Emerging Markets

Highlights President Trump has expressed dissatisfaction with the Fed's policy tightening. However, we do not think he will be able to influence policy in a dovish fashion this cycle. Trump has suggested that many nations are manipulating their exchange rates to the detriment of the U.S. We do not see the U.S. as having the same capacity to force large exchange rate appreciation for its trading partners as it previously did. We expect instead this rhetoric to result in more favorable trade deals for the U.S. As a result, while we believe Trump's rhetoric was the catalyst for a much-needed correction in the dollar, his utterances do not mark the end of the dollar rally for 2018. We have been hedging the dollar's short-term downside by selling USD/CAD. We do not anticipate the BoJ to tweak its YCC policy next week. As a result, we fade the yen's recent strength against the dollar. However, we do believe the global economic outlook warrants staying long the yen against the euro and the Aussie for the remainder of the year. Feature U.S. President Donald Trump has begun to fight back against the impact of his stimulative fiscal policy. Obviously, it is not that he is displeased with the decent growth and job performance of the U.S. Instead, he is not happy that this increase in economic activity and build-up in inflationary pressures is causing the Federal Reserve to hike interest rates faster than he would like, and the dollar to be stronger as well. Despite President Trump's intentions, it is unlikely that he actually has enough levers to push the Fed to conduct easier monetary policy, and it is even more doubtful that he can push the dollar lower by pressuring the euro area, China, and other trading partners to revalue their currencies. The Fed Is No Pushover While BCA has argued that President Trump is unconstrained when it comes to his international agenda, there are certainly large constraints on his domestic agenda. When it comes to the Fed, this constraint is binding, as the Federal Reserve Act of 1913 clearly states that the U.S. central bank is a creature of Congress. Moreover, historically, the Fed has been a staunch defender of its independence. As Chart I-1 illustrates, through the post-war period, even when we include the 1970s when former U.S. President Richard Nixon's interferences temporarily eroded the Fed's independence, the U.S. central bank has been among the most fiercely independent monetary guardians in the G-10. Chart I-1The Fed Values Its Independence Rhetoric Is Not Always Policy Rhetoric Is Not Always Policy The 1970s offer a counter-argument to the view that the President has little influence on the Fed. However, Nixon chose Arthur Burns as Fed Chair in 1970 with the goal of maintaining very easy policy. Moreover, Burns continued to target full employment as his priority, which meant inflationary pressures only grew larger in response to the 1973 oil shock. This is in sharp contrast with today's Fed. In opposition to the period prior to the 1977 amendment of the Federal Reserve Act, which required the Fed to "promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates," the Fed is now much more focused on controlling inflation - even if this means more frequent large overshoots in unemployment (Chart I-2). Chart I-2Trump's Fed Is Not Nixon's Fed Trump's Fed Is Not Nixon's Fed Trump's Fed Is Not Nixon's Fed This means that in today's context, the Fed will continue to push rates higher in order to combat inflationary pressures in the U.S. (Chart I-3). Moreover, as Chart I-4 illustrates, our composite capacity utilization measure shows that the U.S. economy is experiencing its tightest conditions since the late 1980s. Historically, such a dearth of economic slack is accompanied by higher interest rates. Chart I-3Upside Risks To U.S. Inflation Budding Price Pressures Upside Risks To U.S. Inflation Budding Price Pressures Upside Risks To U.S. Inflation Budding Price Pressures Chart I-4Maximum Pressure... Capacity Pressures That Is Maximum Pressure... Capacity Pressures That Is Maximum Pressure... Capacity Pressures That Is This also means that it is highly unlikely the Fed will sit idly by in front of the large amount of fiscal stimulus implemented in the U.S. while the economy is at full employment (Chart I-5). Not since the late 1960s has the U.S. experienced this kind of a policy mix. While in the late 1960s it took some time for inflationary pressures to emerge, they ultimately did with much vigor by 1968. However, for inflation to become as pernicious a force as it was in the 1970s, the Fed had to maintain too-easy monetary policy. With its dual mandate that includes keeping inflation at bay, we doubt the Fed will allow the 1970s experience to repeat itself.1 Chart I-5Trump Will Push Rates Higher Unlike In The Past, The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline Trump Will Push Rates Higher Unlike In The Past, The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline Trump Will Push Rates Higher While this means that President Trump is unlikely to be able to affect policy this cycle, it does not mean that he has zero levers. He can ultimately change the Fed leadership to find a great dove; however, this will require that he waits until Fed Chairman Jerome Powell's term ends - something not in sight until 2020. And really, who can he find today that is that dovish; we doubt that Paul Krugman will make any Trump shortlist for Fed leadership anytime soon. In the meantime, we would anticipate President Trump to continue to voice his displeasure with the Fed's policy, as at the very least it will give him a culprit to blame in 2020 if the economy does not perform as he has promised. As a result, we remain confident that the Fed is likely to try to follow the path of rate hikes it currently envisions in its latest set of forecasts. As Chart I-6 illustrates, this path for policy remains above the path currently anticipated in the market. Moreover, we do not believe the Fed will tighten more than it currently anticipates only to assert its own independence. For the Fed to deviate from its current interest rate forecast, economic growth and inflationary pressures will also have to significantly deviate from current expectations, not for Trump to grow louder. Chart I-6U.S. Rate Pricing Has Upside Market Expectations Have Converged With The Fed Dots U.S. Rate Pricing Has Upside Market Expectations Have Converged With The Fed Dots U.S. Rate Pricing Has Upside Bottom Line: President Trump may express his unhappiness with the Fed's hiking campaign, but he can do little more than complain. For now, he cannot affect monetary policy directly, as the Fed is very independent and is very set on limiting the long-term upside to inflation. Since the White House's policies are inflationary, we expect the Fed to continue to tighten as per its current intended path. Trump will only be able to affect policy in a dovish fashion once he gets to change the Fed's leadership. In the meantime, blaming the Fed is an insurance policy for 2020: if the economy is not as strong as he promised, someone else will be responsible for it. Currency Manipulators? Another issue raised by President Trump has contributed to the recent decline in the dollar: His assertions that various currencies, including the euro, are being manipulated downward. Is there much to this assertion, and can the White House do anything to generate downward pressure on the dollar? Let's begin with China. We have argued that at the very least, the Chinese authorities are facilitating the recent slide in the RMB. As Chart I-7 illustrates, CNY/USD is much softer than implied by the level of the dollar itself. If we want to stretch the argument that one country is pushing down its currency today, it is China. Can President Trump do much about it? For the time being, we doubt it. The White House has announced a flurry of implemented and proposed tariffs on China (Chart I-8), and in the interim, the CNY has not strengthened; it has only weakened. Instead of letting the U.S. bully them on their exchange rate policy, it seems the Chinese authorities are finding other means to alleviate the pain created by U.S. tariffs. Chart I-7China Is Manipulating Its Currency... China Is Manipulating Its Currency... China Is Manipulating Its Currency... Chart I-8... And Is Already Facing An Onslaught Of Tariffs... Rhetoric Is Not Always Policy Rhetoric Is Not Always Policy To begin with, the People's Bank of China has injected RMB502 billion into the banking system in recent weeks in order to put downward pressure on overnight rates. Most importantly, earlier this week, it was revealed that the State Council in Beijing would accelerate the issuance of CNY1.4 trillion in local government bonds to support infrastructure. This significant amount of fiscal stimulus may not be enough to prevent China from slowing in response to its own deleveraging effort, it is nonetheless likely to soften the blow to the Chinese economy created by the Trump tariffs. Essentially, we believe that China wants to avoid the shock Japan suffered in the wake of the 1985 Plaza accord. In the 1980s, U.S. President Ronald Reagan and the American public were fed up with the growing Japanese trade surplus with the U.S. The White House started proposing tariffs on Japanese exports and ultimately got Japan to revalue the yen violently. However, this huge yen rally had massively deflationary consequences for Japan. At first, the Bank of Japan responded by cutting rates, inflating the Japanese bubble in the process. Once the bubble popped and the Japanese private sector debt burden was laid bare, the true deflationary impact of the sudden yen revaluation became evident (Chart I-9). To this day, Japan is still dealing with the consequences of these series of policy mistakes. Chart I-9... But It First And Foremost ##br##Wants To Avoid Japan's Fate ... But It First And Foremost Wants To Avoid Japan's Fate ... But It First And Foremost Wants To Avoid Japan's Fate Today, Chinese policymakers not only benefit from the insight of Japan's disastrous experience, but also they already face an enormous debt problem. China's corporate debt stands at 160% of GDP, versus Japan's corporate debt, which stood at 110% of GDP in 1985 when the yen began appreciating and 135% of GDP in 1989 just before the bubble burst. The deflationary consequences of a large FX revaluation are thus at least as dangerous in China today as they were in Japan in the 1980s. In fact, if China is serious about deleveraging and reforming its economy, it will need a cheap currency to ease the deflationary impact of these domestic economic adjustments. On the political front, the U.S. does not have the same levers on China today as it did on Japan in the 1980s. The U.S. is not a military ally; it does not defend the Middle Kingdom against foreign attacks. However, the U.S. was - and still is - Japan's most important military ally, its protector against the Soviet Union in the 1980s and China today. As a result, while Reagan was able to threaten Tokyo with the removal of the U.S. military umbrella, Trump does not have the same tool when it comes to China. Hence, we continue to expect that the outcome of the China-U.S. trade conflict to more likely result in a renegotiation of bilateral investments, tariffs and quotas than a sharply higher RMB. What about Trump's stance on the euro? After all, the U.S. does remain the EU's most important military ally, and the key financial contributor to NATO. This should count as leverage, no? Politically Europe is not as beholden to the U.S today as it was in the 1980s. As Marko Papic argues in BCA's Geopolitical Strategy service, the international political order has entered a multipolar state, with various regional powers vying for local dominance. In the 1980s, the world had two poles of power: the U.S. and the Soviet Union. Back then, Moscow constituted a real threat to Western Europe, as Warsaw Pact nations had tanks parked at the EUs border. Today, this is no longer the case. Russia has weakened, its army is technologically beleaguered, and, in fact, Russia is more dependent on the EU than a threat. As a result, the support of the U.S. is not as crucial to Europe as it once was. Moreover, as Marko also argues, global trade is not expanding as fast as it once was. This means that the U.S. allies are not as likely to tolerate a higher exchange rate as they once were. Essentially, in the 1970s and 1980s, Europe was willing to pushup its exchange rates and absorb an immediate negative shock in order to reap the benefits of growing trade later. This is not feasible anymore as future export growth will not be large enough to compensate for the immediate cost of a euro revaluation. This will limit the tolerance of Europeans to pushup the euro just because the U.S. asked them to do so.2 Nonetheless, President Trump is correct to insist that the euro is cheap, and that this is contributing to the huge trade surplus that Europe runs with the U.S. (Chart I-10). However, the euro area does not target a lower exchange rate, and the European Central Bank does not actively sell euros in the open market. Instead, the undervaluation of EUR/USD simply reflects the fact that the ECB continues to conduct very stimulative monetary policy, which is dragging European real rates lower versus the U.S. It is because of this domestic imperative that EUR/USD remains cheap (Chart I-11). Chart I-10European Exports Are ##br##Benefiting From A Cheap Euro.. ...And The Euro's Undervaluation Has Driven The U.S./Euro Area Trade Imbalance European Exports Are Benefiting From A Cheap Euro.. ...And The Euro's Undervaluation Has Driven The U.S./Euro Area Trade Imbalance European Exports Are Benefiting From A Cheap Euro.. Chart I-11... But This Cheapness Is A Consequence##br## Of Diverging Monetary Policies Relative Monetary Policy Has Driven The Euro's Undervaluation... ... But This Cheapness Is A Consequence Of Diverging Monetary Policies Relative Monetary Policy Has Driven The Euro's Undervaluation... ... But This Cheapness Is A Consequence Of Diverging Monetary Policies However, we think Europe does still need much easier monetary policy than the U.S. because: European growth is lagging that of the U.S. (Chart I-12); The European output gap remains negative, while the U.S.'s is now positive; The U.S. will receive a much larger dose of fiscal stimulus than Europe in 2018 and 2019 (Chart I-13). Chart I-12U.S. Growth Still##br## Outperforms Europe's... U.S. Growth Still Outperforms Europe's... U.S. Growth Still Outperforms Europe's... Chart I-13... And The Relative Fiscal Policy Points##br## To Continued Monetary Divergences Rhetoric Is Not Always Policy Rhetoric Is Not Always Policy This means that we do not expect the euro's long-term undervaluation to get anywhere near corrected this year. In fact, while we have argued that the dollar is likely to experience a correction in the very near term,3 we continue to anticipate that EUR/USD will make deeper lows later in 2018. As we have highlighted, the euro may be cheap on a long-term basis, but it continues to trade at a premium to its short-term drivers (Chart I-14). Moreover, relative inflation between the U.S. and the euro area has been a powerful driver of anticipated monetary policy shifts between these two economies. As a result, relative core inflation has been a good prognosticator of EUR/USD, and currently points to a lower euro (Chart I-15). Therefore, we are not closing our long DXY trade in the face of the dollar's anticipated correction. Instead, we prefer to hedge our risk through this countertrend move by selling USD/CAD. Chart I-14The Euro Is Not A Buy Yet... The Euro Is Not A Buy Yet... The Euro Is Not A Buy Yet... Chart I-15... And Will Not Become So Until Later This Year ... And Will Not Become So Until Later This Year ... And Will Not Become So Until Later This Year Bottom Line: President Trump can call China and Europe currency manipulators if he wants to, but this does not mean he has much leverage over these two economies. China already has a large debt load and is vulnerable to the kind of deflationary shock that Japan endured in the wake of the yen's appreciation following the 1985 Plaza Accord. This limits Beijing's willingness to let the CNY appreciate. Meanwhile, the euro is not manipulated per se; its undervaluation only reflects the fact that Europe needs much easier monetary policy than the U.S. This state of affairs is not changing this year. Thus, only once Europe is ready to withstand higher interest rates will the euro's undervaluation disappear. Japan: The End of YCC? Rumors have been circulating this week that the Bank of Japan may tweak its Yield Curve Control Strategy as soon as next week's Monetary Policy meeting. We are skeptical. First, it is true that Japanese wages have been accelerating in response to the tightest labor market conditions in 30 years (Chart I-16). However, Japanese inflation excluding food and energy has again weakened to 0.3%, pointing to the difficulty the country has in achieving its 2% inflation target. Second, economic numbers have been quite mixed. Japanese Manufacturing PMIs have weakened to 51.6 from as high as 54.8, five months ago. Moreover, industrial production has softened, heeding the message from the sagging shipments-to-inventories ratio (Chart I-17). As a result, capacity utilization will remain too low to be consistent with upward risk to core CPI. Chart I-16Strengthening Japanese ##br##Wages Are Inflationary... Strengthening Japanese Wages Are Inflationary... Strengthening Japanese Wages Are Inflationary... Chart I-17... But Capacity Utilization Concerns ##br##Cap The Upside To Inflation ... But Capacity Utilization Concerns Cap The Upside To Inflation ... But Capacity Utilization Concerns Cap The Upside To Inflation Third, money growth has also slowed significantly in Japan, and is now at the low end of the post-Abenomics experience (Chart I-18). This weighs on the outlook for both growth and inflation. Fourth, if there were a valid reason to removed YCC it would be if banks were in danger. After all, low rates and a flat yield curve hurt banks' profitability, potentially creating risks to the financial system. However, as Chart I-19 shows, Japanese regional banks have not experienced any meaningful downward pressure on their profits since YCC has been implemented, and are far from generating aggregate losses. Chart I-18Japanese Money Trends Do Not Justify Tweaking YCC Japanese Money Trends Do Not Justify Tweaking YCC Japanese Money Trends Do Not Justify Tweaking YCC Chart I-19YCC Does Not Yet Threaten Japanese Banks Health YCC Does Not Yet Threaten Japanese Banks Health YCC Does Not Yet Threaten Japanese Banks Health Fifth, it is customary in Japan policy circles to float trial balloons to test policy ideas. It is very likely that the recent rumors of a tweak to YCC were such a balloon. However, the market impact of this trial was clear: a rallying yen, rising yields and falling equity prices. All these market moves suggest that if YCC was indeed tweaked next week, Japan would experience a violent tightening in monetary conditions - exactly what the BoJ wants to avoid if it ever wishes to hit its 2% inflation target. Moreover, we do not read much into the decline of JGB purchases by the Japanese central bank. The BoJ does not need to buy many JGBs in order to cap Japanese bond yields. Instead, speculators can force JGB yields towards the BoJ's target, on the expectation that if JGB yields deviate too much from this target, the BoJ will force bond prices back to its objective. We think these dynamics are currently at play, explaining why the BoJ has not been buying JPY80 trillion of JGBs per annum. Instead, we think that the BoJ will stay the course with YCC. While Japanese wages are stronger than they have been for 20 years, they are still not consistent with 2% inflation. As such, the BoJ needs to engineer further labor market tightening for inflation to move to target. Even in the U.S., where the economy is not in the thralls of deep-seated deflationary pressures, the job-hoppers are the ones pocketing the lion's share of accelerating wages - not people staying in their current positions (Chart I-20). Since Japanese workers do not tend to switch jobs, the Japanese labor market needs to become a genuine pressure cooker before inflation can rise meaningfully. The BoJ will thus need to maintain very easy monetary policy. Chart I-20You Need To Leave Your Job To Get A Raise You Need To Leave Your Job To Get A Raise You Need To Leave Your Job To Get A Raise As a result, we are not buying into the current rally in the yen versus the dollar. We do believe the yen can continue to perform well this year versus the euro and the AUD, but this is because we expect the U.S. monetary policy to tighten along with China's efforts to de-lever to continue to weigh on EM asset prices, EM economic activity, and thus global trade. In the short term, the yen could correct against these currencies as we continue to foresee a temporary correction in "growth slowdown" trades. But ultimately we expect the yen to continue to rally against the more pro-cyclical euro and Australian dollar. Bottom Line: The BoJ will not adjust YCC next week. Japanese wages may have picked up, but inflation itself is not only still well below target, it has weakened of late. Additionally, economic growth is not strong enough to justify a removal of monetary accommodation, especially as YCC has not negatively affected the health of regional banks. As a result, we recommend investors fade the recent strength in the yen versus the dollar. The yen still has room to rally further against the EUR and AUD over the course of the next six to nine months, but this is a reflection of our stance on global growth and EM asset prices, not a consequence of any anticipated shift in YCC. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, "Trump: No Nixon Redux", dated December 2, 2016, available at fes.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, "The Dollar May Be Our Currency, But It Is Your Problem", dated July 25, 2018, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Reports, "Time To Pause And Breathe" dated July 6, 2018 and "That Sinking Feeling", dated July 13, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Recent data in the U.S. has been mixed: Markit Manufacturing PMI came in at 55.5, outperforming expectations. It also increased from last month's reading. However, both services and composite PMI underperformed expectations, coming in at 56.2 and 55.9 respectively. Finally, existing home sales surprised to the downside, coming in at 5.38 million. This measure also decreased compared to last month's reading. The DXY has declined by roughly 1.3% this week. We are bearish on the dollar on a tactical basis. Stretched positioning in the USD as well as a respite in the global growth slowdown due to Chinese easing will combine to temporarily weigh on the greenback. However, we believe the DXY will resume its uptrend before year-end, as a combination of fed tightening, slower global growth, and positive momentum will help the dollar on a cyclical basis. Report Links: Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn’t Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The Euro Recent data in the Euro area has been mixed: Manufacturing PMI outperformed expectations, coming in at 55.1, and increasing from last month's reading. Moreover the German IFO, also outperformed expectations, coming in at 101.7. However, both Markit Composite PMI and Markit Services PMI underperformed expectations, coming in at 54.3 and 54.4 respectively, while also decreasing from last month's numbers. Finally, Belgian Business confidence showed a deceleration in the month of July. EUR/USD is flat this week, as the surge at the beginning of the week was counteracted by a relatively dovish announcement by the ECB yesterday. On a 6-month basis we are bearish on the euro, given that the cumulative tightening by both the People's Bank of China and the Fed will still combined in a toxic cocktail for global growth, and hence, drag the euro lower in the process. Report Links: Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn’t Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 The Yen Recent data in Japan has been mixed: The Nikkei Manufacturing PMI underperformed expectations, coming in at 51.6. It also decreased from last month's reading of 53. However, the All Industry Activity Index month-on-month growth outperformed expectations, coming in at 0.1%. USD/JPY has declined by roughly 1.5%, partly due to the fall in the U.S. dollar, but also because of the newly perceived hawkish tone by the BoJ. On a short-term basis, we continue to be bullish on the yen against the euro and the Aussie, as we expect Chinese deleveraging to add volatility to the markets. On a longer-term basis, however, we are bearish on the yen, as the BoJ will have to remains very accommodative in order to meet its inflation mandate. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 British Pound Recent data in the U.K. has been positive: Public sector net borrowing outperformed expectations, coming in at 4.530 billion pounds. This measure also increased relatively to last month's number. Moreover, mortgage approvals also surprised to the upside, coming in at 40.541 thousand. This measure also increased relatively to last month's number. Finally, the CBI Distributed Trades Survey also surprised positively, coming in at 20%. GBP/USD has risen by nearly 1.5% this week. Overall, we are cyclically bearish on the pound, as the uncertainty of the Brexit negotiations continue to weigh on capital flows into the U.S. Moreover, the rise in the dollar will add further downward pressure to cable. That being said, the pound could have some upside against the euro, given that the U.K. is less exposed to global trade and industrial activity than its continental counterpart. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Australian Dollar Recent data in Australia has been mixed: Headline inflation came in at 2.1%, underperforming expectations. However, this measure increased from 1.9% the month before. Meanwhile, the RBA trimmed mean CPI yearly growth came in at 1.9%, in line with expectations and with the previous' month number. AUD/USD has rallied by roughly 1.7%, in part due to the fall in the dollar, as well as in response to positive news in China concerning the issuance of infrastructure bonds. Despite these temporary positives, we continue to be cyclically bearish on the Aussie, as a slowdown in the Chinese industrial cycle will weigh heavily on this currency, given its high exposure to base metals, and given the continued presence of slack in the Australian labor market. Report Links: What Is Good For China Doesn’t Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 New Zealand Dollar NZD/USD has risen by roughly 1.7% this week, as trade tensions have eased following the announcement by President Trump that the EU and the United States would collaborate to eliminate tariffs between the two economies. Moreover, Chinese authorities have implemented some easing at the margin, which should provide a temporary boost to high beta economies like New Zealand. However, on a cyclical basis, we remain bearish on the kiwi, as the tightening campaign in China is likely to continue. Moreover, a tightening fed will continue to put pressure on EM dollar borrowers, affecting New Zealand in the process, given its high exposure to global growth. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Canadian Dollar Recent data in Canada has been mixed: Headline inflation came in at 2.5%, surprising to the upside. It also increased from last month's reading. Moreover, retail sales and retail sales ex-autos month-on-month growth both outperformed expectations, coming in at 2% and 1.4% respectively. However, core inflation underperformed expectations, coming in at 1.3%. This measure stayed stable compared to last month's reading. USD/CAD has declined by roughly 1.4% this week. In our view, the best cross to play what we believe will be a temporary correction in the greenback is to short USD/CAD, as the Canadian dollar trades at a deep discount to fair value, while short positions are likely overextended. Moreover, the BoC is the only nation among the G10 commodity producers raising rates, adding another boon for the Lonnie. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Swiss Franc EUR/CHF is down roughly 0.5% this week, especially after the perceived dovish tone to the ECB's press conference on Thursday. On a short-term basis, we are bearish on this cross, given that tightening by the fed and a sluggish Chinese economy should cause a risk-off period in markets, creating a supportive environment for the franc. On the other hand, we are bullish on this cross on a longer-term basis, given that the SNB will likely continue with its ultra-dovish monetary policy, as well as currency intervention to make sure that an appreciating franc does not derail its campaign to reach its inflation target. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Norwegian Krone USD/NOK is down roughly 0.7% this week. Overall we continue to be bullish on this cross, given that the tightening of the fed should increase the interest rate differential between Norway and the U.S., counteracting any further appreciation in oil prices due to OPEC output cuts. That being said, we are positive on the NOK within the commodity complex, as Norway will likely be less affected than New Zealand or Australia by the tightening campaign in China, given that oil has a lower beta to Chinese growth than other commodities. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Swedish Krona EUR/SEK is down by slightly more than 1% this week, falling substantially after the interest rate decision by the ECB. We are bullish on the krona on a long-term basis, as inflationary pressures continue to be strong in Sweden, and the Riksbank has become progressively more hawkish. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights A flurry of policy announcements over the past month has given investors the impression that Beijing has turned the policy dial in the direction of supporting growth. We agree that China is easing at the margin, but several observations suggest that the stimulus proposed so far falls short of a "big bang" response that would reverse both the looming export shock as well as the underlying slowdown in China's old economy. Investors should remain neutrally positioned towards Chinese stocks within a global equity portfolio, and should favor low-beta sectors within the Chinese investable universe. Feature There have been several policy-related announcements over the past month in China. This has led many market participants to question whether China is in the process of entering full-blown stimulus mode, and if we are on the cusp of another upswing in Chinese economic activity. Our answer to both questions is, for now, no. China appears to merely be easing off the brake, rather than pressing hard on the accelerator. Given that export growth will certainly slow to some degree due to the imposition of import tariffs, and that an industrial sector slowdown was already underway in China prior to President Trump's protectionist actions, it is far from clear that any stimulus will be a net positive for the country's "old economy". In other words, stimulus may counteract an upcoming export shock, but we would need to see more evidence before concluding that it will lead to a renewed cyclical uptrend in China's economy. A Flurry Of Policy Announcements... Several policy actions, announcements, and signals have occurred over the past month: The RMB has fallen nearly 6% since mid-June, which we have argued has been at least partially policy-driven. As we highlighted in our June 27 report,1 the decline in CNY/USD has been large, has occurred very rapidly, and cannot be explained by its previous relationship with the U.S. dollar (Chart 1). The PBOC cut its reserve requirement ratio for both big and small banks at the end of June, following the cut in April (Chart 2). It also provided incentives for banks to buy speculative-rated corporate bonds, clarified that its new asset management rules would permit mutual funds to invest in non-standard assets, and recently injected 500 billion RMB of liquidity into the banking system via its medium-term lending facility (MLF). Chart 1An Enormous, At Least Partially Policy-Driven Move An Enormous, At Least Partially Policy-Driven Move An Enormous, At Least Partially Policy-Driven Move Chart 2A Second Cut To Bank Reserve Requirement Ratios A Second Cut To Bank Reserve Requirement Ratios A Second Cut To Bank Reserve Requirement Ratios The Ministry of Finance (MOF) signaled that it would speed up spending that was planned to occur later in the year, and the State Council signaled that it would accelerate the issuance of 1.4 trillion RMB in local government bonds to support infrastructure investment. It also green-lighted a comparatively small 6.5 billion RMB in tax cuts for corporate R&D. China's legislature released a draft version of proposed tax changes that would cut the rate paid for individuals. The flurry of policy announcements over the past month has given investors the impression that Beijing has turned the policy dial in the direction of supporting growth. We agree that China is easing at the margin, and that these policy announcements are important: without them, the Chinese economy would likely face a substantial deceleration that would risk a serious slowdown in global growth. ...That Will Not Cause A Material Re-Acceleration In The Economy But several observations suggest that the stimulus proposed so far falls short of a "big bang" response that would reverse both the looming export shock as well as the underlying slowdown in China's old economy: Fiscal Stimulus: Chart 3 shows that China's on-budget deficit expanded by 3 percentage points over an 18-month period from 2014 to 2016. An equivalent expansion today would imply a 2.6 trillion RMB rise in the budget deficit, meaning that the local government bond issuance announced on Monday is 40% smaller than the deficit expansion that occurred from 2014 to 2016. If the infrastructure projects financed by these bonds turn out to be multi-year initiatives tied to China's structural reform plans, the intensity of this round of fiscal stimulus will likely turn out to be less than half, or even a fraction, of what occurred previously. Fiscal Vs. Credit Expansion: While an increase in fiscal spending was important in catalyzing an economic recovery in 2014/2016, Chart 4 highlights that the expansion of credit was considerably larger. The chart shows on-budget fiscal spending and the change in adjusted total social financing (TSF) as a percent of GDP, and highlights that the latter dwarfs the former. By our calculations, adjusted TSF accelerated by 5 trillion RMB from 2015 to 2016, which from our perspective could only have been achieved by very aggressive monetary easing. Currency Depreciation: A simple framework that equates the equilibrium/required currency depreciation to the size of the tariffs imposed as a share of total exports to the U.S. suggests that a 6% decline in CNY/USD may be adequate at negating an export shock if the proposed tariffs stop after the recently proposed new round of 10% tariffs on $200 billion worth of goods. But first, this approach suggests that a further 6-7% decline may be needed if President Trump follows through with his threat to impose tariffs on all imports from China. Second, in either case the currency decline merely addresses the prospective export shock, not the underlying slowdown in China's old economy that has been occurring over the past year. Chart 3Bond-Financed Infrastructure Spending Unlikely To Match 2015's Fiscal Expansion Bond-Financed Infrastructure Spending Unlikely To Match 2015's Fiscal Expansion Bond-Financed Infrastructure Spending Unlikely To Match 2015's Fiscal Expansion Chart 4Three Years Ago, The Expansion In Credit Dwarfed That Of Fiscal Spending Three Years Ago, The Expansion In Credit Dwarfed That Of Fiscal Spending Three Years Ago, The Expansion In Credit Dwarfed That Of Fiscal Spending From our perspective, China's monetary policy actions have so far been the most convincingly stimulative developments in response to the threat to exports. We downplayed China's most recent reserve requirement ratio cut in our June 27 Weekly Report,1 and we acknowledge that this initial assessment was overly pessimistic. Chart 5 shows that the 3-month repo rate, China's de-facto policy rate, has broken meaningfully below the lower band that had prevailed since the beginning of 2017. This suggests that the targeted addition of liquidity, particularly to China's small banks, was at least somewhat effective at easing financial conditions. Chart 5The PBOC Has Successfully Lowered The 3-Month Repo Rate... The PBOC Has Successfully Lowered The 3-Month Repo Rate... The PBOC Has Successfully Lowered The 3-Month Repo Rate... Chart 6...But This Is Unlikely to Significantly Drop Average Lending Rates ...But This Is Unlikely to Significantly Drop Average Lending Rates ...But This Is Unlikely to Significantly Drop Average Lending Rates Still, we remain unconvinced that what has been announced so far is likely to generate an acceleration in credit growth even approaching what occurred three years ago. Chart 6 shows the weighted average lending rate in China, alongside a simple regression model for the rate based on the benchmark lending rate and the 3-month interbank repo rate (China's "old" and "de-facto new" policy rates, respectively). The chart highlights the likely minimal impact of the recent decline in the repo rate on the average lending rate. In fact, Chart 6 underscores an important point about China's stimulus in 2014-2016: a good portion of that episode's reflationary impact appears to have been caused by the PBOC's 170 bps cut to its benchmark lending rate, which has so far remained unchanged (without any hint from policymakers that it might be lowered). Finally, we are similarly underwhelmed by the PBOC's incentives to banks to buy "junk" corporate bonds: debt securities are a small (albeit fast growing) portion of China's total nonfinancial credit, and junk-rated bonds are a small fraction of that market. We thus see this announcement as an attempt to provide some marginal liquidity support for issuers of these bonds that have upcoming refinancing requirements, rather than a policy of any true macro significance. Conclusions And Investment Strategy Recommendations Two important insights emerge from our above analysis. The first is that the intensity and timing of the infrastructure projects alluded to by the State Council are important factors in determining the likely impact of increased government spending. We suspect that any boost to the economy over the coming year from infrastructure spending will be relatively small, but this will be an important element to monitor over the coming months. The second insight is that we would become considerably more constructive towards China's economy were the PBOC to cut its benchmark lending rate. This would be clear sign that the China is pressing on the accelerator, rather than attempting to simply "fine tune" the economy in the face of an external economic shock. For now, however, our view is that the stimulative measures that have been announced are not likely to lead to a renewed cyclical uptrend in China's economy. This implies that investors should remain neutrally positioned towards Chinese stocks within a global equity portfolio, and should favor low-beta sectors within the Chinese investable universe. Chart 7 shows that the latter position, which we initiated on June 27, has risen almost 1% in relative terms over the past month, and we expect further gains over the remainder of the year. Finally, we noted in our July 5 Weekly Report that the selloff in Chinese domestic stocks was advanced,2 and that we would consider implementing a long MSCI China A Onshore index / short MSCI China index trade in response to a 5% rally in relative common currency performance. It is conceivable that "easing off the brake" will be enough for A-shares to rally non-trivially relative to investable stocks, given how much they have fallen since the beginning of the year. Chart 8 shows that A-shares have approached this threshold in response to recent stimulus announcements, but have yet to break through. We will be watching relative A-share performance closely over the coming weeks for a green light to initiate the position. Stay tuned! Chart 7Low-Beta Sectors Are Outperforming China's Investable Market Low-Beta Sectors Are Outperforming China's Investable Market Low-Beta Sectors Are Outperforming China's Investable Market Chart 8Conditions May Soon Warrant A Pair Trade Favoring Domestic Stocks Conditions May Soon Warrant A Pair Trade Favoring Domestic Stocks Conditions May Soon Warrant A Pair Trade Favoring Domestic Stocks Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Pease see China Investment Strategy Weekly Report "Now What?", dated June 27, 2018, available at cis.bcaresearch.com 2 Pease see China Investment Strategy Weekly Report "Standing On One Leg", dated July 5, 2018, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Chart of the WeekTrade Fears Weighing On Ag Complex Trade Fears Weighing On Ag Complex Trade Fears Weighing On Ag Complex Bearish sentiment in ag markets is overdone. We believe prices have bottomed. But we are not yet ready to get bullish, given the elevated trade-policy uncertainty dominating markets at present. The evolution of grains and bean prices from here will depend on whether ongoing trade disputes between the U.S. and some of its largest ag markets are transitory or permanent (Chart of the Week). Highlights Energy: Overweight. We closed our Dec18 Brent $65 vs. $70/bbl call spread last week with a net gain of 80%. We remain long call spreads along the Brent forward curve in 2019, which are down an average 2.7%, and the SP GSCI, which is up 12.1%. Base Metals: Neutral. Aluminum prices are down ~ 1.6% in the past week, following indications from U.S. Treasury Secretary Steven Mnuchin sanctions against Russian aluminum supplier Rusal could be removed. Precious Metals: Neutral. Gold prices recovered slightly over the past week, but remain under pressure, given continued strength in the broad trade-weighted USD and real U.S. interest rates. We remain long gold as a portfolio hedge, nonetheless. Ags/Softs: Underweight. Fundamentals support higher grain and bean prices. However, trade-policy uncertainty - particularly re Sino - U.S. relations - will keep them under pressure (see below). Feature Weather-related uncertainty typically is center stage when it comes to forecasting ag prices during the growing season. This year, trade-policy uncertainty emanating from Washington will contend with weather risk as the dominant influence on prices. We do not expect ag-related trade policies to become more hostile. This means the path of ag prices will be contingent on whether the current trade disputes - primarily between the U.S. and China - are transient or permanent features of international trade. Given what we've seen already, we can expect American farmers will fare poorly in the ongoing trade spats. U.S. agricultural exports have been disproportionately hard hit by tariffs from their most important foreign consumer markets, levied in retaliation against U.S. tariffs (Chart 2). BCA Research's Geopolitical Strategy analysts assign a high probability to the escalation of current tensions into a full-blown trade war.1 Nevertheless, we believe the negative sentiment in ag markets is overdone, and that there is not much further downside from here. It is unsurprising that agriculture is a natural first target in this trade dispute. More than a quarter of U.S. crops are exported, with the share rising above 50% in many cases (Chart 3). This provides foreign consumers with ammunition in the dispute. Furthermore, these exports account for a large chunk of global ag trade, in some cases making American exports price makers in the global market. Importantly, many farmers and farm-belt voters cast ballots for Donald Trump. Chart 2American Ags Hit Hard##BR##By Trade Barriers... Policy Uncertainty Could Trump Ag Fundamentals Policy Uncertainty Could Trump Ag Fundamentals Chart 3...Because They Are Exposed##BR##To Foreign Markets Policy Uncertainty Could Trump Ag Fundamentals Policy Uncertainty Could Trump Ag Fundamentals The USDA's plans announced earlier this week to spend as much as $12 billion between September and end of harvest to help soften the impact of tariff retaliations against U.S. farm states loyal to Trump are not unexpected. The measures will entail (1) direct payments to soybean, sorghum, cotton, corn, wheat, dairy and pork farmers, (2) the procurement and subsequent re-distribution of ag products to nutrition programs, and (3) working with the private sector to promote trade and develop new export markets.2 Trade Spats Hit Grain Markets Hard Grain markets have been especially hard hit in the cross-fire between the U.S. and some of its key trade partners (Table 1). China's retaliatory tariffs are especially consequential, due to its outsized role as a main ag demand market. Table 1Ags Caught In The Crossfire Policy Uncertainty Could Trump Ag Fundamentals Policy Uncertainty Could Trump Ag Fundamentals All in all, the Thomson Reuters Equal Weight Grains & Oilseeds Index is down ~ 10% since end-May on the back of these tariffs. Soybeans lead the decline with a 17% loss. We have been foreshadowing this since the beginning of the year.3 Now that it's played out consistent with our previous expectations, it leaves us wondering "now what?" We see three potential scenarios unfolding in the ongoing trade skirmish: Scenario 1: The current tariffs remain in place with no significant increase in ag-relevant trade barriers.4 Scenario 2: The disputes peak soon, and de-escalate. In this scenario, tariffs imposed since the beginning of the year are reversed, ultimately leading to a free and now-fairer global trade order. Scenario 3: A complete breakdown in global trade. This scenario can take on a soft outcome whereby tariffs are increased, or to a more aggressive scenario, resulting in a seismic collapse in world trade agreements. The first two scenarios are clearly more optimistic. In Scenario 1, near-term downside to prices would be restrained, contingent on the responses of major ag consumers. We discuss their four main options and potential courses of action below. Scenario 2 is the most bullish, with price formation once again a function of supply-demand-inventory fundamentals. In this scenario, exogenous risks primarily stem from weather and U.S. financial variables. However, Scenario 3, in which a prolonged trade war pushes the global economy into a recession, would intensify the pain. This would lead to a contraction in the global flow of goods and services, reducing access to foreign markets. Additionally, it would hurt ag demand through the income channel. Consumption growth of ags is correlated with income growth. If the trade war bears down on incomes, it will reduce per-capita demand for ag commodities, which ultimately depresses prices. This is especially true in the case of lower income and emerging economies, where demand is more elastic. Impact Of Tariffs In face of higher costs brought on by U.S. tariffs, foreign buyers are essentially faced with four options: Reduce imports from the U.S., and opt to purchase more from other major producers; Reduce consumption of particular crops by substituting with others; Consume out of inventory, or Continue purchasing U.S. crops, but at a higher price. Chart 4Soybean Farmers Are Most Vulnerable Policy Uncertainty Could Trump Ag Fundamentals Policy Uncertainty Could Trump Ag Fundamentals Given the heightened risks surrounding the Sino-American trade dispute, we analyze these possibilities with reference to China. In addition, since soybeans are the most vulnerable of the crops hit by the trade dispute, we focus on beans, arguing that in most cases similar courses of action can be taken for other crops (Chart 4). Chinese authorities have already communicated that they plan to use options 1 - 3, and, as such, have assessed the impact of these restrictions on Chinese buyers to be minimal. Furthermore, according to a comment earlier this month by Lu Xiaodong, deputy general manager of state stockpile Sinograin, China is capable of fully meeting its needs without importing soybeans from the U.S.5 The extent to which buyers are successful in doing so will ultimately determine the overall impact of the trade dispute on U.S. ag markets. We expect China's solution will be a mélange of these four options. Below we assess these possibilities. Option 1: Chinese Buyers Are Turning To Other Major Producers An oft-noted change in Chinese purchasing behavior in reference to U.S. soybeans has been cited as the rationale for the negative sentiment towards U.S. ags. While it is true that Chinese buyers have been shunning American beans, the conclusion fails to recognize a few key points (Chart 5). Chart 5U.S. Soybean Exports Down On Weak Sales To China Policy Uncertainty Could Trump Ag Fundamentals Policy Uncertainty Could Trump Ag Fundamentals First, due to the difference in crop calendars - South American beans are harvested in spring while the U.S. crop is harvested in the fall - there is a clear seasonal pattern in China's purchasing behavior (Chart 6). Thus, greater Chinese imports of Brazilian soybeans are typical for this time of year. In addition, agricultural commodities are fungible, which means a reduction of China's imports of U.S. crops does not mean the U.S. crops will go to waste. While American crops are clearly trading at a disadvantage from the perspective of a Chinese buyer, there are still other foreign markets open to American ag exports. Now that these crops are selling at a discount, they have become much more competitive, incentivizing a shift in trade flows. This has already started - the U.S. has increased exports to consumers such as Egypt and Mexico, and even found soybeans buyers in Argentina and Brazil, both major producers of soybeans (Chart 7)! Chart 6Seasonality Is Partly To Blame Seasonality Is Partly To Blame Seasonality Is Partly To Blame Chart 7New Markets Opening Up For American Beans New Markets Opening Up For American Beans New Markets Opening Up For American Beans Option 2: China Will Adjust Its Feed Recipe China's decision to remove import tariffs on animal feed ingredients from Asian suppliers also highlights another policy route. To the extent possible, Chinese consumers will attempt to find substitutes for the now-more-costly U.S. imports. This includes supplies from alternative producers, and imports of substitute products. The potential from this option depends on the availability of close substitutes to replace ags exports affected by the Sino - U.S. trade dispute. In the case of soybeans, Chinese bean imports are crushed to produce meal and oil. The former is then used as a primary protein in livestock feed, while the latter is refined to be used in foods. Similarly, the majority of corn is also used as a critical ingredient in animal feed. As such, in face of higher costs, bean crushers will likely turn to meal from other protein substitutes such as rapeseed, peanuts and sunflower seeds. Nevertheless, soybean meal remains the optimal source of protein for livestock. Thus, while China will attempt to reduce its consumption of the tariff-laden U.S. ags, alternatives are not perfect substitutes. Consequently, this option does not completely eliminate the need for soybean imports. Option 3: Eat Into Ag Inventories Chart 8Chinese Stocks Will - Partially -##BR##Cushion The Blow Chinese Stocks Will - Partially - Cushion The Blow Chinese Stocks Will - Partially - Cushion The Blow Chinese ag inventories are relatively high and can cushion the blow to supply, at least temporarily (Chart 8). This means we may see a decline in Chinese stocks, on the back of drawdowns to fill in the gap left by lower imports from the U.S. While Beijing's stocks are notoriously large, there are reports that, in some cases, they are of low quality, and are unfit for human and animal consumption. Thus, this policy may appear more feasible on paper than in reality. Without accurate information regarding the size and quality of China's ag inventories, it is impossible to determine the potential of this option. Option 4: Absorb the Price Hike: Continue Importing - Now Pricier - U.S. Ags Chinese buyers likely will attempt to exhaust options 1 - 3 above, before resorting to purchasing now-pricier U.S. grains and beans. Nevertheless, it is inevitable - some U.S. ags will continue to flow to China. The relevant question - admittedly extremely difficult to quantify - is with regards to the magnitude of the impact. This essentially will depend on China's ability to use options 1 - 3, to avoid the now-higher import costs. While in the case of soybeans, U.S. exports have been shunned for now, the true test will come in the fall after the Brazilian harvest is over, and the market is flooded with the American crops. Furthermore, the 25% increase in costs due to the tariffs will, to some extent, be offset by the discount in the price of the American crops. Fundamentals Imply Higher Ag Prices While ag markets have taken several direct hits recently, we believe global fundamentals are not as bearish as current pricing conditions suggest. In the event there is a de-escalation of trade disputes - Scenario 2 above - prices will rebound to levels implied by fundamentals. While soybeans are expected to record a small surplus in the 2018 - 19 crop year, wheat and corn will be in a global deficit (Chart 9). Furthermore, global inventories - measured in stocks-to-use terms - are expected to come down. In the case of corn and soybeans, this will be the second consecutive annual decline (Chart 10). Chart 9Bullish Fundamentals On Back##BR##Of Corn And Wheat Deficits... Bullish Fundamentals On Back Of Corn And Wheat Deficits... Bullish Fundamentals On Back Of Corn And Wheat Deficits... Chart 10...And Falling##BR##Inventories ...And Falling Inventories ...And Falling Inventories In the corn market, the inventory drawdown is , to a large extent, driven by Chinese policy which is incentivizing the consumption of stocks by offering lower subsidies to corn farmers vs. soybeans, and through measures to encourage corn use for ethanol. This is expected to bring stocks down to levels last witnessed in the 1960s! On the other hand, U.S. soybean stocks are expected to continue increasing in line with lower demand for American beans by the world's largest soybean consumer (China). As always, weather is the biggest source of near term supply-side uncertainty. Wheat prices are supported by weather concerns in Europe - particularly the Black Sea region - which is damaging crops there. This is especially important given the expectation of a smaller crop there this year. Some Final Notes A couple of distinctions within the ags space reveals some ags are more vulnerable to the ongoing dispute than others. These are the number of sellers and the number of buyers in these markets. For instance, U.S. soybean exports have fewer foreign markets than corn, making them relatively more susceptible to downward price movements as supplies back up and are forced to find alternative markets. This is especially true since China is the single largest consumer of soybeans (Chart 11). Chart 11Global Wheat Market Relatively Insulated From Trade Frictions Policy Uncertainty Could Trump Ag Fundamentals Policy Uncertainty Could Trump Ag Fundamentals On the other hand, the global wheat market resembles a perfectly competitive market. This means that there are many buyers and sellers, each with limited ability to influence prices. Given that both the U.S. and China are price takers in this market, wheat prices will be relatively more insulated from trade headwinds. As such, we favor wheat in the current environment. Bottom Line: American farmers will be the losers in the still-evolving Sino - American trade disputes, as barriers are imposed on their exports, rendering them uncompetitive for their most significant foreign consumer. However, this will open markets for other global producers - most notably Brazil, Argentina, and the Black Sea region - making farmers there the winners in this dispute. Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see BCA Research's Geopolitical Strategy Special Report titled "The U.S. And China: Sizing Up The Crisis," dated July 11, 2018, available at gps.bcaresearch.com. 2 Please see "Factbox: USDA's $12 billion farmer relief package," dated July 24, 2018, available at reuters.com. 3 Please see BCA Research's Commodity & Energy Strategy Weekly Reports titled "Ags Could Get Caught In U.S. Tariff Imbroglio," dated March 15, 2018, page 9 from "Oil Price Forecast Steady, But Risks Expand," dated March 22, 2018, and "Ag Price Volatility Will Pick Up," dated May 3, 2018. 4 Our colleagues at BCA's Geopolitical Strategy team expect the trade dispute to intensify, especially before the mid-terms. However, tariffs already have been placed on most ag commodities we follow. This leaves little room for further risk from this direct channel, unless tariff rates are increased. 5 Please see "China does not need U.S. soybeans for state reserves: Sinograin official," dated June 12, 2018, available at reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Policy Uncertainty Could Trump Ag Fundamentals Policy Uncertainty Could Trump Ag Fundamentals Trades Closed in 2018 Summary of Trades Closed in 2017 Policy Uncertainty Could Trump Ag Fundamentals Policy Uncertainty Could Trump Ag Fundamentals

Highlights Our forecast of higher geopolitical risk in 2018 is coming to fruition; President Trump's two key policies, economic populism (fiscal stimulus) and mercantilism (trade tariffs), will counteract each other; Stimulus is leading to trade deficits and a stronger dollar, while a stronger dollar encourages trade deficits. This is a problem for Trump in 2020; The administration will seek coordinated international currency moves, but the U.S. has less influence today than it did at the time of key 1971 and 1985 precedents; Favor DM over EM assets; favor U.S. over DM stocks; and expect Trump to threaten tariffs against currency manipulation. Feature "China, the European Union and others have been manipulating their currencies and interest rates lower, while the U.S. is raising rates while the dollars [sic] gets stronger and stronger with each passing day - taking away our big competitive edge. As usual, not a level playing field... The United States should not be penalized because we are doing so well. Tightening now hurts all that we have done. The U.S. should be allowed to recapture what was lost due to illegal currency manipulation and BAD Trade Deals. Debt coming due & we are raising rates - Really?" - President Donald Trump, tweet, July 20, 2018 "The dollar may be our currency, but it is your problem." - Treasury Secretary John Connally, 1971, speaking to a group of European officials Chart 1A Fiscal Boost Will Accelerate Inflation A Fiscal Boost Will Accelerate Inflation A Fiscal Boost Will Accelerate Inflation In April 2017, BCA's Geopolitical Strategy concluded that "Political Risks Are Overstated In 2017," but also "Understated In 2018."1 At the heart of our forecast was the interplay between three factors: "Domestic Policy Is Bullish USD:" We argued in early 2017 that the political "path of least resistance" would lead to "tax cuts in 2017" and that President Trump's economic policies "will involve greater budget deficits than the current budget law augurs." The conclusion was that "even a modest boost to government spending will motivate the Fed to accelerate its tightening cycle at a time when the output gap is nearly closed and unemployment is plumbing decade lows" (Chart 1). "Chinese Growth Scare Is Bullish USD:" We also correctly predicted that "Chinese data is likely to decelerate and induce a growth scare." Even though Chinese data was peachy in early 2017, we pointed out that "Chinese policymakers have gone forward with property market curbs and begun to tighten liquidity marginally in the interbank system." We would go on to produce several in-depth research reports throughout the year that outlined these reform efforts and linked them to President Xi Jinping's reduced political constraints following the nineteenth National Party Congress in October.2 "European Political Risks Are Bullish USD:" Finally, we argued that a combination of political risks - e.g., the 2018 Italian election - and the slowdown in China would reverberate in Europe, forcing "the ECB to be a lot more dovish than the market expects." Our conclusion in April 2017 - quoted verbatim below - was that these three factors would combine to force President Trump to try to talk down the greenback: The combination of Trump's domestic policy agenda and these global macro-economic factors will drive the dollar up. At some point in 2018, we assume that USD strength will begin to irk Donald Trump and his cabinet, particularly as it prevents them from delivering on their promise of shrinking trade deficits. We suspect that President Trump will eventually reach for the "currency manipulation" playbook of the 1970s-80s. On July 20, President Trump put a big red bow on our forecast by doing precisely what we expected: talking down the USD by charging the rest of the world with currency manipulation. Speaking with CNBC, Trump pointed out that "in China, their currency is dropping like a rock and our currency is going up, and I have to tell you it puts us at a disadvantage." President Trump is correct: Beijing is definitely manipulating the currency, as we pointed out last week (Chart 2).3 Chart 2The CNY Is Much Weaker Than The DXY Implies The CNY Is Much Weaker Than The DXY Implies The CNY Is Much Weaker Than The DXY Implies Chart 3U.S. Outperformance Should Be Bullish USD U.S. Outperformance Should Be Bullish USD U.S. Outperformance Should Be Bullish USD But President Trump wants to have his cake and eat it too. His economic stimulus is inevitably leading to a widening trade deficit. With tax cuts and increased capital spending, U.S. demand is growing faster than demand in the rest of the world. This economic outperformance in the context of stalling global growth is leading to the greenback rally that we forecast (Chart 3). When the U.S. economy outperforms the rest of the world, the Fed tends to be in the lead of tightening policy among G10 economies, spurring a rally in the trade-weighted dollar index (Chart 4).4 A rising currency then reinforces the trade deficit. Chart 42018 Rally Is Not Over 2018 Rally Is Not Over 2018 Rally Is Not Over There is much uncertainty regarding President Trump's true preferences, but we know two things: he is an economic populist and a mercantilist. He has been clear on both fronts throughout his campaign. The problem for President Trump is that the two policies are working against one another. His stimulus has spurred a USD rally that will likely offset the impact of his tariffs, particularly the more modest 10% variety he has said he will impose on all Chinese imports (Chart 5). Chart 5Trump Threatens Tariffs On All ##br##Chinese Imports (And Then Some) The Dollar May Be Our Currency, But It Is Your Problem The Dollar May Be Our Currency, But It Is Your Problem The Trump administration is therefore facing a choice: triple-down on tariffs, potentially causing a market and economic calamity in the process; or, use protectionism as a bargaining chip in a bout of orchestrated and negotiated, global, currency manipulation. As we pointed out last April, President Trump would not be the first to face this choice: 1971 Smithsonian Agreement President Richard Nixon famously closed the gold window on August 15, 1971 in what came to be known as the "Nixon shock."5 Less understood, but also part of the "shock," was a 10% surcharge on all imported goods, the purpose of which was to force U.S. trade partners to appreciate their currencies against the USD. Much like Trump, Nixon had campaigned on a mercantilist platform in 1968, promising southern voters that he would limit imports of Japanese textiles. As president, he staffed his cabinet with trade hawks, including Treasury Secretary John Connally who was in favor of threatening reduced U.S. military presence in Europe and Japan to force Berlin and Tokyo to the negotiating table. Connally also gave us the colorful quote for the title of this report and also famously quipped that "foreigners are out to screw us, our job is to screw them first." The economists in the Nixon cabinet - including Paul Volcker, then the Undersecretary of the Treasury under Connally - opposed the surcharge, fearing retaliation from trade partners, but policymakers like Connally favored brinkmanship. The U.S. ultimately got other currencies to appreciate, mostly the deutschmark and yen, but not by as much as it wanted. Critics in the administration - particularly the powerful National Security Advisor Henry Kissinger - feared that brinkmanship would hurt Trans-Atlantic relations and thus impede Cold War coordination. As such, the U.S. removed the surcharge merely four months later without meeting most of its objectives, including increasing allied defense-spending and reducing trade barriers to U.S. exports. Even the currency effects dissipated within two years. 1985 Plaza Accord The U.S. reached for the mercantilist playbook once again in the early 1980s as the USD rallied on the back of Volcker's dramatic interest rate hikes. The subsequent dollar bull market hurt U.S. exports and widened the current account deficit (Chart 6). U.S. negotiators benefited from the 1971 Nixon surcharge because European and Japanese policymakers knew that the U.S. was serious about tariffs and had no problem with protectionism. The result was coordinated currency manipulation to drive down the dollar and self-imposed export limits by Japan, both of which had an almost instantaneous effect on the Japanese share of American imports (Chart 7). Chart 6Dollar Bull Market And Current Account Balance In 1980s-90s Dollar Bull Market And Current Account Balance In 1980s-90s Dollar Bull Market And Current Account Balance In 1980s-90s Chart 7The U.S. Got What It Wanted From Plaza Accord The U.S. Got What It Wanted From Plaza Accord The U.S. Got What It Wanted From Plaza Accord The Smithsonian and Plaza examples are important for two reasons. First, they show that Trump's mercantilism is neither novel nor somehow "un-American." It especially is not anti-Republican, with both Nixon and Reagan having used overt protectionism and currency manipulation in recent history. Second, the experience of both negotiations in bringing about a shift in the U.S. trade imbalance will motivate the Trump administration to reach for the same "coordinated currency manipulation" playbook. In fact, Trump's Trade Representative, Robert Lighthizer, is a veteran of the 1985 agreement, having negotiated it for President Ronald Reagan. Should investors get ahead of the Plaza Accord 2.0 by shorting the greenback? The knee-jerk reactions of the market suggest that this is the thinking of the median investor. For instance, the DXY fell by 0.7% on the day of Trump's tweet. We disagree, however, and are sticking with our long DXY position, initiated on January 31, 2018, and up 6.17% since then.6 Why? Because 2018 is neither 1985 nor 1971. President Trump, and America more broadly, is facing several constraints today. As such, we do not expect that he will find eager partners in negotiating a coordinated currency manipulation. Chart 8Globalization Has Reached Its Apex Globalization Has Reached Its Apex Globalization Has Reached Its Apex Chart 9Global Protectionism Has Bottomed Global Protectionism Has Bottomed Global Protectionism Has Bottomed Economy: Europe and Japan were booming economies in the early 1970s and mid-1980s, and had the luxury of appreciating their currencies at the U.S.'s behest. Today, it is difficult to see how either Europe or China (now in Japan's place) can afford significant monetary policy tightening that would engineer structural bull markets in their currencies. For Europe, the risk is that the peripheral economies may not survive a back-up in yields. For China, if the PBOC engineered a persistently strong CNY/USD, it would tighten financial conditions and hurt the export sector. Apex of Globalization: U.S. policymakers were able to negotiate the 1971 and 1985 currency agreements in part because of the underlying promise of growing trade. Europe and Japan agreed to a tactical retreat to get a strategic victory: ongoing trade liberalization. In 2017-18, however, this promise has been muted. Global trade has peaked as a percent of GDP (Chart 8), average tariffs have bottomed (Chart 9), and the number of preferential trade agreements signed each year has collapsed (Chart 10). Temporary trade barriers have ticked up since 2008 (Chart 11). To be clear, these signs are not necessarily proof that globalization is reversing, but merely that it has reached its apex. Nonetheless, America's trade partners will be far less willing to agree to coordinated currency manipulation in an era where the global trade pie is no longer growing. Chart 10Low-Hanging Fruit Of Globalization Already Picked The Dollar May Be Our Currency, But It Is Your Problem The Dollar May Be Our Currency, But It Is Your Problem Chart 11Temporary Trade Barriers Ticking Up The Dollar May Be Our Currency, But It Is Your Problem The Dollar May Be Our Currency, But It Is Your Problem Multipolarity: The U.S. is simply not as powerful - relatively speaking - as it was at the height of the Cold War (Chart 12). As such, it is difficult to see how President Trump can successfully bully major economies into self-defeating currency manipulation. The Cold War gave the U.S. far greater leverage, particularly vis-à-vis Europe and Japan. Today, Trump's threats of pulling out of NATO are merely spurring Europeans to integrate further as Russia is no longer the threat it once was. There are no Soviet tank divisions arrayed across the Fulda Gap in Eastern Germany. In fact, Russia is cutting defense spending and further integrating into the European economy with new pipeline infrastructure (which Trump has pointedly criticized). And China is overtly hostile to the U.S. and thus completely unlike Japan, which huddled under the American nuclear umbrella during the U.S.-Japan trade war. Chart 12The U.S. Has Less Weight To Throw Around The U.S. Has Less Weight To Throw Around The U.S. Has Less Weight To Throw Around Is the Trump administration ignoring these major differences? No. There may be a much simpler explanation for President Trump's dollar bearishness: domestic politics. We only see a probability of around 20% that the U.S. trade deficit will shrink during the course of Trump's first term in office. Most likely, the trade deficit will widen as domestic stimulus supercharges the U.S. economy relative to the rest of the world and the greenback rallies. Economic slowdown in China and EM will likely further expand the U.S. trade deficit as these economies cut interest rates and allow their exchange rates to drop. President Trump therefore has a problem. The only way the trade deficit will shrink by 2020 is if the U.S. enters a recession and domestic demand shrinks - but presidents do not survive re-election during recessions. If a recession does not develop, he will have to explain to voters in early 2020 why the trade deficit actually surged, despite all his tough rhetoric, tariffs, and trade negotiations. The charge of currency manipulation could therefore do the trick, blaming the rest of the world for the USD rally that was largely caused by U.S. stimulus. Bottom Line: We do not expect the Fed to respond to President Trump's rhetoric. The current Powell Fed is not the 1970s Burns Fed. As such, we would fade any upcoming weakness in the USD. We expect the dollar bull market to carry on in 2018 and to continue weighing on global risk assets, namely EM equities and currencies. Investors should remain overweight DM assets relative to EM in terms of broad global asset allocation, and overweight U.S. equities in particular relative to other DM equities. The major risk to our bullish USD view is not a compliant Fed but rather a China that "blinks." Beijing has begun some modest stimulus in the face of the economic slowdown produced by the Xi administration's aforementioned efforts to contain systemic financial risk. Over the next month, we will dive deep into Chinese politics to see if the trade conflict will prompt Xi to reverse his attempt to tighten policy and once again embrace a resurgence in credit growth. In the long term, however, we expect that the Trump administration will grow frustrated with the fact that its two main policies - economic populism at home and mercantilism abroad - will offset each other and that the U.S. trade imbalance will continue to grow apace. At that point, President Trump may decide to reach for two levers: staffing the Fed with über doves and/or ratcheting up tariffs to much higher levels. We expect the latter to be the more likely outcome than the former, and either would result in a serious blowback from the rest of the world that would unsettle markets. More importantly, it would be the death knell of globalization, stranding trillions of dollars of capex behind suddenly very relevant national borders. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, and "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy, "China Down, India Up," dated March 15, 2017, "China: Looking Beyond The Party Congress," dated July 19, 2017, "China's Nineteenth Party Congress: A Primer," dated September 13, 2017, "China: Party Congress Ends... So What?" dated November 1, 2017, "A Long View Of China," dated December 28, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Whoever Said Anything About Bluffing?" dated July 18, 2018, available at gps.bcaresearch.com. 4 Please see BCA Foreign Exchange Strategy Weekly Report, "The S&P Doesn't Abhor A Strong Dollar," dated July 20, 2018, available at fes.bcaresearch.com. 5 Please see Douglas A. Irwin, "The Nixon shock after forty years: the import surcharge revisited," World Trade Review 12:01 (January 2013), pp. 29-56, available at www.nber.org; and Barry Eichengreen, "Before the Plaza: The Exchange Rate Stabilization Attempts of 1925, 1933, 1936, and 1971," Behl Working Paper Series 11 (2015). 6 Please see BCA Geopolitical Strategy Weekly Report, "America Is Roaring Back! (But Why Is King Dollar Whispering?)," dated January 31, 2018, available at gps.bcaresearch.com.

Highlights The 2016-2017 China/EM recovery was not the beginning of a new economic and financial cycle. We view it as a mid-cycle recovery, or hiatus, in an unfinished downtrend that began in 2011. Our basis: In EM at large and especially in China, the excesses and "deadwood" left from the 2009-2011 credit boom were not cleansed. Easy money masked the negative fundamentals in 2016-2017. Yet as Chinese money and credit growth continues to fall and the Federal Reserve steadily shrinks its balance sheet, cracks are re-surfacing in EM and China. In Thailand, continue overweighting equities, currency and fixed-income market versus their respective EM benchmarks. Feature The most striking difference between our view on EM and that of the overwhelming majority of investors and experts is as follows: Most investors and commentators view the 2016-2017 EM recovery as the beginning of a new economic and financial cycle. Hence, the narrative goes that both the EM economic expansion and the rally in EM financial markets are still at an early stage, and barring severe tightening from the U.S. Federal Reserve, it is unlikely that EM growth will slump much. BCA's Emerging Markets Strategy team regards the 2016-2017 revival in EM economies in general and China in particular as a mid-cycle recovery, or hiatus, in an unfinished downtrend that began in 2011. This is why we were reluctant to turn bullish after EM financial markets rallied in 2016-2017. China is more important to EM than the U.S. In our opinion, it was only a matter of time before China's and the Fed's tightening would lead to a considerable relapse in EM financial markets. In brief, the rally of last year was nothing more than a bull trap. In this week's report we highlight where EM and China are in their respective economic cycles, and elaborate on why we believe their pre-2016 downturns and adjustments remain incomplete.1 EM/China Cycles Chart I-1 presents the best way to visualize the EM/China cycles. Chart I-1Where Are EMs & Commodities In The Cycle? Where Are EMs & Commodities In The Cycle? Where Are EMs & Commodities In The Cycle? Following the devastating crises of 1997-'98, the new structural bull market in EM began in 1999-2001. By the early 2000s, crises-hit EM banks had recognized and provisioned for their bad assets, and were in the process of restructuring. In turn, companies had considerably ameliorated their financial health by restructuring debt (including foreign debt), and cutting capital spending and employment, thereby boosting their free cash flows. By 2004, China completed aggressive structural reforms, such as shutting down unprofitable SOEs, tolerating massive layoffs and allowing market forces to play a greater role in the economy (Chart I-2, top panel). The Middle Kingdom also joined the WTO in 2001, which opened global markets for Chinese exports (Chart I-2, bottom panel). The structural reforms of the late 1990s and the WTO accession created fertile ground for China's structural growth boom in the 2000s. Chart I-2China Implemented Structural ##br##Reforms In Late 1990s China Implemented Structural Reforms In Late 1990s China Implemented Structural Reforms In Late 1990s China's nominal manufacturing output growth - depicted on the top panel of Chart I-1 on page 2 - accelerated throughout the 2000s, reaching a 20% annual growth rate in 2007. Consistently, commodities prices and EM share prices were in a structural bull market over that period (Chart I-1, bottom panel). The U.S. credit crisis in 2008 compelled a vicious, but relatively brief, bust in commodities and EM equities. Following the Lehman crash that year, China and many other developing nations injected considerable monetary and fiscal stimulus into their economies. As a result, Chinese and EM domestic demand boomed well before the DM recovery in the second half of 2009. It was in 2009-2011 that EM and China were in the late cycle phase. This period was characterised by booming credit and capital spending, strong income growth, capacity shortages, and a surge in inflation across many economies. Starting in 2011-2012, China and EM economies entered a major downtrend. Consistently, the bear market in commodities began in 2011.2 In 2015, the downtrend escalated, and the selloff became vicious. In the second half of 2015, Chinese policymakers became unnerved and, once again, injected enormous amounts of credit and fiscal stimulus into the mainland economy. These reflationary efforts led to a revival in China's economy, which in turn lifted commodities prices in 2016-2017. China's growth impulse boosted many EM economies that are more leveraged to China than to the U.S. It is this 2016-2017 mid-cycle revival in EM/China/commodities'- that we refer to as a hiatus in a bear market. Chart I-3Chinese Money Growth ##br##Points To More Downside bca.ems_wr_2018_07_19_s1_c3 bca.ems_wr_2018_07_19_s1_c3 Recognizing the long-run unsustainability of this easy money-based growth model and the need to manage escalating financial risks (China's official code word for "bubbles") motivated Chinese policy makers to begin tightening in late 2016. Consequently, money/credit have decelerated, and with a time lag, the business cycle has rolled over (Chart I-3, top panel). In turn, EM risk assets and commodities have been suffering since early 2018 (Chart I-3, bottom panel). Diagnosis Of EM Fundamentals Like doctors examining and diagnosing patients in regard to their medical conditions and prescribing medicines to cure them, the global investment community attempts to diagnose the health of economies and companies, and predict their outlook. In turn, a forecast of the future will have higher odds of being right if the diagnosis it relies upon is correct. Applying this reasoning to EM and the Chinese economies, we need to diagnose their conditions: Have the hangovers following their respective credit/easy money booms dissipated? What are the productivity trends in these economies, and are they in a position to embark on a structural growth trajectory? Our hunch has been and remains that EM economies have not sufficiently dealt with their excesses and are therefore not ready to embark on a new structural growth trajectory for the following reasons: First, China's credit and money excesses remain enormous (Chart I-4). Mild deleveraging has been occurring only in the past 12 months. Importantly, the consequence of this deleveraging is that the current growth slowdown will deepen. Domestic credit has tightened somewhat in the past 12 months, but Chinese companies' and banks' foreign indebtedness has surged (Chart I-5, top panel). Remarkably, external debt repayments and interest payments due in 2018 amount to $125 billion (Chart I-5, bottom panel). This presents a risk to the value of the yuan. Chart I-4China: Not Much Deleveraging So Far bca.ems_wr_2018_07_19_s1_c4 bca.ems_wr_2018_07_19_s1_c4 Chart I-5China: A Lot of Foreign Debt Is Due In 2018 China: A Lot of Foreign Debt Is Due In 2018 China: A Lot of Foreign Debt Is Due In 2018 Second, the mainland's economy recovered in 2016 due to exceptionally soft budgets for SOEs and local governments as well as easier access to credit for the private sector. Notably, consistent with skyrocketing credit, money supply has been exploding in China. Chart I-6 illustrates that broad money in China has expanded by RMB 170 trillion (equivalent to $28 trillion) in the past 12.5 years - which is equal to the entire money supply in the U.S. and the euro area combined, i.e., the same as the money created by the U.S.'s and euro area's respective banking systems over their entire history. Chart I-6Helicopter Money' In China bca.ems_wr_2018_07_19_s1_c6 bca.ems_wr_2018_07_19_s1_c6 The overwhelming majority of commentators mistakenly believe that China's money and credit excesses are due to households' high savings rates. We have documented - in a series of Special Reports3 on money, credit and savings - that banks do not need savings to originate loans - i.e., there is no relationship between the savings rate of a nation and the rate of deposits growth in the banking system (Chart I-7). Banks create money (deposits) out of thin air when they originate loans or buy assets from non-banks. This is true for any country, regardless of income level and type of economic system. Chart I-7No Link Between Savings And Deposits No Link Between Savings And Deposits No Link Between Savings And Deposits In short, the enormous money boom in China is just the mirror image of the gigantic credit bubble. The bottom panel of Chart I-6 illustrates that money growth in China has hugely exceeded money growth in countries that have undertaken QE programs. Hence, one can argue that China has done more than QE - it is fair to say the Middle Kingdom has dropped "helicopter money." And if the supply of money has any relevance to its price, the RMBs value is set to drop relative to other countries. The behavior of mainland households corroborates that there is an oversupply of local currency. Eagerness among households in China to exchange their RMBs for foreign currency and assets confirms that they are very concerned about preserving the purchasing power of their savings. This pent-up demand for dollars from mainland firms and banks due to forthcoming foreign debt servicing obligations - see Chart I-5 on page 5 - along with lingering pent-up demand for foreign assets among households and companies will weigh on the RMB's value. On top of that, the narrowing interest rate differential between China and the U.S. also points to further yuan depreciation (Chart I-8). Do the authorities hold enough international reserves to satisfy Chinese individuals' and companies' demand for foreign currency? Chart I-9 reveals the central bank's foreign exchange reserves including gold (about US$3 trillion) are equal to 10% and 14% of broad money (M3) and total deposits, respectively. In brief, the US$3 trillion foreign exchange reserves are not sufficient to back up the enormous deposit base which has been created by banks out of thin air. Chart I-8More RMB Weakness Ahead More RMB Weakness Ahead More RMB Weakness Ahead Chart I-9China: FX Reserves Are Thin ##br##Relative RMB Deposits bca.ems_wr_2018_07_19_s1_c9 bca.ems_wr_2018_07_19_s1_c9 Importantly, these money excesses and ultimately Chinese households' willingness to hold RMBs - with the exchange rate acting as the litmus test - represent a major constraint on policymakers to indefinitely stimulate the economy. Third, the mainland's real estate market bubble has in recent years moved from coastal areas to third- and fourth-tier cities. Consistently, construction activity has recovered in the past two years, but the sustainability of the revival is dubious. The decline in inventories in third- and fourth-tier cities has been achieved via the monetization of excess housing inventories. The central bank has been funding "slum" development in smaller cities via cheap and direct financing. Since the start of 2014, the PSL program has injected RMB 3 trillion into housing and construction in tier-3 and smaller cities. In brief, the authorities have extended the property cycle by a few more years by conducting outright monetization of housing stock. In the process, property developers' leverage has continued surging, while their net cash flows have more recently deteriorated (Chart I-10). In short, the adjustment in the real estate market has been delayed, and imbalances have become larger. Fourth, consistent with easy money policies and soft budget constraints for government entities, efficiency and productivity continue to deteriorate in China (Chart I-11). Chart I-10Chinese Property Developers: ##br##Leverage And Cash Flow Chinese Property Developers: Leverage And Cash Flow Chinese Property Developers: Leverage And Cash Flow Chart I-11China: Declining Efficiency ##br##And Productivity China: Declining Efficiency And Productivity China: Declining Efficiency And Productivity In any economy, easy money leads to less productivity. Other EMs are no different (Chart I-12). Fifth, easy money in China finds its way into many other developing economies via mainland imports. As such, slower Chinese growth will translate into weaker mainland imports of commodities, materials and industrial goods. As a result, EM ex-China trade balances will deteriorate. In turn, EM corporate profits are at major risk of plunging due to a slowdown in China. Chart I-13 illustrates that the mainland's money/credit cycle leads EM corporate profits. This is why we spend ample time understanding and discussing China's cycle and fundamentals. Chart I-12EM Ex-China: Weak Productivity Growth EM Ex-China: Weak Productivity Growth EM Ex-China: Weak Productivity Growth Chart I-13EM Corporate Earnings Are At Risk bca.ems_wr_2018_07_19_s1_c13 bca.ems_wr_2018_07_19_s1_c13 Remarkably, EM non-financial companies' return on assets and profit margins are at levels that prevailed at the height of previous major downturns/crises (Chart I-14). If they relapse from these levels, this would entail very poor corporate profitability, and investors may question the multiples they are paying for EM equities. Finally, there has been little deleveraging in EM ex-China, Korea and Taiwan: External debt and debt servicing in 2018 remains elevated (Chart I-15). Chart I-14EM Non-Financials: Return On Assets Are ##br##At Levels Seen In Major Downturns EM Non-Financials: Return On Assets Are At Levels Seen In Major Downturns EM Non-Financials: Return On Assets Are At Levels Seen In Major Downturns Chart I-15EM Ex-China: External Debt And Servicing EM Ex-China: External Debt And Servicing EM Ex-China: External Debt And Servicing Local currency debt has been reduced in the Brazilian, Russian and Indian corporate sectors only. There has been little deleveraging outside of these segments. In Brazil, loan contraction in the banking system has been offset by a surge in public debt. Public debt dynamics in Brazil are unsustainable - the result will be either the monetization of public debt or severe fiscal contraction and renewed recession. We will discuss the outlook for Brazil in a Special Report next week. More importantly, banking systems not only in China but in most EM countries, have not provisioned for non-performing loans (NPLs). NPL recognition and provisioning are very low relative to the magnitude of preceding credit booms. Notably, with nominal GDP growth relapsing in many EM economies, their NPL provisions should rise, as demonstrated in Chart I-16A and Chart 16 I-B (nominal GDP growth is shown inverted in this chart). Chart I-16AEM Banks' Provisions Are Set To Rise EM Banks' Provisions Are Set To Rise EM Banks' Provisions Are Set To Rise Chart I-16BEM Banks' Provisions Are Set To Rise EM Banks' Provisions Are Set To Rise EM Banks' Provisions Are Set To Rise Bottom Line: In EM at large and in China above all, the excesses and "deadwood" of 2009-2011 were not cleansed during the 2011-2015 downturn. Specifically, credit excesses have gotten larger - not smaller - in China while the property market has become even more bubbly. Likewise, the misallocation of capital, inefficiencies and speculative behavior in both the financial system and real economy have proliferated. Easy money masked all these negatives in 2016-'17. Yet, as money and credit growth in China have plunged and the Fed steadily shrinks its balance sheet, these negatives are now re-surfacing. EM And The Fed Fed policy and U.S. interest rates are not irrelevant to EM, but they are of secondary importance. The primary driver of EM economies are their domestic fundamentals and the overall global business cycle. Historically, the correlation between EM risk assets and the fed funds rate has been mixed, albeit more positive than negative (Chart I-17). On this chart, we shaded the periods when EM stocks rallied despite a rising fed funds rate. Chart I-17EM Share Prices And Fed Funds Rate: Mixed Correlation EM Share Prices And Fed Funds Rate: Mixed Correlation EM Share Prices And Fed Funds Rate: Mixed Correlation The episodes when EMs crashed amid rising U.S. interest rates were the 1982 Latin America debt crisis and the 1994 Mexican Tequila crisis. Yet, it is vital to emphasize that these crises occurred because of poor EM fundamentals: elevated foreign currency debt levels, negative terms-of-trade shocks, large current account deficits and pegged exchange rates. Dire EM fundamentals also prevailed before the Asian/EM crises of 1997-1998. However, these late-1990s EM crises occurred without much in the way of Fed tightening or rising U.S. bond yields. Importantly, EM stocks, credit markets and currencies did well during periods of rising fed funds rate in 1988-1989, 1999-2000, and 2017, as illustrated in Chart I-17. Presently, the Fed's policy is bullish for the U.S. dollar, and, hence bearish for EM currencies. When EM currencies depreciate, their equities, credit and local bond markets typically sell off. As the Fed is shrinking its balance sheet, commercial banks' reserves at the Fed are also declining. In recent years, changes in banks' excess reserves have been inversely correlated with the dollar (the dollar is shown inverted in the chart) (Chart I-18). Furthermore, U.S. dollar liquidity is also relapsing, which is a bad omen for EM risk assets (Chart I-19). Chart I-18Fed Balance Sheet And U.S. Dollar Fed Balance Sheet And U.S. Dollar Fed Balance Sheet And U.S. Dollar Chart I-19U.S. Dollar Liquidity Is Bearish For EM U.S. Dollar Liquidity Is Bearish For EM U.S. Dollar Liquidity Is Bearish For EM Bottom Line: Rising U.S. interest rates in of themselves are not a sufficient condition for EM to sell off. Only in combination with poor EM fundamentals or a weakening global business cycle are rising U.S. borrowing costs negative for EM financial markets. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Thailand: Will It Be A Low-Beta Market? 19 July 2018 Thai equities have been selling off in absolute terms and have lately begun to underperform the emerging markets (EM) equity benchmark (Chart II-1, top panel). Meanwhile, the currency has also been weakening (Chart II-1, bottom panel). Chart II-1Thai Financial Markets Thai Financial Markets Thai Financial Markets It is very unlikely that Thai share prices and the currency will decouple from their EM peers. Hence, given our negative outlook on EM stocks and currencies, odds are that Thai stocks and the baht will weaken further in absolute terms. However, we believe that Thai financial markets will act defensively amid the ongoing EM selloff. The basis on which we are reiterating our overweight stance on both Thai equities and the baht relative to their EM peers, is founded on the relative resilience of this country's macro fundamentals: Thailand runs a very large current account surplus of 10% of GDP and this provides the baht with a significant cushion. Further, Thai exports are not susceptible to a rollover in commodities prices and a downtrend in Chinese demand. Thailand's main exports are electronics, semiconductor chips, and autos - all of which account for about 40% of total exports. These categories are facing less downside risks than industrial metals and oil prices from weaker Chinese demand. Importantly, exports to China make up 12% while shipments to the U.S. and EU account for 12% and 11% of Thai total goods exports, respectively. We are less negative on the outlook of exports to the U.S. and EU than to China. Thailand has the lowest levels of foreign debt servicing obligations and foreign funding requirements among EM countries (Charts II-2). This stands in stark contrast to the onset of the Asian financial crisis when Thailand had the highest level of external debt. Accordingly, low external debt will limit Thai baht selling by local companies looking to hedge their foreign debt liabilities. Finally, foreign ownership of local government bonds is relatively low (15%). This will limit potential outflows. Chart II-2FX Debt Vulnerability Ranking: Foreign Debt Service Obligations (FX Debt Service In Next 12 Months) Understanding The EM/China Cycles Understanding The EM/China Cycles Remarkably, domestic demand in Thailand is beginning to improve. Chart II-3 shows that loan growth is picking up noticeably. In turn, growth in manufacturing production and consumption is starting to turn upwards (Chart II-3, middle panel). Passenger vehicle sales are also growing robustly (Chart II-3, bottom panel). Improving domestic demand will continue to be supported by low and stable domestic rates. In the recent months, interest rates have risen in many South East Asian countries but not in Thailand (Chart II-4). This is a critical difference that places Thailand apart from many of its peers. The Bank of Thailand (BoT) is in no rush to raise its policy rates even if the currency depreciates further. Thai core inflation remains slightly below target and the currency depreciation can in fact be viewed as a positive reflationary force. In a nutshell, the enormous current account surplus, low public debt/fiscal deficit and structurally low inflation provide Thailand with the ability to maintain low interest rates amid the ongoing EM storm. This will in turn fortify domestic demand resilience to a negative external shock. Chart II-3Thai Growth Is Firming Up Thai Growth Is Firming Up Thai Growth Is Firming Up Chart II-4Policy Divergence Policy Divergence Policy Divergence A quick comment on political risks is warranted. The Thai military junta and political institutions have begun preparations to hold elections sometime next year (likely February to May) that will return the country to civilian rule. A transfer of power from the currently stable military rule to a more uncertain civilian rule will likely trigger a period of rising volatility. However, the junta's economic management has been fairly successful. Growth is strong and, crucially, public debt is low at 33% of GDP and the fiscal deficit is manageable. The junta has the capacity to continue to appease rural voters - who traditionally vote for the populist, anti-junta Pheu Thai party - by increasing government spending. Moreover, the junta has rewritten the constitution, which was approved in a popular referendum and ratified in 2017, to influence both the electoral system and parliament in its favor. Nevertheless, the opposition Pheu Thai Party, which has won every election since 2001, retains the edge in popular opinion. Our colleagues from the Geopolitical Strategy team believe that in the 20%-30% chance scenario where the elections enable the opposition to form a government, policy uncertainty will spike. Yet, this will only occur next year and in the meantime macro factors still make Thailand immune to external shocks. Importantly, uncertainty over the transition period, and the outcome of the elections has probably caused an exodus of foreign investors from this bourse (Chart II-5). However, foreigners' diminished holdings of Thai stocks will limit the downside in the months ahead and allow this market to outperform the EM equity benchmark. Chart II-5Foreigners Have Bailed Out of Thai Stocks Foreigners Have Bailed Out of Thai Stocks Foreigners Have Bailed Out of Thai Stocks Bottom Line: We recommend EM dedicated portfolios keep an overweight position in Thai equity, currency and fixed income markets. Macro factors make Thailand more immune to external shocks vis a vis other EM economies. Political risks by themselves do not justify this bourse's underperformance versus the EM benchmark. In turn, the Thai baht should outperform other EM currencies amid the ongoing weakness in global growth. In line with this view, we maintain the long 5-year Thai bonds / short 5-year Malaysian bonds trade. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report "Where Are EMs In The Cycle?," dated May 3, 2018, available on page 20. 2 Industrial metals prices began falling and oil prices peaked in 2011 even though oil prices stayed flat till 2014 when they crashed. 3 Please see Emerging Markets Strategy Special Report "The True Meaning Of China's Great 'Savings' Wall," dated December 20, 2017, available on ems.bcaresearch.com; and Emerging Markets Strategy Special Report "Is Investment Constrained By Savings? Tales Of China And Brazil," dated March 22, 2018, available on page 20. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Rising non-OPEC production and the Trump administration's successful efforts at jawboning OPEC into increasing oil production - including a not-so-subtle threat that American protection of the Cartel's Gulf Arab producers would be withheld if production weren't ramped - will keep oil prices under pressure in 2H18. Markets could become chaotic in 2019: Iran's capacity to close the Strait of Hormuz - discussed below in this Special Report written jointly by BCA's Commodity & Energy Strategy and Geopolitical Strategy - cannot be dismissed. An extended closure of the Strait - our most dire scenario - could send prices on exponential trajectories: In one simulation, above $1,000/bbl. We are keeping our forecast for 2H18 Brent at $70/bbl, unchanged from June, and lowering our 2019 expectation by $2 to $75/bbl. We expect WTI to trade $6/bbl below Brent. Rising geopolitical uncertainty will widen the range in which oil prices trade - i.e., it will lift volatility. Energy: Overweight. We are moving to a tactically neutral weighting, while maintaining our strategic overweight recommendation. We are closing our Dec18 Brent $65 vs. $70/bbl call spread but are retaining long call-spread exposures in 2019 along the Brent forward curve. Base Metals: Neutral. Contract renegotiations at Chile's Escondida copper mine are yet to be resolved. The union rejected BHP's proposal late last week, and threatened to vote for a strike unless substantial changes were made. Failure to reach a labor deal at the Escondida mine led to a 44-day strike last year, and an extension of the contract. This agreement expires at the end of this month. Precious Metals: Neutral. Increasing real rates in the U.S. and a stronger USD are offsetting safe-haven demand for gold, which is down 10% from its 2018 highs of $1360/oz. Ags/Softs: Underweight. The Chinese agriculture ministry lowered its forecast for 2018/19 soybean imports late last week to 93.85 mm MT from 95.65 mm MT. This is in line with its adjustment to consumption this year, now forecast at 109.23 from 111.19 mm MT. Tariffs are expected to incentivize Chinese consumers to prefer alternative proteins - e.g., rapeseed - and to replace U.S. soybean imports with those from South America. Feature U.S. President Donald Trump jawboned OPEC Cartel members - particularly its Gulf Arab members - into raising production. This was accompanied with a none-too-subtle threat implying continued U.S. protection of the Gulf Arab states was at risk if oil production were not lifted.1 OPEC, particularly KSA, responded by lifting production and pledging to keep it at an elevated level. In addition, non-OPEC production growth has been particularly strong this year, and will remain so. These combined production increases will contribute to a modest rebuilding of inventories in 2H18, as markets prepare for the loss of as much as 1 MMb/d of Iranian oil exports beginning in November (Chart of the Week). Chart of the WeekOECD Inventory##BR##Depletion Will Slow OECD Inventory Depletion Will Slow OECD Inventory Depletion Will Slow Chart 2Global Balances Will Loosen,##BR##As Higher Supply Meets Steady Demand Global Balances Will Loosen, As Higher Supply Meets Steady Demand Global Balances Will Loosen, As Higher Supply Meets Steady Demand Estimated 2H18 total OPEC production rose a net 130k b/d, led by a 180k b/d increase on the part of KSA, which will average just under 10.6 MMb/d in the second half of the year. Non-OPEC production for 2H18 was revised upward by 180k b/d in our balances models - based on historical data from the U.S. EIA and OPEC - led by the U.S. shales, which were up close to 700k b/d over 1Q18 levels. This led to a combined increase in global production of 310k b/d in 2H18. With demand growth remaining at 1.7 MMb/d y/y for 2018 and 2019, we expect the higher output from OPEC and non-OPEC sources to loosen physical balances in 2H18 (Chart 2 and Table 1).2 Table 1BCA Global Oil Supply - Demand Balances (MMb/d) (Base Case Balances) U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic In and of itself, increased production will reverse some of the depletion of OECD inventories targeted by OPEC 2.0 in its effort to rebalance the market. All else equal, this would be bearish for prices. However, we are keeping our price forecast for 2H18 unchanged from last month - $70/bbl for Brent in 2H18 - and lowering our expectation for Brent to $75/bbl in 2019. This adjustment in next year's expectation reflects our belief that this round of increased production by OPEC 2.0 arguably is being undertaken specifically to rebuild storage ahead of the re-imposition of export sanctions by the U.S. against Iran. Re-imposing sanctions unwinds a deal negotiated by the U.S. and its allies in 2015, which relaxed nuclear-related sanctions against Iran in exchange for commitments to scale back its involvement across the Middle East in the affairs of Arab states with restive Shia populations.3 The re-imposition of sanctions by the U.S. against Iran has set off a round of diplomatic barbs and thrusts on both sides. President Trump declared he wanted Iran's oil exports to go to zero, which was followed by Iran's threat to close the Strait of Hormuz. This set oil markets on edge, given that close to 20% of the world's oil flows through the Strait on any given day.4 Geopolitics Reasserts Itself In The Gulf Oil prices will become increasingly sensitive to geopolitical developments, particularly in the Gulf, now that the U.S. and its allies - chiefly KSA - and Iran and its allies are preparing to square off diplomatically, and possibly militarily. This will lead to a wider range in which oil will trade - i.e., we expect more significant deviations from fundamentally implied values, as markets attempt to price in highly uncertain outcomes to political events.5 Tensions around the Strait of Hormuz - discussed below - will remain elevated post-sanctions being re-imposed, even if we only see threats to traffic through this most-important oil transit. Chart 3 shows that in periods when the error term of our fundamental econometric model increases, it typically coincides with higher implied volatilities. Specifically, the confidence interval around our fundamental-based price forecast widens in times of heightened uncertainty and volatility. The larger the volatility, the larger the squared deviation between our fitted Brent prices against actual prices.6 This indicates the probability of ending 2H18 exactly at our $70/bbl target is reduced as mounting upside - e.g. faster-than-expected collapse in Venezuelan crude exports, rising tensions around the Strait of Hormuz or larger-than-expected Permian pipeline/production bottlenecks - and downside - e.g. escalating U.S.-Sino trade war tensions, increasing Libyan and Nigerian production - risks push the upper and lower bounds around our forecast further apart. Chart 3Increasing Sensitivity To Geopolitics Will Widen Crude's Price Range Increasing Sensitivity To Geopolitics Will Widen Crude's Price Range Increasing Sensitivity To Geopolitics Will Widen Crude's Price Range This directly translates into a wider range in which prices will trade - uncertainty is high, and, while it is being resolved, markets will remain extremely sensitive to any information that could send prices on an alternative path (Chart 4). Chart 4Greater Geopolitical Uncertainty Widens Oil Price Trading Range Greater Geopolitical Uncertainty Widens Oil Price Trading Range Greater Geopolitical Uncertainty Widens Oil Price Trading Range Risks related to a closure of the Strait are not accounted for in our forecasts. However, given the magnitude of the risks implied by even the remote possibility of a closure, we expect markets will put a risk premium into prices. In an attempt to frame out price estimates from a short (10-day) and long (100-day) closure, we provide some cursory simulation results below.7 Can Iran Close The Strait Of Hormuz? The Strait of Hormuz, through which some 20% of global oil supply transits daily, is the principal risk that will keep markets hyper-vigilant going forward.8 A complete closure of the Strait of Hormuz (Map 1) would be the greatest disruption of oil production in history, three times more significant than the supply loss following the Islamic Revolution in 1979 (Chart 5). By our estimate, a 10-day closure at the beginning of 2H19 could pop prices by ~ $25/bbl. A 100-day closure could send prices above $1,000/bbl in our estimates. Map 1Iran Threatens Gulf Shipments Again U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic Chart 5Geopolitical Crises And Global Peak Supply Losses U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic So, the question naturally arises, can Iran's forces close the Strait? Iran's ability is limited by structural and military factors, but it could definitely impede traffic through the globe's most crucial energy chokepoint. There are two scenarios for the closure of the Strait: (i) Iran does so preemptively in retaliation to crippling economic sanctions; or (ii) Iran does so in retaliation to an attack against its nuclear facilities. Either scenario is possible in 2019, as the U.S. intends to re-impose sanctions against Iranian oil exports on November 9, a move that could lead to armed conflict if Iran were to retaliate (Diagram 1).9 Diagram 1Iran-U.S. Tensions Decision Tree U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic SCENARIO I - Preemptive Closure In the past, Tehran has threatened to preemptively close the Strait of Hormuz whenever tensions regarding its nuclear program arose. The threats stopped in mid-2012, as U.S. and Iranian officials engaged in negotiations over the country's nuclear program. However, on July 4 of this year, Iran's nominally moderate President Hassan Rouhani pledged that Tehran would retaliate to an oil export embargo by closing the Strait. Rouhani's comments were reinforced on July 5 by the commander of Iran's elite Revolutionary Guards, whose forces patrol the Strait, Mohammad Ali Jafari. Could Iran actually impede traffic through the Strait of Hormuz?10 Yes. Our most pessimistic scenario posits that Iran could close the waterway for about three or four months. This is based on three military capabilities: mines, land-based anti-ship cruise missiles (ASCM), and a large number of small boats for suicide-like attack waves. In our pessimistic scenario, we assume that Iran would be able to deploy about 700 mines and threaten the Strait by firing only one anti-ship cruise missiles (ASCM) operated via land-based batteries or ship per day, in order to prolong the threat.11 In that way, Iran could draw out the threat indefinitely. The length of closure is based on how long it would take the U.S. naval assets in the region to clear the mines, establish a Q-route - corridor within which the probability of hitting a mine is below 10% - and locate ASCM radars and batteries. The pessimistic scenario is unlikely to occur because of several countermeasures that the U.S. and its regional allies could employ - anti-mine operations, meant to clear a so-called Q route allowing safe passage of oil tankers under U.S. naval escort; punitive retaliation, which would inflict punitive damage on Iran's economy and infrastructure; and, lastly, Iran would not want to risk exposing its radar-guided anti-ship missiles to U.S. suppression of enemy air-defense (SEAD) operations that seek and destroy radars. Despite Iran's growing capability, we still posit that its forces would only be able to close the Strait of Hormuz for between three-to-four months. However, the more likely, "optimistic," scenario is that the closure itself lasts 7-10 days, while Iran then continues to threaten, but not actually close, the Strait for up to four months. It would be worth remembering that the U.S. has already retaliated against a potential closure, precisely 30 years ago. Midway through the Iran-Iraq war, both belligerents began attacking each other's tankers in the Gulf. Iran also began to attack Kuwaiti tankers after it concluded that the country was assisting with Iraq's war efforts. In response, Kuwait requested U.S. assistance and President Ronald Reagan declared in January 1987 that tankers from Kuwait would be flagged as American ships. After several small skirmishes over the following year, the USS Samuel B Roberts hit a mine north of Qatar. The mine recovered was linked to documents found by the U.S. during an attack on a small Iranian vessel laying mines earlier in 1987. The U.S. responded by launching Operation Praying Mantis on April 18, 1988. During the operation, which only lasted a day, the U.S. navy seriously damaged Iran's naval capabilities before it was ordered to disengage as the Iranians quickly retreated. Specifically, two Iranian oil platforms, two Iranian ships, and six gunboats were destroyed. The USS Wainwright also engaged two Iranian F-4s, forcing both to retreat after one was damaged. From this embarrassing destruction of Iran's naval assets, the country realized that conventional capabilities stood little chance against a far superior U.S. navy. As a result, Iran has strengthened its asymmetrical sea capabilities, such as the use of small vessels, and has made evident that the use of mines would be integral to its engagements with foreign navies in the Gulf. However, the switch to asymmetrical warfare means that Iran would likely threaten, rather than directly close, the Strait. From an investment perspective, the threat to shipping would have to be priced-in via higher insurance rates. According to research by the University of Texas Robert S. Strauss Center, the insurance premiums never rose above 7.5% of the price of vessel during the 1980s Iran-Iraq war and actually hovered around 2% throughout the conflict. Rates for tankers docking in Somali ports, presumably as dangerous of a shipping mission as it gets, are set at 10% of the value of the vessel. A typical very large crude carrier (VLCC) is worth approximately $120 million. Adding the market value of two million barrels of crude would bring its value up to around $270 million at current prices. If insurance rates were to double to 20%, the insurance costs alone would add around $30 per barrel, $15 per barrel if rates stayed at the more reasonable 10%. This is without factoring in any geopolitical risk premium or direct loss of supply of Iran's output due to war. Bottom Line: Iran's military capabilities have increased significantly since the 1980s when it last threatened the shipping in the Strait. Iran has also bolstered its asymmetric capabilities since 2012, while the U.S. has largely remained the same in terms of anti-mine capabilities. If Iran had the first-mover advantage in our preemptive closure scenario, the most likely outcome would be that it could close the Strait for up to 10 days and then threaten to close it for up to four months in total. SCENARIO II - Retaliatory Closure A retaliatory closure is possible in the case of a U.S. (or Israeli) attack against Iran's nuclear facilities. Following from the military analysis of a preemptive closure, we can ascertain that a retaliatory closure would be far less effective. The U.S. would deploy all of its countermeasures to Iranian closure tactics as part of its initial attack. If Iran loses its first-mover advantage, it is not clear how it would lay the mines that are critical to closing the Strait. Iran's Kilo class submarines, the main component of a covert mine-laying operation, would be destroyed in port or hunted down in a large search-and-destroy mission that would "light up" the Strait of Hormuz with active sonar pings. The duration of the closure could therefore be insignificant, even non-existent. The only potential threat is that of Iran's ASCM capability. Iran would be able to use its ASCMs in much the same way as in the preemptive scenario, depending on the rate of fire and rate of discovery by U.S. assets. Bottom Line: It makes a big difference whether Iran closes the Strait of Hormuz preemptively or as part of a retaliation to an attack. The U.S. would, in any attack, likely target Iran's ability to retaliate against global shipping in the Persian Gulf. As such, Tehran's asymmetric advantages would be lost. Putting It All Together - Can Iran Close The Strait? Our three scenarios are presented in Table 2. Iran has the ability to close the Strait of Hormuz for up to three-to-four months. That "pessimistic" scenario, however, is highly unlikely. The more likely scenarios are the "preemptive optimistic" and retaliatory scenarios. Table 2Closing The Strait Of Hormuz: Scenarios U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic Assessing the price implications of these scenarios is extremely difficult. Even though the "preemptive optimistic" and the "retaliatory" scenarios are short-lived, up to 20% of the world's daily demand would be removed from the market in the event the Strait of Hormuz was closed. Of course, the U.S. would release barrels from its 660mm-barrel Strategic Petroleum Reserve (SPR) - likely the full maximum of 30 million barrels authorized under law, released over 30 days for a 1 MMb/d release - and Europe would also release ~ 1 MMb/d or so from its crude and product stocks. China likely would tap its SPR as well for 500k b/d. In addition, there is ~ 2 MMb/d of spare capacity in OPEC, which could be brought on line in 30 days (once the Strait is re-opened), and delivered for at least 90 days. How and when a closure of the Strait of Hormuz occurs cannot be modeled, since, as far as prices are concerned, so much depends on when it occurs, and its duration. For this reason, and the extremely low probability we attach to any closure of the Strait, we do not include these types of simulations in our analysis of the various scenarios we include in our ensemble. That said, it is useful to frame the range implied by the scenarios above. We did a cursory check of the impact of scenarios 1 and 2 above, in which we assume 19 MMb/d flow through the Strait is lost for 10 days and 100 days due to closure by Iran in July 2019. We assume this will be accompanied by a 2 MMb/d release from various SPRs globally. In scenario 1, the 10-day closure of the Strait lifts price by $25/bbl, and is resolved in ~ 2 months, with prices returning to ~ $75/bbl for the remainder of the year. In scenario 2, the Strait is closed for 100 days, and this sends prices to $1,500/bbl in our simulation. This obviously would not stand and we would expect the U.S. and its allies - supported by the entire industrialized world - would launch a powerful offensive to reopen the Strait. This would be extremely destructive to Iran, which is why we give it such a low probability. Bottom Line: While the odds of a closure of the Strait of Hormuz are extremely low - to the point of not being explicitly modeled in our balances and forecasts - framing the possible outcomes from the scenarios considered in this report reveals the huge stakes involved. A short closure of 10 days could pop prices by $25/bbl before flows are restored to normal and inventory rebuilt, while an extended 100-day closure could send prices to $1,500/bbl or more. Because the latter outcome would result in a massive offensive against Iran - supported by oil-consuming states globally - we view this as a low-probability event. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 President Trump's tweets calling for higher oil production have consistently been directed at the original OPEC Cartel, as seen July 4: "The OPEC monopoly must remember that gas prices are up & they are doing little to help. If anything, they are driving prices higher as the United States defends many of their members for very little $'s. This must be a two way street. REDUCE PRICING NOW!" Since the end of 2016, we have been following the production and policy statements of OPEC 2.0, the name we coined for the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. 2 We will be exploring the rising risks to our demand projections in future research. Still, we are in broad agreement with the IMF's most recent assessment of global economic growth, which remains at 3.9% p.a. Please see "The Global Expansion: Still Strong but Less Even, More Fragile, Under Threat," published July 16, 2018, on the IMF's blog. 3 We discuss this at length in the Special Report we published with BCA's Geopolitical Strategy on June 7, 2018, entitled "Iraq Is The Prize In U.S. - Iran Sanctions Conflict." It is available at ces.bcaresearch.com. 4 In an apparent recognition of what it would mean for world oil markets if Iran's exports did go to zero - particularly with Venezuela so close to collapse, which could take another 800k b/d off the market - U.S. Secretary of State Mike Pompeo announced waivers to the sanctions would be granted, following Trump's remarks at the beginning of July. See "Pompeo says US could issue Iran oil sanctions waivers" in the July 10, 2018, Financial Times. The Trump administration, however, is keeping markets on their toes, with Treasury Secretary Steven Mnuchin telling the U.S. Congress, "We want people to reduce oil purchases to zero, but in certain cases, if people can't do that overnight, we'll consider exceptions." See "Iran sues US for compensation ahead of re-imposition of oil sanctions," published by S&P Global Platts on July 17, 2018, on its spglobal.com/platts website. 5 Technically, this means the confidence interval around the target is now wider, which implies high probability of going above $80/bbl as well as the probability of going under $70/bbl. Still, the 2019 risks are skewed to the upside, in our view. 6 Given that our model is based solely on a variety of fundamental variables - i.e. supply-demand-inventory - the deviations can be interpreted as movements in the risks premium/discount. 7 This exercise does not include any estimate of oil flows through KSA's East-West pipeline, and possible exports therefrom. The rated capacity of the 745-mile line is 5 MMb/d, possibly 7 MMb/d. KSA's Red Sea loading capacity and the capacity of the Suez Canal and Bab el Mandeb under stress - i.e., the volumes either can handle with a surge of oil-tanker traffic - is not considered either. 8 This is the U.S. EIA's estimate. The EIA notes that in 2015 the daily flow of oil through the Strait accounted for 30% of all seaborne-traded crude oil and other liquids. Natural gas markets also could be affected by a closure: In 2016, more than 30% of global liquefied natural gas trade transited the Strait. Please see "Three important oil trade chokepoints are located around the Arabian Peninsula," published August 4, 2017, at eia.gov. 9 We encourage our clients to read our analysis of potential Iranian retaliatory strategies, penned by BCA's Geopolitical Strategy team. Please see BCA Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 10 Analysis of Iran's military strategy and U.S. counterstrategy used in this paper relies on research from three heavily cited papers. Eugene Gholz and Daryl Press are skeptical of Iran's ability to close the Strait in their paper titled "Protecting 'The Prize': Oil and the National Interest," published in Security Studies Vol. 19, No. 3, 2010. Caitlin Talmadge gives Iran's capabilities far more credit in a paper titled "Closing Time: Assessing the Iranian Threat to the Strait of Hormuz," published in International Security Vol. 33, No. 1, Summer 2008. Eugene Gholz also led a project at the University of Texas Robert S. Strauss Center for International Security and Law that published an extensive report titled "The Strait of Hormuz: Political-Military Analysis of Threats to Oil Flows." 11 In the Strauss Center study, the most likely number is 814 mines, if Iran had a two-week period to do so covertly. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic Trades Closed in 2018 Summary of Trades Closed in 2018 U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic

Highlights President Trump is a prisoner of his own mercantilist rhetoric - there is more trade tension and volatility to come; China's depreciation of the RMB can go further - and will elicit more punitive measures from Trump; Gasoline prices are a constraint on Trump's Maximum Pressure campaign against Iran, but only until midterm elections are done; Brexit woes are keeping us short GBP/USD, but Theresa May has discovered the credible threat of new elections - we are putting a trailing stop on this trade at 2%; The EU migration "crisis" is neither a real crisis nor investment relevant. Feature General Hummel: I'm not about to kill 80,000 innocent people! We bluffed, they called it. The mission is over. Captain Frye: Whoever said anything about bluffing, General? The Rock, 1996 As BCA's Geopolitical Strategy has expected since November 2016, the risk of trade war poses a clear and present danger for investors.1 The U.S. imposed tariffs of 25% on $34 billion of Chinese goods on July 6, with tariffs on another $16 billion going into effect on July 20. President Trump announced on July 10 that he would levy a 10% tariff on an additional $200 billion of Chinese imports by August 31 and then on another $300 billion if China still refused to back down. That would add up to $550 billion in Chinese goods and services that could be subject to tariffs, more than China exported to the U.S. last year (Chart 1)! Chart 1President Trump Magically Threatens ##br##Even Non-Existent China Imports Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? Table 1Market's Couldn't Care##br## Less About Tariffs Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? The S&P 500 couldn't care less. Trade-related events - and other geopolitical crises - have thus far had a negligible impact on U.S. equities (Table 1). If anything, stocks appear to be slowly climbing the geopolitical wall of worry since plunging to a low of 2,581 on February 8, which was before any trade tensions emerged in full focus (Chart 2A and Chart 2B).2 Chart 2AStocks Climbing The 'Wall Of Worry' On Trade Tensions... Stocks Climbing The 'Wall Of Worry' On Trade Tensions... Stocks Climbing The 'Wall Of Worry' On Trade Tensions... Chart 2B...And On Military Tensions ...And On Military Tensions ...And On Military Tensions Speaking with clients, the consensus appears to be that President Trump is "bluffing." After all, did he not successfully create a "credible threat" amidst the tensions with North Korea, thus forcing Pyongyang to stand down, change its bellicose rhetoric, free U.S. prisoners, and freeze its nuclear device and ballistic tests? This was a genuinely successful application of his "Maximum Pressure" tactic and he did not have to fire a shot!3 Yes, but the Washington-Pyongyang 2017 brinkmanship caused 10-year Treasuries to plunge 35bps from their July 7 peak to their September 7 low.4 Our colleague Rob Robis - BCA's Chief Fixed Income Strategist - assures us that this move in Treasuries last summer was purely North Korea-related, which suggests that not all investors were relaxed and expecting tensions to resolve themselves.5 President Trump may be bluffing on protectionism, on Iran, and on the U.S.'s trade and geopolitical relationship with its G7 allies. However, we should consider two risks. The first is that his opponents might not back down. Yes, we agree with the consensus that China will ultimately lose a trade war with the U.S. It is a trade surplus country fighting a trade war with its chief source of final export demand (Chart 3). Chart 3China Has More To Lose Than The U.S. China Has More To Lose Than The U.S. China Has More To Lose Than The U.S. Forecasting when China backs down, however, is difficult. If Beijing backs down in 2018, investors betting on stocks ignoring trade risks will be proven correct. We do not see this happening. Instead, we expect Beijing to continue using CNY depreciation to offset the impact of tariffs, likely exacerbating the ongoing USD rally in the process, and eventually putting pressure on U.S. corporate earnings in Q3 and Q4. China does not appear to be panicking about the threat of a 10% tariff. In fact, Beijing may decide to double-down on its structural reform efforts, which have negatively impacted growth in the country thus far, blaming President Trump's protectionist policies for the pain. The other question is whether the U.S. political context will allow President Trump to end the trade war. Our clients, colleagues, and friends in the financial industry seem to have collective amnesia about the "trade truce" orchestrated by Treasury Secretary Steven Mnuchin on May 20. The truce lasted merely a couple of days, with the U.S. ultimately announcing on May 29 that the tariffs on $50 billion of Chinese imports would go forward. President Trump may have wanted to present the Mnuchin truce as a big victory ahead of the midterm elections. His tweets the next day were triumphant.6 However, once the collective American establishment (Congress, pundits, and even Trump's ardent supporters in the conservative media) got hold of the details of the deal, they were shocked and disappointed.7 Why? The American "median voter" is far more protectionist than the political establishment has wanted to admit. Now that this public preference has been elucidated, President Trump himself cannot move against it. He is a prisoner of his own mercantilist rhetoric. President Trump may be dealing with a situation similar to the one General Hummel faced in the iconic mid-1990s action thriller The Rock. Hummel, played by the steely Ed Harris, holed up in Alcatraz with VX gas-armed M55 rockets, threatening to take out tens of thousands in San Francisco unless a ransom was paid by the Washington establishment. Unfortunately for Hummel, the psychotic marines he brought to "The Rock" turned against him when he suggested that the entire operation was in fact a bluff. As such, we reiterate: Whoever said anything about bluffing? China: Beware Beijing's Retaliation Since 2017, we have cautioned investors that Beijing was likely to retaliate to the imposition of tariffs by weakening the CNY/USD.8 June was the largest one-month decline in CNY/USD since the massive devaluation in 1994 (Chart 4). BCA's China Investment Strategy has shown that the PBOC is indeed allowing China's currency to depreciate against the U.S. dollar.9 Chart 5 shows the actual CNY/USD exchange rate alongside the value that would be predicted based on its relationship with the dollar over the year prior to its early-April peak. The chart suggests that the decline in CNY/USD appears to have reflected the strength in the U.S. dollar until very recently. However, CNY/USD has fallen over the past few days by a magnitude in excess of what would be expected given movements in the greenback, implying that the very recent weakness is likely policy-driven. Chart 4The Biggest One-Month Yuan Drop Since 1994 The Biggest One-Month Yuan Drop Since 1994 The Biggest One-Month Yuan Drop Since 1994 Chart 5The CNY Is Much Weaker Than The DXY Implies The CNY Is Much Weaker Than The DXY Implies The CNY Is Much Weaker Than The DXY Implies BCA's Foreign Exchange Strategy has pointed out that currency depreciation is also a way to stimulate the economy in the face of the central government's ongoing deleveraging policy.10 Not only does a weaker CNY dull the impact of Trump's tariffs, it also insulates China against a slowdown in global trade volumes (Chart 6). Moreover, China's current account fell into deficit last quarter (Chart 7). A weaker RMB helps deal with this issue, but the PBoC may be forced to cut Reserve Requirement Ratios (RRRs) further if the deficit remains in place, forcing the currency even lower. Chart 6China Needs A Buffer Against Slowing Trade China Needs A Buffer Against Slowing Trade China Needs A Buffer Against Slowing Trade Chart 7Supportive Conditions For A Lower CNY Supportive Conditions For A Lower CNY Supportive Conditions For A Lower CNY There is no silver lining in this move by Beijing. Evidence that China is manipulating its currency would be a clear sign of an outright, full-scale trade war between the U.S. and China. On one hand, a falling RMB will improve the financial position of China's exporters. On the other hand, it may invite further protectionist action from the U.S., including a threat by the White House to increase the tariff levels on the additional $500 billion of imports from the current 10% rate, or to enhance export restrictions on critical technologies, or to add new investment restrictions. Several of our clients have pointed out that China does not want a trade war, that it cannot win a trade war, and that it is therefore likely to offer concessions ahead of the U.S. midterm election. We agree that China is at a disadvantage.11 But we also reiterate that the concessions have already been offered, in mid-May following the Mnuchin negotiations with Chinese Vice Premier Liu He. China and the U.S. may of course resume negotiations at any time, but it will likely take months, at best, to arrange a deal that reverses this month's actual implementation of tariffs. We think that the obsession with "who will win the trade war" is misplaced. Of course, the U.S. will "win." The problem is that what the Trump administration and what investors consider a "victory" may be starkly different: victory may not include a rip-roaring stock market. In fact, President Trump may require a stock market correction precisely to convince his audience, including those in Beijing, that his threats are indeed credible. Bottom Line: President Trump's promise of a 10% tariff on $500 billion of Chinese imports can easily be assuaged by a CNY/USD depreciation. If we know that Beijing is depreciating its currency, so does the White House. The charge against Beijing for currency manipulation could occur as late as the Treasury Department's semiannual Report to Congress in October, or informally via a presidential tweet at any time before then. While the formal remedies against a country deemed to be officially engaged in currency manipulation are relatively benign in the context of the ongoing trade war, we would expect President Trump to up the pressure on China regardless. Iran: Can Midterm Election Stay President Trump's Hand? We identified U.S.-Iran tensions in our annual Strategic Outlook as the premier geopolitical risk in 2018 aside from trade concerns.12 We subsequently argued that President Trump's application of "Maximum Pressure" against Iran would likely exacerbate tensions in the Middle East, add a geopolitical risk premium to oil prices, and potentially lead to a military conflict in 2019 (Diagram 1).13 Diagram 1Iran-U.S. Tension Decision Tree Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? The Brent crude oil price has come off its highs just below $80/bbl in late May and appears to be holding at $75/bbl. Is the market once again ignoring bubbling U.S.-Iran tensions or is there another factor at play? We suspect that investors are placing their hopes on White House pressure on producers to bring massive amounts of crude online to offset the impact of "Maximum Pressure" on Iran. First, Trump tweeted in April that "OPEC is at it again," keeping oil prices artificially high. He followed this with another tweet at the end of June, directly requesting that Saudi Arabia increase oil production by up to 2 million b/d so that he may continue to play brinkmanship with Tehran. Second, the Libyan media leaked that President Trump sent letters to the representatives of Libya's warring factions, imploring them to restart oil exports or face international prosecution and potential U.S. military intervention.14 The pressure on the Libyan authorities appears to have worked, with the Tripoli-based National Oil Corporation (NOC) ending its force majeure, a legal waiver on contractual obligations, on the ports of Ras Lanuf, Es Sider, Zueitina, and Hariga. Third, Secretary of State Mike Pompeo signaled on July 10 that the U.S. would consider granting waivers to countries seeking to avoid being sanctioned for buying oil from Iran. On July 15, however, the administration clarified the comment by stating that it would only grant limited exceptions based on national security or humanitarian efforts. The White House is realizing that, unlike its brinkmanship with North Korea, "Maximum Pressure" on Iran comes with immediate domestic costs: higher gasoline prices (Chart 8). The last thing President Trump wants to see is his household tax cut trumped by the higher cost of gasoline. Chart 8How Badly Do Americans Want A New Iran Deal? How Badly Do Americans Want A New Iran Deal? How Badly Do Americans Want A New Iran Deal? Chart 9Iran Is Not Yet At Peak North Korean Levels Of Threat Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? Applying Maximum Pressure on Iran is tricky. Politically, the upside is limited for President Trump. First, a majority of Americans (62%) do not want to see the U.S. withdraw from the deal, and do not consider Iran to be as critical of a threat as North Korea (Chart 9). That said, 40% believe that Iran is a "very serious" threat - up from just 30% in October, 2017 - and 62% of Americans believe that "Iran has violated the terms" of the nuclear agreement. These are numbers that President Trump can "work with," but not if gasoline prices rise to consumer-pinching levels. As such, the question is whether we should stand down from our bullish oil outlook given President Trump's active role in eking out new supply. We should, if there were supply to be eked out. BCA's Commodity & Energy Strategy believes that global supply capacity will not be sufficient to keep prices below $80/bbl in the event that Venezuela collapses in 2019 or that Iranian export losses are greater than the 500,000 b/d we are currently projecting.15 The U.S. EIA estimates there is only 1.8mm b/d of spare capacity available worldwide this year, to fall to just over 1 mm b/d next year (Chart 10). Our commodity strategists believe that the idle and spare capacity of KSA, Russia, and other core OPEC 2.0 states that can actually increase production would be taxed to the extreme to cover losses of Iranian exports, especially if the losses reached 1 mm b/d. In fact, many secondary OPEC 2.0 producers are struggling to produce at their 2017-2018 production quota, suggesting that lack of investment and natural depletion have already taken their toll (Chart 11). Chart 10Global Spare Capacity##br## Stretched Thin Global Spare Capacity Stretched Thin Global Spare Capacity Stretched Thin Chart 11OPEC 2.0's Core Producers Would##br## Struggle To Replace Lost Exports OPEC 2.0's Core Producers Would Struggle To Replace Lost Exports OPEC 2.0's Core Producers Would Struggle To Replace Lost Exports Could President Trump back off from the threat of brinkmanship with Iran due to the risk of rising oil prices? Yes, absolutely. We have argued in the past that President Trump appears to be an intensely domestically-focused president. We also see little logic, from the perspective of U.S. interests broadly defined or President Trump's "America First" strategy specifically, in undermining the Obama-era nuclear agreement. As such, domestic constraints could stay President Trump's hand. On the other hand, these constraints would have the greatest force ahead of the November 2018 midterm and the 2020 general elections. This gives President Trump a window between November 2018 and at least the early summer of 2020 to put Maximum Pressure on Iran. As such, we think that investors should fade White House attempts to shore up global supply. Once the midterm election is over, the pressure will fall back on Iran. What about Iran's calculus? Tehran has an interest in dampening tensions ahead of the midterms as well. However, if the U.S. actually enforces sanctions, as we expect it will, we are certain that Iran will begin to ponder the retaliatory action we describe in Diagram 1. In fact, Iran's population appears to be itching for a confrontation, with an ever-increasing majority supporting the restart of Iranian nuclear facilities in response to U.S. withdrawal from the JCPOA nuclear agreement (Chart 12). Iranian officials have also already threatened to close the Straits of Hormuz as we expected they would. Chart 12Iranians Supported Ending Nuclear Deal If The U.S. Did (And It Did!) Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? Bottom Line: Between now and November, U.S. policy towards Iran may be much ado about nothing. However, we expect the pressure to rise by the end of the year and especially in 2019. Our subjective probability of armed conflict remains at an elevated 20%, by the end of 2019. This is four times greater than our probability of kinetic action amidst the tensions between the U.S. and North Korea. Brexit: Has Theresa May Figured Out How Credible Threats Work? We have long argued that a soft Brexit is incompatible with Euroskeptic demands for increased sovereignty (Diagram 2). And, indeed, sovereignty was one of the main demands - if not the main demand - of Brexit voters ahead of the referendum. A large percent, 32% of "leave" voters, said they would be willing to vote "stay" if a deal with the EU gave "more power to the U.K. parliament," an even greater share than those focused on migration (Chart 13). As such, since March 2016, we have expected the U.K. Conservative Party to split into factions regardless of the outcome of the vote on EU membership.16 Diagram 2The Illogic Of ##br##Soft Brexit Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? Chart 13Sovereignty Topped The##br## List Of Brexit Voter Concerns Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? U.K. Prime Minister Theresa May has fought against the inevitable by inviting notable Euroskeptics into her cabinet and by trying to pursue a hard Brexit in practice. The problem with this strategy is that it won't work in Westminster, where a whopping 74% of all members of parliament, and 55% of all Tory MPs, declared themselves as "remain" supporters ahead of the 2016 referendum (Chart 14). Given that the House of Commons has to approve the ultimate U.K.-EU deal, a hard-Brexit deal is likely to fail in Parliament. While such a defeat would not automatically bring up an election, May would be essentially left without any political capital with which to continue EU negotiations and would either have to resign or call a new election. Chart 14Westminster MPs Support Bremain! Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? Theresa May therefore has two options. The first is to trust the political instincts of David Davis and Boris Johnson and try to push a hard Brexit through the House of Commons. But with a slim majority of just one MP, how would she accomplish such a feat? Nobody knows, ourselves included, which is why we shorted the GBP as long as May stubbornly listened to the Euroskeptics in her cabinet. However, it appears that May has finally decided to ditch her Euroskeptic cabinet members and establish the "credible threat" of a new election. While May has not uttered the phrase directly, she hinted at a new election when she suggested that "there may be no Brexit at all." The message to hard-Brexit Tory rebels is clear: back my version of Brexit or risk new elections. From an economic perspective, retaining some semblance of Common Market membership is obviously superior to the hard-Brexit alternative. It is so superior, in fact, that Boris Johnson himself called for it immediately following the referendum!17 From a political perspective, it is also much easier to persuade less than two-dozen committed Tory Euroskeptics that a new election would be folly than it is to convince half of the party that the economic risks of a hard-Brexit are inconsequential. The switch in May's tactic therefore warrants a cautionary approach to our current GBP/USD short. The recommendation is up 5.55% since February 14. However, the GBP could be given a tailwind if investors sniff out fear amongst hard Brexit Tories. We still believe that downside risks exist in the short term. First, there is no telling if the EU will accept the particularities of May's Brexit strategy. In fact, the EU may want to make May's life even more difficult by asking for more concessions. Second, Euroskeptic Tories in the House of Commons may be willing martyrs, rebelling against May regardless of the economic and political consequences. Bottom Line: We are keeping our short GBP/USD on for now, which has returned 5.55% since February 14, but we will tighten the stop to just 2%. We think that Theresa May has finally figured out how to use "credible threats" to cajole her party into a soft Brexit. The problem, however, is that she still needs Brussels to play ball and her Euroskeptic MPs to act against their ideology. Europe: Will The Immigration Crisis End The EU? Chart 15European Migration Crisis Is Over European Migration Crisis Is Over European Migration Crisis Is Over No. There is no migration crisis in the EU (Chart 15). Despite the posturing in Europe over the past several months, the migration crisis ended in October 2015. As we forecast at the time, Europe has since taken several steps ovet the succeeding years to increase the enforcement of its external borders, including illiberal methods that many investors thought beyond European sensibilities.18 Today, EU member states are openly interdicting ships carrying asylum seekers and turning them away in international waters. Chancellor Angela Merkel has become just the latest in a long line of policymakers to succumb to her political constraints - and abandon her preferences - by agreeing to end the standoff with her conservative Bavarian allies. Merkel has agreed to set up transit centers on the border of Austria from where migrants will be returned to the EU country where they were originally registered, or simply sent across the border to Austria. The idea behind the move is to end the "pull" that Merkel inadvertently created by openly declaring that Germany was open to migrants regardless of where they came from. Why wouldn't migrants keep coming to Europe regardless? Because if the promise of a job and a legal status in Germany or other EU member states is no longer available, the cost - in treasure, limb, and life - of the journey through the Sahara and unstable states like Libya, and the Mediterranean Sea will no longer make sense. As Chart 15 shows, potential migrants are capable of making the cost-benefit calculation and are electing to stay put. Bottom Line: The EU migration crisis is not investment-relevant. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see the Appendices for the detailed description of events. 3 Please see BCA Geopolitical Strategy Special Report, "Pyongyang's Pivot To America," June 8, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 5 BCA Global Fixed Income Strategy Weekly Report, "Have Bond Yields Peaked For The Cycle? No," dated September 12, 2017, available at gfis.bcaresearch.com. 6 His tweets in the immediacy of the deal suggest that this was the case. He tweeted, immediately following Mnuchin's Fox News appearance, "China has agreed to buy massive amounts of ADDITIONAL Farm/Agricultural Products - would be one of the best things to happen to our farmers in many years!" He then tweeted again, suggesting that his deal was superior to anything President Obama got, "I ask Senator Chuck Schumer, why didn't President Obama & the Democrats do something about Trade with China, including Theft of Intellectual Property etc.? They did NOTHING! With that being said, Chuck & I have long agreed on this issue! Trade, plus, with China will happen!" His third tweet suggested that the deal being negotiated was indeed a big compromise, "On China, Barriers and Tariffs to come down for first time." All random capitalizations are President Trump's originals. 7 We reacted to the truce by arguing that it would not "last long." It lasted merely three days! Please see BCA Geopolitical Strategy Weekly Report, "Some Good News (Trade), Some Bad News (Italy)," dated May 23, 2018, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, and "Are You 'Sick Of Winning' Yet?" dated June 20, 2018, available at gps.bcaresearch.com. 9 Please see BCA China Investment Strategy Weekly Report, "Now What?" dated June 27, 2018, available at cis.bcaresearch.com. 10 Please see BCA Foreign Exchange Strategy Weekly Report, "What Is Good For China Doesn't Always Help The World," dated June 29, 2018, available at fes.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Strategic Outlook, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 14 Please see "Trump's letter to rivals allegedly results in resumption of oil exports in Libya," Libyan Express, dated July 11, 2018, available at libyanexpress.com. 15 Please see BCA Commodity & Energy Strategy Weekly Report, "Brinkmanship Fuels Chaos In Oil Markets, And Raises The Odds Of Conflict In The Gulf," dated July 5, 2018, available at ces.bcaresearch.com. 16 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 17 Johnson stated right after the referendum that "there will continue to be free trade and access to the single market." Please see "U.K. will retain access to the EU single market: Brexit leader Johnson," Reuters, dated June 26, 2016, available at uk.reuters.com. 18 Please see BCA Geopolitical Strategy Special Report, "The Great Migration - Europe, Refugees, And Investment Implications," dated September 23, 2015, available at gps.bcaresearch.com. Appendix Appendix 2A Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? Appendix 2B Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? Appendix 2B (Cont.) Whoever Said Anything About Bluffing? Whoever Said Anything About Bluffing? Geopolitical Calendar

Highlights Duration Checklist: An update of our medium-term Duration Checklist highlights that the strategic backdrop for global government bonds remains bearish. A below-benchmark overall portfolio duration stance is still warranted - even after our recent move to downgrade spread product exposure. Canada: The Bank of Canada hiked rates again last week, and additional increases are likely given growing capacity constraints and accelerating Canadian inflation. Stay underweight Canadian government bonds. Feature Chart of the WeekStagflation Keeping Yields Afloat Stagflation Keeping Yields Afloat Stagflation Keeping Yields Afloat Developed market bond yields are lacking direction at the moment, pulled by competing forces. Overall global economic activity has lost some momentum and is now less synchronized. Yet the majority of major countries in the developed world are still growing at an above-potential pace that is keeping unemployment low and slowly boosting wages. This is helping underpin inflation, both realized and expected, while keeping government bond yields elevated despite increasing concerns about the future path of the global economy (Chart of the Week). The growing worries about a potential "U.S. versus the world" trade war are weighing on growth expectations, although not yet by enough to cause a meaningful pullback in global equity markets which remain supported by current solid earnings growth. Credit spreads have increased for both developed market corporate debt, but are still at historically narrow levels suggesting that investors are not overly concerned about default/downgrade risk. Emerging market (EM) debt has seen more significant spread widening in recent months, with a stronger U.S. dollar playing a large role there, but there has been little spillover from weaker EM markets into developed market credit valuations. We recently downgraded our recommended allocation to global corporate debt to neutral, while also upgrading our weighting on government bonds to neutral. Yet we maintained our below-benchmark overall duration stance, given our view that bond markets were still underpricing the potential for faster global inflation and tighter monetary policies given the persistent underlying strength of economic growth (especially in the U.S.). In light of that change in our view, an update of one of more reliable tools over the past eighteen months - our Duration Checklist - is timely. The Duration Checklist Is Still Bearish We have maintained our strategic below-benchmark stance on duration exposure for some time now, dating back to January 2017. Shortly afterward, we introduced a list of indicators to monitor going forward to determine if that defensive duration posture on U.S. Treasuries and German Bunds was still justified.1 We called that list our "Duration Checklist", and it contains elements focused on economic growth, inflation, central bank policy biases, investor risk appetite and bond market technicals. The Checklist is meant to be a purely objective read on the data and how it relates to the likely future path of bond yields. We last updated the Checklist back on January 30th of this year.2 The conclusion was that the underlying economic and inflation backdrop was still indicating more upside for yields on a 6-12 month horizon in both the U.S. and Europe. There was a risk, however, that the bond selloff could pause given heightened bullishness on risk assets and extremely oversold conditions in government bond markets. Since that last update of the Checklist, the 10-year U.S. Treasury yield is higher (2.86% vs. 2.72%) while the 10-year German Bund yield is lower (0.36% vs. 0.70%). Although yields in both markets did climb to even higher levels - 3.12% and 0.78%, respectively - in February and March before pulling back to current levels. As we update the Checklist once again this week, we see that the backdrop is still conducive to rising bond yields in the U.S. and Europe, but with differing risks compared to six months ago (Table 1). Note that the Checklist was designed to assess if we should maintain our duration tilt, thus we apply a checkmark ("check") to any indicator that points to potentially higher bond yields, and an "x" to any element that could signal a bond market rally. Table 1The Message From Our Duration Checklist Is Still Bearish For Both USTs & Bunds The Trendless, Friendless Bond Market The Trendless, Friendless Bond Market Global growth momentum is decelerating. The OECD's global leading economic indicator (LEI) is in a clear downtrend, having fallen for five consecutive months (Chart 2). That weakening is broad based, as shown by the depressed level of our LEI diffusion index. The global ZEW index, measuring investor sentiment towards growth in the major developed economies, has been falling sharply since March of this year and now sits at the lowest level since January 2012. The Citigroup Global Data Surprise index peaked at the beginning of 2018 and has fallen steadily to below zero, although it may be in the process of bottoming out. Meanwhile, our global credit impulse - a reliable leading indicator of global growth - has noticeably slowed. We are giving an "x" to all these elements of our Duration Checklist, indicating that the current "soft patch" of global growth represents a risk to the performance of our below-benchmark duration stance. U.S. growth remains solid, but Europe is cooling a bit. The U.S. economy is firing on all cylinders at the moment (Chart 3). The ISM manufacturing index is near 60, while both consumer and business confidence are above the mid-2000s peak of the previous business cycle. Corporate profits are growing around 20% and our models suggest that this trend can continue over the rest of 2018. All these indicators earn a "check" on the U.S. side of our Duration Checklist. Chart 2Global Growth Indicators Are##BR##No Longer Bond Bearish Global Growth Indicators Are No Longer Bond Bearish Global Growth Indicators Are No Longer Bond Bearish Chart 3U.S. Growth##BR##Remains Strong U.S. Growth Remains Strong U.S. Growth Remains Strong The growth story is mixed in the euro area, however (Chart 4). The manufacturing PMI has been steadily falling since February of this year, but still remains well above the 50 line indicating an expanding economy. Consumer and business confidence are both at cyclical highs, but the upward momentum has stalled. Corporate profits are growing at a robust pace, but our models suggest that earnings should slow over the remainder of this year. In our Duration Checklist, the momentum of the growth indicators is the relevant measure and not the level. So we are now placing an "x" on the manufacturing PMI, which is giving a clear signal on slowing growth, while maintaining a "check" next to confidence and profit growth but with a question mark given that both may be in the process of rolling over. Inflation pressures are strengthening on both sides of the Atlantic. Back in January, the inflation elements of the Checklist were providing the most mixed signals. That is no longer the case (Charts 5 & 6). Oil prices are accelerating in both U.S. dollar and euro terms, which suggests upside risks on headline inflation in the U.S. and euro area. Unemployment rates are now below the OECD estimates of full employment, and wage inflation is accelerating, in both regions. Thus, all the inflation components of our Duration Checklist earn a "check". Chart 4Is Euro Area Growth Peaking? Or Just Cooling? Is Euro Area Growth Peaking? Or Just Cooling? Is Euro Area Growth Peaking? Or Just Cooling? Chart 5U.S. Inflation Backdrop Is Bond Bearish U.S. Inflation Backdrop Is Bond Bearish U.S. Inflation Backdrop Is Bond Bearish Chart 6Euro Area Inflation Backdrop Is Bond Bearish Euro Area Inflation Backdrop Is Bond Bearish Euro Area Inflation Backdrop Is Bond Bearish Both the Fed and European Central Bank (ECB) are biased to tighten monetary policy. The Fed continues to signal that additional rate hikes are coming given the underlying strength of the U.S. economy and rising trend in U.S. inflation. The ECB has announced that it will taper its net new bond purchases to zero by year-end in its asset purchase program, and has provided forward guidance on the timing of a first rate hike in 2019. Both policies are credible given falling unemployment and rising core inflation rates in both the U.S. and euro area. Thus, we are keeping the "check" on both sides of the policy portion of the Checklist. Investor risk appetite has grown more cautious. This element of our Checklist was a potential headwind to our below-benchmark duration stance back in January, but is much less of an impediment to higher yields now (Charts 7 & 8). Chart 7U.S. Investor Risk Appetite##BR##Has Cooled Off A Bit U.S. Investor Risk Appetite Has Cooled Off A Bit U.S. Investor Risk Appetite Has Cooled Off A Bit Chart 8European Investor Risk Appetite##BR##Has Also Cooled Off European Investor Risk Appetite Has Also Cooled Off European Investor Risk Appetite Has Also Cooled Off The cyclical advances of both the S&P 500 and EuroStoxx 600 have stalled, and both indices are now back close to their 200-day moving averages, suggesting that equity markets are not overstretched (and, therefore, ripe for a correction that could drive down bond yields in a risk-off move). The VIX and VStoxx volatility indices remain at low levels, even after the spike that occurred in early February and the more modest volatility shock in the aftermath of the Italian election in May. This implies that investors still prefer owning risky assets over risk-free government bonds. These elements warrant a "check" on both sides of our Duration Checklist. Corporate bond spreads, however, have widened over the past few months, suggesting that investors are pricing in some increased uncertainty over future creditworthiness. While the overall level of spreads is still historically low, the rising trend justifies an "x" in our Checklist as a possible headwind to rising Treasury and Bund yields from waning investor risk appetite. Treasuries and Bunds are not as oversold compared to January, but large short positions remain an issue. The 10-year U.S. Treasury yield is now trading just above its 200-day moving average, while the deeply oversold price momentum seen earlier in the year has eased up a bit but remains negative (Chart 9). The combined signal is a neutral one but, in our Checklist framework, neither of these measures is stretched enough to suggest that yields cannot move higher. Thus, we are giving a weak "check" to both momentum elements on the U.S. side. There is still a large short position in 10-year Treasury futures according to the CFTC data, however, and this remains an impediment to higher Treasury yields - we are keeping the "x" for this piece of the Checklist. For Bunds, yields are now trading just below the 200-day moving average while price momentum has turned slightly positive (Chart 10). While neither indicator is stretched from an historical perspective, they are not sending a message that Bunds are oversold. Thus, we are giving a weak "check" to both technical elements on the European side of our Checklist (note that due to a lack of available data, we exclude investor positioning when evaluating the technical backdrop for Bunds). Chart 9USTs Not Oversold,##BR##But Large Short Positions Remain USTs Not Oversold, But Large Short Positions Remain USTs Not Oversold, But Large Short Positions Remain Chart 10Bund Technicals##BR##Are Neutral Bund Technicals Are Neutral Bund Technicals Are Neutral The majority of indicators in our Duration Checklist continue to point to upward pressure on U.S. Treasury and German Bund yields. Thus, we conclude that a continued below-benchmark duration stance is warranted for both markets. Not all of the news is bond bearish, however. The cooling of global growth indicators, the euro area manufacturing PMI, the widening of corporate credit spreads and the persistent short position in the Treasury market remain potential headwinds to a renewed period of rising bond yields. Yet without evidence that U.S. or European capacity constraints are loosening up, triggering a dovish shift from the Fed and ECB, the upward trend in inflation will prevent any meaningful decline in yields from current levels. Bottom Line: An update of our medium-term Duration Checklist highlights that the strategic backdrop for global government bonds remains bearish. A continued below-benchmark overall portfolio duration stance is warranted - even after our recent move to downgrade spread product exposure. Canada Delivers Another Rate Hike, With More To Follow Chart 11The BoC & The Fed: Follow The Leader The BoC & The Fed: Follow The Leader The BoC & The Fed: Follow The Leader The Bank of Canada (BoC) hiked its policy rate last week by 25bps to 1.5%, once again delivering a tightening in lagged response to U.S. rate increases over the past year. The hike was not a surprise, as the Canadian economy is operating at full capacity and core inflation is at the midpoint of the BoC's 1-3% target band. Overnight Index Swap (OIS) markets are now pricing that both the BoC and the Fed will raise rates by another 75bps over the next twelve months, and we see the potential for even more increases than that - even with the Canadian economy cooling from the very rapid growth seen last year (Chart 11). The current spread between 2-year government bond yields in the U.S. and Canada is the widest since 2008, which is weighing on the level of the Canadian dollar versus the greenback (3rd panel). The latter is helping to ease financial conditions in Canada (bottom panel), especially at a time when the country is benefitting from the positive terms of trade impact of strong oil prices. The loonie is also being impacted by worries about future U.S. trade policy. The Trump administration has already imposed tariffs on Canadian steel and aluminum exports and is demanding serious concessions in the renegotiation of the North American Free Trade Agreement (NAFTA). In their latest Monetary Policy Review (MPR) that was released after the BoC policy meeting last week, the central bank provided an estimate of the impact of the steel and aluminum tariffs that went into effect on June 1st. The conclusion was that the 25% tariff on U.S. imports of Canadian steel, and 10% levy on U.S. aluminum imports, would have little net impact on the Canadian economy once the Canadian response was factored in. The BoC concluded that the level of total real Canadian exports would be reduced by -0.6% by year-end, but that Canadian real imports would also decline by a similar amount as the Canadian government slapped its own tariffs on U.S. exports of steel, aluminum and various consumer products. This neutral view on U.S.-Canada trade tensions appeared throughout the BoC's updated economic forecasts, as its projections on the growth of Canadian exports, imports and U.S. real GDP growth (the critical driver of Canadian trade) were all increased from the previous MPR published in April. That may be an overly optimistic assessment of the potential impact of a trade dispute with the U.S. Yet the BoC did admit that it can only estimate the impact of tariffs once the precise details are known, thus it cannot adjust its forecasts based on what might happen in the NAFTA negotiations. The BoC can only base its forecasts on what they can observe now, which is that Canada's overall economy remains in decent shape, even though the composition of growth is shifting. The BoC's latest Business Outlook Survey indicates that Canadian firms continue to see robust demand and are facing increasing capacity constraints. This is boosting hiring plans and keeping capital spending intentions reasonably firm even with the uncertainties over NAFTA that is causing some firms to delay investment (Chart 12). The BoC is projecting that overall Canadian real GDP will only grow by 2% in 2018, even with a smaller contribution to growth from consumer spending and housing. The year-over-year rate of change in retail sales volumes has already dipped into negative territory and is now at the lowest since the end of 2009 (Chart 13). The BoC has attributed this to some slowing in interest-sensitive spending in response to tighter BoC monetary policy. At the same time, household debt growth has been slowing and house price inflation has plunged over the past year (although most of this decline occurred in the overheated Toronto market). The BoC is not concerned about the impact of its rate hikes on the interest burden for households, despite the high level of household debt, given the accelerating pace of wages and income growth. The BoC is likely happy to see a shift away from overheating consumption fueled by speculative increases in house prices, but there is a risk that additional rate hikes could finally trigger the long-awaited bursting of the Canadian housing bubble. Chart 12Canadian Businesses Are Optimistic,##BR##Even With Trade Worries Canadian Businesses Are Optimistic, Even With Trade Worries Canadian Businesses Are Optimistic, Even With Trade Worries Chart 13Higher BoC Rates##BR##Do Have An Impact Higher BoC Rates Do Have An Impact Higher BoC Rates Do Have An Impact (On a related note - the topic of housing bubbles will be discussed at the upcoming BCA Investment Conference in Toronto on September 23-25 by Hilliard Macbeth of Richardson GMP, who has written several books on the topic of global asset bubbles and has some particularly strong views to share on Canadian housing.) Yet the BoC will have to take the risk that additional rate increases could cause a bigger shakeout in the Canadian housing market, given that Canadian inflation is trending higher. Headline CPI inflation is now above the midpoint of the BoC's 1-3% target band, while all the various measures of core inflation that the BoC monitors are hovering around 2% (Chart 14). The BoC estimates that the output gap in Canada is now closed, and that the tight labor market will continue to boost inflation. Chart 14Inflation On The Rise In Canada Inflation On The Rise In Canada Inflation On The Rise In Canada Chart 15Market Is Underpricing The BoC Market Is Underpricing The BoC Market Is Underpricing The BoC Already, the average hourly earnings measure of wage inflation is growing close to 4% on a year-over-year basis, although the BoC has noted in recent research that other measures of labor costs are not growing as fast.3 Nonetheless, with 10-year inflation expectations in the Canadian inflation-linked government bond market now trading just below the BoC's 2% target (bottom panel), and with a high number of Canadian businesses reporting increasing difficulties in sourcing quality labor, the inflationary message sent by the surging rate of average hourly earnings growth will likely prove to be correct. Even though the Canadian OIS curve is now discounting another 75bps of rate hikes over the next year, that would only take the BoC policy rate to 2.25% - still below the central bank's estimate of the neutral policy rate, which is between 2.5-3% (Chart 15). Given the likely need for the BoC to eventually move to a restrictive stance to cool off an overheating economy and keep inflation around the 2% target, we see more potential upside for Canadian bond yields, especially with very little increase currently priced in the forwards. Stay underweight Canada in hedged global bond portfolios. Bottom Line: The Bank of Canada hiked rates again last week, and additional increases are likely given growing capacity constraints and accelerating Canadian inflation. Stay underweight Canadian government bonds. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "A Duration Checklist For U.S. Treasuries & German Bunds", dated February 15th, 2017, available at gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Some Thoughts On The Treasury-Bund Spread", dated January 30th, 2018, available at gfis.bcaresearch.com. 3 https://www.bankofcanada.ca/wp-content/uploads/2018/01/san2018-2.pdf Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Trendless, Friendless Bond Market The Trendless, Friendless Bond Market Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA's Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA's 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA's Geopolitical Strategy (GPS) in 2012. It is the financial industry's only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers' options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA's Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating "geopolitical alpha;" Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant "war games," which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Arthur Budaghyan, Senior Vice President Chief Emerging Markets Strategist Highlights The authorities in China have begun easing liquidity conditions but that is not sufficient to turn positive on mainland growth. For the next six months at least, the mainland's growth conditions will continue deteriorating and that warrants a negative stance on China-related risk assets, including commodities and EM. The path of least resistance for the dollar is up. This will continue to weigh on EM risk assets. A narrowing interest rate differential between China and the U.S. will continue exerting downward pressure on the RMB's value versus the dollar. Our credit stress test on Turkish banks suggests their stocks are not yet cheap assuming the non-performing loan ratio rises to 15%. Stay short banks and the lira. Feature China's economic slowdown, ongoing trade wars and accumulating U.S. inflation pressures will continue propping up the U.S. dollar, thereby sustaining a perfect storm for EM financial markets. This is taking place amid the poor structural fundamentals in the developing economies and the existing overhang of investor positions in EM. Altogether this argues for more downside in EM financial markets. A strong dollar is also a bad omen for developed markets' stock indexes. The reason being that the dollar is a countercyclical variable, and the greenback's rallies usually coincide with global trade downturns that are bearish for global cyclical equity sectors (Chart I-1). Needless to say, tariffs on imports are ultimately negative for global trade, and will exacerbate the global growth slowdown that has been occurring since early this year. In fact, there is anecdotal evidence that global trade has so far temporarily benefited from mounting expectations of tariffs.1 Companies have ordered more inputs and shipped more goods in advance of higher tariffs coming into effect. This is why global shipments and manufacturing production have so far held up reasonably well, while business expectations have plummeted (Chart I-2). Consequently, global trade and manufacturing production will likely record considerable weakness later this year. Since markets are typically forward looking, asset prices will adjust beforehand. Chart I-1Global Industrial Stocks And U.S. Dollar Global Industrial Stocks And U.S. Dollar Global Industrial Stocks And U.S. Dollar Chart I-2Global Trade Is Heading South Global Trade Is Heading South Global Trade Is Heading South We are maintaining our negative stance on EM stocks, currencies, credit markets and high-yielding local bonds. China Is Easing Liquidity, But Don't Hold Your Breath Chart I-3Chinese Interest Rates And EM Stocks: ##br##Positively Correlated Chinese Interest Rates And EM Stocks: Positively Correlated Chinese Interest Rates And EM Stocks: Positively Correlated China's softening industrial data, growing anecdotal evidence of a worsening credit crunch in the economy, U.S. tariffs, and plunging domestic share prices have been sufficient for the authorities to ease liquidity conditions in the Chinese banking system. Not surprisingly, many investors are wondering whether the worst is over for Chinese stocks and China-related financial markets worldwide, including those in EM. At the current juncture, liquidity easing by the PBOC is a necessary but not sufficient condition to turn positive on this nation's industrial cycle as well as EM risk assets. We have the following considerations on this topic: First, China's risk-free interest rates - government bond yields - led the selloff in both EM and Chinese stocks (Chart 3). These bond yields have plunged since November, foreshadowing the slowdown in China's growth and the carnage in EM/Chinese financial markets. By and large, there has been a positive correlation between EM share prices and China's local bond yields and interbank rates as illustrated on Chart I-3. For example, EM stocks, currencies and credit markets rallied substantially in 2017 in the face of rising interest rates in China. Likewise, they dropped in the second half of 2015 as bond yields and money market rates in China plunged. The rationale behind the positive correlation between EM risk assets and Chinese interest rates is that the latter rise and EM risk assets rally when the mainland economy is improving. The opposite is also true. At the moment, Chinese risk-free bond yields will likely continue to drop as additional slowdown in growth is in the cards. This heralds a further drop in EM financial markets. Second, any major stimulus will constitute a retraction of the Chinese government's policy of deleveraging and containing financial risks. The latter is the code phrase Chinese authorities use to stop fueling bubbles and speculative excesses. Hence, any policy stimulus will for now be measured and insufficient to boost growth this year. China is saddled with massive debt and money overhangs and a bubbly property market. Ongoing enormous expansion in money supply (i.e., RMB deposits)2 (Chart I-4) and a narrowing interest rate differential over the U.S. will continue exerting downward pressure on the RMB's value (Chart I-5). Chart I-4'Helicopter Money' In China Helicopter Money' In China Helicopter Money' In China Chart I-5The RMB Will Depreciate Further The RMB Will Depreciate Further The RMB Will Depreciate Further Even though capital controls have tightened since 2015, the capital account is not perfectly closed. As such, shrinking interest rate deferential versus the U.S. warrants further yuan depreciation. In short, the authorities cannot reduce interest rates further and expand money/credit growth at a double-digit rate without tolerating sizable currency deprecation. If the Chinese authorities opt for a large fiscal and credit stimulus again, the nation's structural imbalances will grow further. In this scenario, the Middle Kingdom's secular growth outlook will deteriorate, and policymakers' manoeuvring room to stimulate in the future will narrow. Chart I-6China: The Industrial Cycle Is Slumping China: The Industrial Cycle Is Slumping China: The Industrial Cycle Is Slumping Crucially, China's enormous money and credit creation are entirely unrelated to its high savings rate. Money and credit in China have been driven by speculative behavior of Chinese banks and borrowers not households' high savings rate. We have discussed these issues in detail in our past special reports3 and will not expand on them here. Third, there has been money/credit tightening on three fronts in China - liquidity, regulatory and anti-corruption. Even though liquidity conditions in the banking system are now ameliorating, as evidenced by the plunge in interbank rates, the regulatory clampdown on the shadow banking system as well as the anti-corruption campaign targeting the financial industry are still underway. The latter policy initiatives will continue to curb credit creation by suppressing banks' and shadow banking institutions' ability and willingness to finance the real economy. In fact, it is not inconceivable that the regulatory clampdown and anti-corruption campaign will have a larger impact on credit supply than the decline in borrowing costs. Finally, policy easing and tightening works with a time lag. China's business cycles and related financial markets do not always respond swiftly to changes in policy stance. Specifically, monetary and fiscal policies were easing substantially from the middle of 2015, yet EM/China-related risk assets continued to plummet for six months until February 2016. Conversely, policy was tightening in China throughout 2017, yet EM/China-related asset markets did well in 2017. In brief, there could be a long lag between a change in policy stance and a reversal in financial markets. For now, we reckon that the cumulative effect of policy tightening of the past 18 months will continue to seep through the Chinese economy till the end of this year. Chart I-6 demonstrates that various industrial cycle indicators continue to deteriorate. Bottom Line: The authorities in China have begun easing liquidity conditions but that is not sufficient to turn positive on Chinese growth and China-related risk assets, including commodities and EM. For the next six months at least, the mainland's growth conditions will continue deteriorating and that warrants a negative stance on China-related risk assets. More Downside The indicators that have been useful in foretelling the turmoil in EM financial markets this year are signaling that a negative stance is still warranted: One indicator that gave an early warning signal for the current EM selloff was EM sovereign and corporate bond yields. At the moment, the average of EM dollar-denominated corporate and sovereign bond yields continues to presage lower EM stock prices, as demonstrated in Chart I-7 - bond yields are shown inverted in this chart. Chart I-7Rising EM Borrowing Costs Are Bearish For Their Stocks Rising EM Borrowing Costs Are Bearish For Their Stocks Rising EM Borrowing Costs Are Bearish For Their Stocks Notably, EM share prices display lower correlation with U.S. bond yields and U.S. TIPS yields than with EM corporate and sovereign bond yields (Chart I-8). Why are EM share prices exhibiting a stronger correlation with EM bond yields rather than with U.S. Treasury yields? The basis is that EM equities are sensitive to EM - not U.S. - borrowing costs. So long as the rise in U.S. bond yields is offset by compressing EM credit spreads, EM corporate and sovereign U.S. dollar bond yields - i.e. EM borrowing costs in dollars - will decline, and EM share prices will rally (Chart I-7). But when EM corporate (or sovereign) yields rise - irrespective of whether because of rising U.S. Treasury yields or widening EM credit spreads - EM borrowing costs in dollars rise, and consequently equity prices come under considerable selling pressure. In other words, a drop in U.S. bond yields on its own is not enough for EM share prices to advance, and conversely, a rise in U.S. bond yields is not sufficient for EM stocks to drop. It is movements in EM U.S. dollar bond yields, which are comprised of U.S. Treasury yields and EM credit spreads, that matter for the direction of EM equity prices. Regarding local bond yields, EM share prices typically exhibit a strong negative correlation with EM domestic government bonds yields - the latter are shown inverted on this chart (Chart I-9). Since we expect EM currencies to depreciate further and, given the negative correlation between EM currency values and their local bond yields, the latter will continue rising. Chart I-8EM Stocks And U.S. Rates: ##br##Mixed Relationship EM Stocks And U.S. Rates: Mixed Relationship EM Stocks And U.S. Rates: Mixed Relationship Chart I-9EM Equities And Local Bond Yields: ##br##Strong Correlation EM Equities and Local Bond Yields: Strong Correlation EM Equities and Local Bond Yields: Strong Correlation The risky-to-safe-haven currency ratio4 continues to fall after experiencing a major breakdown early this year (Chart I-10, top panel). Historically, this ratio has been correlated with EM share prices and currently heralds further downside (Chart I-10, bottom panel). This ratio also is agnostic to the dollar's direction - it swings between risk-on versus risk-off regimes in financial markets, regardless of the general trend in the greenback. Hence, this indicator answers the question of the direction of EM share prices, regardless of the dollar's trend. Finally, key to EM performance has been corporate profits. Presently, the outlook for EM corporate profits is still negative, as suggested by the negative readings on China's money and credit (Chart I-11). Chart I-10Are Risk Assets In A Bear Market? bca.ems_wr_2018_07_12_s1_c10 bca.ems_wr_2018_07_12_s1_c10 Chart I-11EM Corporate Profits Will Likely Shrink EM Corporate Profits Will Likely Shrink EM Corporate Profits Will Likely Shrink Bottom Line: EM risk asset will continue selling off and underperforming their DM counterparts. Stay short/underweight EM risk assets. The Dollar's Trend Is Still Up The U.S. dollar is instrumental to EM financial market trends. We expect the dollar rally to persist for now - at least through the end of this year. The underlying inflation gauge measure calculated by New York Fed points to further acceleration in U.S. consumer price inflation (Chart I-12). Furthermore, America's job market is continuing to tighten. In brief, U.S. domestic demand will stay robust even as global trade slumps. These will limit the Federal Reserve's ability to back off from tightening, even if EM financial markets continue to sell off. Chart I-12U.S. Inflation Risks Are To The Upside U.S. Inflation Risks Are To The Upside U.S. Inflation Risks Are To The Upside Remarkably, a strong U.S. exchange rate is needed to cap America's growth and inflation and to boost growth in the rest of the world, especially in Asia. Given the widening growth momentum between the U.S. and Asia, the dollar will likely need to rally significantly to reverse the growth differential currently moving in favor of America. This will be especially true if more trade tariffs are imposed. Odds are that the RMB will depreciate further given the backdrop of lower interest rates in China - discussed above. That will cause a downturn in emerging Asian currencies. A strong dollar, a slowdown in Chinese/EM demand for commodities and large net long positions by investors in oil and copper all argue for a considerable drop in commodities prices in the months ahead. This is bearish for Latin American and many other EM exchange rates. Bottom Line: The path of least resistance for the dollar is up. This will continue to weigh on EM risk assets. With respect to currency positions, we recommend investors to continue to short a basket of EM currencies such as BRL, ZAR, TRY, MYR and IDR versus the dollar. CLP and KRW are also among our shorts given our bearish outlook for copper prices, global trade and Asian currencies. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Turkish Banks: A Bargain Or Value Trap? 12 July 2018 Turkish bank stocks have now fallen by 40% in local currency terms and by 55% in U.S. dollar terms since their peak early this year (Chart II-1), prompting the question whether they have become a bargain or are still a value trap. Banks represent 30% of the Turkey MSCI index and are integral to the performance of this bourse. Although Turkish banks appear to be cheap with their price-to-trailing earnings ratio at 4.5 and their price-to-book value ratio at 0.62, they are still vulnerable to a substantial rise in non-performing loans (NPL) and ensuing provisioning, write-off and equity dilution. Turkey has been experiencing an enormous credit binge for years and its interest rates have risen by 600 basis points since the start of the year. Yet, current NPLs and provisions stand at a mere 3% and 2.3% of total outstanding loan, respectively (Chart II-2). Chart II-1Turkish Stocks: A Long-Term Perspective Turkish Stocks: A Long-Term Perspective Turkish Stocks: A Long-Term Perspective Chart II-2Turkish Banks Are Underprovisioned Turkish Banks Are Underprovisioned Turkish Banks Are Underprovisioned The creditworthiness of debtors is worse when one takes into account that Turkish companies have large foreign currency debt and a record amount of foreign debt obligations due in 2018 (Chart II-3). In our credit stress test, we assume that in the baseline scenario the non-performing credit assets (NPCA) ratio will rise to 15% (Table II-1). Taking into account that the NPL-to-total loan ratio reached 18% in 2002 after the 2001 currency crisis, we believe 15% is a reasonable estimate. Chart II-3Turkey: Record High Foreign Debt Obligations Turkey: Record High Foreign Debt Obligations Turkey: Record High Foreign Debt Obligations Table II-1Credit Stress Test For Turkish Banks EM: A Perfect Storm EM: A Perfect Storm To put this number further into perspective, India - one of the very few countries within the EM universe to have somewhat fully recognized its NPLs - currently has an NPL ratio of 15% on its public banks. Chart II-4Turkish Equities: ##br##A Cyclically-Adjusted P/E Ratio Turkish Equities: A Cyclically-Adjusted P/E Ratio Turkish Equities: A Cyclically-Adjusted P/E Ratio If we assume that Turkish bank stocks at the end of this cycle will trade at a price-to-book ratio of 1 after adjusting for all credit losses, then banks' stock prices are currently about 17% overvalued in the baseline scenario of 15% NPCA (Table II-1, the middle row). In all three scenarios, we assume a recovery rate of 40%. With regards to the overall equity market, Chart II-4 demonstrates that the cyclically-adjusted P/E (CAPE) ratio for Turkish stocks is currently around 5, compared to the historical average of 8. For the bourse's CAPE ratio to drop to two standard deviations below its mean, share prices have to fall by another 20-25%. This is plausible given the outlook for more populist economic policies following the recent elections. Besides, corporate profits will contract considerably because of the monetary tightening that has occurred since early this year. The exchange rate is critical for Turkish financial markets. As such, revisiting currency valuation is also important. Our favorite measure of currency valuation is the real effective exchange rate based on unit labor costs. This takes into account both wages and productivity. Hence, it gauges competitiveness much better than the measures of real effective exchange rate based on consumer and producer prices. Using this measure, as of July 11 the lira was slightly more than one standard deviation below its historical mean (Chart II-5). For it to reach two standard deviations below its mean, it would roughly take another 15-17% depreciation, versus an equal-weighted basket of the dollar and euro. Given the current macroeconomic backdrop and the outlook for more unorthodox policies, including possible capital controls following President Erdogan's appointment of his son-in law as the key economic policymaker, the lira will likely undershoot. Meantime, foreign holdings of Turkish local bonds and stocks were not yet depressed as of June 29 (Chart II-6). Chart II-5Turkish Lira: An Undershoot Is Likely Turkish Lira: An Undershoot Is Likely Turkish Lira: An Undershoot Is Likely Chart II-6Foreign Ownership Is Still High Foreign Ownership Is Still High Foreign Ownership Is Still High Bottom Line: Provided Turkey's political outlook has deteriorated further after the recent elections, we assess that only after a 15% depreciation in the lira versus an equal-weighted basket of the dollar and euro, in combination with a 15-20% drop in stocks in local currency terms, will Turkish equities be a true bargain and warrant a positive stance. For now, dedicated EM equity and fixed income portfolios (both credit and local currency bonds) should continue to underweight Turkey. Our open directional trades at the moment remain: Short Turkish bank stocks Short TRY / long USD. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please refer to the following article Global automakers hail more ships as trade battles heat up. 2 Please see Emerging Markets Strategy Weekly Report "Follow The Money, Not The Crowd," dated July 26, 2017, available on ems.bcaresearch.com 3 Please see Emerging Markets Strategy Special Report "The True Meaning Of China's Great 'Savings' Wall," dated December 20, 2017, available on ems.bcaresearch.com; and Emerging Markets Strategy Special Report "Is Investment Constrained By Savings? Tales Of China And Brazil," dated March 22, 2018, link is available on page 17. 4 Average of cad, aud, nzd, brl, clp & zar total return indices relative to average of jpy & chf total returns (including carry); rebased to 100 at January 2000. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Dear Client, Geopolitical analysis is a fundamental part of the investment process. My colleague, and BCA’s Chief Geopolitical Strategist, Marko Papic will introduce a one-day specialized course - Geopolitics & Investing - to our current BCA Academy offerings. This special inaugural session will take place on September 26 in Toronto and is available, complimentary, only to those who sign up to BCA’s 2018 Investment Conference. The course is aimed at investors and asset managers and will emphasize the key principles of our geopolitical methodology. Marko launched BCA’s Geopolitical Strategy (GPS) in 2012. It is the financial industry’s only dedicated geopolitical research product and focuses on the geopolitical and macroeconomic realities which constrain policymakers’ options. The Geopolitics & Investing course will introduce: The constraints-based methodology that underpins BCA’s Geopolitical Strategy; Best-practices for reading the news and avoiding media biases; Game theory and its application to markets; Generating “geopolitical alpha;” Manipulating data in the context of political analysis. The course will conclude with two topical and market-relevant “war games,” which will tie together the methods and best-practices introduced in the course. We hope to see you there. Click here to join us! Space is limited. Robert P. Ryan, Chief Commodity & Energy Strategist The London Metal Exchange Index (LMEX) will remain under significant downward pressure, unless and until fears of escalating Sino - U.S. trade disputes are allayed. Should this dispute devolve into full-blown trade war - something our geopolitical strategists expect - EM economies deeply embedded in global supply chains could be especially hard hit.1 This would have ramifications for commodity prices in general, base metals in particular. Alternatively, if this trade dispute evolves into a more open and free global trading system, EM income growth will drive commodity demand - particularly for metals - significantly higher. Highlights Energy: Overweight. China's $5 billion loan and $250mm direct investment in Venezuela's oil industry will alleviate the country's oil-production and -export collapse for a brief interval. However, unless China brings its own industry experts in to run Venezuela's state-owned oil company, which has suffered a near-total loss of highly trained personnel, and manages to reverse government mismanagement and corruption, it is difficult to see the collapse in that country's oil industry being reversed. Separately, China's investment in and commitment to Venezuela could be a harbinger of future deals between it and Iran, if China decides to flex its economic muscle and widen the playing field in its trade dispute with the U.S. beyond ags. Base Metals: Neutral. Fears of a global trade war overly punishing EM economies, many of which are deeply entwined in global supply chains, are weighing on base metals prices (see below). Right-tail - i.e., upside risks - are, for the most part, being ignored. Our assessment of balances and upside risk, particularly in copper, makes getting long attractive. We are, therefore, going long the Dec/18 $3.00 COMEX calls vs. short $3.20/lb calls at tonight's close. This is a tactical position. Precious Metals: Neutral. Gold recovered somewhat - trading above $1,260/oz earlier in the week - as global trade tensions increased. It since settled to the $1,250/oz level as trade anxieties re-emerged. Ags/Softs: Underweight. Prompt soybeans futures are probing five-year lows, after the U.S. announced an additional $34 billion in tariffs against China, which were immediately followed by Chinese reprisals, highlighted by 25% tariffs against soybeans. Feature Prices of the six base metals futures comprising the LMEX are highly sensitive to EM growth, which has benefited from the expansion of global supply chains. As a result, metals' prices are highly sensitive to EM incomes, EM trade volumes, and FX levels. Our modeling indicates these global macro variables will continue to play an outsized role in determining the trajectory of the metals' prices, particularly as relates to EM - China trade (Chart of the Week).2 Chart Of The WeekEM Macro Variables Drive LMEX EM Macro Variables Drive LMEX EM Macro Variables Drive LMEX EM incomes and trade volumes have, for the most part, held up well this year. Our base case outlook is for the resilience underpinning the global economy to continue for the remainder of the year, in line with the IMF and World Bank expectations.3 However, escalating trade disputes are threatening to weigh on the global flow of goods, which, if they persist and deepen, will dampen demand for raw materials in general, and metals in particular. An acceleration in trade restrictions would dent not only trade flows, but also would harm EM incomes in the process. Our base case longer term gets cloudier. In the left tail of returns distributions, rising interest rates on the back of the Fed's interest-rate normalization process will remain on track, particularly as inflation and inflation expectations pick up. This will support a stronger dollar, which, all else equal, will increase EM debt servicing costs. Our colleagues in BCA Research's Global Investment Strategy note, "Emerging markets are particularly sensitive to changes in U.S. financial conditions. About 80% of EM foreign-currency debt is denominated in dollars. A stronger dollar and higher U.S. interest rates make it more difficult for EM borrowers to service their debts. While EM foreign-currency debt has declined as a share of total debt outstanding, this is only because the past decade has seen a boom in local debt issuance. As a share of GDP, exports, and international reserves, U.S. dollar debt is at levels not seen in over 15 years."4 We expect the Sino - U.S. trade dispute will get nastier, but we are mindful of the right tail risks in this process, as well. If leaders in the U.S., China, and EU can agree to revamp and modernize the rules of the road for global trade - i.e., protect intellectual property, remove forced technology transfers, and make markets more open and transparent - the upside risks to base metals returns, and commodities in general, would be significant. In such an evolution, EM income growth would accelerate, super-charging global trade volumes, and commodity demand. Trade Volumes Resilient For Now, But Protectionism Looms Overhead At present, global trade in goods amounts to more than $17 trillion of merchandise exports, while commercial services exports are more than $5 trillion.5 Accounting for tariffs imposed by the U.S. under Sections 232, and 301, as well as retaliatory action by China, Mexico, the EU, and Canada, barriers have so far been implemented on ~$150 billion worth of traded goods. This represents less than 1% of merchandise trade. Thus, current restrictions -- while intensifying -- will not significantly curb global flows (Chart 2). And, so far, EM trade volumes have held up well, with resilience in the flow of goods: Our forward-looking models are pointing toward continued trade-related support for base metals in coming months (Chart 3). Chart 2U.S.-China Trade Hit By Tariffs Escalating Trade Disputes Pressuring Base Metals Escalating Trade Disputes Pressuring Base Metals Chart 3EM Trade Will Hold Up, Absent A Trade War EM Trade Will Hold Up, Absent A Trade War EM Trade Will Hold Up, Absent A Trade War This should - ceteris paribus - translate into greater demand for metals, and a strong LMEX. Our modelling finds that the LMEX and EM trade volumes are cointegrated, and that a 1% increase in EM import volumes maps to a 1.3% increase in the LMEX, in line with the overall income elasticity of trade reported by the World Bank last month.6 However, risks surrounding the flow of goods globally - especially between the U.S. and China and the U.S. and EU - are mounting. This is jeopardizing our base case for resilient EM trade and income in the near term. Most notable is the recent U.S. trade restriction imposed on $34 billion worth of Chinese imports effective July 6, and China's subsequent retaliation in kind, which hit U.S. ag exports - particularly soybeans - hard. Additional barriers similar to the tit-for-tat of late between the U.S. and China, raise the odds of a global trade war and further depress metal prices.7 If this U.S.-Sino trade spat devolves into a full-blown trade war, in which the U.S., China and the EU erect trade barriers, or raise tariffs or restrictions on foreign investment, global trade momentum could slow significantly, which would be devastating for EM income growth. The World Bank finds that if tariffs were to reach legal maximum rates under WTO commitments, global trade flows would decline by 9% - in line with the decline experienced during the global financial crisis (GFC) (Chart 4).8 In addition to mounting trade restrictions, the sustainability of Chinese demand is also relevant to our metals demand-side outlook. China's imports account for the bulk of EM import volumes, and a significant domestic slowdown that dents import demand would weigh on the metals complex. To date, China's import volume growth appears to be holding up, reflecting a controlled domestic demand environment (Chart 5). Chart 4Trade War Would Hurt EM Trade Escalating Trade Disputes Pressuring Base Metals Escalating Trade Disputes Pressuring Base Metals Chart 5China Trade Indicates Slowdown Is Controlled China Trade Indicates Slowdown Is Controlled China Trade Indicates Slowdown Is Controlled Trade Barriers Would Hit EM Incomes Hard As noted above, in line with our base case outlook of supportive trade volumes so far this year, the IMF and World Bank expect the global economy to remain strong this year and next, highlighting trade as one of the two main growth catalysts (Table 1). DM growth, while showing signs of moderating, remains perched above potential. We expect this to persist, especially given fiscal stimulus measures in the U.S. announced earlier this year. According to our modelling, a 1% increase in EM GDP translates to a 1.1% rise in the LMEX. Global PMIs remain above the 50 mark, indicating global manufacturing continues to expand, which will remain supportive of commodity demand generally (Chart 6). Table 1Global Growth Expected To Remain Supportive Escalating Trade Disputes Pressuring Base Metals Escalating Trade Disputes Pressuring Base Metals Chart 6U.S. Will Outperform, Supporting DM Growth U.S. Will Outperform, Supporting DM Growth U.S. Will Outperform, Supporting DM Growth China's ~ $14 trillion GDP accounts for some ~ 16% of global GDP and is the highest among the EM economies.9 China accounts for ~ 50% of global demand for metals represented in the LMEX (Chart 7). China's base-metals demand has been resilient, despite tighter credit and monetary conditions and little in the way of fiscal stimulus in China. We continue to expect Chinese domestic demand will experience a managed slowdown as the government tackles its reform agenda in 2H18. Chart 7China's Outsized Role In Metal Markets China's Outsized Role In Metal Markets China's Outsized Role In Metal Markets Since 2000, the impact of income growth in China has only a slightly larger effect on the LME's price index versus that of DM regions such as the Euro Area.10 Our analysis indicates that, unlike the rest of the world, China's metal consumption is trend-stationary - i.e., mean reverting - and behaves almost as it if were a policy variable, which is to say a time series that is more a function of government policy than the laws of supply and demand. Bottom Line: EM income and trade volumes are expected to remain strong, which will be supportive of metals prices. Even so, markets are now dealing with a trade spat that could metastasize into a full-blown trade war. We are not there yet. However, the tail risks are increasing and markets now have to account for a higher likelihood of a slowdown in EM trade volumes, which could be followed by a redistribution of base-metals demand and re-ordering of trade flows. On the flip side, a resolution of the trade frictions would resolve many of these tail risks, and likely would lend support to metal prices via higher EM income growth. In any case, the FX outlook is not supportive for metal prices. A stronger dollar - our base case expectation - will weigh on metal demand and the LMEX. Fundamentals Will Play A Secondary Role Individual market fundamentals, such as aluminum supply cuts, copper mine strikes, and zinc's physical deficit contributed to the LMEX's outperformance last year (Chart 8). Metal-specific supply, demand and inventory conditions will continue influencing the individual metals in the index. Aluminum and copper constitute three-quarters of the LMEX, and fundamental developments in these two markets are especially relevant (Chart 9). Chart 8Individual Fundamentals Supported LMEX Last Year Escalating Trade Disputes Pressuring Base Metals Escalating Trade Disputes Pressuring Base Metals Chart 9Copper, Aluminum Markets Are Key Escalating Trade Disputes Pressuring Base Metals Escalating Trade Disputes Pressuring Base Metals U.S. sanctions on leading Russian aluminum producer Rusal and its top shareholder, the oligarch Oleg Deripaska, led to a 9% surge in the LMEX in the first few weeks of April, followed by a 6% retracement by the end of the month (Chart 10). While risks from this politically motivated tailwind have mostly faded - the U.S. announced that a change in ownership will exempt Rusal from these sanctions - geopolitical tensions remain relevant. Chart 10Individual Markets Remain Relevant Individual Markets Remain Relevant Individual Markets Remain Relevant In the very near term, ongoing contract renegotiations at Chile's Escondida mine are an upside risk to the LMEX in the coming weeks. BHP's final offer to the labor union is due on July 24. Reuters reports that little progress has been made to settle the disputes between BHP and the union: agreement has been reached on only one-fifth of the points of contention.11 While June upside from these renegotiations have since faded and taken a back seat to downside pressures from the fear of a global trade war, a labor strike at the mine which dents supply, would support copper prices, and offset at least part of the index's downside macro risks. At 14.8% of the index, zinc accounts for a much smaller weight in the LMEX. After strong gains last year, the metal has been a headwind to the LMEX since March. Following two consecutive years of physical deficits, the market is moving toward a surplus, causing prices to slide. However, recent news of a possible production cut by Chinese smelters is preventing major declines. If this were to materialize - details remain vague at best - we would expect to see some support in the zinc market. Bottom Line: Demand-side macro variables - EM trade, incomes, and currencies - explain almost all of the movements in the LMEX. To date, these variables exhibit resilience pointing to support for metal prices. Left-side tail risks arising from possible trade wars have the market's attention and have been weighing on the complex of late. We expect these downside risks to be most relevant in the remainder of this year, and to take a front seat to individual market fundamentals. Nevertheless, individual metals' fundamentals will be important to follow. Right-side tail risks also bear watching, particularly if the current trade spats involving the U.S., China and the EU are resolved in favor of freer, more open global trade. This would super-charge EM growth, which would be bullish for commodities generally, base metals and oil in particular. Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see BCA Research's Geopolitical Strategy titled "The U.S. And China: Sizing Up The Crisis," published July 11, 2018, available at gps.bcaresearch.com. 2 The adjusted R-squared for each of our two cointegrating regressions is greater than 0.95. These models cover the 2000 to present period. Our modelling also indicates that the LMEX is cointegrated with these three explanatory variables, i.e., they share a long-term trend, wherein the LMEX rises as these variables rise. 3 Please see the IMF's World Economic Outlook of April 2018 (https://www.imf.org/en/Publications/WEO/Issues/2018/03/20/world-economic-outlook-april-2018), and the World Bank's June 2018 Global Economic Prospects (http://www.worldbank.org/en/publication/global-economic-prospects). 4 Please see BCA Research Global Investment Strategy Weekly Report titled "Who Suffers When The Fed Hikes Rates?" dated June 1, 2018, available at gis.bcaresearch.com. 5 Please see "Strong trade growth in 2018 rests on policy choices," published by the World Trade Organization April 12, 2018. 6 The period for our estimate is 2000 to now. We discuss the World Bank's trade elasticities in "Trade Wars, China Credit Policy Will Roil Global Copper Markets" published by BCA Research's Commodity & Energy Strategy June 21, 2018. It is available at ces.bcaresearch.com. 7 The U.S. is threatening to impose tariffs on an additional $200 billion worth of Chinese imports. 8 This is based on a simulation where WTO members increase tariffs to bound rates under WTO commitments as well as a 3% increase in the cost of traded services. This would mean average global tariff rates would legally more than triple from the current 2.7% to 10.2%. This exercise does not take into account the impact of other non-tariff restrictions, such as those on investments. Please see World Bank Policy Research Working Paper 8277 titled "The Global Costs of Protectionism," dated December 2017. 9 Please see "The world's biggest economies in 2018," published by The World Economic Forum at https://www.weforum.org/agenda/2018/04/the-worlds-biggest-economies-in-2018/. 10 A 1 percentage-point (p.p.) increase in China's year-on-year (y/y) GDP rate translates to a 1.8% increase in the LMEX, while a 1 p.p. increase in y/y changes in the Euro Area's y/y GDP rate is associated with a 1.6% increase in the LMEX. These results are based on a dynamic OLS model which also includes the JPM EM currency index and EM export volumes as explanatory variables. The adjusted R2 for the model is 0.97. 11 "Conversations can continue until July 24, at which point BHP must present its final offer, according to a negotiation schedule provided by the company. Between July 27 and July 31, the union will vote to either accept the company's offer or go on strike. After the vote, either party has as many as four days to request a period of government mediation that can last 10 days." Please see "Labour talks at BHP's Escondida mine in Chile enter 'home stretch," dated July 6, 2018, available at reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Escalating Trade Disputes Pressuring Base Metals Escalating Trade Disputes Pressuring Base Metals Trades Closed in 2018 Summary of Trades Closed in 2017 Escalating Trade Disputes Pressuring Base Metals Escalating Trade Disputes Pressuring Base Metals