Diplomacy/Foreign Relations

Highlights Investors are becoming less concerned about China's growth outlook, but there is no sign of euphoria. Monitor three risk factors that could disrupt the positive growth outlook and the bull market in Chinese stocks. For now, the risks appear reasonably contained, and the lack of a complacency in the marketplace means it is too early to bet against the herd. Remain positive and stay invested. Feature The latest purchasing managers surveys released early this week confirm that the Chinese economy remains buoyant. The manufacturing and service PMIs from both official and private sources remain comfortably in expansionary territory, and there are no signs of a material deterioration from the readings of the sub-indices. Improving growth also appears to be reflected in the stock market. Chinese investable equities have rallied by over 30% so far this year, beating the major global and EM benchmarks (Chart 1). Despite the improvement in the growth numbers and the rally in stock prices, there is no sign of euphoria among investors with respect to China. On the contrary, Chinese stocks' multiples are still among the lowest of the major global bourses (Chart 2). Importantly, ETFs investing in Chinese assets are still witnessing net redemptions: China-focused ETFs listed in the U.S. and Hong Kong have been witnessing constant net capital outflows since 2013 (Chart 3). Even in the first half of this year, these ETFs have continued to lose capital despite rising stock prices - which means retail investors have not participated in the rally. Attractive valuations and lack of "irrational exuberance" suggest the rally in Chinese investable stocks should have further to run. Chart 1Chinese Equities Have Outperformed... Chinese Equities Have Outperformed... Chinese Equities Have Outperformed... Chart 2...But Still With Much Lower Multiples ...But Still With Much Lower Multiples ...But Still With Much Lower Multiples Chart 3... And Net ETF Redemptions China: What Could Go Wrong? China: What Could Go Wrong? Overall, we remain positive on both Chinese equities and the economy's cyclical outlook, and see limited downside risks in the near term, as discussed in detail in recent weeks.1 However, as growth and stock market performance have been largely in line with our expectations, it is always useful to reflect on risk factors. We see three potential risks that could upset the economy and the ongoing rally in Chinese stocks that need to be closely monitored. Will The Trump Wildcard Strike Again? There are increasing signs that tensions between the U.S. and China are on the rise again after a period of relative tranquility. The first round of U.S.-China Comprehensive Economic Dialogue (CED) resulted in no material progress or concrete plans to improve bilateral trade imbalances. U.S. President Donald Trump has continued to pull "China hawks" into his trade policy team, naming Dennis Shea, well known for being highly critical of China's trade practices, as deputy U.S. Trade Representative. Furthermore, the U.S. State Department recently approved a major weapon package to Taiwan, the first arms sales to the Island since 2015. More recently, President Trump has openly accused China of not helping deal with the North Korea nuclear issue after the country tested an intercontinental ballistic missile (ICBM) that it claims can reach continental America. In addition, the Trump administration is reportedly planning trade measures to force Beijing to crack down on intellectual-property theft and ease requirements that American companies share advanced technologies to gain entry to the Chinese market. Overall, it is widely viewed that the brief "honeymoon" in U.S.-China relations following the April Summit between the leaders of the two countries has decisively ended, and the odds for protectionism tactics against Chinese products have increased. The "Trump wildcard" has always been a key risk with respect to our outlook for China2 - the latest developments suggest this risk remains firmly in place. President Trump and his inner circle appear genuinely convinced that punitive tactics could solve the country's chronic trade deficit. Moreover, President Trump has been increasingly bogged down by domestic policy, and he may lash out on the international front in an effort to boost his popularity. Furthermore, the U.S. President has few legal constitutional constraints to using tariffs against trade partners, giving him maneuvering room. From a big-picture perspective, the conflict between the U.S. and China has deep ideological and geopolitical roots, which are even harder to deal with than trade issues. Chart 4Steel Is No Longer Relevant For ##br##U.S.-China Trade China: What Could Go Wrong? China: What Could Go Wrong? Nonetheless, we maintain our guarded optimism that unilateral protectionism measures will not materially undermine Chinese exports, at least in the near term. On the U.S. side, even though President Trump has toughened his rhetoric on China and trade issues of late, it is still far less extreme compared to the promises he made on the campaign trail, in which he pledged to slap a 45% tariff on all imports from China and to label the country a currency manipulator on "day one." So far, the U.S. administration has mainly been focusing on specific industries, particularly steel, rather than broad-based tariffs, the impact of which should be marginal. For example, China accounts for only 3% of American steel imports. Sales to the U.S. account for less than 1% of China's massive steel output (Chart 4). In other words, steel appears to be a highly symbolic sector in Trump's trade policy, but the real impact on China-U.S. trade is negligible. On the Chinese side, the authorities have hard-drawn redlines on political and sovereign issues, but have much greater flexibility on trade-related issues. Chinese officials understand that the country's large surplus with the U.S. puts it at a near-term disadvantage in a trade war, and therefore will likely cave to pressure from the U.S. Moreover, the sectors that President Trump has been complaining about, namely steel and some other base metals, are the same sectors the Chinese government wants to restrict. Therefore, China will not fight for its own "out of favor" industries to disrupt the broader picture in exports. Taken together, President Trump's trade policy has once again become unpredictable, and some punitive measures on specific products appear likely in the near term. However, we still assign low odds of a drastic escalation in trade frictions, and we expect the Chinese authorities to refrain from tit-for-tat retaliation that could lead to a trade war. Protectionism risks, however, will remain a long-term structural issue that complicates the global trade and growth outlook. Deflationary Pressures And The Risk Of Policy Overkill? Chart 5Headline CPI Is Set To Drop Further Headline CPI Is Set To Drop Further Headline CPI Is Set To Drop Further A key feature of the Chinese economy is strong disinflationary/deflationary pressures, despite robust growth and job creation. Headline inflation to be released next week will likely once again surprise to the downside, mainly due to food prices (Chart 5). Wholesale prices of agricultural products have weakened substantially in recent months, pointing to sharply lower food CPI. Core CPI remains around 1%, underscoring incredibly low inflationary pressures. The key challenge for the Chinese authorities is figuring out how to manage economic policies to achieve the delicate balance between growth and disinflation/deflation. We have long viewed that one of the critical reasons behind China's sharp growth deterioration between 2012 and 2015 was a policy mistake, in which the authorities allowed monetary conditions to tighten dramatically. We are hopeful that the authorities have realized the cost of policy overkill, and will avoid similar mistakes down the road, but the risk certainly cannot be dismissed entirely. For now, we see low odds of policy overkill that could lead to price deflation and negative growth surprises. First, as growth has improved, some policy tightening is warranted. The authorities recently reported that the economy added 7.35 million new jobs in the first half of the year, far exceeding the government's target, pushing the registered urban unemployment rate to 3.95%, the lowest in recent years. In fact, the People's Bank of China may still be behind the curve, meaning that further tightening is simply a "catch-up" and is not immediately restrictive. Chart 6Another Sharp Rally ##br##In The Trade Weighted RMB is Unlikely Another Sharp Rally In The Trade Weighted RMB is Unlikely Another Sharp Rally In The Trade Weighted RMB is Unlikely Second, a major factor behind China's drastic tightening in monetary conditions in previous years was the sharp rally in the trade-weighted RMB, which appreciated by almost 30% between mid-2011 and early/late 2015 - a massive deflationary shock to Chinese exporters (Chart 6). Looking forward, it is extremely unlikely that the PBoC will allow the RMB to rise by a similar magnitude anytime soon. Finally, from investors' perspective, producer output prices are more important to watch for pricing power and profitability. On this front, PPI inflation has also rolled over and will likely continue to downshift, but will not turn to outright deflation in our view. It is important to note that the sharp decline in producer prices in previous years was due to a multi-year deterioration in Chinese growth, which has historically been an anomaly. The only other period in China's post-reform history with falling PPI happened in the late 1990s in the aftermath of the Asian crisis (Chart 7). In other words, falling PPI only occurs under rather extreme growth difficulties. Our model suggests that PPI inflation may decelerate to 3% by year end. Our PPI diffusion index, which measures the percentage of industrial sectors experiencing rising prices, suggests the majority of sectors are still witnessing higher prices both compared with previous months and a year ago (Chart 8). We are monitoring the PPI diffusion index closely to heed a leading signal on corporate pricing power and overall deflationary pressures in the corporate sector. Chart 7Producer Prices: A Historical Perspective Producer Prices: A Historical Perspective Producer Prices: A Historical Perspective Chart 8PPI Watch PPI Watch PPI Watch Bottom Line: A policy mistake of overtightening by the Chinese authorities remains a key threat to the near-term growth outlook, but is not our base case scenario. The Resumption Of The Dollar Bull Market? The U.S. dollar has rapidly dropped out of favor among global investors. The dollar index has fallen by 10% so far this year, the weakest among the major currencies. The weak U.S. dollar has provided a Goldilocks scenario for both the Chinese economy and financial markets: a weaker dollar depreciates the RMB in trade-weighted terms, which is reflationary for the Chinese economy. For investors, the broad dollar weakness also alleviates downward pressure on the CNY/USD, and a stable CNY/USD in turn reduces investors' anxiety on China's macro conditions, pushing up stock prices. This Goldilocks scenario could once again be disrupted if the dollar bull market resumes, and the positive feedback loop goes into reverse. A stronger dollar tends to strengthen the trade-weighted RMB, which is bad news for exporters. Meanwhile, it could rekindle downward pressure on the CNY/USD, re-intensifying domestic capital outflows, which could be viewed as a sign of China's macro troubles. Fears of an economic hard landing would quickly resurface. In our view, Chinese stocks are more vulnerable if the dollar's strength resumes, but the real damage on the broader economy should not be material. It is highly unlikely that Chinese policymakers would allow the trade-weighted RMB to rise alongside the dollar, and will tighten capital account controls to stop domestic capital flight. Chinese equities will suffer in this scenario, as investors' risk aversion increases. However, so long as the Chinese economy and corporate profits do not suffer a major relapse, the rally in stocks should eventually resume. All in all, the three risk factors should be closely monitored in the coming months, especially if investors become increasingly comfortable with the Chinese growth outlook. For now, the risks appear reasonably contained, and the lack of a complacency in the marketplace means it is too early to bet against the herd. We remain positive on Chinese growth, and favor Chinese equites both in absolute terms and against global/EM benchmarks. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Reports, "China Outlook: A Mid-Year Revisit", dated July 13, 2017, "Rising Odds Of PBoC Rate Hikes", dated July 20, 2017, and Special Report, "Focusing On Chinese Money Supply", dated July 27, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China: The 2017 Outlook, And The Trump Wildcard", dated January 12, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights The G20 summit highlighted our theme of multipolarity, which encourages global instability; U.S.-China tensions have resumed their escalation after a brief pause; The Middle East is still a "red herring" for investors this year, but tail risks are rising; Any negative impact on oil production from these risks should be minor; Iran stands to benefit; Egypt is a buy on the back of cyclical recovery and Saudi support. Feature For the first time in the history of G20 summits, the "sherpas" (emissaries) who prepared the event failed to reach any notable policy agreements. Allegedly, the only policy that the U.S. administration endorsed prior to the summit was women's entrepreneurialism, Ivanka Trump's pet project. Why should investors care? G20 meetings have always been abstract, retroactive (as opposed to proactive), and barely able to move the markets. But they have occasionally mattered. The summits in Washington D.C. (November 2008) and London (April 2009) set the agenda for economic stimulus and global financial regulatory reform that brought the world back from the brink of abyss. The London summit, in particular, set the stage for coordinated, global, fiscal policy that reflated the economy. At the September 2009 Pittsburgh summit, the G20 replaced the Western-dominated G8 as the premier economic governance platform. (The latter is now the G7 because of Russia's exclusion after annexing Crimea.) The idea behind the expanded forum was to give emerging markets like China, India, and Brazil a say in the global economic architecture. It was the forum's expansion that ultimately doomed its effectiveness. To our knowledge, no multilateral framework has ever successfully coordinated global affairs. Global stability has always been underpinned by hegemony, which is why we have warned our readers since 2011 that emerging global multipolarity - caused by America's relative geopolitical decline - would lead to instability.1 The press will inevitably blame President Trump's "America First" for the failures of the G20. We do not disagree, but there is more to it than just politics. "America First" is a natural political reaction to the reality of American geopolitical decline. It is also a reaction to nearly two decades of foreign policy decisions to commit massive amounts of U.S. hard and soft power to pursuing nation-building policies in the Middle East. As such, "America First" is a symptom, not the cause, of global multipolarity. The "Trump Doctrine" could indeed be highly destabilizing, if followed through to its logical conclusion.2 Ostensibly, President Trump seeks to renegotiate global security and economic arrangements that have taken advantage of American magnanimity. But it was America that initially designed these arrangements, at the height of its power in the immediate aftermath of the Second World War, to secure its own interests. Institutions like NATO, the IMF, and the World Bank underpin, they do not undermine, American hegemony. Without these institutions, American allies will seek their own negotiated arrangements more freely and frequently with U.S. adversaries, slowly eroding Washington's global influence. Over the long term, the Trump Doctrine could also undermine the U.S. dollar's status as the global reserve currency. The dollar's reserve currency status is a privilege that monetizes American geopolitical hegemony. America's allies are essentially already paying for American hegemony: through their investments in U.S. dollar assets.3 Chart 1 illustrates this so-called "exorbitant privilege."4 Foreigners hold U.S. assets because of the size of the economy, the sustainability of the market, and its deep liquidity, but also because the U.S. provides them with assurances of peace through security. If Washington raises barriers to its markets and becomes a doubtful provider of security, states may gradually see less of a payoff in holding U.S. assets and thus diversify more rapidly. They could also be forced to diversify by new security guarantors, regional hegemons, and geopolitical bullies. Chart 1Exorbitant Privilege G19 G19 The concept of exorbitant privilege - and its economic benefits - cannot easily be explained to voters. What voters understand is that China's rapid industrialization has been accomplished at the cost of American manufacturing jobs. Candidate Trump successfully tapped into this angst during the campaign. President Trump, however, initially shied away from seriously applying the "America First" doctrine. The April Trump-Xi summit at Mar-a-Lago was hailed as evidence that fears of global protectionism were overblown and that the "globalist" camp of advisers in the White House were prevailing over the nationalists. As we expected, however, the détente did not last long. Over the past several weeks, China and the U.S. have clashed over several key issues: Taiwan: On June 29, the U.S. announced that it will sell $1.42 billion worth of arms to the island nation.5 Secondary sanctions: At the end of June, the Trump administration sanctioned a Chinese shipping company, bank, and two citizens for their ties to North Korea. Human rights: Also at the end of June, the U.S. State Department announced it would list China among the worst human trafficking offenders, which could trigger punitive actions and complicate trade negotiations in the future. Steel tariffs: President Trump asked the Department of Commerce back in April to study whether steel imports were harming national security, under the authority of the Trade Expansion Act of 1962, and a potential decision by Trump on tariffs is due within days. While China only accounts for 2% of U.S. steel imports, new tariffs could set in motion more protectionist measures that target additional industries. Sovereignty claims: The U.S. Navy and Air Force have made sojourns into disputed maritime areas. The navy conducted a "freedom of navigation" operation in the South China Sea in July, with USS Stethem steaming within 12 nautical miles of Triton Island. The air force also conducted separate missions sending B-1 bombers over the South China Sea, and over the Korean peninsula and East China Sea along with Japanese and South Korean F-15 fighter jets. This flurry of brinkmanship has largely emanated from Washington, not Beijing. As Trump's domestic political agenda stalled - with both health care and tax reform now in doubt - the administration has set its sights on the policy realm where the U.S. president has few constraints: foreign and trade policy. That is not to say that Beijing has not invited these actions. It has continued to militarize its artificial islands in the South China Sea and has failed to impose meaningful sanctions on North Korea. The Trump administration is clearly disappointed that its Mar-a-Lago summit failed to produce any tangible effect on these fronts, particularly with North Korea having launched a purported intercontinental ballistic missile for the first time. It is the Trump administration itself, however, that is to be blamed for China's lack of enthusiasm. One of the first acts of the Trump administration was to bring into question Washington's "One China" policy. As we remarked at the time, this would have serious implications for Sino-American policies. Defending sovereignty is a core pillar of the Chinese Communist Party; it is part of its "creation myth," and this is nowhere truer than in regard to Taiwan. When Trump brought into question the "One China" principle, he signaled to Beijing policymakers that Washington is not to be trusted. North Korea is both formally and in practical terms a Chinese ally. Though the Xi administration evidently wishes that the North was not providing the U.S. with excuses to enhance the American position on the Korean Peninsula, nevertheless it is longstanding Chinese policy to avoid destabilizing the North Korean regime. A collapse, possibly followed by a unified Korean Peninsula, could benefit the U.S. in the region. In other words, China will pressure the North enough to encourage a new round of talks but not enough to risk fracturing the regime. Chart 2Mar-A-Lago Summit Is Over Mar-A-Lago Summit Is Over Mar-A-Lago Summit Is Over What investors are seeing today is the impact of words - "signaling" to be technical - in geopolitics. To be fair to President Trump, he has not pursued a revolutionary foreign policy yet. However, his mere words - literally dithering on NATO's Article V and calling into question the "One China" policy - have pushed other global powers into realignment. The rest of the world takes Trump very seriously because he may one day act on his unorthodox policies, or because American voters may elect someone in the future who will. The likely result is further erosion of U.S. global influence. Notably, the U.S. president stood alone on several crucial global issues at the G20 summit in Germany, making it look more like a "G19" summit. American isolation makes sense from Trump's short-term, domestic-political vantage. In the long term, however, it accelerates the drift toward geopolitical multipolarity and thus encourages global instability. Over the near term, we are particularly concerned that Sino-American tensions could escalate and spill over into a trade war. Since Donald Trump's election, and particularly since the Mar-a-Lago summit, the market has largely priced out economic tensions between the two superpowers, with China-exposed S&P 500 equities outperforming the market (Chart 2). We would bet against the continuation of this trend. Lack of cooperation over North Korea is a sign that the Sino-American relationship is systematically broken. Middle East Update: Watch Power Vacuums In Iraq And Syria At the beginning of this year, we made a forecast that geopolitics in the Middle East would not be investment relevant.6 So far we are correct. However, we continue to worry that vacuums in Iraq and Syria - in the Sunni-dominated territories formerly occupied by the now-collapsing Islamic State - could become greater sources of instability in the region. We are particularly concerned about three potential flash points: North Iraq, North Syria, and East Syria. East Syria In East Syria, the Syrian Arab Army (SAA) loyal to President Bashar al-Assad - as well as its Lebanese Shia ally Hezbollah - has aggressively moved to establish control over the Syrian-Iraqi border. As indicated on Map 1, SAA forces have created a land-bridge through Islamic State territory to Tayyara on the Iraqi border. This has put SAA troops in close proximity to "Free Syrian Army" (FSA) forces operating in the southeast of the country. Map 1Syria's Army Has Created A Land-Bridge To Iraq G19 G19 The FSA was created by the U.S. and its allies. Its forces are trained by the U.S., and the U.S. Air Force provides cover for its territory. The recent downing of Syrian fighter jets and Iranian drones have occurred near the U.S. FSA base, which is based in the proximity of the FSA stronghold at Al Tanf. Without committing land troops, however, the best the U.S. can hope for is to limit SAA incursions into FSA-held territory. The push by SAA and Hezbollah to the Iraqi border creates an all-important land-bridge from Iran to the Mediterranean. It allows Tehran to reinforce Assad's SAA and Hezbollah by land, rather than relying on sea routes - which can be intercepted by the U.S. and Israel's superior naval capabilities in the Mediterranean - or through air. Not only will Iran and Shia-dominated Iraq be able to supply Assad with weapons, but also with troops. After a five-year war of attrition, the main resource that has been depleted on all sides is manpower. A significant influx of "fresh blood" means that the power balance will shift more easily in favor of Assad. Following the collapse of the Islamic State in Mosul, Iraq will be able to deploy significant resources from its Shia militias to Syria. This could be the game changer that ends the conflict in Syria in Assad's favor over the next 12 months. The SAA penetration to Tayyara has now set up the next target: Al Bukamal to the north and also on the Iraqi border. From there, the SAA will be able to round back deep into Islamic State territory and capture Deir ez-Zor. This will give Assad control over most of Syria's border with Iraq as well as the country's highway infrastructure. It will also pin the U.S.-backed FSA to a largely irrelevant corner of Syria. The success of Iranian and Russian-backed SAA in Eastern Syria is very important for the geopolitics of the region. By creating a land-bridge between Iran and the Mediterranean, Syrian forces have now opened up the possibility of one day hosting massive natural gas and oil pipeline infrastructure that would link natural gas from the Persian Gulf, developed jointly by Qatar and Iran, and oil from Iran and Iraq to European markets (Map 2). Map 2The Path Is Opening For Iranian Pipelines Through Syria G19 G19 Such an alternative route to Iranian energy exports would give Tehran an upper hand over Saudi Arabia and its GCC allies. In a hypothetical conflict scenario between Iran and Saudi Arabia, for example, Tehran would be more willing to try to close shipping in the Straits of Hormuz if it possessed an alternative route for energy exports. This is clear to Saudi Arabia, which is why it has lashed out against Qatar in recent weeks. The main Saudi demand of Qatar is that it abandon its pro-Iranian foreign policy. It is becoming clear to Saudi Arabia that Iran's power is set to grow in the wake of the Islamic State's defeat in Iraq and Syria. As such, Saudi Arabia is trying to tie loose ends in its own coalition, starting with Qatar. Despite the reported Trump-Putin ceasefire agreed at the G19, U.S. and Russian forces could still become entangled as their proxies battle in the strategic regions near the Syrian-Iraqi border. SAA troops have also begun to operate near Raqqa, where the Kurdish forces supported by the U.S. are currently encircling the Islamic State capital. Final stages of wars tend to be erratic and even more violent. As belligerents glimpse the end of conflict they rush to seize as much territory as possible before negotiations begin. This is effectively what is happening in East Syria and around Raqqa today. Northern Syria In the Kurdish dominated northern Syria, the People's Protection Units (YPG) have massively increased the territory under their control. Supported by the U.S., YPG have encircled Raqqa and will soon defeat the Islamic State in the North. Assad's SAA will concede Raqqa in order to move onto the more strategic Resafa and Deir ez-Zor, effectively abandoning northern Syria to the Kurds to focus on establishing the land-bridge with Iraq. Turkey, however, is not interested in conceding northern Syria to YPG. The latter are allied to the Kurdistan Workers' Party (PKK) that Ankara considers a terrorist organization. With SAA focused on controlling population centers and the Syrian-Iraqi border, northern Syria will descend further into Kurdish domination. This would give PKK militants a large territory from which to regroup and resupply operations in Turkey. It is therefore a real possibility that Turkey will invade YPG-controlled northern Syria as soon as the operations against the Islamic State end. This will put the U.S. into a difficult position. On one hand, Turkey is a NATO ally. On the other, the Kurds are informal U.S. allies. The YPG have fought valiantly against the Islamic State and are perhaps the group most deserving of thanks for the defeat of its so-called Caliphate. Northern Iraq In northern Iraq, a similar dynamic has emerged where the Kurds have benefited the most from the rise of the Islamic State (Map 3). Operations in Mosul will soon end the Islamic State's dominion over parts of Iraq, which will allow Iraqi forces to focus on two tasks. First, resupplying Assad's SAA with weapons and troops. Second, turning to Kurdish gains in the north, particularly in the city of Kirkuk. Map 3Kurdish Gains Threaten Conflicts With Iraqi Government ... And Turkey G19 G19 Iraqi Kurds, for their part, have called an independence referendum for September 25, 2017. President Masoud Barzani will not necessarily proclaim an independent Kurdistan following the referendum. The exercise could be a bid to negotiate more autonomy with Baghdad or a pre-election ploy to secure a majority in upcoming general elections and bolster the eventual presidential bid of his nephew, Nechirvan Barzani (current Prime Minister of Iraqi Kurdistan). Iraqi Kurds may be able to find some sort of an arrangement with Baghdad for greater autonomy. The problem is that both sides claim parts of the region. Kirkuk, for example, is not officially part of Iraqi Kurdistan. However, Kurds see it as their ancient capital and thus seized it in June 2014 as a preventative move to ensure that it did not fall into the hands of the Islamic State. Not only is Kirkuk a major Iraqi population center, but it is also a significant oil-producing region. Investment Implications Over the next several months, we would expect tensions in these three geographies to increase. Given the proximity of Russian, Iranian, Turkish, and American forces, we would expect the probability of accidents to rise significantly. This could temporarily move the markets and assign some geopolitical risk premium to oil prices. However, investors should realize that the regions involved are not major producers of oil, aside from Iraqi Kurdistan where we do not expect large-scale warfare. As such, any effect on oil production would be a minor blip in the global supply. Over the long term, the clear winner in the region remains Iran. Bashar al-Assad, Iran's ally in Syria, will stay in power. It is also clear that the Sunni Islamic State Caliphate will disappear, giving back the Shia-dominated Iraqi government control over its territory. For Saudi Arabia, this is a reality that cannot be changed at the moment. As we have pointed out before, low oil prices are a constraint to war.7 They reduce government revenue and force leaders to focus on domestic stability. A major conflict between Saudi Arabia and Iran is therefore unlikely. However, Saudi Arabia will respond by building a Sunni alliance against Iran. With Syria and Iraq now in the Iranian sphere, the imperative for Saudi Arabia is to counter Iranian regional hegemony through alliances. Egypt will remain a clear beneficiary of this strategy. The country is already the Middle East's candidate for the "too big to fail" moniker. Its population, economy, demographics, and security challenges all make it the main candidate for chief regional security risk. As such, it will continue to receive support from the international community. For Saudi Arabia, Egypt is a way to diversify its security portfolio away from the aloof United States. As such, we would expect the Saudis to continue to prop up the Egyptian economy with loans and grants in return for being able to call on the Egyptian military in time of need. Given a cyclical recovery in Egypt, which BCA's Frontier Markets Strategy has recently elucidated, this creates a structural buying opportunity in the country's equity market.8 Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Oleg Babanov, Editor/Strategist EM Equity Sector Strategy obabanov@bcaresearch.co.uk 1 The closest the world ever got to a powerful and effective multilateral structure was the nineteenth-century "Concert of Europe," which kept general peace in Europe for a century (1814-1914), but at the cost of dividing up the rest of the planet into imperial spheres of influence where European states could play out their mercantilist rivalries. Ultimately, even that architecture crumbled as the British hegemony that underpinned it weakened after the 1870s. 2 Please see BCA Geopolitical Strategy Weekly Report, "The Trump Doctrine," dated February 1, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Monthly Report, "The Socialism Put," dated May 11, 2016, available at gps.bcaresearch.com. 4 While the U.S. runs a massively negative net international investment position, its net international income remains positive. In other words, foreigners receive almost nothing for holding U.S. assets, while the U.S. benefits from risk premia in foreign markets. 5 The deal is not particularly significant in a military sense, and it is smaller in value than the last deal in December 2015, but it still sends a signal that angers Beijing, which also expects more controversial deals to be forthcoming given the Trump administration's signals that it plans to strengthen the Taiwan alliance. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Saudi Arabia's Choice: Modernity Or Bust?" dated May 11, 2016, available at gps.bcaresearch.com. 8 Please see BCA Frontier Markets Strategy Special Report, "Egypt: A Cyclical Recovery Amid Lingering Structural Challenges," dated June 20, 2017, available at fms.bcaresearch.com.

Highlights Unilateral economic sanctions show that geopolitical risks are rising in Asia Pacific; China is using sanctions to get its way with its neighbors; South Korea was the latest victim, and will be rewarded for its pro-China shift; Trump's Mar-a-Lago honeymoon with Xi Jinping is over; Tactically, go long South Korean consumers / short Taiwanese exporters. Feature Geopolitical risk is shifting to the Asia Pacific region - and the increasing use of economic sanctions is evidence of the trend. Korean stocks have rallied sharply since the leadership change from December 2016 through May of this year (Chart 1). The impeachment rally was entirely expected after a year of domestic political turmoil.1 The election is also eventually expected to decrease Korean geopolitical risks - the country's new President Moon Jae-in, of the left-leaning Democratic Party, aims to patch up relations with China and revive diplomacy with North Korea.2 Chart 1South Korean Impeachment Rally Over South Korean Impeachment Rally Over South Korean Impeachment Rally Over A key barometer of Moon's success will be whether he convinces China to remove economic sanctions imposed since last summer as punishment for his predecessor's agreement to host the U.S. THAAD missile defense system. Moon has suspended the system's deployment in a nod to China.3 South Korea is thus the latest example of an important trend in the region: China's successful use of "economic statecraft" to pressure wayward neighbors into closer alignment with its interests. Since 2014, Thailand, Malaysia, Vietnam and the Philippines have each sought in different ways to reorient their foreign policies toward China, either to court Chinese assistance or get relief from Chinese pressure. Judging by our research below, the rewards are palpable, and a sign of Beijing's rising global influence. Because U.S.-China tensions are rising structurally, we see these country-by-country shifts toward China not as a decisive loss for the U.S. alliance but rather as the latest phase in a long game of tug-of-war that will intensify in the coming years.4 Hence the trend of unilateral economic sanctions will continue. Who is next on China's hit list? How will the U.S. respond? What countries are most and least likely to be affected? And what are the market implications? China's Economic Statecraft The United States launched a "pivot to Asia" strategy under the Obama administration to reassert American primacy in Asia Pacific and address the emerging challenge from China. The U.S.'s Asian partners largely welcomed this shift. Over the preceding decade, they had struggled with China's emergence as a military and strategic superior. The most prominent flashpoints came in the East and South China Seas. Beijing's newfound naval and air power caused regional anxiety. As the allies invited a larger U.S. role, Beijing began to assert its sovereignty claims over disputed waters and rocks, most ambitiously by creating artificial islands in the South China Sea and fortifying them with military capabilities. In three notable periods since the Great Recession, China's tensions with its neighbors have splashed over into the economic realm, prompting Beijing to impose punitive measures: Chart 2Japan's 2012 Clash With China Japan's 2012 Clash With China Japan's 2012 Clash With China Chart 3Chinese Boycotted Japanese Cars... Chinese Boycotted Japanese Cars... Chinese Boycotted Japanese Cars... Japan 2010-2012: In 2010, China and Japan clashed as the former challenged Japan's control of the Senkaku (Diaoyu) islands in the East China Sea. In the September-November 2010 clash, China notoriously cut off exports of rare earths to Japan.5 A greater clash occurred from July-November 2012. Chinese people rose up in large-scale protests, damaging Japanese and other foreign property and assets. Impact: The growth of Japanese exports to China slowed noticeably between the 2010 and 2012 clashes, underperforming both that of China's neighbors and Europe (Chart 2). In particular, Chinese consumers stopped buying as many Japanese cars and switched to other brands (Chart 3). Chinese investment in Japan, which is generally very small, fell sharply in the year after the major 2012 clash, by contrast with the global trend (Chart 4). Chinese tourism to Japan also fell sharply after both incidents, though only for a short period of time (Chart 5). Chart 4...And Cut Investments In Japan... ...And Cut Investments In Japan... ...And Cut Investments In Japan... Chart 5...While Tourists Went Elsewhere ...While Tourists Went Elsewhere ...While Tourists Went Elsewhere Philippines 2012-2016: Tensions between China and the Philippines over the contested Spratly Islands and other rocks in the South China Sea have a long history. The latest round began in the mid-2000s, and the two countries have skirmished many times since then, including in a major showdown at Scarborough Shoal in 2012 that required the intercession of the United States to be resolved. The pressure intensified after January 2013, when the Philippines brought a high-profile case against China's maritime-territorial claims to the Permanent Court of Arbitration at the Hague. The U.S. and the Philippines upped the ante in April 2014 by signing an Enhanced Defense Cooperation Agreement. Ultimately, the court dealt a humiliating blow to China's maritime-territorial claims in July 2016, but a bigger confrontation was avoided because of what had happened in the remarkable May 2016 Philippine elections, which put China-friendly populist President Rodrigo Duterte in Manila on July 1. Impact: China tightened phytosanitary restrictions on Philippine bananas during the 2012 crisis and Philippine exports to China underperformed those of its neighbors after the onset of diplomatic crisis in 2013 (Chart 6). Nevertheless, the overall impact on headline exports is debatable. Tourism suffered straightforwardly both after the 2012 showdown at sea and after the new U.S.-Philippines military deal in 2014 (Chart 7). As with Japan, the impact was temporary. Chart 6Philippine Clash With China Over Sovereignty Philippine Clash With China Over Sovereignty Philippine Clash With China Over Sovereignty Chart 7Chinese Tourists Snub The Philippines Chinese Tourists Snub The Philippines Chinese Tourists Snub The Philippines Vietnam 2011-14: China's quarrels with Vietnam go back millennia, but in recent years have centered on the South China Sea. As with the Philippines, frictions began rising in the mid-2000s and flared up after the global financial crisis. In the summer of 2012, Vietnam and China engaged in a dispute over new laws encompassing their territorial claims. In May 2014, the two countries fought a highly unorthodox sea-battle near the Paracel Islands. Anti-Chinese protests erupted throughout Vietnam, prompting China to restrict travel.6 Impact: It is not clear that China imposed trade measures against Vietnam - export growth was plummeting in 2012 because of China's nominal GDP slowdown as well - but certainly exports skyrocketed after the two sides began tothaw diplomatic relations in August 2014 (Chart 8).7 Direct investment from China into Vietnam fell in 2014, even as that from the rest of the world rose. Chinese tourism to Vietnam shrank in the aftermath. Chart 8Vietnam Reboots China Trade Vietnam Reboots China Trade Vietnam Reboots China Trade The above incidents complement a growing body of academic research demonstrating China's use of unilateral economic sanctions and their trade and market impacts.8 Bottom Line: China has employed unilateral, informal, and discrete economic sanctions and has encouraged or condoned citizen boycotts and popular activism against Japan, the Philippines, Vietnam, Taiwan, and other states since at least the early 2000s. Moreover, three international confrontations since 2010 suggest that China's foreign policy is growing bolder - it is not afraid to throw its economic weight around to get what it wants politically or to deter countries from challenging its interests. How Significant Is China's Wrath? Both our evidence and the scholarly literature reveal that China-inflicted economic damage tends to be temporary and sometimes ambiguous from a macro-perspective.9 For instance, if there were negative trade effects of Vietnam's 2014 clash with China, they were overwhelmed by Vietnam's rising share of China's market in the following years (Chart 9). And, as hinted above, Chinese sanctions on Philippine banana exports in 2012 can be overstated according to close inspection of the data.10 Nevertheless, since 2016, three new episodes have reinforced the fact that China's punitive measures are a significant trend with potentially serious consequences for Asian economies: Taiwan 2016: Taiwanese politics have shifted away from mainland China in recent years. The "Sunflower Protests" of 2014 marked a shift in popular opinion away from the government's program of ever-deeper economic integration with the mainland. Local elections later that year set the stage for a sweeping victory by the Democratic Progressive Party (DPP), taking both the presidency and, for the first time, the legislature, in January 2016.11 Tsai is a proponent of eventual Taiwanese independence and dissents from key diplomatic agreements with the mainland, the "One China Policy" and "1992 Consensus." Within six months of the election Beijing had cut off diplomatic communication. Impact: The number of mainland visitors has nosedived, by contrast with global trends (Chart 10). Taiwan's exports and access to China's market are arguably weaker than they would otherwise be. Given the historic cross-strait Economic Cooperation Framework Agreement in 2010, and the strong export growth in the immediate aftermath of that deal, it is curious that exports have been so weak since 2014 (Chart 11). Chart 9China Flings Open Doors To Vietnam China Flings Open Doors To Vietnam China Flings Open Doors To Vietnam Chart 10Mainland Tourists Punish Rebel Taiwan Mainland Tourists Punish Rebel Taiwan Mainland Tourists Punish Rebel Taiwan Chart 11So Much For Cross-Strait Trade Deals? So Much For Cross-Strait Trade Deals? So Much For Cross-Strait Trade Deals? South Korea 2016-17: China and South Korea are on the cusp of improving relations after a year of Beijing-imposed sanctions. The former government of President Park Geun-hye, who was impeached in December 2016 and removed from office in March this year, moved rapidly with the U.S. to deploy the THAAD missile defense system on South Korean soil while her government was collapsing, so as to make it a fait accompli for her likely left-leaning (and more China-friendly) successor. Her government agreed to the deployment in July 2016 and since then China has exacted substantial economic costs via Korean exports and Chinese tourism.12 The new President Moon Jae-in is now calling on China to remove these sanctions, while initiating an "environmental review" that will delay deployment of THAAD, possibly permanently. Impact: South Korean exports to China have underperformed the regional trend throughout the downfall of the Park regime and its last-minute alliance-building measures with both the U.S. and Japan (Chart 12). South Korea has also lost market share in China since agreeing to host THAAD in July 2016 (Chart 13). Furthermore, Korean car sales on the mainland have deviated markedly both from their long-term historical trend and from Japan's contemporary sales (Chart 14), the inverse of what occurred in 2012 (see Chart 3 above). Chinese tourism to South Korea has sharply declined. Chart 12China Cools On Korean Imports China Cools On Korean Imports China Cools On Korean Imports Chart 13China Hits South Korea Over THAAD China Hits South Korea Over THAAD China Hits South Korea Over THAAD Chart 14Korean Car Sales And Tourist Sales Slump Korean Car Sales And Tourist Sales Slump Korean Car Sales And Tourist Sales Slump North Korea 2016-17: Ironically, China brought sanctions against both Koreas last year - the South for THAAD, the North for its unprecedented slate of missile and nuclear tests. These provoked the United States into pressuring China via "secondary sanctions." Impact: China's sanctions on the North - which include a potentially severe ban on coal imports - are limited so far, according to the headline trade data, as China is wary of destabilizing the hermit kingdom (Chart 15). But if China does grant President Trump's request and increase the economic pressure on North Korea, it will be no less of a sign of a greater willingness to utilize economic statecraft, especially given that the North is China's only formal ally. Other countries will not fail to see the implications should they, like either Korea, cross Beijing's interests. Bottom Line: Doubts about China's new foreign policy "assertiveness" are overstated. China is increasing its unilateral use of economic levers to pressure political regimes in its neighborhood, including major EMs like Taiwan and South Korea over the past year. Korean President Moon Jae-in's rise to power is likely to produce better Sino-Korean relations, but neither it nor Taiwan is out of the woods yet, according to the data. Moreover, the rest of the region may be cautious before accepting new U.S. military deployments or contravening China's demands in other ways. The Asian "Pivot To China" Over the past two years, several Asian states have begun to vacillate toward China, not because they fear American abandonment but because the U.S. "pivot" gave them so much security reassurance that it threatened to provoke conflict with China - essentially risking a new Cold War. They live on the frontlines and wanted to discourage this escalation. At the same time, the growth slump in China/EM in 2014 - followed by China's renewed stimulus in 2015 - encouraged these states to improve business with China. Thailand began to shift in 2014, when a military junta took power in a coup and sought external support. China's partnership did not come with strings attached, as opposed to that of the U.S., with its demands about democracy and civil rights.13 The rewards of this foreign policy shift are palpable (Chart 16). China signed some big investment deals and improved strategic cooperation through arms sales. It did the same with Malaysia for similar reasons.14 China's "One Belt One Road" (OBOR) economic development initiative provided ample opportunities for expanding ties. Chart 15No Chinese Embargo On North Korea... Yet No Chinese Embargo On North Korea... Yet No Chinese Embargo On North Korea... Yet Chart 16China Opens Doors To Thai Junta China Opens Doors To Thai Junta China Opens Doors To Thai Junta The year 2016 was a major turning point. Three of China's neighbors - two of which U.S. allies - underwent domestic political transitions ushering in more favorable policies toward China: Vietnam: The Vietnamese Communist Party held its twelfth National Congress in January 2016. Prime Minister Nguyen Tan Dung, a pro-market reformer from the capitalist south, failed to secure the position of general secretary of the party and retired. The incumbent General Secretary Nguyen Phu Trong retained his seat, and oversaw the promotion of key followers, strengthening Vietnam's pro-China faction. Since then Trong has visited President Xi in Beijing and signed a joint communique on improving strategic relations. As mentioned above, Vietnamese exports to China have exploded since tensions subsided in 2014. South Korea: In April 2016, South Korean legislative elections saw the left-leaning Democratic Party win a plurality of seats, setting the stage for the 2017 election discussed above, when Korea officially moved in a more China-friendly direction under President Moon. The Philippines: In May 2016, the Philippines elected Duterte, a firebrand southern populist who declared that the Philippines would "separate" itself from the U.S. and ally with Russia and China. Though Duterte has already modified his anti-American stance - as we expected - he is courting Chinese trade and investment at the expense of the Philippines' sovereignty concerns.15 Trump's election contributed to this regional trend. By suggesting a desire for the U.S. to stop playing defender of last resort in the region, Trump reinforced the need for allies like Thailand, the Philippines, and South Korea to go their own way. And by canceling the Trans-Pacific Partnership, Trump forced Malaysia and Vietnam to make amends with China, while vindicating those (like Thailand and Indonesia) that had remained aloof. Bottom Line: Having brandished its sticks, China is now offering carrots to states that recognize its growing regional influence. These do not have to be express measures, given that China is stimulating its economy and increasing outbound investment for its own reasons. All China need do is refrain from denying access to its market and investment funds. Whom Will China Sanction Next? Geopolitical risk on the Korean peninsula remains elevated given that North Korea remains in "provocation mode" and Trump has prioritized the issue. However, we expect that Moon will cooperate with China enough to give a boost to South Korean exports and China-exposed companies and sectors. With South Korea's shifting policy, Beijing has a major opportunity to demonstrate the positive economic rewards of pro-China foreign policy. If a new round of international negotiations gets under way and North Korean risk subsides for a time (our baseline view),16 then East Asian governments will turn to other interests. We see two key places of potential confrontation over the next 12-24 months: Taiwan is the top candidate for Chinese sanctions going forward. The cross-strait relationship is fraught and susceptible to tempests. The ruling DPP lacks domestic political constraints, which could be conducive to policy mistakes. Moreover, Trump has signaled his intention to strengthen the alliance with Taiwan, which could cause problems. China is likely to oppose the new $1.4 billion package of U.S. arms more actively than in the past, given its greater global heft. Trump's initial threat of altering the One China Policy has not been forgotten. In terms of timing, China may not want to give a tailwind to the DPP by acting overly aggressive ahead of the 2018 local elections, which are crucial for the opposition Kuomintang's attempt to revive in time for the 2020 presidential vote. But this is not a hard constraint on Beijing's imposing sanctions before then. Japan is the second-likeliest target of Chinese economic pressure. Japanese Prime Minister Shinzo Abe is up for re-election no later than December 2018 and is becoming more vulnerable as he shifts emphasis from pocketbook issues to Japan's national security.17 Needless to say, the revival of the military is the part of Abe's agenda that Beijing most opposes. China would like to see Abe weakened, or voted out, and would especially like to see Abe's proposed constitutional revisions fail in the popular referendum slated for 2020. China would not want to strengthen Abe by provoking Japanese nationalism. But if Abe is losing support, and Beijing calculates that the Japanese public is starting to view Abe and his constitutional revisions as too provocative and destabilizing, then a well-timed diplomatic crisis with economic sanctions may be in order.18 Next in line are Hong Kong and Singapore, though Beijing has already largely gotten its way in recent disputes with the two city-states.19 Other possibilities on the horizon: The eventual return to a fractious civilian government in Thailand, or improved U.S.-Thai relations, could spoil China's infrastructure plans and sour its willingness to support an otherwise lackluster Thai economy. Also, a surprise victory by the opposition in Malaysian general elections (either this year or next) could see the recent rapprochement with China falter. The latter would be cyclical tensions, whereas suppressed structural tensions with Vietnam and the Philippines could boil back up to the surface fairly quickly at any time and provoke Chinese retaliation. Bottom Line: The most likely targets of Chinese economic sanctions in the near future are Taiwan and Japan. South Korea could remain a target if events should force Moon to abandon his policy agenda, though we see this as unlikely. Hong Kong and Singapore also remain in the danger zone, as do Vietnam and the Philippines in the long run. Investment Implications Cyclical and structural macro trends drive exports and investment trends in Asia Pacific. The biggest immediate risk to EM Asian economies stems not from Chinese sanctions - given that most of these economies have adjusted their policies to appease China to some extent - but from China's economic policy uncertainty, which remains at very elevated levels (Chart 17). It was after this uncertainty surged in 2015 that China's neighbors took on a more accommodating stance with a focus on economic cooperation rather than strategic balancing. Chart 17Chinese Economic Policy Uncertainty Still Asia's Biggest Risk Does It Pay To Pivot To China? Does It Pay To Pivot To China? Currently Chinese economic policy uncertainty is hooking back up as a result of the decision by state authorities to intensify their financial crackdown - the so-called "deleveraging campaign." BCA's Emerging Markets Strategy has recently pointed out that China's slowing fiscal and credit impulse will drag down both Chinese import volumes and emerging market corporate earnings in the coming months (Chart 18). Already commodity prices and commodity currencies have dropped off, heralding a broader slowdown in global trade as a result of China's policy tightening. This trend will overwhelm the effect of almost any new geopolitical spats or sanctions. The same can be said for Chinese investment as for Chinese trade. Over the past couple of decades, China has emerged as one of the world's leading sources of direct investment (Chart 19). This is a secular trend. Thus while foreign relations have affected China's investment patterns - most recently in giving the Philippines a boost under Duterte - the general trend of rising Chinese investment abroad will continue regardless of temporary quarrels. This is particularly true in light of China's efforts to energize OBOR. Chart 18China: Stimulus Fading China: Stimulus Fading China: Stimulus Fading Chart 19China's Emergence As Major Global Investor Does It Pay To Pivot To China? Does It Pay To Pivot To China? The key question is how will China's political favor or disfavor impact neighboring economies on the margin, in relative terms, on a sectoral basis, or in the short term? The evidence above feeds into several trends in relative equity performance: China fights either Japan or Korea: Going long Korea / short Japan would have paid off throughout the major Sino-Japanese tensions 2010-12, and would have paid off again during the South Korean impeachment rally (Chart 20). Of course, geopolitics is only one factor. But even Japan's economic shift in 2012 (Abenomics) is part of the geopolitical dynamic. Chart 20China Fights Either Japan Or Korea China Fights Either Japan Or Korea China Fights Either Japan Or Korea Chart 21Taiwan's Loss = Japan's Gain Taiwan's Loss = Japan's Gain Taiwan's Loss = Japan's Gain Taiwan's loss is Japan's gain: China's measures against Japanese exporters from 2010-12 coincided with a period of intense cross-strait economic integration that benefited Taiwanese exporters. Then Japan adopted Abenomics and dialed down tensions with China, and Taiwan underwent a pro-independence turn, provoking Beijing's displeasure (Chart 21). If one of these countries ends up quarreling with China in the near future, as we expect, the other country's exporters may reap the benefit. If relations worsen with both, South Korea stands to gain. Favor EM reformers: Vietnamese and Philippine equities outperformed EM from 2011-16 despite heightened tensions in the South China Sea (Chart 22). During this time, we recommended an overweight position on both countries relative to EM, even though we took the maritime tensions very seriously, because we favored EM reformers and both countries were undertaking structural reforms.20 Later, in May 2016, we downgraded the Philippines to neutral, expecting a loss of reform momentum after Duterte's election. The Philippines has notably underperformed the EM equity benchmark since that time.21 The "One China Policy": We closed out our "long One China Policy" trade on June 14 as a result of China's persistence in its crackdown on the banks, which we see as very risky.22 However, we may reinitiate the trade in the future, as Hong Kong and Taiwan remain vulnerable both to the slowdown in globalization and to Beijing's sanctions over deepening political differences (Chart 23). Chart 22Reforms Pay... Even During Island Tensions Reforms Pay... Even During Island Tensions Reforms Pay... Even During Island Tensions Chart 23The 'One China Policy' As A Trade The 'One China Policy' As A Trade The 'One China Policy' As A Trade From Sunshine to Moonshine: South Korea's Moon Jae-in has substantial political capital and we expect that he will succeed in boosting growth, wages, and the social security net, all of which will be bullish for South Korean consumer stocks. Yet we remain wary of the fact that North Korea is not yet falling into line with new negotiations. A way to hedge is to go long the South Korean consumer relative to Taiwanese exporters (Chart 24), which will live under the shadow of Beijing's disfavor at least until the 2020 elections, if not beyond. Taiwan has also allowed its currency to appreciate notably against the USD since Trump's post-election phone call with President Tsai, which is negative for Taiwanese exporters. Chart 24Go Long Korean Consumer /##br## Short Taiwanese Exporter Go Long Korean Consumer / Short Taiwanese Exporter Go Long Korean Consumer / Short Taiwanese Exporter China's sanctions are essentially a "slap on the wrist" in economic terms. But sometimes they reflect deeper structural tensions, and thus they may foreshadow far more damaging clashes down the road that could have longer term consequences, just as the Sino-Japanese incident of 2012 demonstrated. That is all the more reason to hedge one's bets on Taiwan today. These sanctions are bound to recur and will provide investors with trading opportunities, if not long-term investment themes. It will pay to capitalize quickly at the outset of any serious increase in tensions going forward. As a final word, the Trump administration's recent moves to impose economic penalties on China - namely through "secondary sanctions" due to North Korea, but also through potential trade tariffs and/or penalties related to human trafficking and human rights - highlight the fact that the use of unilateral sanctions is not limited to China. Geopolitical risk is rising in Asia as a result of actions on both sides of the Pacific. Sino-American antagonism in particular poses the greatest geopolitical danger to global markets, as we have frequently emphasized.23 And as Trump's domestic agenda struggles he will seek to get tougher on China, as he promised to his populist base on the campaign trail. In the event of a major geopolitical crisis in the region, we recommend the same mix of safe-haven assets that we have recommended in the past: U.S. treasuries, Swiss bonds, JGBs, and gold.24 Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. For our longstanding investment theme of rising geopolitical risk in East Asia, please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, and Monthly Report, "The Great Risk Rotation," dated December 11, 2013, available at gps.bcaresearch.com. 2 Please see BCA Emerging Market Equity Sector and Geopolitical Strategy Special Report, "South Korea: A Comeback For Consumer Stocks?" dated June 27, 2017, available at gps.bcaresearch.com. 3 However, Moon is walking a tight rope in relation to the United States. During his visit to Washington on June 29, he assured Congressman Paul Ryan among others that he did not necessarily intend to reverse the THAAD agreement as a whole. That would depend on the outcome of the environmental review and due legal process in South Korea as well as on whether North Korea's behavior makes the missile defense system necessary. Please see Kim Ji-eun, "In US Congress, Pres. Moon Highlights Democratic Values Of Alliance With US," The Hankyoreh, July 1, 2017, available at English.hani.co.kr. 4 Please see BCA Geopolitical Strategy Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 5 Please see Jeffrey R. Dundon, "Triggers of Chinese Economic Coercion," Naval Postgraduate School, September, 2014, available at calhoun.nps.edu. 6 For a very conservative estimate of China's actions during the Haiyang Shiyou 981 incident, please see Angela Poh, "The Myth Of Chinese Sanctions Over South China Sea Disputes," Washington Quarterly 40:1 (2017), pp. 143-165. 7 Please see "Vietnam Party official heads to China to defuse tensions," Thanh Nien Daily, August 25, 2014, available at www.thanhniennews.com. 8 Please see Faqin Lin, Cui Hu, and Andreas Fuchs, "How Do Firms Respond To Political Tensions? The Heterogeneity Of The Dalai Lama Effect On Trade," University of Heidelberg Department of Economics Discussion Paper Series 628, August 2016, available at papers.ssrn.com. This study improves upon earlier ones, notably Andreas Fuchs and Nils-Hendrik Klann, "Paying A Visit: The Dalai Lama Effect On International Trade," Journal Of International Economics 91 (2013), pp 164-77. See also Christina L. Davis, Andreas Fuchs, and Kristina Johnson, "State Control And The Effects Of Foreign Relations On Bilateral Trade," October 16, 2016, MPRA Paper No. 74597, available at https://mpra.ub.uni-muenchen.de/74597/ ; Yinghua He, Ulf Nielsson, and Yonglei Wang, "Hurting Without Hitting: The Economic Cost of Political Tension," Toulouse School of Economics Working Papers 14-484 (July 2015), available at econpapers.repec.org; Raymond Fisman, Yasushi Hamao, and Yongxiang Wang, "Nationalism and Economic Exchange: Evidence from Shocks to Sino-Japanese Relations," NBER Working Paper 20089 (May 2014) available at www.nber.org; Scott L. Kastner, "Buying Influence? Assessing the Political Effects of China's International Trade," Journal of Conflict Resolution 60:6 (2016), pp. 980-1007. 9 The "Dalai Lama effect," in which countries that host a visit from the Dalai Lama suffer Chinese trade retaliation, has been revised downward over the years - the trade costs are only statistically significant in the second quarter after the visit. Please see "How Do Firms Respond," cited in footnote 8. 10 See "Myth Of Chinese Sanctions," cited in footnote 6. Chinese sanctions on Norwegian salmon exports after Liu Xiaobo's Nobel Peace Prize in 2010 also fall under this category. 11 Please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, available at gps.bcaresearch.com. 12 Please see Lee Ho-Jeong, "Thaad may lead to $7.5B in economic losses in 2017," Joongang Daily, May 4, 2017, available at www.joongangdaily.com. 13 Please see Ian Storey, "Thailand's Post-Coup Relations With China And America: More Beijing, Less Washington," Yusof Ishak Institute, Trends in Southeast Asia 20 (2015). 14 Malaysia began to move closer to China after its 2013 election, which initiated a period of political turbulence and scandal. This trend, along with economic slowdown, prompted the ruling coalition to turn to Beijing for support. 15 He is also, as current chair of the Association of Southeast Asian Nations (ASEAN), assisting China's negotiations toward settling a "Code of Conduct" in the South China Sea. This is not likely to be a binding agreement - China will not voluntarily reverse its strategic maritime-territorial gains - but it could dampen tensions for a time in the region and encourage better relations between China and Southeast Asia. For the 2016 Asian pivot to China discussed above, please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, and Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 17 The LDP's dramatic defeat in Tokyo's local elections on July 2 is the first tangible sign that the constitutional agenda, Abe's corruption scandals, and the emergence of a competing political leader, Yuriko Koike, are taking a toll on the LDP. 18 Also, Beijing may at any point rotate its maritime assertiveness back to the East China Sea, where tensions with Japan have quieted since 2013-14. Further, Beijing will want to exploit worsening relations between Japan and South Korea, and drive a wedge between Japan and Russia as they attempt a historic diplomatic thaw. 19 Beijing is attempting to steal a march on these states, especially in finance, while putting pressure on them to avoid activities that undermine Beijing's regional influence. So far there is only small evidence that tensions have affected trade. First, Hong Kong saw a drop in tourists and a block on cultural exports amid the Umbrella Protests of 2014. China's central government has acted aggressively over the past year to suppress Hong Kong agitation, by excluding rebel lawmakers from office and by drawing a "red line" against undermining Chinese sovereignty. Yet agitation will persist because of the frustration of local political forces and the youth, both of which resent the mainland's increasing heavy-handedness. Meanwhile, China and Singapore are in the process this month of improving relations after the November-January spat relating to Singapore-Taiwanese military ties. But China's encroachment on Singapore's traditional advantages - finance, oil refining, freedom of navigation, strong military relations with the U.S. and Taiwan, political stability - is likely to continue. 20 Please see BCA Geopolitical Strategy Monthly Report, "The Coming Bloodbath In Emerging Markets," dated August 12, 2015, "Geopolitical Risk: A Golden Opportunity?" dated July 9, 2014, and "In Need Of Global Political Recapitalization," dated June 2012, available at gps.bcaresearch.com. See also Frontier Markets Strategy Special Report, "Buy Vietnamese Stocks," dated July 17, 2015, available at fms.bcaresearch.com. 21 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. 22 Please see BCA Geopolitical Strategy Weekly Report, "Has Europe Switched From Reward To Risk," dated June 7, 2017, available at gps.bcaresearch.com. 23 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. 24 Please see The Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Unilateral economic sanctions show that geopolitical risks are rising in Asia Pacific; China is using sanctions to get its way with its neighbors; South Korea was the latest victim, and will be rewarded for its pro-China shift; Trump's Mar-a-Lago honeymoon with Xi Jinping is over; Tactically, go long South Korean consumers / short Taiwanese exporters. Feature Geopolitical risk is shifting to the Asia Pacific region - and the increasing use of economic sanctions is evidence of the trend. Korean stocks have rallied sharply since the leadership change from December 2016 through May of this year (Chart 1). The impeachment rally was entirely expected after a year of domestic political turmoil.1 The election is also eventually expected to decrease Korean geopolitical risks - the country's new President Moon Jae-in, of the left-leaning Democratic Party, aims to patch up relations with China and revive diplomacy with North Korea.2 Chart 1South Korean Impeachment Rally Over South Korean Impeachment Rally Over South Korean Impeachment Rally Over A key barometer of Moon's success will be whether he convinces China to remove economic sanctions imposed since last summer as punishment for his predecessor's agreement to host the U.S. THAAD missile defense system. Moon has suspended the system's deployment in a nod to China.3 South Korea is thus the latest example of an important trend in the region: China's successful use of "economic statecraft" to pressure wayward neighbors into closer alignment with its interests. Since 2014, Thailand, Malaysia, Vietnam and the Philippines have each sought in different ways to reorient their foreign policies toward China, either to court Chinese assistance or get relief from Chinese pressure. Judging by our research below, the rewards are palpable, and a sign of Beijing's rising global influence. Because U.S.-China tensions are rising structurally, we see these country-by-country shifts toward China not as a decisive loss for the U.S. alliance but rather as the latest phase in a long game of tug-of-war that will intensify in the coming years.4 Hence the trend of unilateral economic sanctions will continue. Who is next on China's hit list? How will the U.S. respond? What countries are most and least likely to be affected? And what are the market implications? China's Economic Statecraft The United States launched a "pivot to Asia" strategy under the Obama administration to reassert American primacy in Asia Pacific and address the emerging challenge from China. The U.S.'s Asian partners largely welcomed this shift. Over the preceding decade, they had struggled with China's emergence as a military and strategic superior. The most prominent flashpoints came in the East and South China Seas. Beijing's newfound naval and air power caused regional anxiety. As the allies invited a larger U.S. role, Beijing began to assert its sovereignty claims over disputed waters and rocks, most ambitiously by creating artificial islands in the South China Sea and fortifying them with military capabilities. In three notable periods since the Great Recession, China's tensions with its neighbors have splashed over into the economic realm, prompting Beijing to impose punitive measures: Chart 2Japan's 2012 Clash With China Japan's 2012 Clash With China Japan's 2012 Clash With China Chart 3Chinese Boycotted Japanese Cars... Chinese Boycotted Japanese Cars... Chinese Boycotted Japanese Cars... Japan 2010-2012: In 2010, China and Japan clashed as the former challenged Japan's control of the Senkaku (Diaoyu) islands in the East China Sea. In the September-November 2010 clash, China notoriously cut off exports of rare earths to Japan.5 A greater clash occurred from July-November 2012. Chinese people rose up in large-scale protests, damaging Japanese and other foreign property and assets. Impact: The growth of Japanese exports to China slowed noticeably between the 2010 and 2012 clashes, underperforming both that of China's neighbors and Europe (Chart 2). In particular, Chinese consumers stopped buying as many Japanese cars and switched to other brands (Chart 3). Chinese investment in Japan, which is generally very small, fell sharply in the year after the major 2012 clash, by contrast with the global trend (Chart 4). Chinese tourism to Japan also fell sharply after both incidents, though only for a short period of time (Chart 5). Chart 4...And Cut Investments In Japan... ...And Cut Investments In Japan... ...And Cut Investments In Japan... Chart 5...While Tourists Went Elsewhere ...While Tourists Went Elsewhere ...While Tourists Went Elsewhere Philippines 2012-2016: Tensions between China and the Philippines over the contested Spratly Islands and other rocks in the South China Sea have a long history. The latest round began in the mid-2000s, and the two countries have skirmished many times since then, including in a major showdown at Scarborough Shoal in 2012 that required the intercession of the United States to be resolved. The pressure intensified after January 2013, when the Philippines brought a high-profile case against China's maritime-territorial claims to the Permanent Court of Arbitration at the Hague. The U.S. and the Philippines upped the ante in April 2014 by signing an Enhanced Defense Cooperation Agreement. Ultimately, the court dealt a humiliating blow to China's maritime-territorial claims in July 2016, but a bigger confrontation was avoided because of what had happened in the remarkable May 2016 Philippine elections, which put China-friendly populist President Rodrigo Duterte in Manila on July 1. Impact: China tightened phytosanitary restrictions on Philippine bananas during the 2012 crisis and Philippine exports to China underperformed those of its neighbors after the onset of diplomatic crisis in 2013 (Chart 6). Nevertheless, the overall impact on headline exports is debatable. Tourism suffered straightforwardly both after the 2012 showdown at sea and after the new U.S.-Philippines military deal in 2014 (Chart 7). As with Japan, the impact was temporary. Chart 6Philippine Clash With China Over Sovereignty Philippine Clash With China Over Sovereignty Philippine Clash With China Over Sovereignty Chart 7Chinese Tourists Snub The Philippines Chinese Tourists Snub The Philippines Chinese Tourists Snub The Philippines Vietnam 2011-14: China's quarrels with Vietnam go back millennia, but in recent years have centered on the South China Sea. As with the Philippines, frictions began rising in the mid-2000s and flared up after the global financial crisis. In the summer of 2012, Vietnam and China engaged in a dispute over new laws encompassing their territorial claims. In May 2014, the two countries fought a highly unorthodox sea-battle near the Paracel Islands. Anti-Chinese protests erupted throughout Vietnam, prompting China to restrict travel.6 Impact: It is not clear that China imposed trade measures against Vietnam - export growth was plummeting in 2012 because of China's nominal GDP slowdown as well - but certainly exports skyrocketed after the two sides began tothaw diplomatic relations in August 2014 (Chart 8).7 Direct investment from China into Vietnam fell in 2014, even as that from the rest of the world rose. Chinese tourism to Vietnam shrank in the aftermath. Chart 8Vietnam Reboots China Trade Vietnam Reboots China Trade Vietnam Reboots China Trade The above incidents complement a growing body of academic research demonstrating China's use of unilateral economic sanctions and their trade and market impacts.8 Bottom Line: China has employed unilateral, informal, and discrete economic sanctions and has encouraged or condoned citizen boycotts and popular activism against Japan, the Philippines, Vietnam, Taiwan, and other states since at least the early 2000s. Moreover, three international confrontations since 2010 suggest that China's foreign policy is growing bolder - it is not afraid to throw its economic weight around to get what it wants politically or to deter countries from challenging its interests. How Significant Is China's Wrath? Both our evidence and the scholarly literature reveal that China-inflicted economic damage tends to be temporary and sometimes ambiguous from a macro-perspective.9 For instance, if there were negative trade effects of Vietnam's 2014 clash with China, they were overwhelmed by Vietnam's rising share of China's market in the following years (Chart 9). And, as hinted above, Chinese sanctions on Philippine banana exports in 2012 can be overstated according to close inspection of the data.10 Nevertheless, since 2016, three new episodes have reinforced the fact that China's punitive measures are a significant trend with potentially serious consequences for Asian economies: Taiwan 2016: Taiwanese politics have shifted away from mainland China in recent years. The "Sunflower Protests" of 2014 marked a shift in popular opinion away from the government's program of ever-deeper economic integration with the mainland. Local elections later that year set the stage for a sweeping victory by the Democratic Progressive Party (DPP), taking both the presidency and, for the first time, the legislature, in January 2016.11 Tsai is a proponent of eventual Taiwanese independence and dissents from key diplomatic agreements with the mainland, the "One China Policy" and "1992 Consensus." Within six months of the election Beijing had cut off diplomatic communication. Impact: The number of mainland visitors has nosedived, by contrast with global trends (Chart 10). Taiwan's exports and access to China's market are arguably weaker than they would otherwise be. Given the historic cross-strait Economic Cooperation Framework Agreement in 2010, and the strong export growth in the immediate aftermath of that deal, it is curious that exports have been so weak since 2014 (Chart 11). Chart 9China Flings Open Doors To Vietnam China Flings Open Doors To Vietnam China Flings Open Doors To Vietnam Chart 10Mainland Tourists Punish Rebel Taiwan Mainland Tourists Punish Rebel Taiwan Mainland Tourists Punish Rebel Taiwan Chart 11So Much For Cross-Strait Trade Deals? So Much For Cross-Strait Trade Deals? So Much For Cross-Strait Trade Deals? South Korea 2016-17: China and South Korea are on the cusp of improving relations after a year of Beijing-imposed sanctions. The former government of President Park Geun-hye, who was impeached in December 2016 and removed from office in March this year, moved rapidly with the U.S. to deploy the THAAD missile defense system on South Korean soil while her government was collapsing, so as to make it a fait accompli for her likely left-leaning (and more China-friendly) successor. Her government agreed to the deployment in July 2016 and since then China has exacted substantial economic costs via Korean exports and Chinese tourism.12 The new President Moon Jae-in is now calling on China to remove these sanctions, while initiating an "environmental review" that will delay deployment of THAAD, possibly permanently. Impact: South Korean exports to China have underperformed the regional trend throughout the downfall of the Park regime and its last-minute alliance-building measures with both the U.S. and Japan (Chart 12). South Korea has also lost market share in China since agreeing to host THAAD in July 2016 (Chart 13). Furthermore, Korean car sales on the mainland have deviated markedly both from their long-term historical trend and from Japan's contemporary sales (Chart 14), the inverse of what occurred in 2012 (see Chart 3 above). Chinese tourism to South Korea has sharply declined. Chart 12China Cools On Korean Imports China Cools On Korean Imports China Cools On Korean Imports Chart 13China Hits South Korea Over THAAD China Hits South Korea Over THAAD China Hits South Korea Over THAAD Chart 14Korean Car Sales And Tourist Sales Slump Korean Car Sales And Tourist Sales Slump Korean Car Sales And Tourist Sales Slump North Korea 2016-17: Ironically, China brought sanctions against both Koreas last year - the South for THAAD, the North for its unprecedented slate of missile and nuclear tests. These provoked the United States into pressuring China via "secondary sanctions." Impact: China's sanctions on the North - which include a potentially severe ban on coal imports - are limited so far, according to the headline trade data, as China is wary of destabilizing the hermit kingdom (Chart 15). But if China does grant President Trump's request and increase the economic pressure on North Korea, it will be no less of a sign of a greater willingness to utilize economic statecraft, especially given that the North is China's only formal ally. Other countries will not fail to see the implications should they, like either Korea, cross Beijing's interests. Bottom Line: Doubts about China's new foreign policy "assertiveness" are overstated. China is increasing its unilateral use of economic levers to pressure political regimes in its neighborhood, including major EMs like Taiwan and South Korea over the past year. Korean President Moon Jae-in's rise to power is likely to produce better Sino-Korean relations, but neither it nor Taiwan is out of the woods yet, according to the data. Moreover, the rest of the region may be cautious before accepting new U.S. military deployments or contravening China's demands in other ways. The Asian "Pivot To China" Over the past two years, several Asian states have begun to vacillate toward China, not because they fear American abandonment but because the U.S. "pivot" gave them so much security reassurance that it threatened to provoke conflict with China - essentially risking a new Cold War. They live on the frontlines and wanted to discourage this escalation. At the same time, the growth slump in China/EM in 2014 - followed by China's renewed stimulus in 2015 - encouraged these states to improve business with China. Thailand began to shift in 2014, when a military junta took power in a coup and sought external support. China's partnership did not come with strings attached, as opposed to that of the U.S., with its demands about democracy and civil rights.13 The rewards of this foreign policy shift are palpable (Chart 16). China signed some big investment deals and improved strategic cooperation through arms sales. It did the same with Malaysia for similar reasons.14 China's "One Belt One Road" (OBOR) economic development initiative provided ample opportunities for expanding ties. Chart 15No Chinese Embargo On North Korea... Yet No Chinese Embargo On North Korea... Yet No Chinese Embargo On North Korea... Yet Chart 16China Opens Doors To Thai Junta China Opens Doors To Thai Junta China Opens Doors To Thai Junta The year 2016 was a major turning point. Three of China's neighbors - two of which U.S. allies - underwent domestic political transitions ushering in more favorable policies toward China: Vietnam: The Vietnamese Communist Party held its twelfth National Congress in January 2016. Prime Minister Nguyen Tan Dung, a pro-market reformer from the capitalist south, failed to secure the position of general secretary of the party and retired. The incumbent General Secretary Nguyen Phu Trong retained his seat, and oversaw the promotion of key followers, strengthening Vietnam's pro-China faction. Since then Trong has visited President Xi in Beijing and signed a joint communique on improving strategic relations. As mentioned above, Vietnamese exports to China have exploded since tensions subsided in 2014. South Korea: In April 2016, South Korean legislative elections saw the left-leaning Democratic Party win a plurality of seats, setting the stage for the 2017 election discussed above, when Korea officially moved in a more China-friendly direction under President Moon. The Philippines: In May 2016, the Philippines elected Duterte, a firebrand southern populist who declared that the Philippines would "separate" itself from the U.S. and ally with Russia and China. Though Duterte has already modified his anti-American stance - as we expected - he is courting Chinese trade and investment at the expense of the Philippines' sovereignty concerns.15 Trump's election contributed to this regional trend. By suggesting a desire for the U.S. to stop playing defender of last resort in the region, Trump reinforced the need for allies like Thailand, the Philippines, and South Korea to go their own way. And by canceling the Trans-Pacific Partnership, Trump forced Malaysia and Vietnam to make amends with China, while vindicating those (like Thailand and Indonesia) that had remained aloof. Bottom Line: Having brandished its sticks, China is now offering carrots to states that recognize its growing regional influence. These do not have to be express measures, given that China is stimulating its economy and increasing outbound investment for its own reasons. All China need do is refrain from denying access to its market and investment funds. Whom Will China Sanction Next? Geopolitical risk on the Korean peninsula remains elevated given that North Korea remains in "provocation mode" and Trump has prioritized the issue. However, we expect that Moon will cooperate with China enough to give a boost to South Korean exports and China-exposed companies and sectors. With South Korea's shifting policy, Beijing has a major opportunity to demonstrate the positive economic rewards of pro-China foreign policy. If a new round of international negotiations gets under way and North Korean risk subsides for a time (our baseline view),16 then East Asian governments will turn to other interests. We see two key places of potential confrontation over the next 12-24 months: Taiwan is the top candidate for Chinese sanctions going forward. The cross-strait relationship is fraught and susceptible to tempests. The ruling DPP lacks domestic political constraints, which could be conducive to policy mistakes. Moreover, Trump has signaled his intention to strengthen the alliance with Taiwan, which could cause problems. China is likely to oppose the new $1.4 billion package of U.S. arms more actively than in the past, given its greater global heft. Trump's initial threat of altering the One China Policy has not been forgotten. In terms of timing, China may not want to give a tailwind to the DPP by acting overly aggressive ahead of the 2018 local elections, which are crucial for the opposition Kuomintang's attempt to revive in time for the 2020 presidential vote. But this is not a hard constraint on Beijing's imposing sanctions before then. Japan is the second-likeliest target of Chinese economic pressure. Japanese Prime Minister Shinzo Abe is up for re-election no later than December 2018 and is becoming more vulnerable as he shifts emphasis from pocketbook issues to Japan's national security.17 Needless to say, the revival of the military is the part of Abe's agenda that Beijing most opposes. China would like to see Abe weakened, or voted out, and would especially like to see Abe's proposed constitutional revisions fail in the popular referendum slated for 2020. China would not want to strengthen Abe by provoking Japanese nationalism. But if Abe is losing support, and Beijing calculates that the Japanese public is starting to view Abe and his constitutional revisions as too provocative and destabilizing, then a well-timed diplomatic crisis with economic sanctions may be in order.18 Next in line are Hong Kong and Singapore, though Beijing has already largely gotten its way in recent disputes with the two city-states.19 Other possibilities on the horizon: The eventual return to a fractious civilian government in Thailand, or improved U.S.-Thai relations, could spoil China's infrastructure plans and sour its willingness to support an otherwise lackluster Thai economy. Also, a surprise victory by the opposition in Malaysian general elections (either this year or next) could see the recent rapprochement with China falter. The latter would be cyclical tensions, whereas suppressed structural tensions with Vietnam and the Philippines could boil back up to the surface fairly quickly at any time and provoke Chinese retaliation. Bottom Line: The most likely targets of Chinese economic sanctions in the near future are Taiwan and Japan. South Korea could remain a target if events should force Moon to abandon his policy agenda, though we see this as unlikely. Hong Kong and Singapore also remain in the danger zone, as do Vietnam and the Philippines in the long run. Investment Implications Cyclical and structural macro trends drive exports and investment trends in Asia Pacific. The biggest immediate risk to EM Asian economies stems not from Chinese sanctions - given that most of these economies have adjusted their policies to appease China to some extent - but from China's economic policy uncertainty, which remains at very elevated levels (Chart 17). It was after this uncertainty surged in 2015 that China's neighbors took on a more accommodating stance with a focus on economic cooperation rather than strategic balancing. Chart 17Chinese Economic Policy Uncertainty Still Asia's Biggest Risk Does It Pay To Pivot To China? Does It Pay To Pivot To China? Currently Chinese economic policy uncertainty is hooking back up as a result of the decision by state authorities to intensify their financial crackdown - the so-called "deleveraging campaign." BCA's Emerging Markets Strategy has recently pointed out that China's slowing fiscal and credit impulse will drag down both Chinese import volumes and emerging market corporate earnings in the coming months (Chart 18). Already commodity prices and commodity currencies have dropped off, heralding a broader slowdown in global trade as a result of China's policy tightening. This trend will overwhelm the effect of almost any new geopolitical spats or sanctions. The same can be said for Chinese investment as for Chinese trade. Over the past couple of decades, China has emerged as one of the world's leading sources of direct investment (Chart 19). This is a secular trend. Thus while foreign relations have affected China's investment patterns - most recently in giving the Philippines a boost under Duterte - the general trend of rising Chinese investment abroad will continue regardless of temporary quarrels. This is particularly true in light of China's efforts to energize OBOR. Chart 18China: Stimulus Fading China: Stimulus Fading China: Stimulus Fading Chart 19China's Emergence As Major Global Investor Does It Pay To Pivot To China? Does It Pay To Pivot To China? The key question is how will China's political favor or disfavor impact neighboring economies on the margin, in relative terms, on a sectoral basis, or in the short term? The evidence above feeds into several trends in relative equity performance: China fights either Japan or Korea: Going long Korea / short Japan would have paid off throughout the major Sino-Japanese tensions 2010-12, and would have paid off again during the South Korean impeachment rally (Chart 20). Of course, geopolitics is only one factor. But even Japan's economic shift in 2012 (Abenomics) is part of the geopolitical dynamic. Chart 20China Fights Either Japan Or Korea China Fights Either Japan Or Korea China Fights Either Japan Or Korea Chart 21Taiwan's Loss = Japan's Gain Taiwan's Loss = Japan's Gain Taiwan's Loss = Japan's Gain Taiwan's loss is Japan's gain: China's measures against Japanese exporters from 2010-12 coincided with a period of intense cross-strait economic integration that benefited Taiwanese exporters. Then Japan adopted Abenomics and dialed down tensions with China, and Taiwan underwent a pro-independence turn, provoking Beijing's displeasure (Chart 21). If one of these countries ends up quarreling with China in the near future, as we expect, the other country's exporters may reap the benefit. If relations worsen with both, South Korea stands to gain. Favor EM reformers: Vietnamese and Philippine equities outperformed EM from 2011-16 despite heightened tensions in the South China Sea (Chart 22). During this time, we recommended an overweight position on both countries relative to EM, even though we took the maritime tensions very seriously, because we favored EM reformers and both countries were undertaking structural reforms.20 Later, in May 2016, we downgraded the Philippines to neutral, expecting a loss of reform momentum after Duterte's election. The Philippines has notably underperformed the EM equity benchmark since that time.21 The "One China Policy": We closed out our "long One China Policy" trade on June 14 as a result of China's persistence in its crackdown on the banks, which we see as very risky.22 However, we may reinitiate the trade in the future, as Hong Kong and Taiwan remain vulnerable both to the slowdown in globalization and to Beijing's sanctions over deepening political differences (Chart 23). Chart 22Reforms Pay... Even During Island Tensions Reforms Pay... Even During Island Tensions Reforms Pay... Even During Island Tensions Chart 23The 'One China Policy' As A Trade The 'One China Policy' As A Trade The 'One China Policy' As A Trade From Sunshine to Moonshine: South Korea's Moon Jae-in has substantial political capital and we expect that he will succeed in boosting growth, wages, and the social security net, all of which will be bullish for South Korean consumer stocks. Yet we remain wary of the fact that North Korea is not yet falling into line with new negotiations. A way to hedge is to go long the South Korean consumer relative to Taiwanese exporters (Chart 24), which will live under the shadow of Beijing's disfavor at least until the 2020 elections, if not beyond. Taiwan has also allowed its currency to appreciate notably against the USD since Trump's post-election phone call with President Tsai, which is negative for Taiwanese exporters. Chart 24Go Long Korean Consumer /##br## Short Taiwanese Exporter Go Long Korean Consumer / Short Taiwanese Exporter Go Long Korean Consumer / Short Taiwanese Exporter China's sanctions are essentially a "slap on the wrist" in economic terms. But sometimes they reflect deeper structural tensions, and thus they may foreshadow far more damaging clashes down the road that could have longer term consequences, just as the Sino-Japanese incident of 2012 demonstrated. That is all the more reason to hedge one's bets on Taiwan today. These sanctions are bound to recur and will provide investors with trading opportunities, if not long-term investment themes. It will pay to capitalize quickly at the outset of any serious increase in tensions going forward. As a final word, the Trump administration's recent moves to impose economic penalties on China - namely through "secondary sanctions" due to North Korea, but also through potential trade tariffs and/or penalties related to human trafficking and human rights - highlight the fact that the use of unilateral sanctions is not limited to China. Geopolitical risk is rising in Asia as a result of actions on both sides of the Pacific. Sino-American antagonism in particular poses the greatest geopolitical danger to global markets, as we have frequently emphasized.23 And as Trump's domestic agenda struggles he will seek to get tougher on China, as he promised to his populist base on the campaign trail. In the event of a major geopolitical crisis in the region, we recommend the same mix of safe-haven assets that we have recommended in the past: U.S. treasuries, Swiss bonds, JGBs, and gold.24 Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. For our longstanding investment theme of rising geopolitical risk in East Asia, please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, and Monthly Report, "The Great Risk Rotation," dated December 11, 2013, available at gps.bcaresearch.com. 2 Please see BCA Emerging Market Equity Sector and Geopolitical Strategy Special Report, "South Korea: A Comeback For Consumer Stocks?" dated June 27, 2017, available at gps.bcaresearch.com. 3 However, Moon is walking a tight rope in relation to the United States. During his visit to Washington on June 29, he assured Congressman Paul Ryan among others that he did not necessarily intend to reverse the THAAD agreement as a whole. That would depend on the outcome of the environmental review and due legal process in South Korea as well as on whether North Korea's behavior makes the missile defense system necessary. Please see Kim Ji-eun, "In US Congress, Pres. Moon Highlights Democratic Values Of Alliance With US," The Hankyoreh, July 1, 2017, available at English.hani.co.kr. 4 Please see BCA Geopolitical Strategy Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 5 Please see Jeffrey R. Dundon, "Triggers of Chinese Economic Coercion," Naval Postgraduate School, September, 2014, available at calhoun.nps.edu. 6 For a very conservative estimate of China's actions during the Haiyang Shiyou 981 incident, please see Angela Poh, "The Myth Of Chinese Sanctions Over South China Sea Disputes," Washington Quarterly 40:1 (2017), pp. 143-165. 7 Please see "Vietnam Party official heads to China to defuse tensions," Thanh Nien Daily, August 25, 2014, available at www.thanhniennews.com. 8 Please see Faqin Lin, Cui Hu, and Andreas Fuchs, "How Do Firms Respond To Political Tensions? The Heterogeneity Of The Dalai Lama Effect On Trade," University of Heidelberg Department of Economics Discussion Paper Series 628, August 2016, available at papers.ssrn.com. This study improves upon earlier ones, notably Andreas Fuchs and Nils-Hendrik Klann, "Paying A Visit: The Dalai Lama Effect On International Trade," Journal Of International Economics 91 (2013), pp 164-77. See also Christina L. Davis, Andreas Fuchs, and Kristina Johnson, "State Control And The Effects Of Foreign Relations On Bilateral Trade," October 16, 2016, MPRA Paper No. 74597, available at https://mpra.ub.uni-muenchen.de/74597/ ; Yinghua He, Ulf Nielsson, and Yonglei Wang, "Hurting Without Hitting: The Economic Cost of Political Tension," Toulouse School of Economics Working Papers 14-484 (July 2015), available at econpapers.repec.org; Raymond Fisman, Yasushi Hamao, and Yongxiang Wang, "Nationalism and Economic Exchange: Evidence from Shocks to Sino-Japanese Relations," NBER Working Paper 20089 (May 2014) available at www.nber.org; Scott L. Kastner, "Buying Influence? Assessing the Political Effects of China's International Trade," Journal of Conflict Resolution 60:6 (2016), pp. 980-1007. 9 The "Dalai Lama effect," in which countries that host a visit from the Dalai Lama suffer Chinese trade retaliation, has been revised downward over the years - the trade costs are only statistically significant in the second quarter after the visit. Please see "How Do Firms Respond," cited in footnote 8. 10 See "Myth Of Chinese Sanctions," cited in footnote 6. Chinese sanctions on Norwegian salmon exports after Liu Xiaobo's Nobel Peace Prize in 2010 also fall under this category. 11 Please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, available at gps.bcaresearch.com. 12 Please see Lee Ho-Jeong, "Thaad may lead to $7.5B in economic losses in 2017," Joongang Daily, May 4, 2017, available at www.joongangdaily.com. 13 Please see Ian Storey, "Thailand's Post-Coup Relations With China And America: More Beijing, Less Washington," Yusof Ishak Institute, Trends in Southeast Asia 20 (2015). 14 Malaysia began to move closer to China after its 2013 election, which initiated a period of political turbulence and scandal. This trend, along with economic slowdown, prompted the ruling coalition to turn to Beijing for support. 15 He is also, as current chair of the Association of Southeast Asian Nations (ASEAN), assisting China's negotiations toward settling a "Code of Conduct" in the South China Sea. This is not likely to be a binding agreement - China will not voluntarily reverse its strategic maritime-territorial gains - but it could dampen tensions for a time in the region and encourage better relations between China and Southeast Asia. For the 2016 Asian pivot to China discussed above, please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, and Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 17 The LDP's dramatic defeat in Tokyo's local elections on July 2 is the first tangible sign that the constitutional agenda, Abe's corruption scandals, and the emergence of a competing political leader, Yuriko Koike, are taking a toll on the LDP. 18 Also, Beijing may at any point rotate its maritime assertiveness back to the East China Sea, where tensions with Japan have quieted since 2013-14. Further, Beijing will want to exploit worsening relations between Japan and South Korea, and drive a wedge between Japan and Russia as they attempt a historic diplomatic thaw. 19 Beijing is attempting to steal a march on these states, especially in finance, while putting pressure on them to avoid activities that undermine Beijing's regional influence. So far there is only small evidence that tensions have affected trade. First, Hong Kong saw a drop in tourists and a block on cultural exports amid the Umbrella Protests of 2014. China's central government has acted aggressively over the past year to suppress Hong Kong agitation, by excluding rebel lawmakers from office and by drawing a "red line" against undermining Chinese sovereignty. Yet agitation will persist because of the frustration of local political forces and the youth, both of which resent the mainland's increasing heavy-handedness. Meanwhile, China and Singapore are in the process this month of improving relations after the November-January spat relating to Singapore-Taiwanese military ties. But China's encroachment on Singapore's traditional advantages - finance, oil refining, freedom of navigation, strong military relations with the U.S. and Taiwan, political stability - is likely to continue. 20 Please see BCA Geopolitical Strategy Monthly Report, "The Coming Bloodbath In Emerging Markets," dated August 12, 2015, "Geopolitical Risk: A Golden Opportunity?" dated July 9, 2014, and "In Need Of Global Political Recapitalization," dated June 2012, available at gps.bcaresearch.com. See also Frontier Markets Strategy Special Report, "Buy Vietnamese Stocks," dated July 17, 2015, available at fms.bcaresearch.com. 21 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. 22 Please see BCA Geopolitical Strategy Weekly Report, "Has Europe Switched From Reward To Risk," dated June 7, 2017, available at gps.bcaresearch.com. 23 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. 24 Please see The Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com.

Highlights The Trump-Xi summit offers hopeful signs that the two sides are mending once-severely tested bilateral relations. The risk of escalation in trade tensions has declined. President Trump and President Xi have different time horizons in setting policy priorities. Trump needs immediate success on trade and job creation to show to his working-class electorates, while Xi's primary objective is to avoid the "Thucydides trap". This offers space for compromises. Unless the Trump administration addresses America's "savings shortage," the country's external deficit will not change materially. Any serious negotiations on bilateral trade imbalances between China and the U.S. must deal with the root causes. Feature The summit between President Donald Trump and President Xi Jinping in Mar-a-Lago last week was hailed by both sides as an "ice breaking" success. Even though no substantive details have been offered, the two countries have formulated a new mechanism for senior-level dialogue, and established a 100-day process for addressing bilateral trade frictions. The risk still exists that Trump could unilaterally impose punitive measures against Chinese goods with his administrative powers, and it is overly simplistic to draw too much information from one particular event. However, the Trump-Xi summit confirms a developing trend: that some of President Trump's highly controversial remarks on his campaign trail are being quickly rolled back. The risk of escalating trade tensions between the world's two largest economies has on margin abated. Trump Goes Mainstream? America's China policy under recent administrations can best be described as "congagement" - an ambiguous mixture of containment and engagement by varying degrees. Trump's remarks on the campaign trail and in his early days in office suggested he was mainly interested in confrontation. But the Trump-Xi summit, along with some recent developments, implies that Trump's China policy is coming back to the middle ground, at least for now. After setting off a fierce firestorm on the Taiwan issue late last year, Trump reaffirmed the "One China" policy in a February phone call with President Xi, re-stating long-standing U.S. policy and easing a key source of diplomatic tensions. Taiwan is still re-emerging as a source of risk.1 But it is unquestionably positive in the short-term that Trump backed away from his initial, highly provocative approach. Treasury Secretary Steven Mnuchin stated in February that the Trump administration will stick to the existing statutory process in judging whether China manipulates its currency, a marked departure from Trump's repeated campaign pledges. It is almost certain that China will not be named a currency manipulator in the U.S. Treasury's upcoming semi-annual assessment due later this week.2 In his visit to Beijing last month, Secretary of State Rex Tillerson used Chinese verbiage to characterize the U.S.-China relationship. This verbiage was not repeated by other officials during Xi's visit to Florida, so it is unclear whether it signals the Trump administration's adoption of China's idea of a "new model of great power relations." Nonetheless, it is a drastic change from Tillerson's aggressive remarks at his congressional confirmation hearings, when he suggested blockading Chinese-built islands in the South China Sea. Separately, Secretary of Defense James Mattis, on his first trip abroad to Japan and South Korea, said he did not anticipate any "dramatic military moves" in the South China Sea. More recently, Steve Bannon, White House Chief Strategist, was removed from the National Security Council. It is futile to try to understand all the internal power struggles within the new administration. Nevertheless, Bannon's departure from the NSC is probably a positive development, viewed through the Chinese lens. Bannon not long ago openly identified China as a major threat to the U.S. and predicted a war in the South China Sea as inevitable. In short, President Trump's summit with President Xi marked continued "mainstreaming" of his China policy. Some strong anti-China rhetoric from him and his inner circle has apparently been sanded off, setting the stage for constructive negotiations with Beijing. Can China Accommodate? The restructuring of the Sino-U.S. comprehensive dialogue and the declaration of a 100-day process for addressing economic frictions are probably the most tangible outcomes from the discussions between the two leaders during the summit. Further detail deserve close attention in order to map out how relations between the world's two largest economies will evolve in the near future. In our view, China is likely to make concessions and avoid confrontations. First, trade appears to be front and center in President Trump's grand dealings with China, an important change compared with previous U.S. administrations that also focused heavily on values and ideological issues, such as democracy, freedom of speech and human rights. From China's perspective, the government has a lot more flexibility in making concessions on trade and economic fronts than in dealing with ideological differences. In the past, China has almost always yielded to U.S. pressure on trade-related issues. For instance, China depegged the RMB from the dollar in 2005 and allowed the RMB to continue to appreciate after the global economic recovery began, all under American political pressure. Chinese senior officials routinely led massive commercial delegations touring the U.S. with big procurement orders for everything from aircraft to agricultural goods in order to address American complaints. Both the U.S. and China understand that bilateral trade imbalances favor the U.S. in the event of an all-out trade war, which China will try its best to avoid. Strategically, President Trump and President Xi have different time horizons in setting policy priorities. Trump needs immediate success on trade and job creation to deliver on promises to his working-class electorate, while Xi is more interested in establishing a cooperative and productive strategic standing with the world's sole superpower. Xi's primary objective is to avoid the "Thucydides trap" - the likelihood of conflict between a rising power and a currently dominant one - by convincing the U.S. to grant China greater global sway. In this vein, Trump's withdrawal from the Trans Pacific Partnership (TPP) has been viewed as an important positive development from Xi's perspective, and it is likely that Beijing will offer incentives to further discourage President Trump to "pivot to Asia". It is already rumored that Beijing has drafted investment plans in the U.S. that could create 700,000 jobs, as well as further opening up agricultural goods imports and financial market access. We suspect these deals will be announced during the 100-day negotiation period, which should give Trump a much-needed boost in his approval ratings. Economically, Trump's resentment of China's trade practices is based on the old growth model that the country no longer adheres to. Trump's version of Chinese manufacturers - "sweat shops" operating in "pollution heaven" heavily dependent on state subsidies and a cheap currency - is increasingly out of touch with today's reality, as discussed in detail in a previous report.3 In a nutshell, Chinese manufacturers have quickly climbed up the value-add ladder due to rapidly rising labor costs, and pollution control has become an urgent social issue. Meanwhile, the RMB has been under constant downward pressure in recent years, and the Chinese authorities may welcome coordinated efforts to weaken the dollar and support the yuan. In short, China will not find it too painful to accept Trump's terms and conditions, as the "sick parts" of the Chinese economy will inevitably be cleansed regardless of pressure from the U.S. The risk to this view is that Trump finds China's progress too slow and grows impatient. Previous American presidents have come to accept China's gradualism and have demurred from punitive measures. Trump, with his populist base and promises, may at some point find it politically expedient to exact a price on China for failing to deliver the desired results on his electoral timeline. Across the board tariffs on Chinese imports are unlikely, but highly symbolic sanctions and anti-dumping measures remain distinct possibility. The End Game Of Sino-U.S. Trade Imbalances However, any immediate concessions from China on trade will do little to fundamentally change the U.S.'s external imbalances. It is well known that a country's current account balance is the residual of its national savings and domestic capital spending. Therefore, it is unrealistic to expect a meaningful reduction in the country's current account deficit without lifting America's domestic savings rate. Chart 1 shows the chronic nature of America's external deficit. It is worth noting that the "Nixon shock" in 1971 - the policy package of closing the gold window and imposing across-the-board tariffs on imports - was triggered when the U.S. was on track to have its first annual trade deficit since the 19th century. Fast forward 46 years later, various attempts by American administrations have failed to rescue the deteriorating trend. Many countries over the years such as Germany, Japan and newly-industrialized economies in Asia were all singled out as conducting unfair trade practices with the U.S., but none of the bilateral and multi-lateral efforts were effective with lasting impact. A fundamental change in global trade over the past four decades has been the rapid industrialization of China. In essence, China has become the final point of an increasingly integrated global assembly line, and therefore America's chronic deficit has been transferred from other countries to China. Chart 2 shows China's surplus with the U.S. has ballooned, while other countries' surpluses have dwindled. This has put China squarely under the spotlight, replacing previous scapegoats. Chart 1America's Secular Deficit... America's Secular Deficit... America's Secular Deficit... Chart 2... From Changing Sources ... From Changing Sources ... From Changing Sources From China's perspective, the country will continue to run a surplus with the U.S. so long as it remains in the most manufacturing-intensive phase of its development curve, though the product mix will continue to shift from lower-value-added goods to higher-value-added ones. Meanwhile, the Chinese corporate sector will shift production capacity to even lower cost countries, similar to what Japan, Hong Kong and Taiwan have done in relation to China since the early 1980s when China began to open up. Already, China's direct investment to Vietnam has surged in recent years, which partially explains the sharp increase in Vietnam's trade surpluses with the U.S. (Chart 3). In fact, Vietnamese trade surplus with the U.S. account for 15% of the country's GDP, even though its overall trade balance is barely positive. This means that America's demand for cheap consumer goods is the main driving forces for its deficit, rather than any particular country's unfair trade practices. The fact is that the U.S. has moved beyond industrialization and become a post-industrial society, where the service sector generates more wealth than the manufacturing sector. China's shrinking share of imports from the U.S. is the mirror image of America's shrinking share of the manufacturing sector in the overall economy (Chart 4). Furthermore, the self-imposed restrictions on some high-tech goods exports to China further limits American firms growth potential, as this is the most competitive segment of America's manufacturing sector in the global market. Without removing these restrictions, it is unrealistic to expect a material increase in sales to China. Chart 3The "China Factor" In Vietnam's##br## Growing Trade Surpluses The "China Factor" In Vietnam's Growing Trade Surpluses The "China Factor" In Vietnam's Growing Trade Surpluses Chart 4America's Deindustrialization And ##br##Shrinking Market Share In China America's Deindustrialization And Shrinking Market Share In China America's Deindustrialization And Shrinking Market Share In China For now, the Trump-Xi summit offers hopeful signs that the two sides are mending severely tested bilateral relations and that the risk of escalation in trade tensions has declined. Trump may adopt a "good cop / bad cop" strategy that creates greater volatility. Longer term, unless the Trump administration addresses America's "savings shortage," the country's external deficit will not change materially. Imposing tariffs on Chinese imports only pushes Chinese surpluses to other less-competitive countries; it does not bring jobs back to the U.S. Any serious negotiations on bilateral trade imbalances between China and the U.S. must deal with the root causes. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "The RMB: Back In The Spotlight," dated March 16, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report, "Dealing With The Trump Wildcard," dated January 26, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Substituting certain imports with local production will ensure that Russia's inflation rate will become less sensitive to fluctuations in the exchange rate and more sensitive to local wages/unit labor costs. In such a scenario, the central bank will not need to pursue pro-cyclical monetary policy. This is on top of the counter-cyclical fiscal policy emerging from the new fiscal rule. Less pro-cyclical monetary and fiscal policies argue for more stability in the real economy than in the past. Altogether, this warrants a lower beta for Russian financial assets relative to EM benchmarks. Meanwhile, geopolitics is likely to remain a tailwind for Russia. Continue overweighting Russian stocks, ruble, local fixed-income and credit relative to their EM counterparts. A new trade: Go long the ruble and short crude oil. Feature Russian equities and the ruble have been high-beta bets on oil prices. While the positive correlation between crude prices and Russian financial markets is unlikely to change soon, the country's stock market and currency will likely become low-beta within the EM universe. Sound macro policies and some import substitutions will make inflation less sensitive to the exchange rate. As such, the central bank will not need to hike interest rates amid falling oil prices. The key point is that fiscal and monetary policies are becoming less pro-cyclical. This will reduce volatility in the real economy, which in turn will warrant a lower risk premium on Russian assets, particularly within the EM aggregates. Meanwhile, geopolitics is likely to remain a tailwind for Russia. Both Europe and the U.S. have lost appetite for direct confrontation. And while some of the exuberance immediately following Trump's victory will wear off, the U.S. and Russia are unlikely to revisit the 2014 nadir in relations. Orthodox Macro Policies... Russia has adhered to orthodox macro policies amid a severe recession over the past two years: On the fiscal front: The government has maintained constant nominal expenditure growth and substantially cut spending in real terms (Chart I-1). The fiscal deficit is still large at 3.8% of GDP, but it typically lags oil prices (Chart I-2). Hence, the recovery in oil prices over the past year should lead to a notable improvement in the budget balance. For 2017, the budget is conservative, as it assumes $/bbl 40 Urals. Early this year, the Ministry of Finance adopted a new fiscal rule where it will buy foreign currency when the price of oil is above the set target level of 2700 RUB per barrel ($40 oil price times 67 USD/RUB exchange rate) and sell foreign exchange when the oil price is below that level (Chart I-3). Chart I-1Russia Has Undergone ##br##Through Real Fiscal Squeeze... Russia Has Undergone Through Real Fiscal Squeeze... Russia Has Undergone Through Real Fiscal Squeeze... Chart I-2...Which Is Now Over ...Which Is Now Over ...Which Is Now Over Chart I-3Oil Price Threshold For ##br##The New Fiscal Rule Oil Price Threshold For The New Fiscal Rule Oil Price Threshold For The New Fiscal Rule The objective of this policy is to create a counter-cyclical ballast that will limit fluctuations in the ruble caused by swings in oil prices. With respect to monetary policy, Russia's central bank has been highly prudent. Unlike many other emerging countries, the central bank has refrained from injecting liquidity into the banking system (Chart I-4) and has maintained high real interest rates (Chart I-4, bottom panel). Chart I-5 demonstrates that the central bank's domestic assets have been flat, while the same measure has surged for many other EM central banks. Although this measure does not reflect central banks' net liquidity injections, it in general validates that Russia's monetary authorities have been more conservative than their counterparts in many developing countries. This is ultimately positive for the currency. Chart I-4Russian Central Bank: ##br##Tight Monetary Stance Russian Central Bank: Tight Monetary Stance Russian Central Bank: Tight Monetary Stance Chart I-5Russian Central Bank Has Been ##br##Conservative Among Its Peers Russian Central Bank Has Been Conservative Among Its Peers Russian Central Bank Has Been Conservative Among Its Peers Furthermore, the central bank has been forcing banks to acknowledge non-performing loans (Chart I-6, top panel) and has been reducing the number of dysfunctional banks by removing their licenses (Chart I-6, bottom panel). This assures that the credit system has already gone through a cleansing process, and a gradual credit recovery will commence soon. This is also in stark contrast with many other EM banking systems, where credit-to-GDP ratios continue to rise. In brief, Russia is advanced on the path of deleveraging (Chart I-7), while many EM countries have not even begun the process. Chart I-6Russian Central Bank Has ##br##Forced Banking Restructuring Russian Central Bank Has Forced Banking Restructuring Russian Central Bank Has Forced Banking Restructuring Chart I-7Russia Is Very Advanced ##br##In Its Deleveraging Cycle Russia Is Very Advanced In Its Deleveraging Cycle Russia Is Very Advanced In Its Deleveraging Cycle Bottom Line: The new fiscal rule will reduce fluctuations in the ruble. The central bank's ongoing tight policy stance will also put a floor under the ruble. Even though we expect oil prices to drop meaningfully in the months ahead, any ruble depreciation will be moderate. ... Plus Some Imports Substitution... The dramatic currency devaluation in 2014-15 and sanctions imposed on Russia by the West have led to the substitution of some imported goods with locally produced ones. First, the most visible import substitution has occurred in the agriculture sector. Chart I-8 suggests that in agriculture import substitution has been broad-based and significant. Second, while there has been some import substitution in the industrial sector, it has been less pronounced. Demand for industrial goods and non-staples (autos and furniture, for example) has plunged significantly. Hence, local production has also collapsed, but less so than imports (Chart I-9). Chart I-8Russia: Import ##br##Substitution In Agriculture Russia: Import Substitution In Agriculture Russia: Import Substitution In Agriculture Chart I-9Some Import ##br##Substitution In Manufacturing Some Import Substitution In Manufacturing Some Import Substitution In Manufacturing As domestic demand recovers, manufacturing production of industrial goods will increase. However, it is not clear how much of this demand recovery will be met by rising imports versus domestic production. On one hand, the ruble is not expensive, and argues for more import substitution going forward - i.e. relying more on domestic production rather than imports. On the other hand, Russia is hamstrung by a lack of manufacturing productive capacity, technology and know-how in many sectors to produce competitive products. FDI by multinational companies will likely rise from extremely low levels (Chart I-10), yet it is unlikely to be sufficient to make a major difference in terms of Russia's competitiveness. Third, the ruble depreciation has helped Russia increase oil and natural gas production (Chart I-11). Chart I-10Russia: Meager Net FDI Inflows Russia: Meager Net FDI Inflows Russia: Meager Net FDI Inflows Chart I-11Russia: Oil And Natural Gas Output Is Robust Russia: Oil And Natural Gas Output Is Robust Russia: Oil And Natural Gas Output Is Robust Finally, in an attempt to lessen dependence on foreigners, Russian President Vladimir Putin has been pushing the use of domestic technology. For example, Microsoft products will be replaced by locally developed software. Bottom Line: The combination of currency depreciation and trade sanctions has led to some import substitution. ...Will Make Inflation Less Sensitive To The Currency Chart I-12Russia: Unit Labor ##br##Costs Have Collapsed Russia: Unit Labor Costs Have Collapsed Russia: Unit Labor Costs Have Collapsed The collapse of the ruble has drastically reduced labor costs in Russia's manufacturing sector (Chart I-12). A diminished share of imports in domestic consumption - import substitution - will ensure Russia's inflation rate becomes less sensitive to fluctuations in the exchange rate and more sensitive to local wages/unit labor costs instead. Tame wages and some improvement in productivity - as output recovers - will cap Russian unit labor costs and restrain inflation in the medium term. In such a scenario, the central bank will not need to pursue pro-cyclical monetary policy - i.e., hike interest rates when oil prices drop and the ruble depreciates. Less pro-cyclical monetary and fiscal policies will diminish fluctuations in the economy, and economic visibility will improve. This bodes well for the nation's financial assets. We do not mean to suggest that the central bank of Russia will immediately pursue counter-cyclical monetary policy - i.e., that it will be able to cut interest rates when oil prices fall. While this would be ideal for the national economy, it is not a practical option for now. Bottom Line: Less pro-cyclical monetary and fiscal policies argue for more stability in the real economy than in the past. Altogether, this warrants a lower beta for Russian financial assets relative to EM benchmarks. The Growth Outlook The Russian economy is about to exit recession (Chart I-13, top panel), but growth recovery will be timid: Bank loans will recover after pronounced contraction over the past two years. The credit impulse - the change in bank loan growth - has already turned positive (Chart I-13, bottom panel). Retail sales volumes and auto sales have not yet recovered but manufacturing output growth is already positive (Chart I-14). Rising nominal and real wages argue for a pick-up in consumer spending (Chart I-14, bottom panel). Capital spending has collapsed both in absolute terms and relative to GDP (Chart I-15). Such an underinvested position and potential recovery in consumer spending warrant a pickup in investment outlays. The key difference between Brazil and Russia - the two economies that plunged into deep recession in the past 2-3 years - is public debt load and sustainability. Chart I-13Russia: Recovery Is At Hand Russia: Recovery Is At Hand Russia: Recovery Is At Hand Chart I-14Russia: Economic Conditions Russia: Economic Conditions Russia: Economic Conditions Chart I-15Russia: Capex Recovery Is Overdue Russia: Capex Recovery Is Overdue Russia: Capex Recovery Is Overdue The public debt-to-GDP ratio is 77% in Brazil and 16% in Russia, while fiscal deficits are 9% and 3.8% of GDP, respectively. Public debt could spiral out of control in Brazil1 in the next two years, while it is not an issue in Russia. Bottom Line: Russia is about to embark on a mild and gradual economic recovery, even if oil prices relapse. Russia Is In A Geopolitical Sweet Spot Geopolitical headwinds will continue to abate for Russia. We expect that some of the loftiest expectations of a U.S.-Russia détente will fail to materialize as the Trump Administration continues to face domestic pressures. However, the 2014 nadir in relations will not be revisited. Meanwhile, Russia will benefit from several geopolitical tailwinds: The path of least resistance for tensions between Russia and the West is down. The Trump administration is highly unlikely to increase sanctions against Russia. Congress is likely to open an investigation into allegations of Russian interference in the 2016 U.S. election, but we highly doubt that any genuine "smoking guns" linking the Kremlin to the election result will be found. As such, we expect the thaw in U.S.-Russia relations to continue, albeit haltingly and without any possibility that the two powers become allies. Washington has recently removed sanctions related to U.S. tech exports to Russia. While U.S. sanction can be easily removed by presidential decree, EU sanctions require a unanimous vote on behalf of the European council. A summary can be found bellow. Table I-1 Russia: Entering A Lower-Beta Paradigm Russia: Entering A Lower-Beta Paradigm Putin's support remains high (Chart I-16), giving him a sense of confidence that modest structural reforms and economic opening is possible without undermining his support base. Military intervention in Syria has largely been a success, from Moscow's point of view. Chart I-16Popularity Of Putin And Government Popularity Of Putin And Government Popularity Of Putin And Government None of the current candidates in the upcoming elections in Europe are overtly anti-Russia. In France, leading candidate Emmanuel Macron is mildly hawkish on Russia, but the other two candidates - Marine Le Pen and François Fillon are downright Russophile. In Germany, the historically sympathetic to Russia Socialist Democratic Party (SPD) has taken a lead against Angela Merkel's ruling party. Even if Angela Merkel retains her Chancellorship, it is likely that the Grand Coalition would have to give the SPD a greater role given their dramatic rise in polling. Despite two major diplomatic incidents between Turkey and Russia,2 relations between the two countries continue to improve. In fact, the Turkstream project - which will connect Russia with Turkey via the Black Sea - has been approved by both sides. This is a positive development for the Russian energy sector as the capacity of that pipeline is large, standing at 63 Bn cubic meters per year. In Syria, the two countries have gone from outright hostility to coordinating their military operations on the ground, a dramatic reversal. The Rosneft IPO was a success, a positive sign for foreign investments in Russia. While the issuance was conducted for budget reasons, it is a sign that Russia is willing to open itself to foreign investors. The caveat being that it will only do so selectively. Further evidence of this selective opening is the recent announcement by the head of the Finance Ministry debt department that the next Eurobond auction will be conducted privately. Past investments from western firms in Russia failed due to the fact that a large number of Western oil companies were complacent in their investment analysis and failed to do due diligence.3 Furthermore, foreign investments in Russia have often failed because it was caught in the cross fire between the Kremlin and the various oligarchs who brought in the foreign investment.4 Given that President Vladimir Putin has largely neutered oligarchs, FDI that arrives in the country will have full blessing of the government. Finally, we would expect western energy companies to be more selective in their foreign investments given the recent crash in oil prices. As BCA's Geopolitical Strategy has been warning since 2014, globalization is in a structural decline and protectionism may follow. The Trump administration has threatened to use tariffs against both geopolitical adversaries, like China, and allies, like Germany. The border adjustment tax, proposed by Republicans in Congress, is a protectionist measure that could launch a global trade war.5 Due to the fact that Russia exports commodities, we would expect Russia's export revenue stream to be unaffected compared to countries who export more elastic goods such as consumer products. Bottom Line: We expect geopolitical dynamics to play in Russia's favor going forward. These will mark a structural shift in how foreign investment is conducted in Russia and risk assets will continue re-pricing. Investment Conclusions Chart I-17Continue Overweighting Russian Stocks Continue Overweighting Russian Stocks Continue Overweighting Russian Stocks Russian stocks will outperform the EM equity benchmark in the months ahead (Chart I-17). Stay overweight. Typically, the Russian bourse has outperformed the EM index during risk-on phases and underperformed in risk-off episodes - i.e., Russia has been a high-beta market. This will likely change, and we expect Russia to outperform in a falling market. Also, maintain the long Russian stocks and ruble / short Malaysian stocks and ringgit trades. Continue overweighting Russian sovereign and corporate credit within the EM credit universe. Continue overweighing local currency bonds within EM domestic bond portfolios. A new trade: Go long the ruble and short oil. When oil prices drop, as BCA's Emerging Markets Strategy team expects to happen in the months ahead, the ruble might weaken too. However, adjusted for the carry, the aggregate long ruble/short oil position will prove profitable. Stephan Gabillard, Research Analyst stephang@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Report titled, "Has Brazil Achieved Escape Velocity?", dated February 8, 2017, link available on page 14. 2 Turkey shot down a Russian Sukhoi Su-24 on November 24th 2015 and Andrei Karlov, the Russian ambassador to Turkey got shot dead by a Turkish police officer in Ankara on December 19th 2016. 3 The BP and TNK deal failed for obvious reasons. BP and TNK had already come in confrontation when in the mid-1990's BP had bought a 10 percent stake in Sidanco only to see TNK strip the company of its asset. Furthermore, TNK was involved in other mergers inside Russia, making extremely confusing to understand what assets it actually owned. 4 Putin's campaign to sideline Khodorkovsky and Berezovsky for example sometimes came at odds with foreign investment in Russia. 5 Please see BCA Geopolitical Strategy Special Report, "Will Congress Pass The Border Adjustment Tax," dated February 8, 2017, available at gps.bcaresearch.com.

Highlights Three emerging macro factors bode poorly for Taiwan's growth outlook and asset prices. Despite the worrying economic and geopolitical backdrop, global investors appear complacent. Foreign ownership in Taiwanese stocks has reached a new record high. Remain cautious on Taiwanese stocks. Short the TSE versus Chinese investable shares. Feature Taiwan's economy and financial markets have shown remarkable resilience of late. Last week's advance GDP release confirmed that the Taiwanese economy continued to accelerate in the final quarter of the year. The Taiwanese dollar (TWD) is among the few currencies that have strengthened since early last year, not only in trade-weighted terms but also against the mighty greenback. Taiwanese stocks have been a bright spot in the emerging market universe, which has been plagued with structural challenges and political instability in recent years. Taiwan's remarkable strength of late is notwithstanding the sudden deterioration in its relationship with mainland China since the DPP party regained power last year, and more recently brewing trade tensions among the major global economies kicked off by the Trump Administration. This highlights the growing disconnect between Taiwan's macro outlook and its financial asset performance, offering a particularly poor risk-return profile. We remain underweight Taiwan among the greater China bourses, and recommend a short position in the TSE versus Chinese H shares. Macro Risks Are Rising... In a nutshell, three emerging macro factors bode poorly for Taiwan's growth outlook and asset prices. First, Taiwan is among the most open economies in the world, and will suffer disportionally in any disruption in global trade (Chart 1). Although having fallen sharply since the global financial crisis, exports of goods and services still account for over 60% of Taiwan's GDP, among the highest of the major economies. Therefore, Taiwan's growth outlook is almost completely dictated by global demand, making it particualrly vulnerable at times of rising global uncertainty. Indeed, Taiwan's growth acceleration since mid-last year has been entirely driven by a synchronized acceleration in overseas demand. Both China and the U.S. have been strengthening, which will likely continue to support Taiwan's growth outlook in the near term.1 However, the strength in the Taiwanese currency is worrisome, as the exchange rate has historically been tightly correlated with overseas new orders and domestic producer prices. Chart 2 shows that the strong TWD has the potential to lead to a sudden deterioration in deflation as well as new export orders. Chart 1Taiwanese Growth: All About Exports Taiwanese Growth: All About Exports Taiwanese Growth: All About Exports Chart 2TWD Strength Is A Headwind For Exports TWD Strength Is A Headwind For Exports TWD Strength Is A Headwind For Exports Second, the cross-strait relationship has already deteriorated notably, and a vicious feedback loop appears to be developing. On the one hand, the Chinese authorities are worried that incumbent President Tsai Ing-wen will not uphold the "1992 Consensus" that forms the foundation of cross-straight integration,2 and will step up efforts to contain her "pro-independence" initiatives. On the other hand, the Taiwanese government, faced with increasing pressure from the mainland, feels the urge to reach out to a broader global audience, which in turn may be perceived by Beijing as provocative. President Tsai's controversial phone call with Donald Trump, her stop-over visit to the U.S. en route to South America and the attendance of the government's delegation to President Trump's inauguration have only further reinforced Beijing's suspicion - and propelled forward a self-feeding negative dynamic in the cross-strait relationship that is difficult to reverse. The consequence of a military conflict between the mainland and Taiwan is unimaginably costly, and still extremely unlikely. However, the economic ties between the two will continue to cool. A telltale sign is that number of mainland Chinese visitors to Taiwan has already dropped precipitously since early last year, causing visible stress in Taiwan's tourism industry (Chart 3). Furthermore, exports to China account for over 40% of total Taiwanese exports, far higher than to any other market, and its trade surplus with China accounts for 5% of Taiwanese GDP - both of which are at risk should cross-strait tensions continue to rise (Chart 4). Moreover, the deteriorating relationship with the mainland is also hurting domestic confidence. Chart 5 shows that Taiwanese consumer confidence has historically been tightly linked with stock market performance, but a widening gap has developed since early last year when stocks began to rebound but confidence continued to weaken, which we suspect is to some extent attributable to the DPP party's dealings with the mainland. Weakening confidence bodes poorly for consumption, making the economy even more vulnerable to external shocks. Chart 3Cross - Strait Relationship ##br##Has Cooled Sharply Cross - Strait Relationship Has Cooled Sharply Cross - Strait Relationship Has Cooled Sharply Chart 4China Trade ##br##Is Crucial For Taiwan China Trade Is Crucial For Taiwan China Trade Is Crucial For Taiwan Chart 5Cooling China - ties##br## Also Hurts Domestic Confidence Cooling China - ties Also Hurts Domestic Confidence Cooling China - ties Also Hurts Domestic Confidence Finally, tensions between China and the U.S. are bound to rise under President Trump, and Taiwan may fall victim to the "clash of the Titans." Trump has openly questioned the "One China" policy that fundamentally underpins the Sino-U.S. relationship. John Bolton, a top adviser to President Trump, has even recommended positioning U.S. troops in Taiwan to counter the mainland. It is likely that Trump is using the "Taiwan card" as a bargaining chip to win concessions from China on trade-related issues.3 However, these remarks are dangerously provocative. Any miscalculation could lead to a drastic escalation in tensions across the Taiwan Strait, and the Taiwanese economy will suffer profoundly. Even if trade tensions are contained between China and the U.S., Taiwan will also suffer because it is a critical part of the highly complex and integrated supply chain in the global technology and electronics industries. It is premature and overly alarmist to predict any "war-like" scenario, but stakes are exceedingly high for Taiwan, and any move in this direction should be monitored extremely carefully. ...But Investors Appear Complacent Despite the worrying economic and geopolitical backdrop, global investors still appear comfortable in Taiwanese stocks. Foreign capital has continued to flock to Taiwan, despite gloomy sentiment among global investors on emerging markets overall. Net foreign purchases of Taiwanese stocks, historically tightly linked with fund flows to U.S. emerging market mutual funds, have rebounded sharply, while EM mutual fund sales have weakened, a rare divergence historically (Chart 6). Cumulative foreign net purchases of Taiwanese stocks have pushed foreign ownership in Taiwanese stocks to 37%, a new all-time high (Chart 7). Foreign fund flows have been a key reason behind the relative strength of both Taiwanese stocks and its exchange rate of late. Chart 6Diverging Fund Flows To EM And Taiwan Diverging Fund Flows To EM And Taiwan Diverging Fund Flows To EM And Taiwan Chart 7Rising Foreign Ownership In Taiwanese Stocks Rising Foreign Ownership In Taiwanese Stocks Rising Foreign Ownership In Taiwanese Stocks Granted, Taiwan's macroeconomic conditions are largely stable, characterized by its massive current account surplus, small fiscal deficit and low government debt - which make it stand out in an otherwise perilous, crisis-prone EM world. However, we suspect large foreign flows to Taiwan in recent years are also due to the tech-heavy nature of its stock market. Chart 8 shows the relative performance of global tech stocks bear a strong resemblance to Taiwan's relative performance against the EM benchmark after the global financial crisis. In other words, investors are largely attracted to the Taiwanese market as a way to play the global tech rally rather than because of any specific macro factors unique to Taiwan. This also means that investors could be blindsided by any escalation of trade or geopolitical tensions across the Taiwan Strait. Moreover, the large percentage of foreign ownership in Taiwanese stocks risks a disorderly unwinding and sudden exodus - and an ensuing sharp spike in volatility. The last episode of military tension between Taiwan and the mainland in the mid-1990s offers the only precedent in terms of how financial markets might respond. China reacted to the U.S. visit of Taiwan's then President Lee-Teng-hui with aggressive saber-rattling by mobilizing troops and firing missiles, which led to the "third Taiwan Strait Crisis" (Chart 9). Even though the crisis officially lasted from July 1995 to March 1996, Taiwanese stocks tumbled well in advance when the tensions first began to emerge. In fact, the crisis itself, and the resolution of it, marked the bottom in Taiwanese stock prices. Chart 8Taiwanese Stocks As A Tech Play Taiwanese Stocks As A Tech Play Taiwanese Stocks As A Tech Play Chart 9The Last Episode Of Cross - Strait Tension The Last Episode Of Cross - Strait Tension The Last Episode Of Cross - Strait Tension Long H Shares, Short Taiwan Taiwanese stocks are the most vulnerable bourse in the Greater China region. A short position of the TSE versus Chinese H shares offers an attractive risk-return profile. Chinese stocks have long been punished by various macro concerns, and are likely under-owned by global investors. Investor sentiment on Taiwan, on the other hand, appear to be unduly complacent, and Taiwanese stocks have likely been overweighted and over-owned. Chinese stocks are much less exposed to global trade than their Taiwanese counterparts. Even though tech stocks are the largest sectors for both markets, the largest Chinese tech companies such as Tencent, Alibaba and Baidu are mainly software and service providers, and derive the majority of their revenue from the domestic market.4 In contrast, Taiwanese tech companies, also the largest constituents in the Taiwanese index, such as TSMC, Hon Hai and Largan, are all hardware producers, and are overwhelmingly dependent on the global market, making them more vulnerable to any disruption in global trade flows. Valuations of Taiwanese stocks are not particularly demanding by global comparison, but they are trading at a premium to their mainland peers (Chart 10, bottom panel). Moreover, the recent improvement in Taiwanese earnings will be tested, given the strength of the TWD and deterioration in terms of trade (Chart 11). Historically, Taiwanese earnings have been highly cyclical and prone to sharp swings, led by global business cycles. Technically speaking, the multi-year underperformance of Chinese investable shares against the Taiwanese market has become very advanced and appears to have formed an enduring bottom (Chart 10, top panel). Chart 10Chinese H Shares Vs Taiwanese Stocks: ##br##Valuation And Technical Perspective Chinese H Shares Vs Taiwanese Stocks: Valuation And Technical Perspective Chinese H Shares Vs Taiwanese Stocks: Valuation And Technical Perspective Chart 11Taiwanese Earnings Improvement##br## Will Be Tested Taiwanese Earnings Improvement Will Be Tested Taiwanese Earnings Improvement Will Be Tested Bottom Line: Remain cautious on Taiwanese stocks. Short the TSE versus Chinese investable shares as a trade. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China: The 2017 Outlook, And The Trump Wildcard," dated January 12, 2017, available at cis.bcaresearch.com. 2 The "1992 Consensus" refers to the outcome of a meeting in 1992 between China and Taiwan's then ruling party KMT. The terms means that both sides recognize there is only one "China": both mainland China and Taiwan belong to the same China, but both sides agree to interpret the meaning of that one China according to their own definition. 3,4 Please see China Investment Strategy Special Report, "Dealing With The Trump Wildcard," dated January 26, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights The U.S. has two geopolitical imperatives: domination of the world's oceans and ensuring the disunity of Eurasia; The Trump Doctrine, as currently defined, has no room for transatlantic alliances; President Trump is pursuing both mercantilism and an isolationist foreign policy; This combination imperils the transatlantic alliance and thus the American anchor in Eurasia; If pursued to its logical conclusion, the Trump Doctrine will end American global hegemony. Feature "Who rules East Europe commands the Heartland; Who rules the Heartland commands the World-Island; Who rules the World-Island commands the world." - Sir Halford John Mackinder Geopolitics is parsimonious and predictive because it posits that states are imprisoned by their geography. For academia, geopolitics is too parsimonious. And the professors are correct! Mountainous terrain combined with ethno-linguistic heterogeneity has destined Afghanistan and Bosnia to centuries of conflict, but Switzerland seems to be doing just fine. As such, BCA's Geopolitical Strategy, despite our name, very rarely relies on pure geopolitics for its analysis. The world is just too complex and geopolitics operates on long time horizons that are rarely investment-relevant. Geography is not destiny. Rather, geography is the ultimate constraint, an immutable factor that can only be conquered with a massive effort or new technology that comes but once in a generation. To fight geography is folly, even for a hegemon. The Trump Doctrine, as it has taken shape thus far, looks to be just such a folly. In this analysis, we explain why and what the investment relevance may be for the U.S. and the world. We still think the U.S. is likely to regain power in relative terms, but Trump's "charismatic authority" and foreign policy pose a risk to this view. American Geopolitical Imperatives There are two notable "fathers" of geopolitics: Alfred Thayer Mahan and Sir Halford John Mackinder. They both dedicated their life to elucidating great power "Grand Strategy," the implicit but real geopolitical imperatives, rooted in geography, from which a country derives its day-to-day foreign policy. For Mahan, a U.S. Navy Admiral and lecturer at the Naval War College, the imperative of the U.S. was to build a navy to dominate the oceans, the global "commons" that is indispensable to modern trade, economy, and thus "hard power."1 A strong navy is the defining characteristic of a great power. It affords the hegemon military supremacy over vital trade routes and ensures that global commerce operates in its interest. If this sounds like present-day U.S. "Grand Strategy," it is because Mahan had a great influence on American policymakers in the early twentieth century. Theodore Roosevelt supported Mahan's thinking, which included building the Panama Canal. Mahan's The Influence of Sea Power Upon History, and similar work by British strategists, provided a historical and strategic framework for the naval race between the U.K. and Germany that ultimately contributed to the start of World War I.2 Mackinder, a British geographer and academic, focused on the Eurasian landmass, rather than the oceans.3 In his view - perhaps colored by Britain's history of fending off invaders from the continent - Eurasia had sufficient natural resources (Russia), population (China), wealth (Europe), and a geographic buffer from naval powers (the seas surrounding it) to become self-sufficient. Hence any great power that managed to dominate Eurasia, or "the World Island" as Mackinder coined it, would have no need for a navy as it would become a superpower by default (Map 1). Map 1The World According To Mackinder The Trump Doctrine The Trump Doctrine American Grand Strategy is today a combination of both Mahan's and Mackinder's thinking. The U.S. has had two explicit geopolitical imperatives since the end of World War II: Dominate the world's oceans (Mahan); Prevent any one power from dominating Eurasia (Mackinder). To accomplish the first, the U.S. has expended an extraordinary amount of resources to build and operate the world's greatest blue-water navy. To accomplish the second, the U.S. has entered two world wars, the Korean War, the Vietnam War, and spent a good part of the twentieth century containing the Soviet Union. In addition, Washington has fostered a close transatlantic alliance to ensure that Europe, its anchor in Eurasia, remains aligned with the U.S. These were not arbitrary decisions made by a corrupt, Beltway elite looking to enrich itself with the spoils of globalization. These were decisions made by American leaders looking to expand American power, establish global hegemony, and retain it against rivals for centuries to come. Both imperatives are necessary for the U.S. to remain a hegemon. And U.S. hegemony is the foundation of the global monetary and financial system. Not least, it underpins the role of the U.S. dollar as the world's reserve currency. Bottom Line: The U.S. has two geopolitical imperatives: domination of the world's oceans and ensuring the disunity of Eurasia. The Trump Doctrine: America First, Second, And Third Every U.S. president tries to enshrine a foreign policy "doctrine" during their presidency. There is no single document that does the job of elucidating the doctrine; scholars and journalists weave the ideas together from speeches, policy decisions, resource allocation, and rhetoric. This early in the Trump presidency, it is not fair to determine what his foreign policy doctrine will be. Already, with Trump's executive orders on immigration and refugees, it is clear that there is a process of trial and error underway, with the administration reversing its position on green card holders (U.S. permanent residents). We therefore take liberty in projecting the little information we have forward. Chances that we are wrong are high and our conviction level is low. Nevertheless, we have two broad conclusions. If the Trump Doctrine develops as these early clues suggest, then it will either be rejected by Congress and the American policy establishment, or it will initiate the collapse of the geopolitical and economic institutions of our era, ushering in something profoundly different. We see no alternatives. So what are the early outlines of the Trump Doctrine? We see three factors that stand out: Isolationism: Long-term alliances and commitments abroad must have a clear, immediate, and calculable benefit for the U.S. economic "bottom line." Therefore, Japan and South Korea should pay more for the benefits of U.S. alliance, and NATO is a drain on American resources. All alliances and American commitments are negotiable. Mercantilism: The U.S. has no permanent allies, only trade balances that must be positive. Trump has not only threatened China and Mexico with protectionism, but also longstanding allies like Germany and Japan.4 Any country that sports a significant trade surplus with the U.S. is in Washington's crosshairs (Chart 1). Chart 1Trump's Hit List The Trump Doctrine The Trump Doctrine Sovereignty: Trump said in his inaugural address, "it is the right of all nations to put their own interests first" and that America does "not seek to impose our way of life on anyone." This is a stark departure from ideologically-driven foreign policies of both the Bush and Obama White House. However, there is an ideology underpinning Trump's foreign policy: nationalism. Professor Ted Malloch, tipped as the next U.S. Ambassador to the EU, revealed in a BBC interview that the new U.S. President "is very opposed to supranational organizations, he believes in nation states." This statement makes explicit what many of Trump's speeches have implied. Under the tenets of this inchoate Trump Doctrine, NATO and the EU are not just nuisances, but are positively detrimental to U.S. interests. This marks a profound shift in U.S. foreign policy thinking, if it stands. First, both NATO and the EU break the ideological tenet of nationalism. They are international organizations that pool sovereignty for some predetermined common goal. Given that the common goal has nothing to do with the immediate, domestic and economic goals of the U.S., the two organizations are not worth supporting, under this interpretation of the emerging Trump Doctrine. Second, NATO demands a U.S. overseas commitment with little material gain in return. This is not a new argument. President Obama complained about the failure of NATO member states to pay their fair share (2% of GDP on defense) for collective self-defense (Chart 2). However, Obama's intention was to cajole European allies to boost defense spending; NATO's existence was not in question. Trump does not see a point in America paying for Germany's defense, especially when Germany sports a sizeable trade surplus with the U.S. Chart 2NATO States That Need To 'Pay Up' The Trump Doctrine The Trump Doctrine Third, the EU runs a large current account surplus in general and a trade surplus with the U.S. in particular (Chart 3). For the Trump administration, the EU is therefore a rival, perhaps more so even than Russia, which, when viewed through a purely mercantilist lens, is not a foe. Trump's foreign policy is based on an understanding that the world is multipolar and that the U.S. is in relative geopolitical decline. Our data supports President Trump's assertion (Chart 4). In that way, Trump's doctrine is similar to that of the Obama presidency. Both recognize that the U.S. can no longer act unilaterally and that it must retrench from its global responsibilities. But while Obama sought to enhance U.S. power by relying on allies and supranational organizations, Trump seeks to withdraw into Fortress America and geopolitically deleverage. Such a deleveraging, when combined with mercantilism, may cause America's traditional allies to try harder for its approval, like Trump assumes, or it may push America's traditional allies away from Washington's orbit. Chart 3Mercantilism Makes The EU A 'Bad Guy' Mercantilism Makes The EU A 'Bad Guy' Mercantilism Makes The EU A 'Bad Guy' Chart 4American Power In Relative Decline American Power In Relative Decline American Power In Relative Decline Bottom Line: President Trump believes in a "what can you do for me" world.5 This world has no room for twentieth-century alliances, which did not anticipate the disenchantment and polarization of the American public (or the benefit of Trump's wisdom!) in their original design. Transatlantic Drift The most important feature of the Trump Doctrine is that it seeks to replace transatlantic links between the U.S. and Europe with bilateral, ad-hoc alliances. The one such alliance that has received much media attention is the thaw between the U.S. and Russia. To be clear here, we are very much aware that many U.S. presidents have had deep disagreements with Europe and that every president since Reagan has tried to thaw relations with Russia early in his presidency. However, Trump is different in that he is the first U.S. president to: Openly question the very existence of NATO; Openly oppose European integration;6 Openly engage in mercantilist trade policies towards allies while simultaneously undermining geopolitical alliances with them. The problem with this course of action is that other countries will pursue alternative economic and security relationships to hedge against America's perceived lack of commitment, or outright hostility. Japan and South Korea, for example, concerned that they may face tariffs and a drop in U.S. military support, will need to turn more friendly toward China to avoid conflict and access new consumer markets. The same goes for Europe, with Germany and others eager to substitute for the U.S. by selling more to China amid U.S.-China trade conflicts.7 Thus, if we are to take the Trump Doctrine to its conclusion, we end up with an American foreign policy that pushes Eurasia towards the kind of integration - if not exactly alliance - that Mackinder feared. Since greater Eurasian coordination could eventually develop into a dynamic of its own, this process directly contravenes the second tenet of American grand strategy: Prevent any one power from dominating Eurasia. But wait, Trump supporters will cry, Trump is going to throw a wrench in Eurasian coordination by allying with Russia! No, he won't. Russia and America will not be allies. At best, they will be friends with benefits. The two countries have no shared economic interests. Russia sees both Europe and China as its economic partners. The former for supply of badly needed technology and investment (Chart 5), the latter as an energy market and another source of investment (Chart 6).8 Chart 5Russia Needs European Technology ... The Trump Doctrine The Trump Doctrine Chart 6... And Chinese Energy Demand ... And Chinese Energy Demand ... And Chinese Energy Demand Russian policymakers may be cheering Trump for the moment, but that is only because he brings relief from the extremely anti-Kremlin policies of the Obama (and potentially Hillary Clinton) presidency. The Kremlin will take advantage of the change in the White House. Bear in mind, all that Russian policymakers know of the U.S. in recent memory is conflict and realpolitik: It was the U.S. that pushed for NATO to expand into Ukraine and Georgia. Chancellor Angela Merkel, in fact, vetoed those plans at the 2008 NATO Summit; It was the Bush Administration that pushed for Kosovo's independence in 2008; Both the Bush and Obama administrations sought to construct a ballistic missile defense shield on Russia's doorstop in Central and Eastern Europe. If Trump stumbles in the next four years, who is to say that Moscow won't have to deal with an antagonistic Washington by the end of 2020? Trump's olive branches will not alter Russian thinking about the country's long-term interests. Russian President Vladimir Putin is going to do what is good for Russia, no matter how much he may think that Trump is a great guy to party with. And what is good for Russia is deeper economic integration with China and Europe. In fact, with the U.S. becoming an energy producer - and potentially a significant LNG exporter soon - America may become Russia's competitor for Europe's natural gas demand. Trump, his supporters and advisors, may believe that the twentieth century is over and that post-WWII American alliances have atrophied. They have! Russia is not the Soviet Union. It is no surprise that NATO is having an identity crisis when it no longer has a peer enemy to defend against. But geography has not changed. The U.S. is still far from Eurasia and Eurasia is still the "World Island." The Trump Doctrine ignores the entire twentieth century during which the U.S. had to intervene in Europe twice, and Asia three times, at a huge cost of blood and treasure, due to the threat of the continent unifying under a single hegemon. The international organizations that the U.S. set up after the Second World War, including NATO and the EU but also the UN, IMF, and others, were created to ensure that the U.S. did not have to intervene in Europe again. The security alliance and commercial system in Asia Pacific served a similar purpose. Bottom Line: Trans-oceanic alliances and organizations are not vestiges of a past that has changed, but vestiges of a geography that is immutable. The Trump Doctrine, such as it is, threatens to undermine an imperative of American hegemony. If pursued to its professed conclusion, it will therefore end American hegemony. Eurasian Alliance How can Europe, Russia, and China overcome their vast differences and unite in an anti-American alliance? It is not easy, but nor is it impossible. Russian point of view: The U.S. remains Russia's chief strategic threat. Sino-Russian distrust and tensions are overstated, as we discussed in a 2014 Special Report.9 Russia depends on China and Germany for 32% of its imports and 17% of its exports (Chart 7). It is deeply integrated with both economies. The U.S., meanwhile is about as relevant for the Russian economy as Poland in terms of imports and as Belarus in terms of exports. China's point of view: The U.S. is also China's chief strategic threat - and probably the only thing standing between China and regional hegemony over the course of this century. For China, integrating with the denizens of Eurasia makes a lot of sense. First, it would allow China to avoid the folly of competing with the U.S. in direct naval and maritime conflict. Overland transportation routes - which Beijing seeks to develop via its ambitious "The Silk Road Economic Belt" project - will bypass China's contentious and cramped South and East China Seas. Second, Europe has everything China needs from the U.S. (technology, aircraft, IT), and could offer them at discount rates due to a weak euro and general economic malaise (entire continent is for sale, at a discount!). Third, neither Europe nor Russia care what China does with its neighborhood in East Asia. If China wants to take some shoal from the Philippines, Berlin and Moscow will be okay with that. Europe's point of view: The European Union has never spent much time thinking seriously about the U.S. as a threat to its existence. The possibility, at very least, will promote efforts at economic substitution. Europe and Russia must overcome their differences over Ukraine in order to cooperate again. However, as we pointed out above, it was not Europe that sought to integrate Ukraine and Georgia into NATO, it was the United States. Europe needs Russian energy and Russia needs Europe's technology and investment. As long as they delineate where each sphere of influence begins and ends, which they have done before (in 1917 and 1939 if anyone is still counting!) they will be fine. Finally, trade with emerging markets is already more important for the EU than with the U.S. (Chart 8). And China remains a major potential growth market for EU products. Chart 7U.S. No Substitute For Russian Partners U.S. No Substitute For Russian Partners U.S. No Substitute For Russian Partners Chart 8Europe Relies On EM More Than U.S. Europe Relies On EM More Than U.S. Europe Relies On EM More Than U.S. We do not think that a formal EU-Russia-China axis is around the corner, or even likely. However, if the U.S. should pursue a policy of undermining its transatlantic and transpacific alliances, cheerleading the dissolution of the EU, and treating foes and allies equally when it comes to trade protectionism, the probability that it faces a united front from Eurasia increases. We are not sure that the Trump Administration understands this, or even cares. From what we can tell right now, the Trump White House is singularly focused on trade and commercial matters. It is mercantilist, pure and simple. But geopolitics is not a single dimension. It is like a game of three-dimensional chess. Foreign policy and security are on the top chess board, trade and economic matters are in the middle, and domestic politics are played on the bottom board. When the Trump administration threatens the "One China" policy or encourages EU dissolution because the bloc has "overshot its mark," it corners its counterparts on the geopolitical and political chess boards for the sake of trade and commercial interests. This is a mistake. Europe and China will give up chess pieces on the economic board to preserve their position on the geopolitical and political boards. In other words, Trump's strategy of tough-nosed negotiations - which he learned in the global real estate sector - will only strengthen opposition against the U.S. in the real world. We don't think that Trump is playing three-dimensional chess. He is singularly focused on America's economy and commercial interests and his own domestic political coalition. This is unique in post-World War Two American foreign policy. Ronald Reagan, who cajoled Japan and West Germany into the 1985 Plaza Accord, did so because both Berlin and Tokyo understood they owed their security to America. If Reagan threatened to withdraw America's security commitment to either, he would not have gotten the economic deal he wanted. Bottom Line: If pursued to its logical conclusion, the Trump Doctrine will end U.S. hegemony. Trump's foreign policy has raised a specter, however faint at present, which has not been seen since the Molotov-Ribbentrop Pact between Russia and Germany in 1939: a united Eurasian continent marshalling all its human, natural, and technological resources against the U.S. The last time that happened, 549,865 U.S. lives were needed to preserve American hegemony, not to mention the global cost in blood and treasure. Investment Implications In our 2017 Strategic Outlook we posited that investors should get used to the revival of charismatic authority.10 We borrow the concept from German sociologist Max Weber, who identified it in his seminal essay, "The Three Types of Legitimate Rule."11 Weber argues that legal-rational authority flows from the institutions and laws that define it, not the individuals holding the office. Today, we are seeing the revival of charismatic authority, which Weber defined as flowing from the extraordinary characteristics of an individual. Such leaders are difficult to predict as they often rise to power precisely because of their opposition to the institutions and laws that define the legal-rational authority. The Trump Doctrine is one example of how charismatic authority can lead to uncertainty. Twentieth century institutions may be flawed, but they have underpinned and continue to underpin American hegemony. The U.S. cannot, at the same time, maintain global hegemony, pursue mercantilist commercial policy, and seek to undermine its global alliances. The Trump White House threatens to push allies and foes, pursuing their own interests, to work in concert to isolate the United States. Perhaps President Trump and his advisors are comforted by the fact that the U.S. has always profited from global chaos. The U.S. benefits from being surrounded by two massive oceans, Canada, and the Sonora-Chihuahuan deserts. Following both the First and Second World Wars, the U.S.'s relative geopolitical power skyrocketed (Chart 9). This is why Trump's election led us to believe that global multipolarity would peak in the coming year and set the stage for an American revival.12 Chart 9The U.S. Benefits From Global Chaos The U.S. Benefits From Global Chaos The U.S. Benefits From Global Chaos However, to maintain primacy while sowing global discord, the U.S. needs more than just Anglo-Saxon allies in the world. It needs an anchor in Eurasia, which is and always will be Europe. Without an anchor, Trump's policies will not sow discord, they will create concord, and unite the "World Island" against America. That is why it is important to see how the Trump Doctrine develops in terms of real policy, as opposed to a year's worth of mostly campaign statements. Already the administration has made some appropriate noises about standing "100% behind NATO" and having an "ironclad commitment" to Japan. But make no mistake, Trump's open doubts have reverberated farther and deeper than these minimal reassurances. It is critical to monitor how the Trump administration approaches NATO, the EU, and bilateral negotiations with key partners. We are already seeing evidence of serious coordination - particularly between Germany and China - that could be a counterweight to U.S. power in the marking. These two outcomes - renewed U.S. hegemony, or U.S. downfall - are essentially binary and it is too soon to know which will prevail. What is the probability of downfall? It is low, but rising. If Trump does not adjust his foreign policy - or, barring that, if the U.S. Congress or American foreign policy, defense, and intelligence establishment do not "correct" Trump's course - then U.S. hegemony will begin to unravel. And with it will go a range of "certainties" underpinning global economic growth and trade, including the U.S. dollar's reserve currency status. If America loses its hegemony, one victim may be the U.S. dollar's role as a safe haven asset. The notion that the greenback is a safe-haven asset even when the chief global risks emanate from the U.S. will be tested. We recommend that long-term investors diversify into other currencies, including the Swiss franc, euro, and, of course, gold. Marko Papic, Senior Vice President marko@bcaresearch.com 1 Alfred Thayer Mahan, The Interest Of America In Sea Power: Present And Future (Boston: Little, Brown and Co., 1918). 2 Mahan, The Influence Of Sea Power Upon History, 1660-1783, 15th ed. (Boston: Little, Brown and Co., 1949). 3 Halford John Mackinder, Democratic Ideals And Reality: A Study In The Politics Of Reconstruction, 15th ed. (Washington, D.C.: National Defense University Press, 1996). 4 Trump has surprised U.S. ally Japan by coupling it with China in some of his statements threatening tariffs. Meanwhile Peter Navarro, chief of the new National Trade Council, has recently accused Germany of currency manipulation and structural trade imbalances. Please see Shawn Donnan, "Trump's top trade adviser accuses Germany of currency exploitation," Financial Times, January 31, 2017 available at www.ft.com. 5 Please see Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. 6 Trump has said that the U.K. was "smart" to leave the EU, and has expressed indifference to the existence of the EU and a belief that "others will leave" following the U.K. Please see "Full Transcript of Interview with Donald Trump," The Times of London, January 16, 2017, available at www.thetimes.co.uk. Also, the aforementioned Professor Malloch, potential U.S. Ambassador to the EU, said in his interview with the BBC that "Trump believes that the European Union has in recent decades been tilted strongly and most favorably towards Germany" and that "the EU has overshot its mark." 7 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 8 Please see Geopolitical Strategy Special Report, "Can Russia Import Productivity From China?" dated June 29, 2016, available at gps.bcaresearch.com. 9 Please see Geopolitical Strategy Special Report, "The Embrace Of The Dragon And The Bear," dated April 11, 2014, available at gps.bcaresearch.com. 10 Please see Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 11 Please see Max Weber, "The Three Types Of legitimate Rule," Berkeley Publications in Society and Institutions 4 (1) (1958): 1-11. Translated by Hans Gerth. Originally published in German in the journal Preussiche Jahrbücher 182, 1-2 (1922). 12 Please see Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com.