from 78%-86% since his inauguration (currently 80%), but this falls to 60% if undecided voters and disapproving voters are netted out. The Social Weather Station polls, which we cite, show a 56% net approval rating, which is mostly in line with Duterte's predecessor President Aquino at this stage in his term. 13 There are currently three draft proposals. The first is Senate Resolution No. 10, filed by Senator Nene Pimentel; the second is House Resolution No. 08, filed by Representatives Aurelio Gonzales and Eugene Michael de Vera; the third is the ruling PDP Laban Party's proposal, from Jonathan E. Malaya at the party's Federalism Institute. 14 The funding to hold a referendum in 2018 does not exist nor are legislators ready. A "special budget" will coincide with the plebiscite, no doubt strictly to pay for the polling and not to grease the wheels of the "yes" vote! Please see Bea Cupin, "Charter Change timetable: Plebiscite in 2018 or May 2019, says Pimentel," I, February 2, 2018, available at www.rappler.com. 15 Please see Gary B. Olivar, "Update On Constitutional Reforms Towards Economic Liberalization And Federalism," American Chamber of Commerce Legislative Committee, dated September 27, 2017, available at www.investphilippines.info. 16 Please see Neri Javier Colmenares, "Legal Memorandum on Charter Change under the Duterte Administration: Resolution of Both Houses No. 8 Proposed Federal Constitution," December 4, 2017, available at www.cbcplaiko.org. 17 Please see the Center for Systemic Peace and Monty G. Marshall, Ted Robert Gurr, and Keith Jaggers, "Polity IV Project: Political Regime Characteristics and Transitions, 1800-2016," July 25, 2017, available at www.systemicpeace.org. 18 Local elections in May 2018 may also provide some indications of popular support, as well as the Senate elections in May 2019 (if the referendum is not simultaneous). 19 Please see Richard Javad Heydarian, "Did China threaten war against the Philippines?" Asia Times, dated May 23, 2017, available at www.atimes.com. 20 Please see BCA Geopolitical Strategy Special Report, "South China Sea: Smooth Sailing?" dated March 28, 2017, available at gps.bcaresearch.com. 21 He has since said the Philippines will leave the International Criminal Court, which it joined in 2014, and arrest any prosecutor of the court who comes to the Philippines to investigate the government and police handling of the drug war. Please see Rosalie O. Abatayo, "Arresting ICC prosecutor could get Duterte in more legal trouble, says lawyer," The Philippine Daily Inquirer, April 22, 2018, available at globalnation.inquirer.net. 22 Please see Jacob Poushter and Caldwell Bishop, "People In The Philippines Still Favor U.S. Over China, But Gap Is Narrowing," Pew Research Center, September 21, 2017, available at www.pewglobal.org. 23 At present the Association of Southeast Asian Nations is negotiating a long-awaited, albeit non-binding, "code of conduct" with China in the South China Sea that could be concluded as early as this or next year. However, South China Sea tensions could heat up again at any point due to Chinese encroachments, U.S. pushback, or other regional actions. Also, with oil prices set to increase rapidly, non-U.S./OPEC/Russia international offshore oil rigs could begin to increase again, renewing an additional source of tension in the sea.

Highlights The U.S. and China have a roughly 60-day period to prevent the current trade "skirmish" from metastasizing into a full-blown trade war; The revised U.S.-Korea trade deal suggests that Trump's trade negotiators are credible and are targeting China, not U.S. allies; The U.S. will demand that China's recent RMB appreciation is backed by a long-term reduction in foreign exchange intervention; Tariff reciprocity is not significant, but market access and investment reciprocity are; China will offer concessions first, and will only go to a trade war if Trump imposes sweeping tariffs anyway; Short Chinese technology stocks; remain short China-exposed S&P500 stocks in expectation of further volatility. Feature The market is coming to terms with the fact that President Trump is willing to put his policies where his campaign rhetoric was, at least on trade policy. U.S. equities are down 5.7% since the White House announced Section 232 tariffs on steel and aluminum and 2.34% since it announced forthcoming Section 301 tariffs against China. Although we have cautioned clients since November 2016 that protectionism is a real risk to global growth and risk assets,1 we believe that the current set of U.S. demands on China justify the moniker of a "trade skirmish," rather than a full-out war.2 That said, the 5.7% drawdown is appropriate, if a bit sanguine. Our "trade skirmish" view is low-conviction. President Trump remains unconstrained on trade policy, giving him leeway to be tougher than the market expects. As such, it is appropriate for the market to price a 20%-30% probability of a full-blown trade war. Given that the market drawdown in such a scenario could be 20% or more, the current market action is appropriately pricing the worst-case scenario. Why would a trade war between the U.S. and China elicit a bear market in U.S. equities if a similar confrontation between Japan and the U.S. did not in the late 1980s? For three reasons. First, the overvaluation of stocks is much greater today. Second, interest rates are much lower, restricting how much policymakers can react to adverse risks. Third, supply chains are much more integrated today, globally and between China and the U.S. Nearly every major S&P 500 multinational corporation is in some way exposed to these supply chains. As such, we think the current drawdown is appropriate. That said, the administration's policy is not haphazard. President Trump and U.S. Trade Representative (USTR) Robert Lighthizer are on the same page, making China - and not NAFTA trade partners or South Korea - the main target of U.S. protectionism (Chart 1). The rapid pace at which the administration pivoted from global tariffs to targeting China gives a clear indication of what is afoot. The U.S. is using the threat of tariffs to cajole its allies into tougher trade enforcement against China (Table 1).3 We think this strategy can work, as outlined last week, but there is plenty of room for mistakes that could derail it. Chart 1China, Not NAFTA, In The Crosshairs China, Not NAFTA, In The Crosshairs China, Not NAFTA, In The Crosshairs Table 1U.S. Gradually Exempting Allies From Tariffs Trump's Demands On China Trump's Demands On China Trump also wants to change U.S. policy on immigration and could use the NAFTA negotiation to gain leverage over Mexico. There is therefore still some probability that Trump triggers Article 2205 to leave NAFTA, but we believe it has declined substantively since we put it at 50% in November, particularly given the U.S.-South Korea negotiations we discuss below.4 This week we take a look at the revised U.S.-Korea trade deal and what it suggests about the Trump administration's trade agenda more broadly. Then we update the status of the U.S.-China trade frictions, which are only temporarily subsiding, if at all. Lessons From The KORUS Talks The just-completed renegotiation of the U.S.-Korea free trade agreement (the "KORUS FTA") offers some clues to the Trump administration's trade tactics that may be relevant for future negotiations with NAFTA partners, China, and others. President Trump has repeatedly criticized the KORUS FTA, as the U.S. trade deficit with South Korea has ballooned since its implementation in March 2012 (Chart 2). Trump used the threat of withdrawing from the deal to pressure South Korean President Moon Jae-in not to ease sanctions on North Korea too rapidly. Chart 2Why Trump Likes Tariffs Why Trump Likes Tariffs Why Trump Likes Tariffs Now USTR Lighthizer and his South Korean counterpart, Hyun Chong-Kim, have agreed to the outlines of a revised deal.5 The key points are as follows: Steel tariff waiver for Korea: South Korea will receive a country-level exemption from the U.S.'s recently imposed steel tariffs.6 Going forward, Korean steel exports will be subject to quotas equivalent to 70% of the average annual import volume during 2015-17. Greater market access for U.S. autos: Korea will double the number of autos it imports on the basis of U.S. safety standards, from 25,000 to 50,000 per year from each U.S. carmaker. It can import more subject to its own safety standards. It will refrain from any new emissions-standards tests, will accept U.S. safety standards on auto parts, and will ease ecological policies and the customs process of verifying the origin of exports. Delayed market access for Korean trucks: The U.S. will retain the existing 25% tariff on Korean trucks through 2041, instead of 2021 (Chart 2, second panel). Fair treatment of U.S. pharmaceutical imports: Korea promises not to discriminate against U.S. drugs but to grant them fair treatment under KORUS provisions. Ancillary currency agreement: The two sides appended a "gentleman's agreement" on currency policies, which is not a formal part of the deal and not subject to legislative confirmation. South Korea agreed not to devalue the won competitively, or to manipulate it more broadly, and to provide greater transparency regarding its interventions in foreign exchange markets. There are three main takeaways from the above. First, the U.S. is obviously focusing on non-tariff barriers to trade, the main hindrance to trade in a world with already low tariff rates. The grievances with Korea were primarily due to safety standards, environmental policies, and burdensome administration that hindered U.S. exports despite the reduction of tariffs under the KORUS agreement. Second, USTR Robert Lighthizer - the seasoned negotiator of the historic 1980s trade disputes with Japan, and the man in charge of the current NAFTA and China negotiations - deserves his reputation as a competent policymaker. He apparently makes concrete demands and is capable of compromising to conclude deals. This reduces the risk, overstated by the media, that the inexperienced U.S. president is driving the trade negotiations. Third, the U.S. is not deliberately trying to punish its allies in pursuit of some mercantilist fantasy of closing every single trade imbalance. Strategic logic dictated that Washington and Seoul needed to conclude a deal quickly so as to better coordinate on North Korea, and they did so. It is highly unlikely that the concluded deal will end the U.S. trade imbalance with South Korea, but it will likely improve it substantively. Moon Jae-in continues to be a pragmatist in his dealings with Trump and Trump is joining Moon's "Moonshine" policy of engagement with North Korea. Talk of the U.S. abandoning its allies did not materialize. (Japan and Taiwan are likely to get deals soon.) Most importantly, this deal is a strong indication that the U.S. will continue to pressure China on its foreign exchange practices. It would make no sense for the U.S. to require its allies to disavow competitive devaluation and reduce currency interventions while not demanding similar assurances from China. On this front, China's recent appreciation of the yuan will not ultimately satisfy the U.S., as it is arbitrary. The U.S. will need to extract deeper guarantees, with the implicit threat of tariffs to prevent China from backsliding. Otherwise the U.S. would yield Chinese exporters a foreign exchange advantage relative to American trade partners who agree to stop intervening to preserve a favorable exchange rate with the USD. A simple comparison of these countries currency moves over the past eight years reveals how they have allowed less appreciation relative to the U.S. than in trade-weighted terms, and how China would benefit if the others were forced to stop this practice while it was left off the hook (Chart 3). Chart 3The U.S. Will Demand Currency Appreciation The U.S. Will Demand Currency Appreciation The U.S. Will Demand Currency Appreciation This last conclusion fits with our study of previous cases of U.S. trade protectionism, in which the end-game was dollar depreciation relative to key trade partners.7 The KORUS case can be considered alongside Lighthizer's and the Trump administration's handling of the Section 301 investigation into China's forced tech transfer and intellectual property theft. The Trump administration came out swinging with unilateral 25% tariffs on about $60 billion worth of goods, to be listed on April 6 and enacted sometime in June. But it also signaled that it would allow a consultation period, and initiated a case through the World Trade Organization, thus reinforcing (rather than undermining) the global trading system. These developments give some grounds for optimism in the NAFTA negotiations and (less so) in the China negotiations. While China is preempting U.S. demands on its currency policy, it will be averse to providing any permanent guarantees, or to painful structural demands. This is due to its concerns about overall stability and its suspicion that the U.S. is pursuing a broader strategic containment policy against it. We discuss these issues below. Bottom Line: The preliminary conclusions of the KORUS FTA negotiation suggest that the Trump administration's trade leadership is credible, while Trump himself is looking for quick and concrete trade "wins" that can be presented to his domestic voter base. This is a marginally market-positive sign. But its ramifications are limited with regard to China, where strategic tensions and geopolitical competition will make it much harder to strike a similar deal quickly. U.S.-China: Fade The "Mirror Tax," Focus On Market Access And Tech China announced tariffs on roughly $3-$3.5 billion worth of U.S. goods on April 2 - ranging from fruits and nuts to wine and pork - in retaliation for the steel and aluminum tariffs that the U.S. imposed in March under Section 232 of the Trade Expansion Act of 1962. China used the exact same tariff rates as the U.S. - 25% and 10% - while selecting the product list so as to produce roughly the same net trade impact in USD terms (Chart 4). The implication is that China will retaliate in kind to deter the U.S., but does not wish to "up the ante." This is largely what we expected, but the implication is significant: the U.S. is about to release a preliminary list on April 6 of $50-$60 billion worth of goods on which it will slap tariffs. This second round of tariffs - which is China-specific - follows from the probe under Section 301 of the Trade Act of 1974. China's recent decision suggests that if negotiations fail, it will respond with tariffs worth roughly the same amount, which is a much bigger exchange of fire for these two economies. The actual retaliatory action would most likely occur in June, when the U.S.'s list is finalized and implemented, though China may hint at its product list much sooner, adding to trade fears and market volatility.8 The Trump administration claims that its product list will be chosen by an algorithm to maximize the impact on Chinese exporters while minimizing the impact on the American consumer. Consistent with this aim, some reports indicate that the goods will be advanced technological products set to benefit from China's "Made in China 2025" plan, in which China has laid down aggressive domestic content requirements (Chart 5). Chart 4Tit For Tat Trump's Demands On China Trump's Demands On China Chart 5China's High-Tech Protectionism Trump's Demands On China Trump's Demands On China What is the Trump administration's goal? Treasury Secretary Steve Mnuchin declared at the G20 finance ministers' meeting that he did not want to penalize Chinese imports so much as promote U.S. exports. Is this a credible basis for assessing the administration's policy? Yes and no. We think Mnuchin is telling the truth, but not the whole truth. When it comes to blocking imports or boosting exports, Mnuchin is right: the U.S. goal is not simply to punish Beijing for past unfair trade practices by blocking imports of Chinese goods. True, the Trump administration has focused on a lack of reciprocity in tariff rates. But a "mirror tax" or "mirror tariff" with China, which Trump has referred to, would not make much of a difference to the trade balance: Chart 6AThe U.S. Exports Soybeans And Cars To China Trump's Demands On China Trump's Demands On China Chart 6BChina Exports Phones And Computers To The U.S. Trump's Demands On China Trump's Demands On China Taking a look at the top ten exports of the U.S. and China to each other (Chart 6 A&B), it is quite clear that China imposes higher tariffs on U.S. goods than the U.S. imposes on Chinese goods (Chart 7 A&B). This follows from World Trade Organization rules and the relative level of economic development of the two countries. Chart 7AAmerican Exports To China Face Higher Tariffs... Trump's Demands On China Trump's Demands On China Chart 7B... Than Chinese Exports To America Trump's Demands On China Trump's Demands On China If we equalize these tariffs by raising U.S. tariffs to the same level as their Chinese counterparts for the same good, we wind up with a very small $6.2 billion gain to the U.S. trade balance (Chart 8). If we focus only on the top ten goods that both countries export to each other, and impose a hypothetical mirror tax, we wind up with an even smaller gain for the U.S. of $3.9 billion (Chart 9). This is small fry and cannot be the administration's goal (at least not its main goal). The real goal is to gain greater market access for U.S. exports in China. Here the U.S. may have a case, as China lags both its developed and emerging market peers in sourcing its imports from the U.S. (Chart 10). While China comprises 24% of total EM imports, it comprises only 15% of U.S. exports to EM. Even in commodity exports, where the U.S. has made major inroads in China, Beijing has recently limited the American share (Chart 10, middle panel). Chart 8Equalizing Tariffs Has Little Impact Trump's Demands On China Trump's Demands On China Chart 9Equalizing Tariffs Has Little Impact (2) Trump's Demands On China Trump's Demands On China Chart 10U.S. Grievance Is About Market Access Trump's Demands On China Trump's Demands On China A simple, back-of-the-envelope comparison of the U.S.'s top exports to China and EM ex-China suggests that the U.S. can make a case that its exports are suffering unduly in China: China's share of top U.S. exports is lower than one might expect it to be relative to EM or EM-ex-China (Chart 11 A&B). The U.S.'s market share of China's imports in key goods is lower than it is in EM or EM-ex-China (Chart 12 A&B). The U.S. share of China's top imports is smaller than the DM-ex-U.S. share (Chart 13 A&B). Chart 11AChina Is Not A Large Enough Share Of U.S. Exports (Broad) Trump's Demands On China Trump's Demands On China Chart 11BChina Is Not A Large Enough Share Of U.S. Exports (Detailed) Trump's Demands On China Trump's Demands On China Chart 12AU.S. Is Not A Large Enough Share Of Chinese Imports (Broad) Trump's Demands On China Trump's Demands On China Chart 12BU.S. Is Not A Large Enough Share Of Chinese Imports (Detailed) Trump's Demands On China Trump's Demands On China Chart 13AU.S. Has Less Market Access In China Than Other Exporters Trump's Demands On China Trump's Demands On China Chart 13BU.S. Has Less Market Access In China Than Other Exporters Trump's Demands On China Trump's Demands On China China has granted the legitimacy of U.S. complaints by pledging several times in the last few months to open market access. The latest news from the negotiations suggests that some progress is being made.9 Clearly the above is a very rough measure. Chinese consumers may not want to buy as much stuff from the U.S. as from Europe and Japan. The U.S. doubtless needs to improve its global competitiveness, and even then it may not gain as much market share in China as its DM peers. Nevertheless, Washington sees itself as the power that brought China into the global economy and allowed it to join the WTO. If China wants the U.S. to allow it to play a greater role in running the world, the U.S. is demanding a beneficial economic relationship in return. One way China is offering to deal with the problem is by buying American goods at the expense of U.S. allies' goods. For instance, Beijing has offered to buy more semiconductors from the U.S. and fewer from Taiwan and South Korea. This would alleviate the U.S. trade deficit a little, but at a greater expense to U.S. allies (Table 2). It would open up an opportunity for China to make more strategic acquisitions in those weakened, neighboring industries. It is not clear that the Trump administration will accept such a "concession," unless it is coupled with much greater concessions as compensation for selling out the allies. Table 2China's Trade Concessions To The U.S. Could Impose Costs On U.S. Allies Trump's Demands On China Trump's Demands On China Similarly, China's concessions that have been offered so far - like lowering the 25% tariff on car imports - are tokens in the right direction but not sufficient to satisfy the U.S. at the current juncture. This means that the U.S. will demand structural changes that increase market access, from a stronger RMB to a more consumer-oriented economy, as part of what will be a drawn-out effort to encourage China to rebalance its macroeconomy. Of course, Treasury Secretary Mnuchin was only telling half the truth: the U.S. also wants to prevent China from stealing too much of America's market share too fast. When we look at China's comparative advantage - the goods categories in which China's export growth has been fastest in recent years, weighted by contribution to the total - the U.S. is the country that has the largest global market share in these very goods (Chart 14). For instance, telecoms equipment, car parts, TVs, electrical circuits, etc. The U.S.'s export mix is not as dependent on these goods as that of China's neighbors (Taiwan, Vietnam, Malaysia, Singapore, South Korea), but it is the chief exporter of these goods nevertheless. Because many of China's most competitive goods are still low value-added (toys, plastics, textiles, furniture), China is pursuing tech upgrades, innovation, and intellectual property: it would eat away at the U.S. share of more advanced goods. Chart 14China's Comparative Advantage Threatens U.S. Global Market Share Trump's Demands On China Trump's Demands On China The Trump administration is trying to slow China's advance and put a stop to China's aggressive poaching of foreign tech and IP.10 This will include restrictions on Chinese direct investment and acquisitions to be announced by Mnuchin on May 21. We expect him to intensify an inherently stringent vetting process. The administration has already taken a proactive stance by blocking Canyon Bridge Capital Partners from acquiring Lattice Semiconductor and Singaporean company Broadcom's attempted acquisition of Qualcomm.11 Rumor has it that the administration is now considering invoking the International Emergency Economic Powers Act of 1977, which authorizes the president to take actions "to deal with any unusual and extraordinary threat, which has its source in whole or substantial part outside the United States, to the national security, foreign policy, or economy of the United States, if the President declares a national emergency with respect to such threat." Trump would be able to cite China's use of state-backed companies, corporate espionage, and cyber-attacks in pursuit of technology and IP (Table 3). Table 3Trump Lacks Legal Constraints On Trade Issues... Especially When National Security Is Involved Trump's Demands On China Trump's Demands On China This is entirely aside from legislation pending in Congress, which the White House appears to support, that would provide the Committee on Foreign Investment in the United States (CFIUS) with the ability to block investments across entire industries, rather than on a case-by-case basis, and with a broader definition of national security and sensitive property and technologies.12 While American presidents have historically vetoed similar legislation against China, the Trump administration may not, depending on the outcome of talks. The key point is that the U.S. political establishment - across the spectrum - is alarmed about China's economic mercantilism. As Senator Elizabeth Warren recently declared to a group of top policymakers in Beijing: "Now U.S. policymakers are starting to look more aggressively at pushing China to open up the markets without demanding a hostage price of access to U.S. technology."13 Warren, a staunchly liberal senator from the Democratic stronghold of Massachusetts, is entirely on the same page as Trump. The takeaway for investors? China's tit-for-tat response to Trump's steel and aluminum tariffs should not be dismissed out of hand. The market is sensitive to trade fears and there is a clear avenue for them to get worse if the 60-day consultation period lapses without any major Chinese concessions. True, negotiations are ongoing and Trump's trade team has been shown to be both credible and willing to pursue trade disputes through the WTO. Nevertheless there are substantial measures aimed at China coming down the pike and the usual restraints on U.S. policy, centered on the U.S. business establishment lobbying policymakers, are not as effective as in the past. Bottom Line: The U.S.'s primary economic goal in the China negotiations is not to equalize tariffs but to open market access. The strategic goal is much larger. The U.S. wants to see China's rate of technological development slow down. As such, Washington will expect robust guarantees to protect intellectual property and proprietary technology. Investment Conclusions Several clients have asked about the constraints on the different players if trade conflict should escalate over the coming months. On the surface the U.S. is in a stronger position because its outsized deficit with China means that measures constricting bilateral trade are inherently more damaging to China's output (Chart 15). Even some of China's best retaliatory options are difficult to put into practice, including selling U.S. treasuries or imposing sanctions on U.S. commodities (Table 4).14 Chart 15China More Exposed To Trade Than U.S. China More Exposed To Trade Than U.S. China More Exposed To Trade Than U.S. Table 4China's Retaliation Options Are Limited... Even In Agriculture Trump's Demands On China Trump's Demands On China The U.S. also faces a constraint in imposing measures on China because manufacturing value chains today sprawl across various countries and multinational corporations. Tariffs therefore punish countries, including U.S. allies, that provide inputs to China or American companies that profit from them - think Apple. Moreover, tariffs will not in themselves change the U.S.'s fundamental savings-investment balance, suggesting that demand for foreign goods will simply shift to other producers and the trade deficit will be unaffected. However, supply chain risk is ultimately not prohibitive for the U.S. China has long ranked among the most exposed to supply-chain disruptions, while the U.S. ranks among the least (Chart 16). Moreover, U.S. allies in Europe and ASEAN stand to benefit if supply chains are rerouted from China (Chart 17). While the U.S. and allies would suffer higher initial costs as a result, they would gain the strategic advantage of reducing China's centrality to global supply chains. The latter has given Beijing an advantage in acquiring technology and moving up the value chain. Chart 16China Most Exposed To Supply-Chain Risk Trump's Demands On China Trump's Demands On China Chart 17U.S. Allies Benefit If Supply Chains Move Trump's Demands On China Trump's Demands On China While the Xi Jinping administration is weaning China off export reliance and U.S. reliance, the country still employs 28% of its workers in the manufacturing sector, which leaves it more exposed to disruptions than the U.S. if trade frictions should spiral out of control and weaken overall demand (Chart 18). While American workers are intimately familiar with the boom-and-bust cycle of free labor markets, China has not struggled with significant unemployment since 2003 (Chart 19). Its middle class was much smaller then. Chart 18Employment Is A Constraint On China Employment Is A Constraint On China Employment Is A Constraint On China Chart 19China Unfamiliar With Large-Scale Job Loss China Unfamiliar With Large-Scale Job Loss China Unfamiliar With Large-Scale Job Loss In short, China will first attempt to appease the Trump administration through market access (and keeping the RMB strong) to maintain its supply-chain centrality and overall stability. If Trump accepts China's concessions, trade frictions will not spiral out of control - at least not this year. China will only accept a full-fledged trade war if Trump rejects its concessions and imposes punitive measures that threaten its stability. At that juncture, Xi would probably find it useful to demonize Trump and execute long-term changes to make China more self-sufficient, blaming the U.S.-initiated trade war for the painful consequences. This is why it matters if Trump's demands go beyond foreign exchange rates, improved market access, and IP enforcement - for instance, if they extend to capital account liberalization, the holy grail of American trade negotiations with China. Thus far, Trump's team has not raised this demand, but it is a subject we will revisit soon as it is likely to be China's red line, at least within the economic sphere. In light of our expectation for further trade-war related volatility, we would recommend shorting Chinese tech stocks15 and remaining short China-exposed U.S. stocks. The latter trade has been in the black by over 5% in just a week, but is currently up only 0.7%. It is a way to hedge the risk of further tensions between U.S. and China. Risks to this view are: if the U.S. reduces the Section 301 tariffs that it is threatening on or after April 6; if Treasury Secretary Mnuchin's investment restrictions due on May 21 are watered down; or if the U.S. makes no structural demands on China's economy but merely accepts temporary RMB appreciation and some big-ticket import orders. Otherwise the risk that trade tensions spiral out of control will remain elevated at least through the U.S. midterm elections on November 6. By then, Trump will need either to have cut a small-scale deal with China that he can tout for voters or to have taken more aggressive trade action pursuant to the Section 301 findings. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War," dated March 6, 2018, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 28, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 5 A 60-day consultation period with both legislatures will follow but the deal will probably remain in more or less the same form. 6 Aluminum was not included, but South Korea is not a major source of aluminum products for the U.S. 7 Please see footnote 2 above. 8 Please see David Lawder, "Trump to unveil China tariff list this week, targeting tech goods," Reuters, April 2, 2018, available at www.reuters.com. 9 Treasury Secretary Steve Mnuchin spoke with Politburo member Liu He, who is Xi Jinping's top economic policymaker, and they reportedly pledged that they are "committed" to a solution on reducing the U.S. trade deficit. The U.S. is asking for a $100 billion reduction to the trade deficit within the year, as well as some progress on intellectual property enforcement. Supposedly the specific demands involve reducing the Chinese tariff on car imports and raising the foreign ownership cap on Chinese financial companies, the latter of which China has previously promised to do. Please see Andrew Mayeda, "U.S. Pushes China On Cars And Finance In Tariff Talks," Bloomberg, March 26, 2018, available at www.bloomberg.com. 10 Please see the U.S. Trade Representative, "Findings of the Investigation into China's Acts, Policies, and Practices Related to Technology Transfer, Intellectual Property, and Innovation under Section 301 of the Trade Act of 1974," March 2018, available at ustr.gov. 11 In September 2017, the White House and Department of Treasury intervened in the attempt by a group of investors, including the state-owned China Venture Capital Fund, from acquiring Lattice, on the advice of CFIUS. Lattice makes computer chips that are highly versatile and can be used in military functions; the Chinese SOE was suspected of pursuing China's state-backed efforts to improve its semiconductor industry. Separately, in March 2018, President Trump blocked Singapore-based Broadcom's attempt to acquire Qualcomm, which would have been a hugely consequential tech merger due to the two companies' dominance in making processors. The Treasury Department feared that Chinese state entities might get access to Qualcomm's IP or that the merger might otherwise hinder Qualcomm's "technological leadership." Please see "CFIUS Case 18-036: Broadcom Limited (Singapore)/Qualcomm Incorporated," dated March 5, 2018, available at www.sec.gov. 12 Please see Andrew Mayeda, Saleha Mohsin, and David McLaughlin, "U.S. Weighs Use of Emergency Law to Curb Chinese Takeovers," March 27, 2018, available at www.bloomberg.com. 13 She was speaking with Liu He, seasoned diplomat Yang Jiechi, and Defense Minister Wei Fenghe. Please see Michael Martina, "Senator Warren, in Beijing, says U.S. is waking up to Chinese abuses," April 1, 2018, available at www.reuters.com. 14 Please see BCA Commodity & Energy Strategy Weekly Report, "Ags Could Get Caught In U.S. Tariff Imbroglio," dated March 15, 2018, and "Oil Price Forecast Steady, But Risks Expand," dated March 22, 2018, available at ces.bcaresearch.com. 15 Please see BCA China Investment Strategy Weekly Report, "After The Selloff: A View From China," dated February 15, 2018, available at cis.bcaresearch.com. Geopolitical Calendar

Highlights With North Korean diplomacy on track, Taiwan is the country most exposed to U.S.-China trade and strategic tensions. The Taiwanese public supports the status quo; however, a majority sees itself as exclusively Taiwanese, and the desire for independence may grow over time. Domestic political changes in mainland China and in the United States are also conducive to greater geopolitical tensions affecting Taiwan. Beijing will likely refrain from excessive pressure in the lead-up to Taiwan's November local elections ... but an independence-leaning outcome could change that. Stay overweight Taiwan within Emerging Market portfolios, but be prepared to downgrade if latent geopolitical risks begin to materialize. Feature The decision by the United States to toughen its enforcement of trade rules with China marks a shift that will have lasting ramifications.1 The U.S. is concerned not only about the trade imbalance but also the national security risk posed by China's economic might and increasing technological prowess. Hence President Donald Trump has imposed trade measures on China despite Chinese President Xi Jinping's cooperation on North Korea. Xi has enforced sanctions on the North and thus forced Kim Jong Un to the negotiating table, even getting him to consider denuclearization (Chart 1). Global financial markets may "climb the wall of worry" about the latest tariffs because the Trump administration has moderated its rhetoric in practice, notably by choosing to prosecute China in the World Trade Organization. However, the protectionist shift in U.S. policy is a lasting one. American power is declining relative to China, and the two countries no longer share the same economic interdependency that acted as a deterrent to conflict in the past (Chart 2).2 Chart 1China Gives Kim To Trump China Gives Kim To Trump China Gives Kim To Trump Chart 2Structural Increase In U.S.-China Tensions Structural Increase In U.S.-China Tensions Structural Increase In U.S.-China Tensions Taiwan is the country that is most exposed to both trade and strategic tensions between the U.S. and China (Chart 3). Indeed, BCA's Geopolitical Strategy has held since January 2016 that Taiwan is a potential geopolitical black swan.3 Does this warrant shifting to an underweight stance in EM portfolios? Not yet. But it is a left tail risk that investors should have on their radar. Taiwan Is Filled With Dry Powder There are three reasons to suspect that Taiwan geopolitical risk is understated. First, Chinese President Xi Jinping has consolidated power and made himself into Chairman Mao Zedong's peer in the Communist Party's ideological hierarchy. He is in power indefinitely. Xi has also followed his predecessor Jiang Zemin, in the 1990s, in taking a tough approach to security and defense. Implicitly he wants to make sure that unification occurs by 2049, but some argue that he wants to achieve it within his lifetime, namely by 2035. The Taiwanese public is resolutely opposed to any timetable. The fundamental risk is that economic slowdown could disappoint the aspirations of a big and ambitious middle class, which could force Xi to pursue nationalism and foreign aggression as a way to maintain domestic control (Chart 4). Beijing is still unlikely to attack Taiwan other than as a last resort, due to the American alliance system protecting it: this remains a hard constraint for now. But aggressive economic sanctions and military posturing with the intention to coerce Taiwan are much more likely than investors realize today. Chart 3Taiwan's Economy As Well As Security On The Line Taiwan's Economy As Well As Security On The Line Taiwan's Economy As Well As Security On The Line Chart 4China's Stability Vulnerable To Growth Slowdown China's Stability Vulnerable To Growth Slowdown China's Stability Vulnerable To Growth Slowdown Second, Taiwan's independence-leaning Democratic Progressive Party (DPP) has gained control of every level of government on the island - the presidency, the legislature, the municipalities - since the large-scale, anti-mainland "Sunflower" protests of 2014. President Tsai Ing-wen, who replaced the outspokenly pro-China President Ma Ying-jeou, is vocally uncomfortable with the status quo. She has refused to positively affirm the "1992 Consensus," which holds that there is only "One China" but two interpretations. Beijing sees this idea as the basis of smooth cross-strait relations. Tsai has not in practice tried to break the status quo, but she is clearly interested in enhancing Taiwan's autonomy. Moreover, a youthful "Third Force" has emerged in Taiwanese politics, with the backing of former presidents Lee Teng-hui and Chen Shui-bian, arguing for independence and the right to hold popular referendums on the question of sovereignty. Any success of this movement will provoke a massive response from China. Third, U.S. President Trump has suggested in several poignant ways that his tougher approach to China will entail a more robust American guarantee of Taiwan's security. While he has promised Xi to uphold the "One China policy," he is actively upgrading diplomatic and possibly naval relations with Taiwan and considering more substantial arms sales to Taiwan.4 His negotiation style suggests that he is not afraid to touch this "third rail" in Sino-American relations. Moreover, in the wake of the 1995-96 Third Taiwan Strait Crisis, and again in the wake of the Global Financial Crisis, a hugely important shift in Taiwanese national identity accelerated. Today the public mostly identifies solely as Taiwanese, as opposed to both Taiwanese and Chinese (Chart 5). This trend has abated somewhat since the DPP rose to full control in 2014-16, but a 55% majority still sees itself as exclusively Taiwanese. Among the youth, that number is 70%. This dynamic raises the possibility that a political independence movement could one day emerge. Beijing, at any rate, is watching with great concern. Of course, this shift in national identity does not imply that Taiwanese want to declare independence for the state of Taiwan anytime soon. Only about 22% want the country to move toward formal independence, and only 5% want to declare independence today. Whereas 69% are comfortable maintaining the status quo for a long time (Chart 6). The Taiwanese want to preserve their de facto independence and continue to prosper. But support for independence has grown faster than support for the status quo since the 1994 consensus. The status quo barely, if at all, holds majority support if one removes from its ranks those who eventually want to see the country declare independence. And younger cohorts have larger majorities than older cohorts in favor of independence. Chart 5Majority Of Taiwanese Are Exclusively Taiwanese ... Taiwan Is A Potential Black Swan Taiwan Is A Potential Black Swan Chart 6... Yet Majority Support Status Quo For Now Taiwan Is A Potential Black Swan Taiwan Is A Potential Black Swan The point is that there is a lot of "dry powder" in Taiwanese public opinion that could be ignited against China in the event of a change of circumstances, i.e. another military crisis or economic shock. Essentially, China is worried that someday this national identity could be weaponized. Chart 7China Gains Leverage Over Time China Gains Leverage Over Time China Gains Leverage Over Time How will China respond to the situation? So far it has not overreacted. Xi Jinping has launched more intimidating military drills and has hardened his rhetoric - including in key reports at the 2017 party congress and this year's National People's Congress. His administration has also pursued policies to emphasize its dominance, such as setting up new air traffic routes over the strait that Taiwan claims violate its rights.5 Nevertheless, the cross-strait status quo has not yet changed in any fundamental way that would suggest relations are about to explode. And this is fitting because the status quo is beneficial to the mainland, having created a vast imbalance of economic influence over Taiwan (Chart 7). This imbalance gives China the ability to use economic coercion to dissuade Taiwan's leaders from trying anything too daring. This year, in particular, there is reason to think that Xi Jinping may want to limit any provocations. Taiwan will hold local elections on November 24, an opportunity for the pro-China Kuomintang (KMT) to at least begin to claw back the political stature it has lost (Chart 8). A good showing in 2018 is essential for the KMT if it is to rebuild momentum for the 2020 general election. Tsai's and the DPP's approval ratings have fallen precipitously since her inauguration (Chart 9). Xi may deem that saber-rattling would be counterproductive by giving Tsai and the DPP a foil, when in fact the tide is already working against them. If the KMT's performance is abysmal in the November elections, then Beijing faces a problem. Its strategy of gaining influence over Taiwan through economic integration has not prevented the emergence of an exclusively Taiwanese identity. So far Beijing has not given up on this strategy but that might become a concern if the Xi administration treads softly this year and yet the DPP broadens its control of local offices. Worse still for Beijing would be sweeping gains for outspoken, pro-independence candidates, since China cannot expel them from the legislature as easily as it did their peers in Hong Kong. Chart 8Kuomintang Needs A Win In 2018 Taiwan Is A Potential Black Swan Taiwan Is A Potential Black Swan Chart 9DPP Only Leads KMT By A Little Now Taiwan Is A Potential Black Swan Taiwan Is A Potential Black Swan Bottom Line: Political changes in China, Taiwan, and the United States are conducive to souring relations across the strait. Moreover, Taiwanese national identity is dry powder that Beijing fears could be exploited by independence-leaning politicians - potentially with American backing from an aggressive President Trump. This three-way dynamic means that Taiwanese geopolitical risk is understated, despite the fact that these powers are all familiar with the dynamics and Beijing may not want to overly provoke voters ahead of local elections, knowing that heavy-handedness in 1995-96 encouraged Taiwanese uniqueness. Macro Backdrop And Trade Tensions Undermine DPP The problem for President Tsai and the ruling DPP, as local elections approach, is that the Taiwanese economy faces headwinds as Chinese and Asian trade slows down and as the Trump administration converts its protectionist rhetoric into action. Since last year, China has tightened financial conditions and regulation and has cracked down on corruption in the financial sector. The result is a slump in broad money supply that is now pointing to a drop in EM and Taiwanese exports (Chart 10). Indeed, a cyclical slowdown is emerging in Taiwan: The short-term loans impulse is weakening which suggests that Taiwanese export growth will slow further (Chart 11, top panel). The basis for this relationship is that short-term loans are used by Taiwanese businesses to fund their working capital needs as well as purchase inputs to fill their export orders. Further, broad money is also weak (Chart 11, bottom panel). Chart 10China Slowdown Spells Trouble For Taiwan bca.gps_sr_2018_03_30_c10 bca.gps_sr_2018_03_30_c10 Chart 11Taiwanese Money/Credit Growth Slowing Taiwanese Money/Credit Growth Slowing Taiwanese Money/Credit Growth Slowing The manufacturing sector is slowing, with the shipments-to-inventories ratio weak and manufacturing PMI dipping sharply (Chart 12). Worryingly, the new orders, export orders, and electronic-sector employment components of the manufacturing PMI are approaching a precarious level. Various prices of semiconductors are also starting to show signs of weakness globally which does not bode well for a market that relies heavily on this trade. The semiconductor shipment-to-inventory ratio has rolled over (Chart 13). Taiwanese exports to ASEAN are also slowing, which signifies that final demand for semiconductors is softening, as ASEAN economies lie at the final stage of the semiconductor supply chain process. Chart 12Manufacturing Indicators Rolling Over Manufacturing Indicators Rolling Over Manufacturing Indicators Rolling Over Chart 13Softness In Key Semiconductor Exports Softness In Key Semiconductor Exports Softness In Key Semiconductor Exports Further, global trade tensions have the potential to harm global growth and especially heavily trade-exposed economies like Taiwan. Taiwan is not guaranteed to benefit from the U.S.'s more aggressive posture toward China. Theoretically, if the U.S. imposes tariffs on goods from China that can be substituted by Taiwan, then Taiwan will benefit. But in practice, the U.S. is using tariffs as a threat to force China to open its market more to U.S. exports. One way that Beijing may respond is by purchasing American goods instead of goods that come from American allies like Taiwan. Beijing has already attempted this strategy by offering to increase imports of American semiconductors at the expense of Taiwan and South Korea. At the moment there are no details on how much of an increase China is proposing. In Table 1 we show several scenarios to assess the damage that could be inflicted on Taiwan if China substituted away from it. The impact on Taiwan's exports is not negligible. For instance, under the benign scenario, if U.S.'s share of semiconductor exports to China rise from 4%6 to 10%, then Taiwan's share of semiconductor exports to China would drop from 15% to 12%. That would amount to a $4 billion loss for Taiwan, approximately, which represents 1.4% share of its total exports and 4% of its overall semiconductor exports. This analysis assumes that the trade losses resulting from China's shift to its semiconductor import mix would harm Taiwan somewhat more than Korea. The latter holds a competitive advantage on Taiwan as Korea designs and manufactures unique semiconductors that are not as easily substitutable. At any rate, the damage to Taiwan's geopolitical and trade outlook would be more concerning than the loss of revenue. Table 1China's Trade Concessions To U.S. Could Impose Costs On U.S. Allies Taiwan Is A Potential Black Swan Taiwan Is A Potential Black Swan It is unlikely that the Trump administration is willing to accept such a deal, which is flagrantly designed to appease the U.S. at the expense of its allies. But the exercise illustrates a broader dynamic in which U.S. negotiations with China threaten to disrupt trade relationships and supply chains that have benefited Taiwan in recent decades. The result will be greater uncertainty and a higher potential for negative shocks. Chart 14China Punishes Taiwan For 2016 Election China Punishes Taiwan For 2016 Election China Punishes Taiwan For 2016 Election Moreover, the Trump administration has not entirely exempted allies from trade pressure. For instance, Taiwan has appreciated the dollar a bit in response to the threat of punishment for currency manipulation from the U.S. Washington has also just secured assurances from South Korea that it will not competitively depreciate the won. If agreements like these stand, and yet China makes less robust or less permanent agreements regarding its own currency, South Korea and Taiwan could suffer marginal losses of competitiveness. Taiwan is also exposed to coercive economic measures from China. Since Tsai's election, Beijing has made a notable effort to reduce tourist travel to Taiwan, which is reflected in tourism and flight data (Chart 14). Given the context of political tensions, the risk of discrete sanctions will persist and could flare up at any time if an incident occurs that aggravates the distrust between the two governments. How will investors know if Taiwanese geopolitical risk is about to spike upwards? At the moment, geopolitical risk is subdued, according to a proxy based on USD/JPY and USD/KRW exchange rates and relative Taiwanese/American inflation (Chart 15). This indicator tracks well with previous cross-strait crises. It even jumped upon the heightened tensions around the 2016 election of Tsai, and her controversial phone call with Donald Trump after his election. At the moment it suggests that cross-strait tensions have subsided significantly, despite the cutoff in formal diplomatic communication. However, the low point of the measure, and the underlying political factors outlined in the previous section, suggest that it should rise going forward. Chart 15Taiwanese Geopolitical Risk Likely To Rise From Here Taiwanese Geopolitical Risk Likely To Rise From Here Taiwanese Geopolitical Risk Likely To Rise From Here In the short run, it will be important to watch the Trump administration's handling of diplomatic visits and arms sales to Taiwan. Trump's signing of the Taiwan Travel Act has elevated diplomatic exchanges in a way that is mostly symbolic but could still spark an episode of heightened tension with China that would result in economic sanctions. An unprecedented naval port call could turn into an incident. At the same time, the U.S. guarantees Taiwan's security and in token of that guarantee periodically provides Taiwan with weapons packages. Beijing, for its part, always protests these sales, more or less vigorously depending on the military capabilities in question. The currently slated one is not too big but there is a rumor that it will include F-35 stealth fighter jets; other surprises could occur. Traditionally, the biggest spikes in sales have fallen under Democratic, not Republican, administrations. However, Trump may change that. There is a consensus in Washington that policy toward China should get tougher. The Taiwan Travel Act, upgrading diplomatic ties, passed with unanimous consent in both the House and Senate. Taiwanese governments have a record of increasing military spending when Republican presidents sit in Washington. And the first DPP government, under Chen Shui-bian from 2000-08, marked a clear upturn in Taiwanese military spending growth (Chart 16). If the Trump administration decides to sell Taiwan weapon systems that make a qualitative difference in the military balance, it will raise tensions with Beijing and likely prompt economic sanctions against Taiwan. Chart 16Arms Sales Could Reemerge As An Irritant Arms Sales Could Reemerge As An Irritant Arms Sales Could Reemerge As An Irritant In the long run, there are three key negotiations taking place in the region that could increase Taiwanese geopolitical risk: U.S.-China trade negotiations: Taiwan has benefited from China's engagement with the U.S., and with the West more broadly, and stands to suffer if they disengage. That would herald rising strategic tensions that would put Taiwan's trade and security in jeopardy. Geopolitical risk would go up. North Korean diplomacy: Kim Jong Un has met with Xi Jinping and formally agreed to hold bilateral summits with Presidents Trump and Moon Jae-in of South Korea. He has also indicated that denuclearization is on the table. If the different parties enter onto a path towards a peace treaty and denuclearization, then Taiwan might worry that the U.S. will eventually remove troops from the peninsula - far-fetched but not out of the question. Taiwan would fear abandonment and could attempt to entangle the U.S. For its part, China could believe that cooperation on North Korea requires the U.S. to give China greater sway over Taiwan. Geopolitical risk would go up. The South China Sea: These sea lanes are vital to Taiwan as well as China, South Korea, and Japan. If the U.S. washes its hands of the matter, ceding China a maritime sphere of influence, Taiwan will face both greater supply risk and greater anxiety about American commitment to its security. Beijing might be emboldened to pressure Taiwan, or Taiwan might act out to try to secure American support. Geopolitical risk would go up. Bottom Line: Taiwan's economy is entering a cyclical slowdown on the back of China's slowdown and rollover in the semiconductor industry. At the same time, trade tensions emanating from the U.S.-China negotiations and political tensions emanating from the other side of the strait suggest that Taiwan's geopolitical risk premium will rise. Over the short term, Taiwan's local elections, the referendum movement, or U.S. diplomacy or arms sales could provide a catalyst for a cross-strait crisis. Over the long term, significant changes in U.S.-China relations, North Korea, or the South China Sea could put Taiwan in a more precarious position. Investment Conclusions While the absolute outlook for Taiwanese stock prices is negative, the potential downside in share prices in U.S. dollar terms is lower than for the EM benchmark. BCA's Emerging Markets Strategy recommends that EM-dedicated investors remain overweight Taiwanese risk assets relative to the EM benchmark. First, the epicenter of China's slowdown is capital spending in general and construction in particular. Various Chinese industrial activity indicators have already begun decelerating. This is negative for industrial commodity prices and countries that produce them. Taiwan is less exposed to China's construction slump than many other EM economies. Second, China's spending on technology will not slow much. As a part of its ongoing reforms, Beijing will encourage more investment in technology as well as upgrading industries across the value-added curve. Hence, China's tech spending will outperform its expenditure on construction and infrastructure. Taiwan is poised to benefit from this relative shift in China's growth priorities. Third, there are no fresh credit excesses in Taiwan like in some other EMs. Taiwan's banking system worked out bad assets extensively following the credit excesses of the 1980s-90s. Hence it is less vulnerable than its peers in the developing world. Finally, Taiwan has an enormous current account surplus of 14% of GDP and, contrary to many other EMs, foreign investors hold few Taiwanese local bonds. When outflows from EM occur, the Taiwanese currency will fall under less pressure and its financial system under much less stress. This will allow Taiwanese stocks to act as a low-beta defensive play. Crucially, despite some appreciation to appease Trump, the Taiwanese dollar is among the cheapest currencies in EM (Chart 17). Chart 17Cheap Taiwanese Dollar Removes Risk Cheap Taiwanese Dollar Removes Risk Cheap Taiwanese Dollar Removes Risk As for heightened geopolitical risk, BCA's Geopolitical Strategy would note that while we view Taiwan as a potential "black swan," nevertheless tail risks are not the proper basis for an investment strategy. We will continue to monitor the situation so that we can alert clients when a major, market-relevant deterioration in cross-strait relations appears imminent, based largely on the factors highlighted above. If the DPP remains dominant after the local elections later this year, or if "Third Forces" make notable gains, we would suspect that the Xi administration will shift to using more sticks than carrots. This could include economic sanctions and military saber-rattling. The question then will be whether Beijing (or Washington or Taipei) attempts a material change to the status quo. Ultimately - from a bird's eye point of view - a war is more likely in the wake of Xi Jinping's elimination of term limits, consolidation of power, and the secular slowdown in China's economy and rise of Chinese nationalism. But we see no reason to fear such a catastrophic outcome in the near term. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 28, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, and "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 4 Trump began, as president-elect, by holding an unprecedented telephone call with the Taiwanese president. His administration has since requested a new $1.4 billion arms package, opened legal space for port calls (including potentially naval port calls) in the 2018 Defense Authorization Act, and for higher-level diplomatic meetings via the Taiwan Travel Act, which became public law on March 16, 2018. 5 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. Military drills have involved symbolic shows, like sailing China's only operational aircraft carrier along the mid-line of the Taiwan Strait, as well as more poignant maneuvers, like drilling north and south of Taiwan simultaneously. As for rhetoric, Xi omitted from his 2017 party congress speech any reference to hopes that the Taiwanese "people" would bring about unification; in his speech after the March National People's Congress, he warned of the "punishment of history" for those who would promote secession. 6 Shown as the average of 2015 and 2017.

Highlights The current U.S.-China trade skirmish is essentially the beginning of a new cold war. The U.S. and China are engaged in a struggle for supremacy, so trade conflicts will persist. The conflict could evolve into a "game of chicken" - the most dangerous type of game. The U.S. needs Europe's help against China - but an adventure in Iran could cost it that help. Geopolitical risks will cap the rise in bond yields over the next six months, push up oil, and give a tailwind to global defense stocks. Feature The opening salvo of the U.S.-China trade war has caught the investment community by surprise as the market is quickly repricing the odds of a global trade war.1 Nervousness over the breakdown of globalization comes at the same time as our key China view - that Beijing's structural reforms will constrain growth - are beginning to have an impact on global growth (Chart 1).2 Chart 1China Reforms Dragging On Global Growth China Reforms Dragging On Global Growth China Reforms Dragging On Global Growth Fortuitously, we found ourselves in Asia at the onset of "hostilities" and were thus able to see regional investors' reactions in real time. Our clients focused their questions on the economic impact of the announced tariffs (yet to be determined, in our view), constraints facing President Trump (minimal as well), and potential Chinese retaliation (understated). The focus, however, should be on the big picture. The March 23 U.S. announcement of tariffs on around $50 billion worth of Chinese imports is not just the opening salvo of a trade war. Rather the emerging trade war is the opening salvo of a new cold war, a global superpower competition between the U.S. and China that will define the twenty-first century. Put simply, the U.S. and China are now enemies. Not rivals, competitors, or sparing partners. Enemies. It will take the market some time for investors to internalize this idea and price it properly. Meanwhile, in the short term, fears of a full-born global trade war are overblown. The trade tensions are really only about two countries, with uncertain global implications. Investors are right to be cautious, but risks to global earnings are overstated at this time. How Did We Get Here? The ongoing trade tensions are not merely a product of a nationalist Trump administration that decided to call out China for decades of unfair trade practices. They are also the product of the geopolitical context, which we have defined through three "big picture" themes. These three themes allowed us to correctly forecast that the defining feature of the twenty-first century would be a Sino-American conflict. We would be thrilled to see this culminate merely in a trade war. The themes are: Multipolarity (Chart 2)3 Apex of globalization (Chart 3)4 The breakdown of laissez-faire economics (Chart 4)5 Chart 2Multipolarity Is Messy And Volatile Multipolarity Is Messy And Volatile Multipolarity Is Messy And Volatile Chart 3When Hegemony Declines, Globalization Declines When Hegemony Declines, Globalization Declines When Hegemony Declines, Globalization Declines Chart 2 elucidates a key lesson of history: the collapse of British hegemony at the end of the nineteenth century ushered in two world wars. Political science, game theory, and history teach us that periods of multipolarity are rarely peaceful.6 Today's world is not exactly multipolar, as the U.S. remains the preeminent global power. However, regional powers - such as China, the EU, Russia, India, Japan, Iran, and perhaps Turkey and Brazil - have a lot more room to maneuver within their spheres of influence. This means that global rules written by the U.S. at the conclusion of the Second World War are being rewritten for regional contexts. Normatively there is nothing wrong with this process. But practically, multipolarity means that "challenger powers" - such as China today or the German empire in the late nineteenth century - seek to undermine rules and norms of behavior that they had little or no say in setting up. And such rules are necessary to underpin geopolitical stability and grease the wheels of globalization. As Chart 3 shows, trade globalization peaked in the past when the hegemon could no longer enforce global rules. We have therefore emphasized to clients since 2014 that, if we are right that the world is multipolar, then we are essentially at the apex of globalization. A parallel process has seen the breakdown of the laissez-faire consensus, which underpinned the expansion of trade in goods, labor, and capital across sovereign borders. Economic globalization has lifted many boats around the world, but outsourcing - combined with technological innovation - has seen the lower middle class in developed nations face diminishing returns (Chart 4). Chart 4Globalization: No Friend To Developed-Market Middle Class We Are All Geopolitical Strategists Now We Are All Geopolitical Strategists Now That said, a revolt against globalization and "globalists" is thus far mainly an Anglo-Saxon phenomenon, and particularly an American one. Why? Because the particularities of the U.S. laissez-faire economic model, with its scant social protections, laid its middle class bare to the vagaries of globalization and technological change (Chart 5). However, there is no guarantee that other DM countries will not succumb to the same pressures down the line. Chart 5The 'Great Gatsby' Curve: Or, How Anglo-Saxons Turned Against Laissez Faire We Are All Geopolitical Strategists Now We Are All Geopolitical Strategists Now This background is important for investors because merely blaming a nationalist Trump administration or a mercantilist Beijing for today's tensions ignores the underlying context. President Trump can change his mind on a dime, but the geopolitical context can only evolve slowly.7 Mercantilism is here to stay; it is a feature, not a bug, of a multipolar world. Contrast today's tensions with those of the 1970s and 1980s between the U.S. and its major trade partners. The 1971 Smithsonian Agreement and the 1985 Plaza Accord ended overt trade protectionism by the U.S. (in 1971), and threats thereof (in 1985), by securing the compliance of these trade partners with Washington's currency and trade demands. Japan further conceded to U.S. demands in 1989 after a two-year trade war. Today, the U.S. and China are not geopolitical allies huddled under the same nuclear umbrella for protection against an ideologically fueled rival. They are ideological rivals. The reason it took a decade for the conflict to erupt is two-fold. First, the U.S. became entangled in the global war on terror after 9/11, which took its focus off of its emerging competitor in Asia. Second, the consensus view - that China would asymptotically approach a Western democracy as it embraced capitalism - has proven to be folly.8 Bottom Line: The China-U.S. trade conflict is a product of today's particular geopolitical context. At heart, it is a conflict for geopolitical primacy in the twenty-first century and thus unlikely to end quickly. Sino-American Conflict Is Intractable The current U.S.-China trade tensions are more of a skirmish than a war. We think that there is considerable room for a step-down in tensions over the next 12 months. First, the Trump administration has not launched an economic war against China. Not only has the U.S. restricted its list of Chinese goods under tariff consideration to just $50 billion of imports - roughly 12% of total Chinese exports to the U.S. - but it has decided to bring a case against China to the World Trade Organization (WTO). The latter is hardly a move by a mercantilist administration dead-set on across-the-board economic nationalism. Second, China has responded almost immediately by offering several concessions, including renewing pledges to open its economy to inward investment and to protect intellectual property (IP) rights. While these may seem like boilerplate concessions that Beijing has floated before, the current context of trade tensions and domestic structural reforms makes it more likely that Chinese policymakers will follow through on their promises. As such, we can see the current round of tensions tapering off, especially after the U.S. midterm elections. However, we doubt that the structural trajectory of Sino-American relations will be significantly altered even if current tensions subside. First, from China's perspective, its extraordinary economic ascent (Chart 6) is merely the return of the millennium's status quo (Chart 7). The last 180 years - roughly from the beginning of the First Opium War in 1839 to today - were the aberration. During this short period of Chinese weakness, the West - with Britain and then the U.S. at the helm - conspired to restructure global rules and norms of geopolitical and economic behavior without input from the Middle Kingdom. Chart 6China's Economic Rise Has Been Extraordinarily Fast... We Are All Geopolitical Strategists Now We Are All Geopolitical Strategists Now Chart 7China Sees Its Success As A Return To The Status Quo We Are All Geopolitical Strategists Now We Are All Geopolitical Strategists Now As such, China's influence in key post-WWII economic institutions like the WTO and the IMF is limited while its military has second-class status even in its own "Caribbean Sea," the South China and East China Seas. From the U.S. perspective, China's growth over the past two decades was made possible by U.S. hegemony. The U.S. secured the global rules and norms that enabled China to integrate seamlessly into the global marketplace and then compete its way to the top. Not only did the U.S. allow China to access its credit-fueled markets, but the U.S. Navy protected China's maritime trade, including vital energy supplies transiting from the Middle East. As a thank you for these efforts, China reneged on its WTO commitments, periodically suppressed its currency, stole American intellectual property, and withheld market access from U.S. corporations via tariff and non-tariff barriers to trade. Washington policymakers, and not only Trump's hawkish advisors, are turning against China. There is an emerging consensus among the U.S. foreign policy, defense, intelligence, and economic policy elites that: Sino-American economic symbiosis is over (Chart 8); Chart 8U.S.-China ##br##Symbiosis Is Dead U.S.-China Symbiosis Is Dead U.S.-China Symbiosis Is Dead Chart 9The U.S. Is Least##br## Exposed To Trade The U.S. Is Least Exposed To Trade The U.S. Is Least Exposed To Trade Chart 10China's Share Of Global##br## Exports Has Skyrocketed China's Share Of Global Exports Has Skyrocketed China's Share Of Global Exports Has Skyrocketed The U.S. can afford to confront China over trade because it is the least exposed major economy to global trade (Chart 9); The Chinese have acquired a massive share of global exports without a commensurate opening of their domestic market (Chart 10); Arresting Chinese technology transfer and intellectual property theft is a national security issue (Chart 11); The U.S. can confront China because it has emerged victorious from every global conflagration in the past (Chart 12). Chart 11China Imports Conspicuously Little U.S. IP We Are All Geopolitical Strategists Now We Are All Geopolitical Strategists Now Chart 12America Is Chaos-Proof America Is Chaos-Proof America Is Chaos-Proof Fundamentally, American policymakers want to see China's rapid economic growth slow, they want to see China's capital markets and companies constrained by openness to global competition, and they want to put a leash on China's catch-up in the technological and manufacturing value chain (Chart 13). This is not their stated objective as it would imply that the U.S. wants to see China weakened, and the Chinese leadership miss its decade and century economic development goals. But this is precisely what the U.S. establishment wants. As such, the political and economic visions of American and Chinese policymakers are directly at odds with one another. What does this mean for investors? Over the past several years we have developed a reputation of being sanguine about geopolitics. While many of our peers in the political analysis industry overstate the probability of geopolitical risk, we have (successfully) bet against the worst-case scenario in several prominent crises.9 We like to think that this is because we combine game theory with an understanding of the underlying power dynamics. By emphasizing constraints, we have successfully identified how power dynamics constrain the worst-case outcome.10 When it comes to Sino-American tensions, however, we have always been alarmists. This is because we believe the constraints to conflict are overstated, not understated. Furthermore, the potential market impact of a new cold war is unclear and potentially very large. Both the U.S. and China fundamentally think they can win a trade war. This means that they are engaged in a "regular game of chicken," named after the 1950s practice of racing hot rods head-on in order to prove one's manhood.11 Game theory teaches us that a game of chicken is the most unpredictable game because it can create an equilibrium in which all rational actors have an incentive to keep driving head on - to stick to their guns - despite the risks. In Diagram 1, we can see that continuing to drive carries the greatest risk, but also the greatest reward, provided that your opponent swerves. Chart 13China's Steady Climb Up##br## The Value Ladder Continues We Are All Geopolitical Strategists Now We Are All Geopolitical Strategists Now Diagram 1A Regular ##br##Game Of Chicken We Are All Geopolitical Strategists Now We Are All Geopolitical Strategists Now Since all actors in a game of chicken assume the rationality of their opponents, they also expect them to eventually swerve. In the current context, this means that the U.S. assumes that China is driven by economic rationality and will not dare face off against the U.S., which has far less to lose given its modest exposure to global trade. Chinese policymakers, however, also think they can win. They look over the Pacific and see a country riven by political polarization (Chart 14) where half of the country thinks the other is "a threat to the nation's well-being" (Chart 15).12 China, meanwhile, has just consolidated its political leadership and feels confident enough in its domestic stability to dabble with growth-constraining economic reforms. Beijing can use any trade tensions with the U.S. to further justify painful reforms. Chart 14Inequality Fuels Political Polarization Inequality Fuels Political Polarization Inequality Fuels Political Polarization Chart 15Live And Let Die We Are All Geopolitical Strategists Now We Are All Geopolitical Strategists Now Who is right? We do not know. And that scares us as it means that the most sub-optimal equilibrium - the bottom-right quadrant of Diagram 1 - is more probable than people think. An important difference maker, one that would alter Beijing's risk calculus considerably, is Europe. Despite being highly leveraged to China's growth, the EU still exports nearly double the value of goods to the U.S. than China (Chart 16). In addition, Europe's trade surplus with the U.S. mostly pays for its deficit with China (Chart 17). Chart 16The EU Exports More To U.S. Than China The EU Exports More To U.S. Than China The EU Exports More To U.S. Than China Chart 17EU Surplus With U.S. Pays For Deficit With China EU Surplus With U.S. Pays For Deficit With China EU Surplus With U.S. Pays For Deficit With China Over the next several months, investors will be able to gauge whether the Trump administration is filled with ideological nationalists who believe in Fortress America or wily realists who know how to get things done. The key question is whether Trump will embrace America's traditional transatlantic alliance with Europe and harness it for the trade war with China. If he embraces it, we will predict that the combined forces of U.S. and Europe will successfully force China to concede to the pressure. If Trump fails, however, we could have a prolonged U.S.-China trade war. Early indications are optimistic. The U.S. gave the EU an exemption from tariffs on steel and aluminum imports on March 22, a delay that will end on May 1. This followed a March 21 meeting between EU Commissioner for Trade Cecilia Malmström and U.S. Secretary of Commerce Wilbur Ross. We suspect, but have no evidence, that the U.S. asked the EU to join in its effort to force China to change its trade practices at the WTO. As an exporting bloc, the EU has a lot more to lose from attacking China than the U.S. But it also has much to lose from unabated Chinese mercantilism and technological theft, and much to gain if China opens its doors wider. As such, we posit that Europe will, in the end, join the U.S. and Japan in a concerted effort to pressure China. This will increase the probability that Beijing ultimately gives in to trade pressure. In the long term, it will also ensure that President Trump does not break the critical transatlantic alliance with Europe, which would be paradigm shifting. But, on the other hand, it will set China and the West on a collision course. China's and the West's suspicions of each other will ossify. Bottom Line: In the short term, trade tensions are likely overstated as U.S. actions against China are largely muted and restrained. In the long term, the U.S.-China trade war could potentially devolve into a "game of chicken," the most dangerous type of conflict. The key variable will be whether the U.S. administration is savvy enough to arrange European collaboration against China. If the U.S. treats the EU harshly and ignores its transatlantic ally on other issues - such as conflict with Iran, discussed below - we could be in for a wild ride in the coming months and years. Either way, Europe stands to gain from a conflict between China and the U.S. Both sides are likely going to try to enlist the EU on their side. As such, we are opening a long Europe industrials / short U.S. industrials trade. Meanwhile, growing trade tensions, policy-induced slowdown in China, and repricing of geopolitical risks in East Asia and the Middle East should cap global bond yields over the next six months. We take 50.4bps and 54.4bps profits on our short U.S. 10-year government bond vs. German bund and short Fed Funds December 2018 futures trades. Iran: The Next Target Of Trump's "Maximum Pressure" Policy President Trump's North Korea policy worked brilliantly in 2017. The policy of "maximum pressure" combined military maneuvers, economic sanctions, and extremely bellicose rhetoric to convince Pyongyang and regional powers that the U.S. has lowered its threshold for full-scale war on the Korean peninsula. China reacted swiftly, starving North Korea of hard currency through economic sanctions (Chart 18). The result was a declaration by Pyongyang in late November that it had finally completed its quest to obtain a nuclear deterrent (an exaggeration at best), an olive branch for the Olympics, and an offer by Supreme Leader Kim Jong Un to meet with President Trump. Chart 18China Gives Kim To Trump China Gives Kim To Trump China Gives Kim To Trump The policy of "maximum pressure" yielded such extraordinary results with North Korea that President Trump is now eager to trademark the process and apply it to Iran and potentially other global issues. Ahead of the all-important May 12 deadline - when the White House will decide whether to end the current waiver of economic sanctions against Iran - President Trump has replaced two establishment advisors with hawks. Secretary of State Rex Tillerson has been replaced with CIA Director and noted Iran-hawk Mike Pompeo. Meanwhile, National Security Advisor H.R. McMaster has been replaced by conservative pundit (and former U.S. Ambassador to the UN) John Bolton. Bolton is on record arguing that the U.S. should bomb Iran. The role of the national security advisor varies with the president. Some presidents rely on the position more than others. However, given this administration's inexperience with foreign policy, the role is critical in shaping the White House worldview. The national security advisor manages the staff of the National Security Council (NSC), whose role is to coordinate with the vast network of U.S. intelligence agencies and filter information to the president. Given how large America's foreign, defense, and intelligence establishment is, and given the nature of human and signals intelligence, U.S. presidents often have to act upon diametrically opposing pieces of intelligence. As such, the national security advisor and the NSC can play a critical role in deciding what intelligence makes it to the president's desk and in what context. Staffers in the National Security Council (NSC) are often apolitical. We have been told that several current experts are leftovers from the Obama administration. It is likely that an ideological pundit like John Bolton, who served briefly in the George W. Bush administration, will set out to quickly eliminate non-partisan staffers on the NSC and tilt the information flow away from the empirical to the conspiratorial. With Bolton and Pompeo effectively in charge of U.S. foreign policy it is possible that the U.S. will misapply "maximum pressure" policy to Iran and bungle the complicated coordination with geopolitical allies on China. In particular, the U.S. has to endear itself to the EU if it wants a global economic alliance against China. But the EU also does not want to renegotiate Iran sanctions. Abrogating the 2015 nuclear deal - the Joint Comprehensive Plan of Action (JCPA) - would throw the tentative Middle East equilibrium into chaos. While Iran has played a role in preserving the regime of Bashar al-Assad in Syria, it has largely kept its vast network of Shia militias and allies in check, particularly in Lebanon and Iraq. Ironically, it was the Obama administration's "flawed" JCPA that has allowed Trump to focus on China in the first place. As we argued when the deal was signed, the conservative critics of the deal itself were correct. The JCPA did not degrade Iran's nuclear capability but merely arrested it.13 The point of the deal was implicitly to give Iran a sphere of influence in the Middle East so that the U.S. could extricate itself and focus on China. The Obama administration assessed, in our view non-ideologically, that the U.S. cannot fight two wars at the same time. If the Trump administration decides not to waive sanctions on May 12, it will be in abrogation of the deal. Unlike North Korea, however, Iran has multiple levers it can deploy against the U.S. and its allies' interests in the region. As such, the policy of "maximum pressure" will create much greater risks when applied to Iran. At the very end, it could be as successful as when applied to North Korea, but our conviction view is much lower (and to remind clients, we were optimists about the strategy when applied to North Korea!).14 Furthermore, and again unlike North Korea, Iran is beset with domestic risks. This actually makes it less likely that Tehran will cooperate with the U.S. North Korea is a simple domestic political system where Kim Jong Un can alter policy on a whim without much domestic pushback. In Iran, the dovish and moderate President Hassan Rouhani has to contend for power with hawks who have been critical of the JCPA. Meanwhile, the restive youth population could rise up at the first sign of elite division or weakness. This complicated domestic dynamic is why we cautioned clients back in January that Iran would likely add geopolitical risk premium to the oil markets.15 Bottom Line: It appears that President Trump, motivated by the success of his "maximum pressure" strategy against North Korea, now thinks he can apply it as successfully to Iran. This raises the prospect that Trump will discontinue the waiver of economic sanctions on May 12, effectively re-imposing a slew of economic sanctions against Iran and foreign companies looking to conduct business with it. Geopolitical risks are likely to rise in the Middle East as a result of U.S.-Iran tensions. As we go to publication, Saudi authorities have intercepted another Houthi missile heading towards Riyadh just days after Saudi Crown Prince Mohammad Bin Salman visited Washington, D.C. The White House appears to relish the opportunity to fight a war on two fronts, a trade war with China and a geopolitical war with Iran. Expect volatility and an elevated geopolitical risk premium in oil markets. Stay overweight global defense companies across markets. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War," dated March 6, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Politics Are Stimulative, Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2013," dated January 16, 2013, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, and "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 6 Please see John Mearsheimer, The Tragedy Of Great Power Politics (New York: Norton, 2001). 7 Would President Hillary Clinton have avoided a trade war with China? We do not think so. Secretary Clinton was considered a "China Hawk" while at the State Department and pushed for the "Pivot to Asia." Jennifer Harris, the lead architect of Clinton's economic statecraft agenda in the U.S. State Department, recently penned a book that called for greater use of economic tools for geopolitical ends. The book, War By Other Means, introduces the term geoeconomics and calls for the U.S. to use economic instruments to promote and defend national interests. Please see BCA Geopolitical Strategy Blog, "We Read (And Liked)... War By Other Means," dated July 13, 2016, available at gps.bcaresearch.com. 8 In 2000, while campaigning on behalf of China's WTO entry, President Bill Clinton remarked, "economically, this agreement (China's WTO entry) is the equivalent of a one-way street. It requires China to open its markets ... to both our products and services in unprecedented new ways. All we do is to agree to maintain the present access which China enjoys ..." Please see "Full Text of Clinton's Speech On China Trade Bill," dated March 9, 2009, available at nytimes.com. 9 To name just a few: the risk of an Israeli attack against Iran, the risk of a full-scale Russian invasion of Ukraine, the risk of Euro Area collapse, the risk of Saudi-Iranian war, the risk of Russian-Turkish war, etc. 10 For the best example of how game theory is combined with our constraint-based paradigm, please see BCA Geopolitical Strategy Special Report, "After Greece," dated July 8, 2015, available at gps.bcaresearch.com. 11 See James Dean in Rebel Without A Cause. 12 Please see BCA Geopolitical Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Client Note, "Trump Re-Establishes America's 'Credible Threat,'" dated April 7, 2017, "North Korea: Beyond Satire," dated April 19, 2017, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, and "Insights From The Road - The Rest Of The World," dated September 6, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com.

Highlights Malaysian elections are likely in April or May and we expect will return the ruling BN coalition to power; Malaysia's banking system is vulnerable and economy is highly exposed to a relapse in Chinese growth and/or commodity prices; Thailand's military junta has delayed elections until February 2019 and may delay again, but that is not cause for a selloff; Transitions from military to civilian rule are historically positive for Thai assets relative to emerging markets; Favor Thai currency, equities, and bonds within the EM space; go long Thai local bonds versus Malaysian, currency unhedged. Feature The word is out that Malaysian Prime Minister Najib Razak will call elections ahead of Ramadan in late April or early May. The timing makes sense, as Malaysia's economy has recovered from the turmoil of 2015 and Najib has survived the political scandals that threatened to topple him (Chart 1). We expect the long-ruling Barisan Nasional coalition to emerge victorious from the vote.1 Chart 1Call Elections While Growth Is Strong Call Elections While Growth Is Strong Call Elections While Growth Is Strong Meanwhile, to the north, Thailand's military junta has delayed elections for the third time, pushing them from November 2018 to February 2019. Having revised the constitution and guided the country through the royal succession,2 the military is running out of excuses to cling to power. It is likely to hand the reins partially back to civilian politicians within the next 24 months, if not next February. The first election since the 2014 coup is likely (though not guaranteed) to favor military-backed parties. In both countries, the political status quo is familiar, and likely to persist for some time. What does this mean for investors? First, it means a degree of certainty. Second, it means mixed prospects for pro-market policies. Both BCA's Geopolitical Strategy and Emerging Markets Strategy favor Thai assets over Malaysian within the EM universe. Malaysia: Election Is Tactically Bullish At Best On the political front, there is a 45% subjective probability that the election impact will be genuinely market-positive and a 55% probability that it will be neutral or status quo. To understand this, investors need to understand how unlucky Malaysia's political opposition is. The twenty-first century was supposed to be the opposition's moment in the sun, when it would defeat the ruling Barisan Nasional (BN) coalition for the first time since the country's independence in 1957. A large and ambitious middle class was emerging on the back of export-led industrialization and a commodity bull market (Chart 2). The time seemed ripe for an unlikely coalition of middle-class progressive Malays, ethnic Chinese entrepreneurs, and rural Islamists to take power in the name of change. Unfortunately for the opposition, the 2008 election came before the global financial crisis struck and the 2013 election came before the oil price plunge of 2014 (Chart 3). The opposition made a valiant showing nonetheless. In the first case it deprived the BN of a supermajority for the first time since 1969; in the second case, it won the popular vote. But in neither case was the opposition able to win a majority of seats in parliament, as its victories were confined to a few small regions (Chart 4). Chart 2Middle Class Angst In Malaysia How To Play Malaysia's Elections (And Thailand's Lack Thereof) How To Play Malaysia's Elections (And Thailand's Lack Thereof) Chart 3Opposition Timing Unlucky... Opposition Timing Unlucky... Opposition Timing Unlucky... Chart 4... Can It Keep Gaining Seats? How To Play Malaysia's Elections (And Thailand's Lack Thereof) How To Play Malaysia's Elections (And Thailand's Lack Thereof) Today the opposition's bad luck continues. The Pakatan Harapan coalition, as it is now called, is headed into the yet-to-be-scheduled 2018 elections at a time when Malaysia's economy and exports have recovered along with global demand and commodity prices (Chart 5). Consumer sentiment and employment have improved, albeit from a low point. Chart 5Economy Recovers Ahead Of Vote Economy Recovers Ahead Of Vote Economy Recovers Ahead Of Vote Moreover, Prime Minister Najib, who became embroiled in scandals almost immediately after winning the 2013 election, has been cleared of wrongdoing by various authorities. What little opinion polling exists suggests that the majority of the populace still disapproves of him, but apathy is widespread.3 Needless to say it is Najib's advantage as prime minister that he gets to decide the timing of the elections. The opposition has also lost a critical partner, the Malaysian Islamic Party (PAS). Najib has lured PAS into joining BN, giving it a larger majority and putting the remaining opposition forces even farther from the 112 seats needed for a majority in the lower house (the Dewan Rakyat) (Chart 6). At the same time, Pakatan Harapan has no platform other than opposition to Najib's government. Malaysia's chief opposition leader and advocate of structural reform, Anwar Ibrahim, has entered into an unholy alliance with his former boss and arch-enemy, the long-ruling strongman Mahathir Mohamad, who will soon turn 93 years old. This alliance is manifestly self-interested and unstable. There is a scenario in which the opposition could take power - but it is the least probable. In Chart 7 we present three scenarios: the first is the best case for the opposition, the second is the best case for BN, and the third is the status quo. To these scenarios we assign subjective probabilities: Scenario 1: Opposition Takes Power (20% probability): For the opposition to win, it needs to retain all of its current 71 seats and stage a historic upset by winning all the seats in Kedah and Johor. It then needs to convince PAS to return to its fold through coalition-building. Winning every seat in Kedah and Johor is a stretch. And PAS has learned how to wield power without the opposition, so why would it rejoin? BN has granted it concessions on its Islamist agenda that the more secular opposition parties would be loath to adopt. Scenario 2: BN Wins Supermajority (25% probability): The real question is whether the BN coalition will retake the supermajority that it lost in 2008. This would require BN to win an additional 19 seats on top of retaining its current 129 seats. If BN retains its current seats and the alliance with PAS, and wins half or more of the 37 seats in Malay-dominant, or mixed-Malay, constituencies currently held by the opposition, then it will achieve this supermajority. In Chart 7 above we illustrate this scenario as an even bigger sweep in which the BN also picks up some seats that it lost in ethnic Chinese and other constituencies. Scenario 3: BN Preserves Status Quo (55% probability): In this scenario, both BN and PAS retain their seats and remain allied, but make zero gains. Najib and his government are relatively unpopular and tainted by scandal, Malaysian governance has worsened, and winning back non-Malay and mixed-Malay seats could be very difficult in practice. What would be the likely market responses to these outcomes? In Scenario 1, an opposition victory would be the most market-friendly outcome in light of Malaysia's poor governance, flagging productivity, and lackluster economy in recent years. It would demonstrate to the world that although Malaysia's demographic trajectory strongly favors the majority Malay population (Chart 8), that trajectory need not condemn the country to a future of ethnic nationalism and communal tensions. Chart 6Defection Helps Ruling Coalition How To Play Malaysia's Elections (And Thailand's Lack Thereof) How To Play Malaysia's Elections (And Thailand's Lack Thereof) Chart 7Malaysia 2018 Election Scenarios How To Play Malaysia's Elections (And Thailand's Lack Thereof) How To Play Malaysia's Elections (And Thailand's Lack Thereof) Chart 8Demographics Favor Malay Majority How To Play Malaysia's Elections (And Thailand's Lack Thereof) How To Play Malaysia's Elections (And Thailand's Lack Thereof) True, the untested Pakatan Harapan coalition would bring a great deal of uncertainty. But the authority of Mahathir, the reformist bent of Anwar, the fact that the Islamist members of the coalition are progressive, and the increased political inclusion of the ethnic Chinese, would all be seen as positives. Moreover a vote against the long-ruling BN, and the BN's expected acceptance of the vote, would show that the country is flexible enough to handle real political change, unlike many EMs. Nevertheless, this is a low probability outcome. In Scenario 2, a BN supermajority would be cheered by markets (less enthusiastically than Scenario 1) for providing a clear sense of direction. It would reaffirm the United Malay National Organization's (UMNO's) status as the institutional ruling party (the core of the BN) after a decade of apparent decay. And it would remove the uncertainty of recent government scandals and mistakes. It would also give Najib enough political capital to press forward with structural reforms (Chart 9), which he has pursued under less ideal conditions. However, the downside of Scenario 2 is that, over the long run, Malaysia's governance would likely deteriorate (Chart 10). BN would regain the ability to pass constitutional amendments on its own and would use this power to reinforce Malay nationalism and authoritarianism, which would exacerbate tensions with the pro-business Chinese community. Chart 9Najib Has Done Some Reforms Najib Has Done Some Reforms Najib Has Done Some Reforms Chart 10Governance Could Fall Further How To Play Malaysia's Elections (And Thailand's Lack Thereof) How To Play Malaysia's Elections (And Thailand's Lack Thereof) The third scenario - a status quo BN simple majority - is the most likely yet least market-friendly outcome. This electoral result would leave Najib only able to do piecemeal reforms and more dependent on his Islamist coalition partner, PAS. The risk is not that radical Islamism would spiral out of control - Malaysia is a moderate Muslim country - but rather that in this scenario both governance and economic orthodoxy could continue to suffer.4 Economic conditions would be better than just after the 2014 commodity bust, but would remain lackluster. The crux of the matter is whether the election enables the government to take a more proactive stance in grappling with Malaysia's latent financial risks and external vulnerabilities. The latter are significant. Indeed, BCA's Emerging Markets Strategy is underweight Malaysian assets versus their EM peers, and argues that Malaysia needs to see the following developments for investors to upgrade this bourse: Progress in recognition of non-performing loans (NPLs) and increased bank provisions. NPLs are too low given the credit boom over the past nine years, and provisions are also extremely inadequate (Chart 11, panels 1 and 2). Further, Malaysian commercial banks have artificially boosted their earnings because they have lowered their provisions for bad loans. Given that global growth and Malaysian exports are likely at or near their peak, Malaysian commercial banks will soon face rising NPLs and will be forced to increase their provisions for bad loans, putting their profit growth at risk. In a scenario where banks raise provisions by 35%, banks' operating profits would fall from 11% to zero. This presents a major risk to bank share prices (Chart 12). Chart 11Bad Loans Are Under-Recognized Bad Loans Are Under-Recognized Bad Loans Are Under-Recognized Chart 12If Provisions Go Up, Profits Will Fall If Provisions Go Up, Profits Will Fall If Provisions Go Up, Profits Will Fall Crucially, commercial bank share prices are extremely important for Malaysia's stock market, as they account for 35% of the country's total MSCI market cap and 38% of the index's total earnings. Commercial banks also have been largely responsible for the recent rally in Malaysian stocks. An outlook of stable demand growth in China and stable-to-higher commodities prices, so that Malaysia's economy would be able to grow without too much reliance on credit and fiscal stimulus. Currently, exports to China comprise 9% of GDP and commodities exports make up 30% of exports and 20% of GDP. An outlook for stable-to-strong currency that would lower the external debt burden and lower debt-servicing costs, which are among the highest in the EM world. In turn, the exchange rate outlook is contingent on commodities prices and the EM carry trade. Importantly, these adjustments may only take place once Chinese growth has slowed and Malaysia's external vulnerabilities have become painfully apparent to investors and discounted in financial markets. Only an opposition victory or a BN supermajority would increase the probability that Malaysia will start trying to reduce these vulnerabilities preemptively, allowing investors to look beyond the valley and price in a better structural outlook. Given that the combined subjective probability of the two scenarios is 45%, we are neutral on Malaysian politics in the near term. Our conviction level on pro-market policies is low, given that the status quo outcome offers only piecemeal reforms, while a transition to opposition rule for the first time or a return to a traditional BN supermajority would be fraught with uncertainty. Bottom Line: The current rally in Malaysian assets can continue as long as the global bull market persists and China's slowdown remains benign. However, there is no guarantee that China will remain benign, and Malaysia is poorly positioned among EMs to deal with external shocks. Thus while there is space for a tactical play on the election, the prudent long-term position is to be underweight Malaysian stocks, local bonds, and currency relative to their EM counterparts. Thailand: Stay Bullish At Least Until Elections While Malaysia prepares to hold elections, Thailand's military junta has delayed them for at least the third time. They are expected by February 2019. While we would not be surprised to see another delay, this period of military rule is getting long in the tooth, by Thai standards, and we would expect the transition to civilian rule to occur within the next year or two.5 The election delay is mildly positive for Thai risk assets, as investors have broadly approved of the junta or at least grown accustomed to it. During previous periods of military rule, such as 1991-92 and 2006-07, Thai stocks have typically underperformed the EM benchmark, both in USD and local currency terms (Chart 13). But the 2014 coup proved to be different. The government of General Prayuth Chan-Ocha has provided three fundamentally stabilizing factors: Banishing the Shinawatras: The junta forced a conclusion (for the time being at least) to the domestic political struggle that has raged in the country since 2001. It did so by ousting Prime Minister Yingluck Shinawatra and sending her to join her brother, former Prime Minister Thaksin Shinawatra, in exile, and by suppressing their rural, populist political coalition. Shepherding the royal succession: The junta's decision to throw a coup in 2014 was heavily influenced by the desire to ensure that a stable royal succession would occur upon the death of the widely revered King Bhumibol Adulyadej. Bhumibol had played a calming role in Thai politics since 1946 and was a major source of authority for the political elite. When the king's death actually occurred in October 2016, the junta was exercising strict control over the country and the succession did not occasion any significant instability. Managing the post-GFC economy: The junta brought relatively competent and stable economic management during the turbulent period in which emerging markets climbed down from the massive DM and EM stimulus policies enacted during the Great Recession. Thailand's uneventful politics differed markedly from those of Malaysia, South Korea, Turkey, Brazil and others that have seen severe considerable political upheaval since 2013. As a result, Thailand has enjoyed greater policy "certainty" over the past four years than would otherwise have been the case. Credit default swaps, for example, have collapsed from the levels witnessed during the Thai political unrest and natural disasters in 2006-13. No surprise, then, that over the past three years, financial markets have cheered any sign that the junta will stay in power for longer (Chart 14). Chart 13Thai Equities Underperform EM Peers And Long-Term Average During Military Rule Thai Equities Underperform EM Peers And Long-Term Average During Military Rule Thai Equities Underperform EM Peers And Long-Term Average During Military Rule Chart 14Market Content With Postponed Elections Market Content With Postponed Elections Market Content With Postponed Elections To be sure, the Thai economy faces immediate, cyclical challenges. Thailand's frequent military coups have always had a deflationary impact due to austere policies and dampened animal spirits (Chart 15). The latest coup specifically initiated a period of macroeconomic deleveraging (Chart 16), and all indications suggest that the deleveraging has farther to go. Banks are repairing their balance sheets and less ready to extend credit. Capital formation is weak and construction is subdued (Chart 17). Chart 15Thai Coups Are Deflationary Thai Coups Are Deflationary Thai Coups Are Deflationary Chart 16Junta Imposed Deleveraging... Junta Imposed Deleveraging... Junta Imposed Deleveraging... This is not even to mention more structural challenges: A shrinking labor force (Chart 18, top panel; High household debt levels (Chart 18, bottom panel); Chart 17...So Economy Is Subdued ...So Economy Is Subdued ...So Economy Is Subdued Chart 18Structural Headwinds Structural Headwinds Structural Headwinds A stark deterioration in governance due to frequent coups and mass protests that are violently suppressed (see Chart 10 above). Furthermore, the impending transition to civilian rule will initiate a new round of political instability. Whenever "free and fair" elections are held in Thailand (i.e. elections not stage-managed by the military), the populace almost always returns the provincial, "democratic" parties to power (the so-called "Red Shirts"), as opposed to urban, royalist parties (the "Yellow Shirts"). This was the case in 2001, 2005, 2006, 2011, and 2014. The military has adjusted the constitution and electoral system to prevent this outcome, and it may succeed in arranging the first post-coup civilian government to come to power in 2019 or 2020. But these periodic constitutional and electoral rewrites have repeatedly failed to prevent the majority of the population from winning elections and forming governments. Even if the military succeeds in rigging the first post-junta election, the return to the democratic process itself will empower the rural populists and trigger a new cycle of conflict with the royalist establishment. After all, the military junta has not resolved the fundamental grievances of the Thai population, particularly in the restive north and northeast regions, where about 51% of the population lives. While poverty has declined rapidly, a hallmark of economic development, this trend has supported the ambitions of the countryside. Meanwhile the share of the population making over $20 per day has only slightly risen (Chart 19). The mean-to-median household wealth ratio is rising sharply, as wealthy households are lifting the national average while the median family's wealth has been virtually flat in absolute terms (Chart 20). Chart 19Lower Middle Class Is Large... How To Play Malaysia's Elections (And Thailand's Lack Thereof) How To Play Malaysia's Elections (And Thailand's Lack Thereof) Chart 20...And Inequality Is Rising ...And Inequality Is Rising ...And Inequality Is Rising The stark disparity between Bangkok, the home of the civil bureaucracy, and the rest of the country is apparent in the fact that public sector wages are almost twice as high as private sector wages. And since the coup, the wages of bureaucrats and soldiers have risen faster than the wages of farmers (Chart 21). It is the latter who in great part fuel the rural opposition movement. All of this suggests that a new cycle of instability will begin in Thailand once civilian government resumes. The good news for investors is that this instability will creep in only gradually. The military will try to orchestrate the initial elections and civilian government (February 2019 at earliest), which means that policy will remain continuous at first. Chart 22 shows what happens to the THB/USD exchange rate, and Thai equity returns (both in absolute and relative to EM), in the months following three key phases in the Thai political cycle: (1) coups and military rule (2) military-arranged governments and initial post-coup elections (3) free and fair elections. Chart 21Stark Economic Disparities Stark Economic Disparities Stark Economic Disparities Chart 22Return To Civilian Rule Good For Stocks How To Play Malaysia's Elections (And Thailand's Lack Thereof) How To Play Malaysia's Elections (And Thailand's Lack Thereof) The first and third phases bring mixed results: coups are bad for the baht and good for equities in the short term, while free elections are good for the baht and mixed for equities. The second phase - the transition to civilian government - is the only one that produces all positive returns. Of course, the external environment will be an overwhelming factor. The THB/USD and equity performances after the 2007 post-coup election and the 2008 military-arranged government were all distorted by the global financial crisis and the V-shaped recovery in 2009. We cannot predict the external environment after Thailand's upcoming transition to civilian rule other than to say that it will likely be worse than today's (as globally synchronized growth is very strong today). What we can say is that Thai equities outperformed EM equities in all three cases of pseudo-civilian government that we observed (1992, 2007, 2008). While history may not repeat itself, the key point is that Thailand's junta has overseen relatively orthodox economic management that makes Thailand relatively well positioned to deal with external volatility and shocks - quite unlike Malaysia. The country runs a massive current account surplus of 10% of GDP. Public debt and external debt are low, as is the share of bonds owned by foreigners who could sell in a fit of volatility. The junta has also capitalized on the strong external backdrop to rebuild Thailand's foreign exchange reserves (Chart 23). And the deflationary and deleveraging tendencies of the junta period mean that Thailand does not face a significant inflation constraint, allowing the Bank of Thailand to cut interest rates if it should need to (Chart 24). Chart 23Junta Knows How To Hoard Junta Knows How To Hoard Junta Knows How To Hoard Chart 24Room To Cut Rates Room To Cut Rates Room To Cut Rates Thus when China's slowdown hits emerging markets, Thailand is relatively well positioned to outperform. Certainly it is better fortified against any trade or commodity shock than its neighbor to the south, Malaysia. Bottom Line: The Thai junta is getting closer to relinquishing power to a civilian government. This will initiate a new cycle of political instability in Thailand, as low- and middle-class angst and regional disparities remain. Nevertheless the junta will be in power for another 12-24 months, and the initial transition is likely to maintain policy continuity at least at the beginning. Investors can benefit from Thailand's relative stability in this regard. Investment Conclusions BCA's Geopolitical Strategy and Emerging Markets Strategy have different tactical approaches to Malaysia, with the political analysts more constructive in the short term due to the fact that the upcoming election will at least enable Najib to continue with piecemeal reforms. However, both strategy services agree that Malaysia remains highly vulnerable to the ongoing slowdown in China and any relapse in commodity prices. On Thailand, by contrast, both teams are clearly positive on this bourse, currency, and local bonds relative to their respective EM benchmarks. The macro context is stable if uninspiring. Politically, Thai politics are a liability in the long run, but not particularly so in the next 24 months. There will be a new bout of instability in two-to-five years, when the rural, populist movement elects a government that is at odds with the military and the Thai political establishment in Bangkok. Until that time, however, the junta's tight grip provides a continuation of the status quo, which has been positive for investors. Thailand stands on much more solid ground than Malaysia and many other EMs when it comes to external debt and foreign funding. It will be able to withstand considerable global/EM turmoil. Therefore Emerging Markets Strategy and Geopolitical Strategy recommend that investors go long Thai / short Malaysian local currency bonds currency unhedged: The Malaysian ringgit will depreciate versus the Thai baht in the next 12 months. The current account surplus is 10% of GDP in Thailand and 2.9% in Malaysia and will move in favor of Thailand as commodity prices slump. The outlook for foreign capital flows favors Thailand over Malaysia. Foreigners own 26% of domestic bonds in Malaysia but only 16% in Thailand. The ringgit depreciation will lead to some selling pressure in local bond markets. Thai local bonds are more immune to this risk. Thailand's public debt position is also smaller than in Malaysia especially when off-balance sheet liabilities are taken into account. That puts Malaysia's true public debt closer to 69% of GDP versus only 33% in Thailand. The Malaysian fiscal deficit is also wide (2.7% of GDP) and the government will face difficulties cutting spending and raising taxes at a time when global growth is slowing. One final word on geopolitics. In an increasingly multipolar world, certain states will be able to parlay their strategic relevance to get advantageous commercial, financial, and military deals from great powers. Both Malaysia and Thailand are well positioned to extract benefits from the U.S. and China in their great power competition. However, Thailand is unlikely to suffer from concentrated U.S. or Chinese antagonism anytime soon, whereas Malaysia faces a more complicated relationship with China due to its geographically strategic location, maritime sovereignty disputes in the South China Sea, tensions between the ethnic Malay and Chinese communities, and lack of mutual defense treaty with the United States.6 Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 2 Please see BCA Emerging Markets Strategy Weekly Report, "The EM Rally: Running Out Of Steam?" dated October 19, 2016, available at ems.bcaresearch.com. 3 Please see Hafiz Noor Shams, "Malaysia Power Shift Unlikely Despite Mahathir Factor," Financial Times, January 29, 2018, available at www.ft.com. 4 Please see footnote 1 above. 5 Thailand's current Prime Minister Prayuth Chan-Ocha has been in power since he launched the coup of May 2014. If elections are held in February 2019, this five-year period will be the third longest period of military rule since 1932. Prayuth himself is already ranked fourth out of thirteen military prime ministers in terms of his time in office. If he steps down in 2019-20 then his term would rival that of Prem Tinsulanonda in the 1980s and Plaek Phibunsongkhram in the 1950s. If he is elected and stays on as prime minister, he could rival Thanom Kittikachorn who ruled for ten years. 6 Please see BCA Geopolitical Strategy Special Report, "Does It Pay To Pivot To China?" dated July 5, 2017, "The South China Sea: Smooth Sailing?" dated March 28, 2017, and Weekly Report "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com.

Highlights The protectionist option in U.S. policy is here to stay; President Trump is likely to impose punitive measures on China before the U.S. midterm elections; The U.S. Section 301 investigation into China's intellectual property theft is about national security more than trade; China's NPC session suggests the Communist Party is downshifting growth rates; The North Korean diplomatic breakthrough is real ... stay focused on U.S.-China tensions. Feature "I won't rule out direct talks with Kim Jong Un. I just won't ... As far as the risk of dealing with a madman is concerned, that's his problem, not mine." - U.S. President Donald J. Trump, March 4, 2018 Two of our key 2018 views came to the fore over the past two weeks. First, U.S. President Donald Trump took protectionist action that rattled the markets.1 Second, North Korean diplomacy surprised to the upside, with Trump accepting an invitation to meet with Kim Jong Un by this May.2 The nuclear program is allegedly up for discussion. Markets recovered quickly from Trump's steel and aluminum tariffs, with the VIX falling and American and global equities continuing to rally (Chart 1). Trump's formal tariff proclamation was not as disruptive as some had feared. He provided exemptions for entire countries - rather than merely companies - based on an appeals process that will include economic as well as geopolitical criteria. But while he struck an optimistic note on NAFTA (on which Canada's and Mexico's exemptions will depend), he struck a pessimistic note on trade talks with China. Chart 1Markets Shrugged Off Protectionism Markets Shrugged Off Protectionism Markets Shrugged Off Protectionism China is quickly becoming the foremost political and geopolitical risk of the year, as we discuss in this report. First, diplomacy with North Korea will not remove the risk of serious U.S. protectionism toward China.3 Second, China's domestic reforms are proceeding, posing downside risks to Chinese imports and hence global growth. We conclude with a brief word on why investors should take the North Korean diplomacy as a hugely positive development. There may be some volatile episodes during the upcoming negotiations, but U.S.-China relations are the real risk and North Korea remains largely a derivative of the emerging "Warm War" between the two global behemoths. "Death By China" In the past few weeks, the Trump administration has moved swiftly to begin implementing its protectionist platform.4 Trump's formal announcement of global tariffs on steel and wrought and unwrought aluminum products marked the shift, although investors got a foreshadowing with the January announcement of washing machine and solar panel tariffs. The latest tariffs are insignificant in macroeconomic terms. They will affect less than 0.3% of global exports and less than 2% of U.S. imports.5 The market has thus far cheered the limited scope of the tariffs and the numerous exemptions that will surely follow. But the danger is that investors are underestimating the political shifts that underpin Trump's move. In fact, there is little reason to think that protectionism will fade when Trump leaves office: Americans are susceptible to it, according to opinion polling (Chart 2). Now that the seal has been broken - and that by a president who hails from the "pro-free trade" Republican Party - the danger is what happens when the next recession occurs. Politicians of all stripes will be more likely to propose protectionist solutions. The long trend of decline in U.S. tariffs since the 1930s may gradually begin to reverse (Chart 3), confirming our key decade theme that globalization has reached its apex. Chart 2Americans Not Immune To Protectionism Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Chart 3U.S. Tariffs: Nowhere To Go But Up! U.S. Tariffs: Nowhere To Go But Up! U.S. Tariffs: Nowhere To Go But Up! How far will the protectionist threat go in the short term? Investors should focus on two bellwethers. First, the outcome of NAFTA re-negotiations.6 Second, a decision by the Trump administration on how to respond to the U.S. Trade Representative Section 301 of the Trade Act of 1974 investigation into China's practices on technology transfer, intellectual property, and innovation, discussed below. China is an industrial powerhouse that is becoming more technologically adept, which threatens the core advantage of the United States in what could soon become a "Warm War" between the two global hegemons. Trump was elected on a pledge to get aggressive on China and is relatively unconstrained on trade policy (Table 1). U.S.-China economic interdependency has declined, reducing the two countries' ability to manage tensions.7 Table 1Trump Lacks Legal Constraints On Trade Issues Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Moreover, Trump is relatively unpopular - which jeopardizes the GOP Congress in November - and he will need to take actions to remain relevant ahead of the November 6 midterm elections (Chart 4). The U.S. and China are currently bickering about the size of the trade imbalance (Chart 5), not to mention the causes and solutions. What will the U.S. demand? This was the question of Xi Jinping's top economic adviser, Politburo member Liu He, when he visited Washington D.C. on March 1-3 for emergency meetings with the U.S. administration. He was rebuffed with the announcement on tariffs. Washington has been arguing that high-level dialogues with China - that investors cheered after the Mar-a-Lago Summit - have failed and that punitive measures will go forward unless China makes quick and concrete improvements to the trade balance, starting with $100 billion worth of new imports.8 Chart 4Trump's Low Approval Jeopardizes Control Of Congress In November Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Chart 5U.S.-China: Disagreeing Even On The Facts U.S.-China: Disagreeing Even On The Facts U.S.-China: Disagreeing Even On The Facts In response, Liu has promised that China will redouble its economic "reform and opening up" process and has asked the United States for an official list of demands. Our sense is that there are broadly two types of demands: Cyclical demands: Beijing often does one-off purchases of big-ticket items to ally Washington's ire over trade. This time, it would have the added benefit for Trump of coming right ahead of the midterm election. Trump's request on March 8 for an immediate $100 billion reduction in the trade deficit could fall in this category. Structural demands: If Trump seeks to be a game changer in the U.S.-China relationship, then he will demand accelerated structural reforms: for instance, a lasting decrease in the deficit due to a permanent opening of market access. He could also begin pushing a "mirror tax" on trade (reciprocal tariffs) so as to reduce the gap between the U.S. and China, which is less justifiable now that China is an economic juggernaut (Chart 6). Trump could also demand action on several long-standing U.S. requests: Chart 6Not All That Much Daylight On U.S.-China Tariff Rates Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Opening foreign investment access to a broad range of sectors (beyond finance), such as transportation, logistics, information technology, or even telecommunications; The right to operate wholly U.S.-owned companies in China; An open capital account and truly free-floating currency; Subsidy cuts for state-owned enterprises (SOEs); Full digital access for U.S. tech companies; An improved arbitration system for legal disputes. Since rapidly implementing many of these demands could threaten China's stability or even undermine the Communist Party, Trump may have to use the threat of sweeping tariffs to try to force them through. The current news flow suggests that Trump is favoring cyclical solutions. At the same time, we expect China to make at least some significant structural compromises: China does not want a trade war. China is more exposed to the U.S. than the U.S. is to China (Chart 7). Moreover, China's political system is rigid and opposed to mass unemployment. The last time China allowed mass layoffs was in 1999, and even then the state controlled the process. A trade war, by contrast, would threaten 223 million manufacturing employees with uncontrolled job losses. The central government is focused on stability; while it will insist on "saving face" internationally through tit-for-tat measures, it will go to great lengths to avoid a negative spiral. This will require compromises. China wants structural reform. Xi Jinping is rebooting a reform agenda that requires transitioning away from old industries. These reforms are long overdue and Xi can parlay many of them to pacify Trump. For instance, China has improved the market-orientation of the renminbi, causing Trump to cease his complaints about currency manipulation (Chart 8). China currently claims it is about to increase imports and open its financial sector further to foreign investment. Chart 7China More Exposed To U.S., But Not By Much Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Chart 8China: Structural Reform As Trade Concession China: Structural Reform As Trade Concession China: Structural Reform As Trade Concession The jury is still out on the deepest structural issues. We expect Xi's latest reform push to surprise to the upside, but it is not clear how far he will go. For instance, while Beijing might begin to ease capital controls imposed in 2016, it would be a shock if it agreed to rapidly liberalize the capital account. The same goes for granting extensive access to strategic sectors, downgrading state support for SOEs, or moderating cyber controls that punish U.S. companies. Any promises of gradual progress on these issues will likely be seen by the U.S. as no different from past promises to past presidents. Hence everything depends on whether Trump will be satisfied by token Beijing actions that look good ahead of the midterms. It is ominous that China has already drastically cut steel and aluminum overcapacity, and yet Trump imposed tariffs anyway. This kind of delayed retribution could become a pattern. Bottom Line: China has the means to prevent a trade war through significant compromises that Trump can advertise as "wins" to his domestic audience this November. If Trump accepts these concessions, the risk of trade war will effectively be removed until the next major electoral test in 2020. However, Trump lacks constitutional and legal constraints on the use of tariffs, which means that he can override China's offers and instigate a trade war anyway. This risk has a fair probability, given midterm politics and the fact that overall U.S.-China interdependency, the key economic constraint to conflict, has eroded over the past decade. A Bellwether: The Intellectual Property Investigation The immediate bellwether for the Trump administration's appetite for trade war will be Trump's handling of the Section 301 investigation on technology transfer, intellectual property (IP), and innovation. A ruling is due no later than August 18, but reports indicate action could come quickly.9 Section 301 of the U.S. Trade Act of 1974 is the prime law by which the U.S. seeks to enforce trade agreements, resolve disputes, and open markets. Under this law, the U.S. executive - i.e. the president - can impose trade sanctions against countries deemed to be violating trade agreements or engaging in unreasonable or discriminatory trade practices. The law is specific in addressing intellectual property violations and closed market access, and yet broad in giving the executive leeway to interpret "unjustifiable" practices and mete out punishment. It does, however, require negotiations with the foreign trading partner to remedy the situation before the U.S. imposes duties or other remedies. We expect the U.S. to draw a hard line. A close look reveals that this Section 301 probe is primarily addressing strategic problems, not trade problems. To be fair, the U.S.'s trade grievances have merit. Clearly there is room for China to improve the IP trade balance. The ratio of IP receipts versus IP payments shows that the U.S. is a world-leader, while China is an extreme IP laggard, as one would expect (Chart 9). And yet the U.S. barely runs a trade surplus with China in IP, and far less of a surplus than with Taiwan and Korea, which are more advanced than China and thus ought to be more competitive with the U.S. than China (Chart 10). The U.S. appears particularly disadvantaged in the Chinese market when it comes to computer software and trademarks (Chart 11), judging by its IP exports to similar Asian partners. Chart 9China Is An Innovation Laggard... Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Chart 10... Yet Its IP Deficit With U.S. Is Small Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Also, in many cases Chinese companies have gained a dominant share of new markets, like e-commerce, where the U.S. would have a larger share if it had been allowed to compete fairly in the nascent stages. The U.S. wants to prevent this from happening again. The "Made In China 2025" program, for example, combines ambitious goals in supercomputers, robotics, medical devices, and smart cars, while setting domestic localization targets that would favor Chinese companies over foreigners (Chart 12). China will have to compromise on this program to stave off tariffs. Chart 11China Skirting Fees On U.S. Software? Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Chart 12China's High-Tech Protectionism Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Nevertheless, China is a large and growing market for U.S. high-tech goods, intellectual property, and services exports (Chart 13). A comparison with Taiwan and South Korea suggests that China could open up greater access to these U.S. exports (Chart 14). The truth is that, unlike with staunch ally Japan, the U.S. harbors deep misgivings about China's strategic intentions. This is why it limits high-tech exports to China - which, as Beijing often points out, creates an abnormal imbalance in this column of the trade book (Chart 15). Chart 13U.S. Tech And IP Exports To China Growing Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Chart 14China Could Give U.S. More Market Share Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Chart 15U.S. Deficit Due To Security Concerns Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Thus while the trade concerns above are not to be scoffed at, the Section 301 probe is clearly about U.S. security. The main practices under investigation are: Forced technology transfer by means of joint-venture (JV) requirements, ownership caps, government procurement, and administrative or regulatory interventions; Unfair licensing and contracting pricing, and abuses of proprietary technology; State-backed investment and/or acquisitions in the U.S. to acquire cutting-edge tech and IP; Cyber-espionage and intrusion to acquire tech and IP. Only one of these is about market pricing. The others speak to the U.S. belief that the Communist Party has orchestrated a "techno-nationalist" agenda that combines aggressive and illegal acquisitions with domestic protectionism. In particular, Chinese companies have made strategic acquisitions in the U.S. through shell companies with state funds or state guidance to access critical technologies and IP, while forcing American companies operating in China to transfer over the same as a precondition to operate there.10 Washington fears that if Beijing' strategy continues unabated, high-tech Chinese companies will be able to gain the best western technology, grow uninhibited in the massive domestic market with state financial support, and then launch competitive operations on a global scale. Moreover, the lack of division between China's ruling party, state apparatus, and corporate sector means that technologies acquired by Chinese companies can be directly appropriated by the country's military and intelligence apparatus to the detriment of the strategic balance with the U.S. How will the U.S. retaliate? We are unsure, and therein lies the risk for the market.11 Trump has floated the idea of levying a large "fine" or indemnity on China for past IP violations. The U.S. believes that IP theft amounts to a "second trade deficit" with China, with estimates of annual losses ranging from $200 billion to nearly $600 billion.12 U.S. remedies will become clearer when the USTR offers its recommendations. Bottom Line: The Section 301 probe is not about the trade deficit alone. It is about the growing tension between U.S. and China in a broader strategic context. We would expect the USTR to propose trade remedies that are more significant than the recent steel and aluminum tariffs. And we would expect Trump to impose some punitive measures. This is a source of near-term risk to markets, as the U.S. and China are less likely to manage their disputes smoothly than in the past. We are short China-exposed U.S. stocks relative to their domestic-oriented peers. China's NPC Session: On Track For Downside Risk Surprises Chart 16Downward Revisions In Chinese Growth Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin China's NPC session is not yet over but some preliminary takeaways are in order. The headlines focused on Xi Jinping's power grab, but for us the real relevance was economic policy. Signs of economic policy tightening are not as hawkish as we expected, but the bias remains in favor of slower growth and tighter monetary, fiscal, and financial policy. The 6.5% GDP growth target was not a surprise. China has various economic targets to meet in 2020 under existing economic plans; only after that does it say it will scrap GDP targets altogether. The GDP target is a fabrication but the point is that the direction is down. Local government GDP targets suggest downward revision as well (Chart 16). To put a point on it, there is no evidence that China's cyclical slowdown is on the cusp of reversing (Table 2).13 Table 2No Convincing Signs Of An Impending Upturn In China's Economy Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin In this context, it is notable that the government got rid of official targets for monetary growth (M2). This confirms the view of our colleagues at BCA's Emerging Markets Strategy that China has been targeting interest rates instead of the quantity of money since 2015 (Chart 17).14 This means that M2 growth can rise or fall as high or as low as necessary to meet the PBoC's interest rate targets. The takeaway for now is that M2 growth can go lower than the recent 8%-9% range in which it has been moving, since the current policy is to "control" money growth and avoid systemic risk. The new leadership at the People's Bank of China will have a challenge to establish its credibility, which means that accommodative compromises may not come as quickly as some expect. Chart 17A New Monetary Policy Regime A New Monetary Policy Regime A New Monetary Policy Regime On the fiscal front, China implied some tightening by lowering its official budget deficit target to 2.6%. Past reports show that China always meets its budget deficit targets perfectly (Chart 18), suggesting that the target is either meaningless or Beijing has a steely discipline unseen in the rest of the world. The IMF publishes an augmented budget deficit which, at 12% of GDP, gives a better indication of why authorities want to maintain control, if not outright tighten the reins (Chart 19).15 The Finance Ministry rushed to dampen speculation that this budget deficit reduction would amount to austerity. Approximately 550 billion yuan of additional "special purpose bonds" - issued by local governments to finance infrastructure projects - will be issued in 2018. This could amount to new spending worth 2% of last year's total spending, i.e. not a negligible sum. The purpose may be to smooth over the conclusion of the local government debt swap program that began in 2014. The debt swap program was a "game changer" by allowing local governments to exchange high-interest or short-term debt for low-interest, long-term, government-backed debt. Now Beijing is winding down the program and telling local governments that new bond issuance will not have the implicit guarantee of the central government, and will face higher interest rates. Chart 18China's Budget Deficit Target Is Meaningless Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Chart 19China's Real Budget Deficit Is Large Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Similarly, Beijing has been attempting to provide formal banks more freedom to lend to offset its crackdown on shadow banks. Pursuant to this goal, it announced that required provisions for non-performing loans (NPLs) will be reduced from 150% of NPLs to 120%. Banks are already holding excess provisions, and provisions have been trending upwards. Meanwhile China's official NPL count is unbelievably low, warranting higher provisions. So it is not clear to what extent banks will lend more as a result of lower requirements. January and February credit numbers imply that credit policy remains tight even aside from the wind-down of the local government debt swap (Chart 20). The dust has not yet settled on the NPC session and we will soon examine some of the other policy announcements, like tax cuts for small businesses and infrastructure spending reductions. However, the implication so far is that the Communist Party wants to keep the fiscal deficit and total social financing flat this year. If this policy were executed faithfully, the fiscal and credit impulse would be zero this year. Simultaneously, new data revealed that, in keeping with the reform reboot, the Xi administration is allowing creative destruction to improve efficiency in the corporate sector. Bankruptcies rocketed upward in 2017 and this trend should continue (Chart 21). This is a notable development given the widespread perception that China does not know how to deal with social consequences of structural reforms. It suggests that policymakers have a higher threshold for economic pain. Chart 20Credit Growth Is Slowing Credit Growth Is Slowing Credit Growth Is Slowing Chart 21Creative Destruction Is Rising Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Finally, the new anti-corruption super-ministry, the National Supervisory Commission, has now received legislative clearance. It is still unclear how the new body will operate in practice. We maintain that on the margin it should be negative for economic growth due to the micro-level impact of corruption probes on local government officials and local state enterprises. Notably, some of the provinces whose GDP-weighted economic growth targets were the most aggressively revised downwards (Tianjin, Chongqing, Inner Mongolia) are also provinces that have been hit heavily with anti-corruption probes, accusations of falsifying data, and canceled infrastructure projects over the past year. The anti-corruption campaign is a tool for enforcing central party dictates more effectively, and at present those dictates call for minimizing systemic financial risk, including misallocation of capital by local authorities (Chart 22). Chart 22Anti-Corruption Campaign Encourages Downward GDP Revisions? Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Bottom Line: Policy settings in China will continue to constrain growth this year. Now that the policy shift toward accelerated reform is more evident, the downside risks of that move will become apparent. We are closing our long China H-shares versus EM trade for a gain of 3%. North Korea: This Time Is Different A brief concluding word on North Korea. While we did not expect that Trump and Kim would arrange to meet so soon, we are not surprised by the fact that the diplomatic track is moving forward. As we wrote in January, Trump demonstrated a credible military threat, forcing China to implement sanctions, which subsequently caused North Korea to stop testing missiles. Trump effectively called Kim Jong Un's bluff, daring him to go beyond missile and nuclear device tests. Instead of ratcheting up tensions, Kim declared victory on the nuclear deterrent and proclaimed the end of the crisis. This is the "Arc of Diplomacy" about which we have written (Chart 23).16 We reject the view in the media that Trump's policy has been erratic and that China is getting left on the sidelines of a Trump-Kim meet-up. China has cut off exports to North Korea (Chart 24), which in turn has cut off the regime's access to hard currency. Because of China, Kim literally cannot afford not to negotiate. Chart 23Credible Threat Cycle: North Korea Mirrors Iran Trump, Year Two: Let The Trade War Begin Trump, Year Two: Let The Trade War Begin Chart 24China Gives Kim To Trump China Gives Kim To Trump China Gives Kim To Trump For the same reason, Kim is not likely to be bluffing or stalling: with limited conventional military capabilities, Kim cannot dial up and dial down the level of tensions at will. If he provokes the U.S. anew, he risks provoking a war that would destroy his regime. Moreover, from the moment he came to power, Supreme Leader Kim established a desire to elevate the importance of economic reforms within state policy, which is impossible without dealing with China and the U.S. to create a favorable international setting. From the U.S. side, Trump has likely notched up a major national security victory that will enhance his credibility in the 2018 midterms and especially 2020 elections. A clear risk to our view that Trump will take protectionist action toward China this year is that he will need China's continued cooperation, as it could relax sanctions enforcement. However, the strategic significance of the Section 301 investigation means that Trump cannot afford to sacrifice his trade agenda so soon. While bad news from North Korea seldom has a substantial impact on markets, our South Korean curve steepener benefited. So far it has returned 2.9%. The JPY/EUR has fallen back from a strong February rally, but we remain long. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, Weekly Report, "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017, and Special Report, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 2 In September we highlighted that the North Korean threat cycle had peaked. Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, and Special Report, "BCA Geopolitical Strategy 2017 Report Card," dated December 20, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 4 The Apprentice-style personnel reshuffle that has seen Peter Navarro, director of the National Trade Council, elevated above the departed Gary Cohn, has signaled the return of the protectionist agenda. 5 Please see BCA Global Investment Strategy Weekly Report, "Trump's Tariffs: A Q&A," dated March 9, 2018, available at gis.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 8 Not $1 billion, as Trump erroneously tweeted! 9 One year after the date of initiation is likely August 18, the date used in the USTR's description in the Federal Register, although President Trump signed off on August 14 which could mark an earlier deadline. Please see Andrew Restuccia and Adam Behsudi, "Trump Eyes Another Trade Crackdown," Politico, March 7, 2018, available at www.politico.com. Note that according to the text of the law, by late May, the U.S. Trade Representative could report that China is making sufficient progress and further action unnecessary (but this is unlikely). The recent handling of the Section 232 investigation into steel and aluminum suggests that punitive measures will be foreshadowed by public statements from U.S. officials. 10 For detailed assessments, please see USTR, "2017 Special 301 Report," which puts China at the top of the priority watch list; USTR, "2017 Report To Congress On China's WTO Compliance," January 2018; U.S.-China Economic and Security Review Commission, "2017 Report To Congress," November 2017. 11 As a frame of reference, in the dispute over U.S. beef exports to the EU, a prominent Section 301 case, the U.S. imposed 100% ad valorem tariffs on 34 products from the EU in 1999 until 2009. However, Trump's actions are likely to go well beyond this due to the strategic nature of the dispute. Not only can he impose tariffs on 100 or more specific goods - since Chinese IP violations run the gamut - but also he can impose restrictions on Chinese investment through the Committee on Foreign Investment in the U.S. (CFIUS), which is tightening scrutiny on China in general. 12 The $600 billion "high water mark" estimate comes from the former Director of National Intelligence Dennis C. Blair and former director of the National Security Agency Keith Alexander. They also emphasize that the U.S. has additional retaliatory options (outside of the 1974 trade law) under the Economic Espionage Act, Section 5 of the Federal Trade Commission Act, and the National Defense Authorization Act. Please see "China's Intellectual Property Theft Must Stop," The New York Times, August 15, 2017, available at www.nytimes.com. 13 Please see BCA China Investment Strategy Weekly Report, "China And The Risk Of Escalation," dated March 7, 2018, available at cis.bcaresearch.com. 14 Please see BCA Emerging Markets Strategy Special Report, "China's Money Creation Redux And The RMB," dated November 23, 2016, available at ems.bcaresearch.com. 15 At the same time, the government issued guidelines suggesting that scrutiny of local government budgets, and specifically expenditures, will get stricter. The cancellation of subway/metro projects is already a trend that is well underway, but other inefficient projects and capital misallocation could be targeted next. 16 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. Geopolitical Calendar

Highlights The political path of least resistance leads to fiscal profligacy - in the U.S. and beyond. The response to populism is underway. The U.S. midterm election is market-relevant. Gridlock between the White House and Congress does, in fact, weigh on equity returns, after controlling for macro variables. The Democratic Party's chances of taking over Congress have fallen, but remain 50% in the House of Representatives. A divided House and Senate is the worst combination for equities, but macro factors matter most. China is clearly rebooting its "reform" agenda as Xi Jinping becomes an irresistible force. We remain long H-shares relative to EM, for now. Emerging markets - including an improved South Africa - will suffer as politics become a tailwind for U.S. growth and a headwind for Chinese growth. Feature The bond market has been shocked into action this month by the twin realizations that the Republican-held Congress is not as incompetent as believed and that the Republican Party is not as fiscally conservative as professed. When combined with steady U.S. wage growth and rising inflation expectations (Chart 1), our core 2018 theme - that U.S. politics would act as an accelerant to growth - has been priced in by the bond market with impressive urgency.1 The tax cuts alone were not enough to wake the bond market. First, the realization that a tax cut would pass Congress struck markets in late October, when it became increasingly clear that the $1.5 trillion Tax Cuts And Jobs Act would indeed pass the Senate. Second, the bill's passage along strict party lines - including the slimmest of margins in the Senate thanks to reconciliation rules - convinced investors that there would be no further compromises down the pipeline. The real game changer was the realization that the political path of least resistance leads towards profligacy. This happened with the signing into law of the February 9 two-year budget compromise (the Bipartisan Budget Act of 2018) that will see fiscal spending raised by around $380 billion.2 The deal failed to gain the support of a majority of Republicans in the House, despite House Speaker Paul Ryan's support, but 73 Democrats crossed the aisle to ensure its passage. They did so despite a lack of formal assurances that the House would consider an immigration bill. The three-day shutdown in late January has forced Democrats, who largely took the blame, to assess whether they care more about preserving their liberal credentials on fiscal policy or immigration policy. The two-year budget agreement is a testament to their concern for the former. The deal will see the budget deficit most likely rise to about 5.5% of GDP in FY2019, up from 3.3% in last year's CBO baseline forecast (Chart 2). Chart 1Rising U.S. Inflation Expectations Rising U.S. Inflation Expectations Rising U.S. Inflation Expectations Chart 2Fiscal Policy Gets Expansive Fiscal Policy Gets Expansive Fiscal Policy Gets Expansive Adding to the newly authorized fiscal spending could be a congressional rule-change that reintroduces earmarks - leading to a potential $20 billion additional spending per year. There is also a 10-year infrastructure plan that could see spending increase by another ~$200 billion over the next decade. The new budget compromise, combined with last year's tax cuts, will massively increase U.S. fiscal thrust beyond the IMF's baseline (Chart 3). The IMF's forecast, done before the tax cuts were passed, suggested that fiscal thrust would contract by about 0.5% of GDP this year, and would only slightly expand in 2019. Now we estimate that fiscal thrust will be a positive 0.8% of GDP in 2018 and 1.3% in 2019. These figures are tentative because it is not clear exactly how much of the spending will take place this year versus 2019 and 2020. Our colleague Mark McClellan, author of BCA's flagship The Bank Credit Analyst, has stressed that the impact on GDP growth will be less than these figures suggest because the economic multipliers related to tax cuts are less than those for spending.3 Our theme that the political path of least resistance will lead to profligacy is not exclusive to the U.S. After all, populism is not exclusive to the U.S, with non-centrist parties consistently capturing around 16% of the electoral vote in Europe (Chart 4). Chart 3The Budget Deal And Tax Cuts##br## Will Expand U.S. Fiscal Thrust Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China Chart 4Populism Will Fuel Fiscal##br##Spending Beyond The U.S. Populism Will Fuel Fiscal Spending Beyond The U.S. Populism Will Fuel Fiscal Spending Beyond The U.S. Policymakers are not price-setters in the political marketplace, but price-takers. The price-setter is the median voter, who we believe has swung to the left when it comes to economic policy in developed markets after a multi-year, low-growth, economic recovery.4 Broadly speaking, investors should prepare for higher fiscal spending globally on the back of this dynamic. Aside from the U.S., the populist dynamic is evident in the world's third (Japan), fourth (Germany), and sixth (the U.K.) largest economies. Japan may have started it all, as a political paradigm shift in 2011-12 spurred a historic reflationary effort.5 Geopolitical pressure from China and domestic political pressures on the back of an extraordinary rise in income inequality, and natural and national disasters, combined to create the political context that made Abenomics possible. While the fiscal arrow has somewhat disappointed - particularly when PM Shinzo Abe authorized the 2014 increase in the consumption tax - Japan has still surprised to the upside on fiscal thrust (Chart 5). On average, the IMF has underestimated Japan's fiscal impulse by 0.84% since the beginning of 2012. Investors often understate the ability of centrist, establishment policymakers to rebrand anti-establishment policies - whether on fiscal spending or immigration - as their own. In January 2015, we asked whether "Abenomics Is The Future?"6 We concluded that rising populism in Europe would require a policy response not unlike the policy mix favored by Tokyo. Today, the details of the latest German coalition deal between the formally fiscally conservative Christian Democratic Union (CDU) and the center-left Social Democratic Party (SDP) means that even Germany has now succumbed to the political pressure to reflate. The CDU has agreed to fork over the influential ministry of finance to the profligate SPD and apparently spend an additional 46 billion euros, over the duration of the Grand Coalition, on public investment and tax cuts. Finally, in the U.K., the end of austerity came quickly on the heels of the Brexit referendum, the ultimate populist shot-across-the-bow. The new Chancellor of the Exchequer, Philip Hammond, announced a shift away from austerity almost immediately, scrapping targets for balancing the budget by the end of the decade. The change in rhetoric has carried over to the new government, especially after the Labour Party pummeled the Tories on austerity in the lead up to the June 2017 election. The bond market action over the past several weeks suggests that investors have not fully appreciated the political shifts underway over the past several years. Bond yields had to "catch up" to the political reality essentially over the course of February. However, the structural upward trajectory is now in place. The end of stimulative monetary policy will accelerate the rise in bond yields. Quantitative easing programs have soaked up more than the net government issuance of the major economies. Chart 6 shows that the flow of the major economies' government bonds available for the private sector to purchase was negative from 2015-2017. This flow will now swing to the positive side as fiscal spending necessitates greater issuance and as central banks withdraw demand. Real interest rates may therefore be higher to the extent that government bonds will have to compete with private-sector issuance for available savings. Chart 5Japan's Abenomics Leads The Way To More Spending Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China Chart 6Lots Of Bonds Hitting The Private Market Lots Of Bonds Hitting The Private Market Lots Of Bonds Hitting The Private Market Bottom Line: The U.S. electorate chose the populist, anti-establishment Donald Trump as president with unemployment at a multi-decade low of 4.6%. The message from the U.S. election, and the rise of anti-establishment parties in Europe, is that the electorate is restless, even with the post-Great Financial Crisis recovery now in its ninth year. Policymakers have heard the message, loud and clear, and are adjusting fiscal policy accordingly. Over the course of the next quarter, BCA's Global Investment Strategy expects the rapid rise in bond yields to peter out, but investors should use any bond rallies as an opportunity to reduce duration risk. BCA's House View calls for the 10-year Treasury yield to finish the year at about 3.25%.7 Our U.S. bond strategists expect the end-of-cycle level of the nominal 10-year Treasury yield to be between 3.3% and 3.5%.8 Does The U.S. Midterm Election Matter? The three-day government shutdown that ended on January 22 has hurt the chances of the Democratic Party in the upcoming midterm election. The Democrats' lead in the generic congressional ballot has gone from a high of 13% at the end of 2017 to just 9% today (Chart 7). As Chart 8 illustrates, this generic ballot has some predictive quality. However, it also suggests that for Democrats, the lead needs to be considerably larger than for Republicans to generate the type of seat-swing needed to win a majority in the House of Representatives in 2018. Chart 7Democrats Have Lost Some Steam Democrats Have Lost Some Steam Democrats Have Lost Some Steam Chart 8Democrats Need Big Polling Lead To Win Majority Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China There are three reasons for this built-in advantage for the Republican Party in recent midterm elections. First, the Republicans dominate the rural vote, which tends to be overrepresented in any electoral system that draws electoral districts geographically. Second, redistricting - or gerrymandering - has tended to favor the Republican Party in the past several elections. While the Supreme Court has recently struck down some of the most egregiously drawn electoral districts, the overall impact of gerrymandering since 2010 overwhelmingly favors the GOP. Third, midterm elections tend to have a lot lower voter turnout than general elections, which hurts the Democrats who rely on the youth and minority vote. Both constituencies tend to shy away from participation in the midterm election. Does the market care who wins the House and Senate? On the margin, yes. If the current GOP control of the White House, House of Representatives, and Senate were to be broken, markets might react negatively. It is often stated that gridlock has a positive effect on stock prices, as it reduces the probability of harmful government involvement in the economy and financial markets. However, research by our colleague Jonathan LaBerge, which we have recently updated, suggests otherwise. After controlling for the macro environment, gridlock between the White House and Congress is actually associated with modestly lower equity market returns.9 This conclusion is based on the past century of data. For most of that period, polarization has steadily risen to today's record-setting levels (Chart 9). As such, the negative impact of gridlock could be higher today. Table 1 illustrates the impact of four factors on monthly S&P 500 price returns. The first two columns demonstrate the effect on returns of recessions and tightening monetary policy, respectively, whereas the last two columns measure the effects of executive/legislative disunity and reduced uncertainty in the 12-months following presidential and midterm elections.10 The table presents the beta of a simple regression based on dummy variables for each of the four components (t-statistics are shown in parentheses). Chart 9U.S. Polarization Has Risen For 60 Years U.S. Polarization Has Risen For 60 Years U.S. Polarization Has Risen For 60 Years Table 1Divided Government Is, In Fact, Bad For Stocks Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China As expected, the macro context has a much larger impact on stock returns than politically driven effects. The impact of political gridlock is shown to be negative regardless of timeframe. The takeaway for equity investors is that, contrary to popular belief, political gridlock is not positive for stock prices after controlling for important macro factors. Absolute results are similarly negative, with the average monthly S&P 500 returns considerably larger during periods of unified executive and legislative branches (Chart 10). Intriguingly, the less negative constellation of forces is when the president faces a unified Congress ruled by the opposing party. We would reason that such periods force the president to compromise with the legislature, which constitutionally has a lot of authority over domestic policy. The worst outcome for equity markets, by far, is when the president faces a split legislature. In these cases, we suspect that uncertainty rises as neither party has to take responsibility for negative policy outcomes, making them more likely. Chart 10A Unified Congress Is A Boon For Stocks Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China In the current context, gridlock could lead to greater political volatility. For example, a Democratic House of Representatives would begin several investigations into the Trump White House and could potentially initiate impeachment proceedings against the president. But as we pointed out last year, impeachment alone is no reason to sell stocks.11 The Democrats would not have the ability to alter President Trump's deregulatory trajectory - which remains under the purview of the executive - nor would they be likely to gain enough seats to repeal the tax cut legislation. Yet given President Trump's populist bias, center-left Democrats could find much in common with the president on spending. This would only reinforce our adage that the political path of least resistance will tend towards profligacy. The only thing that President Trump and the Democrats in Congress will find in common, in other words, will be to blow out the U.S. budget deficit. Bottom Line: The chances of a Democratic takeover following the midterm elections have fallen, but remain at 50% for the House of Representatives. A gridlocked Congress is mildly negative for equity markets, taking into consideration that macro variables still dominate. Nonetheless, investors should ignore the likely higher political volatility and focus on the fact that President Trump and the Democrats are not that far apart when it comes to spending. China: The Reform Reboot Is Here And It Is Still Winter He told us not to believe the people who say it's spring in China again. It's still winter. - Anonymous Chinese government official referring to Liu He, the top economic adviser.12 The one risk to the BCA House View of a structural bond bear market - at least in the near term - is a peaking of global growth and a slowdown in emerging markets. The EM economies, which normally magnify booms in advanced economies, particularly in latter stages of the economic cycle, are currently experiencing a relative contraction in their PMIs (Chart 11). BCA Foreign Exchange Strategy's "carry canary" indicator - which shows that EM/JPY carry trades tend to lead global industrial activity - is similarly flashing warning signs (Chart 12).13 Chart 11EM Economies Underperforming EM Economies Underperforming EM Economies Underperforming Chart 12Yen Carry Trades Signal Distress Yen Carry Trades Signal Distress Yen Carry Trades Signal Distress At the heart of the divergence in growth between EM and DM is China. Beijing has been tightening monetary conditions as part of overall structural reform efforts, causing a sharp deceleration in the Li Keqiang index (Chart 13). In addition, the orders-to-inventories ratio has begun to contract, import volumes are weak, and export price growth is slowing sharply (Chart 14). Chart 13Li Keqiang Index Surprises Downward Li Keqiang Index Surprises Downward Li Keqiang Index Surprises Downward Chart 14China's Economy Weakens... China's Economy Weakens... China's Economy Weakens... The Chinese slowdown is fundamentally driven by politics. Last April we introduced a checklist for determining whether Chinese President Xi Jinping would "reboot" his reform agenda during his second term in office. We define "reform" as policies that accelerate the transition of China's growth model away from investment-driven, resource-intensive growth. Since then, political and economic events have supported our thesis. Most recently, interbank lending rates have spiked due to China's new macro-prudential regulations and monetary policy (Chart 15), and January's total credit growth clocked in at an uninspiring 11.2% (Chart 16). Tight credit control in the first calendar month typically implies that credit expansion will be limited for the rest of the year (Chart 17). A strong grip on money and credit growth is entirely in keeping with the three-year "battle" that Xi Jinping has declared against systemic financial risk.14 Chart 15...While Policy Drives Up Interbank Rates ...While Policy Drives Up Interbank Rates ...While Policy Drives Up Interbank Rates Chart 16January Credit Growth Disappoints... January Credit Growth Disappoints... January Credit Growth Disappoints... Chart 17... And January Credit Is The Biggest Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China In short, we have just crossed the 50% threshold on our checklist, confirming that China is indeed rebooting its reform agenda (Table 2). Going forward, what matters is the intensity and duration of the reform push. Three events at the start of the Chinese New Year suggest that the market will be surprised by both. Table 2How Do We Know China Is Reforming? Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China First, the National People's Congress (NPC), which convenes March 5, is reportedly planning to remove term limits for the president and vice-president, thus enabling Xi Jinping to remain as president well beyond March 2023. Xi was already set up to be the most powerful man in China's politics through the 2020s,15 so we do not consider this a material change in circumstances: the material change occurred last October when "Xi Thought" received the status of "Mao Zedong Thought" in the Communist Party's constitution and reshaped the Politburo to his liking. The point is that Xi's position is irresistible which means that his policies will have greater, not lesser, effectiveness as party and state bureaucrats scramble to enact them faithfully.16 Chart 18Crackdown On Shadow Lending Has Teeth Crackdown On Shadow Lending Has Teeth Crackdown On Shadow Lending Has Teeth Second, the Communist Party is reportedly convening its "Third Plenum" half a year early this year - that is, in late February and early March, just before the annual legislative meeting that begins March 5. This is a symbolic move. The third plenum is known as the "reform plenum," and this year is the fortieth anniversary of the 1978 third plenum that launched China's market reform and opening up to the global economy under Deng Xiaoping. However, the last time China convened a third plenum - in 2013 when Xi first announced his agenda - the excitement fizzled as implementation proved to be slow.17 As we have repeatedly warned clients, China's political environment has changed dramatically since 2013: the constraints to painful structural reforms have fallen.18 If the third plenum is indeed held early, some key decisions on reform initiatives will be made as we go to press, and any that require legislative approval will receive it instantly when the National People's Congress convenes on March 5.19 This will be a "double punch" that will supercharge the reform agenda this year. It is precisely the kind of ambition that we have been expecting. Third, one of the most important administrative vehicles of this new reform push, the Financial Stability and Development Commission (FSDC), has just made its first serious move.20 On February 23, China's top insurance regulator announced that it is taking control of Anbang Insurance Group for one year, possibly two, in order to restructure it amid insolvency and systemic risks. Anbang's troubles are idiosyncratic and have received ample media attention since June 2017.21 Nevertheless, China's government has just seized a company with assets over $300bn. Clearly the crackdown on the shadow financial sector has teeth (Chart 18). Anbang's case will reverberate beyond the handful of private companies involved in shadow banking and highly leveraged foreign acquisitions abroad. Beijing's focus is systemic risk, not merely innovative insurance products. The central government is scrutinizing state-owned enterprises (SOEs) and local governments as well as a range of financial companies and products. We provide a list of reform initiatives in Table 3. Table 3China Is Rebooting Economic Reforms Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China What is the cumulative effect of these three developments? Basically, they raise the stakes for Xi's policies dramatically this year. If Xi makes himself president for life, and yet this year's third plenum is as over-hyped and under-delivered as in 2013, then we would expect China's economic future to darken rapidly. China will lose any pretext of reform just as the United States goes on the offensive against Beijing's mercantilism. It would be time to short China on a long-term time line. However, it would also spell doom for our positive U.S. dollar outlook and bearish EM view. If, on the other hand, Xi Jinping couples his power grab with renewed efforts to restructure China's economy and improve market access for foreigners, then he has a chance of deleveraging, improving China's productivity, and managing tensions with the U.S. This is the best outcome for investors, although it would still be negative for Chinese growth and imports, and hence EM assets, this year. The next political indicator to watch is the March 5 NPC session. This legislative meeting will be critical in determining what precise reforms the Xi administration will prioritize this year. The NPC occurs annually but is more important this year than usual because it installs a new government for the 2018-23 period and will kick off the new agenda. In terms of personnel, there is much speculation (Table 4).22 Investors should stay focused on the big picture: four months ago, the news media focused on Xi Jinping's Maoist thirst for power and declared that all reform efforts were dead in the water. Now the press is filled with speculation about which key reformer will get which key economic/financial position. The big picture is that Xi is using his Mao-like authority in the Communist Party to rein in the country's economic and financial imbalances. His new economic team will have to establish their credibility this year by remaining firm when the market and vested interests push back, which means more policy-induced volatility should be expected. Table 4China's New Government Takes Shape At National People's Congress Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China The risk is that Beijing overcorrects, not that reforms languish like they did in 2015-16. Our subjective probability of a policy mistake remains at 30%, but we expect that the market will start to price in this higher probability of risk as the March political events unfold. As Liu He declared at Davos, China's reforms this year will "exceed the international community's expectations."23 The anti-corruption campaign is another important factor to monitor. In addition to any major economic legislation, the most important law that the NPC may pass is one that would create a new nationwide National Supervisory Commission, which will expand the Communist Party's anti-corruption campaign into every level of the state bureaucracy. In other words, an anti-corruption component is sharpening the policy effectiveness of the economic and financial agenda. In the aforementioned Anbang case, for instance, corporate chief Wu Xiaohui was stung by a corruption probe in June 2017 and is being tried for "economic crimes" - now his company and its counterparty risks are being restructured. The combination of anti-corruption campaign and regulatory crackdown has the potential to cause significant risk aversion among financial institutions, SOEs, and local governments. Add in the ongoing pollution curbs, and any significant SOE restructuring, and Chinese policy becomes a clear source of volatility and economic policy uncertainty this year that the market is not, as yet, pricing (Chart 19). On cue, perhaps in anticipation of rising domestic volatility, China has stopped updating its home-grown version of the VIX (Chart 20). Chart 19Market Expects No Political Volatility Yet Market Expects No Political Volatility Yet Market Expects No Political Volatility Yet Chart 20Has China Halted Its Version Of The VIX? Has China Halted Its Version Of The VIX? Has China Halted Its Version Of The VIX? We would not expect anything more than a whiff, at best, of policy easing at the NPC this March. For instance, poverty alleviation efforts will require some fiscal spending. But even then, the point of fiscal spending will be to offset credit tightness, not to stimulate the economy in any remarkable way. Monetary policy may not get much tighter from here, as inflation is rolling over amid the slowdown (Chart 21),24 but anything suggesting a substantial shift back to easy policy would be contrary to our view. More accommodative policy at this point in time would suggest that Xi has no real intention of fighting systemic risk and - further - that global growth faces no significant impediment from China this year. In such a scenario, the dollar could fall further and EM would outperform. We expect the contrary. We are long DXY and short EUR/JPY. We remain overweight Chinese H-shares within emerging markets, but we will close this trade if we suspect either that reform is a fig leaf or that authorities have moved into overcorrection territory. Otherwise, reform is a good thing for Chinese firms relative to EM counterparts that have come to rely on China's longstanding commodity- and capital-intensive growth model (Chart 22). Chart 21Monetary Policy May Not Tighten From Here Monetary Policy May Not Tighten From Here Monetary Policy May Not Tighten From Here Chart 22Tighter-Fisted China Will Hit EM Tighter-Fisted China Will Hit EM Tighter-Fisted China Will Hit EM Bottom Line: Xi Jinping has rebooted China's economic reforms. The new government being assembled is likely to intensify the crackdown on systemic financial risk. Reforms will surprise to the upside, which means that Chinese growth is likely to surprise to the downside amidst the current slowdown, thus weighing on global growth at a time when populism provides a tailwind to U.S. growth. What It All Means For South Africa And Emerging Markets We spent a full week in South Africa last June and came back with these thoughts about the country's economy and the markets:25 The main driving force behind EM risk assets, year-to-date, has been U.S. TIPS yields and the greenback (Chart 23). Weak inflation data and policy disappointments as the pro-growth, populist, economic policy of the Trump Administration stalled have supported the ongoing EM carry trade. The actual emerging market growth fundamentals and politics are therefore unimportant. Chart 23Weak Inflation And Dollar Drove EM Assets Weak Inflation And Dollar Drove EM Assets Weak Inflation And Dollar Drove EM Assets Chart 24Market Likes Ramaphosa, Unlike Zuma Market Likes Ramaphosa, Unlike Zuma Market Likes Ramaphosa, Unlike Zuma In the near term, South African politics obviously do matter. Markets have cheered the election of Cyril Ramaphosa to the presidency of the African National Congress (ANC), a stark contrast to the market reaction following his predecessor's ascendancy to the same position (Chart 24). However, the now President Ramaphosa's defeat of ex-President Jacob Zuma's former cabinet minister and ex-wife, Nkosazana Dlamini-Zuma was narrow and has split the ANC down the middle. On one side is Ramaphosa's pragmatic wing, on the other is Dlamini-Zuma's side, focused on racial inequality and social justice. Chart 25Chronic Youth Unemployment Chronic Youth Unemployment Chronic Youth Unemployment Chart 26Few Gains In Middle Class Population Few Gains In Middle Class Population Few Gains In Middle Class Population For now, the ANC bureaucracy has served as an important circuit-breaker that will limit electoral choices in the 2019 election to the pro-market Ramaphosa, centrist Democratic Alliance, and radical Economic Freedom Fighters. From investors' perspective, this is a good thing. After all, it is clear that if the South African median voter had her way, she would probably not vote for Ramaphosa, given that the country is facing chronic unemployment (Chart 25), endemic corruption, poor healthcare infrastructure, and a desire for aggressive, and targeted, redistributive economic policies. South Africa stands alone amongst its EM peers when it comes to its tepid rise in the middle class as a percent of the population (Chart 26) and persistently high income inequality (Chart 27). We see no evidence that the electorate will welcome pro-market structural reforms. Chart 27Inequality Remains Very High Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China Nonetheless, Ramaphosa's presidency is a positive given the recent deterioration of South Africa's governance, which should improve as the new regime focuses on fighting corruption and restructuring SOEs. Whether Ramaphosa will similarly have the maneuvering room to correct the country's endemically low productivity (Chart 28) and still large twin deficits (Chart 29) is another question altogether. Chart 28A Distant Laggard In Productivity A Distant Laggard In Productivity A Distant Laggard In Productivity Chart 29Twin Deficits A Structural Weakness Twin Deficits A Structural Weakness Twin Deficits A Structural Weakness Will investors have time to find out the answer to those latter questions? Not if our core thesis for this year - that politics is a tailwind to U.S. growth and a headwind to Chinese growth - is right. In an environment where the U.S. 10-year Treasury yield is rising, DXY stabilizes, and Chinese economy slows down, commodities and thus South African assets will come under pressure. As our colleague Arthur Budaghyan, BCA's chief EM strategist, recently put it: positive political developments are magnified amid a benign external backdrop. Conversely, in a negative external environment, positive political transformations can have limited impact on the direction of financial markets. Bottom Line: Markets are cheering Ramaphosa's ascendancy to the South African presidency. We agree that the development is, all other things being equal, bullish for South Africa's economy and assets. However, the structural challenges are vast and we do not see enough political unity in the ANC to resolve them. Furthermore, we are not sure that the global macro environment will remain sanguine for long enough to give policymakers the time for preemptive structural reforms. To reflect the potential for a positive political change and forthcoming orthodox macro policies, we are closing our recommendation to bet on yield curve steepening in South Africa, which has been flat since initiation on June 28, 2017. However, we will maintain our recommendation to buy South African 5-year CDS protection and sell Russian, even though it has returned a loss of 17.08 bps thus far. We expect that Russia will prove to be a low-beta EM play in the next downturn, whereas South Africa will not be so lucky. On a different note, we are booking gains of 2525bps on our short Venezeulan vs. EM 10-yr sovereign bonds, as our commodity team upgrades its oil-price forecast for this year. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 2 Please see the Congressional Budget Office, "Bipartisan Budget Act of 2018," February 8, 2018, available at www.cbo.gov. 3 Please see BCA The Bank Credit Analyst Monthly Report, "March 2018," dated February 22, 2018, available at bca.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Japan's Political Paradigm Shift: Investment Implications," dated December 21, 2012, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Monthly Report, "Is Abenomics The Future?" dated February 11, 2015, available at gps.bcaresearch.com. 7 Please see BCA Global Investment Strategy Weekly Report, "A Structural Bear Market In Bonds," dated February 16, 2018, available at gis.bcaresearch.com. 8 Please see BCA U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds," dated February 20, 2018, available at usbs.bcaresearch.com. 9 Please see BCA U.S. Investment Strategy Weekly Report, "A Party On The QE2," dated November 8, 2010, available at usis.bcaresearch.com. 10 We include the last factor in the regression because it could be that the market responds positively in the post-election period, irrespective of the election outcome, simply because political uncertainty is diminished. 11 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 12 Please see Tom Mitchell, "Xi's China: The Rise Of Party Politics," Financial Times, July 25, 2016, available at ft.com. See also BCA Geopolitical Strategy and China Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at www.bcaresearch.com. 13 "Carry Canary" indicator tracks the performance of EM/JPY carry trades. These trades short the Japanese Yen and long an emerging market currency with a high interest rate (Brazilian real, Russian ruble, or South African rand), and as such they are highly geared to a positive global growth back-drop. Please see BCA Foreign Exchange Strategy Weekly Report, "The Yen's Mighty Rise Continues ... For Now," dated February 16, 2018, available at fes.bcaresearch.com. 14 The other two battles are against pollution and poverty. 15 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Weekly Report, "Xi Jinping: Chairman Of Everything," dated October 25, 2017, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Monthly Report, "Reflections On China's Reforms," in "The Great Risk Rotation - December 2013," dated December 11, 2013, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 19 Consider that the standard political calendar would have called for Xi to make personnel adjustments at the second plenum (which was held in January), then to formalize those personnel changes at the legislature in March, and then to announce reform initiatives at the third plenum in the fall, leaving implementation until late in the year or even March 2019. Instead, all of this will be done by March of this year, leaving the rest of the year for implementation. 20 The Financial Stability and Development Commission was created last July at an important financial gathering that occurs once every five years. We dubbed it a "Preemptive Dodd Frank" at the time because of China's avowed intention to use it to tackle systemic financial risk. Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. The FSDC's purpose is to coordinate the People's Bank of China with the chief financial regulators - the banking, insurance, and securities regulatory commissions (CBRC, CIRC, and CSRC) and the State Administration of Foreign Exchange (SAFE). There is even a possibility under discussion (we think very low probability of happening) that the FSDC will preside above the central bank - though the precise organizational structure will remain unclear until it is formalized, probably during the March legislative session. 21 Anbang is part of a group of companies, including Foresea, Fosun, HNA, Ping An, and Dalian Wanda, that have been targeted over the past year for shady financial doings, corruption, excessive debt, and capital flight. In particular, Anbang was integral to the development of universal life products, which have been highly restricted since last year. These were not standard insurance products but risky short-term, high-yield shadow investment products. Investors could redeem them easily so there was a risk that purchasers could swamp insurance companies with demands for paybacks if investment returns fell short. This would leave insurance companies squeezed for cash, which in turn could shake other financial institutions. The systemic risk not only threatened legitimate insurance customers but also threatened to leave insurance companies unable to make debt payments on huge leveraged buyouts that they had done abroad. Anbang and others had used these and other shadow products to lever up and then go on a global acquisition spree, buying assets like insurance subsidiaries, hotels, and media/entertainment companies. The targeted firms are also in trouble with the central government for trying to divest themselves of China's currency at the height of the RMB depreciation and capital flight of 2015. They were using China's shadow leverage to springboard into Western assets that would be safe from RMB devaluation and Chinese political risk. The government wants outward investment to go into China's strategic goals (such as the Belt and Road Initiative) instead of into high-profile, marquee Western assets and brands. 22 Particularly over whether Xi Jinping's right-hand man, Liu He, will be appointed as the new central bank governor, to replace long-serving Governor Zhou Xiaochuan, and/or whether he will replace Vice Premier Ma Kai as chairman of the FSDC. It is important whether Liu He takes the place of central banker or chief reformer because those roles are so different. Making him PBoC chief would keep a reformer at the helm of a key institution at an important point in its evolution, but will raise questions about who, if anyone, will take charge of structural reform. Giving him the broader and more ad hoc role of Reformer-in-Chief would be reminiscent of Zhu Rongji at the historic NPC session in March 1998, i.e. very optimistic for reforms. Of course, Liu He is not the only person to watch. It is also important to see what role former anti-corruption czar Wang Qishan gets (for instance, leading U.S. negotiations) and whether rising stars like bank regulator Guo Shuqing are given more authority (he is a hawkish reformer). 23 Please see Xie Yu and Frank Tang, "Xi picks team of problem solvers to head China's economic portfolios," South China Morning Post, dated February 21, 2018, available at www.scmp.com. 24 Please see BCA China Investment Strategy Weekly Report, "Seven Questions About Chinese Monetary Policy," dated February 22, 2018, available at cis.bcaresearch.com. 25 Please see BCA Geopolitical Strategy Special Report, "South Africa: Crisis Of Expectations," dated June 28, 2017, available at gps.bcaresearch.com.

Highlights Japan's reflationary economic policies will be reinforced ahead of the constitutional referendum; The Bank of Japan is a long way from a 2% inflation overshoot; Fiscal thrust will continue to surprise to the upside; Wage law revisions are significant and, on net, inflationary; Go long JPY/EUR as a tactical play on the countertrend yen rally. Feature Despite a 8.5% selloff in Japanese equities over the past week amid the global equity pullback, Japan's underlying economic growth is strong. The unemployment rate has collapsed to 2.8%, the economy is humming along at an impressive 2.1% clip, and inflationary pressures are building at last. A variety of indicators - from sentiment surveys to household incomes to manufacturing output - attest to the fact that "Abenomics" is keeping the fire well lit (Chart 1). Before the pullback began, investors were wondering whether the BoJ's reduction of long-term government bond purchases signaled that a less dovish turn in monetary policy was underway (Chart 2). BoJ Governor Haruhiko Kuroda tried to quiet these rumors by reiterating the need to keep current, easy monetary policy in place. The latest financial shakeup reinforces this message. Chart 1Japan's Macro Fundamentals Are Strong Japan's Macro Fundamentals Are Strong Japan's Macro Fundamentals Are Strong Chart 2The BoJ Has Cut Back Asset Purchases The BoJ Has Cut Back Asset Purchases The BoJ Has Cut Back Asset Purchases Over the long run, the BoJ's moves, and "Abenomics" in general, should be assessed from the perspective of Japan's broader geopolitical revival.1 Prime Minister Shinzo Abe needs reflation to continue for a range of reasons. Policymakers are not constrained by inflation; rather, inflation is constrained by the yen, global growth, and the increasing danger of a Chinese policy mistake. The BoJ Will Not Betray Abenomics Japan's strong consumer and business confidence, white-hot economic growth, and multi-year equity rally have stemmed from three factors: positive fiscal thrust, an EM rebound, and a weak yen.2 As a result, real interest rates have fallen (Chart 3), prompting the BoJ to downgrade its quantitative and qualitative easing policy (QQE). But cutting back bond-buying does not mean that the BoJ is removing accommodative policy. The central bank stopped targeting the quantity of asset purchases when it introduced its "yield curve control" policy in September 2016. Yield curve control ensures that long-term JGB yields stay around 0%, with a de facto cap of 10 basis points that can be adjusted as needed. Therefore the gross amount of asset purchases is arbitrary; it only needs to be sufficient to achieve the yield target. In fact, the BoJ's official annual target of asset purchases, 80 trillion yen, was until recently well above the annual net issuance of JGBs at 35 trillion yen (Chart 4). Fiscal policy, while surprising upward as expected, has not produced the volumes of new bond issuance that would be necessary to justify such a lofty target. Hence the BoJ can reduce bond-buying without turning more hawkish. As for inflation, the core price level has only barely begun to perk up (Chart 5) - and that has occurred after five years of reflationary efforts, which, in turn, followed a sea change in Japanese politics. Prime Minister Abe came to power by declaring war on deflation, putting Governor Kuroda in charge of the BoJ, and seeking a broad-based revival of Japan from the "lost decades" of the 1990s and 2000s. Neither Abe nor Kuroda can afford to remove accommodation too soon and snatch defeat from the jaws of victory. Chart 3Real Interest##br## Rates Have Fallen Real Interest Rates Have Fallen Real Interest Rates Have Fallen Chart 4Bond Purchases Had ##br##Exceeded New Issuances Bond Purchases Had Exceeded New Issuances Bond Purchases Had Exceeded New Issuances Chart 5Weak Yen, Easier Financial ##br##Conditions Pushed Up Inflation Weak Yen, Easier Financial Conditions Pushed Up Inflation Weak Yen, Easier Financial Conditions Pushed Up Inflation Kuroda has repeatedly stressed that he will allow inflation to "overshoot" the 2% target before normalizing policy.3 While it is possible that he will step down when his first term ends on April 8, it is neither required nor probable. We highly doubt that he will. Further, the likeliest candidates to replace him are those that would maintain policy continuity.4 Hence the wind-down of QQE does not portend any additional moves away from easy policy. Any such moves would drive the yen upward, and neither Kuroda nor his acolytes at the BoJ can allow yen strength to undermine their quest to whip deflation. Bottom Line: The BoJ's yield curve control framework will remain intact even if the quantity of asset purchases remains much smaller. No leadership change at the BoJ will alter this new monetary policy framework. With the Fed and other central banks in the midst of rate-hike cycles, and the ECB winding down its QE, the persistent dovishness of the BoJ will act as a depressant on the yen as it experiences upward pressure from abroad. Policy Is Inflationary... Significant inflationary pressures are building in Japan, and reflationary policy will be resolute in the face of any headwinds. First, Abe's political career depends on maintaining the economic revival. His most treasured policy objective - reforming the Japanese constitution to revise the pacifist Article Nine and clear the legal path for the normalization of the country's military - ultimately requires a majority vote in a popular referendum.5 This is no easy task. Abe will almost certainly win the leadership poll within the Liberal Democratic Party in September this year, but he may not wait till then to try to push a constitutional amendment through the Diet. The tentative plan is to present a bill in March and proceed to the national referendum in late 2018. Certainly it is imperative for him to secure two-thirds majority votes in each chamber before the House of Councillors elections in July 2019, since that event puts his near-supermajority in the upper house at risk (Chart 6). The constitutional referendum could coincide with that vote or precede it, but Abe wants the process finished before the 2020 Tokyo summer Olympics. It will be a stretch but it is feasible. Chart 6Abe Has A Virtual Supermajority In Both Houses, Necessary For Constitutional Change Japan: Kuroda Or No Kuroda, Reflation Ahead Japan: Kuroda Or No Kuroda, Reflation Ahead Chart 7A Popular Referendum Will Be Very Close Japan: Kuroda Or No Kuroda, Reflation Ahead Japan: Kuroda Or No Kuroda, Reflation Ahead Opinion polls have consistently showed the public almost evenly split on the topic of revising Article Nine, with the hawkish advocates of revision usually trailing dovish opponents (Chart 7). While Abe's approval rating ranges in the high forties, his constitutional tinkering has similar, sub-50% levels of support. Pacifism runs deep in Japan. The LDP and New Komeito ruling coalition has not won more than 47% of the popular vote in the 2012, 2014, and 2017 general elections (Chart 8). And it has never scored above 50% in popular opinion polls over the course of Abe's term (Chart 9). Chart 8Abe's Coalition Has Not Won 50% Of The Vote... Japan: Kuroda Or No Kuroda, Reflation Ahead Japan: Kuroda Or No Kuroda, Reflation Ahead Chart 9...Nor Polled Above 50% In Popular Opinion ...Nor Polled Above 50% In Popular Opinion ...Nor Polled Above 50% In Popular Opinion Abe will not have forgotten Italy's former Prime Minister Matteo Renzi, who gambled his political career on controversial constitutional reforms in 2016 only to fall from power when he lost the popular referendum. More to the point, Abe knows that large-scale protests - bigger than those he faced in 2015 - could attend his final push to secure the constitutional revision. After all, Abe's grandfather, Nobusuke Kishi, faced mass protests in 1960 and was forced to resign upon concluding a new Treaty of Mutual Cooperation and Security with the United States. This was a consequential update to the "U.S.-Japan Security Treaty" that enabled Japan to build up de facto military forces despite its pacifist constitution. Kishi fell from power even though he had presided over a rapid expansion of real GDP and real wages and a steep drop in unemployment (Chart 10). True, Japan was a very different place in 1960. At that time, the Cold War was raging, and a large and restless youth population energized the protests. Today's youth are complacent and outnumbered by comparison. Nevertheless, Kishi did not need to put his treaty to a popular vote, unlike Abe's constitutional revisions. His grandson has a higher threshold to overcome. It follows that Japan will maintain dovish monetary policy and will continue to outperform conventional estimates of fiscal thrust (Chart 11).6 Abe's decision to abandon the goal of achieving a primary balance budget surplus by 2020 is a clear indication of this policy direction.7 Chart 10Treaty Protests In 1960 Despite Strong Economy Treaty Protests In 1960 Despite Strong Economy Treaty Protests In 1960 Despite Strong Economy Chart 11Fiscal Thrust Surprises To Upside Japan: Kuroda Or No Kuroda, Reflation Ahead Japan: Kuroda Or No Kuroda, Reflation Ahead Wages will be a decisive factor in Abe's economic success.8 Wage growth has remained in the black for most of his term, marking a contrast with the past twenty years of at best sporadic and short-lived wage rises (Chart 12). This is likely to continue. In this spring's "shunto" negotiations between businesses and unions, both the Abe administration and Keidanren, the top business group, are asking for 3% wage increases. The biggest union, Rengo, is only asking for one percentage point more.9 Abe has dedicated the current Diet session, beginning January 22, to "work-style reforms" that should be, on net, positive for wage growth.10 He wants to remove disparities between regular and irregular workers, particularly regarding wages, training opportunities, and welfare benefits. He also wants to impose limits on the workweek - putting a cap on the average 80-hour workweek of Japan's full-time workers so as to force companies to hire more irregular workers on a full-time basis (and to encourage employed people to have children). Companies that raise wages by 3% or more will see a cut in the corporate tax rate from around 30% to 25%. Economic conditions should push wages up regardless of central government policies. The jobs-to-applicants ratio is at the highest level since 1990. The labor participation rate is 60.8%, with female participation at 51.3%, up from 47.8% when Abe took power in 2012. Neither does the adoption of robotics, for which Japan is famous, counteract the tight labor market and inflationary consequences over time.11 In short, wages and core inflation should rise as long as the economic expansion is not derailed. As our colleague Peter Berezin of BCA's Global Investment Strategy has shown, the Phillips Curve will eventually kick in - and it even looks like Japan (Chart 13)!12 Chart 12Wage Growth Is The Key To Abe's Success Wage Growth Is The Key To Abe's Success Wage Growth Is The Key To Abe's Success Chart 13The Phillips Curve In Japan Looks Like Japan Japan: Kuroda Or No Kuroda, Reflation Ahead Japan: Kuroda Or No Kuroda, Reflation Ahead Bottom Line: A growing economy with real wage growth is Abe's only hope not only of beating deflation but also of getting his planned constitutional amendments over the line. Reflationary policy is essential to his legacy and vision of reviving Japan. ... But Not Too Inflationary Still, fiscal thrust is hardly going to explode unless an economic slowdown calls for it. Despite Abe's adoption of a twenty first-century "Takahashi Plan," i.e. simultaneous monetary and fiscal expansion, his administration's fiscal spending has remained relatively restrained. Strong revenue growth has actually improved the primary balance (Chart 14). Until very recently, Abe's "fiscal arrow" has disappointed his cheerleaders - he even raised the consumption tax from 5% to 8% in 2014, undermining his pro-growth fiscal packages. By law Abe is required to raise the consumption tax again, from 8% to 10%, in October 2019. In the latest election he campaigned on using the proceeds of this tax increase to expand social spending.13 Of course, he reserves the option of postponing this decision if he should deem a tax hike detrimental to the economic recovery (or to his odds of revising the constitution). But this flexibility means that any and all inflationary pressures in 2018-19 will increase under the shadow of a statutorily scheduled slug to consumer spending. There are also some constraints on wage growth. First, the reforms are intended to liberalize the labor market, which means their effects are not likely to be exclusively inflationary. "Performance" metrics that put less emphasis on seniority and working overtime, insofar as they are successful, could weigh on wage growth, at least initially. Second, Japan is starting to allow immigration - the number of foreign workers hit a record of 1.28 million total in October 2017 (Chart 15).14 This trend runs contrary to Japan's long status as the least hospitable destination for migrants in the developed world. The influx is apparently not limited to construction workers for the 2020 Olympics, as manufacturing is still the sector with the largest number of foreign workers. The Abe administration is committed to breaking the mold in the name of pro-growth structural reform and immigration is a meaningful change, albeit still in its early stages. Given existing labor market tightness and rising labor costs for companies, we expect this trend to outrun expectations, nudging up labor force growth and at least mildly counteracting wage rises, especially in low-skill sectors.15 Chart 14Primary Balance Improves On Growth Japan: Kuroda Or No Kuroda, Reflation Ahead Japan: Kuroda Or No Kuroda, Reflation Ahead Chart 15Japan Finally Allowing Immigration Japan: Kuroda Or No Kuroda, Reflation Ahead Japan: Kuroda Or No Kuroda, Reflation Ahead Bottom Line: Inflation will continue building if the global economy continues expanding and additional fiscal thrust and wage hikes are added to Japan's negative output gap, tight labor market, and rock-bottom unemployment rate. Nevertheless Japan is far from runaway inflation, and fiscal and labor market policies are nuanced. The BoJ's desired inflation overshoot is still a long way off. China And EM Pose Deflationary Risks Meanwhile deflationary forces lurk in China and emerging markets, which have been key factors in Japan's recent economic outperformance. Japan's trade exposure to China is substantial: The latter accounts for 18% of Japan's total exports, 2.7% of Japan's GDP (Chart 16). At the moment, Japanese manufacturing appears resilient in the face of China's slowdown, especially relative to the "newly industrialized" Asian neighbors. But Chinese Premier Li Keqiang's famous proxy for economic activity is closely correlated with Japanese export growth, and it is slowing. China's monetary conditions and credit and fiscal spending impulse - key leading indicators - also bode ill for Japanese exports (Chart 17). Chart 16Japan Exposed To Chinese Economy Japan Exposed To Chinese Economy Japan Exposed To Chinese Economy Chart 17China Policy Will Hit Japan Directly China Policy Will Hit Japan Directly China Policy Will Hit Japan Directly Beijing has so far tightened policy into the slowdown. It is adding new financial, environmental, and property sector regulations while expanding its anti-corruption campaign into finance, industry, and local government.16 Central government regulatory discipline - and reforms meant to reduce capital and energy intensity - will weigh on China's monetary and credit growth, capex, capital and commodity imports, and hence EM as a whole (Chart 18). And EM ex-China accounts for a further 25% of Japanese exports. In other words, Chinese reforms will bite in 2018-19 and thus encourage Japan to maintain loose fiscal and monetary policy. Recent market turbulence may add to this predicament as it is not easy for China to abandon its newly launched economic reforms - meaning China may ease policy too late if conditions worsen. We put the risk of a policy induced mistake in China at 30%. There are also significant geopolitical risks in East Asia that could cause headwinds to Japan's economy. China's strategic challenge is the key driver of Japan's attempts to revive its economy (including through higher military spending) and normalize its military operations (Chart 19). With Japan re-arming, China and Japan could easily suffer a breakdown in diplomatic relations - and China has already shown the willingness to use sanctions to punish Japan when strategic spats occur.17 Frictions over the Koreas or Taiwan could also encourage safe-haven flows into the yen. In short, Abe and Kuroda must be prepared for any eventuality, which is another reason to expect policy to stay looser for longer. Chart 18China Policy Will Hit Japan Via EM China Policy Will Hit Japan Via EM China Policy Will Hit Japan Via EM Chart 19Strategic Tensions Still A Serious Risk Strategic Tensions Still A Serious Risk Strategic Tensions Still A Serious Risk Bottom Line: Japan's exposure to both China and EM ex-China makes it vulnerable to growth wobbles as China intensifies reforms. Meanwhile Japan's constitutional revisions and remilitarization could spark a spat with China. These are compelling reasons for policymakers to stay the course with loose monetary and fiscal policies. Investment Recommendations In the short run, we would suggest clients go long JPY/EUR. The euro is expensive relative to fair value and purchasing-power-parity models (Chart 20). And investor positioning is skewed heavily in favor of the euro versus the yen (Chart 21).18 Chart 20EUR/JPY Is Expensive EUR/JPY Is Expensive EUR/JPY Is Expensive Chart 21Skewed Positioning In EUR/JPY Skewed Positioning In EUR/JPY Skewed Positioning In EUR/JPY We are closing our long USD/JPY for a loss of 3.23%. In the long run, as long as global growth holds up, any yen rally is likely to be a countertrend one, as a stronger yen will exert deflationary pressures and reinforce persistent, easy policy. Japanese policymakers have little need to fear inflation; they will focus on nurturing the country's economic and strategic rebound. Therefore, investors need not worry about the BoJ pulling the rug out from under the equity and bond markets. While BCA's House View favors Japanese equities over the U.S., BCA Geopolitical Strategy's China view prevents us from sharing this conviction in 2018. We would favor U.S. equities, which are low-beta and poised for continued strong earnings growth due to tax cuts and growth. The big risk for Japanese equities comes if China's central government makes a policy mistake and "overcorrects," triggering a precipitous drop in Chinese imports. We put a 30% subjective probability to such a scenario given the difficulty of reforming the financial sector in a highly leveraged economy. The yen would rally on safe-haven flows and Japanese markets would sell off. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Japan's Political Paradigm Shift: Investment Implications," dated December 21, 2012, available at gps.bcaresearch.com. 2 Please see BCA Foreign Exchange Strategy Weekly Report, "Yen: QQE Is Dead! Long Live YCC!" dated January 12, 2018, available at fes.bcaresearch.com. 3 See for example Haruhiko Kuroda, "Quantitative and Qualitative Monetary Easing and Economic Theory," speech at the University of Zurich, Bank of Japan, November 13, 2017, available at www.boj.or.jp. 4 Technically, Kuroda's term ends on April 8, 2018 but he can be reappointed by the prime minister for another five-year term. Please see "Experts say Haruhiko Kuroda likely to remain at BOJ helm despite failures," Japan Times, October 7, 2017, available at www.japantimes.co.jp. Both of Kuroda's deputies, Hiroshi Nakaso and Kikuo Iwata, as well as other possible successors (Masayoshi Amamiya, Etsuro Honda, and Takatoshi Ito) are dovish candidates likely to maintain continuity with his policies if at the BoJ helm. Nobuchika Mori is the only potential exception but it is still not clear that he would deviate from Abe's and Kuroda's framework if given the top job. 5 Please see BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016; and Special Report, "Japan: The Emperor's Act Of Grace," dated June 8, 2016, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. 7 Abe abandoned the 2020 budget target while campaigning in the general election of October 2017 and has stuck with his higher spending proposals. 8 Please see BCA Geopolitical Strategy Monthly Report, "King Dollar: The Agent Of Righteous Retribution," dated October 12, 2016, available at gps.bcaresearch.com. 9 Please see "Japan business lobby seconds call for 3% pay hikes," Nikkei Asian Review, January 17, 2018, available at asia.nikkei.com. 10 Abe is attempting to amend the Labor Standards Law. Please see Heizo Takenaka, "A prologue to work-style reforms," Japan Times, January 30, 2018, available at www.japantimes.co.jp. 11 Despite labor shortages, Japanese firms are using robots less often. Also, companies with high technology and robot usage are actually companies that tend to pay higher wages, contrary to popular belief. Please see BCA's The Bank Credit Analyst Special Report, "The Impact Of Robots On Inflation," dated January 25, 2018, available at bca.bcaresearch.com. 12 Please see BCA Global Investment Strategy, "Three Tantalizing Trades - Four Months On," dated January 19, 2018, available at gis.bcaresearch.com. 13 Abe reiterated his plans for more social spending, for instance on expanded child care support and free preschool education, in his policy speech ahead of the opening Diet session this year. Please see "Abe delivers policy speech," NHK, January 22, 2018, available at www3.nhk.or.jp. 14 Please see "Number of Foreign Workers in Japan at Record High," NHK, January 26, 2018, available at www3.nhk.or.jp. 15 Please see "Japan quietly accepting foreign workers -- just don't call it immigration," Japan Times, November 3, 2016, available at www.japantimes.co.jp 16 Please see BCA Geopolitical Strategy Special Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, "Does It Pay To Pivot To China?" dated July 5, 2017, available at gps.bcaresearch.com. 18 For full discussion, see footnote 2 above. Geopolitical Calendar

Highlights The U.S.'s twin deficits do not explain the drop in the USD; Global growth is the biggest factor for the USD, and growth depends on China's economic reforms; The U.S. is turning more hawkish on China trade despite Beijing's reform-induced vulnerability; U.S. and Chinese political dynamics suggest upside risks in the former and downside in the latter; Go long DXY. Feature American policymakers scrambled to walk back Treasury Secretary Steven Mnuchin's "weak dollar" comments last week. Investors were left to wonder why Mnuchin broke with the long-held official position of favoring a strong dollar. Was it a "shot across the bow" of China, warning Beijing that the U.S. would engage in currency manipulation if it was not given concessions on trade? Or was it an admission that the U.S. would run large "twin deficits" - a budget deficit and a current account deficit - going forward? We don't have a good explanation for what Mnuchin said in Davos.1 But we can say with some conviction that the "twin deficit" explanation, which has been brought up in almost every client conversation so far this year, is wrong. Chart 1Twin Deficits: Why The Panic? Twin Deficits: Why The Panic? Twin Deficits: Why The Panic? Chart 2Because The Narrative Is Scary Because The Narrative Is Scary Because The Narrative Is Scary First, who says that the U.S. is about to widen its twin deficit (Chart 1)? The concern arises periodically in the marketplace but is often grossly off the mark in predicting the path of deficits or the dollar (Chart 2). We expect the budget deficit to hold steady in 2018, if not contract. Why? Because the fiscal deficit almost always contracts in the eight quarters before a recession, barring, in some cases, one or two quarters just before the recession hits (Chart 3). Unless investors have a high-conviction view that a recession is afoot in the next two quarters, they should ignore the dire predictions about the U.S. budget deficit. Chart 3The Deficit Is Not A Problem... Yet The Deficit Is Not A Problem... Yet The Deficit Is Not A Problem... Yet Chart 4Bond Market Not Sniffing Out Any Twin Deficit Crisis Bond Market Not Sniffing Out Any Twin Deficit Crisis Bond Market Not Sniffing Out Any Twin Deficit Crisis If the risk to the U.S. economy is to the upside, as we believe due to the tax cuts and unleashing of animal spirits, then deficits will come down regardless of additional tax or spending policy.2 In the long term, yes, the budget deficit will almost certainly expand due to entitlement spending, the impact of automatic stabilizers during a recession, and the loss of revenue from tax cuts. But long-term deficit concerns are the purview of the bond market, not currency traders. So what is the bond market telling us? Chart 4 shows that the yield curve tends to steepen as the twin deficit widens; both tend to occur during and after recessions. Today, however, the curve continues to flatten. Another fixed-income market indicator that tends to track budget deficits is the 30-year swap spread, which falls during recessions as budget deficits expand. But today the swap spread is not falling, it is increasing and doing so at the fastest pace since the 2008 recession (Chart 5). This may be a sign of resurgent animal spirits as banks throw caution - and concerns over Obama-era overregulation - to the wind. Credit demand is rising in the economy, which should increase both the velocity of money and growth. Concerns over the widening fiscal deficit are not being reflected in this indicator. Finally, our currency strategist, Mathieu Savary, has pointed out that a widening twin deficit only impacts developed economies' currencies about 50% of the time over 12 month periods. In other words, expansion of the twin deficit predicts currency moves about as well as flipping a coin. What really matters is how central banks respond to the causes and economic effects of the twin deficits. Protectionism, on the other hand, ought to be bullish for the dollar.3 As such, a potential trade war between China and the U.S. should not be the reason for the dollar's deepening doldrums. And while we are generally open to alarmism on trade protectionism - due to the fact that President Trump has few constitutional or political constraints holding him back on this issue - there is still not enough evidence to say whether the Trump administration will impose across-the-board tariffs on China. (See next section.) Could dollar weakness, conversely, be the result of a Plaza Accord 2.0 orchestrated between Chinese and American policymakers to depreciate the greenback in order to avert the need for protectionist policies? We doubt it. First, the U.S. and China economic dialogue has faltered. Second, the dollar would not have declined following the Plaza Accord had the Fed not aggressively cut rates from 1984 to 1985 by 423 basis points (Chart 6). And the Fed is obviously not cutting rates today, it is hiking them. Chart 5No Sign Of Deficit Here No Sign Of Deficit Here No Sign Of Deficit Here Chart 6The Fed Is More Important Than Politics... The Fed Is More Important Than Politics... The Fed Is More Important Than Politics... So, what matters for the U.S. dollar? Higher domestic inflation would matter as it would incentivize the Fed to tighten more than the market expects. Even here, however, recent history warrants caution on this view. Between 2004 and 2006, the Fed tightened 440 basis points and yet the dollar declined 11% from the start of the tightening cycle to its end (Chart 7). This is because the rest of the world's growth outpaced U.S. growth, particularly that of emerging markets, which grew at an annual 19%. We therefore come full circle to the single biggest issue on our forecasting horizon: Chinese policy. China is the most important variable for the U.S. dollar at the moment as it can single-handedly tip the global growth balance back towards the U.S., given its expected contribution to global growth (Chart 8). Chart 7...But Not More Important Than Global Growth ...But Not More Important Than Global Growth ...But Not More Important Than Global Growth Chart 8China Really Matters For Global Growth "America Is Roaring Back!" (But Why Is King Dollar Whispering?) "America Is Roaring Back!" (But Why Is King Dollar Whispering?) Our view is that Chinese policymakers are acting as an accelerant to BCA's House View that the Chinese economy will experience a benign slowdown. Risks are skewed towards the downside. We recently dedicated our monthly Crow's Nest Webcast solely to this issue and we highly encourage our clients to listen to it on replay.4 In today's weekly, we briefly assess where our Chinese view stands and then turn to U.S. politics. News Flash: Chimerica Has Been Dead Since 2012 Two critical aspects of our China view are coming together. The first is U.S. policy, which is becoming more aggressive after a year in which Trump showed restraint for the sake of North Korean negotiations.5 The second is China's renewed focus on domestic economic reforms.6 The "symbiotic" relationship between the U.S. and China is in decay, as we have argued since 2012.7 As China's economy grows, so grows its capacity for challenging the United States in the strategic sphere (Chart 9). Meanwhile the two economies have diverged markedly since U.S. households began to deleverage in 2008 (Chart 10). Chart 9China's Capabilities Are Growing China's Capabilities Are Growing China's Capabilities Are Growing Chart 10China No Longer Addicted To U.S. Demand China No Longer Addicted To U.S. Demand China No Longer Addicted To U.S. Demand The mainstream media is about to become more attuned to this reality now that the Trump administration has published a series of high-level reports declaring that U.S. strategy toward China is changing. Here are a few choice quotations: "China is a strategic competitor using predatory economics to intimidate its neighbors while militarizing features in the South China Sea." (Department of Defense, National Defense Strategy, 2018) "Long-term strategic competitions with China and Russia are the principal priorities for the Department." (Department of Defense, National Defense Strategy, 2018) "[High-level bilateral dialogues] largely have been unsuccessful - not because of failures by U.S. policymakers, but because Chinese policymakers were not interested in moving toward a true market economy." (U.S. Trade Representative, 2017 Report to Congress On China's WTO Compliance, 2018) "The United States also will take all other steps necessary to rein in harmful state-led, mercantilist policies and practices pursued by China, even when they do not fall squarely within WTO disciplines." (U.S. Trade Representative, 2017 Report to Congress On China's WTO Compliance, 2018) "The United States ... is seeking fundamental changes to China's trade regime, including the overarching industrial policies that have continued to dominate China's state-led economy." (U.S. Trade Representative, 2017 Report to Congress On China's WTO Compliance, 2018) "China and Russia want to shape a world antithetical to U.S. values and interests. China seeks to displace the United States in the Indo-Pacific region, expand the reaches of its state-driven economic model, and reorder the region in its favor." (President Trump, National Security Strategy of the United States of America, 2017) We expect to find echoes of this tough rhetoric in Trump's State of the Union Address on January 30, which will air as we go to press. Already commentators have declared that the U.S. is entering a "post-engagement" phase in the U.S.-China relationship.8 The U.S. and China will continue to engage. What is important is the Trump administration's shift toward more aggressive economic statecraft. Trump's view, made amply clear on the campaign trail, and now officially U.S. policy, holds that China is a mercantilist as well as a revisionist power and that it has initiated a trade war against the U.S. Thus the real policy change lies not in naming China a "strategic competitor" antithetical to U.S. values, but in declaring that normal "WTO consistent" remedies are no longer sufficient and the U.S. will have to resort to "all other steps necessary." The question is whether the U.S., in adopting unilateral measures, will pursue trade remedies on an item-by-item basis, as it has done so far, or break out of the mold and levy broader tariffs to try to achieve "fundamental changes" as quoted above. Trump's recent tariffs on solar panels and washing machines adhered closely to U.S. institutional procedures and penalized U.S. ally South Korea as well as China: if this is the trajectory that the U.S. intends to take, then markets can breathe a sigh of relief.9 The basic trade data show that the U.S. has continued to expand imports from China despite past incidents of presidents slapping on tariffs (Chart 11). Chart 11China And U.S.: Ships Passing In The Night China And U.S.: Ships Passing In The Night China And U.S.: Ships Passing In The Night However, the U.S. is likely to draw a harder line than that. The same data also show that the U.S. is not gaining much access to the Chinese market over time, while China has greatly diminished its exposure both to exports and to U.S. trade as a whole. Furthermore, the Trump administration is accusing China of trying to gain superior technology from the U.S. in a way that jeopardizes its security and sovereignty in the pursuit of a better strategic position. This is said to include coercion and corruption of U.S. firms in China, favoring the manufacturing sector by squeezing out competition, preferring domestic-sourced goods over foreign goods, and jeopardizing U.S. companies' intellectual property and network security. The key grievances are forced technology transfer, the "Made in China 2025" industrial strategy, "indigenous innovation" rules, and the new Cyber-Security Law.10 A test case for the U.S.'s harder line will be the ongoing investigation into China's intellectual property theft, which is due by August but is expected to elicit action by Trump sooner. Trump has a range of actions he can take either within or without the WTO. Going outside the WTO would give him greater flexibility, for instance, to impose a "fine," as he called it, for the cumulative "big damages" of China's intellectual property theft - but it would also enable China to claim that the U.S. itself is violating WTO trade rules.11 How will China respond to this turn in U.S. policy? It will continue to focus on rebooting its economic reforms. Reform is both necessary for its own interests, as we have outlined in the past, and expedient in that it enables China to try to deflect and delay U.S. pressure.12 This is not to say that China will not retaliate to particular U.S. moves, but simply that it will prefer to minimize conflict unless and until the Trump administration demonstrates via broad and sweeping trade measures that Beijing has no choice but to engage in open trade war. China's recent declarations that it will accelerate economic reforms aimed at trade and investment openness - particularly in financial services but also more generally - are geared toward allaying Washington. Xi Jinping's right-hand economist, Liu He, who is a key figure, made this clear at the World Economic Forum in Davos, where he said that China's reform and opening up this year would "exceed international expectations." Politburo Standing Committee member Wang Yang made a similar point late last year, saying that the "Made in China 2025" program would not discriminate against foreign or private firms.13 Simultaneously, leading technocrats are calling attention to China's vulnerability as it attempts delicate financial reforms. Guo Shuqing of the China Banking Regulatory Commission has warned of "black swan" or "gray rhino" events as he continues with his financial regulatory crackdown, and he has been echoed by the vice-secretary general of the National Development and Reform Commission.14 These statements are prudent - as it is always risky for highly leveraged countries to tinker with financial tightening - and useful because Beijing wants to warn the U.S. against pushing too hard since it is both "making progress" and vulnerable to instability. We certainly expect the reforms to have a significant, adverse impact on China's economic growth this year. In the latest developments, the policy crackdown is spreading to local governments, where fiscal tightening could ensue (Chart 12). Local governments lack stable sources of revenue, have large hidden debts, face an intensifying debt repayment schedule over the next three years, and have recently begun to cancel infrastructure projects under central government scrutiny (in Inner Mongolia, Gansu, and other provinces, and reportedly even in Xi's favored province of Zhejiang). Furthermore, the reforms have involved a crackdown on shadow lending that has sent non-bank credit into a steep decline (Chart 13). While some market estimates suggest that bank loans could grow by 13%-15% in 2018, such estimates cut against the policy grain. Assuming that non-bank credit does not grow any faster in 2018 than it did in 2017 (9.7%), China can afford to let new bank loans grow at 9.7% and still keep its total social financing (TSF) at its five-year annual average growth rate of 14.5%. Policymakers will not be able to soften their line easily, as several key players are newly appointed and must establish their credibility from the outset. Chart 12Local Government Finances Under Scrutiny Local Government Finances Under Scrutiny Local Government Finances Under Scrutiny Chart 13Shadow Bank Crackdown To Weigh On Credit Growth Shadow Bank Crackdown To Weigh On Credit Growth Shadow Bank Crackdown To Weigh On Credit Growth Our view is that Trump will harden the line despite China's promises both of deeper internal reforms and greater opening up. But the timing is impossible to predict. The real fireworks may be reserved until closer to the U.S. midterm election, as campaigning heats up in the fall. That would be the time for Trump to try to rally his voters by means of a clash of economic nationalisms with China. Beyond the top U.S. grievances cited above, we would highlight the U.S. approach toward China's state-owned enterprises (SOEs). Preferential policies for SOEs are a structural issue that the U.S. is now criticizing. At the party congress in October, President Xi Jinping pledged not only to reform the SOEs but also to make them bigger and stronger. Hence there is a potential collision course. The precise implementation of China's reforms could determine whether the U.S. pursues the issue further. China's State-Owned Assets Supervision and Administration Commission has so far reaffirmed Xi's comments at the party congress but, in keeping with the subtlety of Xi's policies, has also suggested there may be room to intensify reforms. The combination of Trump's economic policies, and China's intensifying reforms, will result in the U.S. economy outperforming expectations relative to China while U.S. corporations will outperform their Chinese counterparts (Chart 14). China will experience higher volatility, both in general and in relation to the U.S., and Chinese companies that suffer from reforms will underperform U.S. companies that benefit most from tax cuts (Chart 15). This is ironic given the popular narrative that the U.S. is suffering from chaotic democratic politics while China's centralized authoritarian model reigns triumphant. Of course, we do think Xi has key capabilities to drive reforms further in his second term than in his first, so these U.S.-China divergences will continue for the next 6-to-12 months at least. China's slowdown and increase in equity volatility should create a policy response: more fiscal spending and credit expansion. The comparison of relative U.S. and Chinese credit impulses suggests that China extends more credit as relative volatility rises (Chart 16). Our view, however, is that China's credit impulse will continue disappointing this year as Beijing prioritizes reform over growth. The credit numbers in January are the next data set to watch, in addition to the aforementioned local government spending. Investors should brace for more uncertainty as the Lunar New Year approaches (Feb. 16). Chart 14U.S. Earnings Surprise Relative To China U.S. Earnings Surprise Relative To China U.S. Earnings Surprise Relative To China Chart 15Xi Adds Volatility Relative To Trump Bump Xi Adds Volatility Relative To Trump Bump Xi Adds Volatility Relative To Trump Bump Chart 16China's Credit Impulse Disappoints China's Credit Impulse Disappoints China's Credit Impulse Disappoints Bottom Line: The Trump administration has issued an ultimatum of sorts on trade. Yet China claims to be redoubling its efforts at reforming and opening up its economy - party to deflect the pressure. We are almost certain that Trump will take further punitive actions, but it is too soon to say when or if he will engage in sweeping measures that threaten to destabilize China and thus initiate a trade war. The political context heading into the U.S. midterm vote will be crucial. Is America Having A Macron Moment? It is unfortunate when one's forecast is challenged only weeks after it is conceived. But that appears to be happening to our view, articulated in late December, that investors should expect no significant legislation to come out of Congress following the passage of the tax cuts.15 Bad news for our forecast is perhaps good news for U.S. policy initiatives and the overall quality of U.S. governance. President Trump has softened his stance on immigration, stating that he would be willing to grant citizenship to roughly 1.8 million "Dreamers" - young adults who came to the U.S. as illegal immigrants.16 Clearing the immigration hurdle would mean that Congress can focus on passing a budget for FY2018 that would see both defense and discretionary spending levels significantly raised. It would also relegate the never-ending saga of the debt ceiling to the dustbin, at least for the duration of this political cycle. Trump also followed up his immigration proposal by sketching a $1.7 trillion infrastructure investment plan (albeit a vague one). Chart 17Bipartisanship = Steeper Bull Market? Bipartisanship = Steeper Bull Market? Bipartisanship = Steeper Bull Market? Could we be approaching a "Macron moment" in U.S. politics? A moment when the "silent majority" rises up and sends a message to politicians that it has had enough of polarizing extremes? Previous such moments have included President Reagan's collaboration with congressional Democrats and President Clinton's with Republicans, which underpinned that glorious stock market run between August 12, 1982 and March 24, 2000 (Chart 17). Both presidents passed significant economic and social reforms during that time. Chart 18Peak Partisanship? Peak Partisanship? Peak Partisanship? Chart 19Independents On The Rise Independents On The Rise Independents On The Rise Yes, polarization remains at extreme levels (Chart 18), but that could also mean that it is reaching its natural limits. Rather than dwell on the high levels of polarization, which are baked into the "expectations cake," we would point out that the percentage of Americans who identify as independents is now fast approaching the combined total who identify as either Republican or Democrat (Chart 19). Ominously for Republicans - who hold both the House and the Senate - midterm electoral sweeps have almost always occurred along with the share of independents crossing the 40% mark (Table 1). Table 1Sweep Elections Coincide With High Independent Affiliation "America Is Roaring Back!" (But Why Is King Dollar Whispering?) "America Is Roaring Back!" (But Why Is King Dollar Whispering?) Meanwhile, President Trump's conciliatory tone on immigration was met with howls of protest from conservative activists. This is despite the fact that his proposal essentially exchanges leniency for Dreamers for considerably tougher immigration laws in general, which would align the U.S. with its developed market peers.17 Conservative activists are, however, massively out of step with the rest of America. Polls show that immigration is not high on the list of priorities for most Americans, and that most Americans continue to believe both that immigration is a positive and that immigration intake should remain at current levels (Chart 20). Chart 20Americans Are Neither Anti-Immigrant Nor All That Concerned About Immigration "America Is Roaring Back!" (But Why Is King Dollar Whispering?) "America Is Roaring Back!" (But Why Is King Dollar Whispering?) Our gut call that President Trump was itching to move to the political middle appears to be correct.18 Whether this becomes investment relevant will ultimately depend on whether the Democrats reciprocate. If Democrats go by data, they will. The government shutdown imbroglio has cost them a double-digit lead in the generic congressional ballot (Chart 21). As a political strategy, the shutdown was a miserable failure. Furthermore, the 2016 election stands as clear evidence that "outrage" does not work. Clinton picked up almost a million more voters in California than President Obama yet failed to beat his performance where it mattered: the Midwest. If Democrats continue to run on a "resistance" platform in order to satisfy their activist base, they will fail to win the House. Chart 21Government Shutdown An 'Own Goal' For Dems Government Shutdown An 'Own Goal' For Dems Government Shutdown An 'Own Goal' For Dems Ironically, the best strategy for Democrats ahead of the midterm election is to cooperate with Trump. The swelling ranks of independent voters will reward them if they do so. That same strategy, however, will paradoxically boost Trump's chances in 2020. Bottom Line: The market is, of course, ideologically nihilist. But a move to the middle - which benefits everyone involved except House Republicans - would be positive for stocks and the economy. Key bellwethers going forward are how Democrats react to Trump's immigration proposal and whether Trump moves to the middle on trade deals, starting with NAFTA, whose sixth round of negotiations just ended inconclusively (although not negatively) in Montreal. Investment Implications From the perspective of global asset allocation, the most important issue today is Chinese economic and regulatory policy. Yes, U.S. inflation is important, but whether it moves the dollar - and therefore commodities and EM assets - will depend on the pace of the current Chinese slowdown. China is therefore the most "diagnostic variable" in 2018. If our House View that inflation is coming back in the U.S. is right and our Geopolitical Strategy view that risks to growth in China are to the downside is also right, then investors should go long the U.S. dollar and underweight EM and EM-leveraged assets. If, on the other hand, we are wrong, then investors should load up with EM risk assets to the hilt right now. It is that simple. For what it is worth, we are putting our moderate-conviction view to the test and opening a long DXY trade. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 But on a completely unrelated note we would like to remind our clients that, over the past 24 months, Mr. Mnuchin was the executive producer of How to Be Single, Midnight Special, Batman v. Superman: Dawn of Justice, Keanu, The Conjuring 2, Central Intelligence, The Legend of Tarzan, Lights Out, Suicide Squad, Sully, Storks, The Accountant, Rules Don't Apply, The Lego Batman Movie, Fist Fight, CHiPs, Going in Style, Unforgettable, King Arthur: Legend of the Sword, Wonder Woman, The House, Annabelle: Creation, The Lego Ninjago Movie, and The Disaster Artist. 2 Please see BCA Geopolitical Strategy Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 3 Please see BCA Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, and Weekly Reports, "Trump and Trade," December 9, 2016, and "The Elusive Gains From Globalization," dated November 25, 2016, available at gis.bcaresearch.com. 4 Please see BCA Research Webcasts, Geopolitical Strategy Crow's Nest, "China: How Is Our View Working Out?" dated January 25, 2018. 5 Please see BCA Geopolitical Strategy Weekly Report, "BCA Geopolitical Strategy 2017 Report Card," dated December 20, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, and "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, and "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 8 Please see Daniel H. Rosen, "A Post-Engagement US-China Relationship," Rhodium Group, January 19, 2018, available at rhg.com. 9 In fact, in the case of washing machines, the U.S.-based GE Appliances stands to gain from the tariff and has been owned by China's Haier Electronics Group since 2016. 10 Several clients have asked us about China's Cyber-Security Law, which has been in the process of implementation since July 2017 and will go fully into effect by the end of 2018. The law is meant to give the Chinese government the option of exercising control over all networks in the country. State security agencies are deeply involved in its enforcement and oversight. Foreign business interests fear that the law's new obligations will be onerous and potentially damaging - including potential violations of corporate security over intellectual property, source code, supply chain details, and data storage and transmission. 11 Please see Stephen E. Becker, Nancy Fischer, and Sahar Hafeez, "Update on US Investigation of China's IP Practices," Lexology, January 8, 2018, available at www.lexology.com. 12 Please see BCA Geopolitical Strategy Special Report, "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017, available at gps.bcaresearch.com. 13 Wang has served as the top interlocutor with the U.S. in the U.S.-China Comprehensive Economic Dialogue. 14 Please see "China eyes black swans, gray rhinos as 2018 growth seen slowing to 6.5-6.8 percent: media," Reuters, January 28, 2018, available at www.reuters.com. "Gray rhinos," coined by author Michele Wucker, refer to high-probability, high-impact risks, whereas the proverbial "black swan" is a low-probability, high-impact risk. These terms have both been making the rounds more frequently in Chinese policymaking circles since last year. 15 Please see BCA Geopolitical Strategy Special Report, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 16 What is fascinating about Trump's statement is that he cited the 1.8 million figure. There are actually only about 800,000 people who officially participated in President Obama's Deferred Action for Childhood Arrivals program. But estimates suggest that another 1,000,000 young adults are in the U.S. illegally, yet did not register. Trump has come under criticism from conservative, anti-immigration groups for essentially moving the goalposts beyond what even the Democrats had wanted. 17 Canada, for example, has a purely merit-based immigration system that is considerably tough on family reunification. (Reunification has even been suspended because of a large backlog.) In Europe, family reunification laws are extremely strict. Even spouses are not automatically allowed residency status in several major European countries unless they fulfill various conditions. 18 Please see footnote 2 above.