Emerging Markets

Highlights Broad Chinese equity market performance since last month's Party Congress is consistent with our view that the pace of reforms over the coming year will not cause a meaningful deceleration in China's industrial sector. Stay overweight Chinese stocks. After accounting for idiosyncrasy, divergent sector performance is largely consistent with the stated intentions of Chinese policymakers. Our new China Reform Monitor, which is based on sector performance, should help investors identify whether the pace of reforms is moving too rapidly to be consistent with a benign growth outlook. We are adding two new reform-themed trades this week, and closing one existing position (with a healthy profit). Feature BCA's China Investment Strategy service has presented a relatively benign view of the economic impact of stepped up reform efforts in China over the coming 6-12 months. As we noted in last week's report, while a "status quo" scenario of no significant reforms is highly unlikely over the coming year, the pace of reforms will be structured at a level of intensity that will be sufficient to avoid an outsized deceleration in China's industrial sector. We also highlighted that monitoring reform progress would be an important theme to revisit, and in this week's report we review the response of investors to the Party Congress, both at the broad market and sector level, to judge whether it is consistent with our outlook and positioning. We also introduce two new reform-themed trades, and recommend booking profits on an existing position. Broad Market Performance Post-Congress Before gauging the market's view of the likely impact of refocused reform efforts on the Chinese economy over the coming year, it is worth revisiting what kind of market performance would be consistent with our view. To recap the view of our Geopolitical Strategy service,1 President Xi's reform agenda is likely to intensify over the next 12 months, suggesting that Chinese policymakers will make meaningful efforts to: Pare back heavy-polluting industry Hasten the transition of China's economy to "consumer-led" growth2 Deleverage the financial sector Continue to crack down on corruption and graft From the perspective of BCA's China Investment Strategy service, a rapid and intense pace of these reforms would likely be a net negative for Chinese equities, as well as for emerging markets (EM) and other plays on China's industrial sector. For example, in terms of the impact on Chinese stock prices, we highlighted in last week's report that MSCI China ex-tech earnings have been closely correlated with the Li Keqiang index, which would likely decline non-trivially in the face of a very pressing reform push. In addition, the potential for a policy mistake would presumably raise the risk premium on Chinese equities, which would reverse at least some of their meaningful re-rating vs the global benchmark since late-2015. As such, to be consistent with our view, broad market performance (relative to emerging market or global stocks) should have been largely unaffected in the immediate aftermath of the Party Congress, but somewhat divergent at the sector level, given the likely creation of at least some industry "winners" and "losers" from renewed reforms. For the overall market, Chart 1 shows that this is exactly what has occurred over the past month. The chart presents the relative performance of Chinese equities versus the emerging market (EM) and global benchmarks, both in US$ terms and rebased to 100 on the day of President Xi's speech at the Party Congress. The initial reaction to the speech was modestly negative, with Chinese stocks falling a little over 2% in relative terms versus their global peers. But this loss disappeared less than three weeks following the speech, underscoring that market participants agree with our assessment that a rebooted reform effort will not threaten the economy as a whole. Investors should stay overweight Chinese stocks relative to their benchmark. Chart 1No Sign That Stepped Up Reforms Will Be A Net Negative For Chinese Economic Growth No Sign That Stepped Up Reforms Will Be A Net Negative For Chinese Economic Growth No Sign That Stepped Up Reforms Will Be A Net Negative For Chinese Economic Growth The Sector Implications Of Renewed Reforms Chart 2 shows that the sector effects of President Xi's speech have indeed been more divergent, which is also in line with our perspective of view-consistent performance. The chart shows that the past month's performance of the 11 level 1 GICS sectors relative to the broad market can be grouped into three distinct categories: Chart 2China's Reforms Will Create Some Winners##br## And Losers China's Reforms Will Create Some Winners And Losers China's Reforms Will Create Some Winners And Losers Clear outperformers, which include health care, energy, information technology, and consumer staples, Neutral to modest underperformers, which include utilities, telecom services, and financials, and Clear underperformers, which include industrials, real estate, consumer discretionary, and materials Several of these results are not surprising, as they clearly resonate with the stated intensions of Chinese policymakers. In particular, the outperformance of health care, technology, and consumer staples stocks and the underperformance of capital-goods intensive industrials straightforwardly reflects the goal of re-orienting "old China" towards a new, consumer-focused economy. While energy stocks are viewed as a traditionally cyclically-sensitive carbon-intensive sector, oil prices have risen over the past month and China's share of global energy consumption is much smaller than that of base metals. However, the relative return profiles of a few sectors mentioned above are at least somewhat counterintuitive. On this front, several observations are noteworthy: At first blush, the significant underperformance of Chinese consumer discretionary stocks is counterintuitive if policymakers are aiming to reduce the country's reliance on investment and increase the share of private consumption. However, as Table 1 shows, Chinese consumer discretionary stocks have likely sold off due to the automobile & components industry group, which is potentially at risk of being negatively impacted by the environmental mandate of President Xi's proposed reforms. The table shows that the automobiles & components industry group accounts for a full 1/3rd of Chinese consumer discretionary market capitalization, which is non-trivially larger than in the case of the global benchmark. Table 1 also highlights that China's retailing industry group is as large as that of automobiles & components, which in theory should have provided an offset to the latter's weakness. However, in market capitalization terms, retailers in the MSCI China index are dominated by two large players, one of which is active in providing corporate travel management services. The continuation and expansion of China's anti-corruption campaign was a key message from the Party Congress, and it would appear that investors are concerned about the potential for anti-graft efforts to negatively impact the demand for goods & services that could be potentially linked to corruption or largesse. The underperformance of the materials sector is seemingly reform-consistent, although here too the details of China's investible indexes matter. Table 2 presents a sub-industry breakdown of the MSCI China materials index, as well as an indication whether rebooted reform efforts are a clear negative for the sub-industry. The table highlights that the likely impact of a renewed reform push is mixed: construction materials firms and copper producers (at least in terms of output) are like to suffer, but there are no obvious negative implications for aluminum,3 gold, and paper products producers. The impact on commodity chemicals producers is ambiguous, given that packaging for consumer goods is a significant end market for the petrochemical industry. Table 1Autos Make Up A Significant Share Of ##br##China's Consumer Discretionary Sector Messages From The Market, Post-Party Congress Messages From The Market, Post-Party Congress Table 2Impact Of Renewed Reforms ##br##On The Materials Sector Is Mixed Messages From The Market, Post-Party Congress Messages From The Market, Post-Party Congress Finally, there appears to be at least somewhat of a discrepancy between the benign performance of Chinese financials and the underperformance of the real estate sector. Attempts to curb "excessive" financial risks and debt could certainly hurt the real estate sector, but this would also negatively impact banks via a slowdown in credit growth. For now, the significant valuation gap between Chinese financials and real estate appears to be the only explanation for this divergent performance post Party Congress, but we will continue to watch these sectors for signs of a wider market implication. Sector idiosyncrasies aside, the broad conclusion from China's equity market performance over the past month is that investors acknowledge that there are likely to be winners and losers from a rebooted reform mandate, but that overall economic growth in China is not likely to significantly decelerate. This is consistent with our view that the pace of reform efforts over the coming year will not be so intense as to trigger a meaningful decline in the growth rate of China's industrial sector. But the potential for an aggressive pace of reforms is a clear risk to our view that the ongoing slowdown in China's economy is likely to be benign and controlled. Chart 3 introduces our China Reform Monitor as one way to monitor this risk, which is calculated as an equally-weighted average of the four "winner" sectors highlighted above relative to an equally-weighted average of the remaining seven sectors. Significant underperformance of "loser" sectors could become a headwind for broad MSCI China outperformance (especially ex-tech), and we will be watching closely for signs that our monitor is rising largely due to outright declines in the denominator. Chart 3Our China Reform Monitor Will Help Us Track The Impact Of A Renewed Reform Push Our China Reform Monitor Will Help Us Track The Impact Of A Renewed Reform Push Our China Reform Monitor Will Help Us Track The Impact Of A Renewed Reform Push Two New Reform-Themed Trade Ideas, And One Trade Closure We have new two trade ideas for investors given the performance of Chinese equities in the wake of the Party Congress: Long investable consumer staples / short investable consumer discretionary Long investable environmental, social and governance (ESG) leaders / short investable benchmark The basis for the first trade stems from our earlier discussion of the current limitations of China's investable consumer discretionary index as a clear-cut play on retail-oriented consumer spending. In addition, while consumer staples stocks are reliably low-beta, they have recently been rising vs consumer discretionary in relative terms despite a rise in the broad investable market (Chart 4). The odds favor a continuation of this trend if a renewed reform push continues to appear likely (i.e., we are banking that this trade will be driven by alpha rather than beta). Chart 4Staples Are A Better Consumer Play Staples Are A Better Consumer Play Staples Are A Better Consumer Play Chart 5ESG Leaders Should Fare Quite Well In A Reform Environment ESG Leaders Should Fare Quite Well In A Reform Environment ESG Leaders Should Fare Quite Well In A Reform Environment The basis for the second trade is to overweight stocks that are best positioned to deliver "sustainable" growth. Our proxy for this trade is the MSCI ESG Leaders index, which favors firms with the highest MSCI ESG ratings in each sector (using a proprietary ranking scheme). The index maintains similar sector weights as the investable benchmark, which limits the beta risk of the trade. Chart 5 highlights that MSCI's ESG Leaders index has outperformed the broad market by almost 7% per year since 2010, with current valuation levels that are broadly similar to the benchmark. To us, this trade represents an attractive risk-reward profile even if the pace of China's reforms are not aggressive over the coming year. Chart 6Close Our China / DM Materials Trade Close Our China / DM Materials Trade Close Our China / DM Materials Trade Finally, we recommend closing our long MSCI China investable materials sector / short developed markets materials trade. A scenario where China continues to shrink the domestic production capacity of metals without significantly curtailing its overall import volume may be modestly positive for global base metals prices, but it would appear that DM materials producers would benefit more from this outcome than Chinese producers (owing to the impact of production constraints on the volume of product sold). While the Chinese material sector remains grossly undervalued versus its DM peer, the bottom line is that the outlook for this trade is cloudier than before at a time when it is correcting sharply from previously overbought conditions (Chart 6). We suggest that investors close the trade for now, booking a healthy profit of 11%. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see BCA Special Report, "China: Party Congress Ends ... So What?" dated November 2, 2016, available at bca.bcaresearch.com. 2 Investors should note that BCA's China Investment Strategy service has long been skeptical of calls to shift China's economy to a consumption-driven growth model, because it significantly raises the odds that the country will not be able to escape the middle-income trap. For example, please see Please see China Investment Strategy Special Report, "On A Higher Note", dated October 5, 2017, available at cis.bcaresearch.com 3 In our view, the use of aluminum in transportation is consistent with an environmental protection mandate, given that its light-weight properties allow for reduced energy consumption. For example, in the U.S. in 2014/2015, Ford Motor Company switched the production of the F150 from a steel to an aluminum frame, resulting in a significant improvement in fuel economy. Cyclical Investment Stance Equity Sector Recommendations

Highlights Middle Eastern geopolitics will add upside risk to our bullish oil view, but not cause a drastic supply shock; Saudi Arabia is at last converting from a feudal monarchy to a modern nation-state; The greatest risk is domestic upheaval, motivating Saudi internal reforms and power consolidation; Abroad, the Saudis are constrained by military weakness, relatively low oil prices, and U.S. foreign policy; Geopolitical risk premia are seeping back into oil prices, but OPEC 2.0 and the Saudi-Iranian détente are still intact. Feature Geopolitical and political turbulence in Saudi Arabia kicked into high gear in November, with Crown Prince Mohammad bin Salman apparently turning the Riyadh Ritz-Carlton into a luxury prison for members of the royal family.1 At the same time, rumors are swirling that the bizarre resignation of Lebanese Prime Minister Saad Hariri, allegedly orchestrated by Saudi Arabia, is a potential casus belli. In this scenario, Lebanon would become a proxy war for a confrontation between Sunni Gulf monarchies led by Saudi Arabia (aided by Israel) and their Shia rivals, led by Iran and its proxy Hezbollah. To our clients around the world we say, "please take a deep breath." In this report, we intend to separate the signal from the noise. The Middle East has been a theater of paradigm shifts since at least 2011.2 Not all of them are investment relevant. In this report, we conclude that: Changes under way in the Middle East are the product of impersonal, structural forces that have been in place since the U.S. pulled out of Iraq in 2011; Saudi Arabia is engaged in belated, European-style nation-building, a volatile process that will raise tensions in the country and the region; Saudi Arabia remains constrained by a lack of resources and military capabilities, and unclear alliance structures. Iran, meanwhile, benefits from the status quo. As such, no major war with Iran is likely in the short term, although proxy wars could intensify. In the short term, we agree that the moves by Saudi leadership will increase tensions domestically and in the region. However, over the long term, the evolution of Saudi Arabia from the world's last feudal monarchy into a modern nation-state should improve the predictability of Middle East politics. Regardless of our view, one thing is clear: Saudi Arabia has an incentive to keep oil prices at the current $64 per barrel, or higher, as domestic and regional instability looms. As such, we believe that risks to oil prices are to the upside, but a global growth-constraining geopolitical shock to oil supply is unlikely. The Paradigm Shift: Multipolarity "Tikrit is a prime example of what we are worried about ... Iran is taking over [Iraq]."3 -- Prince Saud al-Faisal, Saudi Foreign Minister, to U.S. Secretary of State John Kerry, March 5, 2015 Pundits, journalists, investors, and Middle East experts all make the same mistake when analyzing the region: they assume it exists on "Planet Middle East." It does not. The Middle East is part of a global system and its internal mechanic is not sui generis. Its actors are bit players in a much bigger game, which involves nuclear powers like the U.S., China, and Russia. Yes, the whims and designs of Middle East leaders do matter, but only within the global constraints that they are subject to. The greatest such constraint has been the objective and observable withdrawal of the U.S. from the Middle East, emblematized by a dramatic reduction of U.S. troops in the region (Chart 1). The U.S. went from stationing 250,000 troops in 2007 to mere 36,000 in 2017. The withdrawal was not merely a manifestation of President Barack Obama's dovish foreign policy. Rather, it was motivated by U.S. grand strategy, specifically the need to "pivot to Asia" and challenge China's rising geopolitical prowess head on (Chart 2). Chart 1U.S. Geopolitical Deleveraging U.S. Geopolitical Deleveraging U.S. Geopolitical Deleveraging Chart 2China's Ascendancy Challenges The U.S. China's Ascendancy Challenges The U.S. China's Ascendancy Challenges The U.S. As we expected, President Donald Trump has not materially increased the U.S. presence in the region since taking office.4 His efforts to eradicate the Islamic State have largely built on those of his predecessor. While he has rhetorically changed policy towards Iran, and taken steps to imperil the nuclear deal by decertifying it, he has not abrogated the deal. The U.S. president can withdraw from the nuclear deal without congressional approval, yet President Trump has merely passed the buck to Congress, which has until the end of the year to decide whether to re-impose sanctions. For Saudi Arabia, U.S. rhetoric and half measures do not change the fact that Iraq is now devoid of American troops and largely in the Iranian sphere of influence. Following the 1991 Gulf War, Saudi Arabia enjoyed the best of both worlds for two decades: a Sunni-dominated but weakened Iraq serving the role of an impregnable buffer between itself and the much more militarily capable Iran. Since Iraq's paradigm shift in the wake of American invasion, the buffer has not only vanished but has been replaced by a Shia-dominated, Iranian-influenced Iraqi state (albeit still relatively weak). Unsurprisingly, Saudi military spending as a share of GDP nearly doubled from the 2011 U.S. withdrawal to 2015, and in absolute terms has risen from $48.5 billion in 2011 to $63.7 billion in 2016, revealing a deep concern in Riyadh that its northern border has become nearly indefensible (Chart 3). Chart 3Saudis React To U.S. Withdrawal The Middle East: Separating The Signal From The Noise The Middle East: Separating The Signal From The Noise Meanwhile, Baghdad's heavy-handed political and military tactics produced an immediate reaction from the Sunni population.5 Militant Sunni insurgent groups, with material support from unofficial (and probably official) channels in Saudi Arabia and wider Gulf monarchies, began to fight back. Violence escalated and soon melded with the emerging civil war in Syria, which by early 2013 had taken on a sectarian cast as well. This led to the emergence of the Islamic State, which grew out of the earlier Sunni insurgence against the U.S. in the Al Anbar governorate. The military success of the Islamic State in 2014 against the inexperienced and demoralized Iraqi Army forced Baghdad to lean even more heavily on domestic Shia militias, and Iran, for survival. Islamic State militants reached the outskirts of Baghdad in September 2014 and were only beaten back by a combination of hardline Shia militias and Iranian advisers and irregular troops. From the Saudi perspective, this direct intervention by the Iranian military in Iraq was the final straw. Most jarring to the Saudis was the fact that the Americans acquiesced to the Iranian presence in Iraq and even collaborated with Iran. In fact, the overt presence of Iranian military personnel in Syria and Iraq drew no rebuke from the U.S. Some American officials even seemed to praise the Iranian contribution to the global effort against the Islamic State. Meanwhile, the nuclear negotiations continued undisturbed, right down to their successful conclusion in July 2015. Bottom Line: Global multipolarity and the rise of China has forced America's hand, and the dramatic withdrawal of military assets from the Middle East is the direct consequence. Saudi Arabia has suffered a dramatic reversal of geopolitical fortunes, with its crucial geographic buffer, Iraq, now dominated by its strategic rival, Iran. Saudi Arabia "Goes It Alone," And Fails Miserably "Saudi Arabia will go it alone."6 -- Mohammed bin Nawwaf Bin Abdulaziz Al Saud, Saudi ambassador to the U.K., December 17, 2013 To counter growing Iranian influence across the region and its strategic isolation, Saudi Arabia relied on five general strategies, all of which have failed: Map 1Saudi Arabia's Shia-Populated Eastern Province Is A Crucial Piece Of Real Estate The Middle East: Separating The Signal From The Noise The Middle East: Separating The Signal From The Noise Asymmetric warfare: Saudi Arabia has explicitly and implicitly supported radical-Islamist Sunni militant groups around the region. Some of these groups were either directly linked to, or vestiges of, al-Qaeda. The Islamic State, which received implicit support from Saudi Arabia in its early days of fighting president Bashar al-Assad in Syria, eventually turned against Saudi Arabia itself. Its agents claimed multiple mosque attacks in the Shia-populated Eastern Provinces (Map 1), attacks intended to incite sectarian violence in this key oil-producing Saudi area. Saudi officials also became alarmed at a large number of Saudi youth who went to fight with Islamic State fighters across the region, some of whom are now back in the country (Chart 4). "Sunni NATO": Talk of a broad, Sunni alliance against Iran has not materialized. Despite the Saudis' best efforts, the main Sunni military powers - Egypt and Pakistan - have remained aloof of its regional efforts to isolate Iran. The best example is the paltry contribution of its Sunni peers to the ongoing war in Yemen, where anti-government Houthi rebels are nominally allied with Iran. Pakistan contemplated sending a brigade of 3,000 troops to the Saudi-Yemen border earlier this year, but has refused to join the fight directly. Egypt sent under 1,000 troops early in the war, but none since. Talk of a 40,000 Egyptian deployment to the Yemen conflict earlier this year has not materialized. If Pakistan and Egypt are unwilling to help Saudi Arabia against the Houthis, why would they be interested in directly confronting a formidable military power like Iran? Direct warfare: When supporting militants and spending money on allies did not work, Saudi Arabia decided to try its hand at direct warfare. In February 2015, it began airstrikes against the Houthi rebels in Yemen. The war, which costs Saudi Arabia over $70 billion a year, has gone badly for Saudi Arabia.7 Despite two years of intensive involvement by Saudi Arabia and its GCC allies, the capital Sanaa remains in Houthi hands. As far as we are aware, there has been no real Saudi ground troop commitment to the conflict. K-street: Despite its best efforts, and the vast resources spent on lobbyists in Washington, Saudi Arabia could not prevent the U.S. détente with Iran. What the Saudis failed to appreciate was multipolarity, i.e. how the U.S. pivot to Asia would affect Washington's policy toward the Middle East.8 Oil prices: At the fateful November 2014 OPEC meeting, Saudi Arabia refused to cut oil production in the face of falling prices, instead increasing production (Chart 5). Since late 2016, however, Saudi Arabia has reversed this aggressive bid for market share and orchestrated oil production cuts with Russia and OPEC states. Chart 4The Islamic State Movement Threatens Saudi Arabia The Middle East: Separating The Signal From The Noise The Middle East: Separating The Signal From The Noise Chart 5Saudis Surged Production Into Falling Prices Saudis Surged Production Into Falling Prices Saudis Surged Production Into Falling Prices Each and every one of the above strategies has failed. The last one is the most spectacular: Saudi Arabia was forced to backtrack from its oil production surge and negotiate with long-time geopolitical rival Russia, which was courting the Saudis to relieve its budget pressures from low oil prices. Saudi Arabia not only accepted the need to work with Russia, but also acquiesced to Russia's geopolitical demands for détente in the ongoing Syrian Civil War. The latter will force Saudi Arabia at least tacitly to accept the continued leadership of President al-Assad in Syria. Furthermore, Saudi intervention in Yemen has gone nowhere. Pundits who claim that the Saudis are on the verge of a major military engagement in ______ (insert Middle East country), should carefully study the effectiveness of the Saudi military in Yemen. After over two years of Saudi bombardment, the Houthis are further entrenched in the country. Meanwhile, Saudi Arabia's Sunni allies have not committed many ground troops to the effort, save for Sudan, which is impoverished and has no choice but to curry favor with its largest foreign donor. Bottom Line: The past six years have taught the Saudi leadership a series of hard lessons. Saudi Arabia cannot "go at it alone." On the contrary, the rise of the Islamic State - a messianic political entity claiming religious superiority to the Saudi kingdom - has alarmed the Saudi leadership and awoken it to a truly existential risk: domestic upheaval. Nation-Building, Saudi Style "What happened in the last 30 years is not Saudi Arabia. What happened in the region in the last 30 years is not the Middle East. After the Iranian revolution in 1979, people wanted to copy this model in different countries, one of them is Saudi Arabia. We didn't know how to deal with it. And the problem spread all over the world. Now is the time to get rid of it."9 -- Saudi Crown Prince Mohammed bin Salman, October 24, 2017 European nation-states developed over the course of five hundred years, from roughly the end of the Hundred Years' War between England and France to the unification of Italy and Germany in the mid-nineteenth century. Fundamentally, these efforts were about centralizing state power under a single authority by evolving the governance system away from feudal monarchy toward a constitutional, bureaucratic, and national system. The defining feature of feudalism was the separation of feudal society into three "estates": the clergy, the nobility, and the peasantry. The first two estates - the clergy and the nobility - had considerable rights and privileges. The king, who was above all three estates, nonetheless had to curry favor with both in order to raise taxes and wage wars. The state was weak and often susceptible to foreign influence via interference in all three estates. Saudi Arabia is one of the world's last feudal monarchies and it does not have five hundred years to evolve. Still, the best model for what is going on inside Saudi Arabia today is the European nation-building of the past. In brief, recent Saudi policies - from foreign policy assertiveness to domestic reforms - are intended to centralize power and evolve Saudi Arabia into a modern nation-state. Three parallel efforts, modeled on European history from the last millennia, are under way: Curbing the "first estate": Saudi Arabia has begun to curb the power of the religious establishment. In April 2016, it severely curbed the powers of the hai'a - the country's religious police. They no longer have the power to arrest. Instead, they have to report violations of Islamic law to the secular police; and they are only allowed to work during office hours.10 The state has even arrested a prominent cleric who opposed the change in hai'a powers, and has dismissed many other conservative clerics since King Salman came to power. Curbing the "second estate": The detention of members of the Saudi royal family at the Ritz Carlton is part of an ongoing effort to curb the powers of the "landed aristocracy" and bring it under the control of the ruling Sudairi branch of the royal family.11 This is not just palace intrigue, but a necessary step in harnessing the financial resources of the state, which are currently dispersed amongst roughly 2,000 members of the "second estate." Rallying the "third estate": Nationalism was used by European leaders of the nineteenth century to rally the plebs behind the state-building efforts of the time. Similarly, King Salman and his son, Crown Prince Mohammad bin Salman, are building a Saudi national identity. To do so, they are appealing to the youth, which makes up 57% of the country's population (Chart 6), as well as emphasizing the existential threat that Iran poses to the kingdom. Chart 6Still A Young Country Still A Young Country Still A Young Country We do not see these efforts as merely the reckless agenda of an impulsive thirty year-old, as Crown Prince Mohammad bin Salman is often derisively portrayed by his opponents. We see genuine strategy in every policy that has been initiated by Saudi leadership since King Salman took over in January 2015. Several efforts are particularly notable. Vision 2030: A Major Salvo Against The "First Estate" As we indicated in May 2016, we consider the Saudi "Vision 2030" reform blueprint to be a serious document.12 While its plan to address Saudi economic constraints is overly ambitious and vague, there are nonetheless several prominent themes that reveal the preferences of Saudi leaders: Education: The document emphasizes the link between education and economic development. Notably, there is no mention of religion. Gender Equality: Elevating the role of women in the economy will require relaxing many strict social and religious rules that impede gender equality. As if on cue, the Saudi leadership announced that it would soon end its policy of forbidding women to drive. Corruption: A new emphasis on government transparency and reducing corruption will undermine many powerful vested interests, including the religious elites. We were right to emphasize these three themes back in May 2016 as it is now obvious that King Salman and his son Mohammad bin Salman are following the prescriptions of their Vision 2030. What explains their reformist zeal? Over half of the Saudi population of almost 30 million is below 35 years of age. The youth population is facing difficulty entering the labor force, with unemployment above 30% (Chart 7). This rising angst is often expressed online, where the Saudi population is as interconnected as its peers in emerging markets (Chart 8). Saudi citizens have an average of seven social media accounts and the country ranks seventh globally in terms of the absolute number of social media accounts. Between a quarter and a fifth of the population uses Facebook, a quarter of all Saudi teenagers use Snapchat,13 and Twitter has the highest level of penetration in Saudi Arabia of any other country in the region.14 Chart 7A Potential National Security Risk A Potential National Security Risk A Potential National Security Risk Chart 8Saudi Youth Is As Internet Savvy As Others Saudi Youth Is As Internet Savvy As Others Saudi Youth Is As Internet Savvy As Others The idea that the royal family can take on the religious establishment on behalf of the youth seems far-fetched. Skeptics point out that the conservative Sunni Wahhabi religious movement lies at the foundation of the Saudi state. However, commentators who take this mid-eighteenth-century alliance as a key feature of modern Saudi Arabia often overstate its nature and influence. Not only is the Wahhabi hold on power potentially overstated, but Westerners may even overstate the country's religiosity as a whole. According to the World Values Survey, Saudi Arabia is less religious than Egypt and is on par with Morocco.15 Although Saudi Arabia has not appeared in the survey since 2004, it is fair to assume that, with the proliferation of social media and rise in the youth population, the country has not become more religious over the past decade (Chart 9). In addition, Saudis identify with values of self-expression over values of survival (as much as moderate Muslim Malaysians, for example), which is a sign of a relatively wealthy, industrial society. Chart 9Saudi Arabia: More Modern Than You Think The Middle East: Separating The Signal From The Noise The Middle East: Separating The Signal From The Noise The Weekend At The Ritz: The "Second Estate" Is Put On Notice The ongoing effort to curb the power of the Saudi "second estate" is not just about court intrigue and political maneuvering. Without harnessing the economic resources of the wider Saudi aristocracy, the state would succumb to debilitating capital outflows. If the Saudi "second estate" decided to "vote" against King Salman and his son with their "deposits" - and flee the country - the all-important currency peg would collapse. Despite a pickup in oil prices, Saudi Arabia's currency reserves are falling rapidly and could soon dip below the total amount of local-currency broad money (Chart 10). Beneath that point, confidence among locals and foreigners in the currency peg could shatter, leading to massive capital flight, which was clearly a very serious problem as of end-2016 (Chart 11). Chart 10KSA: Forex Reserves Depleting KSA: Forex Reserves Depleting KSA: Forex Reserves Depleting Chart 11KSA: Capital Outflows Persist KSA: Capital Outflows Persist KSA: Capital Outflows Persist The peg of the Saudi riyal to the U.S. dollar is not just an economic tool. It is a crucial social stability anchor for an economy that imports nearly all of its basic necessities. De-pegging would lead to a massive increase in import costs and thus a potential political and social crisis. The Saudi Arabian Monetary Agency (SAMA) has at its disposal considerable resources for the next two years. However, this is only the case if capital outflows do not pick up and oil prices continue to stabilize. The Russia-OPEC deal is in place to ensure the latter. The "weekend at the Ritz" is meant to ensure the former. But doesn't the crackdown against the wealth of 2,000 royal family members represent appropriation of private property? Not in the minds of King Salman and his reformist son. In fact, if the financial wealth of the royal family is used to fill the coffers of the Saudi sovereign wealth fund, there is no reason why members of the Saudi "second estate" cannot benefit from its future investment returns and essentially "clip coupons" for a living. In fact, prior to the anti-corruption crackdown against the "second estate," Saudi officials hosted a completely different event at the Ritz Carlton: a gathering of top international investors for a conference called "Davos in the Desert." Judging by the conversations we had with a number of participants at that event, the point was not to encourage investments in Saudi Arabia. Rather, it was to secure the services of top international managers as Saudi Arabia ramps up the investment activities of its Public Investment Fund (PIF). Investors should therefore consider the first weekend at the Ritz as the launch of a new international investment vehicle by Saudi officials and the second weekend at the Ritz as its capitalization by the wider "second estate." We expect that fighting corruption will remain a major domestic policy thrust going forward. A recent academic study, for example, takes on the difficult job of eradicating wasta - the concept that each favor or privilege in Saudi society flows through middlemen or connections.16 The volume has been edited by Mohamed A. Ramady, professor of Finance and Economics at King Fahd University in Dhahran, Saudi Arabia, and is undoubtedly supported by the royal family. Moreover, King Salman and his son have the example of Chinese President Xi Jinping's impressive power consolidation via anti-corruption campaign right in front of them and are unlikely to have embarked on this course with the expectation that it would be a short process. Iran As An Existential Threat: Harnessing The "Third Estate" Real reform is always and everywhere difficult, otherwise the desired end-state would already be the form. For the Saudi leadership, attacking both the first and second estate presents considerable risks. It is appropriate, therefore, to believe that a palace coup may be attempted against King Salman and his son.17 International tensions with Iran are a particularly useful strategy to distract the opposition and paint all domestic dissent as treasonous. This is not to say that Saudi Arabia does not face considerable strategic challenges from Iran. As mentioned, Iranian influence in Iraq is particularly threatening to Saudi Arabia as it gives Tehran influence over a key strategic buffer that also produces 4.4 million barrels of crude per day. Furthermore, Iran supported the 2011 uprising in Shia-majority Bahrain against the Saudi-allied al-Khalifa monarchy; it at least nominally supports the Houthi rebels in Yemen; it has directly intervened in Syria on behalf of President al-Assad; and it continues to support Hezbollah in Lebanon. It is safe to say that, since 2011, Iran has been ascendant in the Middle East and has surrounded Saudi Arabia with strategic threats on all points of the compass. But to what extent is the Saudi rhetoric on Lebanon, Bahrain, Yemen, and Qatar a real threat to the stability in the Middle East? We turn to this question in our next section. Bottom Line: Saudi Arabia's domestic intrigue is far more logical than pundits and the media make it out to be. King Salman and his son, Crown Prince Mohammad bin Salman, are trying to build a modern nation state from what is today the world's last feudal monarchy. To do so, they have to enlist the support of the third estate - the country's large youth population - and curb the powers of its first and second estates - the religious establishment and the landed aristocracy. The process will be filled with risks and volatility, but is ultimately necessary for the long-term stability of the kingdom. Regional Risk Of War Is Overstated "[I am] positive there will be no implications coming out of this dramatic situation at all."18 -- Secretary of Defense James Mattis, asked about the Qatar crisis and the fight against ISIS, June 5, 2017 As this report goes to publication Saudi Arabia has accused Iranian-allied Hezbollah of forcing Lebanese Prime Minister Saad Hariri to run for his life. Hariri resigned while visiting Saudi Arabia. Although he claims that he is not being held against his will by Saudi authorities, his resignation is highly suspect. Saudi officials have also called a failed missile attack on Riyadh's airport, allegedly launched by Houthi rebels in Yemen, as a possible "act of war" by Iran. Meanwhile, Bahrain's Saudi-allied government has accused Iran of destroying an oil pipeline via terrorist action. The region's rumor mill - one of the most productive in the world - is in overdrive. What are the chances of increased proxy warfare between Saudi Arabia and Iran? We think that there is a good chance that Saudi Arabia will step up its military activity in the ancillary parts of the Middle East. In particular, we could see renewed Saudi military campaigns in Yemen and Bahrain. In isolation, these campaigns would add a temporary risk premium to oil prices. But given that Iran has no intention to become directly involved in either, we would expect Saudi moves to be largely for show. Over the long term, we do not see a direct confrontation between Iran and Saudi Arabia for three reasons. First, Saudi military capabilities are paltry and the kingdom has failed to secure the support of the wider Sunni world for its "Sunni NATO." We have already mentioned Saudi military failures in Yemen. Anyone who thinks that Saudi Arabia is ready to directly confront Iran must answer two questions. First, how does the Saudi military confront a formidable foe like Iran when it cannot dislodge Houthis from Yemen? Second, if Saudi Arabia is itching for a real conflict with Iran, why is it not saber-rattling in Iraq, a far more strategic piece of real estate for Saudi Arabia than any of the other countries where it accuses Iran of meddling? Chart 12Correlation Between Oil Prices And Military Disputes The Middle East: Separating The Signal From The Noise The Middle East: Separating The Signal From The Noise Second, oil prices remain a constraint to war. The reality is that there is a well-known relationship between high oil prices and aggressive foreign policy in oil-producing states (Chart 12). Political science research shows that the relationship is not spurious. Chart 13 shows that oil states led by revolutionary leaders are much more likely to engage in militarized interstate disputes when oil prices are higher.19 While oil prices have recovered from their doldrums from two years ago, they are also a far cry from their pre-2014 highs. In fact, by our calculation, oil prices are still below the Saudi budget break-even price of oil, despite its best efforts to implement austerity (Chart 14). Chart 13More Oil Revenue = More Aggression The Middle East: Separating The Signal From The Noise The Middle East: Separating The Signal From The Noise Chart 14Saudi Spending Binge Raised Oil Breakevens Saudi Spending Binge Raised Oil Breakevens Saudi Spending Binge Raised Oil Breakevens Third, Saudi Arabia has failed to secure a clear security commitment from the U.S. While the Trump administration is far more open to supporting Saudi Arabia than the Obama administration, it still criticized the Saudi decision to ostracize Qatar. Secretary of Defense James Mattis made a visit to Qatar in September to offer American support. In a shocking reversal to over half-a-century of geopolitics, King Salman went to Moscow this October to deepen geopolitical relations with Russia.20 The visit included several business deals in the realm of energy and a significant promise by Saudi Arabia to purchase Russian arms in the future, including the powerful S-400 SAM system. Saudi Arabia is the world's third-largest arms importer and uses purchases as a tool of diplomacy, but has never purchased weapons from Russia in a significant way in the past. While many pundits have pointed to the Saudi-Russian détente as a sign of strength, we see it as a sign of weakness. It illustrates that Saudi Arabia is diversifying its security portfolio away from the U.S. It is doing so because it has to, not because it wants to. As U.S. petroleum imports continue to decline due to domestic shale production, Saudi Arabia is compelled to find new allies (Chart 15). The plan to hold an initial public offering for Aramco, and to target sovereign Chinese entities as major bidders for Aramco assets, fits this pattern as well. Chart 15Saudi Arabia Has To Diversify Its Security ##br##Portfolio As U.S. Oil Imports Decline Saudi Arabia Has To Diversify Its Security Portfolio As U.S. Oil Imports Decline Saudi Arabia Has To Diversify Its Security Portfolio As U.S. Oil Imports Decline However, diversifying the geopolitical security portfolio to include Russia and China will not mean that Saudi Arabia will have a blank check to wage direct war against Iran. Both Russia and China have considerable diplomatic and economic interests in Iran and are as likely to restrain as to enable Saudi ambition. Finally, talk of a Saudi-Israeli alliance against Hezbollah in Lebanon is as far-fetched as a direct Saudi-Iranian confrontation. Israel won the 2006 war against Hezbollah, but at a high cost of 157 soldiers killed and 860 wounded.21 The Israeli public grew tired of the one month campaign, showing political limits to offensive war. Furthermore, twelve years later, Hezbollah is even more deeply entrenched in Lebanon. Unless Saudi Arabia is willing to provide ground troops for the effort (see Yemen discussion above), it is unclear why Israel would want to enter the morass of Lebanese ground combat on behalf of Riyadh. Bottom Line: Constraints to Saudi offensive military action remain considerable: paltry military capability, fiscal constraints imposed by low oil prices, and a lack of clear support from the U.S. While rhetorical attacks on Iran serve the strategic goal of nation-building, we do not expect a major war between oil-producing states that would significantly raise oil prices over the medium term. The rhetoric and posturing will increase volatility and temporarily push up prices from time to time. Investment Implications Of Saudi Nation-Building First, on the question of OPEC 2.0, our baseline case is for the 1.8 million barrel-per-day production cuts to be extended through June 2018, drawing OECD inventories down toward their five-year average and creating the conditions for Brent and WTI prices to average $65 per barrel and $63 per barrel respectively next year.22 Moreover, both Crown Prince Mohammad bin Salman and Russian President Vladimir Putin have endorsed extensions through end-2018. These comments add bullish upside risk to prices, though they also alter perceptions and thus raise the short-term downside risk if no extension is agreed this month (which we think is the least likely scenario). Second, as to broader geopolitical risks in the Middle East, we believe they are rising yet again in the short and medium term, after the relative calm of 2017.23 We could see Saudi officials decide to ramp up military operations in Yemen or revive them in neighboring Bahrain. However, we do not see much of a chance of serious conflict in Lebanon or Qatar. The former would require an Israeli military intervention, which is unlikely given the outcome of the 2006 war. The latter would require American acquiescence, which is unlikely given the vital U.S. strategic presence in the country's Al Udeid military base. Nonetheless, even temporary military operations in any of these locales could add a geopolitical risk premium to oil markets. For example, the 2006 Lebanon-Israel War, which had no impact on oil production, generated a significant jump in oil prices (Chart 16). Chart 16Even The 2006 Israel-Lebanon War Produced A Risk Premium... Even The 2006 Israel-Lebanon War Produced A Risk Premium... Even The 2006 Israel-Lebanon War Produced A Risk Premium... Over the long term, how should investors make sense of the complicated Middle East geopolitical theater? Our rule of thumb is always to seek out the second derivative of any geopolitical event. In the context of the Middle East, by "second derivative" we mean that we are interested in whether the market impact of a new piece of information - of a new geopolitical event - will amount to more than just a random perturbation with ephemeral, decaying market implications. To determine the potential of new information to catalyze a persistent market risk premium or discount, we investigate whether it changes the way things change in a given region or context. For a geopolitical event in the Middle East to have such second derivative implications, and thus global market implications, we would need to see it have an impact on at least two of the following three factors: Oil supply: The event should impact current global oil supply either directly or through a clear channel of contagion. Geography: The event should occur in a geography that is of existential significance to one of the regional or global players. Sectarian contagion: The event should exacerbate sectarian conflict - Sunni versus Shia. When we consider the security dilemma between Iran and Saudi Arabia, Iraq and the Eastern Province in Saudi Arabia are two regions critical to global oil supply. Tellingly, neither has played a role in the recent spate of tensions between the two countries. Saudi Arabia has been very careful not to increase tensions with Iran in Iraq. In fact, the Saudi leadership has reached out to Iraqi Prime Minister Haider al-Abadi, who was received by King Salman in October in the presence of U.S. Secretary of State Rex Tillerson. How should investors price domestic political intrigue in Saudi Arabia? In the long term, any failure of King Salman and his son to reform the country would be negative for internal stability, with risks to oil production if social unrest were to increase. In the short and medium term, however, even a palace coup would likely have no lasting impact on oil prices as it would be highly unlikely that an alternative leadership would imperil the kingdom's oil exports. On the contrary, a coup against King Salman could lead to lower oil prices if the new leadership in Riyadh decided to renege on their oil production cuts with Russia. The bottom line is that the geopolitical risk premium is likely to rise. The evolution of Saudi Arabia away from a feudal monarchy requires the suppression of the kingdom's first and second estates, a dangerous business that will likely be smoothed by nationalism and saber-rattling. Risks to oil prices, therefore, are to the upside. However, given the considerable constraints on Saudi Arabia's military and foreign policy capabilities, we do not foresee global growth-constraining oil supply risks in the Middle East. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 The latest news from Riyadh is that the nearby Courtyard by Marriott Hotel may have been enlisted by the Saudi authorities for the crackdown, in addition to the Ritz Carlton. If true, we can only imagine the horrors that the prisoners are subject to! 2 Please see BCA Geopolitical Strategy Special Report, "Middle East: Paradigm Shift," dated November 13, 2013, and BCA Geopolitical Strategy Special Report, "Middle East: Paradigm Shift (Update)," dated July 9, 2014, available at gps.bcaresearch.com. 3 Please see "Iran 'taking over' Iraq, Saudis warn, blaming U.S. refusal to send troops against ISIS," The National Post, dated March 5, 2015, available at nationalpost.com. 4 Please see BCA Geopolitical Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 5 Iran's influence in Iraq grew almost immediately following the American military withdrawal. Iraq's Shia Prime Minister, Nouri al-Maliki, wasted no time revealing his allegiance to Iran or his sectarian preferences. Baghdad issued an arrest warrant for the Sunni Vice President Tariq al-Hashimi literally the day after the last American troops withdrew from the country, signaling to the Sunni establishment that compromise was not a priority. Persecution of the wider Sunni population soon followed, with counter-insurgency operations in Sunni populated Al Anbar and Nineveh governorates. 6 Please see Mohammed bin Nawwaf bin Abdulaziz al Saud, "Saudi Arabia Will Go It Alone," New York Times, dated December 17, 2013, available at nytimes.com. 7 Please see Bruce Riedel, "Saudi Arabia's Mounting Security Challenges," Al Monitor, dated December 2015, available at al-monitor.com. 8 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 9 Please see Martin Chulov, "I will return Saudi Arabia to moderate Islam, says crown prince," The Guardian, dated October 24, 2017, available at www.theguardian.com. 10 Something tells us that most violations of Islamic law are likely to be committed after hours! 11 The Sudairi branch of the Saud dynasty refers to the issue of Saudi Arabia's founder Abdulaziz Ibn Saud with Hassa bint Ahmed Al Sudairi, one of Ibn Saud's wives and a member of the powerful Al Sudairis clan. The union produced seven sons, the largest faction out of the 45 sons that Ibn Saud fathered. As the largest grouping, the sons - often referred to as the "Sudairi Seven" - were able to consolidate power and unite against the other brothers. In addition to the current King Salman, the other member of the Sudairi faction who became a king was Fahd, ruling from 1982 to 2005. 12 Please see BCA Geopolitical Strategy Special Report, "Saudi Arabia's Choice: Modernity Or Bust," dated May 2016, available at gps.bcaresearch.com. 13 The app is used to transmit photos and videos between users that disappear from the device after being viewed in 10 seconds. It is highly unlikely to be used for religious education. It is highly likely to be used by teenagers for ... well, use your imagination. 14 Please see "Social Media In Saudi Arabia - Statistics And Trends," TFE Times, dated January 12, 2017, available at tfetimes.com; "Saudi social media users ranked 7th in the world," Arab News, November 14, 2015, available at arabnews.com. 15 The World Values Survey is used in academic political science research to track changes in global social and political values. Ronald Inglehart and Christian Welzel have summarized the key findings in Modernization, Cultural Change, and Democracy (Cambridge: Cambridge UP, 2005). For more information, please see http://worldvaluessurvey.org. 16 Please see Mohamed A. Ramady, ed., The Political Economy Of Wasta: Use and Abuse of Social Capital Networking (New York: Springer, 2016). 17 It would not be the first such coup in Saudi history. King Saud was deposed in 1962 by his brother, King Faisal. 18 Please see Nahal Toosi and Madeline Conway, "Tillerson: Dispute Between Gulf States And Qatar Won't Affect Counterterrorism," dated June 5, 2017, available at www.politico.com. 19 Please see Cullen S. Hendrix, "Oil Prices and Interstate Conflict Behaviour," Peterson Institute for International Economics, dated July 2014, available at www.iie.com. 20 Please see BCA Energy Sector Strategy and Geopolitical Strategy Special Report, "King Salman Goes To Moscow, Bolsters OPEC 2.0," dated October 11, 2017, available at gps.bcaresearch.com. 21 Please see "Mideast War, By The Numbers," Associated Press, August 17, 2006, available at www.washingtonpost.com. 22 Please see BCA Commodity & Energy Strategy Weekly Report, "Oil Forecast Lifted As Markets Tighten," dated October 19, 2017, available at ces.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com.

Highlights Clients frequently ask us what long-term returns they should assume when constructing strategic portfolios. In this report, we use a range of methodologies to arrive at reasonable return assumptions for bonds, equities, alternative assets, and currencies on a 10-15 year investment horizon. We conclude that global bonds are likely to return around 1.5% in nominal terms (compared to 5.3% over the past 20 years), and global equities 4.6% (compared to 6.1%). Alternative assets look rather more attractive with, for example, private equity projected to return 9% and real estate 7.1%. Nonetheless, the typical pension fund portfolio, consisting of 50% equities, 30% fixed income, and 20% alts, will be unable to achieve its return target (still typically 7% or higher). Feature Pension plan sponsors and wealth managers need realistic assumptions about the likely returns from different assets in order to construct strategic portfolios, for example when calculating the efficient frontier using a mean-variance optimizer (MVO). Using historical data is the simplest way to do this, but can be very misleading: for example, global bonds have delivered an annual nominal return of 5.3% over the past 20 years but, with bond yields currently so low, it is almost mathematically impossible for them to return anything close to that over coming years (our estimate for future returns is 1.5%). This Special Report is our attempt to produce long-run return assumptions for strategic portfolios, something that GAA clients frequently ask us for. We want to emphasize that these are reasonable assumptions, not forecasts. The value of forecasting the world economy over the next decade or more is questionable. Consider if we had carried out this exercise in 2002: how likely is it that we would have predicted the rise and fall of emerging markets, the U.S. housing crisis, and the subsequent "secular stagnation"? Our analysis, therefore, is mostly based on the philosophy that long-run historical relationships (for example, credit spreads, or the excess return of small cap stocks) are fairly constant, and that most variables (profit margins, valuation, productivity) mean revert over the long term. Our time horizon is 10-15 years. We chose this - rather than the five or seven years that is perhaps more common in such analyses - because it is closer to the investment horizon of pension funds and most individual investors. It also allows us to avoid making a call on where we are currently in the cycle, and how long the next recession and expansion will last. It is likely we are close to the peak of the current economic expansion and equity bull market (the "X" on Chart 1): choosing a shorter time horizon would mean making judgements about the timing of the cycle. Conceptually, we prefer to forecast the trend line on the chart. Chart 1Stylized Trend Versus Cyclical Movements What Returns Can You Expect? What Returns Can You Expect? Our assumptions are inevitably approximate. In many cases (particularly for equity returns), we use multiple methodologies and take the average result. Does it matter that the estimation error of our assumptions is likely to be large? Most academic evidence finds not.1 The reason is that, for closely correlated assets, errors in the return estimates (and therefore the optimal weights in a portfolio) will not greatly affect a portfolio's risk and return; while, for assets that are very different, errors in the estimates will not have much effect on the optimal portfolio weights. Rough estimates, therefore, are sufficient for portfolio construction purposes. In any case, using common-sense projections is better than unrealistic historical averages, and investors do need some assumptions to work with when constructing portfolios. How To Forecast Economic Growth A key input (especially when considering earnings growth, which is one factor driving equity returns) is the likely rate of economic growth in various countries and regions over our time horizon. Our simplified way of deriving this is to assume that GDP growth is a factor of (1) demographics (specifically, the growth in the population of working age), and (2) productivity growth. (We assume that capital intensity is steady.) For the demographic assumptions, we use the United Nations' median forecast of the annual growth in population aged 25-64 between 2015 and 2030 (Table 1). Productivity growth is harder to estimate. Productivity has been poor in recent years compared to history (Chart 2). There is significant uncertainty about whether this is caused by cyclical factors (the Great Recession, for example) or structural factors (the end of positive effects from the IT revolution etc.), and whether a potential new wave of technology (artificial intelligence, self-driving vehicles) will raise productivity in future. Table 1Demographic Assumptions What Returns Can You Expect? What Returns Can You Expect? Chart 2Productivity Growth Productivity Growth Productivity Growth Our approach is to assume that productivity in the U.S. will return to its 40-year average, and that productivity growth in the main European economies will be 50 bp lower than the U.S. and in Japan 80 bp lower (in line with recent averages). The estimate is harder for emerging markets, so we use two scenarios: one in which structural reforms, particularly in China, bring productivity growth back up to the average of the past 10 years, 3.5%; and a second scenario in which governments fail to reform, and therefore productivity growth continues to fall to only 1%. For inflation, we assume that central banks over the long-term largely achieve their current inflation goals. The results of our assumptions for GDP growth are shown in Table 2. Table 3 shows the summary of our results: the 10-15 year return assumptions for all the assets in our analysis. We also show historic returns and volatility for comparison (for the past 20 years, where data is available). Below, we describe in detail how we arrived at these numbers. Table 2GDP Growth Assumptions What Returns Can You Expect? What Returns Can You Expect? Table 3BCA Assumed Returns What Returns Can You Expect? What Returns Can You Expect? All our results are shown in nominal terms and in local currencies. While strictly speaking, it might be theoretically better to estimate real returns, in practice most investors and advisers tend to work on a nominal basis. Moreover, since we have made assumptions for inflation in each region, it is simple to translate our nominal returns into real ones. There is also a trade-off between inflation and currency movements (and interest rates). At the end of the report, we consider the impact of relative inflation rates on currency returns, allowing investors to work the returns back into their own currencies. 1. Fixed income We start from a base that is known: the return on long-term government bonds. If an investor today buys a 10-year U.S. Treasury bond, his or her annual nominal return over the next 10 years will almost certainly be 2.3% (today's yield). The only uncertainties come from (1) reinvesting coupons at the future rate of interest, but the impact of this is small, and (2) the (presumably minimal) risk of a U.S. government default. Of course, investors do not own just 10-year bonds, and indeed the average duration of U.S. Treasuries is currently 5.7 years. But changes in interest rates make relatively little difference to future returns: a rise in interest rates causes a capital loss but a higher yield on rolled-over positions after bonds mature (though, admittedly, the convexity effect is greater when rates are low, as they are now). Even if interest rates were to double over the next decade, the return from U.S. Treasuries would fall only to around 1.5% and, if interest rates fell to 0%, the return would be only about 3%. Moreover, the effect diminishes over time as more bonds are redeemed at par. Empirically, we can see that there is a strong correlation between starting yield on 10-year bonds and long-term returns from U.S. Treasuries (Chart 3). Chart 3Government Bond Returns Driven By The Starting Yield What Returns Can You Expect? What Returns Can You Expect? For our cash assumption, we first calculate a proxy for the current cash yield using the average spread between 10-year government bonds and three-month bills over a long-run history (using data from Dimson, Marsh and Staunton which goes back to 1900 and covers a range of countries, Table 4).2 While it is true that the yield curve steepens and flatten along with the cycle, the average yield curve shape should be a good proxy for long-term future expected returns. Of course, this assumes that the term premium comes back. It may not if bonds now are a good hedge against recession risk. However, we also need to take into account that interest rates and inflation are likely to change over the next 10-15 years. We assume that both will rise to an equilibrium level over that time. Our assumption is that central banks will get close to hitting their inflation targets (in the U.S., 2% on PCE inflation, which translates into 2.5% on CPI; in Europe, "around but below 2%"; and in Japan, 2%). For the equilibrium real rate, we take BCA's current estimate (Chart 4) and assume a small rise over the next decade as some of the after-effects of the Great Recession and secular stagnation wear off: to 0.4% in the U.S., -0.1% in the euro area, and -0.2% in Japan. Table 4Historic Spread Government Bonds To Bills (1900-2016) What Returns Can You Expect? What Returns Can You Expect? Chart 4Current Equilibrium Real Rates Current Equilibrium Real Rates Current Equilibrium Real Rates Our calculation of the return from cash over the 10-15 year horizon is based on a steady rise from the current cash return to that implied by the inflation and equilibrium real rate assumptions (Table 5). Table 5Calculation Of Assumption For Cash Return What Returns Can You Expect? What Returns Can You Expect? For other fixed-income instruments, we make the following assumptions: Government bonds. We assume that the spread between 10-year and 7-year bonds and 3-month bills will be similar to the historical average (Chart 5), and calculate the return from the government bond index based on this and our estimate for 10-year returns, adjusted by the duration of outstanding bonds in the index: 5.7 years for the U.S., 7.1 for Europe and 8.6 for Japan. For U.S. investment-grade and high-yield corporate bonds, we take the average spread, default rate, and recovery rate in history (Table 6). Obviously, spreads and default rates, especially for high-yield bonds, also jump around massively over the cycle (Chart 6), but we think it is reasonable to assume in our long-term projections that they revert to the mean. Reliable data for European and Japanese credit has a short history but, over the past 10 years, spreads and default rates have been similar to the U.S., so we use the U.S. assumptions for these markets too. Chart 5Yield Curves Yield Curves Yield Curves Table 6U.S. Corporate Credit Assumptions What Returns Can You Expect? What Returns Can You Expect? Chart 6Credit Spreads And Default Rates Move With The Cycle Credit Spreads And Default Rates Move With The Cycle Credit Spreads And Default Rates Move With The Cycle Government-related bonds and securitized bonds (MBS, ABS etc.) are an important part of the Barclay's Aggregate Bond indexes: in the U.S., for example, securitized bonds comprise 31% of the index, and government-related ones 7%; in Europe, the weights are 8% and 17% respectively. For our projections of government-related bonds, we assume historic average spreads will continue (Table 7). For securitized bonds, we assume that the historic average spread in the U.S. will continue, and will be the same in Europe and Japan (where historic data is less readily available). Inflation-linked bonds. We assume that the average real yield of the past 10 years, 0%, will continue in future (Chart 7). Table 7Spreads Over Government Bonds What Returns Can You Expect? What Returns Can You Expect? Chart 7Real Yield On U.S. TIPs Real Yield On U.S. TIPs Real Yield On U.S. TIPs 2. Equities There are a number of ways to think about forward equity returns, all with a high degree of uncertainty. These could be based on starting valuations (but which valuation measure to use?); related to likely earnings growth in future years (hard to forecast); or based on a reversion to the mean of valuations and profits. We decided to take a range of different measures, and average the results. In practice, the results are similar, except for emerging markets (see below for more on EM). Table 8 summarizes the equity return calculations. Table 8Equity Return Calculations AVERAGE EQUITY What Returns Can You Expect? What Returns Can You Expect? The thinking behind the six measures we use is as follows. Equity risk premium (ERP). The most obvious methodology: historically, over the long run equities have returned more than government bonds. But which risk premium to use? Dimson, Marsh and Staunton's work includes the excess performance of equities over bonds since 1900 for a range of countries (Table 9). We decided not to choose a different ERP for each developed region, as the historical data would suggest, since it is difficult to argue that the U.S. is likely to be riskier in future than Europe and since, for parts of this history, Japan and the U.S. were essentially emerging markets. We, therefore, take a rounded average of world ERP over the past 116 years, 3.5%. For emerging markets, we multiply this by the average beta of EM relative to global equities over the past 30 years, 1.2, to give an ERP of 4.2%. Growth model. Think of a Gordon Growth Model, which defines the return from equities as the starting dividend yield plus future earnings growth (strictly speaking, dividend growth; we are assuming that the payout ratio will stay constant). We need to make a couple of adjustments to this. First, earnings growth has historically been correlated to nominal GDP growth but has lagged it - in the U.S. by 1.5 percentage points in the period 1918-2016 - although, since 1981, earnings have grown significantly faster than GDP (Chart 8). For the future, we assume that the long-run lag returns. Second, we need to add share buybacks to the dividend yield since, in some countries, such as the U.S., for tax reasons companies prefer to buy back shares rather than increase dividends. However, we should do this on a net basis since equity holders are penalized by companies that issue new shares. In the U.S. net equity withdrawal has been 0.3% over the past 10 years, but in both Europe and Japan, annual net new equity issuance has averaged 1.6% (Chart 9). In EM, the dilution has been even more extreme, averaging 6% over the past 10 years (and much more over the past 25 years). We subtract this dilution from future returns. Table 9Equity Excess Return Over Bonds What Returns Can You Expect? What Returns Can You Expect? Chart 8U.S. EPS Growth Versus Nominal GDP Growth What Returns Can You Expect? What Returns Can You Expect? Chart 9Net Equity Issuance Net Equity Issuance Net Equity Issuance Growth plus reversion to the mean. This takes the Gordon Growth Model but adds to it an assumption that PE multiples and profit margins revert to the historical mean. We again use dividend yield adjusted by net equity issuance. We assume that the current trailing PE and profit margin revert to the average since 1980 (see Table 8 above for the data) over the next 10 years. In the U.S., PE and margins are currently somewhat higher than history, but this is less the case in Europe or Japan (Charts 10 and 11). Additionally, assuming that the mean reversion happens over 10 years means that the effect on annual returns is not especially large, even for the U.S. Chart 10Net Profit Margin Net Profit Margin Net Profit Margin Chart 11Trailing PE History Trailing PE History Trailing PE History Earnings yield (EY). The simplest of the three valuation measures we use, the assumption is that companies reward shareholders either by paying them a dividend this year, or by reinvesting retained earnings to pay dividends in future. If you assume (admittedly a rash assumption) that the future return on investment will be similar to the current return on investment, it should be immaterial how the company pays out to shareholders. Therefore, the trailing earnings yield (1/PE ratio) should be a good proxy for future returns. Empirically, the relationship between earnings yield and 10-year future returns has been quite strong (Chart 12). However, returns have been somewhat higher on average than the EY would indicate (between 1900 and 2006, 9.7% versus an average EY of 7.5%) mainly because of rising PE multiples since 1980 (Chart 13). We think it unlikely that valuations will continue to rise, and so the EY should be a reasonable guide to future returns. Chart 12Earnings Yield And 10-Year Future Returns What Returns Can You Expect? What Returns Can You Expect? Chart 13Trailing Price/Earnings Multiple S&P500 What Returns Can You Expect? What Returns Can You Expect? Shiller PE. The cyclically-adjusted price/earnings ratio (CAPE, or Shiller PE) - the current share price divided by the 10 year average of historic inflation-adjusted earnings - has historically had a good correlation with future long-term returns (Chart 14). A regression model of this indicates that the current Shiller PE points to long-run forward returns for the U.S. of 4.9%, for Japan 3.6%, Europe 8.5% and EM 10.8%. Valuation composite. The Shiller PE has some flaws, for example in using a fixed 10-year period for earnings when the length of cycles varies. It has not necessarily mean-reverted in history (perhaps because of long-term trends in interest rates, which it doesn't take into account). It may be more reasonable, then, to use a mixture of different valuation metrics. BCA's Composite Valuation Indicator has had a good correlation with long-run future returns (Chart 15).3 A regression model of this indicator against 15-year returns currently points to returns from the U.S. of 5.2%, Europe of 4.1%, Japan 5.1% and EM 11.0%. Small-cap stocks. We take the 2.4% excess annual return of small cap stocks over large caps in the U.S. for 1926-2016, as calculated by Dimson, Marsh & Staunton. Chart 14Shiller PE Versus ##br##15-Year Equity Return Shiller PE Versus 15-Year Equity Return Shiller PE Versus 15-Year Equity Return Chart 15Composite Valuation Measure Versus ##br##Long-Run Future Returns Composite Valuation Measure Versus Long-Run Future Returns Composite Valuation Measure Versus Long-Run Future Returns Emerging Markets The return assumption for emerging market equity returns has a much higher degree of uncertainty. On our three valuation measures, EM equities look attractive: the average return expectation of the three valuation indicators points to an annual return of 9.4%. However, the growth outlook is murky: as described above, a wave of structural reform in emerging markets, especially China, would be necessary to keep productivity - and, therefore, earnings growth - up, in order for returns to be as good as the current valuation level suggests. Another worry is the degree of equity dilution: it has averaged 6% a year over the past 10 years, and is unlikely to fall much unless corporate governance improves significantly. The range of expected returns derived from our various methodologies, therefore, varies from -1% to +11% a year. Moreover, as described in the currency section below, investors should expect a depreciation in some EM currencies over the next decade, which will also eat into returns. However, due to the influence of China, where the currency is projected to appreciate almost 2% a year against the USD, the EM equity index will see an overall boost to USD-based returns due to the currency effect. 3. Alternative Assets We consider the likely future returns for nine of the 10 alternative assets that Global Asset Allocation regularly covers (we omit wine, which is hard to value on the basis of fundamental macro factors and, anyway, is owned by few institutional investors).4 Alts are harder to forecast than public securities since data is less easily available (and may be only quarterly and based on estimated values), and since some alternative assets have not existed in their current form for very long (venture capital, for example). Moreover, alternative assets tend to have non-normal returns with skewed distributions. Table 10 shows the historical returns and volatility of the nine alternative asset classes both over the longest period for which we have data, and since 1997, when we have data for all of them. Table 10Returns And Volatility For Alternative Assets What Returns Can You Expect? What Returns Can You Expect? We, therefore, take a more ad hoc approach, projecting each asset class differently. Generally, we assume that future returns will look similar to historical ones. Specifically, the assumptions we use are as follows. Hedge funds. We assume a return of cash + 3.5%. Hedge fund returns have trended down over time (Chart 16), as more entrants have arbitraged away alpha. We choose to use the average return over cash of the past 10 years, 3.5% (net of fees). It is unlikely that hedge funds returns will rise back anywhere close to earlier levels, for example that of the 1990s when they returned cash +14%. Chart 16Hedge Fund Historic Returns Hedge Fund Historic Returns Hedge Fund Historic Returns U.S. Direct real estate. We find reasonably good results (R2 = 24%) from regressing U.S. nominal GDP growth against real estate returns. The regression equation is 1.25 x nominal GDP growth + 1.9%. Conceptually, this probably represents a cap rate plus growth of capital values slightly higher than economic growth due to supply shortages in certain key locations. We project real estate to return 7.2% annually. One risk to this assumption, however, is that commercial real estate prices are already above the previous peak from 2007; high valuations may dampen future returns. U.S. REITs. We find only weak correlations with direct real estate investment, although REITs have outperformed real estate over time (perhaps because of the inbuilt leverage of REITs). Over time, REITs have become increasingly correlated with equities. We, therefore, use a regression against U.S. equity returns (R2 = 42%), with REIT returns 0.49 x equity returns + 7.7%. This indicates 10.1% annual return from REITs in the long run. U.S. Private equity (PE). In the past, returns from private equity have been 5 or 6 percentage points higher than from public equities. This is most likely due to their higher leverage, bias towards small-cap companies, and stronger shareholder control over the companies they invest in; it can also be thought of as an illiquidity premium. However, it seems likely that excess returns will be lower in future given the bigger size of the PE industry now and relatively high valuations currently. Moreover, the PE industry currently has almost USD 1 Trn in dry power (uninvested capital), a sign that investment opportunities are limited. We assume, therefore, a slightly lower premium over public equities in future of 4 ppts. This results in a total annual return of 9.5%. U.S. Venture capital (VC). Historically (using data since 1986) VC returns have been 0.6 ppts higher than for PE (probably representing a premium for greater risk and smaller size of the companies invested in). We assume 0.5 ppt higher return in future. This leads to a return assumption of 10%. U.S. Structured products. As discussed in the fixed income section above, we use the 20-year average spread over the aggregate bond index of 0.7 ppt. Total assumed return, therefore, is 3.3%. U.S. Farmland. The value of farmland has risen by an average of 4.4% a year since 1920, a period which included five agricultural cycles. We assume that the value of land will continue to rise at the same rate. We think this is a reasonable assumption since, although nominal GDP growth in the U.S. may be lower in future than in the past, global demand for food is likely to continue to grow rapidly. The total return from investment in farm land, using a regression, produces: growth of farm land value x 1.81 + 0.64% = 8.6%. Chart 17Long-Term Commodity Prices Long-Term Commodity Prices Long-Term Commodity Prices U.S. Timberland is more defensive than farmland since trees can be stored "on the stump" and don't need to be harvested each year in the way that crops do even when prices are unattractive. Historically, timberland has returned about 1 ppt less a year than farmland, and we assume that this will continue. Commodities move in long-run cycles, with a commodity super-cycle of around 10 years, in which prices rise by 3-4x, followed by a bear market of 20 or 30 years in which they fall or stagnate (Chart 17). This is driven by a build-up of excess supply, because of the capex done during the super-cycle, and often by a structural shift on the demand side too. We see no reason why this pattern should change, with China's re-engineering of its economy away from dependence on infrastructure spending likely to be a particularly important factor over the next decade. We assume that commodity prices will, over the current bear market (now about five years old), fall by the same amount and over the same number of years as the average of previous bear markets since the 19th century. This means they have 16% further to fall over 200 months, giving a return of -1% a year. 4. Currencies Most investors are unable or unwilling to fully hedge currency exposure over very long periods. So, a consideration of how returns from different countries' assets might be affected by relative currency movements over the next 10-15 years is an important element in calculating likely returns. Fortunately, for developed market currencies at least, there is a simple, and historically fairly reliable, way to make assumptions of currency movements: reversion to purchasing power parity. As shown in Chart 18, major currencies have fairly consistently reverted to their PPP over the long run. So we can forecast likely future currency movements as a combination of 1) how far away the currency is currently from PPP against the U.S. dollar, and 2) the likely change in the PPP over the period. The latter we calculate from the IMF's forecasts of relative consumer inflation between each country and the U.S. (the IMF makes this forecast only for the next five years, but we assume that the differential continues at the same rate after 2022). Table 11 shows that most major currencies are expected to rise against the U.S. dollar over the coming decade or so. Except for Australia, they are likely to have slightly lower inflation. And - again with the exception of Australia - they all look a little undervalued currently relative to the USD. Table 11Assumed Annual Change Versus U.S. Dollar Over Next 10-15 Years What Returns Can You Expect? What Returns Can You Expect? Unfortunately, this approach does not work for EM currencies. They have historically traded at a level consistently well below PPP. This is mainly because, while tradable goods prices tend to be driven by international prices movements and relative unit labor costs, local services prices (which cannot be arbitraged across borders) do not. Also, inflation in emerging markets has historically been much higher than in the U.S. (Chart 19), meaning that their PPP has shifted significantly lower over time. However, China's inflation is now not dissimilar to that of the U.S. (the IMF forecasts it will be only 50 basis points a year higher over the coming five years). And China has shown some tendency for the currency to move towards PPP - 20 years ago the RMB was 190% below PPP; now it is "only" 97% below. Chart 18Reversion To PPP Reversion To PPP Reversion To PPP Chart 19U.S. And Emerging Market Inflation U.S. And Emerging Market Inflation U.S. And Emerging Market Inflation We, therefore, take an alternative approach to estimating currency returns for EM economies. We run a regression analysis of the annual change in each country's exchange rate versus the U.S. dollar against its CPI inflation relative to the U.S. We find mostly acceptable r-squared scores (ranging from 57% for Turkey to 1% for Taiwan). For most countries, the intercept is positive (suggesting the currency is trending over time towards PPP) and the coefficient for CPI is, as expected, negative (Table 12). Table 12Calculations For EM Currency Moves What Returns Can You Expect? What Returns Can You Expect? A number of EM currencies, on this analysis, would be expected to depreciate against the U.S. dollar over coming years, including Indonesia, Mexico and Turkey. But, weighting the countries by their weights in the MSCI ACWI index, on average the EM universe would be expected to see a currency appreciation against the U.S. dollar of around 2% a year. This is largely due to the influence of China, which has a 29% weight in the EM index. This would be a much better result than the past 10 years when, for example, the Brazilian real has depreciated by 12% a year, the Indonesian rupiah by 16% and the Turkish lira by 37%. This could be because the IMF forecasts of future inflation (4.9% for India, 4.5% for Brazil and 4.1% for Russia), are too optimistic. They are certainly much better than these countries have achieved in the past 10 years (8.0% in India, 6.2% in Brazil, and 9.2% in Russia). Conclusion Arriving at assumptions for future returns is as much an art as a science. Our analysis is based principally on the concept that the future will be similar to long-term history (but not necessarily to the history of the past 30 years, which in many ways were abnormal for financial markets with, for example, a continuous decline in interest rates and inflation). Obviously, therefore, a very different macro environment over the next 10-15 years (for example, one in which inflation spiked, or secular stagnation deepened) would produce a very different results for economic growth and interest rates. However, it will be clear from our analysis that a great deal of the long-term return for equities and bonds is derived from the valuation at the start. Given that current valuations in almost all asset classes are expensive relative to history, this implies that future portfolio returns will be poor compared to recent, and long-term, history. Based on our return assumptions, a typical global portfolio (with 50% equities, 30% bonds, and 20% alternatives) will produce a nominal return of only 4.1% a year over the next decade or so, and a similar U.S. portfolio only 4.6%. This compares to 6.3% and 7.0% over the past 20 years. For pension funds which assume an 7.5% or 8% annual return (as many in the U.S. do), or individual investors planning their retirement on the basis of, say, a 5% annual real return, that outcome would come as a nasty shock. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 For the best summary of the evidence on this, please see A Practitioner's Guide To Asset Allocation, by William Kinlaw, Mark Kritzman and David Turkington, Wiley 2017. 2 Please see Credit Suisse Global Investment Returns Yearbook 2017 by Elroy Dimson, Paul Marsh and Mike Staunton, February 2017 3 BCA's Composite Valuation Indicator comprises, for the U.S.: market value of equities / non-financial gross value added adjusted for foreign revenues, trailing PE, Shiller PE, and price to sales. And for other regions: divided yield, market Cap/GDP, trailing PE, price to book, forward PE, price to cash flow, price to sales, and enterprise value/total assets. 4 Please see Global Asset Allocation Special Report, "Alternative Assets: More Important Than Ever", dated 11 March 2016, available at gaa.bcaresearch.com Appendix Correlation Matrix What Returns Can You Expect? What Returns Can You Expect?

Highlights Stay short the rand. The South African currency has broken down, and further downside is looming. The rand is cheap for a reason. A lack of import substitution has hampered the benefits of a depreciated currency for the economy. The trade balance will deteriorate as metals prices drop due to growth deceleration in China. Lingering political uncertainty, a poor structural backdrop and reliance on foreign portfolio flows that are at risk of reversal all argue for material downside in the rand's value from current levels. Dedicated EM equity and bond portfolios should continue to underweight South Africa. Feature The South African rand posted an impressive rally in 2016 and early 2017, despite the economy's technical recession (Chart I-1). Yet recently, the rand has started breaking down, despite domestic demand data showing modest improvement. We have argued in the past that lower commodities prices and rising U.S. interest rates along with a negative political backdrop and a weak economy would put downward pressure on the rand. However, domestic demand has recently ticked up, and according to our broad money (M3) impulse, domestic demand will likely continue to improve modestly in the next several months (Chart I-2) - barring the intensifying political headwinds hurting business and consumer sentiment. The M3 impulse is the second derivative of outstanding broad money M3. Chart I-1South Africa: ##br##Economy And Currency South Africa: Economy And Currency South Africa: Economy And Currency Chart I-2South Africa: Modest ##br##Upside In Domestic Demand South Africa: Modest Upside In Domestic Demand South Africa: Modest Upside In Domestic Demand Therefore, today we are posing the following question: Can South African risk assets sell off even as domestic demand continues to recover moderately? Our answer is yes. The basis is that the balance of payments (BoP) is set to deteriorate again. What Drives The Rand? The narrative that a high carry will support high-yielding EM currencies including the rand is misplaced. Chart I-3 illustrates that there has been no positive correlation between the rand's exchange rate and its short-term interest rate differential with those in the U.S. Notably, neither the level nor direction of interest rate differential correlates positively with the value of the rand. If anything, it is the exchange rate that drives interest rates in South Africa and in many high-yielding EM markets, not the other way around. The bottom panel of Chart I-3 demonstrates that the rand's appreciation typically leads to lower interest rates, and vice versa. While in the near term the rand could be under pressure from rising U.S. interest rate expectations and a U.S. dollar rebound, the currency's medium-term outlook will continue be shaped by commodities prices. Chart I-4 demonstrates that the rand's exchange rate is strongly correlated with industrial and precious metals prices. Chart I-3Rand Drives Interest ##br##Rates Not Other Way Around Rand Drives Interest Rates Not Other Way Around Rand Drives Interest Rates Not Other Way Around Chart I-4Rand Is Correlated ##br##With Metal Prices Rand Is Correlated With Metal Prices Rand Is Correlated With Metal Prices The fundamental basis for rand depreciation going forward is a worsening BoP: Industrial metals prices will drop as China's growth slows (Chart I-5). Meanwhile, a moderate pick-up in domestic demand will lead to rising imports and a deteriorating trade balance (Chart I-2, bottom panel on page 2). Precious metals prices will also be under pressure in the near term as U.S. interest rate expectations rise, supporting the U.S. dollar. In fact, the most reliable factor driving gold prices has historically been U.S. real (TIPS) yields (Chart I-6). Chart I-5China's Money/Credit Impulses ##br##Are Bearish For Industrial Metals bca.ems_sr_2017_11_15_s1_c5 bca.ems_sr_2017_11_15_s1_c5 Chart I-6Gold Is Driven By U.S. ##br##Real Rates (TIPS Yields) Gold Is Driven By U.S. Real Rates (TIPS Yields) Gold Is Driven By U.S. Real Rates (TIPS Yields) We expect the rand to depreciate considerably and make new lows against the euro and European currencies. This will contrast with what occurred in 2014-'15, when the rand's depreciation versus the euro and European currencies was much less pronounced than versus the dollar. Chart I-7Foreigners Are Record ##br##Long South African Bonds Foreigners Are Record Long South African Bonds Foreigners Are Record Long South African Bonds As the rand falls versus the majority of DM currencies, foreign investors will be prompted to reduce their holdings of South African local currency bonds and equities. Given foreigners own 42% of the country's local government bonds (Chart I-7, top panel), the bond market will sell off further, and outflows could be meaningful. Another angle to consider is whether a revival in domestic demand would be enough to offset the above negatives and attract enough foreign capital to finance the BoP. In our opinion, not this time around. First, any domestic demand recovery in South Africa will be muted. Given lingering political uncertainty, upside in business spending and job creation will remain subdued. Notably, risks are skewed to the downside for domestic demand due to lingering political uncertainty. Second, in 2016 the rand rallied considerably, even as domestic demand was falling. During 2016 and early 2017, the rand was supported by external forces such as rising metals prices and capital flows to EM. In turn, weakening domestic demand induced an imports contraction, helping the trade balance. Presently, all of these factors are reversing. Finally, portfolio flows have been much more important than FDIs for South Africa in recent years (Chart I-8). This implies that as portfolio flows dry up, FDIs will not finance the BoP. Bottom Line: South Africa's BoP dynamics are set to deteriorate markedly, leading to a major currency downleg. Is The Rand Cheap? A Look At Import Substitution Our valuation measures show that the rand is one standard deviation cheap (Chart I-9). Chart I-8South Africa: FDI Versus Portfolio Flows South Africa: FDI Versus Portfolio Flows South Africa: FDI Versus Portfolio Flows Chart I-9The Rand's Valuation Profile The Rand's Valuation Profile The Rand's Valuation Profile However, we believe it is "cheap for a reason." Structural forces have been and remain currency bearish. Chart I-10No Import Substitution In South Africa No Import Substitution In South Africa No Import Substitution In South Africa A cheap currency leads to import substitution - i.e., domestic producers become more competitive than foreign ones, and they replace imports with locally produced goods. This in turn improves the trade balance and boosts domestic jobs and income. Stronger output growth and higher return on capital allow the economy to withstand higher interest rates. Rising return on capital and interest rates attract foreign capital (both portfolio inflows and FDI), leading to currency appreciation. In South Africa, the inherent problem is that despite substantial weakness in the currency since 2011, there has been very little import substitution. This is true across the most basic types of goods that do not require sophisticated production methods such as footwear, plastic, rubber products and textiles (Chart I-10). Astonishingly, this has continued to hold true even after the collapse of the rand in 2015 to two-standard-deviations below its fair value. Given import substitution has not materialized, economic growth has not benefited much from a depreciated currency, and all the usual drivers that typically mark a bottom in the exchange rate and jump-start sustainable currency appreciation are thus still lacking. Hence, the rand will have to stay cheap. Interestingly, in the absence of a shift from foreign to locally produced goods, a recovery in domestic demand will boost imports, benefiting foreign producers relative to local ones - i.e., "leaking" growth to the rest of the world. Bottom Line: An ongoing lack of import substitution in South Africa has been due to lingering structural malaise. Therefore, the rand will have to stay structurally cheap. Productivity Demise It is not surprising that import substitution has been non-existent, given the demise of productivity within the South African economy. When assessing competitiveness, it is essential to analyze a country's unit labor costs in U.S. dollar terms. South African unit labor costs in U.S. dollar terms have risen by 50% in the manufacturing sector, and by 160% in the overall economy since 2000 (Chart I-11). Chart I-11Comparative Unit Labor Costs In US$: ##br##South Africa & U.S. Comparative Unit Labor Costs In US$: South Africa & U.S. Comparative Unit Labor Costs In US$: South Africa & U.S. For comparison, in the U.S., overall non-farm unit labor costs in U.S. dollars have risen by 20% since 2000, and have been more or less flat in the manufacturing sector. In brief, in the past 17 years, unit labor costs in U.S. dollar in South Africa have risen substantially more than in the U.S. There are also other ramifications of lingering productivity malaise: First, in South Africa, fiscal and monetary stimuli typically widen the current account deficit more than in countries where manufacturing is able to compete with global manufacturers. Second, inflation dynamics in South Africa are even more sensitive to exchange rate movements. A large share of imports for domestic consumption ensures that South African inflation remains correlated with the exchange rate rather than with the domestic business cycle. Third, for monetary policy, the South African Reserve Bank (SARB) has been forced to pursue more pro-cyclical monetary policy - raising rates when metals prices drop and the rand depreciates. Higher interest rates amid a negative terms-of-trade shock - i.e. falling metals prices - has historically reinforced boom-bust cycles in the South African economy and created less visibility for domestic investments, further hindering long-term growth. That said, there are presently low odds that the SARB will hike rates materially, even if the rand drops substantially. The monetary authorities did not significantly cut rates amid the rand's rally in 2016-'17. Hence, odds of rate hikes are low, which heralds yield curve steepening. Bottom Line: Poor productivity has been and remains a major constraint on South African growth and a major drag on the currency. An Update On Politics The December African National Congress (ANC) presidential election is around the corner, and it is worth asking if any positive outcome for the economy and markets may emerge. We do not expect so. At this point, there are two scenarios to consider. The first is that current Deputy President Cyril Ramaphosa wins. Given his recent strong performance in key swing provinces and lack of competition from Nkosazana Dlamini-Zuma, Ramaphosa has decent chances of winning the ANC presidency. However, as our colleagues from the Geopolitical Strategy service argued, the structural reality is that the median voter in South Africa is not in a position to support a pro-market reformer willing to pursue painful structural reforms.1 In a system where policymakers are price takers in the political marketplace and not price makers, even if Ramaphosa wins, he is unlikely to address the majority of South Africa's lingering structural issues in a meaningful way. Furthermore, the rising popularity of the left-wing radical Economic Free Fighters, led by ex-Youth League Leader Julius Malema, will also be a constraint on Ramaphosa in terms of enacting supply side reforms. The second scenario is that Ramaphosa does not win, in which case he and his supporters could split from the ANC and perhaps form a new party with the Democratic Alliance (DA). It is hard to tell at the moment what this scenario would entail for the general elections in 2019. Historically, given the ANC's stronghold on the country's politics, the winner of the ANC Congress has moved on to become President of South Africa. However in the event of an ANC split, some revaluation of the political landscape would be required. Regardless of who wins the elections in 2019, a general lack of appetite for structural and painful reforms point to fiscal policy remaining lax - and being used to boost growth (Chart I-12). At 51% of GDP, the public debt burden is not yet at alarming levels. In the meantime, easy or easing fiscal stance will continue to put downward pressure on the rand. Bottom Line: Odds of structural reforms are low, regardless of who wins the December elections. Fiscal policy will remain easy, and public debt will continue to rise. This is a bad omen for the currency. Investment Recommendations We continue to recommend the following strategy: Continue shorting the ZAR versus the USD. The rand has broken down from a key resistance level, and has much more downside (Chart I-13). Chart I-12South Africa: Fiscal Deficit Is Wide South Africa: Fiscal Deficit Is Wide South Africa: Fiscal Deficit Is Wide Chart I-13The Rand: A Breakdown The Rand: A Breakdown The Rand: A Breakdown Underweight South African domestic bonds and sovereign credit relative to their EM benchmarks. Sovereign spreads have hit a strong technical resistance and are starting to bounce off (Chart I-14). Continue betting on yield-curve steepening. A lack of economic vigor will keep the SARB on hold for now, yet the country's populist fiscal stance and withdrawals by foreigners from the bond market will push up long-dated bond yields. For EM local fixed-income portfolios, we maintain the following trade: short South African and Turkish 5-year bonds / long Polish and Hungarian ones. Lastly, a few words on the stock market: Our cyclically-adjusted P/E ratio for the MSCI South Africa equity index suggests that this bourse is one standard deviation expensive (Chart I-15, top panel). Chart I-14South Africa: Sovereign Spreads ##br##To Move Above EM Benchmark South Africa: Sovereign Spreads To Move Above EM Benchmark South Africa: Sovereign Spreads To Move Above EM Benchmark Chart I-15South African Equites: ##br##Valuation & Technicals South African Equites: Valuation & Technicals South African Equites: Valuation & Technicals Interestingly, the relative performance of this bourse versus the EM benchmark might be on a precipice of a major breakdown (Chart I-15, bottom panel). Continue underweighting South African stocks. Chart I-16Banks To Outperform As Yield Curve Steepens Banks To Outperform As Yield Curve Steepens Banks To Outperform As Yield Curve Steepens As to sectors, we recommend an overweight position in banks and materials. A steepening yield curve typically benefits bank stocks (Chart I-16), while materials will in turn benefit from a depreciating currency. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please refer to BCA Geopolitical Strategy Special Report titled, "South Africa: Crisis Of Expectations," dated June 28, 2017, link available at gps.bcaresearch.com

Highlights There are a number of cracks emerging in global risk assets. Not only have U.S. junk bond prices recently posted sharp declines, but a number of economic and financial market developments within EM also warrant investors' close attention. In particular: Feature The EM manufacturing PMI has rolled over at relatively low levels, despite continued strength in advanced economies' manufacturing PMI (Chart 1). Importantly, the trend in relative manufacturing PMIs heralds EM equity underperformance against DM bourses (Chart 2). Chart 1EM Manufacturing: Rolling Over EM Manufacturing: Rolling Over EM Manufacturing: Rolling Over Chart 2EM Stocks To Underperform DM Stocks EM Stocks To Underperform DM Stocks EM Stocks To Underperform DM Stocks The Shanghai Container Freight Index has relapsed in recent months. This index has been a good indicator for EM/Asian export volumes (Chart 3, top panel). That said, DRAM semiconductor prices continue to surge (Chart 3, bottom panel). DRAM prices have jumped five-fold in less than two years, justifying the massive rally in semiconductors' stock prices. It is hard to know how long and how far the ascent in DRAM prices will continue. Nevertheless, our hunch is that non-technology exports in Asia will slow down, regardless of what happens in the global technology sector. Consistently, we expect EM non-technology stocks to relapse sooner than later, even as tech stocks remain a wild card. Global and EM tech stocks rallied exponentially and appear to be in a mania phase that could make any reasonable assessment and investment strategy off-mark. Weighing the pros and cons, we continue to recommend overweighting the tech sector within the EM universe, even as the outlook for their absolute performance remains highly uncertain. Within EM tech, we favor semi stocks (Samsung and TSMC) versus internet and social media stocks. The sheer magnitude of the EM equity rally has been driven by a few names such as Tencent, Alibaba, Baidu, Samsung and TSMC. Their combined market cap as a share of the overall MSCI EM equity index has risen to 19%. Remarkably, the equal-weighted MSCI EM stock index has massively underperformed the market cap-weighted MSCI EM equity index (Chart 4, top panel). In contrast, the same measure for DM equities has held up much better (Chart 4, bottom panel). Chart 3Asian/EM Exports At Risk Asian/EM Exports At Risk Asian/EM Exports At Risk Chart 4A Perspective On Internal Equity Dynamics: EM And DM A Perspective On Internal Equity Dynamics: EM And DM A Perspective On Internal Equity Dynamics: EM And DM EM stock prices have been firm so far despite the rebound in the broad trade-weighted U.S. dollar (Chart 5). As the greenback continues to advance, odds are that EM share prices will dive, as occurred in 2014 and 2015. In China, the effects of triple tightening - the liquidity squeeze by the central bank, the regulatory clampdown on banks and shadow banking by the Banking Regulatory Commission, and the anti-corruption drive that is targeting the financial industry - are gaining momentum. Onshore corporate bond yields and credit spreads over government bonds have risen further since the end of the most recent Party Congress. One of the reasons why policymakers are tightening is to rein in the enormous excesses prevalent in the credit, money and property markets that have developed in recent years. Given that advanced economies have now recovered, the Chinese authorities feel more confident to tighten domestically. Finally, while less recognized by the investment community, inflationary pressures have been rising in China. Although still at 2.25%, core consumer price inflation is clearly trending up, warranting a policy response (Chart 6, top panel). This is especially true given that real deposit rates - deflated by core consumer price inflation - have plummeted into negative territory (Chart 6, bottom panel). Chart 5U.S. Dollar Rebound = EM Pullback U.S. Dollar Rebound = EM Pullback U.S. Dollar Rebound = EM Pullback Chart 6China: Beware Of Rising Inflation China: Beware Of Rising Inflation China: Beware Of Rising Inflation Consistent with tightening, China's official broad money growth has decelerated to an all-time low (Chart 7, top panel). In the meantime, narrow money (M1) growth is falling rapidly. Remarkably, M1 growth has been correlated with Chinese H-share prices (Chart 7, bottom panel). We have extensively documented in past reports1 that China's money and credit impulses are good leading indicators of the mainland's business cycle. The current readings of these indicators signal considerable growth deceleration. In addition, general (central and local) government spending growth has already slowed a lot (Chart 8). Chart 7China: Broad Money Growth Is At Record Low China: Broad Money Growth Is At Record Low China: Broad Money Growth Is At Record Low Chart 8China: Aggregate Fiscal Spending Growth Is Also Weak China: Aggregate Fiscal Spending Growth Is Also Weak China: Aggregate Fiscal Spending Growth Is Also Weak The fundamentally weakest EM currencies such as the South African rand and the Turkish lira have already broken down. Some others have so far been only marginally weak. A chain, however, typically cracks at its weakest link. Hence, it makes sense that the selloff has begun with the fundamentally weakest currencies. We expect other EM currencies to follow. Currency depreciation in EM will undermine returns for foreign investors, and the latter will become marginal sellers in both EM equity markets and local currency bonds. Meanwhile, EM currency depreciation and potentially falling commodities prices will trigger credit spread widening in EM sovereign and corporate bonds. Investment Positioning Global equity portfolios should continue underweighting EM versus DM. The risk-reward profile for EM stocks' absolute performance is extremely unfavorable. We continue to recommend underweighting EM credit markets relative to U.S. investment grade bonds. Our strongest conviction shorts are a basket of the following currencies: ZAR, TRY, BRL, IDR and MYR. We are also shorting the COP and CLP. For traders who prefer a market neutral currency portfolio, our recommended longs are TWD, THB, SGD, ARS, RUB, PLN and CZK. INR and CNH will also outperform other EM currencies. Unlike in 2014-2015, EM currencies will depreciate not only versus the U.S. dollar but also the euro. This will erode EM returns for European investors, and temporarily halt or reverse capital inflows into EM. Among local currency bond markets, the most vulnerable are Turkey, South Africa, Indonesia and Malaysia. The least vulnerable are Korea, Russia, India, Argentina2 and Central Europe. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report, titled "Questions From The Road", dated September 20, 2017. 2 Please refer to the Emerging Markets Strategy Special Report, titled "Argentina: A Genuine Bull Market", dated October 25, 2017. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Dear Client, Instead of our Weekly Report, we are sending you this Special Report written by my colleague Marko Papic, BCA's Chief Geopolitical Strategist. Marko argues that while there is considerable risk that NAFTA is abrogated, the Trump administration would quickly move to alleviate the effects to trade flows. The risk to our view is that President Trump is a genuine populist, a view that his actions thus far do not support. I hope you will find this report both interesting and informative. Best regards, Peter Berezin, Chief Strategist Global Investment Strategy Highlights NAFTA is truly at risk - as currency markets suggest; NAFTA's impact on the U.S. economy is positive but marginal; The key question is whether Trump is a true populist or a "pluto-populist"; If the former, then NAFTA's failure is likely and portends worse to come; NAFTA's collapse would be bearish MXN, bearish U.S. carmakers versus DM peers, and supportive of higher inflation in the U.S. Feature Fifty years ago at the end of World War II, an unchallenged America was protected by the oceans and by our technological superiority and, very frankly, by the economic devastation of the people who could otherwise have been our competitors. We chose then to try to help rebuild our former enemies and to create a world of free trade supported by institutions which would facilitate it ... Make no mistake about it, our decision at the end of World War II to create a system of global, expanded, freer trade, and the supporting institutions, played a major role in creating the prosperity of the American middle class. - President Bill Clinton, Remarks at the Signing Ceremony for the Supplemental Agreements to the North American Free Trade Agreement, September 14, 1993 No Free Trade Agreement (FTA) has been more widely maligned than the North American Free Trade Agreement (NAFTA). It is, after all, the world's preeminent FTA. Signed in December 1992 by President George H. W. Bush and implemented in January 1994, it preceded the founding agreements of the World Trade Organization (WTO) and launched a two-decade, global expansion of FTAs (Chart 1). By including environmental and labor standards, as well as dispute settlement mechanisms, it created a high standard for all subsequent FTAs. President Trump's presidency began with much fear that his populist preferences would imperil globalization and trade deals such as NAFTA. Other than his withdrawal from the Trans-Pacific Partnership deal, much of the concern has been proven to be misplaced - including our own.1 Even Sino-American trade tensions have eased, with President Trump and President Xi Jinping enjoying a good working relationship so far. So should investors relax and throw caution to the wind? Chart 1NAFTA: Tailwind To Globalization NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism Chart 2U.S. Economy: Largely Unaffected By NAFTA U.S. Economy: Largely Unaffected By NAFTA U.S. Economy: Largely Unaffected By NAFTA In this report, we argue that the answer is a resounding no. The White House rhetoric on NAFTA - a trade deal that has been mildly positive for the U.S. economy and, at worst, neutral for its workers - suggests that greater trade conflicts loom, not only within NAFTA but also with China and others. Furthermore, a rejection of NAFTA would be a symbolic blow to free trade at least as consequential as the concrete ramifications of nixing the deal itself. The deal with Mexico and Canada is not as significant to the U.S. economy as its proponents suggest (Chart 2), but by mathematical logic its detractors therefore overstate its negatives. The opposition to NAFTA by the Trump administration therefore reveals preferences that would become far more investment-relevant if applied to major global economies like China. If NAFTA negotiations are merely a ploy to play to the populist base, however, then the impact of its demise will be temporary and muted. At this time, however, it is unclear which preference is driving the Trump White House strategy and thus risks are to the downside. The Decaying Context Behind NAFTA The North American Free Trade Agreement is more than a trade deal: it is the symbolic beginning of late twentieth-century globalization. According to our trade globalization proxy, this period has experienced the fastest pace of globalization since the nineteenth century (Chart 3). Both NAFTA and the WTO enshrined new rules and standards for global trade upon which trade and financial globalization are based. Underpinning this surge in globalization was the apex of American geopolitical power and the collapse of the socialist alternative, the Soviet Union. As President Clinton's remarks from 1993 suggest (quoted at the beginning of the report), NAFTA was the culmination of a "creation myth" for an American Empire. The myth narrates how the geopolitical and economic decisions made by the U.S. in the aftermath of its victory in World War II laid a foundation for both American prosperity and a new global order. With the ruins of Communism still smoldering in the early 1990s, the U.S. decided to double-down on those same, globalist impulses. Today those impulses are waning if not completely dead. As we argued in our 2014 report, "The Apex Of Globalization - All Downhill From Here," three trends have conspired to turn the tides against globalization:2 Chart 3Globalization Has Peaked Globalization Has Peaked Globalization Has Peaked Chart 4Globalization And Its Indebted Discontents Globalization And Its Indebted Discontents Globalization And Its Indebted Discontents Multipolarity - Every period of intense globalization has rested on strong pillars of geopolitical "hegemony," i.e. the existence of a single world leader. Chart 3 shows that the most recent such eras consisted of British and American hegemony, respectively. However, the relative decline of American geopolitical power has imperiled this process, as rising powers look to carve out regional spheres of influence that are by definition incompatible with a globalized political and economic framework. In parallel, the hegemon itself - the U.S. - has begun to vacillate over whether the framework it designed is still beneficial to it, given its declining say in how the global system operates. Great Recession - The 2008 global financial crisis cracked the ideological, macroeconomic, and policy foundations of globalization. Deflation - Globalization is deflationary, which works swimmingly when real household incomes are rising and debts falling. Unfortunately, neither of those has been the case for American households over the past forty years (Chart 4). This is in large part the consequence of globalization, which opened trade with emerging markets and thus suppressed low-income wage growth in developed economies. What is striking about the U.S. is that its social safety net has done such a poor job redistributing the gains of free trade, at least compared to its OECD peers (Chart 5). Chart 5The "Great Gatsby" Curve NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism Chart 6America Belongs To The Anti-Globalization Bloc NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism President Donald Trump shrewdly understood that the tide had turned against free trade in the U.S. (Chart 6). Ahead of the 2016 election, no one (except BCA!) seriously believed that trade and globalization would become the fulcrum of the election.3 Candidate Trump, however, returned to it repeatedly, and singled out NAFTA as "the worst trade deal maybe ever signed anywhere."4 Bottom Line: President Trump's opposition to globalization did not fall from the sky. Trump is the product of his time and geopolitical and macroeconomic context. Trends we identified in 2014 are today headwinds to globalization. Myths About NAFTA The geopolitical and macroeconomic context may be dire for globalization, but does NAFTA actually fit that narrative? The short answer is no. The long answer is that there are three myths about NAFTA that the Trump administration continues to propagate. We assume that U.S. policymakers can do simple math. As such, their ignorance of the below data suggests a broad strategy toward free trade that is based in ideology, not factual reality. Alternatively, flogging NAFTA may be motivated by narrower, domestic, political concerns and may not be indicative of a deeply held worldview. Time will tell which is true. Myth #1: NAFTA Has Widened The U.S. Trade Deficit NAFTA has resulted in a huge trade deficit for the United States and has cost us tens of thousands of manufacturing jobs. The agreement has become very lopsided and needs to be rebalanced. We of course have a five-hundred-billion-dollar trade deficit. So, for us, trade deficits do matter. And we intend to reduce them. - Robert Lighthizer, U.S. trade representative, October 17, 2017 Chart 7Long-Term Trade Deficit Is About Commodities Long-Term Trade Deficit Is About Commodities Long-Term Trade Deficit Is About Commodities When it comes to the U.S. trade deficit, NAFTA has had a negligible impact. Three facts stand out: The U.S. has an insignificant trade deficit with Canada - 0.06% of GDP in 2016, or $12 billion. It has a larger one with Mexico - 0.33% of GDP, or $63 billion. However, when broken down by sectors, the deepest trade deficit has been in energy. The U.S. has actually run a surplus in manufactured products with Mexico and Canada for much of the post-2008 era, which only recently dipped back into deficit (Chart 7). The U.S. has consistently run a trade deficit with the rest of the world since 1980, but the size of its trade deficit with Mexico and Canada did not significantly increase as a share of GDP post-implementation of NAFTA. The real game changer has been the widening of the trade deficit with China and the rest of the EM economies outside of China and Mexico (Chart 8). The trade relationship with Mexico and Canada, relative to that with the rest of the world, therefore remains stable. The net energy trade balance with Mexico and Canada has significantly improved due to surging U.S. shale production (Chart 9). Rising shale production has accomplished this both by lowering the need for imports from NAFTA peers, surging refined product exports to Mexico, and by inducing lower global energy prices. In addition, Canada-U.S. energy trade is governed by NAFTA's Chapter 6 rules, which prohibit the Canadian government from intervention in the normal operation of North American energy markets.5 Chart 8U.S. Trade Imbalance Is Not About NAFTA NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism Chart 9Shale Revolution Is A Game Changer Shale Revolution Is A Game Changer Shale Revolution Is A Game Changer Myth #2: NAFTA Has Destroyed The U.S. Auto Industry Before NAFTA went into effect ... there were 280,000 autoworkers in Michigan. Today that number is roughly 165,000 - and would have been heading down big-league if I didn't get elected. - Donald Trump, U.S. President, March 15, 2017 Chart 10NAFTA Has Made U.S. Auto Manufacturing More Competitive NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism What about the charge that NAFTA has negatively impacted the U.S. automotive industry by shipping jobs to Mexican and, to lesser extent, Canadian factories? Again, this reasoning is flawed. In fact, NAFTA appears to have allowed the U.S. automotive industry to remain highly competitive on a global scale, more so than its Mexican and Canadian peers. U.S. exports outside of NAFTA as a percent of total exports have surged since the early 2000s and have remained buoyant recently. Meanwhile, Mexican exports to the rest of the world have fallen, suggesting that Mexico is highly reliant on servicing Detroit (Chart 10). The truth is that the American automotive industry's share of overall manufacturing activity has risen since 2008. In part, this is because American manufacturers have been able to integrate with Canadian and Mexican plants, allowing production to remain on the continent and move seamlessly across the value chain. In other words, Mexico serves as a low-wage outlet for the least-skilled part of the production chain, allowing the rest of the manufacturing process to remain in the U.S. and Canada. Without that cheap "escape valve," the entire production chain might have migrated to EM Asia. Or, worse, the American automotive industry would have become uncompetitive relative to European and Japanese peers. Either way, the U.S. would have potentially faced greater job losses were it not for easier access to Mexican auto production. Both European and Japanese manufacturers have similar low-skilled, low-cost, "labor escape valves" in the region. For Germany and France, this escape valve is in Spain and Central and Eastern Europe; for Japan, it is in Thailand. Myth #3: Mexico And Canada Cannot Retaliate Against The U.S. As far as I can tell, there is not a world oversupply of agricultural products. Unless countries are going to be prepared to have their people go hungry or change their diets, I think it's more of a threat to try to frighten the agricultural community. - Wilbur Ross, Commerce Secretary, October 11, 2017 Chart 11Mexico's Growing Population Is A Potential Market NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism U.S. exports to Canada and Mexico only account for about 2.6% of GDP, whereas exports to the U.S. from Mexico and Canada account for 28% and 18% of GDP respectively. Nonetheless, this does not mean that the U.S. suffers from NAFTA. As we discussed above, NAFTA has been a boon for the global competitiveness of the U.S. automotive industry. In addition, NAFTA gives American and Canadian exporters access to a large and growing Mexican middle class (Chart 11). Furthermore, the U.S. would gain little benefit from leaving NAFTA vis-à-vis Canada and Mexico. By reverting back to WTO tariff levels, the U.S. would be able to raise tariffs from 0% (under NAFTA) to the maximum of 3.4%, where the U.S. average "bound tariff" would remain. Bound tariffs differ across products and countries and represent the maximum rate of tariffs under WTO rules (i.e., without violating those rules). They are indicative of a hostile trade relationship, as trade would otherwise be set at much lower "most favored nation" tariff levels. As Table 1 shows, however, Canada and particularly Mexico have the ability to raise their bound tariffs considerably higher than the U.S. can do. Mexico, in fact, has one of the highest average bound tariff rates for an OECD member state, at a whopping 36.2%! This means that, if NAFTA were to be abrogated, the U.S. would be allowed to raise tariffs, on average, to 3.4%, whereas Mexico would be free to do so by ten times more. Given that Mexico is America's main export destination for steel and corn output, the retaliation would be non-negligible for these two politically powerful sectors. This aspect of the WTO agreement is a latent geopolitical risk, as it feeds into the Trump administration's broader antagonism toward the WTO itself. Table 1WTO Tariff Schedule NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism Despite the hard evidence, we suspect that the Trump administration is driven by ideological and strategic goals and therefore the probability of a calamitous end to the ongoing NAFTA negotiations is high. Nevertheless, the data shows: The North American Free Trade Agreement has allowed trade between its member states to accelerate at a faster pace than global trade for much of the first decade after its signing and at the average global pace over the past decade (Chart 12); U.S. manufacturing employment as a percent of total labor force has been declining for much of the past half-century, with absolute numbers falling off a cliff as China joined the WTO and, along with EM Asia, became integrated into the global supply chain (Chart 13); Employment in auto-manufacturing follows the same pattern as overall manufacturing employment (Chart 13, bottom panel), suggesting that it was not NAFTA that caused job flight but rather competition from the rest of the world along with automation. In fact, auto-manufacturing employment has recovered post-2008, as American car manufacturers underwent structural reforms to improve competitiveness. Chart 12NAFTA Trade Has Beaten Global Trade NAFTA Trade Has Beaten Global Trade NAFTA Trade Has Beaten Global Trade Chart 13Who Hurt U.S. Manufacturing Employment: China Or NAFTA? Who Hurt U.S. Manufacturing Employment: China Or NAFTA? Who Hurt U.S. Manufacturing Employment: China Or NAFTA? As with any free trade agreement, some wages in some sectors may have been lowered by NAFTA's implementation and some jobs were definitely lost due to the agreement. However, the vast majority of academic studies point out that the negative labor market impacts of NAFTA have been negligible. The most authoritative work on the subject, by economists Gary Clyde Hufbauer and Jeffrey J. Schott of the Peterson Institute for International Economics, found that the upper-bound of NAFTA-related job losses in the U.S. is 1.9 million over the first decade of the agreement. Given that U.S. employment rose by 34 million over the same period, the job losses represent "a fraction of one percent of jobs 'lost' through turnover in the dynamic U.S. economy over a decade."6 A June 2016 report by the U.S. International Trade Commission (USITC) provides a good review of academic studies on the trade deal since 2002. Overall, it concludes that NAFTA led "to a substantial increase in trade volumes for all three countries; a small increase in U.S. welfare [overall economic benefit]; and little to no change in U.S. aggregate employment."7 In addition, NAFTA had "essentially no effect on real wages in the United States of either skilled or unskilled workers." This academic work could, of course, be the product of a vast conspiracy by globalist, neo-liberal academics financed by the deep state and its corporate overlords. However, the other side of the debate has little to offer as a counter to the empirical evidence. For example, U.S. Trade Representative Robert Lighthizer, a notable trade hawk, posited that the U.S. government had "certified" that 700,000 Americans had lost their jobs owing to NAFTA. This would represent 30,000 job losses per year over the 24 years of NAFTA's existence. Lighthizer also did not say whether he was speaking in net or gross terms, probably because it is practically impossible to competently answer that question! If that is the best retort to the academic research, there is then no real counter to the conclusion that NAFTA has had a mildly positive effect on the U.S. economy and labor market. Bottom Line: NAFTA has had some positive effects on the U.S. automotive sector, allowing it to integrate the low-cost Mexican labor into its production chain and thus remain competitive vis-à-vis Asian and European manufacturers. It also holds the promise of future export gains to Mexico's growing middle class. Its overall effects on the U.S. budget deficit, wages, and employment are largely overstated. If the impact of NAFTA has largely been marginal to the U.S. economy outside of a select few sectors, why is the Trump administration so dead-set on renegotiating it? And why has the process been so acrimonious? What Does The Trump White House Want? Frankly, I am surprised and disappointed by the resistance to change from our negotiating partners ... As difficult as this has been, we have seen no indication that our partners are willing to make any changes that will result in a rebalancing and reduction in these huge trade deficits. - Robert Lighthizer, U.S. trade representative, October 17, 2017 Chart 14NAFTA Negotiations Are FX-Relevant NAFTA Negotiations Are FX-Relevant NAFTA Negotiations Are FX-Relevant Robert Lighthizer, the U.S. trade representative, closed the fourth round of negotiations with a bang, implying that Canada and Mexico would have to help the U.S. close its $500 billion trade deficit, even though the U.S. trade deficit with its two NAFTA partners is only 15% of the total. The Canadian dollar and the Mexican peso fell by 1.2% and 1.9%, respectively, in the subsequent week of trading. In fact, both the CAD and MXN have faced extended losses since the third round of NAFTA negotiations ended on September 27 (Chart 14). Is the market overreacting? We do not think so. First, the list of demands presented by the White House are quite harsh, with the first two below considered deal-breakers: Dispute Settlement: The White House wants to end the investor-state dispute settlement (ISDS) mechanism (under Chapter 11), which allows corporations to sue governments for breach of obligations under the treaty.8 More importantly, the U.S. also wants to eliminate trade dispute panels (under Chapter 19), which allow NAFTA countries to protest anti-dumping and countervailing duties. The real issue is that Chapter 19 trade dispute panels have acted as a constraint on the U.S. administration in imposing antidumping and countervailing duties in the past. Sunset clause: The White House has also proposed that NAFTA automatically expire unless it is approved by all three countries every five years. Buy American: The White House wants its "Buy American" rules in government procurement to be part of the new NAFTA deal, and yet for Canadian and Mexican government contracts to remain open to U.S. businesses. Rules of origin: The White House has called for an increase in NAFTA's regional automotive content requirement from the current 62.5% to 85%, including that 50% of the value of all NAFTA-produced cars, trucks, and large engines come from the U.S.9 Second, the U.S. Commerce Department - headed by trade hawk Wilbur Ross - has signaled that it is open to aggressively pursuing trade disputes on behalf of American companies. Since President Trump's inauguration, U.S. policy interventions have on balance harmed the commercial interests of its G20 trade partners by higher frequency than during the last three years of Barack Obama's presidency (Chart 15).1 0Specific to NAFTA partners, the Commerce Department has slapped a 20% tariff on Canadian softwood lumber in April and a 300% tariff on Bombardier C-Series in October. When combined with the demand to end trade dispute panels under NAFTA's Chapter 19 - which would resolve such trade disputes - the pickup in activity by the Commerce Department is a clear signal that the new U.S. administration intends to break the spirit of NAFTA whether the agreement remains in place or not. Chart 15Trump: Game Changer In U.S. Trade Policy NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism Third, and more broadly speaking, the Trump administration is playing a "two-level game."11 Two-level game theory posits that domestic politics creates acceptable "win-sets," which are then transported to the geopolitical theatre. Politicians cannot conclude foreign agreements that are outside of those domestic win-sets. For President Trump, his win-set on NAFTA negotiations is set by a domestic coalition that allowed him to win the election. This includes voters in the Midwest states of Wisconsin, Michigan, and Pennsylvania where Trump outperformed polls by 10%, 3%, and 3% respectively (Chart 16), and where Secretary Hillary Clinton garnered less votes in 2016 than President Barack Obama in 2012 (Chart 17). Trump promised this blue-collar base a respite from globalization and he has to deliver it if he intends to win in four years' time. Chart 16Trump Owes The Midwest Trump Owes The Midwest Trump Owes The Midwest Chart 17Hillary Lost Rust Belt Voters NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism At the same time, Trump's domestic policy has thus far fallen far short of other campaign promises. First, there has been no movement on immigration or the promised border wall. Second, the Obamacare repeal and replace effort has failed in Congress. Third, proposed tax cuts are likely to benefit the country's elites, as previous tax reform efforts have tended to do. As such, we fear that the Trump White House may double down on playing hardball with NAFTA in order to fulfill at least one of its promised strategies. But why single out NAFTA if its impact on U.S. jobs and wages is miniscule compared to, for example, the U.S.-China trade relationship?12 There are two ways to answer this question: Pluto-populist scenario: President Trump is in fact a pluto-populist and not a genuine populist, i.e. he is not committed to economic nationalism.13 As such, he does not intend to fulfill any of the demands he has promised to his voters, as the current corporate and household tax cuts suggest. Given NAFTA's limited impact on the U.S. economy, abrogating that deal would have far less detrimental impact than if President Trump went after other trade relationships. As such, the NAFTA deal will either be renegotiated, or, at worst, abrogated and quickly replaced with bilateral deals with both Canada and Mexico. It is a "cheap" and "safe" way to satisfy voter demands without actually hurting business or the economy. Genuinely populist scenario: President Trump is a genuine populist and NAFTA renegotiations are setting the stage for a 2018 in which trade protectionism becomes a genuine, global market risk. Bottom Line: President Trump's negotiation stance on NAFTA is non-diagnostic. We cannot establish with any certainty whether his demands mark the start of a broader, global, protectionist trend, or whether he is merely bullying two trade partners who will ultimately have to kowtow to U.S. demands. Nonetheless, we agree with the market's pricing of a higher probability that NAFTA is abrogated, as witnessed by the currency markets. In both of our political scenarios, NAFTA's fate is uncertain. If Trump is a pluto-populist, NAFTA is an easy target and its abrogation will score domestic political points with limited economic impact. If he is a genuine economic nationalist, failed NAFTA renegotiations are the first step on the path to clashing with the WTO and rewriting global trade rules. Investment And Geopolitical Implications Can President Trump withdraw from NAFTA unilaterally? The short answer is yes. As Table 2 illustrates, Congress has passed several laws that delegate authority to the executive branch to administer and enforce trade agreements and to exercise prerogative amid exigencies.14 Article 2205 of NAFTA states that any party to the treaty can withdraw within six months after providing notice of withdrawal. We see no evidence in U.S. law that the president has to gain congressional approval of such withdrawal. Table 2Trump Faces Few Constraints On Trade NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism Moreover, the past century has produced a series of laws that give President Trump considerable latitude - not only the right to impose a 15% tariff for up to 150 days, as in the Trade Act of 1974, but also unrestricted tariff and import quota powers during wartime or national emergencies, as in the Trading With The Enemy Act of 1917.15 The White House has already signaled that it considers budget deficits a "national security issue," which suggests that the White House is preparing for a significant tariff move in the future.16 Could President Trump's moves be challenged by Congress or the courts? Absolutely. However, time is on the executive's side. Even assuming that Congress or the Supreme Court oppose the executive, it will likely be too late to avoid serious ramifications and retaliations from abroad. Other countries will not wait on the U.S. system to auto-correct. Congress is unlikely to vote to overrule the president until the damage has already been done - especially given Trump's powers delegated from Congress. As for the courts, the executive could swamp them with justifications for its actions; the courts would have to deem the executive likely to lose every single one of these cases in order to issue a preliminary injunction against each of them and halt the president's orders. Any final Supreme Court ruling would take at least a year. International law would be neither speedy nor binding. What are the investment implications of a NAFTA collapse? Short term: Short MXN; short North American automotive sector relative to European/Asian peers. We would expect more downside risk to MXN from a collapse in NAFTA talks, similar in magnitude to the decline of the GBP after the Brexit vote. The Mexican central bank would likely take on a dovish stance towards monetary policy, creating a negative feedback loop for the peso. The automotive sectors across the three economies that make up NAFTA would obviously suffer, given the benefits of the integrated supply-chains, as would U.S. steel and select agricultural producers that export to NAFTA peers. Medium term: Canadian exports largely unaffected, buy CAD on any NAFTA-related dip. Given that 20% of Canadian exports to the U.S. are energy - and thus highly unlikely to come under higher tariffs post-NAFTA - we do not expect exports to decline significantly.17 In fact, the 1987 Canada-United States Free Trade Agreement, which laid the foundation for NAFTA, could quickly be resuscitated given that it was never formally terminated, only suspended. Canada and the U.S. have a balanced trade relationship, which means that it is highly unlikely that America's northern neighbor is in the sights of the White House administration. Long term: marginally positive for inflation. Economic globalization and immigration have both played a marginally deflationary role on the global economy. If abrogation of NAFTA is the first step towards less of both trends, than the economic effect should be mildly inflationary. This could feed into inflation expectations, reversing their recent decline. In broader terms, it is impossible to assess the long-term impact of NAFTA abrogation until we answer the question of whether the Trump administration is pluto-populist or genuinely populist. If pluto-populist, NAFTA's demise would be largely designed for domestic political consumption and would be the end of the matter. No long-term implications would really exist as, the Trump White House would conclude bilateral deals with Canada and Mexico to ensure that trade is not interrupted and that crucial constituencies - Midwest auto workers and farmers - do not turn against the administration. If genuinely populist, however, the White House would likely have to abrogate WTO rules as well in order to make a real dent to its trade deficit. The U.S. has no way to raise tariffs above an average bound tariff of 3.4%, other than for selective imports and on a temporary basis, or through a flagrant rejection of the WTO's authority. Given the likely currency moves post-NAFTA's demise, those levels would have an insignificant effect on U.S. trade with its North American neighbors. President Trump hinted as much when he sent a 336-page report to Congress titled "The President's Trade Policy Agenda," which argued that the administration would ignore WTO rules that it deems to infringe on U.S. sovereignty. The NAFTA negotiations, put in the context of that document, are a much more serious matter that might be part of a slow rollout of global trade policy that only becomes apparent in 2018.18 From a geopolitical perspective, ending NAFTA would make the U.S. less geopolitically secure. If the U.S. turned its back on its own neighbors, one of which is its closest military ally, then Canada and Mexico may seek closer trade relations with Europe and China. This could lead to the diversification of their export markets, including - most critically for U.S. national security - energy. In addition, Canada could allow significant Chinese investment into its technology sector, particularly in AI and quantum computing where the country is a global leader. Additionally, any negative consequences for the Mexican economy would likely be returned tenfold on the U.S. in the form of greater illegal immigration flows, a greater pool of recruits for Mexican drug cartels, and a rise in anti-Americanism in the country. The latter is particularly significant given the upcoming July 2018 presidential election and current solid polling for anti-establishment candidate Andrés Manuel López Obrador (Chart 18). Obrador is in the lead, but his new party - National Regeneration Movement (MORENA) - is unlikely to gain a majority in Congress (Chart 18, bottom panel). However, acrimonious NAFTA negotiations and a nationalist U.S. could change the fortunes for both Obrador and MORENA. Ultimately, everything depends on whether Trump's campaign rhetoric on trade is real. At this point, we lean towards Trump being a pluto-populist. The proposed tax cuts are clearly not designed with blue-collar workers in mind. They are largely a carbon-copy of every other Republican tax reform plan in the past and thus we assume that their consequences will be similar. If the signature legislation of the Trump White House through 2017-2018 will be a tax plan that skews towards the wealthy (Chart 19), than why should investors assume that its immigration and free trade rhetoric are real? Chart 18Populism On The March In Mexico NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism Chart 19Tax Cuts Are Not Populist Tax Cuts Are Not Populist Tax Cuts Are Not Populist If ending NAFTA is merely red meat for the Midwestern base, and is quickly replaced with bilateral "fixes," then long-term implications will be muted. If, on the other hand, it is pursued as a new U.S. policy, then the significance will be much greater: it will mark the dawn of a new trend of twenty-first century mercantilism coming from the former bulwark of international liberalism. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com. 3 Please see BCA Global Investment Strategy Special Report, "Trumponomics: What Investors Need To Know," dated September 4, 2015, available at gis.bcaresearch.com, and Geopolitical Strategy Special Report, "U.S. Election: The Great White Hype," dated March 9, 2016, available at gps.bcaresearch.com. 4 Candidate Donald Trump made this comment during his first debate with Secretary Hillary Clinton. The September 26 debate focused heavily on free trade and globalization. 5 Mexico is exempt from several crucial articles in Chapter 6 due to the political sensitivity of the domestic energy industry. 6 Please see Hufbauer, Gary Clyde and Jeffrey J. Schott, "NAFTA Revisited," dated October 1, 2007, available at piie.com, and Hufbauer, Gary Clyde and Jeffrey J. Schott, NAFTA Revisited, New York: Columbia University Press, 2005. 7 Please see United States International Trade Commission, "Economic Impact of Trade Agreements Implemented Under Trade Authorities Procedures," Publication Number: 4614, June 2016, available at usitc.gov. First accessed via Congressional Research Service, "The North American Free Trade Agreement (NAFTA)," dated May 24, 2017, available at fas.org. 8 Since 1994, Canada has been sued 39 times and has paid out a total of $215 million in compensation. The U.S. is yet to lose a single case! 9 On average, vehicles produced in NAFTA member states average 75% local content; therefore, the first part of the demand is reachable if the White House is willing to budge. 10 Please see Evenett, Simon J. and Johannes Fritz, "Will Awe Trump Rules?" Global Trade Alert, dated July 3, 2017, available at globaltradealert.org. 11 Please see Robert Putnam, "Diplomacy and domestic politics: the logic of two-level games," International Organization 42:3 (summer 1988), pp. 427-460. 12 Please see Autor, David H., David Dorn, and Gordon H. Hanson, "The China Shock: Learning from Labor-Market Adjustment to Large Changes in Trade," Annual Reviews of Economics, dated August 8, 2016, available at annualreviews.org. 13 Pluto-populists use populist rhetoric that appeals to the common person in order to pass plutocratic policies that benefit the elites. 14 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 15 See in particular the Trade Expansion Act of 1962 (Section 232b), the Trade Act of 1974 (Sections 122, 301), the Trading With The Enemy Act of 1917 (Section 5b), and the International Emergency Economic Powers Act of 1977. 16 Peter Navarro, director of the White House's National Trade Council, has argued throughout March that the U.S. chronic deficits and global supply chains were a threat to national security. 17 Unless President Trump and his advisors ignore the reality that the U.S. still imports 40% of its energy needs and will likely be doing so for the foreseeable future. 18 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights NAFTA is truly at risk - as currency markets suggest; NAFTA's impact on the U.S. economy is positive but marginal; The key question is whether Trump is a true populist or a "pluto-populist"; If the former, then NAFTA's failure is likely and portends worse to come; NAFTA's collapse would be bearish MXN, bearish U.S. carmakers versus DM peers, and supportive of higher inflation in the U.S. Feature Fifty years ago at the end of World War II, an unchallenged America was protected by the oceans and by our technological superiority and, very frankly, by the economic devastation of the people who could otherwise have been our competitors. We chose then to try to help rebuild our former enemies and to create a world of free trade supported by institutions which would facilitate it ... Make no mistake about it, our decision at the end of World War II to create a system of global, expanded, freer trade, and the supporting institutions, played a major role in creating the prosperity of the American middle class. - President Bill Clinton, Remarks at the Signing Ceremony for the Supplemental Agreements to the North American Free Trade Agreement, September 14, 1993 No Free Trade Agreement (FTA) has been more widely maligned than the North American Free Trade Agreement (NAFTA). It is, after all, the world's preeminent FTA. Signed in December 1992 by President George H. W. Bush and implemented in January 1994, it preceded the founding agreements of the World Trade Organization (WTO) and launched a two-decade, global expansion of FTAs (Chart 1). By including environmental and labor standards, as well as dispute settlement mechanisms, it created a high standard for all subsequent FTAs. President Trump's presidency began with much fear that his populist preferences would imperil globalization and trade deals such as NAFTA. Other than his withdrawal from the Trans-Pacific Partnership deal, much of the concern has been proven to be misplaced - including our own.1 Even Sino-American trade tensions have eased, with President Trump and President Xi Jinping enjoying a good working relationship so far. So should investors relax and throw caution to the wind? In this report, we argue that the answer is a resounding no. The White House rhetoric on NAFTA - a trade deal that has been mildly positive for the U.S. economy and, at worst, neutral for its workers - suggests that greater trade conflicts loom, not only within NAFTA but also with China and others. Furthermore, a rejection of NAFTA would be a symbolic blow to free trade at least as consequential as the concrete ramifications of nixing the deal itself. The deal with Mexico and Canada is not as significant to the U.S. economy as its proponents suggest (Chart 2), but by mathematical logic its detractors therefore overstate its negatives. Chart 1NAFTA: Tailwind To Globalization NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism Chart 2U.S. Economy: Largely Unaffected By NAFTA U.S. Economy: Largely Unaffected By NAFTA U.S. Economy: Largely Unaffected By NAFTA The opposition to NAFTA by the Trump administration therefore reveals preferences that would become far more investment-relevant if applied to major global economies like China. If NAFTA negotiations are merely a ploy to play to the populist base, however, then the impact of its demise will be temporary and muted. At this time, however, it is unclear which preference is driving the Trump White House strategy and thus risks are to the downside. The Decaying Context Behind NAFTA The North American Free Trade Agreement is more than a trade deal: it is the symbolic beginning of late twentieth-century globalization. According to our trade globalization proxy, this period has experienced the fastest pace of globalization since the nineteenth century (Chart 3). Both NAFTA and the WTO enshrined new rules and standards for global trade upon which trade and financial globalization are based. Chart 3Globalization Has Peaked Globalization Has Peaked Globalization Has Peaked Chart 4Globalization And Its Indebted Discontents Globalization And Its Indebted Discontents Globalization And Its Indebted Discontents Underpinning this surge in globalization was the apex of American geopolitical power and the collapse of the socialist alternative, the Soviet Union. As President Clinton's remarks from 1993 suggest (quoted at the beginning of the report), NAFTA was the culmination of a "creation myth" for an American Empire. The myth narrates how the geopolitical and economic decisions made by the U.S. in the aftermath of its victory in World War II laid a foundation for both American prosperity and a new global order. With the ruins of Communism still smoldering in the early 1990s, the U.S. decided to double-down on those same, globalist impulses. Today those impulses are waning if not completely dead. As we argued in our 2014 report, "The Apex Of Globalization - All Downhill From Here," three trends have conspired to turn the tides against globalization:2 Multipolarity - Every period of intense globalization has rested on strong pillars of geopolitical "hegemony," i.e. the existence of a single world leader. Chart 3 shows that the most recent such eras consisted of British and American hegemony, respectively. However, the relative decline of American geopolitical power has imperiled this process, as rising powers look to carve out regional spheres of influence that are by definition incompatible with a globalized political and economic framework. In parallel, the hegemon itself - the U.S. - has begun to vacillate over whether the framework it designed is still beneficial to it, given its declining say in how the global system operates. Great Recession - The 2008 global financial crisis cracked the ideological, macroeconomic, and policy foundations of globalization. Deflation - Globalization is deflationary, which works swimmingly when real household incomes are rising and debts falling. Unfortunately, neither of those has been the case for American households over the past forty years (Chart 4). This is in large part the consequence of globalization, which opened trade with emerging markets and thus suppressed low-income wage growth in developed economies. What is striking about the U.S. is that its social safety net has done such a poor job redistributing the gains of free trade, at least compared to its OECD peers (Chart 5). Chart 5The 'Great Gatsby' Curve NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism Chart 6America Belongs To The Anti-Globalization Bloc NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism President Donald Trump shrewdly understood that the tide had turned against free trade in the U.S. (Chart 6). Ahead of the 2016 election, no one (except BCA!) seriously believed that trade and globalization would become the fulcrum of the election.3 Candidate Trump, however, returned to it repeatedly, and singled out NAFTA as "the worst trade deal maybe ever signed anywhere."4 Bottom Line: President Trump's opposition to globalization did not fall from the sky. Trump is the product of his time and geopolitical and macroeconomic context. Trends we identified in 2014 are today headwinds to globalization. Myths About NAFTA The geopolitical and macroeconomic context may be dire for globalization, but does NAFTA actually fit that narrative? The short answer is no. The long answer is that there are three myths about NAFTA that the Trump administration continues to propagate. We assume that U.S. policymakers can do simple math. As such, their ignorance of the below data suggests a broad strategy toward free trade that is based in ideology, not factual reality. Alternatively, flogging NAFTA may be motivated by narrower, domestic, political concerns and may not be indicative of a deeply held worldview. Time will tell which is true. Myth #1: NAFTA Has Widened The U.S. Trade Deficit Chart 7Long-Term Trade Deficit Is About Commodities Long-Term Trade Deficit Is About Commodities Long-Term Trade Deficit Is About Commodities NAFTA has resulted in a huge trade deficit for the United States and has cost us tens of thousands of manufacturing jobs. The agreement has become very lopsided and needs to be rebalanced. We of course have a five-hundred-billion-dollar trade deficit. So, for us, trade deficits do matter. And we intend to reduce them. - Robert Lighthizer, U.S. trade representative, October 17, 2017 When it comes to the U.S. trade deficit, NAFTA has had a negligible impact. Three facts stand out: The U.S. has an insignificant trade deficit with Canada - 0.06% of GDP in 2016, or $12 billion. It has a larger one with Mexico - 0.33% of GDP, or $63 billion. However, when broken down by sectors, the deepest trade deficit has been in energy. The U.S. has actually run a surplus in manufactured products with Mexico and Canada for much of the post-2008 era, which only recently dipped back into deficit (Chart 7). The U.S. has consistently run a trade deficit with the rest of the world since 1980, but the size of its trade deficit with Mexico and Canada did not significantly increase as a share of GDP post-implementation of NAFTA. The real game changer has been the widening of the trade deficit with China and the rest of the EM economies outside of China and Mexico (Chart 8). The trade relationship with Mexico and Canada, relative to that with the rest of the world, therefore remains stable. The net energy trade balance with Mexico and Canada has significantly improved due to surging U.S. shale production (Chart 9). Rising shale production has accomplished this both by lowering the need for imports from NAFTA peers, surging refined product exports to Mexico, and by inducing lower global energy prices. In addition, Canada-U.S. energy trade is governed by NAFTA's Chapter 6 rules, which prohibit the Canadian government from intervention in the normal operation of North American energy markets.5 Chart 8U.S. Trade Imbalance Is Not About NAFTA NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism Chart 9Shale Revolution Is A Game Changer Shale Revolution Is A Game Changer Shale Revolution Is A Game Changer Myth #2: NAFTA Has Destroyed The U.S. Auto Industry Before NAFTA went into effect ... there were 280,000 autoworkers in Michigan. Today that number is roughly 165,000 - and would have been heading down big-league if I didn't get elected. - Donald Trump, U.S. President, March 15, 2017 What about the charge that NAFTA has negatively impacted the U.S. automotive industry by shipping jobs to Mexican and, to lesser extent, Canadian factories? Again, this reasoning is flawed. In fact, NAFTA appears to have allowed the U.S. automotive industry to remain highly competitive on a global scale, more so than its Mexican and Canadian peers. U.S. exports outside of NAFTA as a percent of total exports have surged since the early 2000s and have remained buoyant recently. Meanwhile, Mexican exports to the rest of the world have fallen, suggesting that Mexico is highly reliant on servicing Detroit (Chart 10). Chart 10NAFTA Has Made U.S. Auto##br## Manufacturing More Competitive NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism The truth is that the American automotive industry's share of overall manufacturing activity has risen since 2008. In part, this is because American manufacturers have been able to integrate with Canadian and Mexican plants, allowing production to remain on the continent and move seamlessly across the value chain. In other words, Mexico serves as a low-wage outlet for the least-skilled part of the production chain, allowing the rest of the manufacturing process to remain in the U.S. and Canada. Without that cheap "escape valve," the entire production chain might have migrated to EM Asia. Or, worse, the American automotive industry would have become uncompetitive relative to European and Japanese peers. Either way, the U.S. would have potentially faced greater job losses were it not for easier access to Mexican auto production. Both European and Japanese manufacturers have similar low-skilled, low-cost, "labor escape valves" in the region. For Germany and France, this escape valve is in Spain and Central and Eastern Europe; for Japan, it is in Thailand. Myth #3: Mexico And Canada Cannot Retaliate Against The U.S. As far as I can tell, there is not a world oversupply of agricultural products. Unless countries are going to be prepared to have their people go hungry or change their diets, I think it's more of a threat to try to frighten the agricultural community. - Wilbur Ross, Commerce Secretary, October 11, 2017 U.S. exports to Canada and Mexico only account for about 2.6% of GDP, whereas exports to the U.S. from Mexico and Canada account for 28% and 18% of GDP respectively. Nonetheless, this does not mean that the U.S. suffers from NAFTA. As we discussed above, NAFTA has been a boon for the global competitiveness of the U.S. automotive industry. In addition, NAFTA gives American and Canadian exporters access to a large and growing Mexican middle class (Chart 11). Furthermore, the U.S. would gain little benefit from leaving NAFTA vis-à-vis Canada and Mexico. By reverting back to WTO tariff levels, the U.S. would be able to raise tariffs from 0% (under NAFTA) to the maximum of 3.4%, where the U.S. average "bound tariff" would remain. Bound tariffs differ across products and countries and represent the maximum rate of tariffs under WTO rules (i.e., without violating those rules). They are indicative of a hostile trade relationship, as trade would otherwise be set at much lower "most favored nation" tariff levels. Table 1WTO Tariff Schedule NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism As Table 1 shows, however, Canada and particularly Mexico have the ability to raise their bound tariffs considerably higher than the U.S. can do. Mexico, in fact, has one of the highest average bound tariff rates for an OECD member state, at a whopping 36.2%! This means that, if NAFTA were to be abrogated, the U.S. would be allowed to raise tariffs, on average, to 3.4%, whereas Mexico would be free to do so by ten times more. Given that Mexico is America's main export destination for steel and corn output, the retaliation would be non-negligible for these two politically powerful sectors. This aspect of the WTO agreement is a latent geopolitical risk, as it feeds into the Trump administration's broader antagonism toward the WTO itself. Despite the hard evidence, we suspect that the Trump administration is driven by ideological and strategic goals and therefore the probability of a calamitous end to the ongoing NAFTA negotiations is high. Nevertheless, the data shows: The North American Free Trade Agreement has allowed trade between its member states to accelerate at a faster pace than global trade for much of the first decade after its signing and at the average global pace over the past decade (Chart 12); U.S. manufacturing employment as a percent of total labor force has been declining for much of the past half-century, with absolute numbers falling off a cliff as China joined the WTO and, along with EM Asia, became integrated into the global supply chain (Chart 13); Employment in auto-manufacturing follows the same pattern as overall manufacturing employment (Chart 13, bottom panel), suggesting that it was not NAFTA that caused job flight but rather competition from the rest of the world along with automation. In fact, auto-manufacturing employment has recovered post-2008, as American car manufacturers underwent structural reforms to improve competitiveness. Chart 12NAFTA Trade Has ##br##Beaten Global Trade NAFTA Trade Has Beaten Global Trade NAFTA Trade Has Beaten Global Trade Chart 13Who Hurt U.S. Manufacturing Employment:##br## China Or NAFTA? Who Hurt U.S. Manufacturing Employment: China Or NAFTA? Who Hurt U.S. Manufacturing Employment: China Or NAFTA? As with any free trade agreement, some wages in some sectors may have been lowered by NAFTA's implementation and some jobs were definitely lost due to the agreement. However, the vast majority of academic studies point out that the negative labor market impacts of NAFTA have been negligible. The most authoritative work on the subject, by economists Gary Clyde Hufbauer and Jeffrey J. Schott of the Peterson Institute for International Economics, found that the upper-bound of NAFTA-related job losses in the U.S. is 1.9 million over the first decade of the agreement. Given that U.S. employment rose by 34 million over the same period, the job losses represent "a fraction of one percent of jobs 'lost' through turnover in the dynamic U.S. economy over a decade."6 A June 2016 report by the U.S. International Trade Commission (USITC) provides a good review of academic studies on the trade deal since 2002. Overall, it concludes that NAFTA led "to a substantial increase in trade volumes for all three countries; a small increase in U.S. welfare [overall economic benefit]; and little to no change in U.S. aggregate employment."7 In addition, NAFTA had "essentially no effect on real wages in the United States of either skilled or unskilled workers." This academic work could, of course, be the product of a vast conspiracy by globalist, neo-liberal academics financed by the deep state and its corporate overlords. However, the other side of the debate has little to offer as a counter to the empirical evidence. For example, U.S. Trade Representative Robert Lighthizer, a notable trade hawk, posited that the U.S. government had "certified" that 700,000 Americans had lost their jobs owing to NAFTA. This would represent 30,000 job losses per year over the 24 years of NAFTA's existence. Lighthizer also did not say whether he was speaking in net or gross terms, probably because it is practically impossible to competently answer that question! If that is the best retort to the academic research, there is then no real counter to the conclusion that NAFTA has had a mildly positive effect on the U.S. economy and labor market. Bottom Line: NAFTA has had some positive effects on the U.S. automotive sector, allowing it to integrate the low-cost Mexican labor into its production chain and thus remain competitive vis-à-vis Asian and European manufacturers. It also holds the promise of future export gains to Mexico's growing middle class. Its overall effects on the U.S. budget deficit, wages, and employment are largely overstated. If the impact of NAFTA has largely been marginal to the U.S. economy outside of a select few sectors, why is the Trump administration so dead-set on renegotiating it? And why has the process been so acrimonious? What Does The Trump White House Want? Frankly, I am surprised and disappointed by the resistance to change from our negotiating partners ... As difficult as this has been, we have seen no indication that our partners are willing to make any changes that will result in a rebalancing and reduction in these huge trade deficits. - Robert Lighthizer, U.S. trade representative, October 17, 2017 Robert Lighthizer, the U.S. trade representative, closed the fourth round of negotiations with a bang, implying that Canada and Mexico would have to help the U.S. close its $500 billion trade deficit, even though the U.S. trade deficit with its two NAFTA partners is only 15% of the total. The Canadian dollar and the Mexican peso fell by 1.2% and 1.9%, respectively, in the subsequent week of trading. In fact, both the CAD and MXN have faced extended losses since the third round of NAFTA negotiations ended on September 27 (Chart 14). Chart 14NAFTA Negotiations Are FX-Relevant NAFTA Negotiations Are FX-Relevant NAFTA Negotiations Are FX-Relevant Is the market overreacting? We do not think so. First, the list of demands presented by the White House are quite harsh, with the first two below considered deal-breakers: Dispute Settlement: The White House wants to end the investor-state dispute settlement (ISDS) mechanism (under Chapter 11), which allows corporations to sue governments for breach of obligations under the treaty.8 More importantly, the U.S. also wants to eliminate trade dispute panels (under Chapter 19), which allow NAFTA countries to protest anti-dumping and countervailing duties. The real issue is that Chapter 19 trade dispute panels have acted as a constraint on the U.S. administration in imposing antidumping and countervailing duties in the past. Sunset clause: The White House has also proposed that NAFTA automatically expire unless it is approved by all three countries every five years. Buy American: The White House wants its "Buy American" rules in government procurement to be part of the new NAFTA deal, and yet for Canadian and Mexican government contracts to remain open to U.S. businesses. Rules of origin: The White House has called for an increase in NAFTA's regional automotive content requirement from the current 62.5% to 85%, including that 50% of the value of all NAFTA-produced cars, trucks, and large engines come from the U.S.9 Second, the U.S. Commerce Department - headed by trade hawk Wilbur Ross - has signaled that it is open to aggressively pursuing trade disputes on behalf of American companies. Since President Trump's inauguration, U.S. policy interventions have on balance harmed the commercial interests of its G20 trade partners by higher frequency than during the last three years of Barack Obama's presidency (Chart 15).10 Chart 15Trump: Game Changer In U.S. Trade Policy NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism Specific to NAFTA partners, the Commerce Department has slapped a 20% tariff on Canadian softwood lumber in April and a 300% tariff on Bombardier C-Series in October. When combined with the demand to end trade dispute panels under NAFTA's Chapter 19 - which would resolve such trade disputes - the pickup in activity by the Commerce Department is a clear signal that the new U.S. administration intends to break the spirit of NAFTA whether the agreement remains in place or not. Third, and more broadly speaking, the Trump administration is playing a "two-level game."11 Two-level game theory posits that domestic politics creates acceptable "win-sets," which are then transported to the geopolitical theatre. Politicians cannot conclude foreign agreements that are outside of those domestic win-sets. For President Trump, his win-set on NAFTA negotiations is set by a domestic coalition that allowed him to win the election. This includes voters in the Midwest states of Wisconsin, Michigan, and Pennsylvania where Trump outperformed polls by 10%, 3%, and 3% respectively (Chart 16), and where Secretary Hillary Clinton garnered less votes in 2016 than President Barack Obama in 2012 (Chart 17). Trump promised this blue-collar base a respite from globalization and he has to deliver it if he intends to win in four years' time. Chart 16Trump Owes The Midwest Trump Owes The Midwest Trump Owes The Midwest Chart 17Hillary Lost Rust Belt Voters NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism At the same time, Trump's domestic policy has thus far fallen far short of other campaign promises. First, there has been no movement on immigration or the promised border wall. Second, the Obamacare repeal and replace effort has failed in Congress. Third, proposed tax cuts are likely to benefit the country's elites, as previous tax reform efforts have tended to do. As such, we fear that the Trump White House may double down on playing hardball with NAFTA in order to fulfill at least one of its promised strategies. But why single out NAFTA if its impact on U.S. jobs and wages is miniscule compared to, for example, the U.S.-China trade relationship?12 There are two ways to answer this question: Pluto-populist scenario: President Trump is in fact a pluto-populist and not a genuine populist, i.e. he is not committed to economic nationalism.13 As such, he does not intend to fulfill any of the demands he has promised to his voters, as the current corporate and household tax cuts suggest. Given NAFTA's limited impact on the U.S. economy, abrogating that deal would have far less detrimental impact than if President Trump went after other trade relationships. As such, the NAFTA deal will either be renegotiated, or, at worst, abrogated and quickly replaced with bilateral deals with both Canada and Mexico. It is a "cheap" and "safe" way to satisfy voter demands without actually hurting business or the economy. Genuinely populist scenario: President Trump is a genuine populist and NAFTA renegotiations are setting the stage for a 2018 in which trade protectionism becomes a genuine, global market risk. Bottom Line: President Trump's negotiation stance on NAFTA is non-diagnostic. We cannot establish with any certainty whether his demands mark the start of a broader, global, protectionist trend, or whether he is merely bullying two trade partners who will ultimately have to kowtow to U.S. demands. Nonetheless, we agree with the market's pricing of a higher probability that NAFTA is abrogated, as witnessed by the currency markets. In both of our political scenarios, NAFTA's fate is uncertain. If Trump is a pluto-populist, NAFTA is an easy target and its abrogation will score domestic political points with limited economic impact. If he is a genuine economic nationalist, failed NAFTA renegotiations are the first step on the path to clashing with the WTO and rewriting global trade rules. Investment And Geopolitical Implications Can President Trump withdraw from NAFTA unilaterally? The short answer is yes. As Table 2 illustrates, Congress has passed several laws that delegate authority to the executive branch to administer and enforce trade agreements and to exercise prerogative amid exigencies.14 Article 2205 of NAFTA states that any party to the treaty can withdraw within six months after providing notice of withdrawal. We see no evidence in U.S. law that the president has to gain congressional approval of such withdrawal. Table 2Trump Faces Few Constraints On Trade NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism Moreover, the past century has produced a series of laws that give President Trump considerable latitude - not only the right to impose a 15% tariff for up to 150 days, as in the Trade Act of 1974, but also unrestricted tariff and import quota powers during wartime or national emergencies, as in the Trading With The Enemy Act of 1917.15 The White House has already signaled that it considers budget deficits a "national security issue," which suggests that the White House is preparing for a significant tariff move in the future.16 Could President Trump's moves be challenged by Congress or the courts? Absolutely. However, time is on the executive's side. Even assuming that Congress or the Supreme Court oppose the executive, it will likely be too late to avoid serious ramifications and retaliations from abroad. Other countries will not wait on the U.S. system to auto-correct. Congress is unlikely to vote to overrule the president until the damage has already been done - especially given Trump's powers delegated from Congress. As for the courts, the executive could swamp them with justifications for its actions; the courts would have to deem the executive likely to lose every single one of these cases in order to issue a preliminary injunction against each of them and halt the president's orders. Any final Supreme Court ruling would take at least a year. International law would be neither speedy nor binding. What are the investment implications of a NAFTA collapse? Short term: Short MXN; short North American automotive sector relative to European/Asian peers. We would expect more downside risk to MXN from a collapse in NAFTA talks, similar in magnitude to the decline of the GBP after the Brexit vote. The Mexican central bank would likely take on a dovish stance towards monetary policy, creating a negative feedback loop for the peso. The automotive sectors across the three economies that make up NAFTA would obviously suffer, given the benefits of the integrated supply-chains, as would U.S. steel and select agricultural producers that export to NAFTA peers. Medium term: Canadian exports largely unaffected, buy CAD on any NAFTA-related dip. Given that 20% of Canadian exports to the U.S. are energy - and thus highly unlikely to come under higher tariffs post-NAFTA - we do not expect exports to decline significantly.17 In fact, the 1987 Canada-United States Free Trade Agreement, which laid the foundation for NAFTA, could quickly be resuscitated given that it was never formally terminated, only suspended. Canada and the U.S. have a balanced trade relationship, which means that it is highly unlikely that America's northern neighbor is in the sights of the White House administration. Long term: marginally positive for inflation. Economic globalization and immigration have both played a marginally deflationary role on the global economy. If abrogation of NAFTA is the first step towards less of both trends, than the economic effect should be mildly inflationary. This could feed into inflation expectations, reversing their recent decline. In broader terms, it is impossible to assess the long-term impact of NAFTA abrogation until we answer the question of whether the Trump administration is pluto-populist or genuinely populist. If pluto-populist, NAFTA's demise would be largely designed for domestic political consumption and would be the end of the matter. No long-term implications would really exist as, the Trump White House would conclude bilateral deals with Canada and Mexico to ensure that trade is not interrupted and that crucial constituencies - Midwest auto workers and farmers - do not turn against the administration. If genuinely populist, however, the White House would likely have to abrogate WTO rules as well in order to make a real dent to its trade deficit. The U.S. has no way to raise tariffs above an average bound tariff of 3.4%, other than for selective imports and on a temporary basis, or through a flagrant rejection of the WTO's authority. Given the likely currency moves post-NAFTA's demise, those levels would have an insignificant effect on U.S. trade with its North American neighbors. President Trump hinted as much when he sent a 336-page report to Congress titled "The President's Trade Policy Agenda," which argued that the administration would ignore WTO rules that it deems to infringe on U.S. sovereignty. The NAFTA negotiations, put in the context of that document, are a much more serious matter that might be part of a slow rollout of global trade policy that only becomes apparent in 2018.18 From a geopolitical perspective, ending NAFTA would make the U.S. less geopolitically secure. If the U.S. turned its back on its own neighbors, one of which is its closest military ally, then Canada and Mexico may seek closer trade relations with Europe and China. This could lead to the diversification of their export markets, including - most critically for U.S. national security - energy. In addition, Canada could allow significant Chinese investment into its technology sector, particularly in AI and quantum computing where the country is a global leader. Additionally, any negative consequences for the Mexican economy would likely be returned tenfold on the U.S. in the form of greater illegal immigration flows, a greater pool of recruits for Mexican drug cartels, and a rise in anti-Americanism in the country. The latter is particularly significant given the upcoming July 2018 presidential election and current solid polling for anti-establishment candidate Andrés Manuel López Obrador (Chart 18). Obrador is in the lead, but his new party - National Regeneration Movement (MORENA) - is unlikely to gain a majority in Congress (Chart 18, bottom panel). However, acrimonious NAFTA negotiations and a nationalist U.S. could change the fortunes for both Obrador and MORENA. Ultimately, everything depends on whether Trump's campaign rhetoric on trade is real. At this point, we lean towards Trump being a pluto-populist. The proposed tax cuts are clearly not designed with blue-collar workers in mind. They are largely a carbon-copy of every other Republican tax reform plan in the past and thus we assume that their consequences will be similar. If the signature legislation of the Trump White House through 2017-2018 will be a tax plan that skews towards the wealthy (Chart 19), than why should investors assume that its immigration and free trade rhetoric are real? Chart 18Populism On The March In Mexico NAFTA - Populism Vs. Pluto-Populism NAFTA - Populism Vs. Pluto-Populism Chart 19Tax Cuts Are Not Populist Tax Cuts Are Not Populist Tax Cuts Are Not Populist If ending NAFTA is merely red meat for the Midwestern base, and is quickly replaced with bilateral "fixes," then long-term implications will be muted. If, on the other hand, it is pursued as a new U.S. policy, then the significance will be much greater: it will mark the dawn of a new trend of twenty-first century mercantilism coming from the former bulwark of international liberalism. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, “The Apex Of Globalization – All Downhill From Here,” dated November 12, 2014, available at gps.bcaresearch.com. 3 Please see BCA Global Investment Strategy Special Report, “Trumponomics: What Investors Need To Know,” dated September 4, 2015, available at gis.bcaresearch.com, and Geopolitical Strategy Special Report, “U.S. Election: The Great White Hype,” dated March 9, 2016, available at gps.bcaresearch.com. 4 Candidate Donald Trump made this comment during his first debate with Secretary Hillary Clinton. The September 26 debate focused heavily on free trade and globalization. 5 Mexico is exempt from several crucial articles in Chapter 6 due to the political sensitivity of the domestic energy industry. 6 Please see Hufbauer, Gary Clyde and Jeffrey J. Schott, "NAFTA Revisited," dated October 1, 2007, available at piie.com, and Hufbauer, Gary Clyde and Jeffrey J. Schott, NAFTA Revisited, New York: Columbia University Press, 2005. 7 Please see United States International Trade Commission, "Economic Impact of Trade Agreements Implemented Under Trade Authorities Procedures," Publication Number: 4614, June 2016, available at usitc.gov. First accessed via Congressional Research Service, "The North American Free Trade Agreement (NAFTA)," dated May 24, 2017, available at fas.org. 8 Since 1994, Canada has been sued 39 times and has paid out a total of $215 million in compensation. The U.S. is yet to lose a single case! 9 On average, vehicles produced in NAFTA member states average 75% local content; therefore, the first part of the demand is reachable if the White House is willing to budge. 10 Please see Evenett, Simon J. and Johannes Fritz, "Will Awe Trump Rules?" Global Trade Alert, dated July 3, 2017, available at globaltradealert.org. 11 Please see Robert Putnam, "Diplomacy and domestic politics: the logic of two-level games," International Organization 42:3 (summer 1988), pp. 427-460. 12 Please see Autor, David H., David Dorn, and Gordon H. Hanson, "The China Shock: Learning from Labor-Market Adjustment to Large Changes in Trade," Annual Reviews of Economics, dated August 8, 2016, available at annualreviews.org. 13 Pluto-populists use populist rhetoric that appeals to the common person in order to pass plutocratic policies that benefit the elites. 14 Please see BCA Geopolitical Strategy Special Report, “Constraints & Preferences Of The Trump Presidency,” dated November 30, 2016, available at gps.bcaresearch.com. 15 See in particular the Trade Expansion Act of 1962 (Section 232b), the Trade Act of 1974 (Sections 122, 301), the Trading With The Enemy Act of 1917 (Section 5b), and the International Emergency Economic Powers Act of 1977. 16 Peter Navarro, director of the White House's National Trade Council, has argued throughout March that the U.S. chronic deficits and global supply chains were a threat to national security. 17 Unless President Trump and his advisors ignore the reality that the U.S. still imports 40% of its energy needs and will likely be doing so for the foreseeable future. 18 Please see BCA Geopolitical Strategy Weekly Report, “Political Risks Are Understated In 2018,” dated April 12, 2017, available at gps.bcaresearch.com.

Highlights China's mini-cycle has peaked, which has raised concerns among global investors that China may return to below-trend growth over the coming year, similar to what occurred in 2015. In our view, the severe slowdown in the Chinese economy in 2015 was due to overly tight monetary policy coupled with a severely weak external demand environment. A monetary conditions approach has done an excellent job of predicting industrial activity in China over the past several years. While monetary policy has tightened somewhat since the beginning of the year, none of the monetary conditions indexes that we track have come close to returning to 2015 levels. In short, an uncontrolled and sharp deceleration in the Chinese economy is not in the cards. This favors the performance of Chinese stocks, both in absolute and relative terms. Stay overweight. Feature Last week's report was replaced by a Special Report prepared by my colleague Matt Gertken, Associate Vice President of our Geopolitical Strategy team.1 The report presented a full "postmortem" on the Party Congress, and outlined how stepped up reform efforts in China are likely over the coming year, and beyond. By "reforms", our geopolitical team specifically means deleveraging in the financial sector accompanied by a more intense anti-corruption campaign focused on the shadow-banking sector, as well as ongoing restructuring in the industrial sector. The implications of the "reform reboot" scenario presented in last week's report are negative for emerging markets (EM) and other plays on China's industrial sector (such as industrial metals). We agree that a "status quo" scenario of no significant reforms is highly unlikely given that President Xi has succeeded in amassing tremendous political capital and that he has an agenda for reform. But the intensity of reforms pursued over the coming year will have to be closely monitored by policymakers, to avoid a repeat of the significant slowdown that occurred in 2014/2015. As such, the view of BCA's China Investment Strategy service is that the reform efforts over the coming year will be structured at a pace that is sufficient to avoid a meaningful deceleration in China's industrial sector, even though the momentum of China's "mini" economic cycle of the past two years has very likely peaked. However, the potential for a brisk pace of reforms to cause a more acute decline in industrial activity is a risk to our view that the slowdown in China's economy is likely to be benign and controlled. Monitoring reform progress is likely to be a key theme for this publication over the coming year. Over the nearer term, the potential impact of reform efforts is not the only risk to the economy, as many market participants appear to be worried that the peak in China's mini-cycle presages a destabilizing decline in economic activity. This week's report is the second of two parts examining the key differences facing China today from what prevailed in mid-2015,2 when the Chinese economy operated below what investors and market participants considered to be a "stable" pace of growth. In Part II we focus on monetary policy, and outline how the monetary environment remains stimulative despite a significant rise in corporate bond yields over the past year. China's Monetary Policy Stance: A Brief Review Chart 1 presents the one-year policy lending rate over the past decade, and highlights the four distinct phases that have prevailed since the global financial crisis in 2008: Chart 1A Brief Review Of China's Monetary Policy Stance A Brief Review Of China's Monetary Policy Stance A Brief Review Of China's Monetary Policy Stance A long period of significant easing that began during the Great Recession and lasted until late-2010 A material rate tightening cycle that began in late-2010 and ended in mid-2012 A half-reversal of the 2011/2012 rate cycle, which happened quickly in the summer of 2012 and was followed by a long pause until late-2014, and A significant series of rate cuts over the course of 2015, followed by a 2-year pause at current levels. We contend that policymakers were too timid in responding to economic weakness in China at the end of the third monetary policy phase highlighted in Chart 1, and that this hesitation magnified the impact of the serious deterioration in China's external demand environment that we discussed in Part I of this report. Chart 2Monetary Conditions Predict ##br##Chinese Industrial Activity Monetary Conditions Predict Chinese Industrial Activity Monetary Conditions Predict Chinese Industrial Activity Of course, in a large, trade-sensitive, economy like that of China, interest rates are not the only determinant of the degree of monetary accommodation. In order to capture the effects of the exchange rate and other factors affecting the efficacy of monetary policy, we have tended to show a Monetary Conditions Index (MCI) as a stand-in for the policy stance. As shown in Chart 2, the Bloomberg MCI has done an excellent job of leading industrial activity in China over the past several years, particularly during the mini-cycle of the past two years. While the MCI appears to have peaked early this year, it remains well above (i.e. more accommodative) the levels reached in mid-2015 when policymakers finally became serious about easing monetary conditions. Looking Forward Chart 3 presents a few alternative MCIs for China alongside Bloomberg's measure. Analysts tend to employ a variety of approaches when calculating monetary conditions indexes, but the real interest rate and the real effective exchange rate almost always feature prominently. Of the three alternative measures, Citigroup's MCI is the most bearish, as it includes the year-over-year growth rate of M2 which has recently languished. The remaining two measures are BCA calculations, one that deflates interest rates using producer prices, and one that uses core consumer prices. Both of our measures employ an equal split between the real interest rate and the exchange rate. Chart 3 highlights that all four MCIs have either peaked or are now falling, suggesting that a tightening in financial conditions earlier this year has somewhat reduced the degree of monetary accommodation to the economy. However, there are three key points to consider when judging the likely impact of monetary tightening on China's economy over the coming 6-12 months: None of the MCIs shown in Chart 3 have returned to their 2015 low, implying that the policy tightening that has occurred over the past year is not likely to cause Chinese industrial activity to crash in over the coming 6-12 months. Most of the appreciation in the RMB this year has occurred versus the dollar, not against the euro or in trade-weighted terms (Chart 4). In fact, in trade-weighted the RMB remains 6.5% below where it was in August 2015 prior to the currency devaluation. This highlights that the recent appreciation largely reflects dollar weakness, rather than policy-induced strength in the RMB. Chart 3Monetary Conditions Have Not Returned##br## To 2015 Levels Monetary Conditions Have Not Returned To 2015 Levels Monetary Conditions Have Not Returned To 2015 Levels Chart 4Recent RMB Appreciation##br## Reflects Dollar Weakness Recent RMB Appreciation Reflects Dollar Weakness Recent RMB Appreciation Reflects Dollar Weakness Average lending rates have only increased approximately 40 bps over the past year, in comparison to the 200 bps of easing that occurred from 2014 to 2016 (Chart 5). In real terms (when deflated by core consumer prices), average interest rate have barely risen at all this year. The still modest rise in average lending rates is an important consideration, because it contrasts with the rise in Chinese bond yields, both in the government and corporate sectors. For example, Chart 6 shows that corporate bond yields have risen by 160 bps since late-2016 and are 25 bps higher than they were in early-2015. Chart 5Average Lending Rates ##br##Have Risen Only Modestly Average Lending Rates Have Risen Only Modestly Average Lending Rates Have Risen Only Modestly Chart 6Corporate Bond Yields##br## Have Tightened Materially Corporate Bond Yields Have Tightened Materially Corporate Bond Yields Have Tightened Materially But our view is that average lending rates are a more important driver of debt service payments for China's non-financial sector. In fact, Table 1 highlights that while corporate bond financing is a growing component of Chinese private social financing, it is still quite small. The table presents a breakdown of adjusted social financing, which highlights that the sum of local currency loans, foreign currency loans in RMB, trust and entrusted loans equals roughly 85% of total social financial excluding equity issuance. Corporate bonds, by contrast, account for only about 10%, suggesting that the economic impact of the rise in bond yields this year will be relatively small. Table 1Corporate Bonds Account For A Small Percent Of China's Social Financing China's Economy - 2015 Vs Today (Part II): Monetary Policy China's Economy - 2015 Vs Today (Part II): Monetary Policy Investment Implications We noted in our October 12 Weekly Report that the acceleration in the Chinese economy that began in mid-2015 has likely peaked (Chart 7), ending the upswing of this "mini" economic cycle. Chart 7A Stylized View Of China's Recent China's Economy - 2015 Vs Today (Part II): Monetary Policy China's Economy - 2015 Vs Today (Part II): Monetary Policy The framework illustrated in Chart 7 presented three distinct scenarios for China over the coming 6-12 months: A re-acceleration of the economy and a continuation of the V-shaped rebound profile, A benign, controlled deceleration and settling of growth into the "stable" growth range, and An uncontrolled and sharp deceleration in the economy that threatens a return to the conditions that prevailed in early-2015 (or worse). In our view, the Chinese economy in early-2015 began to operate below the "stable" growth range shown in Chart 7, owing to a "double whammy" of excessively tight monetary conditions and a synchronized global downturn. While our research suggests that China's export growth will moderate over the coming year and that monetary conditions have tightened somewhat, the magnitude of these changes are not sufficiently large to return the Chinese economy back to 2015-like conditions. To us, this is consistent with the second scenario presented above. From an absolute equity perspective, this conclusion is positive for Chinese stock prices. Chart 8 highlights that the Li Keqiang index correlates fairly well with the growth in earnings for the MSCI China index ex technology; a moderate decline in the pace of growth in China's industrial sector would blunt the earnings growth of these firms, but not enough to cause an outright contraction. The combination of positive ex-tech earnings growth and very cheap valuation (Chart 9) suggests that the absolute uptrend in Chinese ex-technology stocks that began at the beginning of 2016 is likely to continue. Chart 8Ex-Tech EPS Growth Will Moderate, ##br##But Not Contract Ex-Tech EPS Growth Will Moderate, But Not Contract Ex-Tech EPS Growth Will Moderate, But Not Contract Chart 9Excluding Technology, ##br##China Is Extraordinarily Cheap Excluding Technology, China Is Extraordinarily Cheap Excluding Technology, China Is Extraordinarily Cheap In relative terms, the picture is somewhat cloudier, although for now we would continue to favor the China MSCI index versus global and emerging market stocks. Chart 10 highlights that Chinese equities have outperformed global stocks even when excluding tech companies, although it is clear that most of the recent outperformance is due to the IT sector. On the earnings front, while we expect Chinese ex-tech earnings growth to moderate over the coming year, this is also true of overall U.S. equities (Chart 11). Finally, Chart 12 highlights that while Chinese technology firms are richly priced vs their global counterparts, the multi-year relative outperformance trend has been fundamentally-driven, a situation that does not appear to be threatened by a slowdown in China's industrial sector (given the largely domestic & consumer orientation of Chinese technology firms). Chart 10China Is Beating Global,##br## Even Excluding Technology China Is Beating Global, Even Excluding Technology China Is Beating Global, Even Excluding Technology Chart 11U.S. Earnings Growth##br## Is Set To Moderate U.S. Earnings Growth Is Set To Moderate U.S. Earnings Growth Is Set To Moderate Chart 12China's Tech Rally Is ##br##Fundamentally-Driven China's Tech Rally Is Fundamentally-Driven China's Tech Rally Is Fundamentally-Driven Bottom Line: The economic momentum of China's 2-year mini-cycle has probably peaked, but an uncontrolled and sharp deceleration in the economy is not in the cards. This favors the performance of Chinese stocks, both in absolute and relative terms. Stay overweight. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see BCA Report, "China: Party Congress Ends ... So What?", dated November 2, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China's Economy - 2015 Vs Today (Part I): Trade", dated October 26, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Chart of the WeekChina Developments Significant##BR##To Base Metal Prices Shifting Gears In China: The Impact On Base Metals Shifting Gears In China: The Impact On Base Metals Reading the tea leaves following China's 19th National Communist Party Congress suggests a looming shift in President Xi Jinping's second term from pro-growth to pro-reform. Having consolidated power, Xi now has the capacity to implement his agenda over the next five years. Given China's outsized role in global base metals production and consumption, the direction of Xi's policy changes will have a profound impact on these markets (Chart of the Week).1 The Party Congress set the tone for economic policy and reforms going forward, from which we can extrapolate future policy direction. However, concrete plans and details will not be revealed until the National People's Congress, scheduled in March 2018. In this report we highlight the main takeaways of the Congress specifically those relevant to base metals. Broadly, these can be summarized as: Xi now has the political capital needed to implement real reform in his second term. Based on Xi's remarks at the Congress during his work-report commentary, we believe the environmental and supply-side reforms initiated during his first five-year term will be continued in his second term. Because these reforms will shrink the domestic production capacity for base metals and steel in China, they likely will be a tailwind for these commodities' prices. However, a focus on sustainable growth - i.e., organic growth that is not dependent on regular injections of credit to keep it going - and the elimination of GDP targets past 2021 risk weighing down base metals demand. Real-estate market fundamentals are more supportive than most perceive. This will prevent tighter policies from triggering a significant construction downturn, which will be supportive for steel and copper prices. China's efforts to expand its economic influence globally through the Belt and Road initiative (BRI) will be insufficient in offsetting a mainland slowdown, should one occur. Feature Balancing Stability And Reform Chart 2Stability Was A Priority...Not Anymore Stability Was A Priority...Not Anymore Stability Was A Priority...Not Anymore Despite reiterating a need for economic reforms, the focus of Xi's first term was maintaining stability and garnering the political capital necessary to implement his desired reforms. Emphasizing stability is a recurrent theme in Chinese politics, regardless of who is at the helm. The 2015-16 state interventions in the economy - including higher infrastructure spending, provincial government bailouts, currency depreciation and capital controls - illustrated the dominance of stability over reforms, during Xi's first term (Chart 2).2 The 19th Party Congress was the capstone event in Xi's effort to accumulate the support needed to implement long-sought reforms. BCA's Geopolitical Strategy points to three outcomes that support this assessment: With the inscription of Xi Jinping Thought on Socialism with Chinese Characteristics for a New Era in China's constitution, the president has cemented his position as one of the most powerful leaders of modern China. In fact, according to our geopolitical strategists, this induction signals that he is "second only to Chairman Mao as a philosophical guide in the party."3 Practically speaking, this means his economic initiatives will carry more weight than anything China has seen since at least the 1998-99 intense reform period. The leanings of members of the new Politburo Standing Committee (PSC) also are telling. Each of the three most recent presidents is represented by two protégés on the PSC. This is an almost-ideal configuration for reform.4 Finally, the appointment of Xi loyalist Zhao Leji as chief of the Central Commission for Discipline Inspection (CDIC), and the creation of the National Supervisory Commission to oversee the anti-corruption campaign give Xi the tools he needs to implement his policies. Thus, Xi has garnered sufficient ammunition to be much more effective in implementing reform policies during his second term. As such, we expect the pace of reform to accelerate. While the policy details are yet to be known, many of the takeaways from the party congress point toward supply- and demand-side changes. Supply-Side Reforms: Short-Term Sacrifice For Long-Term Benefit? While the aim for environmental regulation is not new - an "ecological" section was included in the work report for the first time by Xi's predecessor Hu Jintao in 2012 - we have reason to believe that, given Xi's focus on sustainable development, he will tackle environmental policies with more fervor than in the past. This signals that Xi may prioritize environmental preservation and pollution-reduction measures going forward, which would continue the efforts begun in his first term. In fact, environmental spending was the fastest growing category in central-government spending at the beginning of Xi's first term (Table 1). Table 1Xi Jinping Favors A Greener China Shifting Gears In China: The Impact On Base Metals Shifting Gears In China: The Impact On Base Metals Xi's environmental agenda will get an assist from his anti-corruption campaign. Our Geopolitical strategists highlight Xi's use of the CDIC - the anti-corruption watchdog - in enforcing the reforms as a signal of his resolve to implement change. The stakes are high for noncompliant managers who now risk not only financial penalties, but also arrest and jail time. Chart 3Shifting Gears: From Pro-Growth To Pro-Reform Shifting Gears: From Pro-Growth To Pro-Reform Shifting Gears: From Pro-Growth To Pro-Reform This reinforces the message that Xi is still keen on implementing the supply-side structural reforms first announced in 2015, and that he is willing to change the old-line economic model, forgoing potential growth drivers from traditional industries in favor of greener sectors (Chart 3). As the leading base metals producer in the world, a continuation - and potential intensification - of these reforms will weigh on global production and prop up base metal prices, as they have since last year. In fact, some of these reforms have already materialized in the form of earlier-than-anticipated winter production cuts. Steel production in Tangshan - China's largest steel-producing city - will be halved over the winter, with three other top steel producing cities - Shijiazhuang, Anyang, and Handan - expected to announce similar cuts.5 Similarly, the government of Shandong - a major producer of alumina and aluminum - recently instituted a crackdown program that includes production cuts during the winter months.6 Bottom Line: Xi used his platform at the Party Congress to reiterate his resolve to set China's economy on a more sustainable growth path through supply-side reform. Given that he has accumulated the political capital necessary to implement these changes, we expect to see a renewed push toward a "greener" China. Ceteris paribus, this will weigh on base metals production by reducing global supply and will support prices. "Houses Are Built To Be Inhabited, Not For Speculation" During the party congress, Xi reiterated his resolve to tighten control of the real estate market. In fact, the Chinese government has been trying for years to rein in demand for real estate, which typically involves raising mortgage rates. Tightening measures announced in late September include controls on home sales in eight major cities, which, among other things, prevent the resale of homes within five years of purchase. These controls have weighed on both prices and sales of real estate (Chart 4). More recently, the Ministry of Housing and Urban-Rural Development and the National Development and Reform Commission announced that they will jointly inspect real estate developers and commercial property sales agents, looking for "irregularities," including artificially inflating prices and hoarding unsold homes.7 Nonetheless, our China Investment Strategy desk does not foresee a major slowdown in construction activity.8 Simply put, they argue that strong demand amid declining inventories will prevent a construction slowdown, even in face of tighter policies (Chart 5). In fact, they do not see much excess in China's current property market to begin with, and thus doubt we will witness a major downturn. This will be important to bear in mind going forward, given that construction is the most important source of demand for base metals - copper in particular - and steel in China, accounting for about one-third of copper demand and half of steel demand. Chart 4Real Estate Policies Weigh##BR##On Prices And Sales Real Estate Policies Weigh On Prices And Sales Real Estate Policies Weigh On Prices And Sales Chart 5Housing Destocking Becomes Advanced Fundamentals##BR##Will Prevent A Major Real Estate Downturn Housing Destocking Becomes Advanced Fundamentals Will Prevent A Major Real Estate Downturn Housing Destocking Becomes Advanced Fundamentals Will Prevent A Major Real Estate Downturn Bottom Line: Despite efforts to tighten the property market, a sharp downturn in the construction sector, which is a major metals consumer, is unlikely. Structural tailwinds - most notably from China's continued urbanization - will eventually prevail, and the construction sector will remain a major contributor to China's economy, and base metals and steel consumption. Quality Over Quantity: Deleveraging The renewed focus on "sustainable and sound" growth, especially given the elimination of GDP growth targets beyond 2021, elevates the risk of a potential economic slowdown. The Xi administration has signaled that it is not afraid to prioritize financial regulation - targeting excessive risk and under-regulation - over economic growth. It is likely that it will continue doing so. In fact, Xi singled out systemic financial risk as a hazard to overall stability. While this is not China's first time to announce a deleveraging campaign, given that Xi has consolidated power and will use the CDIC to implement reforms, we expect these efforts to be more effective this time around. Furthermore, China has bounced back from the 2015 - 16 deflationary spiral so well that interest rate hikes and tighter financial controls are now on the table (Chart 6). Chart 6Interest Rate Hikes Are Now On The Table Interest Rate Hikes Are Now On The Table Interest Rate Hikes Are Now On The Table While the reforms are expected to improve Chinese productivity in the long-run, they may shake up the economy in the short run. We are somewhat reassured by the fact that traditionally, Chinese leaders have boosted fiscal spending when faced with slowing credit growth in periods when they aim to combat the negative effects of supply-side structural reforms and deleveraging. However, we remain cautious that, as Xi's priorities have shifted, fiscal stimulus may not be used with the same enthusiasm going forward. Given China's outsized role as a consumer of base metals, a slowdown would have serious repercussions on global markets. Researchers at the IMF find that surprises in the strength of China's economy - measured as the scaled deviation of year-on-year industrial production growth from the median Bloomberg consensus estimates immediately prior to the announcements - have significant impacts on base metals prices.9 This is true for all metals they studied - copper, nickel, lead, tin, and aluminum - with the exception of iron ore, which they put down to the relatively recent financialization of iron ore markets. In fact, they find that the more important China is to a specific base metal's fundamentals, the stronger the impact on prices. Using China's import share as a percent of world total as their measure of China's footprint in each individual market, they find that copper is most impacted by Chinese IP shocks, followed by nickel, lead, tin, and aluminum.10 Bottom Line: Beijing is continuously reassuring markets it will push for reforms - in the form of deleveraging the financial sector, restructuring industry, eliminating overcapacity, and environmental controls - without sacrificing growth. Nonetheless these reforms, which we believe are forthcoming following Xi's consolidation of power post-19th Congress, will be headwinds to growth. It is true that Xi may be willing to tolerate slower growth going forward in order to see his policies go through. Yet in all likelihood, fiscal stimulus will be used if social stability is threatened by reform measures. That said, reform is definitely in the cards. The Revival Of China's Silk Road - Enshrined In The Constitution Along with supply-side reforms, the Belt and Road initiative (BRI) - Xi's solution to a global slowdown through the physical integration of China's trading partners - was written into the constitution. This is a reiteration of Xi's intent to shift China away from being the factory of the world and toward playing a key role in global development. The ambition of the BRI plan is to connect many of China's trading partners in Asia, Europe, the Middle East, and Africa through a modern infrastructure of roads, ports, railway tracks, pipelines, airports, transnational electric grids, and fiber-optic lines. The objectives of the project, although speculative, are believed to be two-fold: It is an opportunity to create new markets for Chinese goods - giving the Chinese economy a push even in the event of a mainland slowdown. This is especially relevant, given the need to export excess capacity, most notably in the cases of steel and cement. In fact, Chinese industrial production will also benefit from the secondary effects of an improvement in demand for consumer goods from countries receiving economic aid from China. Furthermore, Xi hopes the project will help revive the economies of China's border regions. There is a possible ancillary benefit, in that heavy industry - e.g., steel mills and aluminum smelters - could be moved away from population centers to support the BRI. Chart 7BRI Investments On The Ascent bca.ces_wr_2017_11_09_c7 bca.ces_wr_2017_11_09_c7 Policymakers foresee the project - which was initiated in 2013 - injecting an estimated $150 billion annually into the construction of massive amounts of infrastructure (Chart 7). BCA's Frontier Markets Strategy (FMS) projects the value of Chinese BRI project investments will reach $168 billion in 2020.11 While this would boost China's economy in general, and base metals, steel and iron ore demand in particular, our FMS strategists argue that at ~ $102 billion, China-funded BRI investment expenditure in 2016 is dwarfed in comparison to China's gross fixed-capital formation (GFCF), which amounted to ~ $4.8 trillion last year. Simply put, the BRI is incapable of offsetting a general slowdown in China, were it to occur. In fact, our FMS desk estimates that a 0.4% contraction in GFCF is all that will be needed to offset BRI-related investments in 2018. Bottom Line: With the Belt and Road Initiative written into the constitution, we expect greater follow-through directed toward meeting the goals specified in it. On its own, this is positive for base metals, which will benefit from greater demand from infrastructure projects, as well as the secondary effects in the form of demand for consumer goods from trading partners. However, the BRI, in and of itself, will not super-charge base metals demand. The BRI will counteract some of the negative impacts of a slowdown in China growth on commodity markets generally. However, since the size of BRI investment expenditure accounts for only a small fraction of China's fixed capital formation, we are skeptical of the extent to which it can offset a slowdown, were it to occur in the mainland. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 In our modelling of base metal prices, we find China's PMI has a large and significant impact on metal prices. Using year-on-year growth rates since 2010, a 1% increase in China's PMI is associated with a 0.54% increase in the LMEX base metals price index. 2 Please see BCA Research's Geopolitical Strategy's Special Report titled "China: Party Congress Ends...So What?," dated November 1, 2017. It is available at gps.bcaresearch.com. 3 Please see BCA Research's Geopolitical Strategy Weekly Report titled "Xi Jinping: Chairman Of Everything," dated October 25, 2017, available at gps.bcaresearch.com. 4 Li Keqiang and Wang Yang are both from Hu Jintao's Communist Youth League, Han Zheng and Wang Huning are Jiang Zemin followers, and Li Zhanshu and Zhao Leji are Xi Jinping loyalists. 5 While this is positive for steel prices, it would dampen demand for iron ore, weighing down on its prices. 6 Alumina, aluminum, and carbon producers that meet emission discharge standards are ordered to cut production by over 30%, around 30%, and over 50%, respectively. Producers that do not meet emission discharge standards are ordered to halt production. 7 Please see "China to launch nationwide inspection on commercial housing sales," published October 25, 2017, available at www.chinadaily.com.cn. Noted "irregularities" include fabricating information on housing sales, publishing fake advertisements and artificially inflating housing prices, market manipulation, and hoarding unsold homes. 8 Please see BCA Research's China Investment Strategy Weekly Report titled "Chinese Real Estate: Which Way Will The Wind Blow?," dated September 28, 2017, available at cis.bcaresearch.com. 9 Please see IMF Spillover Notes, Issue 6 "China's Footprint in Global Commodity Markets," published September 2016, available at www.imf.org. 10 Interestingly, given the U.S.'s role as a harbinger of the global economy, U.S. IP surprises have a similar impact on commodity prices. 11 Please see BCA Research's Frontier Markets Strategy Special Report titled "China's Belt And Road Initiative: Can It Offset A Mainland Slowdown?," dated September 13, 2017, available at fms.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Shifting Gears In China: The Impact On Base Metals Shifting Gears In China: The Impact On Base Metals Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights The private sectors in Brazil, Russia and India have indeed experienced some deleveraging. Yet in China, deleveraging has not even begun. In fact, the money and credit excesses have become ever larger in the past two years. China's broad money (M3) is as large as the entire outstanding stock of broad money in the U.S. and euro area banking systems combined. In China, the triple tightening - higher corporate bond yields and money market rates, ongoing tightening by banking regulators and the anti-corruption campaign - will lead to lessened money and credit origination. That in turn will weigh on mainland capital spending and growth in general. Chart I-1Some Deleveraging In Brazil, Russia, And India Some Deleveraging In Brazil, Russia, And India Some Deleveraging In Brazil, Russia, And India Feature A judgment on the sustainability of the rally in EM/China-related risk assets, from a big picture perspective, should include whether deleveraging in these economies is in late stages - i.e., whether credit and debt excesses accumulated following the 2008 global financial crisis have been unwound, at least partially. The objective of this week's note is to provide an update on the status of deleveraging within EM/China. Herein, deleveraging is defined as a falling debt-to-GDP ratio. The private sectors within Brazil, Russia and India have indeed experienced some deleveraging, with their private sector debt-to-GDP ratio either falling or moving sideways (Chart I-1). However, in China, deleveraging has not yet even begun (Chart I-2). Excluding Korea, Taiwan, and the BRIC economies, the rest of EM has not seen much deleveraging either (Chart I-3) - we exclude Korea and Taiwan because their equity markets are contingent on global demand rather than domestic dynamics. Note that this debt-to-GDP aggregate is weighted by each country's respective market cap in the MSCI EM stock index. The latest stabilization in this ratio might be due to these countries' currency appreciation, which has reduced their foreign currency debt burden relative to GDP. While deleveraging in many individual developing economies will not affect the rest of the world, deleveraging in China will have an impact on global trade in general and EM economies in particular. This remains one of the most important reasons why we believe the current recovery in EM growth will not be sustained. Chart I-2Deleveraging Has Not Started Yet In China... Deleveraging Has Not Started Yet In China... Deleveraging Has Not Started Yet In China... Chart I-3...Nor In The Rest Of EM ...Nor In The Rest of EM ...Nor In The Rest of EM Some investors and commentators have remarked that in the U.S., the euro area and Japan, there was no deleveraging following their respective credit bubbles and crises. As such, they argue that there is no compelling reason to expect deleveraging in EM/China. The point about the lack of deleveraging in Japan, the U.S. and Europe following their credit bubbles is only true when one includes public debt (Chart I-4). Yet, their private sectors did deleverage as can be seen in Chart I-5. Chart I-4DM: Deleveraging Concealed By ##br##Acceleration In Public Credit DM: Deleveraging Concealed By Acceleration In Public Credit DM: Deleveraging Concealed By Acceleration In Public Credit Chart I-5Private Sector Deleveraged ##br##Meaningfully In DM Private Sector Deleveraged Meaningfully In DM Private Sector Deleveraged Meaningfully In DM In the U.S. and euro area, deleveraging lasted an average of about seven years. As to Japan - which had a larger credit bubble but never experienced an acute credit crisis - private sector deleveraging endured over more than 21 years (Chart I-5, bottom panel). Did deleveraging in these DM economies involve outright nominal contraction in private credit and bank loans, or only decline in private debt-to-GDP ratio? Both bank loans and private credit nominal growth contracted, as demonstrated in Chart I-6. In short, despite massive policy support - i.e. monetary and fiscal easing and various bank recapitalization programs - private credit growth shrunk in nominal terms in the U.S. and euro area for a couple of years, and for many more years in Japan. China An update on China's debt burden is in order: Despite the vast local government financing vehicle (LGFV) debt swap of about RMB13 trillion conducted over the past two years the corporate debt-to-GDP ratio has not dropped (Chart I-7, top panel). Chart I-6DM: Bank Loans & Private Sector Credit ##br##Contracted In Nominal Terms DM: Bank Loans & Private Sector Credit Contracted In Nominal Terms DM: Bank Loans & Private Sector Credit Contracted In Nominal Terms Chart I-7China's Breakdown ##br##Of Debt By Sector China's Breakdown Of Debt By Sector China's Breakdown Of Debt By Sector The corporate debt-to-GDP ratio has stopped rising because LGFV debt - which belonged to SOEs and was classified as corporate debt - has been converted into provincial government debt. Since the onset of the Chinese equity market crash in the summer of 2015, our measure of broad money (M3) has expanded by RMB38 trillion ($6 trillion). Similarly, total social financing excluding equity issuance and including local government debt issuance - our so-called TSF+ measure - has surged by RMB49 trillion ($7.4 trillion). In terms of annual growth rates, M3 and TSF+ are still expanding at 10% and 14%, respectively. Chart I-8China's Money Impulse Points ##br##To Growth Deceleration China's Money Impulse Points To Growth Deceleration China's Money Impulse Points To Growth Deceleration We do not expect China's credit growth to contract in nominal terms, but we do expect credit/money growth to slow further. If and when this occurs, the money and credit impulses - the second derivatives - will become negative. The growth rates of GDP, industrial production, capital spending, profits and imports are impacted by the second derivatives of money and credit, which have been declining. In fact, the M3 impulse is already negative, which is consistent with deceleration in China's business cycle (Chart I-8). Some commentators and strategists have argued that debt should be compared with debtors' assets not GDP. This is a very weak argument. The sustainability of debt is contingent on borrowers' ability to service it. In turn, the ability to service debt is determined by debtors' cash flow generation which can be measured / approximated by nominal GDP. This is why the debt-to-nominal GDP ratio is the best metric for debt sustainability on a macro scale. It factually measures debt relative to corporate nominal revenues and household income. What about assets? Just because a company has assets does not mean it can service its debt. Note that in China, debt sustainability concerns are primarily around companies not households or government. First, if a company's assets do not generate sufficient cash flow to service debt, the value of these assets will be low. Second, asset valuations in EM state-controlled companies in general and among Chinese SOEs in particular, where most of the debt is concentrated, cannot be taken at face value. When evaluating the creditworthiness of a debtor, should investors rely on the accounting value of buildings that a debtor owns, or on the cash flow that these assets generate? We believe the latter is a much more prudent approach to investment analysis than the former. Third, if assets indeed need to be liquidated to service debt across many debtors, the situation is already very dire. Finally, we acknowledge that the Chinese government has a lot of fiscal room to bail out corporate debtors. When the authorities do so and overall corporate debt declines, we will seriously contemplate changing our view and investment strategy. So far, corporate indebtedness has not declined. For all of the above reasons, the debt-to-nominal GDP ratio is a much more reasonable measure than the debt-to-assets ratio. To be clear, we are not suggesting that Chinese companies are heading into a massive default and liquidation cycle. Our key premise as it relates to China's debt burden is as follows: overleveraged companies that could potentially struggle to service their debt are unlikely to embark on major capital spending initiatives. And in fact, their creditors should not lend to these debtors. As a result, capital spending will slow, weighing on commodities and other related areas. Conclusions The credit and money excesses in China and EM have been increasingly getting larger. Not only does China have too much corporate debt, but its stock of outstanding broad money is very high compared to any other economy in the world (Chart I-9). Chart I-9China's 'Money Bubble' China's 'Money Bubble' China's 'Money Bubble' Money is created by banks "out of thin air" (subject to regulatory capital ratios and other constraints) when they lend or buy assets from non-bank entities. Banks' ability to originate money does not relate to or depend on consumers or national savings. We have explored these issues in detail in Trilogy of reports in the past.1 Chart I-10China: Beware Of Rising Inflation China: Beware Of Rising Inflation China: Beware Of Rising Inflation Chart I-9 illustrates that China's official broad money (M2) is equivalent to $25 trillion while our measure of broad money (M3) is equivalent to about $29 trillion. This compares with broad money of $14 trillion in each of the U.S. and the euro area. Hence, China's broad money (M3) is as large as the U.S. and euro area's aggregate broad money combined. Furthermore, as of January 1, 2009, China's M2 and M3 were only $7.3 trillion and $8 trillion, respectively. This entails that the Chinese banking system has increased the broad money supply by the equivalent of $18-21 trillion. The triple tightening - higher corporate bond yields and money market rates, ongoing tightening by banking regulators and the anti-corruption campaign that is moving into the financial system - will lead to lessened money and credit origination. This will weigh on capital spending and growth in general. The odds are that tightening will escalate. First, after the party Congress, President Xi has consolidated power and can now enact meaningful structural reforms. Second, as we documented several weeks ago, core consumer inflation is rising (Chart I-10). Producer prices inflation is holding up around 7%. This is not surprising, given the amount of money that has been created in the economy in the past two years. Even marginal policy tightening amid lingering credit excesses is very dangerous. Yet a moderate slowdown in credit growth can translate into a notable drop in the credit impulse, weighing on growth as a result. This is especially true for capital spending and construction and is one of the primary reasons why we maintain a negative stance on China-related and EM risk assets. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Reports from October 26, 2016, November 23, 2016 and January 18, 2017; available on ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations