Emerging Markets

Highlights Shorting the RMB against the dollar is no longer a one-way bet. Investors should look to reduce bearish positions on the RMB going forward. The RMB is no longer overvalued. Therefore, any further decline will push the RMB deeper into undershoot territory, which is ultimately subject to mean reversion. The recent focus on China's low and falling reserve-to-M2 ratio largely reflects lopsided expectations on continued capital outflows and further RMB declines. The PBoC should have no difficulties maintaining control over the exchange rate with the country's massive current account surplus, low foreign currency debt and pervasive capital account control measures. Feature With widespread consensus among investors and market-watchers for the RMB to continue depreciating against the U.S. dollar, a key question is whether the seemingly unloved RMB could once again become appreciated. Indeed, the widely shared consensus a mere three years ago - that the RMB had nowhere to go but up - has now become a highly controversial rhetorical question. The current prevailing view is that the RMB is under intense downward pressure against the dollar, and the People's Bank of China (PBoC) is fighting an uphill battle in maintaining exchange rate stability. Some have gone even further, relating the RMB's ongoing weakness to "money printing" and "credit largess." According to these pundits, the country's mighty official foreign reserves pale in comparison to domestic capital flight, and the end game will have to be a substantial currency depreciation before a new equilibrium is re-established. Chart 1The RMB's Rollercoaster Ride The RMB's Rollercoaster Ride The RMB's Rollercoaster Ride In June 2013, amid the comfortable consensus that the RMB would perpetually rise against the dollar and the RMB "carry trade" was running amok, we published a Special Report titled "Is The RMB Still Undervalued?"1 We argued at the time that "the large valuation buffer for the RMB has mostly been eliminated," and that "there is a strengthening case for the RMB to fall against the greenback." Fast forward four years, the CNY/USD peaked in January 2014 and has since depreciated by about 15% (Chart 1). As the consensus on the RMB has now completely swung to the other extreme, it is time for a new reality check and some provocative rethinking. What Has Changed? With the benefits of hindsight, it is easy to spot what went wrong for the RMB as well as for the Chinese economy. In our 2013 Special Report, we concluded that "the dollar appears to be bottoming out from its structural bear market" and that "the Chinese central bank should guide the RMB lower versus the greenback in order to maintain a relatively stable exchange rate against a currency basket." In reality, the sharp dollar rally of 2014-'15 pushed up the trade-weighted RMB by another 10% and led to draconian tightening in China's monetary conditions - a major policy mistake that caused relentless deflationary pressure and growth woes. By the same token, the depreciation of the RMB since early 2016 has turned out to be a key reflationary force that has helped stabilize the Chinese economy. As far as the RMB is concerned, there have been a few important changes in the macro environment. Chart 2The Dollar: A Long Term Perspective The Dollar: A Long Term Perspective The Dollar: A Long Term Perspective First, the dollar's multi-year bull market has pushed the greenback up by 25% since 2014. The U.S. economy is currently a bright spot in the world, and the Federal Reserve appears to be the most determined to tighten among the major monetary authorities - two factors that are likely to maintain dollar bullishness. However, it is important to note that the sharp rally has already pushed the dollar close to two sigma above its long-term trend (Chart 2). The dollar may remain well bid in the near term, but another major up leg similar to the one in 2014-'15 is highly unlikely. Second, the valuation froth in the RMB accumulated in previous years has been squeezed out (Chart 3). The trade-weighted RMB has fallen back to its long-term trend line after a two-sigma overshoot. Its spot rate against the dollar has now dropped below our PPP model fair value estimate. In real effective terms, the RMB has also quickly swung back from overvalued territory. The increase in Chinese producer prices since September 2016 also suggests the RMB may have become cheap again. Third, the massive RMB "carry trade" has been largely unwound. Before 2014, the RMB's one-way ascendance attracted speculative "hot money" inflows to China in anticipation of both higher yields and further currency upside. Chinese companies also sharply ramped up borrowing in foreign currencies, mostly U.S. dollars, for lower rates and potential exchange rate gains. Both trends abruptly reversed as the RMB began to fall, with hot money fleeing and domestic borrowers rushing to pay back foreign currency obligations. Chart 4 shows the abnormal surge of the RMB "carry trade" before 2014 has essentially vanished. Chart 3The RMB Is No Longer Overvalued The RMB Is No Longer Overvalued The RMB Is No Longer Overvalued Chart 4The Unwinding Of The RMB "Carry Trade" The Unwinding Of The RMB "Carry Trade" The Unwinding Of The RMB "Carry Trade" Finally, the reflationary benefit of a weaker exchange rate on the Chinese economy has been proven since 2016, which in of itself rules out the possibility of an endless RMB decline. As the largest manufacturer and exporter in the world, a weaker RMB is good news for the Chinese industrial sector's pricing power, profit margins and overall business activity - unless broad protectionist backlash blocks the positive feedback loop.2 The bearish argument on the RMB fixating on Chinese credit, even if true, ignores the reflationary impact on a major part of the Chinese economy, which in turn puts a floor under its exchange rate. What's Intact? Meanwhile, some factors that were widely viewed in previous years as supportive for an ever-rising RMB have remained largely intact. China still runs by far the largest trade surplus in the world, amounting to an annualized US$ 500 billion. Chinese foreign reserves, although having fallen by US$ 1 trillion since their all-time peak, still accounts for almost 30% of the global total (Chart 5). In comparison, China's official hoarding of foreign assets accounted for about 15% of the world in 2005, when the RMB was de-pegged from the greenback and began a decade-long ascent. In addition, Chinese exporters have continued to gain global market share, currently accounting for about 14% of world exports, more than double 2005 levels. Meanwhile, it is fairly likely that China's recent export numbers have been under-reported, as exporters have hidden part of their overseas proceeds offshore in anticipation of further RMB declines. Overall, there is no evidence that the value of the RMB has hindered Chinese exporters' competitiveness. From a long-term perspective, a country's productivity growth relative to the rest of the world fundamentally determines its relative competitiveness in global trade, which in turn is the ultimate driving force behind its exchange rate (Chart 6). On all these fronts, China still compares favorably to other major countries. Chart 5China's Foreign Official ##br##Reserves Remain Massive China's Foreign Official Reserves Remain Massive China's Foreign Official Reserves Remain Massive Chart 6Relative Productivity Determines ##br##Export Sector Competitiveness Relative Productivity Determines Export Sector Competitiveness Relative Productivity Determines Export Sector Competitiveness Are China's Foreign Reserves Enough? Chart 7 shows that the ebbs and flows of China's foreign exchange reserves are tightly linked with the USD/CNY "risk reversal" indicator, defined as the implied volatility for call options minus the implied volatility for put options on the cross rate. Chinese foreign reserves have increased for three consecutive months, a sign of slower capital outflows and easing concerns surrounding the RMB. It remains to be seen whether this is a permanent shift or a temporary pause. A more important question is whether China's foreign reserves are large enough for the PBoC to maintain control over its exchange rate. Chart 7The RMB Risk Aversion And Capital Flows The RMB Risk Aversion And Capital Flows The RMB Risk Aversion And Capital Flows Central banks' precautionary holdings of foreign reserves are mainly to reduce the likelihood of balance-of-payments pressures. From this perspective, for a country running chronic and massive trade surpluses with minimal foreign currency debt, China should not hold large foreign reserves at all. This is also why its massive foreign reserve holdings were long regarded as wasteful before 2014 by both market participants and Chinese policymakers - and since 2014 as the RMB has weakened the exact opposite: as not enough. Based on traditional yardsticks for reserve adequacy such as coverage ratios for imports or short-term foreign currency debt, China's reserves are far more than adequate. The more recent focus has been on additional metrics proposed by the IMF, particularly the ratio of reserves relative to a country's broad money supply (M2). This ratio captures potential residents' capital flight through the liquidation of their highly liquid domestic assets, which reflects potential drains on the balance of payments. Chart 8 shows a sharp decline in China's reserves-to-M2 ratio in recent years. However, this does not mean that Chinese foreign reserves are insufficient for the following reasons. Historically China's reserve-to-M2 ratio has had no direct correlation with the broad RMB trend. China's reserve-to-M2 ratio peaked at 28% in 2008, long before the RMB peaked. At 13% currently, the ratio is comparable to 2005 when the RMB began to rise against the dollar. Globally speaking, there is no empirical evidence that a higher reserve-to-M2 ratio helps alleviate downward pressure on a country's exchange rate. Other major emerging countries such as Brazil, Russia and India have much higher reserve-to-M2 ratios than China, but their currencies have suffered brutal declines in recent years (Chart 9). In contrast, Japan's reserve-to-M2 ratio is comparable to China, but the Bank of Japan has been trying desperately to weaken the yen. Germany's ratio is even lower. Finally, China's pervasive capital account control measures and its largely state-controlled financial institutions are powerful tools to hinder capital outflows, and can be adjusted to accommodate changes in the marketplace. This further diminishes the usefulness of this ratio. Chart 8China's Reserves-To-M2 Ratio Has Been Falling... China's Reserves-To-M2 Ratio Has Been Falling... China's Reserves-To-M2 Ratio Has Been Falling... Chart 9...But Does It Matter? ...But Does It Matter? ...But Does It Matter? Overall, the recent focus on China's low and falling reserve-to-M2 ratio largely reflects lopsided expectations on continued capital outflows and further RMB declines. This has all but ignored the prospect for capital inflows. True, Chinese households and companies will likely continue to diversify into foreign assets. However, there is an equally compelling case that foreign demand for RMB-denominated assets will also increase going forward. For example, Chinese local bond yields, both sovereign and credit, are substantially higher than other major economies. Meanwhile, foreign ownership in Chinese bonds is practically non-existent compared with other bourses (Chart 10). It is almost a sure bet that foreign demand for RMB bonds will increase significantly, especially if market expectations on the RMB stabilize. Given how dramatic market expectations on the RMB have shifted in the past several years, this could come much sooner than many expect. Chart 10The Case For Increasing Foreign Demand##br## For RMB Bonds The Case For Increasing Foreign Demand For RMB Bonds The Case For Increasing Foreign Demand For RMB Bonds Investment Conclusions We are not making the case for an immediate resumption of a rising RMB. In the near term, the USD/CNY cross rate will continue to be dominated by the broad dollar trend, the upside of which may not yet be exhausted. However, the prevailing bearish consensus means that shorting the RMB against the dollar has become a very crowded trade. Meanwhile, our valuation models suggest the RMB is currently no longer overvalued. Therefore, any further decline will push the RMB deeper into undershoot territory, which is ultimately subject to mean reversion. Overall, we caution against being overly negative at the moment, and investors should begin to reduce bearish bets on the RMB going forward. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Special Report, "Is The RMB Still Undervalued?," dated June 12, 2013, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Reflecting On The Trump-Xi Summit," dated April 13, 2017 available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights The risk to EM currencies is to the downside over the next 12 months - i.e., they will depreciate more than their carry. In this context, investors in local currency bonds should consider hedging against currency depreciation. The cross-currency basis spread can be used to calculate exchange rate-hedged yield on local currency bonds for U.S. dollar and euro-based investors. On a currency-hedged basis, Korean, Russian and Mexican local bonds offer the highest yield, while Turkish, South African and Chinese fixed-income securities stand at the opposite end of the spectrum. Feature The Big Picture: A Stampede Into EM Bonds There has been a stampede into EM risk assets since early this year. Fixed-income investors' search for yield is understandable, given DM bond yields are very low. However, we believe investors are underappreciating currency and other risks embedded in EM that are likely to manifest in the next 6-12 months. In other words, the fact that DM bond yields are low in of itself does not justify chasing EM bonds and currencies. Investment in EM should primarily be based on the merits of EM fundamentals. With respect to EM local bonds, total returns for international investors are greatly influenced by exchange rate moves. Not only does currency depreciation undermine returns for foreign investors, but in many high-yielding fixed income markets, bond yields also rise when their respective country's currency depreciates, and vice versa (Chart I-1). Furthermore, Chart I-2 demonstrates that high or rising interest rates historically have not precluded bear markets in EM currencies. On the contrary, historically, it was exchange rate that determined the direction and level of local interest rates: a strong currency led to lower interest rates and a weak currency warranted rising interest rates. This was especially true with the recent darlings of investors, the Brazilian real and South African rand. Chart I-1EM Local Bond Yields And ##br##Currencies: Negative Correlation EM Local Bond Yields And Currencies: Negative Correlation EM Local Bond Yields And Currencies: Negative Correlation Chart I-2In EM, Currencies Drive ##br##Interest Rates Not Vice Versa In EM, Currencies Drive Interest Rates Not Vice Versa In EM, Currencies Drive Interest Rates Not Vice Versa In our weekly reports, we have argued at length why EM currencies are set to depreciate considerably, and we will not repeat the rationale in this report. Instead, our focus this week is on hedging mechanisms and the concept of cross-currency basis swap. Specifically, we calculate what yields would be on offer to U.S. dollar- and euro-based investors in EM local currency bonds after hedging the EM exchange rate risk. This can be done via cross-currency basis swaps. We also demonstrate the mechanism behind the hedge, and present the relative attractiveness of local yields across the EM universe after hedging. EM local currency bonds are only comparable to each other as well as to U.S. Treasurys and German bunds after hedging exchange rate risk. We conclude that Korea, Russia and Mexico local bond markets offer the highest hedged yields, while Turkey, South Africa and China provide the lowest hedged yield. Bottom Line: The risk to EM currencies is to the downside in the next 12 months - i.e., they will depreciate more than their carry. In this context, investors in local currency bonds should consider hedging against currency depreciation. Cross-Currency Basis Swap The cross-currency basis spread is the price of a cross-currency basis swap. This spread is directly quoted in the marketplace. The swap allows two parties involved to temporarily access each other's currencies without having to take on foreign currency exposure. Chart I-3 demonstrates an equal-weighted average basis spread for nine EM currencies (Mexico, Russia, Korea, Malaysia, Turkey, South Africa, China, Hungary, Poland) and the aggregate EM exchange rate versus the greenback. Chart I-4 does the same but against the euro - i.e., EM cross-currency basis spread versus the euro, and the EM aggregate exchange rate against the euro. Chart I-3EM Versus U.S. Dollar And Cross-Currency Basis Swap With Dollar EM Versus U.S. Dollar And Cross-Currency Basis Swap With Dollar EM Versus U.S. Dollar And Cross-Currency Basis Swap With Dollar Chart I-4EM Versus Euro And Cross-Currency Basis Swap With Euro EM Versus Euro And Cross-Currency Basis Swap With Euro EM Versus Euro And Cross-Currency Basis Swap With Euro A few considerations are in order: A negative basis spread means that U.S. dollar investors are paid to hedge their EM currency exposure - i.e., they can enhance their U.S. dollar yield by forgoing their EM local yield and hedging their EM exchange rate risk. The aggregate EM basis spread was very wide in 2011 before the EM bear market began. This meant that not many investors hedged their EM currency exposure before the second half of 2011. From 2011 through to mid-2016, various EM cross-currency basis spreads narrowed. The narrowing occurred at an uneven pace, at times in sync with EM rallies and at other times with EM selloffs. This suggests that fixed-income investors were periodically hedging their EM currency exposure via basis swaps until the middle of 2016. Since the middle 2016 - the point when confidence in EM fixed-income rally was cemented - the basis swap spread has widened. This entails that EM fixed-income investors have been reluctant to hedge their currency risk via basis swaps. This corroborates the lingering complacency among the investment community with respect to EM risk. Chart I-5EM Domestic Bond Yields ##br##Over U.S. Treasurys Are Low EM Domestic Bond Yields Over U.S. Treasurys Are Low EM Domestic Bond Yields Over U.S. Treasurys Are Low There is no strong and stable correlation between the EM basis swap spread and EM exchange rate moves (appreciation/depreciation). However, the persisting negative sign of the basis spread implies stronger secular demand for hedged U.S. dollar funding from EM companies and banks than demand for hedged EM currency exposure among foreign investors and companies. Remarkably, the spread of EM local bond yields over 5-year U.S. Treasurys is at the bottom of the trading range that has prevailed over the past seven years (Chart I-5). Provided that EM exchange rate risk is currently considerable, the current level of EM local yields does not warrant blind yield chasing. Hedging Mechanism While obtaining funds in the spot foreign exchange market and hedging via forwards is possible, liquidity in forwards becomes very poor beyond 12 months. Cross-currency basis swaps allow hedging up to multiple years, effectively locking in yields until the maturity of the bond. The following illustrates the transactions involved in the hedging process. A fixed-income portfolio manager (PM) starts with $1 U.S. dollar. This investor enters into a cross-currency basis swap with Counterparty A who, let's say, owns Malaysian ringgits. The PM gives $1 and receives 4.3 MYR, where 4.3 is the spot exchange rate. The PM also agrees to swap back 4.3 MYR for $1 at maturity. The PM then takes the 4.3 MYR and purchases a Malaysian 5-year local currency government bond yielding 3.7% (Chart I-6). During the lifetime of the swap, the PM receives U.S. LIBOR from Counterparty A. In return, she/he must pay Counterparty A KLIBOR (the Kuala-Lumpur interbank offered rate, presently 3.9%) plus the basis spread, which is currently -50 basis points. The PM collects 3.7% yield from the ownership of Malaysian government bonds (Chart I-7). Thus, a negative basis spread of 50 basis points implies that the PM would be paying less than KLIBOR, which is the ordinary rate for borrowing ringgits. At the maturity of the swap contract, the PM redeems the bond and pays 4.3 MYR back to Counterparty A. In exchange, Counterparty A returns $1 U.S. dollar (Chart I-8). Chart I-6Hedging Mechanism: Step 1 EM Local Bonds: Looking At Hedged Yields EM Local Bonds: Looking At Hedged Yields Chart I-7Hedging Mechanism: Step 2 EM Local Bonds: Looking At Hedged Yields EM Local Bonds: Looking At Hedged Yields Chart I-8Hedging Mechanism: Step 3 EM Local Bonds: Looking At Hedged Yields EM Local Bonds: Looking At Hedged Yields The transaction allowed the international fixed-income investor to gain exposure to local currency Malaysian government bonds with almost no currency risk, as the PM received all of the payments in U.S. dollars. On a net basis, the investor receives the following yield: U.S. LIBOR + local yield - (KLIBOR + BASIS), or 2.3% = 2.0% + 3.7% - (3.9%-0.5%). Importantly, this yield is in U.S. dollars, meaning the PM has secured the principal investment and the yield on it in U.S. dollars while gaining exposure to Malaysian local currency sovereign bonds. The latter entails that the portfolio will gain/lose from changes in prices of Malaysian government bonds. Besides, the investor still has some currency exposure on the quarterly flows of interest payments. However, this is miniscule in comparison to the notional. Currency-Hedged Local Bond Yields Using the method described above to calculate hedged returns for individual countries, we ranked the resulting yields for EM countries with available data. Unfortunately, some markets like Brazil do not have a cross-currency basis swap market. Chart I-9 ranks currency-hedged yield for U.S. dollar investors for investments in 5-year local currency fixed-income bonds. Chart I-9EM Local Bonds: Currency-Hedged Yields For U.S. Dollar Investors EM Local Bonds: Looking At Hedged Yields EM Local Bonds: Looking At Hedged Yields We also did the same calculation for the euro using German bunds as a proxy. For pairs that do not have direct cross-currency basis swaps with the euro or U.S. dollar, we use the euro/U.S. dollar cross-currency basis to do the conversion. Chart I-10 classifies EM countries according to their hedged euro yield for euro-based international fixed-income investors. Chart I-10EM Local Bonds: Currency-Hedged Yields For Euro-Based Investors EM Local Bonds: Looking At Hedged Yields EM Local Bonds: Looking At Hedged Yields For 5-year local bonds, the highest hedged yields are offered by Korea, Russia and Mexico. In contrast, the lowest hedged yields for 5-year domestic local bonds are offered by Turkey, South Africa and China. These hedged yields are calculated on our best estimate of transactions happening at the mid-point of the bid-ask spread. The EM cross-currency swap market is often illiquid. Coupled with the fact that the hedging process requires multiple transactions, the hedged return can be quite lower. To conclude, the highest-yielding local bond markets do not always offer the highest yield when taking currency hedging into account. A caveat is in order: Applying hedging via basis swaps eliminates exchange rate risk, but it does not eliminate risk from fluctuations in bond prices (capital gains/losses). Therefore, in the event that EM local bond yields rise as their currencies depreciate, hedging via basis swaps will not protect against capital losses. Therefore, basis swap hedging should be used by long-term fixed-income investors who have deployed a lot of capital in EM local bond markets and share our concerns on EM exchange rates. These investors typically have a higher tolerance for asset price swings compared with traders who have little tolerance for short-term losses. The latter should sell out of EM domestic bonds altogether. Investment Implications This exercise reinforces our existing overweights in Korean, Russian and Mexican bonds within the EM local currency bond universe. Similarly, it also corroborates our underweights in Turkish and South African domestic bond markets. Although we expect most EM currencies will depreciate versus both the U.S. dollar and the euro in the next 12 months, the Korean won (as well as other low-yielding Asian currencies such as the TWD and the SGD), the Russian ruble and the Mexican peso are less vulnerable, and will outperform other EM currencies. By contrast, the TRY and the ZAR are among the most vulnerable, even after adjusting for their high carry. A plunge in these currencies will also force their local bond yields higher. Hence, capital losses on local bonds even after hedging exchange rate risk could be substantial in these countries. Furthermore, we also continue to recommend overweight positions in local currency bonds in Poland, Hungary, India and Chile within the EM universe. Henry Wu, Research Analyst henryw@bcaresearch.com

Please note that we are publishing a Special Report today titled "EM Local Bonds: Looking At Hedged Yields". Feature Commodities prices have plunged lately, even though the U.S. dollar, up until this past week, has been weak versus European currencies. Hence, the recent selloff in the commodities complex cannot be attributable to U.S. dollar strength. Something else has been at work. Furthermore, EM share prices and currencies have decoupled from both commodities prices and DM commodities currencies such as the AUD, NZD and the CAD (Chart I-1). Chart I-1Unsustainable Divergence Unsustainable Divergence Unsustainable Divergence Is this time different, and are we entering a new era in EM investing? We do not think so. This divergence is unsustainable and reflects irrational exuberance and fund flows into EM. The decoupling is already overstretched - although it could last another several weeks, it will not continue for much longer. We have the following observations: The commodities selloff has been very broad-based, and has been especially intense in commodities that are trading in China as well as those that are leveraged to Chinese growth (Chart I-2A & Chart I-2B). Such a simultaneous gap down in various commodities prices can be explained either by a decline in speculative long positions in commodities or weakness in real demand. It cannot be attributed to supply because the selloff has transpired at the same time across various commodities. Commodities' supply dynamics are idiosyncratic. China's central bank has been tightening liquidity, forcing deleveraging in the financial system. It is very plausible that this has led to an unwinding of long positions in commodities trading in China. Chart I-2AWidespread Carnage In Commodities Widespread Carnage In Commodities Widespread Carnage In Commodities Chart I-2BWidespread Carnage In Commodities Widespread Carnage In Commodities Widespread Carnage In Commodities China bulls would correctly argue that the selloff in commodities is indicative of a reduction in speculative trading activities - not in final demand. However, to be consistent, we should also accept that that the commodities rally in 2016 was not entirely due to demand improvement in China. Instead, it was at least partially due to speculative investment demand. It is impossible to quantify the magnitude of speculative activity in China's commodities markets, yet it has probably been a non-trivial force supercharging both last year's rally as well as the latest selloff. In regard to commodities demand from the real economy, China's growth has not yet turned decisively down. That said, the growth outlook is downbeat as credit growth downshifts in response to the ongoing policy tightening. Chart I-3 illustrates that the annual growth in the number and value of newly started projects has recently contracted. This heralds weaker demand for commodities, materials and capital goods in the months ahead. The surge in new projects launched last year marked the beginning of an upturn in industrial activity, and could well be indicative of a budding downtrend now. Besides, Chinese imports of industrial metals (excluding iron ore) has by and large been flat since 2010 (Chart I-4). The mainland's iron ore imports have been strong because inefficient/expensive domestic production has been shut down, leading to an increase in imports. Chart I-3China: Capital Spending To Slump Again China: Capital Spending To Slump Again China: Capital Spending To Slump Again Chart I-4China: No Growth In Industrial Metals' Imports China: No Growth In Industrial Metals' Imports China: No Growth In Industrial Metals' Imports Although China's oil imports have been strong (Chart I-5, top panel), underlying final demand has been weaker as there is evidence that the country has used imports of crude to increase inventories (Chart I-5, bottom panel). Provided that inventories are mean-reverting, such a large build-up in crude inventories poses a risk to China's oil demand and oil prices in the months ahead. Remarkably, the Brazilian real and South African rand have recently decoupled from the overall commodities price index and platinum prices, respectively (Chart I-6). These divergences represent a substantial departure from historical correlations. We cannot find any explanation other than the ongoing irrational exuberance in EM financial markets. Finally, signposts of potential growth deceleration are not only limited to the commodities complex. For example, Taiwanese narrow money (M1) impulse has decisively rolled over; it typically leads Taiwanese exports and correlates well with the equity market (Chart I-7). Chart I-5China's Oil Imports And An Inventories Proxy China's Oil Imports And An Inventories Proxy China's Oil Imports And An Inventories Proxy Chart I-6EM Commodity Currencies And Commodities Prices EM Commodity Currencies And Commodities Prices EM Commodity Currencies And Commodities Prices Chart I-7Taiwanese Export Growth And Equities Are At Risk Too Taiwanese Export Growth And Equities Are At Risk Too Taiwanese Export Growth And Equities Are At Risk Too Bottom Line: The recent decoupling between commodities prices and EM risk assets is unsustainable. This divergence reflects irrational exuberance that typically transpires around a major market top. While not chasing this rally has been painful, there is no point in doing so at current levels. We recommend investors maintain a negative stance on EM risk assets. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Duration: U.S. growth expectations have become overly pessimistic. A Q2 rebound will lead to higher global bond yields and a steeper U.S. Treasury curve. UST / Bund Spread: The extreme divergence between the European and U.S. economic surprise indexes is not sustainable, especially in the face of weakening Chinese economic data. The Treasury / Bund spread is biased wider in the near term, though could tighten in the second half of this year as the ECB shifts to a less accommodative policy. USD Hedging Costs: Declining hedging costs driven by interest rate differentials and negative basis swap spreads make international bond investment very attractive for U.S. investors. Feature Chart 1Global Recovery Will Persist Global Recovery Will Persist Global Recovery Will Persist The synchronized global recovery that took hold in the second half of 2016 has stalled so far this year. Measures of economic sentiment, such as the Global ZEW survey and our own Boom/Bust Indicator, have rolled over from high levels and global bonds have clawed back some of last year's lost returns (Chart 1). Year-to-date, the Bloomberg Barclays Global Government Bond index has returned +3%, after having lost more than 9% between the July trough in the Global ZEW index and the end of last year. In our view, a repeat of early 2016's global growth slowdown and bond market rally, which saw the Global ZEW index fall below zero and the Global Government Bond index return 11.6% in 2016H1, is not in the cards. The global economy is on much firmer footing than at this time last year. U.S. Growth: Past Peak Pessimism First quarter U.S. GDP growth was a disappointing 0.7%, but is poised to bounce back strongly in Q2. The volatile inventories component subtracted 0.9% from overall Q1 growth, harsh weather wreaked havoc on the March employment report and there continue to be problems with residual seasonality depressing first quarter GDP data.1 The outlook is much brighter moving forward. The latest employment report showed that the U.S. economy added a healthy 211k jobs in April and our model is pointing toward a further acceleration (Chart 2). Economic growth can be thought of as a combination of aggregate hours worked and labor productivity (Chart 3). With aggregate hours worked growing at 1.7% year-over-year and labor productivity growth having averaged 0.6% (annualized) per quarter since 2012, real U.S. GDP growth of around 2.3% seems like a reasonable forecast. Chart 2Labor Market Still Strong Labor Market Still Strong Labor Market Still Strong Chart 3Look For Above 2% Growth Look For Above 2% Growth Look For Above 2% Growth There is even some reason to suspect that labor productivity could strengthen during the next few quarters. A recent IMF paper2 attributed weak post-crisis productivity growth to a combination of structural and cyclical factors, but also noted that weak investment in physical capital may be responsible for lowering total factor productivity growth by nearly 0.2 percentage points per year in advanced economies during the post-crisis period. With leading indicators pointing to still further gains in fixed investment (Chart 3, bottom panel), we would not be shocked to see productivity growth enjoy a modest late-cycle rebound. Chart 4Stronger Productivity = Steeper Curve Stronger Productivity = Steeper Curve Stronger Productivity = Steeper Curve All else equal, a late-cycle rebound in productivity growth would slow the increase in unit labor costs. Unit labor costs are a combination of wages (compensation-per-hour) and productivity (output-per-hour), and have historically tracked changes in the slope of the U.S. yield curve (Chart 4). Faster wage growth tends to coincide with Fed tightening, and slower wage growth with Fed easing. For this reason, all wage measures perform reasonably well tracking changes in the yield curve. But unit labor costs perform best because they also incorporate productivity growth, and low productivity growth can flatten the yield curve by pulling down long-dated yields. Rapid increases in compensation-per-hour and muted productivity growth have combined to give the yield curve a strong flattening bias during the past several years. Any increase in productivity growth would slow the uptrend in unit labor costs relative to other wage measures, allowing the yield curve to steepen. In fact, we continue to recommend that investors position for a steeper U.S. yield curve by going long the 5-year Treasury note and shorting a duration-matched barbell consisting of the 2-year and 10-year notes. This trade produces positive returns when the 2/10 slope steepens (Chart 4, panel 3), but has also returned +19 bps since we initiated the position last December, even though the curve has flattened since then. The reason for the trade's strong performance in an unfavorable curve environment is that the 5-year yield had been unusually elevated compared to the rest of the curve. Our model of the 2/5/10 butterfly spread versus the 2/10 slope showed that the 5-year note was one standard deviation cheap on the curve as recently as mid-March (Chart 4, bottom panel). This undervaluation has mostly dissipated and the 5-year note now appears only slightly cheap. For our curve trade to outperform from here, it will likely require the 2/10 slope to steepen.3 Bottom Line: With weak Q1 GDP now in the rearview mirror, we are likely past the point of peak pessimism on U.S. growth. Expect global bond yields to rise and the U.S. yield curve to steepen as the economic data start to reflect an environment of above-trend growth, in the neighborhood of 2% - 2.5%. European Growth & The Risk From China While the U.S. data have disappointed in recent weeks, as evidenced by the U.S. Economic Surprise Index having dipped below zero (Chart 5), the European economy has consistently bested expectations (Chart 5, panel 2). As a result, the Treasury / Bund spread has narrowed from high levels during the past few months. In practice, economic surprise indexes tend to mean revert because positive data surprises beget increasingly optimistic expectations. Eventually, overly optimistic expectations become too high a hurdle and the data start to disappoint. In our view, U.S. expectations have become unduly pessimistic while the Eurozone surprise index appears overdue for a correction. Against this back-drop, we expect the Treasury / Bund spread to widen in the near term as the large divergence between the U.S. and European surprise indexes starts to narrow. Further making the case for a wider Treasury / Bund spread is the recent performance of the Chinese economy. Our Foreign Exchange Strategy service recently observed that growth differentials between the U.S. and Europe are highly correlated with indicators of Chinese growth.4 This should not be overly surprising since Europe trades more with China and other Emerging Markets than does the United States. Along those lines, the IMF has calculated that a 1% growth shock to Emerging Markets impacts European growth by nearly 40 basis points, while it impacts U.S. growth by only 10 basis points.5 The worry at the moment is that Chinese monetary conditions have started to tighten, and China's Manufacturing PMI is rolling over alongside weaker commodity prices. These trends usually coincide with the underperformance of Europe relative to the U.S. (Chart 6). Chart 5Surprise Indexes Will Converge Surprise Indexes Will Converge Surprise Indexes Will Converge Chart 6Look To China To Trade UST / Bund Spread Look To China To Trade UST / Bund Spread Look To China To Trade UST / Bund Spread Our China Investment Strategy service highlights the importance of the trade-weighted RMB as a driver of Chinese growth.6 The RMB's 30% appreciation between 2012 and 2015 applied a massive deflationary force to China's economy, while its more recent depreciation helped boost producer prices, enhance profit margins and reduce the real cost of funding (Chart 7). Chart 7Monetary Conditions ##br##Still Fairly Stimulative Monetary Conditions Still Fairly Stimulative Monetary Conditions Still Fairly Stimulative More recently, the pace of the RMB's depreciation has slowed and this likely explains the weakness in China's Manufacturing PMI and commodity prices. Our China strategists are quick to note that while the pace of RMB depreciation has slowed, it is still not appreciating, and real interest rates deflated by the producer price index remain negative. In other words, monetary conditions have become somewhat less stimulative, but they should still be supportive of further economic growth. Although the Chinese economic data are likely to moderate in the coming months, barring the major policy mistake of aggressive tightening, Chinese growth will avoid a collapse and remain reasonably buoyant. Similarly, we would also expect European growth expectations to soften in the coming months, but growth is very likely to remain above trend and the ECB is still on track to adopt a less accommodative policy stance over the next year. In the most likely scenario, a few hints will be given at the June ECB meeting, and then an announcement that asset purchases will be tapered in 2018 will be made at the September meeting. The market will correctly assume that rate hikes will follow the taper, and this re-pricing of rate expectations will open up a window in the second half of this year when the Treasury / Bund spread can tighten. However, it is still too soon to adopt this position. Bottom Line: The extreme divergence between the European and U.S. economic surprise indexes is not sustainable, especially in the face of weakening Chinese economic data. The Treasury / Bund spread is biased wider in the near term, though could tighten in the second half of this year as the ECB shifts to a less accommodative policy. U.S. Bond Investors Should Expand Their Borders Divergences that have opened up between U.S. short-term interest rates and short-term rates in other developed countries mean that U.S. bond investors now face much lower currency hedging costs. In addition, increasingly negative cross-currency basis swap spreads have become a permanent feature of the post-crisis investment landscape, and unless significant regulatory changes occur, we expect they are here to stay. Combined, both of these factors make it incredibly attractive for U.S. bond investors to swap their U.S. dollars for foreign currencies and invest in foreign government bonds. In this week's report we explain why this is an attractive trade for U.S. investors and why it will likely remain so for quite some time. What Is The Basis Swap Spread? An excellent definition of the cross-currency basis comes from the Bank for International Settlements (BIS) who define it as "the difference between the direct dollar interest rate in the cash market and the implied dollar interest rate in the [currency] swap market".7 In essence, the existence of a negative basis swap spread should mean that there is an opportunity to arbitrage the difference between interest rates in the cash market and implied interest rates in the currency swap market. However, post-crisis regulatory constraints on bank balance sheets appear to have made this arbitrage prohibitive. Banks are either unable or unwilling to arbitrage the basis swap spread back to zero, and this increases the cost of U.S. dollars in FX swap markets. As a quick example, we can calculate the 10-year German Bund yield hedged into U.S. dollars using currency forwards. Hedged yield = Unhedged yield - Cost of hedging Where: Cost of hedging = forward exchange rate / spot exchange rate In this case, we define the exchange rates as euros per 1 U.S. dollar. By covered interest rate parity, we can also calculate the cost of hedging as: Cost of hedging = (1 + euro interest rate + basis swap spread) / (1 + USD interest rate) Using current 3-month interest rates, this means that the cost of hedging from euros into U.S. dollars is: Cost of hedging = (1 - 0.36% - 0.3%) / (1 + 1.18%) = -1.82% This means that the 10-year German Bund yield rises from 0.42% to 2.24%, from the perspective of a U.S. dollar investor, after hedging the currency on a 3-month horizon. In other words, U.S. investors can significantly increase the average yield of their portfolios by lending U.S. dollars over short time horizons and investing the proceeds into non-U.S. bonds. In Chart 8 we show the difference this currency hedging makes for German, Japanese and French 10-year government bonds. Current hedged 10-year yields for all the major bond markets are also shown on page 13 of this report. But for how long can this trade continue? In short, it can continue for as long as U.S. short-term interest rates increase relative to non-U.S. short-term interest rates and for as long as basis swap spreads move further into negative territory. At the moment there is no widespread agreement on what drives the day-to-day fluctuations in the basis swap spread. The BIS has posited a model where dollar strength weakens the capital positions of bank balance sheets, causing them to back away from providing liquidity to the FX swap market, and leading to increasingly negative basis swap spreads (Chart 9, top panel). Chart 8Higher Yields Via Currency Hedging Higher Yields Via Currency Hedging Higher Yields Via Currency Hedging Chart 9Basis Swaps, Reserves And The Dollar Basis Swaps, Reserves And The Dollar Basis Swaps, Reserves And The Dollar Meanwhile, Zoltan Pozsar from Credit Suisse has identified a link between basis swap spreads and reserves on the Fed's balance sheet (Chart 9, bottom panel).8 Specifically, as the Fed winds down its balance sheet it will be draining cash reserves from the banking system and replacing them with Treasury securities. This could cause money to leave the FX swap market and flow into Treasuries. The result is less liquidity in the FX swap market and increasingly negative basis swap spreads. Interestingly, the run-up to the debt ceiling in the U.S. has presented a test of this view. To stay under the debt ceiling the U.S. Treasury department has drawn down its cash account at the Fed and removed T-bill supply from the market. The result has been a temporary increase in reserve balances. As the theory would have predicted, basis swap spreads have moved closer to zero as reserves have increased. Going forward, the Fed is very likely to start winding down its balance sheet later this year. In all likelihood this will serve to pressure basis swap spreads even further below zero. Meanwhile, short-term interest rates in the U.S. will probably continue to rise more quickly than in most other developed markets. This means that the cost of hedging should become increasingly negative for U.S. investors. In Chart 10 we show that as the cost of hedging becomes more negative, total returns from a USD-hedged position in German bunds tend to outpace total returns from a position in U.S. Treasuries. Similarly, Chart 11 shows that USD-hedged Japanese government bonds (JGBs) also tend to outperform U.S. Treasuries when the cost of hedging falls. Chart 10Hedging Costs & Bond Returns: Germany Hedging Costs & Bond Returns: Germany Hedging Costs & Bond Returns: Germany Chart 11Hedging Costs & Bond Returns: Japan Hedging Costs & Bond Returns: Japan Hedging Costs & Bond Returns: Japan We should note that the relationships between hedging costs and relative total returns shown in Charts 10 & 11 are not perfect, and there will be instances when Treasuries can outperform even if hedging costs continue to decline. However, in the long run, as long as short-term U.S. interest rates continue to rise more quickly than short-term interest rates in the Eurozone or Japan, and especially if the Fed's upcoming balance sheet contraction leads to more deeply negative basis swap spreads, then U.S. investors should continue to boost their yields by lending dollars and investing in bunds and JGBs. Bottom Line: Declining hedging costs driven by interest rate differentials and negative basis swap spreads make international bond investment very attractive for U.S. investors. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Our U.S. Investment Strategy service took up the issue of residual seasonality in a recent report. Please see U.S. Investment Strategy Weekly Report, "Spring Snapback?", dated April 24, 207, available at usis.bcaresearch.com 2 IMF Staff Discussion Note, "Gone with the Headwinds: Global Productivity", https://www.imf.org/en/Publications/Staff-Discussion-Notes/Issues/2017/04/03/Gone-with-the-Headwinds-Global-Productivity-44758 3 Our outlook for the U.S. yield curve was discussed in detail in a recent report. Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report, "ECB: All About China?", dated April 7, 2017, available at fes.bcaresearch.com 5 IMF Multilateral Policy Issues Report: 2014 Spillover Report https://www.imf.org/external/np/pp/eng/2014/062514.pdf 6 Please see China Investment Strategy Weeky Report, "Has China's Cyclical Recovery Peaked?", dated May 5, 2017, available at cis.bcaresearch.com 7 http://www.bis.org/publ/work592.pdf 8 https://ftalphaville.ft.com/2017/04/13/2187317/where-would-you-prefer-your-balance-sheet-banks-or-the-federal-reserve/ Fixed Income Sector Performance Recommended Portfolio Specification

Highlights China's recent growth moderation is due to marginally tighter monetary conditions. There is no case for severe policy tightening that could lead to a material growth relapse. There are plenty of signs the economy could continue to run hotter on almost all fronts. The downside risk in the economy remains fairly low, even if annual growth rates of various macro variables do not continue to accelerate. Feature Chart 1Tighter Monetary Conditions ##br##Led To Growth Moderation Tighter Monetary Conditions Led To Growth Moderation Tighter Monetary Conditions Led To Growth Moderation Our team was in China over the past two weeks, talking to investors and exchanging views with our local contacts for some on-the-ground reconnaissance. Investors appeared more upbeat on China's cyclical outlook than during our recent past trips, but generally speaking conviction remained low, and concern on some structural issues - particularly credit and the housing market - remained deeply rooted. Investors' more upbeat sentiment on growth reflected China's cyclical recovery since early last year, but the rapidly-emerging consensus appeared to be that the growth acceleration peaked in the first quarter, and the economy is facing growing downward pressure, even though few investors seem worried about a chaotic "hard landing" at the moment. Collectively, investors appeared largely preoccupied with downside risks and mindful of negative surprises, while the upside risks were not really discussed. China's latest PMI numbers released this week seemed to validate the consensus view of an imminent growth top. Most major components of the PMI surveys in both the manufacturing and service sectors had setbacks, which were also reflected in softer commodities prices (Chart 1).1 A key reason for the growth moderation is likely the performance of the RMB. We have long argued that the RMB's depreciation has been a key reflationary force for China, which boosted producer prices, enhanced profit margins and reduced the real cost of funding.2 By the same token, the pace of RMB depreciation has moderated in recent months, removing some reflationary impulses within the economy. However, it is important to note that China's worsening growth deterioration in previous years was in part attributable to sharp RMB appreciation, a replay of which is highly unlikely going forward (Chart 2). The RMB appreciated by almost 30% between 2012 and 2015, a massive deflationary shock to the economy. Currently, the trade-weighted RMB is still depreciating, albeit at a slower pace, and real interest rates deflated by PPI are still negative. In other words, although tighter on the margin, monetary conditions are still fairly stimulative, which should continue to help the economy improve. On the fiscal front, the government significantly reduced fiscal stimulus toward the end of last year, but quickly reversed course (Chart 3).3 Both direct fiscal spending and infrastructure investment have picked up notably, and its impact will continue to ripple through the broader economy. Moreover, China's fiscal spending tends to be pro-cyclical: growth recovery typically boosts fiscal revenues, which gives the government more financial resources for fiscal expenditures, and vice versa. Unless the government steps on the brakes, there is no case for a sudden retrenchment in fiscal stimulus soon. Chart 2China: But Monetary Conditions ##br##Remain Fairly Stimulative But Monetary Conditions Remain Fairly Stimulative But Monetary Conditions Remain Fairly Stimulative Chart 3... Meets Waning Fiscal Stimulus China: ##br##Fiscal Retrenchment Has Been Reversed Fiscal Retrenchment Has Been Reversed Fiscal Retrenchment Has Been Reversed In short, China's policy setting remains expansionary, a major departure from previous years when the Chinese economy was under the heavy weight of policy tightening while external demand also weakened. Looking forward, there is little chance that the Chinese authorities will commit similar policy mistakes that could lead to a major growth downturn. Chart 4China: More Upside In Exports? More Upside In Exports? More Upside In Exports? Barring a major policy mistake of aggressive tightening, Chinese growth should remain buoyant. In fact, there are plenty of signs the economy could continue to run hotter on almost all fronts: Exports are likely to continue to accelerate, according to our model, barring disruptions from major external shocks such as election surprises in Europe and /or broad protectionist measures from the Trump administration (Chart 4). America's latest anti-dumping measures on some Chinese steel products are irrelevant from a big picture point of view, as U.S. steel imports from China only account for a mere 1% of Chinese steel output.4 The upturn in the profit cycle will likely boost investment, particularly among private industrial enterprises (Chart 5). Rising profits and higher output prices indicate tighter capacity utilization, which would in turn encourage capital spending. The prolonged downturn in China's capital spending cycle has likely come to an end. Domestic consumption may further benefit from improvement in the labor market, which is lifting both income and confidence. This is particularly important for large-ticket consumer durable goods such as automobiles and household appliances. Housing construction will likely continue to improve, driven by strong demand. The most recent central bank survey showed that households' home-buying intentions jumped to an all-time high in the last quarter, underscoring a massive increase in pent-up demand (Chart 6). Developers are also warming to increasing supply - and land purchases have resumed positive growth in recent months after a prolonged slump. Tighter housing policies in major cities will prevent a massive boom, but will not short-circuit the recovery. Chart 5China: Private Capex Should Have Bottomed Private Capex Should Have Bottomed Private Capex Should Have Bottomed Chart 6China: A Sharp Recovery In Housing Demand A Sharp Recovery In Housing Demand A Sharp Recovery In Housing Demand All in all, we reiterate our view that the downside risk in the Chinese economy is low from a cyclical perspective, even if annual growth rates of various macro variables do not continue to accelerate. Growth figures to be released in the coming weeks will become noisy, but we lean against being overly bearish. Overall, business activity will remain fairly robust, and a major relapse in growth is unlikely. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Chinese Growth: Testing Time Ahead" dated April 6, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "2016: A Choppy Bottoming" dated January 6, 2016, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "Be Aware Of China's Fiscal Tightening" dated February 16, 2017, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report, "Reflecting On The Trump-Xi Summit" dated April 13, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights The headwinds against commodity currencies are still brewing, the selloff is not over. Global liquidity conditions are deteriorating and EM growth will disappoint. The valuation cushion in commodity currencies and EM plays is not large enough to compensate for the red flags emanating from financial markets. The euro is peaking. A capitulation by shorts is likely early next week. A move to 1.12 should be used to sell EUR/USD. Feature Commodity currencies have had a tough nine weeks, weakening by 5% in aggregate, helping boost our short commodity currency trade returns to 3.8%. At this juncture, the key questions on investors' minds is whether or not this trend will deepen and if this selloff will remain playable. We believe the answer to both questions is yes. A Less Friendly Global Backdrop When observed in aggregate, the past 12 months represented a fertile ground for commodity currencies to perform well as both global liquidity and growth conditions were on one of the most powerful upswings in the past two decades, lifting risk assets in the process (Chart I-1). Chart I-1The Zenith Is Passing The Zenith Is Passing The Zenith Is Passing Global Liquidity Is Drying When we look at the global liquidity picture, the improvement seems to be over, especially as the Fed, the key anchor to the global cost of money, is more confidently embracing its switch toward a tighter monetary policy. It is true that U.S. Q1 data has been punky at best; however, like the Fed, we think this phenomenon will prove to be temporary. Recently, much ink has been spilled over the weakness in the auto sector. However, when cyclical spending is looked at in aggregate, the picture is not as dire and even encourages moderate optimism. Driven by both corporate and housing investment, cyclical sectors have been growing as a share of GDP (Chart I-2). This highlights that poor auto sales may have been a sector specific development and do not necessarily provide an accurate read on the state of household finances. Chart I-2Autos Do Not Paint The Full Picture For The U.S. Cyclical Spending Is Firm... Autos Do Not Paint The Full Picture For The U.S. Cyclical Spending Is Firm... Autos Do Not Paint The Full Picture For The U.S. Cyclical Spending Is Firm... Moreover, the outlook for household income is still positive. Our indicator for aggregate household disposable income continues to point north (Chart I-3). As we have highlighted in recent publications, various employment surveys are suggesting that job growth should improve in the coming months.1 Also, this week's productivity and labor cost report showed that compensation is increasing at a nearly 4% annual pace. This healthy outlook for household income, combined with the consumer's healthy balance sheets - debt to disposable income stands near 14 year lows while debt-servicing ratios are still near 40 year lows - and elevated confidence suggests that house purchases can expand. With the inventory of vacant homes standing at 11 year lows, this positive backdrop, along with the improving household-formation rate, is likely to prompt additional housing starts, lifting residential investment (Chart I-4). Chart I-3Bright U.S. Household ##br##Income Prospects Bright U.S. Household Income Prospects Bright U.S. Household Income Prospects Chart I-4As Households Get Formed,##br## Housing Starts To Pick up As Households Get Formed, Housing Starts To Pick up As Households Get Formed, Housing Starts To Pick up For the corporate sector, the strength in survey data is also likely to result in growing capex (Chart I-5). Not only have "soft" data historically been a good leading indicator of "hard" data, but the outlook for profit growth has also improved substantially. Profit growth is the needed ingredient to realize the positive expectation of business leaders embedded in "soft" data. Profit itself is very often dictated by the trend in nominal revenue growth. The fall in profits in 2016 mostly reflected the fall in nominal GDP growth to 2.5%, which produced a level of revenue growth historically associated with recessions (Chart I-6). As such, the recent rebound in nominal GDP growth, suggests that through the power of operating leverage, profit should also continue to grow, supporting capex in the process. Chart I-5Business Confidence Points ##br##To Better Growth And Capex... Business Confidence Points To Better Growth And Capex... Business Confidence Points To Better Growth And Capex... Chart I-6...Especially As A Key Profit##br## Driver Is Improving ...Especially As A Key Profit Driver Is Improving ...Especially As A Key Profit Driver Is Improving With the most cyclical sector of the U.S. economy still on an upswing, the Fed will continue to increase rates, at least more aggressively than the 45 basis points of tightening priced into the OIS curve over the next 12 months. With liquidity being sucked into the U.S. economic machine, international dollar-based liquidity, which is already in a downtrend, is likely to deteriorate further (Chart I-7). Moreover, global yield curves, which were steepening until earlier this year, have begun flattening again, highlighting that the tightening in global liquidity conditions is biting (Chart I-8). This will represent a continuation of the expanding handicap against global growth, and EM growth in particular. Chart I-7Global Dollar Liquidity Is Already Poor Global Dollar Liquidity Is Already Poor Global Dollar Liquidity Is Already Poor Chart I-8A Symptom Of The Tightening In Liquidity A Symptom Of The Tightening In Liquidity A Symptom Of The Tightening In Liquidity Global Growth Conditions Are Also Past Their Best, Especially In EM Global growth conditions are already showing a few troubling signs, potentially exerted by the tightening in global liquidity. To begin with, while our global leading economic indicator is still pointing north, its own diffusion index - the number of nations with improving LEIs versus those with deteriorating ones - has already rolled over. Normally, this represents a reliable signal that growth will soon peak (Chart I-9). For commodity currencies, the key growth consideration is EM growth. Here too, the outlook looks precarious. The impulse to EM growth tends to emerge from China as Chinese imports have been the key fuel to boost exports, investments, and incomes across a wide swath of EM nations. Chinese developments suggest that Chinese growth, while not about to crater, may be slowing. Chinese monetary conditions have been tightening abruptly (Chart I-10, top panel). Moreover, this tightening seems to be already yielding some results. The issuance of bonds by smaller financial firms has been plunging, which tends to lead the growth in aggregate total social financing (Chart I-10, bottom panel). This is because the grease in the shadow banking system becomes scarcer as the cost of financing rises. Chart I-9Deteriorating Growth##br## Outlook Deteriorating Growth Outlook Deteriorating Growth Outlook Chart I-10Chinese Monetary Conditions ##br##Are Tightening Chinese Monetary Conditions Are Tightening Chinese Monetary Conditions Are Tightening This situation could continue. Some of the rise in Chinese interbank rates to two-year highs reflects the fact that easing capital outflows have meant that the PBoC can tighten monetary policy through other means. However, the recent focus by the Beijing and president Xi Jinping on financial stability and bubble prevention, suggests that there is a real will to see tighter policy implemented. This means that the decline in total credit growth in China should become more pronounced. As a result, this will weigh on the country's industrial activity, a risk already highlighted by the decline in Manufacturing PMIs (Chart I-11). Additionally, this decline in credit growth tends to be a harbinger of lower nominal GDP growth, and most importantly for EM and commodity producers, a foreboding warning for Chinese imports (Chart I-12). Chart I-11China Industrial ##br##Growth Worry China Industrial Growth Worry China Industrial Growth Worry Chart I-12Slowing Chinese Credit Impulse ##br##Will Weigh On EM Growth Slowing Chinese Credit Impulse Will Weigh On EM Growth Slowing Chinese Credit Impulse Will Weigh On EM Growth Financial markets are already flashing red signals. The Canadian Venture exchange and various coal plays have historically displayed a tight correlation with Chinese GDP growth.2 Today, they are breaking below key trend lines that have defined their bull markets since the February 2016 troughs (Chart I-13). This message is corroborated by the recent weakness in copper, iron ore, and oil prices. Additionally, the price of platinum relative to that of gold is also breaking down. While the VW scandal has a role to play, this breakdown is also a symptom of the pain on growth created by the tightening in global liquidity conditions. In the past, the message from this ratio have ultimately been heeded by EM stock prices, suggesting that the recent divergence is likely to be resolved with weaker EM asset prices (Chart I-14). Confirming this risk, the sectoral breadth of EM equities has also deteriorated, and is already at levels that in the past have marked the end of stock advances (Chart I-15). At the very least, the narrowing of the EM bull market should prompt investors in EM-related plays to pause and reflect. Chart I-13Two Worrisome Breakdowns##br## On Chinese Plays Two Worrisome Breakdowns On Chinese Plays Two Worrisome Breakdowns On Chinese Plays Chart I-14Platinum's Dark##br## Omen For EM Platinum's Dark Omen For EM Platinum's Dark Omen For EM Chart I-15The Falling Participation ##br##In The EM Rally The Falling Participation In The EM Rally The Falling Participation In The EM Rally This moment of reflection seems especially warranted as EM assets do not have much cushion for unanticipated growth disappointment. The implied volatility on EM stocks is near cycle lows, so are EM sovereign CDS and corporate spreads (Chart I-16). This picture is mimicked by commodity currencies. Even after the recent bout of weakness, the aggregate risk-reversal in options points to a limited amount of concern, and therefore, a growing risk of negative surprises (Chart I-17). Chart I-16Little Cushion##br## In EM Assets Little Cushion In EM Assets Little Cushion In EM Assets Chart I-17Commodity Currency Options##br## Turn Optimistic As Well Commodity Currency Options Turn Optimistic As Well Commodity Currency Options Turn Optimistic As Well If commodity currencies have already depreciated in the face of a slightly soft dollar and perky EM asset prices, we worry that further weaknesses will emerge if the dollar strengthens again and EM assets self-off on the back of less liquidity and more EM growth disappointment. If the price of platinum relative to that of gold was a signal for EM assets, it is also a good indicator of additional stress in the commodity-currency space (Chart I-18). Chart I-18Platinum Raises Concerns ##br##For Commodity Currencies As Well Platinum Raises Concerns For Commodity Currencies As Well Platinum Raises Concerns For Commodity Currencies As Well We remain committed to our trade of shorting a basket of commodity currencies. AUD is the most expensive and most exposed to the Chinese tightening of the group, but that doesn't mean much. The Canadian housing market seems to be under increased scrutiny thanks to the combined assault of rising taxes on non-residents and growing worries about mortgage fraud, which is deepening the underperformance of Canadian banks relative to their U.S. counterparts. If this two-front attack continues, the housing market, the engine of the domestic economy, may also prove to weaken faster than we anticipated. Finally, the New Zealand dollar too is expensive even if domestic economic developments suggest that its fair value may be understated by most PPP metrics. Bottom Line: The outlook for the U.S. economy remains good, but this will deepen the tightening in global liquidity. When combined with the tightening of monetary conditions in China, this suggests that global industrial activity and EM growth in particular could disappoint, especially as cracks in the financial system are beginning to appear. Moreover, EM assets and commodity currencies do not yet offer enough of a valuation cushion to fade this risk. Stay short commodity currencies. Macron In = Buy The Euro? The euro has rallied a 3.6% since early April, mostly on the back of Emmanuel Macron's electoral victories. Obviously, the last big hurdle is arriving this weekend with the second round. The En Marche! candidate still leads Marine Le Pen by a 20% margin. Wednesday's bellicose debate is unlikely to overturn this significant lead. The Front National candidate's lack of substance seems to have weighed against her in flash polls. If anything, her performance might have prompted some undecided Mélanchon voters to abstain or cast a "vote blanc" this weekend instead of picking her. This was her loss, not Macron's win. Does this mean that the euro has much upside? A quick rally toward 1.12 early next week still seems reasonable. New polls are beginning to show that En March! might perform much better than anticipated in the legislative election. Also, the center-right Les Républicains should also perform very well, resulting in the most right wing, pro-market Assemblée Nationale in nearly 50 years. While these polls are much too early to have any reliability, they may influence the interpretation by traders of Sunday's presidential election. However, we would remain inclined to fade any such rally. As we highlighted last week in a Special Report, our EUR/USD intermediate-term timing model shows that the euro is becoming expensive tactically, and that much good news is now in the euro's prices (Chart I-19).3 Additionally, investors have been excited by the rebound in core CPI in the euro area, a development interpreted as giving a carte-blanche to the ECB to hike rates sooner than was anticipated a few months ago. Indeed, currently, the first hike by the ECB is estimated to materialize in 27 months, versus the more than 60 months anticipated in July 2016. We doubt that market participants will bring the first rate hike closer to the present, a necessary development to prompt the euro to rally given our view on the Fed's tightening stance. We expect the rebound in the European core CPI to prove transient. Not only does European wage dynamics remain very poor outside of Germany, our country-based core CPI diffusion index has rolled over and points to a decelerating euro area core CPI (Chart I-20). Chart I-19EUR/USD: ##br##Good News In The Price EUR/USD: Good News In The Price EUR/USD: Good News In The Price Chart I-20European Core CPI Rebound ##br##Should Prove Transient European Core CPI Rebound Should Prove Transient European Core CPI Rebound Should Prove Transient Additionally, as we argued four weeks ago, tightening Chinese monetary conditions and EM growth shocks weigh more heavily on European growth than they do on the U.S.4 As such, our EM view implies that the euro area's positive economic surprises might soon deteriorate. Therefore, the favorable growth differential between Europe and the U.S. could be at its zenith. Shorting the euro today may prove dangerous, as a violent pop next week is very possible if the last euro shorts capitulate on a positive electoral outcome. Instead, we recommend investors sell EUR/USD if this pair hits 1.12 next week. Moreover, for risk management reasons, despite our view on the AUD, we are closing our long EUR/AUD position at a 6.9% gain this week. Bottom Line: Emmanuel Macron's likely victory this weekend could prompt a last wave of euro purchases. However, we are inclined to sell the euro as economic differentials between the common currency area and the U.S. are at their apex. Moreover, European core CPI is likely to weaken in the coming quarters, removing another excuse for investors to bid up the euro. Close long EUR/AUD. A Few Words On The Yen The yen has sold-off furiously in recent weeks. The tension with North Korea and the rise in the probability of a Fed hike in June to more than 90% have been poisons for the JPY. We are reluctant to close our yen longs just yet. Our anticipation that EM stresses will become particularly acute in the coming months should help the yen across the board. That being said, going forward, we recommend investors be more aggressive on shorting NZD/JPY than USD/JPY. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled “The Last Innings Of The Dollar Correction”, dated April 21, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report titled "Healthcare Or Not, Risks Remain", dated March 24, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report titled "Updating Our Intermediate Timing Models", dated April 28, 2017, available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report titled "ECB: All About China?", dated April 7, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The Fed decided to keep the federal funds rate unchanged at the 0.75% - 1% range. The Committee highlighted the Q1 GDP weakness as transitory, as the labor market has tightened more since their last meeting, inflation is reaching its 2% target, and business investment is firming. Continuing and initial jobless claims both beat expectations; However, ISM Manufacturing PMI came in less than expected at 54.8; PCE continues to fluctuate around the 2% target, coming in at 1.8% from 2.1%; ISM Prices Paid came in at 68.5, beating expectations. Furthermore, the Committee expects that "near-term risks to the economic outlook appear roughly balanced", and that "economic activity will expand at a moderate pace". The market is now pricing in a 93.8% probability of a hike. We therefore expect the dollar to continue its appreciation after the French elections. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Macron's lead over Le Pen has risen after the heated debate between the two rival candidates. We believe these dynamics were a key bullish support for the euro in the run up to elections as the possibility of a Le Pen victory is being completely priced out. Adding to this optimism is a plethora of positive data from Europe. Business and consumer confidences have both pick up. German HICP came in at 2% yoy; Overall euro area headline CPI came in at 1.9%, and core at 1.2%. Nevertheless, labor market data in the peripheries, as well as the overall euro area, was disappointing. We believe this highlights substantial slack in the economy, and will keep the ECB from increasing rates any time soon. We expect the euro to climb in the short run, but the longer-run outlook remains bleak. Look to short EUR/USD at 1.12. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Economic data in Japan has been positive this past week: The unemployment rate went down to 2.8%, outperforming expectations. Retail trade annual growth came in 2.1%, also outperforming expectations. The jobs offer-to-applicants ratio came in at 1.45. This last number is significant, as this ratio has reached it 1990 peak, and it provides strong evidence that the Japanese labor market is very tight. Eventually, this tight labor market will exert pressures on wage inflation. In an environment like Japan, where nominal rates are capped, rising inflation would mean a collapse in real rates and consequently a collapse on the yen. Thus, we are maintaining our bearish view on the yen on a cyclical basis. On a tactical basis, we continue to be positive on the yen, given that a risk-off period in EM seems imminent. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 In spite of the tougher rhetoric coming from Brussels recently, the pound has maintained resilient and has even gain against the U.S. dollar. Indeed, recent data from the U.K. has been positive: Markit Services PMI came in at 55.8, outperforming expectations. Meanwhile, Markit Manufacturing PMI came in at 57.3, crushing expectations. Additionally, both consumer credit and M4 money supply growth also outperformed. Overall we continue to be positive on the pound, particularly against the euro, as we believe that expectations on Britain are too pessimistic, while the ability for the ECB to turn hawkish limited given that peripheral economies are still too weak to sustain tighter monetary conditions. Against the U.S. dollar the pound will have limited upside from now, given that it has already appreciated substantially. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The RBA left its cash rate unchanged at 1.5%. The Bank also stated that its "forecasts for the Australian economy are little changed." It remains of the opinion that the low interest rate environment continues to support the outlook. This will also be a crucial ingredient to generate a positive outcome in the labor market in the foreseeable future. This past month has been very negative for the antipodean currency, with copper and iron ore prices displaying a similar behavior, losing almost 10% and 25% of their values since February, respectively. With China tightening monetary policy, and dissipating government spending soon to impact the Chinese economy, we remain bearish on AUD. In brighter news, the Bank's trimmed mean CPI measure increased by 1.9% on an annual basis, beating expectations of 1.8%. This is definitely a positive, but economic slack elsewhere could limit this development. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Data for New Zealand was very positive this week: The participation rate came in at 70.6%, outperforming expectations. Employment growth outperformed expectations substantially in the first quarter of 2017, coming in at 1.2%. The unemployment rate also outperformed coming in at 4.9% This recent data confirms our belief that inflationary pressures in New Zealand are stronger than what the RBNZ would lead you to believe. Indeed, non-tradable inflation, which measures domestically produced inflation is at its highest since 2014. Eventually, this will lead the RBNZ to abandon its neutral bias and embrace a more hawkish one, lifting the NZD in the process, particularly against the AUD. Against the U.S. dollar the kiwi dollar will likely have further downside, as the tightening in monetary conditions in China should weigh on commodity prices. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The oil-based currency has once again succumbed to fleeting oil prices, depreciating to a 1-year low. U.S. crude inventories have recently been declining by less than expected and production in Libya has been increasing. Moreover, headline inflation dropped 0.5% from its January high of 2.1%. The Bank of Canada acknowledged the weak core CPI data in its last monetary policy meeting, but instead chose to focus on stronger economic data to change their stance to neutral. As the weakness in oil prices proves temporary due to another likely OPEC cut, headline inflation should pick up again. However, labor market conditions and economic activity remain questionable based on the weakness of recent data: retail sales are contracting 0.6% on a monthly basis, and the raw materials price index dropped 1.6%. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 AUD And CAD: Risky Business - March 10, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been mixed: Real retail sales growth came in at 2.1%, crushing expectations. However, Aprils PMI underperformed coming in at 57.4 against expectations of 58.3. Additionally, the KOF leading indicator came in at 106, al coming below expectations. EUR/CHF now stands at its highest level since late 2017 and while data has not been beating expectations it still very upbeat. We believe that conditions are slowly being put into place for the SNB to abandon its implied floor, given that core inflation is approaching its long term average. Therefore, once the French elections are over, EUR/CHF will become an attractive short, given that the euro will once again trade on economic fundamentals rather than political risks. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 The krone continues to depreciate sharply. This comes as no surprise given that oil is now down 13% in 2017. Overall we expect that oil currencies will outperform metal currencies given that oil prices will have less sensitivity to EM liquidity and economic conditions. That being said, it is hard to be too bullish on oil if China slows anew, even if one believe that the OPEC deal will stay in place . This means that USD/NOK could have additional upside. On a longer term basis, there has been a slight improvement in Norwegian data, as nominal retail sales are growing at a staggering 10% pace, while real retail sales are growing at more than 2%, which are a 5-year and a 2-year high respectively. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 The April Monetary Policy meeting delivered an unexpected decision, with members deciding to extend asset purchases till the end of the year, while delaying the forecast for a rate hike to mid-2018. Recent inflationary fluctuations and weak commodity prices support the Riksbank's actions. Forecasts for both inflation and the repo rate were lowered for 2018 and 2019. The Riksbank highlighted that "to support the upturn in inflation, monetary policy needs to be somewhat more expansionary", and is prepared to be more aggressive if need be. This increasingly dovish rhetoric by the Riksbank contrasts markedly with the FOMC's hawkish tilt, a dichotomy that will prove bearish for the krona relative to the greenback. Implications for EUR/SEK are a little more blurred, as the ECB will also remain dovish for the foreseeable future. However, Sweden's attentive and cautious stance on its currency's strength will cap any downside in EUR/SEK. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Chart 1European Policy Uncertainty Down European Policy Uncertainty Down European Policy Uncertainty Down Macron remains on target to win the French election, but Italy looms as a risk ahead; Fade any relief rally after South Korean elections; Russia is not a major source of geopolitical risk at present; Stay underweight Turkey and Indonesia within the EM universe. Feature The supposed pushback against populism is emerging as a theme in the financial industry. The expected defeat of nationalist-populist Marine Le Pen in the second round of the French election on May 7 has reduced Europe's economic policy uncertainty, despite continued elevated levels globally (Chart 1). We are not surprised by this outcome. A year ago, ahead of both the Brexit referendum and the U.S. election, we cautioned investors that it was the Anglo-Saxon world, not continental Europe, which would experience the greatest populist earthquake.1 The middle class in the U.S. and the U.K. lacks the socialist protections of large welfare states (Chart 2), leading to frustrating outcomes in terms of equality and social mobility (Chart 3). In other words, the gains of globalization have not been redistributed in the two laissez-faire economies. Hence the Anglo-Saxon world got Trump and Brexit while the continent got market-positive outcomes like Rajoy, Van der Bellen, Rutte, and (probably) Macron. Chart 2Given The Qualities Of The##br## Anglo-Saxon Economy ... What About Emerging Markets? What About Emerging Markets? Chart 3...Brexit And Trump ##br##Should Not Be A Surprise What About Emerging Markets? What About Emerging Markets? Looking forward, we agree with the consensus that Marine Le Pen will lose, as we have been stressing with high conviction since November.2 Despite a poor start to the campaign, Macron remains 20% ahead of Marine Le Pen with only four days left to the election (Chart 4). Could the polls be wrong? No. And not just because they were right in the first round. Polls are likely to be right because French polls have an exemplary track record (Chart 5) and there is no Electoral College to throw off the math. Chart 4Le Pen Unlikely To Bridge This Gap Le Pen Unlikely To Bridge This Gap Le Pen Unlikely To Bridge This Gap Chart 5French Polls Have Strong Track Record What About Emerging Markets? What About Emerging Markets? As we go to press, the two candidates are set to face off in an important televised debate. Given Le Pen's post-debate polling performance in the first round (Chart 6), we doubt she will perform well enough to make a change. Next week, we will review the second round and its implications for the legislative elections in June and French politics beyond. Overall, we think Europe's policy uncertainty dip is temporary, as the all-important Italian election risk looms just ahead in 2018.3 For now, we are sticking with our bullish European risk asset view, but will look to pare it back later in the year. Chart 6Debates Have Not Helped Le Pen Debates Have Not Helped Le Pen Debates Have Not Helped Le Pen Chart 7Commodity Currencies Suggest Global Trade Is At Risk... Commodity Currencies Suggest Global Trade Is At Risk... Commodity Currencies Suggest Global Trade Is At Risk... What about emerging markets? With investors laser-focused on developed market political risks - Trump's policies and protectionism, European elections, Brexit, etc - have EM political risks fallen by the wayside? Chart 8...And Commodities Are At Risk Too ...And Commodities Are At Risk Too ...And Commodities Are At Risk Too Chart 9China's Growth To Decelerate Again China's Growth To Decelerate Again China's Growth To Decelerate Again We don't think so. According to BCA's Emerging Market Strategy, the recent performance of the commodity currency index (an equally weighted average of AUD, NZD, and CAD) augurs a deceleration of global growth in the second half of this year (Chart 7) and a top in the commodity complex (Chart 8).4 At the heart of the reversal is the slowdown in China's credit and fiscal spending impulse (Chart 9).5 Given China's critical importance as the main source of EM final demand (Chart 10), the slowdown in money and credit growth is a significant risk to EM growth in the latter part of the year (Chart 11).6 Chart 10EM Is Leveraged To China Much More Than DM EM Is Leveraged To China Much More Than DM EM Is Leveraged To China Much More Than DM Chart 11China: Money/Credit Growth Is Slowing China: Money/Credit Growth Is Slowing China: Money/Credit Growth Is Slowing At the heart of China's credit slowdown are efforts by policymakers to cautiously introduce some discipline in the financial sector. Chinese interbank rates have risen noticeably, which should have a material impact on credit growth (Chart 12). Given that the all-important nineteenth National Party Congress is six-to-seven months away, we doubt that the tightening efforts will be severe. But they may foreshadow a much tighter policy in 2018, following the conclusion of the Congress, when President Xi has full reign and the ability to redouble his initial efforts at reform, namely to control the risks of excessive leverage to the state's stability. With both the Fed and PBoC looking to tighten over the next 12-18 months, in part to respond to improvements in global inflation expectations (Chart 13), highly leveraged EM economies may face a triple-whammy of USD appreciation, Chinese growth plateauing, and easing commodity demand. In isolation, none is critical, but as a combination, they could be challenging. Chart 12Chinese Policymakers End The Credit Party? Chinese Policymakers End The Credit Party? Chinese Policymakers End The Credit Party? Chart 13Global Tightening Upon Us? Global Tightening Upon Us? Global Tightening Upon Us? In this weekly report, we take an around-the-world look at several emerging economies that we believe are either defying the odds of political crisis or particularly vulnerable to growth slowdown. South Korea: Here Comes The Sunshine Policy, Part II South Korea's early election will be held on May 9. The victory of a left-wing candidate has been likely since April 2016, when the two main left-wing parties, the Democratic Party and the People's Party, won a majority of the 300-seat National Assembly. It has been inevitable since the impeachment of outgoing President Park Geun-hye in December - whose removal was deemed legal by the Constitutional Court in March - for a corruption scandal that split the main center-right party and decimated its popular support after ten years of ruling the country.7 The only question was whether Moon Jae-in, leader of the Democratic Party and erstwhile chief of staff of former President Roh Moo-hyun, would finally get his turn as president, or whether Ahn Cheol-soo, an entrepreneurial politician who broke from the Democratic Party to form the People's Party, would defeat him. At the moment, Moon has a significant lead in the polls, while Ahn has lost the bump in support he received after other candidates were eliminated through the primary process (Chart 14). Moon's lead has grown throughout the recent spike in saber-rattling between the United States and North Korea, which suggests that Moon is most likely to win the race. The debates have also hurt Ahn. Moon leads in every region, among blue collar and white collar voters, and among centrists as well as progressives. Also, the pollster Gallup Korea has a solid track record for presidential elections going back to 1987, with a margin of error of about 3%, so Moon is highly likely to win if polls do not change in Ahn's or Hong's favor. The key difference between Moon and Ahn boils down to this: Moon is the established left-wing candidate and has mainstream Democratic Party machinery backing him, a clear platform, and experience running the country from 2003-8. Ahn does not have experience in the executive branch (Blue House) and his policy platform is less clear. His party is a progressive offshoot of the Democratic Party, yet he is bidding for disenchanted center-right voters, a contradiction that has at times given him the appearance of flip-flopping on important issues. Thus Ahn's election would bring greater economic policy uncertainty than Moon's, though Ahn is more business-friendly by preference. Regardless, the new president will have to work with the opposing left-wing party in the National Assembly if he intends to get anything accomplished. The combined left-wing vote is 164, yielding only a 13-seat majority if the two parties work together. Differences between them will cause problems in passing legislation. It would be easier for Moon to legislate with his party's 119-seat base than for Ahn with his party's 40-seat base, unless Ahn can steer his party to cooperate with the center right like he is trying to do in the presidential campaign. Markets may celebrate the election regardless of the victor because it sets the country back on the path of stable government. The Kospi bottomed in November when the political crisis reached a fever pitch and has rallied since December 5, when it became clear that the conservatives in the assembly would vote for Park's impeachment. This suggested an early government change to restore political and economic leadership. The market rallied again when the Constitutional Court removed Park, which pulled the presidential elections forward to May and cut short what would otherwise have been another year of uncertainty until the original election date in December 2017 (Chart 15). Chart 14South Korea: Moon In The Lead What About Emerging Markets? What About Emerging Markets? Chart 15Korean Stocks Cheered Impeachment Korean Stocks Cheered Impeachment Korean Stocks Cheered Impeachment Investors can reasonably look forward to an increase in fiscal thrust after the election, particularly if Moon is elected. Table 1 compares the key policy initiatives of the top three candidates - both Moon and Ahn are pledging increases in government spending. Note that South Korean fiscal thrust expanded in the first two years of the last left-leaning government, i.e. the Roh Moo-hyun administration (Chart 16). Table 1South Korean Presidential Candidates And Their Policy Proposals What About Emerging Markets? What About Emerging Markets? Chart 16Left-Wing Leaders Drive Up Fiscal Spending Left-Wing Leaders Drive Up Fiscal Spending Left-Wing Leaders Drive Up Fiscal Spending Beyond any initial relief rally, however, investors may experience some buyer's remorse. South Korea is experiencing a leftward swing of the political pendulum that is not conducive to higher growth in corporate earnings. This is the implication of the April legislative elections and the collapse of President Park's support prior to the corruption scandal; it will also be the takeaway of either Moon's or Ahn's election win over a discredited conservative status quo (both fiscal and corporate). The leftward shift is motivated by structural factors, not mere political optics. Average growth rates have fallen since the Great Recession, yet South Korea lacks the social amenities of a slower-growing developed economy. The social safety net is comparable to Turkey's or Mexico's and wages have been suppressed to maintain competitiveness (Chart 17). Inequality has grown dramatically (Chart 18). Chart 17Keeping Labor Cheap Keeping Labor Cheap Keeping Labor Cheap Chart 18Fueling The Populist Fire What About Emerging Markets? What About Emerging Markets? Therefore the policies to come will emphasize redistribution, job security, and social benefits. Moon's policies, in particular, are aggressive. He has pledged to require the public sector to increase employment by 5% per year and add 810,000 jobs by 2022, and to expand welfare for the elderly regardless of their income level. This will swell the budget deficit and public debt, especially over time, given South Korea's demographic profile, which is rapidly graying (Chart 19). Moon also intends nearly to double the minimum wage, require private companies to hire 3-5% more workers each year, depending on company size, and give substantial subsidies to SMEs that hire more workers. He supports a hike in corporate taxes, though the details of any tax changes have yet to be disclosed. Chart 19Society Turning Gray Society Turning Gray Society Turning Gray Ahn's policy preferences are more focused on productivity improvements than social welfare. While Moon panders to middle-aged workers concerned about job security - among whom he leads Ahn by 30 percentage points - Ahn panders to the youth, who are currently battling an unemployment rate of 11%. He would pay subsidies to young workers while they look for jobs immediately after graduation ($266 per month) and for the first two years of their employment at an SME ($532 per month). He would direct budgetary funds to research and development, high-tech industries, and job training. The SME policies speak to the general dissatisfaction with the cozy relationship between large, export-oriented industrial giants - the chaebol - and the political elite. Both Moon and Ahn will attempt to remove subsidies and privileges from the chaebol, potentially forcing them to sell or spin-off branches that are unrelated to their core business, and will seek to incentivize SMEs. Chaebol reform is a long-running theme in South Korean politics with very little record of success, but the one thing investors can be sure of on this front is greater uncertainty regarding policies toward the country's multinationals. Bottom Line: South Korea is experiencing a swing of the political pendulum to the left regardless of who wins the presidential race on May 9. What About Geopolitics? Internationally, Moon, if he wins, will attempt to improve relations with China and North Korea at the expense of the U.S. and Japan. His voter base came of age during the democracy movement of the 1980s and is friendlier toward China and less hostile toward North Korea than other age groups (Chart 20 A&B). Ahn may attempt a similar foreign policy adjustment, but he is less willing to confront the United States. His attempt to woo the youth will constrain any engagement with Pyongyang, since young South Koreans feel the least connection with their ethnic brethren to the north. Given that a Moon presidency would be paired with that of Trump, it would likely precipitate tensions in the U.S.-Korean relationship. News headlines will announce that South Korea is "pivoting" toward China, much in the way that U.S. ally the Philippines was perceived as shifting toward China after President Rodrigo Duterte's election in 2016. This will be an exaggeration, since Koreans still generally prefer the U.S. to China and view North Korea as an enemy (Chart 21). Nevertheless, there is potential for real, market-relevant disagreements. Chart 20Moon's Middle-Aged Constituency What About Emerging Markets? What About Emerging Markets? Chart 21Constraints On The Sunshine Policy What About Emerging Markets? What About Emerging Markets? In the short term, the risk is to trade, given the South Korean Left's strain of opposition to the U.S.-Korea free trade agreement (KORUS) and Trump's intention to renegotiate it, or even impose tariffs. Trump is bringing a protectionist tilt to U.S. trade policy - at very least - and he is relatively unconstrained on trade so we consider this a high-level risk over his four-year term in office. Trade tensions could become consequential if South Korea breaks with the U.S. over North Korea, angering the Trump administration. At the same time, South Korea's trade with China (Chart 22) is a risk due to China's secular slowdown, protectionism, and intention to move up the value chain and compete with South Korea in global markets. Chart 22South Korea's Twin Trade Risks South Korea's Twin Trade Risks South Korea's Twin Trade Risks In the short and long term, Moon's attempt to revamp Kim Dae-jung's "Sunshine Policy" of economic engagement and denuclearization talks with North Korea could create serious frictions with the U.S. What Moon is proposing is to promote economic integration so that South Korea has more leverage over the North, which is increasingly reliant on China, and also to reduce military tensions via negotiations toward a peace treaty (the 1950-3 war ended with an armistice only). The idea is to launch a five-year plan toward an inter-Korean "economic union." This would begin by re-opening shuttered cooperative projects like the Kaesong Industrial Complex and Mount Kumgang tours and later establish duty-free agreements, free trade zones, and multilateral infrastructure projects that include Russia and China.8 The problem is that any new Sunshine Policy - which is ostensibly a boon for the region's security - will clash with the Trump administration's attempt to rally a new international coalition to tighten sanctions on North Korea to force it to freeze its nuclear and ballistic missile programs. North Korea will want to divide the allies and thus will be receptive to China's and South Korea's offers of negotiations; the U.S. and Japan will not want to allow any additional economic aid to the North without a halt to tests and tokens of eventual denuclearization. How will this tension be resolved? Trump is preparing for negotiations and over the next couple of years the U.S. and Japan are highly likely to give diplomacy at least one last chance, as we have argued in recent reports.9 Eventually, if the U.S. becomes convinced of total collaboration between China and South Korea with the North (i.e. skirting sanctions and granting economic benefits), while the North continues testing capabilities that would enable it to strike the U.S. homeland with a nuclear weapon, some kind of confrontation is inevitable. But first the U.S. will try another round of talks. The "arc of diplomacy" could extend for several years, as it did with Iran (Chart 23), if the North delays its missile progress or appears to do so. Chart 23The 'Arc Of Diplomacy' Can Last For Several Years What About Emerging Markets? What About Emerging Markets? Despite our belief that the North Korean situation will calm down as diplomacy gets under way, South Korea is seeing rising geopolitical headwinds for the following reasons: Sino-American tensions: U.S.-China competition is growing over time, notwithstanding the apparently friendly start between the Trump and Xi administrations.10 Trump's North Korea policy: The Trump administration has signaled that the U.S. does not accept a nuclear-armed North Korea and the need to maintain the credibility of the military option will keep tensions at a higher level than in recent memory.11 Japanese re-armament: Japanese tensions with China and both Koreas are rising as Japan increases military expenditures and maritime defenses and moves to revise its constitution to legitimize military action.12 The costs of peace: If diplomacy prevails, South Korean engagement with the North still poses massive uncertainties about the future of the relationship, the North's internal stability amid liberalization, whether the transition to greater economic integration will be smooth, and whether the South Korean economy (and public finances) can absorb the associated costs. This is not even to mention eventual unification. Bottom Line: The current saber-rattling around the Korean peninsula is not over yet, but tensions are soon to fall as international negotiations get under way. Still, geopolitical risks for South Korea are rising over the long run. Investment Conclusions The currency will be the first to react to the election results and will send a signal about whether the fall in policy uncertainty is deemed more beneficial than the impending rise in pro-labor policies. Beyond that, the won has been strong relative to South Korea's neighbors and competitors (Chart 24). The Korean central bank is considering cutting rates at a time when fiscal policy is set to expand substantially, a negative for the currency. Chart 24Won Strength, Yen Weakness Won Strength, Yen Weakness Won Strength, Yen Weakness Therefore we remain short KRW / long THB. Thailand, another U.S. ally, is running huge current account surpluses, is more insulated from U.S.-China geopolitical conflicts, and has navigated tensions between the two relatively well. We expect a relief rally in stocks due to resolution of the campaign and the likelihood of an easing in trade tensions with China. However, this is the only reason we are not yet ready to join our colleagues in the Emerging Markets Strategy in shorting Korean stocks versus Japanese. We will look to put on this trade in future. We do not have high hopes for Korean stocks over the long run due to the headwinds listed above. As for bonds, both Moon's and Ahn's agendas, particularly Moon's, will be bond bearish because they will increase deficits and debt. At the short end of the curve, yields may have reason to fall; but the long end should reflect looser fiscal policy, the worsening debt and demographic profile, and increasing geopolitical risk, whether from conflicts with the U.S. and North Korea, or from the rising odds of a greater future burden from subsidizing (or even merging with) North Korea. Therefore we recommend going long 2-year government bonds / short 10-year government bonds. Russia: Defying Odds Of A Political Crisis Russia has emerged from the oil-price shocks scathed, but unbowed.13 Its textbook macro policy amid a severe recession over the past two years has been exemplary: The government has maintained constant nominal expenditure growth and substantially cut spending in real terms (Chart 25). The fiscal deficit is still large at 3.7%, but it typically lags oil prices (Chart 26). Hence, the recovery in oil prices over the past year should lead to a notable improvement in the budget balance. For 2017, the budget is conservative, as it assumes $40/bbl Urals crude. Chart 25Russia Has Undergone##br## Through Real Fiscal Squeeze... Russia Has Undergone Through Real Fiscal Squeeze... Russia Has Undergone Through Real Fiscal Squeeze... Chart 26...Which Is##br## Now Over ...Which Is Now Over ...Which Is Now Over Early this year, the Ministry of Finance adopted a new fiscal rule where it will buy foreign currency when the price of oil is above the set target level of 2700 RUB per barrel (the price of oil in rubles at the $40 bbl Urals) and sell foreign exchange when the oil price is below that level (Chart 27). The objective of this policy is to create a counter-cyclical ballast that will limit fluctuations in the ruble caused by swings in oil prices. Chart 27Oil Price Threshold For New Fiscal Rule Oil Price Threshold For New Fiscal Rule Oil Price Threshold For New Fiscal Rule Chart 28Forex Reserves Have Stabilized Forex Reserves Have Stabilized Forex Reserves Have Stabilized The recovery of oil prices and strict macroeconomic policy has allowed Russia to stabilize its foreign exchange reserves (Chart 28), although they remain at a critical level as a percent of broad money supply. However, the GDP growth recovery will be tepid and fall far short of the high growth rates of the early part of the decade (Chart 29). Chart 29Russia: ##br##Recovery Is At Hand Russia: Recovery Is At Hand Russia: Recovery Is At Hand Chart 30Inventories Remain Far ##br##Above Average Levels Inventories Remain Far Above Average Levels Inventories Remain Far Above Average Levels Russian policymakers should be cautiously optimistic. On one hand, they have been able to withstand a massive decline in oil prices. On the other, the situation is still precarious and warrants caution given the delicate situation in oil markets. OECD oil inventories remain elevated and could precipitate an oil-price collapse without OPEC's active oil-production management (Chart 30). From this macroeconomic context, we would conclude that: Russia will abide by the OPEC 2.0 production-cut agreement: While the new budget rule will go a long way in insulating the ruble from swings in oil prices, Russia is still an energy exporter. As such, we expect Russia to play ball with Saudi Arabia and continue to abide by the conditions of the OPEC deal. Thus far, Russia has been less enthusiastic in cutting production than the Saudis, but still going along (Chart 31). Russia will not destabilize the Middle East: While Russia will continue to support President Bashar al-Assad of Syria, its involvement in the civil war will abate. Moscow already began to officially withdraw from the conflict in January. While part of its forces will remain in order to secure Assad's government, Russia has no intention of provoking its newfound OPEC allies with geopolitical tensions. Russia will talk tough, but carry a small stick: Shows of force will continue in the Baltics and the Arctic, but investors should fade any rise in the geopolitical risk premium (Chart 32). It is one thing to fly strategic bombers close to Alaska or conduct military exercises near the Baltic States; it is quite another to act on these threats. In fact, Russia has been doing both since about 2004 and its bluster has amounted to very little with respect to NATO proper. This is because Russia depends on Europe for almost all of its FDI and export demand and it is only in the very early innings of replacing European demand with Chinese (Chart 33). As long as Russia lacks the pipeline infrastructure to export the majority of its energy production to China, it will be reluctant to confront Europe. Chart 31Moscow Will Play ##br##Ball With OPEC Moscow Will Play Ball With OPEC Moscow Will Play Ball With OPEC Chart 32Fade Any Spike ##br##In Geopolitical Risk Fade Any Spike In Geopolitical Risk Fade Any Spike In Geopolitical Risk Chart 33Russia Relies On Europe;##br## China Not A Replacement What About Emerging Markets? What About Emerging Markets? As we have posited in the past, energy exporters are emboldened to be aggressive when oil prices are high.14 When oil prices collapse, energy exporters become far more compliant. Nowhere is this dynamic more true than with Russia, whose military interventions in foreign countries have served as a sure sign that the top of the oil bull market is at hand! Bottom Line: We do not expect any serious geopolitical risk to emanate from Russia, despite the supposed souring of relations between the Trump and Putin administrations due to the U.S. cruise-missile strike against Syria.15 And we also do not expect President Putin to manufacture a geopolitical crisis ahead of Russia's March 2018 presidential elections, given that his popularity remains high and that the opposition is in complete disarray. While Russia may continue to talk tough on a number of fronts, investors should fade the rhetoric as it is purely for domestic consumption. Turkey: Deceitful Stability Turkey held a constitutional referendum that dramatically expands the powers of the presidency on April 16.16 The proposed 18 amendments passed with a 51.41% majority and a high turnout of 85%. As with all recent Turkish referenda and elections, the results reveal a sharply divided country between the Aegean coastal regions and the Anatolian heartland, the latter being a stronghold of President Recep Tayyip Erdogan. Is Turkey Now A Dictatorship? First, some facts. Turkey has not become a dictatorship, as some Western press allege. Yes, presidential powers have expanded. In particular, we note that: The president is now both head of state and government and has the power to appoint government ministers; The president can issue decrees; however, the parliament has the ability to abrogate them through the legislative process; The president can call for new elections; however, he needs three-fifths of the parliament to agree to the new election; The president has wide powers to appoint judges. What the media is not reporting is that the parliament can remove or modify any state of emergency enacted by the president. In addition, overriding a presidential veto appears to be exceedingly easy, with only an absolute majority (not a super-majority) of votes needed. As such, our review of the constitutional changes is that Turkey is most definitely not a dictatorship. Yes, President Erdogan has bestowed upon the presidency much wider powers than the current ceremonial position possesses. However, the amendments also create a trap for future presidents. If the president should face a parliament ruled by an opposition party, he would lose much of his ability to govern. The changes therefore approximate the current French constitution, which is a semi-presidential system. Under the French system, the president has to cohabitate with the parliament. This appears to be the case with the Turkish constitution as well. Bottom Line: Turkish constitutional referendum has expanded the powers of the presidency, but considerable checks remain. If the ruling Justice and Development Party (AKP) were ever to lose parliamentary control, President Erdogan would become entrapped by the very constitution he just passed. Is Turkey Now Stable? The market reacted to the results of the referendum with a muted cheer. First, we disagree with the market consensus that President Erdogan will feel empowered and confident following the constitutional referendum that gives him more power. This is for several reasons. For one, the referendum passed with a slim majority. Even if we assume (generously) that it was a clean win for the government, the fact remains that the AKP has struggled to win over 50% of the vote in any election it has contested since coming to power in 2002 (Chart 34). Turkey is a deeply divided country and a narrow win in a constitutional referendum is not going to change this. Chart 34Turkey's Ruling Party Struggles To Get Over 50% Of The Vote What About Emerging Markets? What About Emerging Markets? Second, Erdogan is making a strategic mistake by giving himself more power. It will focus the criticism of the public on the presidency and himself if the economy and geopolitical situation surrounding Turkey gets worse. If the buck now stops with Erdogan, it means that all the blame will go to him in hard times. We therefore do not expect Erdogan to push away from populist economic and monetary policies. In fact, we could see him double down on unorthodox fiscal and monetary policies as protests mount against his rule. While he has expanded control over the army, judiciary, and police, he has not won over the major cities on the Aegean coast, which not only voted against his constitutional referendum but also consistently vote against AKP rule. Events in Turkey since the referendum have already confirmed our view. Despite rumors that the state of emergency would be lifted following the referendum, the parliament in fact moved to expand it by another three months. Furthermore, just a week following the plebiscite, the government suspended over 9,000 police officials and arrested 1,120 suspects of the attempted coup last summer, with another 3,224 at large. This now puts the total number of people arrested at around 47,000. Investors are confusing lack of opposition to stability. Yes, the opposition to AKP remains in disarray. As such, there is no political avenue for opposition to Erdogan. The problem is that such an arrangement raises the probability that the opposition takes the form of a social movement and protest. We would therefore caution investors that a repeat of the Gezi Park protests from 2013 could be likely, especially if the economy stumbles. Bottom Line: The referendum has not changed the facts on the ground. Turkey remains a deeply divided country. Erdogan will continue to feel threatened by the general sentiment on the ground and thus continue to avoid taking any painful structural reforms. We believe that economic populism will remain the name of the game. What To Watch? We would first and foremost watch for any sign of protest over the next several weeks. Any Gezi Park-style unrest would hurt Erdogan's credibility. May Day protests saw police scuffle with protesters in Istanbul, for example. Given his penchant for equating any dissent with terrorism, President Erdogan is very likely to overreact to any sign that a social movement is rising in Turkey to oppose him. It is not our baseline case that the constitutional referendum will motivate protests, but it is a risk investors should be concerned with. Next election is set for November 2019 and the constitutional changes will only become effective at that point (save for provisions on the judiciary). Investors should watch for any sign that Erdogan's or the AKP's popularity is waning in the interim. A failure to secure a majority in parliament could entrap Erdogan in an institutional fight with the legislature that creates a constitutional crisis. Chart 35Turkey Constrained By European Ties Turkey Constrained By European Ties Turkey Constrained By European Ties Relations with the EU remain an issue as well. Erdogan will likely further deepen divisions in the country if he goes ahead and makes a formal break with the EU, either by reinstituting the death penalty or holding a referendum on the EU accession process. Erdogan's hostile position towards the EU should be seen from the perspective of his own insecurity as a leader: he needs an external enemy in order to rally support around his leadership. We would recommend that clients ignore the rhetoric. Turkey depends on Europe far more than any other trade or investment partner (Chart 35). If Turkey were to lash out at the EU by encouraging migration into Europe, for example, the subsequent economic sanctions, which we are certain the EU would impose, would devastate the Turkish economy and collapse its currency. Nonetheless, Ankara's brinkmanship and anti-EU rhetoric will likely continue. It is further evidence of the regime's insecurity at home. Bottom Line: The more that Erdogan captures power within the institutions he controls, the greater his insecurities will become. This is for two reasons. First, he will increase the risk of a return of social movement protests like the Gezi Park event in 2013. Second, he will become solely responsible for everything that happens in Turkey, closing off the possibility to "pass the buck" to the parliament or the opposition when the economy slows down or a geopolitical crisis emerges. As such, we see no opening for genuine structural reform or orthodox policymaking. Turkey will continue to be run along a populist paradigm. Investment Conclusions BCA's Emerging Market Strategy recommends that clients re-instate short positions on Turkish assets, specifically going short TRY versus the U.S. dollar and shorting Turkish bank stocks. The central bank's net liquidity injections into the banking system have recently been expanded again (Chart 36). This is a form of quantitative easing and warrants a weaker currency. To be more specific, even though the overnight liquidity injections have tumbled, the use of the late liquidity money market window has gone vertical. This is largely attributed to the fact that the late liquidity window is the only money market facility that has not been capped by the authorities in their attempt to tighten liquidity when the lira was collapsing in January. The fact remains that Turkish commercial banks are requiring continuous liquidity and the Central Bank of Turkey (CBT) is supplying it. Commercial banks demand liquidity because they continue growing their loan books rapidly. Bank loan and money growth remains very strong at 18-20% (Chart 37). Such extremely strong loan growth means that credit excesses continue to be built. Chart 36Liquidity Injections Reaccelerating Liquidity Injections Reaccelerating Liquidity Injections Reaccelerating Chart 37Money And Credit Growth Strong Money And Credit Growth Strong Money And Credit Growth Strong Besides, wages are growing briskly - wages in manufacturing and service sector are rising at 18-20% from a year ago (Chart 38, top panel). Meanwhile, productivity growth has been very muted. This entails that unit labor costs are mushrooming and inflationary pressures are more entrenched than suggested by headline and core consumer price inflation. It seems Turkey is suffering from outright stagflation: rampant inflationary pressures with a skyrocketing unemployment rate (Chart 38, bottom panel). The upshot of strong credit/money and wage growth as well as higher inflationary pressures is currency depreciation. Excessive credit and income/wage growth are supporting import demand at a time when the current account deficit is already wide. This will maintain downward pressure on the exchange rate. The currency has been mostly flat year-to-date despite the CBT intervening in the market to support the lira by selling U.S. dollars (Chart 39). Without this support from the CBT, the lira would be much weaker than it currently is. That said, the CBT's net foreign exchange rates (excluding commercial banks' foreign currency deposits at the CBT) are very low - they stand at US$ 12 billion and are equal to 1 month of imports. Therefore, the central bank has little capacity to defend the lira by selling its own U.S. dollar. Chart 38Turkish Stagflation Turkish Stagflation Turkish Stagflation Chart 39Turkey Props Up The Lira Turkey Props Up The Lira Turkey Props Up The Lira We also believe there is an opportunity to short Turkish banks outright. The currency depreciation will force interbank rates higher (Chart 40, top panel). Chart 40Weak Lira Will Push Interbank Rates Higher Weak Lira Will Push Interbank Rates Higher Weak Lira Will Push Interbank Rates Higher Historically, currency depreciation has always been negative for banks' stock prices as net interest margins will shrink (Chart 40, bottom panel). Surprisingly, bank share prices in local currency terms have lately rallied despite the headwinds from higher interbank rates and the rollover in net interest rate margin. This creates an attractive opportunity to go short again. Bottom Line: We are already short the lira relative to the Mexican peso. In addition, we are recommending two new trades based on the recommendations of BCA's Emerging Market Strategy: long USD/TRY and short Turkish bank stocks. Dedicated EM equity as well as fixed-income and credit portfolios should continue underweighting Turkish assets within their respective EM universes. Indonesia: A Brief Word On Jakarta Elections President Joko "Jokowi" Widodo saw his ally, Basuki Tjahaja Purnama (nicknamed "Ahok"), badly defeated in the second round of a contentious gubernatorial election on April 19. Preliminary results suggest that Ahok received 42% against 58% for his contender, Anies Baswedan, a technocrat and defector from Jokowi's camp whose own party only expected him to receive 52% of the vote. This was a significant setback. Jokowi's loss of the Jakarta government is a rebuke from his own political base, a loss of prestige (since he campaigned to help Ahok), and a boost to the nationalist opposition party Gerindra and other opponents of Jokowi's reform agenda. Ahok is a Christian and ethnic Chinese, which makes him a double-minority in Muslim-majority Indonesia, which has seen anti-Chinese communal violence periodically and has also witnessed a swelling of Islamist politics since the decline of the oppressive secular Suharto regime in 1998. Ahok fell under popular scrutiny and later criminal charges for allegedly insulting the Koran in September 2016 by casting doubt on verses suggesting that Muslims should not be governed by infidels. Mass Islamist protests ensued in November. Gerindra exploited them, as did political forces behind the previous government of Susilo Bambang Yudhoyono and trade unions opposed to the Jokowi administration's attempt to regularize minimum wage increases.17 Ahok's sound defeat shows that the opposition succeeded in making the race a referendum on him versus Islam. Despite the blow, Jokowi's popularity remains intact (Chart 41). The latest reliable polling is months out of date but puts Jokowi 24% above Prabowo Subianto, leader of Gerindra, whom he has consistently led since defeating him in the 2014 election. Jokowi remains personally popular, maintains a large coalition in the assembly, and is still the likeliest candidate to win the 2019 election. Jokowi's approval ratings in the mid-60 percentile are comparable to those of former President Yudhoyono at this time in 2007, and the latter was re-elected for a second term. Moreover Yudhoyono slumped at this point in his first term down to the mid-40 percentile in 2008 before recovering dramatically in 2009, despite the global recession, to win re-election. In other words, according to recent precedent, Jokowi could fall much farther in the public eye and still recover in time for the election. However, Jokowi will now have to shore up his support among voters with a strong Muslim identity, which is a serious weak spot of his, as indicated in the regional electoral data in Table 2. Jokowi relies on two key Islamist parties in the National Assembly. He cannot afford to let opposition grow among Muslim voters at large (notwithstanding Gerindra's own problems working with Islamist parties). Chart 41Jokowi Still Likely To Be Re-Elected In 2019 What About Emerging Markets? What About Emerging Markets? Table 2Islamist Politics A Real Risk For Jokowi What About Emerging Markets? What About Emerging Markets? He clearly faces a tougher re-election bid now than he did before. Risks to China and EM growth on the two-year horizon are therefore even more threatening than they were. And since a Prabowo victory would mark the rise of a revanchist and nationalist government in Indonesia that would upset markets for fear of unorthodox economic policies, the political dynamic will be all the more important to monitor. These election risks also suggest that traditional interest-group patronage is likely to rise at the expense of structural economic reform over the next two years. Bottom Line: We remain bearish on Indonesian assets. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Client Note, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 4 Please see BCA Emerging Markets Strategy Weekly Report, "Signs Of An EM/China Growth Reversal," dated April 12, 2017, available at ems.bcaresearch.com. 5 Please see BCA Emerging Markets Strategy Weekly Report, "EM: The Beginning Of The End," dated April 19, 2017, available at ems.bcaresearch.com. 6 Please see BCA Emerging Markets Strategy Weekly Report, "Toward A Desynchronized World?" dated April 26, 2017, available at ems.bcaresearch.com. 7 Please see BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016; Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017; and Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, all available at gps.bcaresearch.com. 8 Please see "Moon Jae-in's initiative for 'Inter-Korean Economic Union," National Committee on North Korea, dated August 17, 2012, available at www.ncnk.org. 9 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 10 For our latest feature update on what is one of our major themes, please see BCA Geopolitical Strategy and EM Equity Sector Strategy, "The South China Sea: Smooth Sailing?" dated March 28, 2017, available at gps.bcaresearch.com. 11 Please see footnote 7 above. 12 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 13 Please see BCA Emerging Markets Strategy and Geopolitical Strategy Special Report, "Russia: Entering A Lower-Beta Paradigm," dated March 8, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Client Note, "Trump Re-Establishes America's 'Credible Threat'," dated April 7, 2017, available at gps.bcaresearch.com. 16 An original version of this analysis of Turkey appeared in BCA Emerging Market Strategy Weekly Report, "EM: The Beginning Of The End," dated April 19, 2017, available at ems.bcaresearch.com. 17 Please see "Indonesia: Beware Of Excessive Wage Inflation" in BCA Emerging Markets Strategy Special Report, "Turkey: Military Adventurism And Capital Controls," dated December 7, 2016, available at ems.bcaresearch.com.

Highlights Ongoing monetary tightening in China poses a substantial threat to EM risk assets. Yet financial markets remain highly complacent. Mind the gap between EM risk assets and commodities currencies/various commodities prices. Business conditions in EM ex-China will diverge from the U.S. and European economies and recouple to the downside with China's growth. The pillars of the EM business cycle are China, commodities, and their own domestic credit cycle, rather than the U.S. and Europe. Continue shorting/underweighting the Malaysian currency, stocks and sovereign credit. Feature Chart I-1China: Ongoing Liquidity Tightening China: Ongoing Liquidity Tightening China: Ongoing Liquidity Tightening There is one major underappreciated risk in global financial markets: China's gradual yet unrelenting monetary tightening. Though slow and measured, this policy tightening constitutes a significant risk, particularly for emerging markets. The basis is that it could trigger a disproportionally large negative effect on Chinese growth because it is taking place amid a lingering credit bubble in China.1 Mainland interbank rates and onshore corporate bond yields have risen as the People's Bank of China (PBoC) has reduced its net liquidity injections via open market operations (Chart I-1, top panel). The PBoC's monetary tightening is bound to reduce money/credit growth in China. The bottom panel of Chart I-1 demonstrates that changes in the central bank's claims on commercial banks lead by 3 months asset growth at commercial banks. Diminished liquidity injections by the PBoC will soon push commercial banks to reduce the pace of their balance sheet expansion. Asset growth/loan origination among policy banks2 has already slowed (Chart I-2). On top of this, China's regulatory tightening aimed at curbing speculative (high-risk) financial activity will also curtail commercial banks' loan origination. For example, bank regulators are forcing banks to bring off-balance-sheet assets onto their balance sheets. As a result, money/credit growth is set to decelerate meaningfully. This, in turn, will cause another slump in this credit-addicted economy. It is very probable that the mini-business cycle in China has already reached its peak - our credit and fiscal impulse heralds further drop in the manufacturing PMI (Chart I-3). Chart I-2Commercial Banks And Policy ##br##Banks' Loan Growth To Slow Further Commercial Banks And Policy Banks' Loan Growth To Slow Further Commercial Banks And Policy Banks' Loan Growth To Slow Further Chart I-3China's Growth Has Rolled Over China's Growth Has Rolled Over China's Growth Has Rolled Over While China's monetary tightening is not a direct risk to domestic demand in the U.S. or Europe, it poses an imminent risk to commodities prices and EM risk assets. Consistent with slowing Chinese manufacturing output growth, commodities prices trading in mainland China have lately tanked. Bottom Line: BCA's Emerging Markets Strategy team maintains that ongoing monetary tightening in China poses substantial risks to EM risk assets and commodities. Yet financial markets remain complacent. Perplexing Complacency It is very perplexing that EM risk assets have so far ignored the risks stemming from China's tightening and renewed relapse in commodities prices. It seems portfolio allocation into risk assets, including those in the EM universe, is pushing prices higher irrespective of a major relapse in forward-looking indicators for both China and EM growth. EM stocks, currencies and credit spreads have decoupled from a number of indicators with which they historically had a high correlation: In recent weeks, we have brought to investors' attention that an unsustainable gap has been opening between the commodities currencies index - an equal-weighted average of AUD, NZD and CAD - and both EM exchange rates and EM share prices in local currency terms (Chart I-4A & Chart I-4B). Chart I-4AHeed The Message From Commodities Currencies Heed The Message From Commodities Currencies Heed The Message From Commodities Currencies Chart I-4BHeed The Message From ##br##Commodities Currencies Heed The Message From Commodities Currencies Heed The Message From Commodities Currencies Not only have commodities currencies decisively rolled over, but also commodities prices have begun sliding. Historically, EM risk assets in general and the sovereign credit market in particular have always sold off when commodities prices have drifted lower (Chart I-5). EM equity volatility is back to its lows (Chart I-6). This corroborates reigning complacency in the marketplace. Chart I-5Commodities Prices And ##br##EM Sovereign Spreads Commodities Prices And EM Sovereign Spreads Commodities Prices And EM Sovereign Spreads Chart I-6A Sign Of Complacency A Sign Of Complacency A Sign Of Complacency EM sovereign and corporate spreads have also fallen to their narrowest levels in recent years (Chart I-7). Notably, our valuation model for EM corporate bonds - which is constructed based on our EM Corporate Financial Health Index - posits that EM corporate credit is very expensive (Chart I-8). Chart I-7EM Sovereign And Corporate Spreads EM Sovereign And Corporate Spreads EM Sovereign And Corporate Spreads Chart I-8EM Corporate Credit Is Expensive bca.ems_wr_2017_05_03_s1_c8 bca.ems_wr_2017_05_03_s1_c8 Finally, EM local currency bond yield spreads over U.S. Treasurys have also dropped a lot, signifying complacency on the part of EM investors (Chart I-9). Chart I-9EM Local Bond Yield Spreads ##br##Over U.S. Treasurys Are Low EM Local Bond Yield Spreads Over U.S. Treasurys Are Low EM Local Bond Yield Spreads Over U.S. Treasurys Are Low Bottom Line: EM financial markets are not cheap, and investors are highly complacent. Mind the gap between EM risk assets and commodities currencies/various commodities prices. Can EM Decouple From China? An oft-asked and relevant question is whether EM ex-China can decouple from China itself. Not for the time being, in our view. On the contrary, as we argued in last week's report titled Toward A Desynchronized World,3 China's slowdown will weigh on the majority of the EM investable equity, currency and credit markets. As a result, growth conditions in EM ex-China will diverge from the U.S. and European economies and recouple to the downside with China's growth. The three pillars of EM ex-China growth are commodities, China and their domestic credit cycles. The primary link is via commodities. As China's growth decelerates and its imports relapse, commodities prices will plunge (Chart I-10). Latin America, Africa, the Middle East, Russia, Malaysia and Indonesia are set to experience negative terms-of-trade shocks as commodities prices deflate. As a result, their currencies will depreciate and growth will suffer. Although Mexico is leveraged to the U.S., oil prices still matter for it. This leaves non-commodities producing economies in Asia and central Europe. The latter is too small to matter for EM benchmarks. Central Europe correlates with Europe's business cycle rather than EM. In emerging Asia, Korea and Taiwan - the largest equity market cap weights after China in the MSCI EM index - sell much more to China than to the U.S. and Europe combined. Korea's shipments to China account for 25% of total exports while those to the U.S. and Europe combined make up 22%. For Taiwan the numbers are 27% and 20%, respectively. Thailand sells to China as much as it does to the U.S. This by and large leaves only three mainstream EM economies that are not substantially exposed to China: India, the Philippines and Turkey (Table I-1). Indian and Philippine stocks are expensive, and these nations confront their own unique problems. Turkey in turn is facing major political, economic and financial predicaments. Chart I-10Industrial Metals Prices To head Lower bca.ems_wr_2017_05_03_s1_c10 bca.ems_wr_2017_05_03_s1_c10 Table I-1Export To China And U.S. Perplexing Complacency: Underappreciated EM Risk Perplexing Complacency: Underappreciated EM Risk In short, among mainstream EM countries, there are very few plays not exposed to China or commodities and offer a reasonable risk/return profile. Investors also often ask if commodities importing economies in Asia can rally in absolute terms when and as commodities prices drop. Chart I-11 illustrates the Korean and Taiwanese equity indexes have historically (in the past 20 years) been strongly correlated with oil and industrial metals prices. The reason is that commodity price swings partially reflect global growth conditions. Being heavily dependent on exports, Korea and Taiwan are highly sensitive to fluctuations in global growth. We expect global trade to slow down anew, driven by weakness in China/EM imports, even if U.S. and European demand remains resilient. We elaborated on this theme in last week's report.4 Therefore, Korean and Taiwanese export shipments are set to slow as well. We are not bearish on Korean and Taiwanese domestic demand - we are in fact overweight these bourses within the EM equity universe, with a focus on technology and domestic sectors. That said, consumer and business spending in these economies is relatively small in a global context to make a difference for other EM markets. In addition, given these economies' mature phase of development, the pace of their income and domestic demand growth will be moderate. Many EM countries have experienced excessive credit growth in the past 15 years, but their banking systems have not restructured - i.e. banks have not sufficiently provisioned for non-performing loans. Until they do so, domestic loan growth remains at risk of weakening. There has been modest deleveraging in Brazil, Russia and India (Chart I-12). However, there is no evidence that these economies have embarked on a new credit cycle. Chart I-11Korean And Taiwanese Stocks ##br##Correlate With Commodities Korean And Taiwanese Stocks Correlate With Commodities Korean And Taiwanese Stocks Correlate With Commodities Chart I-12Some Moderate Deleveraging ##br##In Brazil, Russia And India Some Moderate Deleveraging In Brazil, Russia And India Some Moderate Deleveraging In Brazil, Russia And India Case in point are Indian state-owned banks: their experience shows that deleveraging can be more protracted and painful than one might initially expect. The reason is that it takes time for banks to acknowledge non-performing loans, be recapitalized and get ready to boost loan growth again. In addition, Brazil and Russia are still commodities plays at the mercy of commodities price dynamics. Besides, Brazil needs to undergo painful fiscal adjustment/reforms. In other developing countries, bank loan growth remains elevated and bank loan-to-GDP ratios continue to rise (Chart I-13). In these economies, credit retrenchment and even a mild deleveraging has not yet occurred. Prominently, as EM currencies come under downward pressure, interest rates in many economies running current account deficits will be pressured higher. This will lead to a slowdown in bank credit growth and will depress demand. Finally, if it were not for the pick-up in Chinese imports, the EM ex-China business cycle and commodities prices would not have ameliorated in the past 12 months. Notably, excluding China, Korea and Taiwan, developing nations' retail sales volumes and new vehicle sales remain dormant (Chart I-14). Similarly, there has not been much recovery in capital spending and, consistently, imports of capital goods in EM ex-China, Korea and Taiwan (Chart I-15). Chart I-13No Deleveraging In Many EMs No Deleveraging In Many EMs No Deleveraging In Many EMs Chart I-14EM Ex-China, Korea And Taiwan: ##br##Stabilization But No Revival EM Ex-China, Korea And Taiwan: Stabilization But No Revival EM Ex-China, Korea And Taiwan: Stabilization But No Revival Chart I-15EM Ex-China, Korea And Taiwan: ##br##Not Much Of Recovery EM Ex-China, Korea And Taiwan: Not Much Of Recovery EM Ex-China, Korea And Taiwan: Not Much Of Recovery As credit growth slows or fails to pick up in these economies, domestic demand recovery will be tepid, and will certainly disappoint market expectations. Bottom Line: Given budding divergence between U.S./Europe and Chinese growth, EM ex-China growth will fail to recover and will surprise to the downside. The basis is that the pillars of the EM's business cycle are China, commodities and their own domestic credit cycle, rather than the U.S. and Europe. 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, the links are available on page 16. 2 Policy banks are China Development Bank, Agricultural Development Bank and Export-Import Bank of China. 3 Please refer to the Emerging Markets Strategy Weekly Report titled, "Toward A Desynchronized World", dated April 26, 2017, link available on page 16. 4 Please refer to the Emerging Markets Strategy Weekly Report titled, "Toward A Desynchronized World", dated April 26, 2017, link available on page 16. Malaysia: Not Out Of The Woods Arenewed relapse in Chinese growth later this year coupled with lower commodities prices will once again expose Malaysia's vulnerabilities. Notably, 26% of Malaysia's exports are related to commodities - mainly crude oil, natural gas, petroleum products and palm oil. Another downleg in the ringgit's value along with lower commodities prices will cause domestic interest rates to rise. However, Malaysia is in no position to tolerate higher interest rates. Leverage has risen considerably in the past ten years in Malaysia, and is very high (Chart II-1A). Indeed, the country has one of the highest debt-servicing costs in the EM universe, according to BIS data (Chart II-1B). Chart II-1A...And Debt Servicing Costs High Leverage... High Leverage... Chart II-1BHigh Leverage... High Leverage... High Leverage... If the Malaysian central bank attempts to cap interest rates by injecting local currency liquidity into the system, the ringgit will plunge even further. Chart II-2 shows that in recent years local interbank rates have tended to rise when the central bank curtailed its net liquidity injection. If on the other hand the Bank Negara of Malaysia (BNM) does not inject liquidity into the banking/financial system, interest rates will rise as the currency depreciates. Interestingly, despite strong inflows into EM generally, the BNM has continued to inject local liquidity into the economy - albeit at a slower pace than in recent years - to keep local rates tame (Chart II-2). Additionally, despite the significant growth slowdown that has occurred in the past two years in Malaysia, banks' NPLs have not risen much (Chart II-3). As banks start acknowledging loan losses and setting provisions for them, their profitability will decline, capital will be eroded, and loan origination will fall. Chart II-2BNM Has Been Injecting Liquidity ##br##To Control Interest Rates BNM Has Been Injecting Liquidity To Control Interest Rates BNM Has Been Injecting Liquidity To Control Interest Rates Chart II-3Malaysian Banks Haven't ##br##Acknowledged Enough Losses Yet Malaysian Banks Haven't Acknowledged Enough Losses Yet Malaysian Banks Haven't Acknowledged Enough Losses Yet Meanwhile, even though global trade and commodities prices have picked in the past 15 months, Malaysia's economy has failed to recover. This reflects the country's underlying economic vulnerability as the borrowing/credit spree of the past decade has come to a halt: Commercial and passenger vehicle sales are shrinking. Retail trade and employment are also still anemic. Property sales volumes and housing construction approvals are collapsing (Chart II-4). Capital expenditures are depressed (Chart II-4, bottom panel). On the external side, the semiconductor/electronics sector has boomed in Asia since early 2016, but Malaysia has failed to benefit much. Indeed, the recovery in Malaysia's electronics sector has been weak compared to other technology hubs such as Taiwan and Korea. This confirms why Malaysia has been losing market share in electronics products to Korea, Taiwan and the Philippines (Chart II-5). Chart II-4Cyclical Growth Remains Anemic Cyclical Growth Remains Anemic Cyclical Growth Remains Anemic Chart II-5Malaysia Is Losing Tech Market ##br##Share To Its Asian Competitors Malaysia Is Losing Tech Market Share To Its Asian Competitors Malaysia Is Losing Tech Market Share To Its Asian Competitors Bottom Line: Continue shorting MYR versus the U.S. dollar and the Russian ruble. Equity investors should continue to underweight Malaysian stocks within an EM equity portfolio. Relative value traders should maintain our long Russian / short Malaysia equity trade. Buy/hold Malaysian CDS or underweight this sovereign credit market within an EM credit portfolio. Ayman Kawtharani, Associate Editor aymank@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Dear Client, In addition to an abbreviated Weekly Report that you will receive later tonight, I am sending you this Special Report written by my colleague Mark McClellan of our monthly Bank Credit Analyst publication. Following up on many of the themes discussed in our latest Quarterly Strategy Outlook, Mark makes a convincing case that most of the factors that have suppressed global interest rates since the financial crisis could begin to unwind or even reverse over the coming years. Best regards, Peter Berezin, Chief Global Strategist Highlights The fundamental drivers of the low rate world are considered by many to be structural, and thus likely to keep global equilibrium bond yields quite depressed by historical standards for years to come. However, some of the factors behind ultra-low interest rates have waned, while others have reached an inflection point. The age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool. Global investment needs will wane along with population aging, but the majority of the effect on equilibrium interest rates is in the past. In contrast, the demographic effects that will depress desired savings are still to come. The net impact will be bond-bearish. Moreover, the massive positive labor supply shock, following the integration of China and Eastern Europe into the world's effective labor force, is over. Indeed, this shock is heading into reverse as the global working-age population ratio falls. This may improve labor's bargaining power, sparking a shift toward using more capital in the production process and thereby placing upward pressure on global real bond yields. It is too early to declare globalization dead, but the neo-liberal trading world order that has been in place for decades is under attack. This could be inflationary if it disrupts global supply chains. Anti-globalization policies could paradoxically be positive for capital spending, at least for a few years. As for China, the fundamental drivers of its savings capacity appear to rule out a return to the days when the country was generating a substantial amount of excess savings. Technological advance will remain a headwind for real wage gains, but at least the transition to a world that is less labor-abundant will boost workers' ability to negotiate a larger share of the income pie. We are not making the case that real global bond yields are going to quickly revert to pre-Lehman averages. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations for bond yields are too low. Investors should have a bond-bearish bias on a medium- and long-term horizon. Feature In the September 2016 The Bank Credit Analyst, we summarized the key drivers behind the major global macroeconomic disequilibria that have resulted in deflationary pressure, policy extremism, dismal productivity, and the lowest bond yields in recorded history (Chart 1). The disequilibria include income inequality, the depressed wage share of GDP, lackluster capital spending, and excessive savings. Chart 1Global Disequilibria Beware Inflection Points In The Secular Drivers Of Global Bonds Beware Inflection Points In The Secular Drivers Of Global Bonds The fundamental drivers of the low bond yield world are now well documented and understood by investors. These drivers generally are considered to be structural, and thus likely to keep global equilibrium bond yields and interest rates at historically low levels for years to come according to the consensus. Based on discussions with BCA clients, it appears that many have either "bought into" the secular stagnation thesis or, at a minimum, have adopted the view that growth headwinds preclude any meaningful rise in bond yields. However, bond investors might have been lulled into a false sense of security. Yields will not return to pre-Lehman norms anytime soon, but some of the factors behind the low-yield world have waned, while others have reached an inflection point. Most importantly, the age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool. We have reached the tipping point. Equilibrium real bond yields will gradually move higher as a result. But before we discuss what is changing, it is important to review the drivers of today's macro disequilibria. Several of them predate the Great Financial Crisis, including demographic trends, technological advances, and the integration of China's massive workforce and excess savings into the global economy. Ultra-Low Rates: How Did We Get Here? (A) Demographics And Global Savings Chart 2Global Shifts In The Saving And Investment Curves Beware Inflection Points In The Secular Drivers Of Global Bonds Beware Inflection Points In The Secular Drivers Of Global Bonds The so-called Global Savings Glut has been a bullish structural force for bonds for the past couple of decades. We won't go through all of the forces behind the glut, but a key factor is population aging in the advanced economies. Ex-ante desired savings rose as baby boomers entered their high-income years. The Great Financial Crisis only served to reinforce the desire to save, given the setback in the value of boomers' retirement nest eggs.1 The corporate sector also began to save more following the crisis. Even more importantly, the surge in China's trade surplus since the 1990s had to be recycled into the global pool of savings. While China's rate of investment was very high, its propensity to save increased even faster, resulting in a swollen external surplus and a massive net outflow of capital. Other emerging economies also made the adjustment from net importers of capital to net exporters following the Asian crisis in the late 1990s. By leaning into currency appreciation, these countries built up huge foreign exchange reserves that had to be recycled abroad. In theory, savings must equal investment at the global level and real interest rates shift to ensure this equilibrium (Chart 2). China's excess savings, together with a greater desire to save in the developed countries, represented a shift in the saving schedule to the right. The result was downward pressure on global interest rates. (B) Demographics And Global Capital Spending Demographics and China's integration also affected the investment side of the equation. A slower pace of labor force growth in the developed countries resulted in a permanently lower level of capital spending relative to GDP. Slower consumer spending growth, as a result of a more moderate expansion in the working-age population, meant a reduced appetite for new factories, malls, and apartment buildings. Chart 3 shows that the growth rate of global capital spending that is required to maintain a given capital-to-output ratio has dropped substantially, due to the dramatic slowdown in the growth of the world's working-age population.2 Keep in mind that this estimate refers only to the demographic component of investment spending. Actual capital expenditure growth will not be as weak as Chart 3 suggests because firms will want to adopt new technologies for competitive or environmental reasons. Nonetheless, the point is that the structural tailwind for global capex from the post-war baby boom has disappeared. Chart 3Demographics Are A Structural Headwind For Global Capex Beware Inflection Points In The Secular Drivers Of Global Bonds Beware Inflection Points In The Secular Drivers Of Global Bonds (C) Labor Supply Shock And Global Capital Spending While the working-age population ratio peaked in the developed countries years ago, it is a different story at the global level (Chart 4). The integration of the Chinese and Eastern European workforces into the global labor pool during the 1990s and 2000s resulted in an effective doubling of global labor supply in a short period of time. Relative prices must adjust in the face of such a large boost in the supply of labor relative to capital. The sudden abundance of cheap labor depressed real wages from what they otherwise would have been, thus incentivizing firms to use more labor and less capital at the margin. The combination of slower working-age population growth in the advanced economies and a surge in the global labor force resulted in a decline in desired global capital spending. In terms of Chart 2, the leftward shift of the investment schedule reinforced the impact of the savings impulse in placing downward pressure on global interest rates. (D) Labor Supply Shock And Income Inequality The wave of cheap labor also aggravated the trend toward greater inequality in the advanced economies and the downward trend in labor's share of the income pie (Chart 5). In theory, a surge in the supply of labor is a positive "supply shock" that benefits both developed and developing countries. However, a recent report by David Autor and Gordon Hanson3 highlighted that trade agreements in the past were incremental and largely involved countries with similar income levels. The sudden entry of China to the global trade arena, involving a massive addition to the effective global stock of labor, was altogether different. The report does not argue that trade has become a "bad" thing. Rather, it points out that the adjustment costs imposed on the advanced economies were huge and long-lasting, as Chinese firms destroyed entire industries in developed countries. The lingering adjustment phase contributed to greater inequality in the major countries. Management was able to use the threat of outsourcing to gain the upper hand in wage negotiations. The result has been a rise in the share of income going to high-income earners in the Advanced Economies, at the expense of low- and middle-income earners (Chart 6). The same is true, although to a lesser extent, in the emerging world. Chart 4Working-Age Population Ratios Have Peaked Working-Age Population Ratios Have Peaked Working-Age Population Ratios Have Peaked Chart 5Labor Share Of Income Has Dropped Labor Share Of Income Has Dropped Labor Share Of Income Has Dropped Chart 6Hollowing Out Hollowing Out Hollowing Out Greater inequality, in turn, has weighed on aggregate demand and equilibrium interest rates because a larger share of total income flowed to the "rich" who tend to save more than the low- and middle-income classes. (E) The Dark Side Of Technology Advances in technology also contributed to rising inequality. In theory, new technologies hurt some workers in the short term, but benefit most workers in the long run because they raise national income. However, there is evidence that past major technological shocks were associated with a "hollowing out" or U-shaped pattern of employment. Low- and high-skilled employment increased, but the proportion of mid-skilled workers tended to shrink. Wages for both low- and mid-skilled labor did not keep up with those that were highly-skilled, leading to wider income disparity. Today, technology appears to be resulting in faster, wider and deeper degrees of hollowing-out than in previous periods of massive technological change. This may be because machines are not just replacing manual human tasks, but cognitive ones too. A recent IMF report made the case that technology and global integration played a dominant role in labor's declining fortunes. Technology alone explains about half of the drop in the labor share of income in the developed countries since 1980.4 Falling prices for capital goods, information and communications technology in particular, have facilitated the expansion of global value chains as firms unbundled production into many tasks that were distributed around the world in a way that minimized production costs. Chart 7 highlights that the falling price of capital goods in the advanced economies went hand-in-hand with rising participation in global supply chains since 1990. Falling capital goods prices also accelerated the automation of routine tasks, contributing especially to job destruction in the developed (high-wage) economies. In other words, firms in the developed world either replaced workers with machinery in areas where technology permitted, or outsourced jobs to lower-wage countries in areas that remained labor-intensive. Both trends undermined labor's bargaining power, depressed labor's share of income, and contributed to inequality. The effects of technology, global integration, population aging and China's economic integration are demonstrated in Chart 8. The world working-age-to-total population ratio rose sharply beginning in the late 1990s. This resulted in an upward trend in China's investment/GDP ratio, and a downward trend in the G7. The upward trend in the G7 capital stock-per-capita ratio began to slow as a result, before experiencing an unprecedented contraction after the Great Recession and Financial Crisis. Chart 7Economic Integration And Falling Capital Goods Prices Economic Integration And Falling Capital Goods Prices Economic Integration And Falling Capital Goods Prices Chart 8Macro Impact Of Labor Supply Shock Macro Impact Of Labor Supply Shock Macro Impact Of Labor Supply Shock The result has been a deflationary global backdrop characterized by demand deficiency and poor potential real GDP growth, both of which have depressed equilibrium global interest rates over the past 20 to 25 years. Transition Phase Chart 9Working-Age Population To Shrink in G7 and China Working-Age Population To Shrink in G7 and China Working-Age Population To Shrink in G7 and China It would appear easy to conclude that these trends will be with us for another few decades because the demographic trends will not change anytime soon. Nonetheless, on closer inspection the global economy is transitioning from a period when cyclical economic pressures and all of the structural trends were pushing equilibrium interest rates in the same direction, to a period in which the economic cycle is becoming less bond-friendly and some of the secular drivers of low interest rates are gradually changing direction. First, the massive labor supply shock of the past few decades is over. The world working-age population ratio has peaked according to United Nations estimates. This ratio is already declining in the major advanced economies and is in the process of topping out in China. The absolute number of working-age people will shrink in China and the G7 countries over the next five years, although it will continue to grow at a low rate for the world as a whole (Chart 9). Unions are unlikely to make a major comeback, but a backdrop that is less labor-abundant should gradually restore some worker bargaining power, especially as economies regain full employment. The resulting upward pressure on real wages will support capital spending as firms substitute toward capital and away from (increasingly expensive) labor. Consumer demand will also receive a boost if inequality moderates and the labor share of income begins to rise. Globalization On The Back Foot Chart 10Globalization Peaking? Globalization Peaking? Globalization Peaking? Second, it is too early to declare globalization dead, but the neo-liberal trading world order that has been in place for decades is under attack. Global exports appear to have peaked relative to GDP and average tariffs have ticked higher (Chart 10). The World Trade Organization has announced that the number of new trade restrictions or impediments outweighed the number of trade liberalizing initiatives in 2016. The U.K. appears willing to sacrifice trade for limits to the free movement of people. The new U.S. Administration has ditched the Trans-Pacific Partnership (TPP) and is threatening to impose punitive tariffs on some trading partners. Anti-globalization policies could paradoxically be positive for capital spending, at least for a few years. If the U.S. were to impose high tariffs on China, for example, it would make a part of the Chinese capital stock redundant overnight. In order for the global economy to produce the same amount of goods and services as before, the U.S. and other countries would need to invest more. Any unwinding of globalization would also be inflationary as it would disrupt international supply chains. Demographics And Saving: From Tailwind To Headwind... Third, the impact of savings in the major advanced economies and China on global interest rates will change direction as well. In the developed world, aggregate household savings will come under downward pressure as boomers increasingly shift into retirement. Economists are fond of employing the so-called life-cycle theory of consumer spending. According to this theory, consumers tend to smooth out lifetime spending by accumulating assets during the working years in order to maintain a certain living standard after retirement. The U.N. National Transfer Accounts Project has gathered data on spending and labor income by age cohort at a point in time. Chart 11 presents the data for China and three of the major advanced economies. The data for the advanced economies suggest that spending tends to rise sharply from a low level between birth and about 15 years of age. It continues to rise, albeit at a more modest pace, through the working years. Other studies have found that consumer spending falls during retirement. Nonetheless, these studies generally include only private spending and therefore do not include health care that is provided by the government. The data presented in Chart 11 show that, if government-provided health care is included, personal spending rises sharply toward the end of life. The profile is somewhat different in China. Spending rises quickly from birth to about 20 years of age, and is roughly flat thereafter. Indeed, consumption edges lower after 75-80 years of age. These data allow us to project the impact of changing demographics on the average household saving rate in the coming years, assuming that the income and spending profiles shown in Chart 11 are unchanged. We start by calculating the average saving rate across age cohorts given today's age structure. We then recalculate the average saving rate each year moving forward in time. The resulting saving rate changes along with the age structure of the population. Chart 11Income And Consumption By Age Cohort Beware Inflection Points In The Secular Drivers Of Global Bonds Beware Inflection Points In The Secular Drivers Of Global Bonds The results are shown in Chart 12. The saving rates for all four economies have been indexed at zero in 2016 for comparison purposes. The aggregate saving rate declines in all cases, falling between 4 and 8 percentage points between 2016 and 2030. Germany sees the largest drop of the four countries. Chart 12Aging Will Undermine Aggregate Saving Aging Will Undermine Aggregate Saving Aging Will Undermine Aggregate Saving The simulations are meant to be suggestive, rather than a precise forecast, because the savings profile across age cohorts will adjust over time. Moreover, governments will no doubt raise taxes to cover the rising cost of health care, providing a partial offset in terms of the national saving rate.5 Nonetheless, the simulations highlight that the major economies are past the point where the baby boom generation is adding to the global savings pool at a faster pace than retirees are drawing from it. The age structure in the major advanced economies is far enough advanced that the rapid increase in the retirement rate will place substantial downward pressure on aggregate household savings in the coming years. It is well known that population aging will also undermine government budgets. Rising health care costs are already captured in our household saving rate projection because the data for household spending includes health care even if it is provided by the public sector. However, public pension schemes will also be a problem. To the extent that politicians are slow to trim pension benefits and/or raise taxes, public pension plans will be a growing drain on national savings. Could younger, less developed economies offset some of the demographic trends in China and the Advanced Economies? Numerically speaking, a more effective use of underutilized populations in Africa and India could go a long way. Nevertheless, deep-seated structural problems would have to be addressed and, even then, it is difficult to see either of these regions turning into the next "China story" given the current backlash against globalization and immigration. ...And The Capex Story Is Largely Behind Us Demographic trends also imply less capital spending relative to GDP, as discussed above. In terms of the impact on global equilibrium interest rates, it then becomes a race between falling saving and investment rates. Some analysts point to the Japanese experience because it is the leading edge in terms of global aging. Bond yields have been extremely low for many years even as the household saving rate collapsed, suggesting that ex-ante investment spending shifted by more than ex-ante savings. Nonetheless, Japan may not be a good example because the deterioration in the country's demographics coincided with burst bubbles in both real estate and stocks that hamstrung Japanese banks for decades. A series of policy mistakes made things worse. Economic theory is not clear on the net effect of demographics on savings and investment. The academic empirical evidence is inconclusive as well. However, a detailed IMF study of 30 OECD countries analyzed the demographic impact on a number of macroeconomic variables, including savings and investment.6 They estimated separate demographic effects for the old-age dependency ratio and the working-age population ratio. Applying the IMF's estimated model coefficients to projected changes in both of these ratios over the next decade suggests that the decline in ex-ante savings will exceed the ex-ante drop in capex requirements by about 1 percentage point of GDP. This is a non-trivial shift. Chart 13Demographics And Capex Requirements Beware Inflection Points In The Secular Drivers Of Global Bonds Beware Inflection Points In The Secular Drivers Of Global Bonds Moreover, our simulations highlight that timing is important. The outlook for the household saving rate depends on the changing age structure of the population and the distribution of saving rates across age cohorts. Thus, the average saving rate will trend down as populations continue to age over the coming decades. In contrast, the impact of demographics on capital spending requirements is related to the change in the growth rate of the working-age population. Chart 13 once again presents our estimates for the demographic component of capital spending. The top panel presents the world capex/GDP ratio that is necessary to maintain a constant capital/output ratio, and the bottom panel shows the change in that ratio. The important point is that the downward adjustment in world capex/GDP related to aging is now largely behind us because most of the deceleration in the growth rate of the working-age population is done. This is in contrast to the household saving rate adjustment where all of the adjustment is still to come. China Is Transitioning Too China must be treated separately from the developed countries because of its unique structural issues. As discussed above, household savings increased dramatically beginning in the mid-1990s (Chart 14). This trend reflected a number of factors, including: the rising share of the working-age population; a drop in the fertility rate, following the introduction of the one-child policy in the late 1970s that allowed households to spend less on raising children and save more for retirement; health care reform in the early 1990s required households to bear a larger share of health care spending; and job security was also undermined by reform of the state-owned enterprises (SOE) in the late 1990s, leading to increased precautionary savings to cover possible bouts of unemployment. These savings tailwinds have turned around in recent years and the household saving rate appears to have peaked. China's contribution to the global pool of savings has already moderated significantly, as measured by the current account surplus. The surplus has withered from about 9% in 2008 to 2½% in 2016. A recent IMF study makes the case that China's national saving rate will continue to decline. The IMF estimates that for every one percentage-point rise in the old-age dependency ratio, the aggregate household saving rate will fall by 0.4-1 percentage points. In addition, the need for precautionary savings is expected to ease along with improvements in the social safety net, achieved through higher government spending on health care. The household saving rate will fall by three percentage points by 2021 according to the IMF (Chart 15). Competitive pressure and an aging population will also reduce the saving rates of the corporate and government sectors. Chart 14China's Savings Rates Have Peaked... China's Savings Rates Have Peaked... China's Savings Rates Have Peaked... Chart 15...Suggesting That External Surplus Will Shrink ...Suggesting That External Surplus Will Shrink ...Suggesting That External Surplus Will Shrink Of course, investment as a share of GDP is projected to moderate too, reflecting a rebalancing of the economy away from exports and capital spending toward household consumption. The IMF expects that savings will moderate slightly faster than investment, leading to a narrowing in the current account surplus to almost zero by 2021. A lot of assumptions go into this type of forecast such that we must take it with a large grain of salt. Nonetheless, the fundamental drivers of China's savings capacity appear to rule out a return to the days when the country was generating a substantial amount of excess savings. Moreover, a return to large current account surpluses would likely require significant currency depreciation, which is a political non-starter given U.S. angst over trade. The risk is that China's excess savings will be less, not more, in five year's time. Tech Is A Wildcard It is extremely difficult to forecast the impact of technological advancement on the global economy. We cannot say with any conviction that the tech-related effects of "hollowing out", "winner-take-all" and the "skills premium" will moderate in the coming years. Nonetheless, these effects have occurred alongside a surge in the world's labor force and rapid globalization of supply chains, both of which reinforced the erosion of employee bargaining power. Looking ahead, technology will still be a headwind for some employees, but at least the transition from a world of excess labor to one that is more labor-scarce will boost workers' ability to negotiate a larger share of the income pie. We will explore the impact of technology on productivity, inflation, growth, and bond yields in a companion report to be published in the next issue. Conclusion: Table 1Key Secular Drivers Beware Inflection Points In The Secular Drivers Of Global Bonds Beware Inflection Points In The Secular Drivers Of Global Bonds The main points we made in this report are summarized in Table 1. All of the structural factors driving real bond yields were working in the same (bullish) direction over the past 30-40 years. Looking ahead, it is uncertain how technological improvement will affect bond prices, but we expect that the others will shift (or have already shifted) to either neutral or outright bond-bearish. No doubt, our views that globalization and inequality have peaked, and that the labor share of income has bottomed, are speculative. These factors may not place much upward pressure on equilibrium yields. Nonetheless, it seems likely that the demographic effect that has depressed capital spending demand is well advanced. We see it shifting from a positive factor for bond prices to a neutral factor in the coming years. It is also clear that the massive positive labor supply shock is over, and is heading into reverse as the global working-age population ratio falls. This may improve labor's bargaining power and the resulting boost consumer spending will be negative for bonds. This may also spark a shift toward using more capital in the production process and thereby place additional upward pressure on global real bond yields. Admittedly, however, this last point requires more research because theory and empirical evidence on it are not clear. Perhaps most importantly, the aging of the population in the advanced economies has reached a tipping point; retirees will drain more from the pool of savings than the working-age population will add to it in the coming years. We have concentrated on real equilibrium bond yields in this report because it is the part of nominal yields that is the most depressed relative to historical norms. The inflation component is only a little below a level that is consistent with central banks meeting their 2% inflation targets in the medium term. There is a risk that inflation will overshoot these targets, leading to a possible surge in long-term inflation expectations that turbocharges the bond bear market. This is certainly possible, as highlighted by a recent Global Investment Strategy Quarterly Strategy Outlook. Pain in bond markets would be magnified in this case, especially if central banks are forced to aggressively defend their targets. Please note that we are not making the case that real global bond yields will quickly revert to pre-Lehman averages. It will take time for the bond-bullish structural factors to unwind. It will also take time for inflation to gain any momentum, even in the United States. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations suggest that investors have adopted an overly benign view on the outlook for yields. For example, implied real short-term rates remain negative until 2021 in the U.S. and 2026 in the Eurozone, while they stay negative out to 2030 in the U.K. (Chart 16). We doubt that short-term rates will be negative for that long, given the structural factors discussed above. Another way of looking at this is presented in Chart 17. The market expects the 10-year Treasury yield in ten years to be only slightly above today's spot yield, which itself is not far above the lowest levels ever recorded. Market expectations are equally depressed for the 5-year forward rate for the U.S. and the other major economies. Chart 16Market Expects Negative Short-Term Rates For A Long Time Market Expects Negative Short-Term Rates For A Long Time Market Expects Negative Short-Term Rates For A Long Time Chart 17Forward Rates Very Low Vs. History Forward Rates Very Low Vs. History Forward Rates Very Low Vs. History The implication is that investors should have a bond-bearish bias on a medium- and long-term horizon. Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 It is true that observed household saving rates fell in some of the advanced economies, such as the United States, at a time when aging should have boosted savings from the mid-1990s to the mid-2000s. This argues against a strong demographic effect on savings. However, keep in mind that we are discussing desired (or ex-ante) savings. Ex-post, savings can go in the opposite direction because of other influencing factors. As discussed below, global savings must equal investment, which means that shifts in desired capital spending demand matter for the ex-post level of savings. 2 Arithmetically, if world trend GDP growth slows by one percentage point, then investment spending would need to drop by about 3½ percentage points of GDP to keep the capital/output ratio stable. 3 David H. Autor, David Dorn, and Gordon H. Hanson, "The China Shock: Learning from Labor-Market Adjustment to Large Changes in Trade," Annual Review of Economics, Vol 8, pp. 205-240 (October 2016). 4 Please see "Understanding The Downward Trend In Labor Income Shares," Chapter 3, IMF World Economic Outlook (April 2017). 5 In other words, while the household saving rate, as defined here to include health care spending by governments on behalf of households, will decline, any associated tax increases will blunt the impact on national savings (i.e., savings across the household, government, and business sectors). 6 Jong-Won Yoon, Jinill Kim, and Jungjin Lee, "Impact Of Demographic Changes On Inflation And The Macroeconomy," IMF Working Paper no. 14/210 (November 2014).

Highlights Despite Saudi-Iranian tensions, the OPEC 2.0 production-cut deal will survive; Petro-state balance sheets remain under pressure; OPEC 2.0 agreement will backwardate the forward curve, and slow the pace of shale recovery; Aramco IPO will motivate Saudi Arabia to over-deliver on the cuts; In expectation of backwardation, investors should go long Dec/17 Brent vs. short Dec/18 Brent, while also going long Dec/17 $65/bbl Brent calls vs. short Dec/17 $45/bbl Brent puts. Feature Despite cooperating to reduce oil production and drain global oil inventories, the Kingdom of Saudi Arabia (KSA) and Iran still compete at every level for dominance of the Gulf region's economic and geopolitical order. We have maintained that KSA's aggressive push to privatize (or de-nationalize) its state oil company - ARAMCO - is an extension of this battle. Now that a state-led Chinese consortium has emerged as a potential cornerstone investor in the $100 billion Saudi Armco initial public offering (IPO) expected next year, we believe a key element of KSA's strategy in the Persian Gulf's "security dilemma" is falling into place.1 The Interests At Stake By aggressively courting Chinese investors for its potential record-breaking Aramco IPO next year, KSA doesn't just secure funding to pursue its goal of becoming the largest publicly traded vertically integrated oil company in the world. It tangibly expands the number of powerful interests in the world with a deep economic stake in its execution of Vision 2030, the grand plan to diversify away from its near-total dependence on oil revenues. China, too, benefits from this arrangement: By expanding its financial and economic commitments to KSA, it pursues its global investment and technology strategy, and gradually its standing as a "Great Power" with a vested interest in protecting those investments. These states jointly benefit from Aramco's expansion of its refining business into the Asian refined-product markets, which will remain the most heavily contested space in the oil market. It also does not hurt China, where crude oil production has been falling since June 2015 (Chart 1), to be financially invested in a petro-super-state like KSA, which has been supplying on average 14% of its imports over the same period (Chart 2). China's product demand will breach 12mm b/d this year, with gasoline demand growing some 300k b/d, according to the IEA. Overall product demand will grow close to 345k b/d, keeping China the premier growth market in the world for refined products. Investing in the refining system meeting this consumption - and Asia's other growing markets - therefore is attractive to Chinese companies on numerous fronts. Chart 1Chinese Oil Production Falling ... Chinese Oil Production Falling ... Chinese Oil Production Falling ... Chart 2... And Imports From KSA Steady ... And Imports From KSA Steady ... And Imports From KSA Steady Iran has yet to execute on its apparent strategy to attract FDI to its oil and gas sector, where the resource potential is of the same order of magnitude as KSA's. When combined with the development potential of Iraq, a neighboring petro-state, the potential of OPEC's "Shia Bloc" is enormous. Iran has the largest natural gas reserves in the world, and Iraq's oil endowment is second only to KSA's in terms of the vast low-cost, high-quality resource available for development. Yet Iran's success in lining up the investment and technical expertise required to develop its resource endowment as it approaches critical post-sanctions elections next month has been halting at best.2 Aside, that is, from deepening its relationship with Russia, which also is seeking desperately needed FDI in the wake of the oil-price collapse brought about by OPEC's market-share was during 2015 - 16. The KSA-Iran Security Dilemma In Context Before we get into the intricacies of energy geopolitics, a brief recap is in order.3 Chart 3Saudi Spending Binge Raised Oil Breakevens Saudi Spending Binge Raised Oil Breakevens Saudi Spending Binge Raised Oil Breakevens Prior to the lifting of nuclear-related sanctions against Iran beginning in 2015, KSA and OPEC benefited from an undersupplied oil market that kept oil prices above $100/bbl which allowed these states to increase domestic and military spending massively while experiencing few problems in oil exports or development. This can be seen in the evolution of KSA's fiscal breakeven oil prices, which increased dramatically in the lead-up to the 2014 price collapse (Chart 3), as production grew more slowly than spending. As the Saudi Manifa field came online in early 2014, global production expanded from various quarters, and it became apparent that sanctions against Iran would be lifted, KSA led OPEC into a market-share war. Oil prices fell from $100/bbl before OPEC's November 2014 meeting to below $30/bbl by the beginning of 2016. This strategy turned out to be a complete failure.4 We correctly predicted the failed market-share strategy would force an alliance between OPEC and non-OPEC petro-states - led by KSA and Russia, respectively - to cut production in the face of considerable market skepticism in the lead-up to OPEC's November 2016 Vienna meeting and in consultations with the Russian-led non-OPEC petro-states shortly thereafter.5 We remain convinced that this coalition, which we've dubbed OPEC 2.0, will extend its production cuts to the end of this year.6 As a result, OECD commercial inventories will decline by 10% or so, despite rising in Q1.7 Petro-State Balance Sheets Still Under Pressure The oil-price evolution described above buffeted petro-state budgets, particularly KSA's and Russia's. The pressures generated by this evolution hold the key to understanding where oil prices will go next. Finances: While both Saudi Arabia and Russia have managed to weather the decline in oil prices, the pain has been palpable. BCA's Frontier Market Strategy has detailed Saudi fiscal woes in detail.8 Based on their estimates, Saudi authorities will have enough reserves to defend the country's all-important currency peg for the next 18-24 months (Table 1). Without the peg, prices of imports would skyrocket. Table 1Saudi Arabia: Projected Debt Levels And Foreign Reserves OPEC 2.0: Fear And Loathing In Oil Markets OPEC 2.0: Fear And Loathing In Oil Markets Given that Saudi Arabia imports almost all of its consumer staples, such a price shock could lead to social unrest. Beyond the next two years, the government will have to rely on debt issuance to fund its deficits and focus its remaining foreign exchange resources on maintaining the peg. The problem is that this strategy will leave the country with just $350 billion in reserves by the end of 2018, lower than local currency broad money (Chart 4). At that point, confidence among locals and foreigners in the currency peg could shatter, leading to even greater capital flight than is already underway (Chart 5). Chart 4KSA: Forex Reserves Depleting KSA: Forex Reserves Depleting KSA: Forex Reserves Depleting \ Chart 5KSA: Capital Outflows Persist KSA: Capital Outflows Persist KSA: Capital Outflows Persist While Russia has weathered the storm much better, largely by allowing the ruble to depreciate, its foreign exchange reserves are down to 330 billion, the lowest figure since 2007 (Chart 6). OPEC 2.0's shale-focused strategy: The market strategy behind the OPEC 2.0 agreement is complex. The roughly 1.8 mm b/d of coordinated production cuts is supposed to draw down global storage by ~ 300 mm bbls by the end of 2017. This should lead to forward curves backwardating - a process that is clearly under way (Chart 7). According to BCA's Commodity & Energy Strategy, a backwardated forward curve is critical in slowing down the pace of tight oil production in the U.S. given the reliance of shale producers on hedging future production prices to lock in minimum revenue.9 Geopolitics: Countries with an unlimited resource like oil tend to be authoritarian regimes (Chart 8). This phenomenon is referred to as the "resource curse," and is well documented in political science. Chart 6Russia: Forex ##br##Reserves Depleting Russia: Forex Reserves Depleting Russia: Forex Reserves Depleting Chart 7Backwardation ##br##Under Way Backwardation Under Way Backwardation Under Way Chart 8Unlimited Resources ##br##Undermine Democracy OPEC 2.0: Fear And Loathing In Oil Markets OPEC 2.0: Fear And Loathing In Oil Markets What does it have to do with geopolitics? Basically, it suggests that the main national security risk to energy-producing regimes is not each other but their own populations. In countries where the political leadership generates its wealth from the sale of natural resources, the citizenry becomes a de facto "cost center" requiring social benefits and security expenditures to ensure the unemployed remain peaceful. By contrast, manufacturing nations benefit from an industrious citizenry that is a "profit center" for government coffers. In this paradigm, the main national security risk for energy-producing regimes is not external, but rather derives from their own under-utilized or restless populations. Thus, when the "unlimited resource" is re-priced for lower demand or greater global supply, the real risk becomes domestic unrest. At that moment, expensive geopolitical imperatives take a back seat to domestic stability. This explains the current détente between, on one side, Russia and the OPEC "Shia Bloc" (Iran and Iraq), and on the other, Saudi Arabia and its OPEC allies. Even with this détente, Saudi Arabia, its allies, and the "Shia Bloc" are finding it difficult to maintain fiscal spending that funds their still-massive social programs with prices trading in the low- to mid-$50/bbl range (Chart 9). Saudi's fiscal breakeven oil price is estimated to be $77.70/bbl this year by the IMF. Iran and Iraq require $60.70/bbl and $54/bbl, respectively, putting them in slightly better shape than their Gulf rival, but still in need of higher prices to sustain the spending required to quell social unrest.10 Given Russia's relatively superior domestic economic situation and political stability (Chart 10), we suspect that Moscow cares a little less about oil market rebalancing than Saudi Arabia. President Vladimir Putin will face reelection in less than a year, but he is unlikely to face a serious challenger. Chart 9Oil Prices Too Low For National Budgets OPEC 2.0: Fear And Loathing In Oil Markets OPEC 2.0: Fear And Loathing In Oil Markets Chart 10Support For Putin Holding Up Support For Putin Holding Up Support For Putin Holding Up Even so, Russia still feels the pain of lower energy prices. Oil and gas revenues constituted 36% of state revenues last year, down from 50% in 2014, when prices were trading above $100/bbl. This pushed Russia's budget deficit out to more than 3% of GDP in 2016. According to The Oxford Institute for Energy Studies, "even with planned spending cuts (the deficit) will still be more than 1% of GDP by 2019 ... Russia's Reserve Fund could be exhausted by the end of 2017, on the government's original forecast of an oil price of $40/barrel in 2017."11 Oil-Market Rebalancing Critical For KSA's Aramco IPO For Saudi Arabia, however, rebalancing is critical, which explains why it has over-delivered on the promised production cuts, while Russia and the "Shia Bloc" have dragged their feet (Chart 11 and Chart 12). Not only is the currency peg non-negotiable, but Riyadh's clear interest is oil-price stability in the lead-up to its Aramco IPO. It is not enough to attract a mega investor from China; the entire oil-investment community has to be convinced they are not pouring money into an enterprise that could lose value close on the heels of the IPO. Chart 11Saudis Cut Production More Than Russians ... Saudis Cut Production More Than Russkies ... Saudis Cut Production More Than Russkies ... Chart 12... Or The 'Shia Bloc' ... Or The 'Shia Bloc' ... Or The 'Shia Bloc' To attract foreign capital at reasonable prices for Aramco's massive privatization, KSA must prove it can exert some control over the oil price "floor." As such, the Kingdom's motivation to stick to the OPEC 2.0 agreement is serious. In a joint report done by BCA's Geopolitical Strategy and Commodity & Energy Strategy last January, we argued that three factors are critical to this IPO:12 Moving downstream: Saudi Arabia intends to become a major global refiner with up to 10 million b/d of refining capacity (an addition of about 5 mm b/d of capacity). If realized, this volume of refining capacity would rival that of ExxonMobil's 6 mm+ b/d, the largest in the world. Because OPEC does not set quotas for refined-product exports, Saudi Arabia's shift downstream would allow it to capture higher revenues from international sales of gasoline, diesel, jet fuel, and other refined products. This could eventually mean that Saudi Arabia would fly above ongoing crude oil market-share wars. Instead, it could rely on its access to short-haul domestic supplies and state-of-the-art technology - Aramco's principal endowments - to command massive crack spreads, or the difference between the price of input, crude oil, and output, refined product. FDI wars: With estimates of its value hovering ~ $100 billion, the Aramco IPO expected next year will be the largest ever executed. It is likely to divert FDI that Iraq and Iran desperately need to revitalize their production, transportation, and refining infrastructure. This is a crucial long-term goal for Saudi Arabia. At the moment, its oil production dwarfs that of its "Shia Bloc" OPEC rivals. However, Iran and Iraq are projected to close the gap and potentially export even more oil than the Kingdom in future (Chart 13). Bringing China into the region: The U.S. deleveraging from the Middle East continues. President Donald Trump may have ordered cruise missile strikes against Syria, but he is not interested in getting bogged down in another land war in the region. Chart 14 speaks for itself. As such, Saudi Arabia is largely on its own when facing off against Iran, its regional rival. Appeals to Chinese state energy companies are therefore designed to give Beijing a stake in Saudi energy infrastructure. This would force China to start caring more about what happens to Saudi Arabia, as with Iraq, where it is heavily invested, and Iran, where it has long flirted with investing more. Chart 13Shia Bloc Gaining On KSA Shia Bloc Gaining On KSA Shia Bloc Gaining On KSA Chart 14U.S. Has Deleveraged From Middle East U.S. Has Deleveraged From Middle East U.S. Has Deleveraged From Middle East When we first penned our report, we were speculating on the China link. Since then, Beijing has created a consortium consisting of state-owned energy giants Sinopec and PetroChina and banks, led by the country's sovereign wealth fund, to compete in the expected $100 billion equity sale.13 Given the financial, economic, and geopolitical importance of the Aramco IPO, we continue to expect that Saudi Arabia will push to extend the OPEC 2.0 production cut when the group meets in Vienna on May 25. Judging by the commitments to the cuts thus far, the deal appears to be an agreement for Saudi Arabia and its Gulf allies to continue to cut and for Russia and the "Shia Bloc" (Iran and Iraq) not to increase production.14 (Both of the latter states still have a lot of "skin in the game," so to speak.) As such, an extension of the deal is in the interests of KSA, Russia, and their respective allies. And, importantly, it will continue to provide a floor to oil prices. Meanwhile, downside and upside risks to supply continue. In terms of supply increase, the usual suspects -Libya and Nigeria - are working to increase production. In terms of supply decrease, we continue to worry about the dissolution of Venezuela as a functioning state and the potential that supply disruptions may occur. Bottom Line: Geopolitical drivers still support the continuation of OPEC 2.0's efforts to restrain production and draw down global oil stockpiles. As such, our positioning recommendations for an expected backwardation - i.e., long Dec/17 Brent vs. short Dec/18 Brent - and our fade of the option-market skew favoring put - the long Dec/17 $65/bbl Brent calls vs. short Dec/17 $45/bbl Brent puts - remain intact. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com 1 A "security dilemma" refers to a situation in which a state's pursuit of "security" through military strength and alliances leads its neighbors to respond in kind, triggering a spiral of distrust and tensions. Please see BCA Commodity & Energy Strategy and Geopolitical Strategy Special Report, "Desperate Times, Desperate Measures: Aramco And The Saudi Security Dilemma," dated January 14, 2016, available at ces.bcaresearch.com and gps.bcaresearch.com. NB: The $100-billion figure often attached to the estimated size of the IPO, which will seek to float 5% of Aramco, is a placeholder for the moment. There is considerable disagreement over the level at which the market will value Aramco, which some estimates significantly below the value assumed by the $100-billion estimate. We will be examining this in future research. 2 The New York Times provided an excellent summary of post-sanctions development recently in "Even Bold Foreign Investors Tiptoe in Iran," March 31, 2017. 3 For a summary of BCA Commodity & Energy Strategy recommendation performance, please contact your relationship manager. 4 Please see "The Game's Afoot, But Which One," for the consequences of OPEC's market-share war. It was published April 6, 2017, in BCA Research's Commodity & Energy Strategy, and is available at ces.bcaresearch.com. 5 Please see BCA Commodity & Energy Strategy Weekly Report, "Raising The Odds Of A KSA-Russia Oil-Production Cut," dated November 3, 2016, available at ces.bcaresearch.com. 6 Please see BCA Commodity & Energy Strategy Weekly Report, "OPEC-Russia Oil Deal On Track To Deliver," dated February 9, 2017, available at ces.bcaresearch.com. 7 Please see BCA Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Cuts Will Be Extended Into 2017H2; Fade The Skew And Get Long Calls Vs. Short Puts," dated April 20, 2017, available at ces.bcaresearch.com. 8 Please see BCA Frontier Market Strategy Special Report, "Saudi Arabia: Short-Term Gain, Long-Term Pain," dated February 1, 2017, available at fms.bcaresearch.com. 9 Contango markets - where prices for prompt delivery are less than prices for deferred delivery - favor shale producers when the front of the WTI forward curve is ~ $50/bbl, and - all else equal - incentivizes them to hedge forward so as to lock in future revenues and maximize the number of rigs they deploy. In backwardated markets, however, the number of rigs a shale operator is able to deploy is lower, all else equal, which means the revenue they can lock in by hedging forward is lower. Please see BCA Commodity & Energy Strategy Weekly Report, "North American Oil Pipeline Buildout Complicates Price And Storage Expectations," dated February 16, 2017, available at ces.bcaresearch.com. 10 Please see the IMF, Regional Economic Outlook: Middle East and Central Asia, October 2016, Table 5. 11 Please see "Russia Oil Production Outlook to 2020," Oxford Institute for Energy Studies, February 2017. 12 Please see BCA Geopolitical Strategy and Commodity & Energy Strategy Special Report, "Desperate Times, Desperate Measures: Aramco And The Saudi Security Dilemma," dated January 14, 2016, available at ces.bcaresearch.com. 13 Please see "Exclusive: China gathers state-led consortium for Aramco IPO - sources," Reuters, dated April 19, 2017, available at reuters.com. 14 In "OPEC 2.0 Cuts Will Be Extended Into 2017H2; Fade The Skew And Get Long Calls Vs. Short Puts," dated April 20, 2017, we noted, "Without pulling storage down to more normal levels, inventories remain too close to topping out, which puts markets at higher risk of the sort of price collapse seen in 2015-16. At the beginning of 2016, global oil markets were close to pricing in the approach of a full-storage event. In such an event, as global inventories approach capacity, prices trade below the cash-operating costs of the most expensive producers, until enough supply is forcibly knocked off line to drain excess stocks. This is an extremely high-risk scenario for states like KSA, Russia and their allies, which are heavily dependent on oil-export revenues to fund government budgets and much of the private sector. After the last such event at the beginning of 2016, these states were left reeling, as fiscal spending was slashed, projects were canceled and governments burned through foreign reserves in an effort to make up for lost revenue." This report is available at ces.bcaresearch.com.