Fiscal

Highlights President Trump has little to do with the ongoing EM selloff; The macro backdrop is the real culprit behind Turkey's woes, particularly the strong dollar... ... Which is a product of global policy divergence, with the U.S. stimulating while China pursues growth-constraining reforms; Chinese stimulus is important to watch, as it could change the game, but we do not expect China to save EM as it did in 2015; Turkey's troubles are a product of its late-stage populist cycle and will not end with Trump's magnanimity; The positive spin on the EM bloodbath is that it may force the Fed to slow its rate hikes, prolonging the business cycle. Feature Chart 1EM: Bloodbath EM: Bloodbath EM: Bloodbath Markets are selling off in Turkey and the wider EM economies (Chart 1), with the financial media focusing on the actions taken by the U.S. President Donald Trump in the escalating diplomatic spat between the two countries. Investors should be very clear what it means to ascribe the ongoing selloff to President Trump's aggressive posture with Ankara in particular and trade in general. If President Trump started EM's troubles with his tweets, he can then end them with another late-night missive. This is not our view. Turkey is enveloped in a deep morass of populism and weak fundamentals since at least 2013. What is worse, the ongoing selloff is likely going to ensnare at least the other fragile EM economies and potentially take down EM as an asset class. In this Report, we recount the pernicious macro backdrop - both geopolitical and economic - that EM economies face today. We then focus on Turkey itself and show that President Trump has little to do with the current selloff. The Bloodbath Is Afoot, Again Every financial bubble, and every financial bust, begins with a compelling story grounded in solid fundamentals. The now by-gone EM "Goldilocks Era" (2001-2011) was primarily driven by exogenous factors: a generational debt-fueled consumption binge in DM; an investment-fueled double-digit growth rate in China that kicked off a structural commodity bull market; and the unleashing of pent-up EM consumption/credit demand (Chart 2).1 These EM tailwinds petered out by 2011. Subsequently, China and EM economies entered a major downtrend that culminated in a massive commodity rout that began in 2014. But before the bloodbath could motivate policymakers to initiate painful structural reforms, Chinese policymakers stimulated in earnest. In the second half of 2015, Beijing became unnerved and injected enormous amount of credit and fiscal stimulus into the mainland economy (Chart 3). The intervention, however, did not change the pernicious fundamentals driving EM economies but merely caused "a mid-cycle recovery, or hiatus, in an unfinished downtrend," as our EM strategists have recently pointed out (Chart 4).2 Chart 2Goldilocks Era##BR##Is Over For EM Goldilocks Era Is Over For EM Goldilocks Era Is Over For EM Chart 3Is China About To Cause Another##BR##EM Mid-Cycle Recovery? Is China About To Cause Another EM Mid-Cycle Recovery? Is China About To Cause Another EM Mid-Cycle Recovery? Take Brazil, for example. Instead of using the 2014-2015 generational downturn to double-down on painful fiscal and pension reforms, the country's politicians declared President Dilma Rousseff to be the root-cause of all evil that befell the nation, impeached her in April 2016, and then proceeded to unceremoniously punt all painful reforms until after this year's election (if ever). They were enabled to do so by the "mid-cycle recovery" spurred by Chinese stimulus. In other words, Brazil's policymakers did nothing to actually deserve the recovery in asset prices but got one anyway. The country now will experience "faceoff time" with the markets, with no public support for painful reforms (Chart 5) and hardly an orthodox candidate in sight ahead of the October general election.3 Chart 4Where Are China/EM In The Cycle? Where Are China/EM In The Cycle? Where Are China/EM In The Cycle? Chart 5Brazil's Population Is Not Open To Fiscal Austerity The EM Bloodbath Has Nothing To Do With Trump The EM Bloodbath Has Nothing To Do With Trump Could Brazilian and Turkish policymakers be in luck, as Chinese policymakers have blinked again?4 Our assessment is that the coming stimulus will not be as stimulative as in 2015. First, President Xi's monetary and fiscal policy, since coming into office in 2012, has been biased towards tightening (Chart 6). Second, Chinese leverage has plateaued (Chart 7). In fact, "debt servicing" is now the third-fastest category of fiscal spending growth since Xi came to power (Table 1). Third, the July 31 Politburo statement pledged to make fiscal policy "more proactive" and "supportive," but also reaffirmed the commitment to continue the campaign against systemic risk. Chart 6Xi Jinping Caps##BR##Government Spending And Credit Xi Jinping Caps Government Spending And Credit Xi Jinping Caps Government Spending And Credit Chart 7The Rise And Plateau##BR##Of Macro Leverage The EM Bloodbath Has Nothing To Do With Trump The EM Bloodbath Has Nothing To Do With Trump Whether China's mid-year stimulus will be globally stimulative is now the question for global investors. The key data to watch out of China will be August credit numbers, to be released September 9th through 15th. Is President Trump not to be blamed at all for the EM selloff? What about the trade war against China? If anything, tariffs against China have caused Beijing to "blink" and implement some stimulative measures this summer. If one must find fault in U.S. policy, it is the double dose of fiscal stimulus that has endangered EM economies. A key theme for BCA's Geopolitical Strategy this year has been the idea that global policy divergence would replace the global growth convergence.5 Populist economic stimulus in the U.S. and structural reforms in China would imperil growth in the latter and accelerate it in the former, forming a bullish environment for the U.S. dollar (Chart 8). Table 1Total Government Spending Preferences (Under Leader's General Control) The EM Bloodbath Has Nothing To Do With Trump The EM Bloodbath Has Nothing To Do With Trump Chart 8U.S. Outperformance Should Be Bullish USD U.S. Outperformance Should Be Bullish USD U.S. Outperformance Should Be Bullish USD As such, the White House is partly responsible for the EM selloff, but not in any way that can be changed with a tweet or a handshake. Furthermore, we do not see the upcoming U.S. midterm election as somehow capable of altering the global growth dynamics.6 It is highly unlikely that Democrats will seek to spend less, and they cannot raise taxes under Trump. Bottom Line: EM economies have never adjusted to the end of their Goldilocks era. A surge in global liquidity pushed investors further down the risk-curve, propping up EM assets despite poor macro fundamentals. China's massive 2015-2016 stimulus arrested the bear market, giving investors a perception that EM economies had recovered. This mid-cycle hiatus, however, has now been overtaken by the global policy divergence between Washington and Beijing, which is bullish USD. President Trump's trade tariffs and aggressive pressure on Turkey do not help. However, they are merely the catalyst, not the cause, of the selloff. As such, investors should not "buy" EM on a resolution of China-U.S. trade tensions or of the Washington-Ankara diplomatic dispute. Contagion Risk BCA's Emerging Market Strategy is clear: in all episodes of a major EM selloff, the de-coupling between different regions proved to be unsustainable, and the markets that showed initial resilience eventually re-coupled to the downside (Chart 9).7 One reason to expect contagion risk among all EM markets is that the primary export market for China and other East Asian exporters are other EM economies, particularly the commodity producers (Chart 10). As such, it is highly unlikely that East Asian EM economies will be able to avoid a downturn. In fact, leading indicators of exports and manufacturing, such as Korea's manufacturing shipments-to-inventory ratio and Taiwan's semiconductor shipments-to-inventory ratio herald further deceleration in their respective export sectors (Chart 11). Chart 9Asian And Latin American Equities:##BR##Unsustainable Divergences Asian And Latin American Equities: Unsustainable Divergences Asian And Latin American Equities: Unsustainable Divergences Chart 10EM Trades##BR##With EM EM Trades With EM EM Trades With EM Chart 11Asia Export##BR##Slowdown Is Afoot Asia Export Slowdown Is Afoot Asia Export Slowdown Is Afoot In respect of foreign funding requirements of EM economies, our EM strategists have pointed out that there is a substantive amount of foreign currency debt coming due in 2018 (Table 2), with majority EM economies facing much higher foreign debt burdens than in 1996 (Table 3).8 Investors should not, however, rely merely on debt as percent of GDP ratios for their vulnerability assessment. For example, Malaysia's private sector FX debt load stands at 63.7% of GDP, the second highest level after Turkey. But relative to total exports (a source of revenue for its indebted corporates) and FX reserves (which the central bank can use to plug the gap in the balance of payments), Malaysia actually scores fairly well. Table 2EM: Short-Term (Due In 2018) FX Debt The EM Bloodbath Has Nothing To Do With Trump The EM Bloodbath Has Nothing To Do With Trump Table 3EM Private Sector FX Debt: 1996 Versus Today The EM Bloodbath Has Nothing To Do With Trump The EM Bloodbath Has Nothing To Do With Trump Chart 12 shows the most vulnerable EM economies in terms of foreign currency private sector debt exposure relative to FX reserves and total exports. Unsurprisingly, Turkey stands as the most vulnerable economy, along with Argentina, Brazil, Indonesia, Chile, and Colombia. Chart 12BCA's Emerging Markets Strategy Has Already Pinned Turkey As The Most Vulnerable EM Economy The EM Bloodbath Has Nothing To Do With Trump The EM Bloodbath Has Nothing To Do With Trump Will the EM selloff eventually ensnare DM economies as well, particularly the U.S.? We think yes. The drawdown in EM will bid up safe-haven assets like the U.S. dollar. The dollar can be thought of as America's second central bank, along with the Fed. If both the greenback and the Fed are tightening monetary conditions, eventually the U.S. economy will feel the burn. As such, it is dangerous to dismiss the ongoing crisis in Turkey as a merely localized problem that could, at its worst, spread to other EM economies. In 1997, Thailand played a similar role to that of Turkey. The Fed tightened rates in early 1997 and largely remained aloof of the developing East Asia crisis that eventually spread to Brazil and Russia, ignoring the tumult abroad until September 1998 when it finally cut rates three times. Fed policy easing at the end of 1998 ushered in the stock market overshoot and dot-com bubble, whose burst caused the end of the economic cycle. The same playbook may be occurring today. The Fed, motivated by the strong U.S. economy and fears of being too close to the zero-bound ahead of the next recession, is proceeding apace with its tightening cycle. It is likely to ignore troubles in the rest of the world until the USD overshoots or U.S. equities are impacted directly. At that point, perhaps later this year or early next year, the Fed will back off from tightening, ushering the one last overshoot phase ahead of the recession in 2020 - or beyond. Bottom Line: Research by BCA's EM strategists shows that EM contagion is almost never contained in just a few vulnerable economies. For investors who have to remain invested in EM economies, we would recommend that they go long Chinese equities relative to EM, given that Beijing policymakers are stimulating the economy to ensure that Chinese growth is stabilized. While this will be positive for China, it is likely to fall short of the 2015 stimulus that also stimulated non-China EM. An alternative play is to go long energy producers vs. the rest of EM - given our fundamentally bullish oil view combined with rising geopolitical risks regarding sanctions against Iran.9 We eventually expect EM risks to spur an appreciation in the USD that the Fed has to lean against by either pausing its tightening cycle, or eventually reversing it as it did in the 1997-1998 scenario. This decision will usher in the final blow-off stage in U.S. equities that investors will not want to miss. What About Turkey? Chart 13Turkey: Volatile Politics, Volatile Stocks Turkey: Volatile Politics, Volatile Stocks Turkey: Volatile Politics, Volatile Stocks In 2013, we called Turkey a "canary in the EM coal mine" arguing that its historically volatile financial markets would mean-revert as domestic politics became turbulent (Chart 13).10 Turkey is a deeply divided society equally split between the secularist cities, which are primarily located on the Mediterranean (Istanbul, Izmir, Bursa, Adana, etc.), and the religiously conservative Anatolian interior. This split dates back to the founding of the modern Turkish Republic in the post-World War I era (and in truth, even before that). The ruling Justice and Development Party (AKP), a religiously conservative but initially pro-free-market party, managed to appeal to the conservative Anatolia while neutering the most powerful secularist institution in Turkey, its military. Investors hailed AKP's dominance because it reduced political volatility and initially promised both pro-market policies and even accession to the EU. However, the AKP has struggled to win more than 50% of the popular vote in a slew of elections and referendums since coming to power (Chart 14), a fact that belies its supposed iron-grip hold on Turkish politics since it came to power in 2002. The vulnerability behind AKP's hold on office has largely motivated President Recep Tayyip Erdogan's attempt to consolidate political power. While we disagree with the consensus view that Erdogan's constitutional changes have turned Turkey into a dictatorship, some of his actions do suggest a deep fear of losing power.11 Populist leadership is characterized by a strategy of "giving people what they want" so that the policymakers in charge remain in office. Erdogan's perpetually slim hold on power has motivated several populist policy decisions that have stretched Turkey's macro fundamentals. First, Turkey's central bank has essentially been conducting quantitative easing since 2013 via net liquidity injections into the banking system (Chart 15). Notably, these injections began at the same time as the May 2013 Gezi Park protests, which saw a huge outpouring of anti-government sentiment across Turkey's large cities. Essentially, politics has been motivating Ankara's monetary policy over the past five years. Chart 14AKP's Stranglehold On Power Is Overstated The EM Bloodbath Has Nothing To Do With Trump The EM Bloodbath Has Nothing To Do With Trump Chart 15Turkey's Populist Policies Began##BR##With Gezi Park Protests Turkey's Populist Policies Began With Gezi Park Protests Turkey's Populist Policies Began With Gezi Park Protests Second, Turkey's current account balance has suffered under the weight of rising energy costs, with no attempt to improve the fiscal balance (Chart 16). The government has done little in terms of structural reforms or fiscal austerity, instead President Erdogan has continued to challenge central bank independence on interest rates, despite a clear sign that the country is experiencing a genuine inflationary breakout (Chart 17). Chart 16Populism Means No Austerity Is In Sight Populism Means No Austerity Is In Sight Populism Means No Austerity Is In Sight Chart 17Genuine Inflation Breakout Genuine Inflation Breakout Genuine Inflation Breakout Overall, Turkey is a classic example of how populism in a highly divided and polarized country can get out of control. Foreign investors have long assumed that Erdogan's populism was benign, if not even positive, given the presumably ample political capital at the president's disposal. However, with every election or referendum, the government did not double-down on pro-market structural reforms. Instead, the pressure on the central bank only increased while Turkey's expensive and extravagant geopolitical adventures in neighboring Syria accelerated. In this pernicious macro context, it has not taken much to knock Turkey's assets off balance. President Trump's threats to expand sanctions to Turkish trade are largely irrelevant, given that the vast majority of Turkey's exports and FDI sources are non-American (Chart 18). However, given past behavior - such as after the shadowy Gülen "plot" to take over power or the 2016 coup d'état - markets are by now conditioned to expect that Turkish policymakers will double-down on populist policies in the face of renewed pressure. Chart 18Turkey-U.S. Relationship Is Not Economic Turkey-U.S. Relationship Is Not Economic Turkey-U.S. Relationship Is Not Economic What of Turkey's membership in NATO? Should investors fear broader geopolitical instability due to the domestic crisis? No. Ankara has used its membership in NATO, and particularly the U.S. reliance on its Incirlik air base in southern Turkey, as levers in previous negotiations and diplomatic spats with Europe and the U.S. If Ankara were to renege on its commitments to the Western military alliance, it would likely face a united front from Europe and the U.S. As such, we would expect Turkey neither to threaten exit from NATO, which it has not done in the past, nor even to threaten U.S. operations in Incirlik, which Erdogan's government has threatened before. The most likely outcome of the ongoing diplomatic spat, in fact, would be to see Ankara give in to U.S. demands, given the accelerating financial and economic crisis. Such an outcome, however, will not arrest the downturn. Turkey's economy and assets are fundamentally under pressure due to the realization by investors that this year's main macro theme is not the resynchronized global growth recovery, but rather the global policy divergence between the U.S. and China, which has appreciated the U.S. dollar. No amount of kowtowing by Ankara will change this macro trend. Bottom Line: The list of Turkish policy sins is long. Erdogan's reign has been characterized by deep polarization and populism, leading to suboptimal policy choices since at least 2013. The latest U.S.-Turkey spat is therefore merely one of many problems plaguing the country. As such, its resolution will not be a buying opportunity for investors. Investment Implications Our main investment theme in 2018 was that the global policy divergence between the U.S. and China - emblematized by fiscal stimulus in the U.S. and structural reforms in China - would end the global growth resynchronization. As the U.S. economy outperformed the rest of the world, the U.S. greenback would appreciate, imperiling EM economies. The best cognitive roadmap for today is the late 1990s, when the U.S. economy continued to grow apace as the rest of the world suffered from an EM crisis. The problems eventually washed onto American shores in the form of a stronger dollar, forcing the Fed to back off from tightening in mid-1998. Policy easing then led to the overshoot phase in U.S. equities in 1999. Investors should prepare for a similar roadmap by being long DXY relative to EM currencies, long DM equities (particularly U.S.) relative to EM equities, and tactically cautious on all global risk assets. Strategically, however, it makes sense to remain overweight equities as a Fed capitulation would be a boon for risk assets. If the current selloff in EM gets worse, we would expect that the Fed would again back off from tightening as it did in 1998, ushering in a blow-off stage in equities ahead of the next recession. Once the dollar peaks and EM assets bottom, U.S. equities will become the laggard, with global cyclicals outperforming. A secondary conclusion is that President Trump's trade rhetoric in general, and aggressive policies towards Turkey in particular, are merely a catalyst for the selloff. As such, if President Trump changes his mind, we would fade any rally in EM assets. The fundamental policy decisions that have led to the greenback rally have already been taken in 2017 and early 2018. The profligate tax cuts and the two-year stimulative appropriations bill, combined with Chinese policymakers' focus on controlling financial leverage, are the seeds of the current EM imbroglio. Finally, a small bit of housekeeping. We are booking gains on our long Malaysian ringgit / short Turkish lira trade for a gain of 51.2% since May. We are also closing our speculative long Russian equities relative to EM trade for a loss of -0.9% as a result of the persistent headwind from U.S. sanctions. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "The Coming Bloodbath In Emerging Markets," dated August 12, 2015, available at gps.bcaresearch.com. 2 Please see BCA Emerging Markets Strategy Weekly Report, "Understanding The EM/China Cycles," dated July 19, 2018, available at ems.bcaresearch.com. 3 Please see BCA Emerging Markets Special Report, "Brazil: Faceoff Time," dated July 27, 2018, available at ems.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "China: How Stimulating Is The Stimulus?" dated August 8, 2018, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Strategic Outlook, "Three Questions For 2018," dated December 13, 2017, and Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Weekly Report, "Will Trump Fail The Midterm?" dated April 18, 2018, available at gps.bcaresearch.com. 7 Please see BCA Emerging Markets Strategy Weekly Report, "EM: Sustained Decoupling, Or Domino Effect?" dated June 14, 2018, available at ems.bcaresearch.com. 8 Please see BCA Emerging Markets Strategy Special Report, "A Primer On EM External Debt," dated June 7, 2018, available at ems.bcaresearch.com. 9 Please see BCA Geopolitical Strategy and Commodity & Energy Strategy Special Report, "U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic," dated July 19, 2018, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Monthly Report, "Turkey: Canary In The EM Coal Mine?" in "The Coming Political Recapitalization Rally," dated June 13, 2013, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Weekly Report, "Turkey: Deceitful Stability," in "EM: The Beginning Of The End," dated April 19, 2017, available at ems.bcaresearch.com.

Highlights Without a true banking union it is impossible to have a true monetary union. The result is a fragmented monetary policy. A fragmented monetary policy with an inflexibly rigid fiscal policy is a recipe for economic and political polarization. Until the banking union is complete, policymakers must permit a more fragmented fiscal policy as a crucial economic counterbalance. Expect a multi-year narrowing in core euro area long bond yield spreads versus their counterparts in the U.K. and U.S. Extremely loose monetary policy is inappropriate for Germany and France and ineffective for Italy. If Italy's banking system does recover to full functionality, the best long-term investment play will be Italy's real estate market. The equity play is Covivio. Feature The European Monetary Union is a contradiction because European monetary policy is not united; it is fragmented. Granted, the euro area has one policy interest rate, and one currency. But monetary policy works principally through accelerations and decelerations in the broad money supply, whose main component is bank credit. It follows that when the banking system is fragmented, a genuine monetary union is elusive. Italy Is 'Yin', The Rest Of Europe Is 'Yang' Economist Richard Koo distinguishes two distinct phases of an economy, a 'yin' phase and a 'yang' phase, with the key difference being the financial health of the private sector including the all-important banking system. In a yang economy, the private sector and the banks are solvent and functional. In such an economy, the smaller and less intrusive the government, the better. Fiscal policy is ineffective because it crowds out private investment. But monetary policy is highly effective because a forward-looking private sector generates a demand for bank credit which will accelerate or decelerate according to the policy interest rate. In a yin economy, the opposite is true. The private sector and/or the banks are insolvent and dysfunctional. In such an economy, monetary policy is ineffective. No amount of depressing interest rates, central bank liquidity injections, or bond buying is able to stimulate bank lending. This is because impaired balance sheets prevent the private sector from borrowing and/or the banks from lending. But in a yin economy, fiscal policy is highly effective. Because the private sector is single-mindedly paying down debt, the government can borrow and spend these private sector debt repayments and excess savings with no danger of crowding out. Indeed in a yin economy, if the government consistently applies an appropriately sized fiscal stimulus, the economy can continue to grow at a healthy pace. Chart I-1-Chart I-6 should make it crystal clear that while Germany and France have a yang economy, Italy has a yin economy. Chart I-1Italy Has A 'Yin' Economy: ##br##Monetary Policy Is Not Effective... Italy Has A Yin Economy: Monetary Policy Is Not Effective... Italy Has A Yin Economy: Monetary Policy Is Not Effective... Chart I-2...But Fiscal Policy##br## Is Effective ...But Fiscal Policy Is Effective ...But Fiscal Policy Is Effective Chart I-3France Has A 'Yang' Economy: ##br##Monetary Policy Is Effective... France Has A Yang Economy: Monetary Policy Is Effective... France Has A Yang Economy: Monetary Policy Is Effective... Chart I-4...But Fiscal Policy##br## Is Not Effective ...But Fiscal Policy Is Not Effective ...But Fiscal Policy Is Not Effective Chart I-5Germany Has A 'Yang' Economy:##br## Monetary Policy Is Effective... Germany Has A Yang Economy: Monetary Policy Is Effective... Germany Has A Yang Economy: Monetary Policy Is Effective... Chart I-6...But Fiscal Policy ##br##Is Not Effective ...But Fiscal Policy Is Not Effective ...But Fiscal Policy Is Not Effective A Monetary Union Needs A Banking Union In Germany and France, bank credit has surged in response to the ECB's ultra-accommodative monetary policy. But in Italy, bank credit growth is almost non-existent. Through the past ten years, no amount of depressing interest rates, central bank liquidity injections, or bond buying has been able to stimulate Italy's money supply (Chart I-7 and Chart I-8). Chart I-7Italian Banks Are ##br##Not Lending... Italian Banks Are Not Lending... Italian Banks Are Not Lending... Chart I-8...Because The Italian Banking System Has##br## Been Left Undercapitalised For A Decade ...Because The Italian Banking System Has Been Left Undercapitalised For A Decade ...Because The Italian Banking System Has Been Left Undercapitalised For A Decade Furthermore, when the ECB bought Italian government bonds from investors, where did Italian investors deposit the hundreds of billions of euros they received? Not in the local Italian banks, but in German banks, which they deemed to be much safer. Italian banks are not lending, and their depositors are still very wary, because the Italian banking system has been left undercapitalized for a decade. The irony is that the ECB's bond-buying was supposed to help Italy the most, but has probably helped it the least (Chart I-9). Chart I-9The ECB's Bond-Buying Has Exacerbated##br## The Target2 Imbalances The ECB's Bond-Buying Has Exacerbated The Target2 Imbalances The ECB's Bond-Buying Has Exacerbated The Target2 Imbalances Europe's full-fledged banking union is still years away. Europe has established a single supervisor for its 130 largest banks. It has also set up a single resolution fund (SRF) to wind down failing banks in an orderly fashion. Unfortunately, the SRF's coffers will not be full for another six years.1 Until then, the SRF will not be credible to the financial markets without a backstop. A candidate to provide such a backstop would be the European Stability Mechanism (ESM), but this is work in progress. Europe also lacks a common deposit insurance scheme. Knowing that the buck stops with the national government makes depositors wary, as has been the case recently in Italy. The large international banks are keen to implement a pan-European deposit insurance scheme. But this requires a clean-up of bank balance sheets in certain countries, notably Italy. Otherwise, the prudent banks will balk at the prospect of paying for the past mistakes of their less prudent competitors. Again, this is work in progress which may take several years to complete. A Fragmented Monetary Policy Requires A Fragmented Fiscal Policy If the entire euro area economy enters a yin phase, the constituent governments are allowed to use fiscal policy to support growth. For example, when the whole euro area went into a yin phase during the debt crisis, the European Commission relaxed the normal 3% cap on government deficits, and this fiscal stimulus helped the most troubled countries to weather the storm. But what if one country enters a yin phase, while the others are still in a yang phase? For example, a 'no-deal' Brexit would hit Ireland much harder than other euro area economies. The EU budget can help to an extent but, at just 1% of Europe's GDP compared to almost 20% in the U.S., the budget is small. This might still be sufficient to help Ireland, but it is insufficient for a large economy like Italy. The ESM can also help, but the assistance arrives too late - when the troubled country has already lost market access, and thereby is in, or close to, a recession. The unfortunate truth is that without a true banking union it is impossible to have a true monetary union. The result is a fragmented monetary policy, as is the case right now. A fragmented monetary policy with an inflexibly rigid fiscal policy is a recipe for economic polarization and thereby, political polarization. Therefore, until the banking union is complete, policymakers must permit a more fragmented fiscal policy as a crucial economic counterbalance. Because ultimately, a less economically polarized euro area will be a more successful and united euro area. An important test to this thesis has now arrived, as the new government in Italy prepares next year's budget. The government must agree its fiscal plan by September and present a draft to the European Commission by mid-October. Italy was projected to reduce its structural deficit by about 0.8 percent. But given that Italy will have one of the world's lowest structural deficits in the coming years, this reduction seems unnecessarily drastic (Table I-1). Because an increase in the deficit might unnerve the markets, the optimal outcome would be to leave the structural deficit close to its current level. Table 1Italy Will Have One Of The World's Lowest Structural Deficits Why Europe Must Fragment To Unite Why Europe Must Fragment To Unite We end with two brief thoughts for investors. The evidence clearly shows that the ECB's extremely loose monetary policy is wholly inappropriate for the euro area's mostly yang economy and largely ineffective for Italy's yin economy. On this premise, expect a multi-year narrowing in core euro area long bond yield spreads versus their counterparts in the U.K. and U.S. Finally, if Italy's banking system does gradually recover to full health and functionality, the best long-term investment play will be Italy's real estate market, in which prices have been bid down to depressed levels due to a lack of a lack of bank financing. On this premise, the long-term equity play is Covivio. Please note that I am taking a brief summer break, so the next weekly report will come out on August 23. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 The SRF will be gradually built up during 2016-2023 and shall reach the target level of at least 1% of the amount of covered deposits of all credit institutions within the Banking Union by December 31 2023. Fractal Trading Model* We have seven open positions, so we are not adding any new trades this week. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 Long EM / short DM Long EM / short DM The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights China is turning moderately reflationary, but Xi's reform agenda will remain a drag on the economy, as China will not entirely abandon the "Reform Reboot" that began last October. Fiscal spending, rather than a sharp acceleration in credit growth, will dominate China's reflationary efforts, and even a strong fiscal response would involve more "soft infrastructure" than in the past. Consequently, expectations that Chinese reflation will dramatically reverse both the looming export shock as well as the underlying slowdown in China's old economy are not likely to be met. The goal of policymakers is merely to prevent a substantial, uncontrolled downturn in domestic demand. Convincing signs that China is likely to end up overstimulating in a way that results in a net positive for the global economy would cause us to advocate a more pro-cyclical investment stance. There is a small chance this may occur, but it is far from our base case view. For now, stay neutrally positioned towards Chinese stocks within a global equity portfolio, and favor low-beta sectors within the Chinese investable universe. Feature Today's Weekly Report is abridged, as we are sending you part 1 of a 2-part report written by my colleague Matt Gertken, Associate Vice President of BCA's Geopolitical Strategy (GPS) service. Last year our geopolitical team made the case that China's General Secretary Xi Jinping would double down on his reform agenda in 2018, specifically the bid to control financial risk. This view has played out quite well, and today's report presents an assessment of the likely impact of China's recent stimulus announcements along with the implications for investors. Matt's report concludes that China is turning moderately reflationary: a substantial boost to fiscal thrust, and possibly a smaller boost to credit growth, is in the works. Yet Xi's reform agenda will remain a drag on the economy, as China will not entirely abandon the "Reform Reboot" that began last October. This will be discussed next week in the second-part of the two-part series. Today's GPS report is quite timely, as the intensity of China's reflationary efforts is at the forefront of investor attention. BCA's China Investment Strategy (CIS) argued in our July 26 Weekly Report that China is taking its foot off of the brake rather than pressing the accelerator,1 meaning that so far the stimulus announced has fallen short of a substantially reflationary response that would dramatically reverse both the looming export shock as well as the underlying slowdown in China's old economy. Chart 1 shows that market signals are so far consistent with this view, at least in terms of fiscal and/or infrastructure spending. The chart shows how domestic infrastructure stocks are outperforming the broad domestic market (in response to news two weeks ago of stepped up infrastructure spending), but that their performance remains anemic relative to global stocks. Presumably, "big bang" fiscal spending in China would cause the earnings outlook for domestic infrastructure stocks to brighten considerably relative to the global average. Matt notes in today's joint report that even a strong fiscal response would involve more "soft infrastructure" than in the past, and for now investors do not seem to be betting on an intense, "hard infrastructure" boom. Chart 1The Performance Of Infrastructure Stocks Does Not Herald "Big Bang" Stimulus The Performance Of Infrastructure Stocks Does Not Herald "Big Bang" Stimulus The Performance Of Infrastructure Stocks Does Not Herald "Big Bang" Stimulus Chart 2At First Blush, This Implies Maximum Reflationary Efforts At First Blush, This Implies Maximum Reflationary Efforts At First Blush, This Implies Maximum Reflationary Efforts However, one development that is not consistent with CIS' "foot off the brake" view is the extraordinary decline in interbank interest rates that has occurred over the past month. Chart 2 shows that the 3-month interbank repo rate (China's "de-facto" policy rate) has collapsed even further than it had when we published our July 26 report which, at first blush, suggests that the PBOC has turned the policy dial to maximum reflation. Chart 3 presents a stylized view of the possible PBOC reactions to the imposition of U.S. tariff imposition against China. In scenario 1, the PBOC eases policy in a way that is proportional to the tariff-induced deterioration in the growth outlook, which would stabilize the economy but not result in an acceleration in growth from conditions in place prior to the impact of tariffs on exports. In scenario 2, the PBOC stimulates disproportionately, giving investors license to expect that monetary easing will result in a growth outcome that is net positive. Chart 3A Proportional Monetary Response To A Deceleration In Growth Isn't A Net Positive For The World Somewhere Between Fire And Ice Somewhere Between Fire And Ice As Matt notes in his report, the decline in interbank interest rates may not feed through into significantly stronger credit growth if banks are afraid to lend, which could occur as long as the Xi administration remains even partially committed to its crackdown on the financial sector. The decline in the repo rate may not reflect the PBOC's intention to forcefully stimulate credit growth via lower borrowing rates, but rather is a necessary consequence of substantially increasing liquidity in the banking system to avoid any financial system instability stemming from a major shock to exports. We agree that the collapse in the 3-month repo rate is more consistent with scenario 2 than scenario 1, although there are two important counterpoints to consider: Chart 4Possibly Due To Rising NIMs, Rather Than A Significant Acceleration In Credit Growth Possibly Due To Rising NIMs, Rather Than A Significant Acceleration In Credit Growth Possibly Due To Rising NIMs, Rather Than A Significant Acceleration In Credit Growth On the second point, the crackdown on shadow banking over the past 18 months has substantially (negatively) impacted small Chinese banks, and it is conceivable that the PBOC has acted to prevent a liquidity problem from become an outright solvency problem for some financial institutions. If true, this suggests that the extent of the decline in the repo rate may be temporary, or that policymakers will employ other tools to limit the feedthrough from lower interbank borrowing costs to lending rates in the real economy in order to limit the resulting pickup in credit growth. The latter option would, in effect, purposely engineer an expansion in bank net interest margins, a scenario that could explain the recent uptick in domestic bank relative performance without resorting to a forecast of surging credit growth (Chart 4). What does this all mean for investors? Were we to see convincing signs that China is likely to end up overstimulating in a way that results in a net positive for the global economy, we would recommend a more pro-cyclical investment stance. This could likely include the constituent assets of the China Play Index presented by my colleague Mathieu Savary, Vice President of BCA's Foreign Exchange Strategy service in his last Weekly Report,2 and we plan on employing the index as a gauge of investors' stimulus expectations. But for now, we are comfortable with our existing recommendations: investors should remain neutrally positioned towards Chinese stocks within a global equity portfolio, and should favor low-beta sectors within the Chinese investable universe. We will be monitoring the upcoming export shock as well as further policymaker responses continually over the coming weeks and months, and invite investors to come along for the ride. Stay tuned! Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see BCA Research's China Investment Strategy Special Report "China Is Easing Up On The Brake, Not Pressing The Accelerator," published July 26, 2018. Available at cis.bcaresearch.com. 2 Please see BCA Research's Foreign Exchange Strategy Weekly Report "The Dollar And Risk Assets Are Beholden To China's Stimulus," published August 3, 2018. Available at fes.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Xi Jinping is trying to do two things at once: ease policy while cracking down on systemic financial risk; The trade war with the U.S. is a genuine crisis for China and is eliciting fiscal stimulus; Credit growth is far more likely to "hold the line" than it is to explode upward or collapse downward; The 30% chance of a policy mistake from financial tightening has fallen to 20% only, as bad loan recognition is underway and a critical risk to monitor; Hedge against the risk of a stimulus overshoot. Feature "We have upheld the underlying principle of pursuing progress while ensuring stability." - Xi Jinping, General Secretary of the Communist Party of China, October 18, 2017 "Any form of external pressure can eventually be transformed into impetus for growth, and objectively speaking will accelerate supply-side structural reforms." - Guo Shuqing, Secretary of the China Banking and Insurance Regulatory Commission, July 5 Last year we made the case that China's General Secretary Xi Jinping would double down on his reform agenda in 2018, specifically the bid to control financial risk, and that this would bring negative surprises to global financial markets as policymakers demonstrated a higher pain threshold.1 This view has largely played out, with economic policy uncertainty spiking and a bear market in equities developing alongside an increase in corporate and even sovereign credit default risk (Chart 1). We also argued, however, that Xi's "deleveraging campaign" would be constrained by the Communist Party's need for overall stability. Trade tensions with the U.S., and Beijing's perennial fear of unemployment, would impose limits on how much pain Beijing would ultimately tolerate: The Xi administration will renew its reform drive - particularly by curbing leverage, shadow banking, and local government debt. Growth risks are to the downside. But Beijing will eventually backtrack and re-stimulate, even as early as 2018, leaving the reform agenda in limbo once again.2 Over the past month, China has clearly reached its pain threshold: authorities have announced a series of easing measures in the face of a slowing economy, a trade war, and a still-negative broad money impulse (Chart 2). Chart 1Policy Uncertainty Up, Stocks Down Policy Uncertainty Up, Stocks Down Policy Uncertainty Up, Stocks Down Chart 2PMI Falling, Money Impulse Still Negative PMI Falling, Money Impulse Still Negative PMI Falling, Money Impulse Still Negative How stimulating is the stimulus? Will it lead to a material reacceleration of the Chinese economy? What will it mean for global and China-dedicated investors? We expect policy to be modestly reflationary. A substantial boost to fiscal thrust, and at least stable credit growth, is in the works. Yet Xi's reform agenda will remain a drag on the economy. While this new stimulus will not have as dramatic an effect as the stimulus in 2015-16, it will have a positive impact relative to expectations based on China's performance in the first half of the year. We advise hedging our negative EM view against a rally in China plays and upgrading expectations for Chinese growth in 2019. The policy headwind is receding for now. Xi Jinping's "Three Tough Battles" Xi will not entirely abandon the "Reform Reboot" that began last October. From the moment he came to power in 2012-13, he pursued relatively tight monetary and fiscal policy. Total government spending growth has dropped substantially under his administration, while private credit growth has been capped at around 12% (Chart 3). Chart 3Xi Jinping Caps Government Spending And Credit Xi Jinping Caps Government Spending And Credit Xi Jinping Caps Government Spending And Credit Xi partly inherited these trends, as China's credit growth and nominal GDP growth dropped after the massive 2008 stimulus. But he also embraced tighter policy as a way of rebalancing the economy away from debt-fueled, resource-intensive, investment-led growth. A comparison of government spending priorities between Xi and his predecessor makes Xi's policy preferences crystal clear: the Xi administration has increased spending on financial and environmental regulation, while minimizing subsidies for housing and railways to nowhere (Table 1 and 2). Table 1Central Government Spending Preferences (Under Leader's Immediate Control) China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? Table 2Total Government Spending Preferences (Under Leader's General Control) China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? These policies are "correct" insofar as they are driven not merely by Xi's preferences but by long-term constraints: The middle class: Pollution and environmental degradation threaten the living standards of the country's middle class. Broadly defined, this group has grown to almost 51% of the population, a level that EM politicians ignore only at their peril (Chart 4). Asset bubbles: The rapid increase in China's gross debt-to-GDP ratio since 2008 is a major financial imbalance that threatens to undermine economic stability and productivity as well as Beijing's global aspirations (Chart 5). The constraint is clear when one observes that "debt servicing" is the third-fastest category of fiscal spending growth since Xi came to power (Table 2). Chart 4Emerging Middle Class A Latent Political Risk Emerging Middle Class A Latent Political Risk Emerging Middle Class A Latent Political Risk Chart 5The Rise And Plateau Of Macro Leverage China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? The problem is that Xi also faces a different, shorter-term set of constraints arising from China's declining potential GDP, "the Middle-Income Trap," and the threat of unemployment.3 The interplay of these short- and long-term constraints has forced Xi to vacillate in his policies. In 2015, the threat of an economic "hard landing," ahead of the all-important mid-term party congress in 2017, forced him to stimulate the "old" industrial economy and sideline his reforms. Only when he had consolidated power over the Communist Party in 2016-17 could he resume pushing the reform agenda.4 In July 2017, Xi announced the so-called "Three Critical Battles" against systemic financial risk, pollution, and poverty. The three battles are interdependent: continuing on the capital-intensive economic model will overwhelm any efforts to cut excessive debt or pollution (Chart 6), yet sudden deleveraging could derail the Communist Party's basic claim to legitimacy through improving the lot of poor Chinese. The macroeconomic impact of the three battles is broadly deflationary, as credit growth falls and industries restructure. The first battle - the financial battle - will determine the outcome of the other two battles as well as the growth rate of China's investment-driven economy, Chinese import volumes, and emerging market stability (Chart 7). Chart 6Credit Stimulus Correlates With Pollution Credit Stimulus Correlates With Pollution Credit Stimulus Correlates With Pollution Chart 7Credit Determines Growth And Imports Credit Determines Growth And Imports Credit Determines Growth And Imports On July 31, in the midst of worldwide speculation about China's willingness to stimulate, Xi reaffirmed this "Three Battles" framework. Remarkably, despite a general slowdown, a sharp drop in the foreign exchange rate, the revival of capital flight, and a bear market, he announced that the battle against systemic financial risk would continue in the second half of 2018. However, he also admitted that domestic demand needed a boost in the short term. Hence there should be no doubt in investors' minds about the overarching policy framework or Xi Jinping's intentions in the long run. The question driving the markets today is what China will do in the short term and whether it will initiate a material reacceleration in economic activity. Bottom Line: Xi Jinping remains committed to the reform agenda that he has pursued since coming to power in 2012. But he is forced by circumstances to vary the pace and intensity. At the top of the agenda is the control of systemic financial risk. This is a policy driven by the belief that China's economic and financial imbalances threaten to undermine its overall stability and global rise. Why The Shift Toward Easier Policy? The gist of the July 31 Politburo statement was that policy will get more dovish in the short term. It mentioned "stability" five times. The Politburo pledged to make fiscal policy "more proactive" and to find a better balance between preventing financial risks and "serving the real economy." This direct promise from Xi Jinping of more demand-side support gives weight to the State Council's similar statement on July 23 and will have reflationary consequences above and beyond the central bank's marginal liquidity easing thus far. What is motivating this shift in policy, which apparently flies in the face of Xi's high-profile deleveraging campaign? If we had to name a single trigger for China's change of tack, it is not the economic slowdown so much as the trade war with the United States. The war began when the U.S. imposed sanctions on Chinese firm ZTE in April and China depreciated the RMB, but it escalated dramatically when the U.S. posted the Section 301 tariff list in June (Chart 8).5 This is a sea change in American policy that is extremely menacing to China. China runs a large trade surplus and has benefited more than any other country from the past three decades of U.S.-led globalization. Its embrace of globalization is what enabled the Communist Party to survive the fall of global communism! Chart 8More Than Market Dynamics At Work More Than Market Dynamics At Work More Than Market Dynamics At Work Chart 9China Is Less Export-Dependent China Is Less Export-Dependent China Is Less Export-Dependent True, China has already seen its export dependency decline (Chart 9). But Beijing has so far managed this transition gradually and carefully, whereas a not-unlikely 25% tariff on $250-$500 billion of Chinese exports will hasten the restructuring beyond its control (Chart 10). A very large share of China's population is employed in manufacturing (Chart 11). To the extent that the tariffs actually succeed in reducing external demand for Chinese goods, these jobs will be affected. Chart 10Tariffs Will Add More Pain To Factory Workers Tariffs Will Add More Pain To Factory Workers Tariffs Will Add More Pain To Factory Workers Chart 11Manufacturing Unemployment A Huge Threat Manufacturing Unemployment A Huge Threat Manufacturing Unemployment A Huge Threat Unemployment is anathema to the Communist Party. And China is simply not as experienced as the U.S. in dealing with large fluctuations in unemployment (Chart 12). While Chinese workers will blame "foreign imperialists" and rally around the flag, the pain of unemployment will eventually cause trouble for the regime. Domestic demand as well as exports will suffer. It is even possible that worker protests could evolve into anti-government protests. Chart 12China Not Experienced With Layoffs China Not Experienced With Layoffs China Not Experienced With Layoffs Given that Chinese and global growth are already slowing, it is no surprise that the Politburo statement prioritized employment.6 China's leaders will prepare for social instability as the worst possible outcome of the showdown with America - and that will push them toward stimulus. In addition, there will be no short-term political cost to Xi Jinping for erring on the side of stimulus, as there is no opposition party and the public is not demanding fiscal and monetary austerity. Moreover, the main macro implication of Xi's decision last year to remove term limits - enabling himself to be "president for life" in China - is that his reforms do not have to be achieved by any set date. They can be continually procrastinated on the basis that he will return to them later when conditions are better.7 The policy response to tariffs from the Trump administration also signals another policy preference: perseverance. Xi would not be straying from his reform priorities if not for a desire to counter American protectionism. China is not interested in kowtowing but would rather gird itself for a trade war. Still, our baseline view is that the Xi administration will stimulate without abandoning the crackdown on shadow lending or launching a massive "irrigation-style" credit surge that exacerbates systemic risk.8 Policy will be mixed, as Xi is trying to do two things at once. Bottom Line: China's slowdown and the outbreak of a real trade war with the United States is forcing Xi Jinping to ease policy and downgrade the urgency of his attempt to tackle systemic financial risk this year. Can Fiscal Easing Overshoot? Yes. How far will China's policy easing go? China has a low level of public debt, and fiscal policy has been tight, so we fully expect fiscal thrust to surprise to the upside in the second half of the year, easily by 1%-2% of GDP, possibly by 4% of GDP. A remarkable thing happened this summer when researchers at the People's Bank of China and the Ministry of Finance began debating fiscal policy openly. Such debates usually occur during times of abnormal stress. The root of the debate lay in the national budget blueprint laid out in March at the National People's Congress. There, without changing official rhetoric about "proactive fiscal policy," the authorities revealed that they would tighten policy this year, with the aim of shrinking the budget deficit from 3% of GDP target in 2017 to 2.6% in 2018. The IMF, which publishes a more realistic "augmented" deficit, estimates that the deficit will contract from 13.4% of GDP to 13% (Chart 13). This fiscal tightening coincided with Xi's battle against systemic financial risk. Hence both monetary and fiscal policy were set to tighten this year, along with tougher regulatory and anti-corruption enforcement.9 Thus it made sense on May 8 when the Ministry of Finance revealed that the quota for net new local government bond issuance this year would increase by 34% to 2.18 trillion RMB. This quota governs new bonds that go to brand new spending (i.e. it is not to be confused with the local government debt swap program, which eases repayment burdens but does not involve a net expansion of debt). Local government spending is the key because it makes up the vast majority (85%) of total government spending, which itself is about the same size as new private credit each year. Chart 13Fiscal Tightening Was The Plan For 2018 China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? Table 3Local Government Bond Issuance And Quota China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? In June, local governments took full advantage of this opportunity, issuing 316 billion RMB in brand new bonds (up from a mere 17 billion in May - an 11.8% increase year-on-year) (Table 3). This spike in issuance is later than in previous years. Combined with the Politburo and State Council pledging to boost fiscal policy and domestic demand, it suggests that net new issuance will pick up sharply in H2 2018 (Chart 14).10 Chart 14Local Government Debt Can Surprise In H2 China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? Chart 15June Issuance Surged, Special Bonds To Pick Up China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? At the same time, the risk that special infrastructure spending will fall short this year is receding. About 1.4 trillion RMB of the year's new bond allowance consists of special purpose bonds to fund projects. The State Council said on July 23 it would accelerate the issuance of these bonds, since, at most, only 27% of the quota was issued in the first half of the year (Chart 15). The risk of a shortfall - due to stricter government regulations over the quality of projects - is thereby reduced. What is the overall impact of these moves? The Chinese government provides an annual "debt limit" that applies to the grand total of explicit, on-balance-sheet, local government debt. The limit increased by 11.6% for 2018, to 21 trillion RMB (Table 4), which, theoretically, enables local governments to splurge on a 4.5 trillion RMB debt blowout. Should that occur, 2.6 trillion RMB of that amount, or 3% of GDP, would be completely unexpected new government spending in 2018 (creating a positive fiscal thrust).11 Table 4Local Government Debt Quota Is Not A Constraint China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? Such a blowout may not be likely, but it is legally allowed - and the political constraints on new issuance have fallen with the central government's change of stance. This means that local governments' net new bond issuance can move up toward this number. More feasibly, local governments could increase their explicit debt to 19.3 trillion RMB, a 920 billion RMB increase on what is expected, which would imply 1% of GDP in new spending or "stimulus" in 2018.12 The above only considers explicit, on-balance-sheet debt. Local governments also notoriously borrow and spend off the balance sheet. The total of such borrowing was 8.6 trillion RMB at the end of 2014, but there is no recent data and the stock and flow are completely opaque.13 The battle against systemic risk is supposed to curtail such activity this year. But the newly relaxed supervision from Beijing will result in less deleveraging at minimum, and possibly re-leveraging. Similarly, the government has said it is willing to help local governments issue refinancing bonds to deal with the spike in bonds maturing this year.14 This frees them up to actually spend or invest the money they raise from brand new bonds. In short, our constraints-based methodology suggests that the risk lies to the upside for local government debt in 2018, given that it is legal for debt to increase by as much as 2.5 trillion RMB, 3% of GDP, over the 1.9 trillion RMB increase that is already expected in the IMF's budget deficit projections for 2018. What about the central government? Its policy stance has clearly shifted. The central government could quite reasonably expand the official budget deficit beyond the 2.6% target. Indeed, that target is already outdated given that new individual tax cuts have been proposed, which would decrease revenues (add to the deficit) by, we estimate, a minimum of 0.44% of GDP over a 12-month period starting in October.15 Other fiscal boosts have also been proposed that would add an uncertain sum to this amount.16 The total of these measures can quite easily add up to 1% of GDP, albeit with the impact mostly in 2019. Finally, the strongest reason to err on the side of an upward fiscal surprise is that an expansion of fiscal policy will allow the Xi administration to boost demand without entirely relying on credit growth. First, local governments are actually flush with revenues due to strong land sales (Chart 16), which comprise around a third of their revenues. This enables them to increase spending even before they tap the larger debt allowance. Second, China's primary concern about financial risk is due to excessive corporate (and some household) leverage, particularly by state-owned enterprises (SOEs) and shadow banking. It is not due to public debt per se. It is entirely sensible that China would boost public debt as it attempts to limit leverage. In fact, this would be the Zhu Rongji playbook from 1998-2001. This was the last time that China announced a momentous three-year plan to crack down on profligate lending, hidden debts, and credit misallocation. The authorities deliberately expanded fiscal policy to compensate for the anticipate credit crunch and its drag on GDP growth (Chart 17).17 Chart 16Land Sales Enable Non-Debt Fiscal Spending Land Sales Enable Non-Debt Fiscal Spending Land Sales Enable Non-Debt Fiscal Spending Chart 17China Boosted Fiscal During Last Bad Debt Purge China Boosted Fiscal During Last Bad Debt Purge China Boosted Fiscal During Last Bad Debt Purge As for the impact on the economy, the money multiplier will be meaningful because the economy is slowing and fiscal policy has been tight. But fiscal spending does operate with a six-to-ten month lag, meaning that China/EM-linked risk assets will move long before the economic data fully shows the impact. Our sense, judging by the unenthusiastic response of copper prices thus far, is that the market does not anticipate the fiscal overshoot that we now do. Bottom Line: The political constraints on local government spending have fallen. Fiscal policy could add as much as 1%-3% of GDP to the budget deficit in H2 2018, namely if local government spending is unleashed by the recently announced policy shift. This is comparable to the 4% of GDP fiscal boost in 2008-09 and 3% in 2015-16. Can Monetary Easing Overshoot? Yes, But Less Likely. Credit is China's primary means of stimulating the economy, especially during crisis moments, and it has a much shorter lag period than fiscal spending (about three months). But Xi's agenda makes the use of rapid, credit-fueled stimulus more problematic. Based on the sharp drop in the interbank rate - in particular, the three-month interbank repo rate that BCA's Emerging Markets Strategy and China Investment Strategy use as a proxy for China's benchmark rate - it is entirely possible that credit growth will increase to some degree in H2 2018. Interbank rates have now fallen almost to 2016 levels, while the central bank never hiked the official 1-year policy rate during the recent upswing (Chart 18). In other words, the monetary setting has now almost entirely reversed the financial crackdown that began in 2017. The sharp drop in the interbank rate is partly a consequence of the three cuts to required reserve ratios (RRRs) this year, which amounts to 2.8 trillion RMB in new base money from which banks can lend.18 One or two more RRR cuts are expected in H2 2018, which could free up another roughly 800 billion-to-1.6 trillion RMB in new base money. With China accumulating forex reserves at a slower pace than in the past, and facing a future of economic rebalancing away from exports and growing trade protectionism, RRRs can continue to decline over the long run (Chart 19). China will not need to sterilize as large of inflows of foreign exchange.19 Chart 18Monetary Settings Back To Easy Levels Monetary Settings Back To Easy Levels Monetary Settings Back To Easy Levels Chart 19RRR Cuts Can Continue RRR Cuts Can Continue RRR Cuts Can Continue If China's banks and borrowers respond as they have almost always done, then credit growth should rise. The risk to this assumption is that the banks may be afraid to lend as long as the Xi administration remains even partially committed to its financial crackdown. Moreover, the anti-corruption campaign is continuing to probe the financial sector. While this has only produced a handful of anecdotes so far, they are significant and may have helped cause the decline in loan approvals since early 2017. Critically, China has begun the process of recognizing non-performing loans (NPLs), by requiring that "special mention loans" be reclassified as NPLs, thus implying that NPL ratios will spike, especially among small and regional lenders (Chart 20). This is part of the deleveraging process we expect to continue, but it can take on a life of its own and will almost certainly weigh on credit growth to some extent for as long as it continues. Chart 20NPL Recognition Underway (!) NPL Recognition Underway (!) NPL Recognition Underway (!) Chart 21Three Scenarios For Private Credit In H2 2018 China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? What will be the prevailing trend: monetary easing or the financial crackdown? In Chart 21 we consider three scenarios for the path of overall private credit growth (total social financing, ex-equity) for the rest of the year, with our subjective probabilities: In Scenario A, 10% probability, we present an extreme case in which Beijing panics over the trade war and the banks engage in a 2009-style lending extravaganza. Credit skyrockets up to the 2010-17 average growth rate. This would mark a massive 11.9 trillion RMB or 13.8% of GDP increase in excess of the amount implied by the H1 2018 data. This size of credit spike would be comparable to the huge spikes that occurred during past crises, such as the 22% of GDP increase in 2008-09 or the 9% of GDP increase in 2015-16. Needless to say, this is not our baseline case, but it could materialize if the trade war causes a global panic. In Scenario B, 70% probability, we assume, more reasonably, that traditional yuan bank loans are allowed to rise toward their average 2010-17 growth rate as a result of policy easing, yet Xi maintains the crackdown on non-bank credit in accordance with this "Three Battles" framework. Credit growth would still decelerate in year-on-year terms, but only just: it would fall from 12.3% in 2017 to 11.5% in 2018. Additional policy measures could easily bump this up to a modest year-on-year acceleration, of course. This scenario would result in a credit increase worth 2.9 trillion RMB or 3.4% of GDP on top of the level implied by H1 2018. In Scenario C, 20% probability, we assume that the 2018 YTD status quo persists: bank credit and non-bank credit continue growing at the bleak H1 2018 rate. The administration's attempt to maintain the crackdown on financial risk could frighten banks out of lending. This would mean no credit increase in 2018 beyond what is naturally extrapolated from the H1 2018 data. Credit growth would slow from 12.3% to 10.7% in 2018. This scenario would be surprising, but not entirely implausible given that the Politburo is insisting on continuing the Three Battles. The collapse in interbank rates and the easing measures already undertaken - such as reports that the Macro-Prudential Assessments will lighten up, and that the People's Bank is explicitly softening banks' annual loan quotas20 - lead us to believe that Scenario B is most likely, and possibly too conservative. This is the scenario most consistent with the latest Politburo statement: that authorities will continue the campaign against systemic risk, namely through the policy of "opening the front door" (traditional bank loans go up) and "closing the back door" (shadow lending goes down), which began in January. The Chinese government has always considered control of financial intermediation to be essential. The only way to reinforce the dominance of the state-controlled banks, while preventing a sharp drop in aggregate demand, is to allow them to grow their loan books while regulators tie the hands of their shadow-bank rivals (Chart 22). Chart 22Opening The Front Door, Closing The Back Opening The Front Door, Closing The Back Opening The Front Door, Closing The Back One factor that could evolve beyond authorities' control is the velocity of money. Money velocity is essentially a gauge of animal spirits. If a single yuan changes hands multiple times, it will drive more economic activity, but if it is deposited away for a rainy day, then the bear spirit is in full force. Thus, if credit growth accelerates, but money in circulation changes hands more slowly, then nominal GDP can still decelerate - and vice versa.21 China's money velocity suffered a sharp drop during the tumult of 2015, recovered along with the policy stimulus in 2016, and has tapered a bit in 2018 in the face of Xi's deleveraging campaign. Yet it remains elevated relative to 2012-16 and clearly responds at least somewhat to policy easing. The implication is that money velocity should remain elevated or even pick up in H2. Again, the risk to this view is that Xi's ongoing battle against financial risk, and anti-corruption campaign in the financial sector, could suppress money velocity as well as credit growth. Bottom Line: We see a subjective 70% chance that the drop in credit growth will be halted or reversed in H2 as a result of the central bank's liquidity easing and the Politburo's willingness to let traditional bank lending grow while it discourages shadow lending. Our baseline case says the impact could amount to new credit worth 3.4% of GDP in H2 2018 that markets do not yet expect. Investment Conclusions Beijing's shift in policy suggests that our subjective probability of a policy mistake this year, leading to a sharp economic deceleration, should be reduced from 30% to 20% (Credit Scenario C above).22 Why is this dire scenario still carrying one-to-five odds? Because we fear that the financial crackdown and rising NPLs could take on a life of their own. Meanwhile the risk of aggressive re-leveraging has risen from 0% to 10% (Credit Scenario A above). Summing up, Table 5 provides a simple, back-of-the-envelope estimate of the size of both fiscal and monetary policy measures as a share of GDP. Table 5Potential Magnitude Of Easing/Stimulus China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? Our bias is to expect a strong fiscal response combined with a weak-to-moderate credit response. This would reflect the Xi administration's desire to prevent asset bubbles while supporting growth. A more proactive fiscal policy harkens back to China's handling of its last financial purge in 1998-2001. If banks prove unable or unwilling to lend sufficiently, additional fiscal expansion will pick up the slack. New local government debt can surprise by 1% of GDP or more, while formal bank lending amidst an ongoing crackdown on shadow lending could add new credit of around 3.4% of GDP and hence mitigate or halt the slowdown in credit growth. The combined effect would be an unexpected boost to demand worth 4.4% of GDP in H2 2018, which would exert an unknown, but positive, multiplier effect. We are replacing our "Reform Reboot" checklist, which has seen every item checked off, with a new "Stimulus Checklist" that we will monitor going forward (Appendix). Chart 23How To Monitor The Stimulus Impact How To Monitor The Stimulus Impact How To Monitor The Stimulus Impact Neither the size of this stimulus, nor the composition of fiscal spending, will be quite as positive for EM/commodities as were past stimulus efforts. China's investment profile is changing as the reform agenda seeks to reduce industrial overcapacity and build the foundations for stronger household demand and a consumer society. Increases in fiscal spending today will involve more "soft infrastructure" than in the past. We recommend reinstituting our long China / short EM equity trade, using MSCI China ex-tech equities. We also recommend reinitiating our long China Big Five Banks / short other banks trade, to capture the disparity of the financial crackdown's impact. To capture the new upside risk for global risk assets, our colleague Mathieu Savary at BCA's Foreign Exchange Strategy has devised a "China Play" index that is highly sensitive to Chinese growth - it includes iron ore prices, Swedish industrial stocks, Brazilian stocks, and EM junk bonds (all in USD terms), as well as the Aussie dollar-Japanese yen cross. BCA Geopolitical Strategy also recommends this trade as a portfolio hedge to our negative EM view (Chart 23).23 A major risk to the "modest reflation" argument in this report will materialize if the RMB depreciates excessively in response to the escalating trade war (Trump will likely post a new tariff list on $200 billion worth of goods in September).24 This could result in renewed capital outflows breaking through China's capital controls, the PBC appearing to lose control, EM currencies and capital markets getting roiled, EM financial conditions tightening sharply, and global trade and growth slowing sharply. China would ultimately have to stimulate more (moving in the direction of Credit Scenario A above), but a market selloff would occur first and much economic damage would be done. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Qingyun Xu, Senior Analyst qingyun@bcaresearch.com Yushu Ma, Contributing Editor yushum@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 3 Please see The Bank Credit Analyst Special Report, "A Long View Of China," dated December 28, 2017, available at bca.bcaresearch.com. 4 The fact that he began tightening financial policy in late 2016 and early 2017 was especially significant because only a very self-assured leader would attempt something so risky ahead of a midterm party congress. 5 Please see BCA Geopolitical Strategy Weekly Reports, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, and "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 6 The statement declared in its first paragraph that China would "maintain the stability of employment," with employment being the first item in a list. A similar emphasis on employment has not been seen in Politburo statements since the troubled year of 2015, and it has not been mentioned substantively in 11 key meetings since the nineteenth National Party Congress last October. 7 Please see footnote 2 above. 8 After the State Council meetings on July 23 and 26, Vice-Minister of Finance Liu Wei elaborated on the government's thinking: "These [measures] further add weight to the overall broad logic at the start of the year ... It isn't at all that the macro-economy has undergone any major volatility, and we are not undertaking any irrigation-style, shock-style measures." Please see "Beijing Sheds Light On Plans For More Active Fiscal Policy," China Banking News, July 27, 2018, available at www.chinabankingnews.com. 9 Our colleagues in BCA's Emerging Markets Strategy service have dubbed this policy "triple tightening." Please see BCA Emerging Markets Strategy Weekly Report, "EM And China: A Deleveraging Update," dated November 8, 2017, available at gps.bcaresearch.com. 10 This spike in net new issuance in the single month of June is equivalent to 19.8% of the total net new issuance in 2017. It is also much higher than the average monthly issuance in 2014-17 or in 2017 alone. However, since June and July have typically seen the largest spikes in new issuance, it will be critical to see if new issuance in 2018 remains elevated after July. Notably, local government bond issuance is currently divided between brand new bonds, debt swap bonds, and refinancing bonds, but the debt swap program will expire in August, and the refinancing bonds are separate, meaning that a larger share of the allowed new issuance will involve new spending. 11 The IMF expects the change in local government explicit debt this year to be 1.9 trillion RMB. That is, a rise from 16.5 trillion existing to 18.4 trillion estimated. 12 This number is derived by assuming that total debt reaches 92.2% of the debt limit in 2018, which is the share it reached in 2015 (since 2015 the share has fallen to 87.5% in 2017). However, 2015 was a year of fiscal easing, so it is not unreasonable to apply this ratio to 2018 as an upper estimate, now that the government's easing signal is clear. One reason that local governments have been increasing debt more slowly than allowed was that the central government was tightening investment restrictions, for instance on urban rail investment. Many new subway projects of second-tier cities have been suspended, and after raising the qualifications for subway and light rail, the majority of third- and fourth-tier cities were not qualified to build urban rail at all. As a result, local governments' investment intentions were dropping. Now this may change. 13 This estimate comes from the Ministry of Finance. The previous estimate was from the National Accounting Office and stood at 7 trillion RMB as of June 2013. 14 Maturities will spike in the coming years, so this policy signal suggests that further support for refinancing will be forthcoming. There are even unconfirmed rumors of a second phase of the local government debt swap program, which would cover "hidden debt." 15 We say "minimum" because we do not include projections of the impact of tax deductions, lacking details. We only estimate the headline savings to household incomes - loss to government revenues - based on the increase of the individual income tax eligibility threshold and the reduction in tax rates for different income brackets. 16 Additional fiscal measures include corporate tax cuts, R&D expense credits, VAT rebates, and reductions in various fees. 17 Please see BCA Geopolitical Strategy Monthly Report, "What Geopolitical Risks Keep Our Clients Awake?" dated March 9, 2016, available at gps.bcaresearch.com. 18 In fact it is more like 1.9 trillion due to strings attached, but a fourth or even fifth RRR cut could push it 3.5 trillion for the year, assuming the average 800 billion cut. 19 Ultimately this trend will result in tightening liquidity conditions in China, but for now forex reserves are not draining massively, while the RRR cuts are easing domestic liquidity. 20 Please see "China Said To Ease Bank Capital Rule To Free Up More Lending," Bloomberg, July 25, and "China's Central Bank Steps Up Effort To Boost Lending," August 1, 2018, available at www.bloomberg.com. 21 Please see BCA Emerging Markets Strategy Special Report, "Ms. Mea Challenges The EMS View," dated October 19, 2017, available at ems.bcaresearch.com. 22 Please see BCA Research Special Report, "China: Party Congress Ends ... So What?" dated November 2, 2017, available at bca.bcaresearch.com. 23 Please see BCA Foreign Exchange Strategy Weekly Report, "The Dollar And Risk Assets Are Beholden To China's Stimulus," dated August 3, 2018, available at fes.bcaresearch.com. 24 Please see BCA Global Investment Strategy Weekly Report, "Three Macro Paradoxes Are About To Come True," dated August 3, 2018, available at gis.bcaresearch.com. Appendix China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus? China: How Stimulating Is The Stimulus?

Highlights The 2018 dollar rally is principally the consequence of the slowdown in global industrial activity and global trade, itself a reverberation of China's efforts to de-lever and reform its economy. For China, reforms and deleveraging are here to stay, suggesting the dollar rally and EM rout are not over. However, in response to U.S. President Donald Trump's trade battling, China is stimulating its economy in order to limit its own downside. The chances of miscalculation on the part of Beijing are high. This raises the risk that investors begin pricing in a much more aggressive reflation campaign. Such a reflation campaign would cause a correction in the dollar and give more lift to the current rebound in EM assets. In order to track this risk and hedge it, investors should monitor and buy a portfolio made up of iron ore, Brazilian equities, AUD/JPY, Swedish industrial equities and EM high-yield bonds. Feature Many assign the strength in the dollar this year to the Federal Reserve increasing interest rates at a faster pace than other advanced economies. While monetary divergences seems like both a historically plausible and intuitive explanation, it rings hallow. The Fed was hiking rates at a much faster pace than the rest of the world last year, yet the dollar had a horrendous 2017, falling 10%. In our view, the trend in global growth has had a much more important role in explaining the dollar's performance. When global trade and global industrial production is strong, this normally leads to a period of weakness in the dollar. The opposite also holds true; soft global growth is associated with a strong dollar (Chart I-1). Behind this relationship lies the low-beta nature of the U.S. economy. Since its economy is not as levered to exports and manufacturing as the rest of the world is, the U.S. benefits less when global growth is improving (Chart I-2). As a result, when global growth is on the up and up, investors can upgrade the economic and inflation outlook for Europe faster than they can for the U.S. In the process, long-term rate expectations rise faster in Europe than the U.S., attracting money into Europe and out of the U.S. The process can be replicated across most economies outside the U.S. This hurts the dollar. Chart I-1The Dollar Likes ##br##Poor Global Growth The Dollar Likes Poor Global Growth The Dollar Likes Poor Global Growth Chart I-2The U.S. Economy Is Less##br## Sensitive To Global Growth The Dollar And Risk Assets Are Beholden To China's Stimulus The Dollar And Risk Assets Are Beholden To China's Stimulus To understand the outlook for the greenback, it is crucial to understand the outlook for global economic activity. Many commentators have pinned the blame of slowing global growth on the back of rising protectionism. The problem with this thesis is that global growth began slowing before investors took protectionist risks seriously. Instead, in our view, the key culprit behind the global growth slowdown has been policy tightening in China. Therein lies the issue. China has slowed, and President Xi Jinping is signaling that his administration will continue to push ahead with deleveraging the Chinese economy. This should imply weaker industrial growth in China and in the rest of the world and therefore a stronger dollar. However, with protectionism on the rise, the Chinese authorities are announcing virtually every day new measures to soften the blow to the Chinese economy. This stimulus could support global growth, and hurt the dollar, at least tactically. Our Geopolitical Strategy team believes the desire to reform and de-lever the Chinese economy will ultimately prevail, and thus so will a stronger dollar. However, the growing list of stimulus measures implemented in China supports our thesis, articulated last month, that a counter-trend correction in the dollar will first materialize before the greenback rally begins anew.1 As such, we continue to recommend investors hedge their long USD bets, and that traders with a short-term horizon take advantage of a portfolio we propose in this report. China Drives Growth And Returns Differentials We have long argued that China has a disproportionate role in determining what happens to growth outside the U.S. To some extent, this argument is almost tautological: at PPP exchange rates, China produces 24% of global GDP outside the U.S. But there is more than meets the eye to this argument. China is the world largest investor, with Chinese capital investment accounting for 26% of global capital formation, or 6.5% of the world's GDP. This means that the growth rate of Chinese investment has a large direct impact on global industrial good exports around the world. There is a second-round effect as well: China is also the largest consumer of industrial commodities globally. This implies that China is the marginal consumer and thus the price-setter of many natural resources. However, commodity producers account for a large share of global capex, 10.5% from 2004 to 2017. Thus, through its impact on commodity prices, China also impacts the demand for global industrial and capital goods via the capex needs of commodity exports. This large footprint can result in some counterintuitive relationships. For example, why is it that Chinese economic variables explain so well the gyrations of French exports to Germany, its largest export market (Chart I-3)? This conundrum is explained by the fact that German economic activity is deeply affected by Chinese growth. Since German growth is the key determinant of German imports, it follows that Chinese activity plays a large role in driving French exports. This pattern gets repeated across Europe, as Germany is the leading trading partner of most European nations. China does not have the same impact on the U.S. economy (Chart I-4) as total U.S. exports only represent 13% of GDP and exports to China, a measly 0.6% of GDP. Manufacturing also only represents 11% of U.S. GDP, again limiting the impact of secondary benefits of Chinese growth on the U.S. economy. Chart I-3What Drives French Exports To Germany: China What Drives French Exports To Germany: China What Drives French Exports To Germany: China Chart I-4Chinese Growth Has Little Impact On U.S. Growth Chinese Growth Has Little Impact On U.S. Growth Chinese Growth Has Little Impact On U.S. Growth Thanks to this difference, we can spot one very useful relationship that we have highlighted to our clients for more than a year: when the Chinese authorities stimulate their economy, European growth picks up sharply vis-a-vis the U.S. (Chart I-5).2 In this optic, the growth outperformance of Europe in 2017 made perfect sense; it was a consequence of China's aggressive push to reflate after 2015. 2018 is the mirror image of 2017; European growth is underperforming as a result of China's efforts to limit growth. This also means that wherever China goes going forward, so will the growth gap between the euro area and the U.S. Chart I-5AIf European Growth Beats That ##br##Of The U.S., Thank China (I) If European Growth Beats That Of The U.S., Thank China (I) If European Growth Beats That Of The U.S., Thank China (I) Chart I-5BIf European Growth Beats That ##br##Of The U.S., Thank China (II) If European Growth Beats That Of The U.S., Thank China (II) If European Growth Beats That Of The U.S., Thank China (II) Since Chinese growth affects the distribution of economic activity around the world, China affects the distribution of rates of returns around the world as well. Nowhere is the influence of China more evident than in the spread between U.S. and global bond yields. If we accept that Chinese growth exerts a limited influence on the domestically driven U.S. economy but exerts a large impact on the rest of the world, Chinese economic fluctuations should have an implication on the relative interest rate outlook between the U.S. and the rest of the world. This is indeed the case. As Chart I-6 shows, when the growth of China's nominal manufacturing GDP slows relative to the U.S., U.S. bond yields rise relative to yields in other major economies. Since money flows where it is best treated, the impact of China on relative rates of returns and interest rates around the world should be felt in the dollar. This is also the case. When Chinese nominal manufacturing GDP growth accelerates, the dollar tends to suffer as money leaves the U.S. and finds its way into Europe, Australia, Canada, EM and so forth to take advantage of rising marginal rates of returns relative to the U.S. (Chart I-7). Chart I-6Treasurys Vs. The World Equals U.S. Nominal GDP ##br##Vs. Chinese Manufacturing Treasurys Vs. The World Equals U.S. Nominal GDP Vs. Chinese Manufacturing Treasurys Vs. The World Equals U.S. Nominal GDP Vs. Chinese Manufacturing Chart I-7The DXY Moves In Opposition##br## To Chinese Manufacturing The DXY Moves In Opposition To Chinese Manufacturing The DXY Moves In Opposition To Chinese Manufacturing Bottom Line: The U.S. economy does not benefit as much from rising Chinese economic activity as the rest of the world does. This means that U.S. relative rates of return fall when China booms and rise when China busts. This also implies that China is just as important as the Fed in determining the trend in the dollar: A strong China is associated with a weak dollar, and vice-versa. Chinese Deleveraging Is Dollar Bullish, But... Despite its large debt load, China does not have a debt problem per se. With a savings rate of 46% of GDP and a limited stock of foreign currency debt, China does not exhibit the necessary conditions to end up like Argentina or Asian economies in the late 1990s. Instead, China's problem remains misallocated capital. China's debt load has increased by USD23.6 trillion since 2008. This is a lot of capital to invest in a short time span. Poor investments have been made, resulting in excess capacity in many industries, and most crucially a collapse in total factor productivity (Chart I-8). This decline in productivity represents a real threat to China's long-term viability, especially as China's labor force is set to begin declining and its leadership wants to avoid the middle-income trap that has plagued so many EM economies in the past. In order to avoid this trap, China's long-term growth is dependent on a sustained effort to de-lever and reform. Our Geopolitical Strategy team is adamant that Xi Jinping remains committed to this agenda. Long-term growth is his priority - a luxury now made possible by his "long-term" mandate.3 The impact of reforms is most evident through the evolution of credit growth. As Chart I-9 illustrates, total social financing has been slowing. The bottom panel of Chart I-9 also illustrates that the collapse in the Chinese credit impulse has followed the implosion of bond issuance by small financial institutions. This essentially tells us that the ongoing administrative and regulatory tightening of the shadow banking system is bearing fruit: Financial institutions are curtailing their issuance of exotic instruments, which is hurting overall credit growth - even if old-school bank loans are proving resilient. Chart I-8China: Labor Force And Total Factor ##br##Productivity The Need For Reforms China: Labor Force And Total Factor Productivity The Need For Reforms China: Labor Force And Total Factor Productivity The Need For Reforms Chart I-9Deleveraging In ##br##Action Deleveraging In Action Deleveraging In Action Since credit growth is so fundamental to generating investment and supporting the country's manufacturing sector, this implies that Chinese manufacturing activity has ample downside. As a result, we would anticipate that China will continue to be a drag on the rest of the world for many more quarters. This implies that the U.S. dollar has upside, and that EM plays as well as commodity currencies are especially vulnerable. While this view seems clear, and most investors now well understand the investment ramifications of Chinese reforms and deleveraging, sand has been thrown in the wheels of this narrative. As a result, the uptrend in the dollar and the downtrend in EM assets may take a pause. Bottom Line: China needs to de-lever further and reform its economy. Without this growth strategy, the country will be stuck in the dreaded middle-income trap, as its productivity has collapsed. Since deleveraging in China means less investment and slower manufacturing sector growth, this also means that the dollar should benefit, and EM-related assets should suffer, but... ... Stimulus Is A Potent Narrative The sand in the wheels of the dollar-bullish scenario created by Chinese reforms and their retardant effect on Chinese industrial growth is, paradoxically, President Trump's trade war with China. China decided to implement reforms last year because stronger growth out of the euro area and the U.S., its two largest export markets, should have buffeted its economy against some of the deflationary consequences of deleveraging. However, if President Trump tries to limit the growth of Chinese exports to the U.S., this create yet another shock that China does not need. This makes it much more difficult for China to deal with the deflationary consequences of its own reform efforts. As a result, not only have the Chinese authorities let the yuan depreciate by 8% since April, the fastest pace of decline since the 1994 devaluation, they have also begun announcing a slew of stimulus measures over the course of recent weeks: The People's Bank of China has engaged in RMB502 billion of liquidity injections, especially through its medium-term lending facility; Three reserve requirement ratio cuts have been implemented, freeing up RMB2.8 trillion of liquidity; Local governments have been allowed to increase net new bond issuance this year by up to RMB2.2 trillion; The issuance of special purpose bonds by local governments has been accelerated; Banks with high credit quality standards can reduce provisioning for NPLs; Individual income tax cuts have been announced; And modifications to the macro prudential assessment's structural component have been announced, which will free up new lending by commercial banks. These stimulus measures are not designed to cause growth to accelerate. In fact, as Jonathan LaBerge argues in our China Investment Strategy service, they pale in comparison to the total amount of stimulus implemented in 2015, especially as back then, RMB5 trillion in credit had also been injected into the economy.4 However, a problem remains for investors. Even if these measures are far from enough to cause Chinese growth to re-accelerate, they can easily foment the following narrative: Chinese policymakers are trying to calibrate their policy response in order to support growth. However, they are human beings, and do not know a priori how much stimulus will be needed to support growth without causing credit growth to actually surge. As a result, they will push stimulus into the system until the economy responds. But once the economy responds, it will be too late, and the lagged impact of stimulus will cause a sharp rebound in credit and capex. The opacity of Chinese policy and data raises the chance that this simplification will take over the investment community. Such reversion to simplicity in the face of ambiguity and intractable complexity is a well-documented phenomenon in sociology.5 Even if this narrative is mistaken and not based in actual reality, investors who view Chinese fundamentals as bullish to the dollar and bearish to EM and commodity plays need to be ready for this eventuality. We are reluctant to close our long dollar trade based on a narrative alone. Instead, we have purchased protection by selling USD/CAD as a hedge. However, we also offer investors a mean to observe if this narrative does take hold of the market, by tracking a portfolio of assets very sensitive to the outlook for Chinese growth, and thus very sensitive to Chinese reflation. These assets are: Chinese Iron ore prices, expressed in USD; Swedish industrial equities, expressed in USD; Brazilian equities, expressed in USD; AUD/JPY; And EM high-yield bond denominated in USD. Chart I-10 illustrates the performance of a portfolio composed of these assets, weighted in such a way that they contribute equally to the variance of the portfolio. As the chart illustrates, not only is this portfolio massively oversold, suggesting there is plenty of negatives already priced into China-linked assets, it has begun to rebound. Chart I-11 illustrates that the Chinese Li-Keqiang Index of industrial activity leads this index.6 The recent rebound in the LKI already supports the idea that this portfolio could have upside in the coming months. Moreover, if investors do extrapolate that additional stimulus measures are likely to come out of Beijing, this will support even greater upside to this portfolio. Chart I-10An Index To Monitor... An Index To Monitor... An Index To Monitor... Chart I-11...Or A Vehicle To Bet On Impactful Stimulus ...Or A Vehicle To Bet On Impactful Stimulus ...Or A Vehicle To Bet On Impactful Stimulus As a result, we would go one step beyond suggesting this portfolio as a tracker for Chinese reflation. Investors should buy it. If you are bearish on the Chinese growth outlook, buying this portfolio offers protection against countertrend moves that would hurt long-dollar and short-EM bets (our preferred strategy). If, however, you are bullish on Chinese reflation, this portfolio should prove a very rewarding vehicle to implement such views. Bottom Line: Chinese reforms are a tailwind for the dollar. However, they are now confronted with the reality of trade wars, which is causing the Chinese authorities to stimulate their economy to put a floor under growth. Nevertheless, this exercise is fraught with calibration errors - a risk that market participants can easily uncover. This raises the probability that a countertrend correction in the dollar will emerge. To monitor this risk, we recommend investors track a portfolio of assets heavily influenced by Chinese growth: Iron ore, Swedish industrial equities, Brazilian stocks, AUD/JPY, and EM high-yield bonds. Moreover, if one is already long the dollar, this portfolio can also be used as a hedge against the risk created by investors pricing in large-scale Chinese stimulus. If one disagrees with our view that reforms will ultimately take primacy on stimulus, one can also use this portfolio as a high-octane way to play Chinese reflation. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Reports, titled "Time To Pause And Breathe", dated July 6, 2018 and "That Sinking Feeling" dated July 13, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, "ECB: All About China?" dated April 7, 2017, available at fes.bcaresearch.com 3 Please see Geopolitical Strategy Special Reports, titled "China: Looking Beyond The Party Congress" dated July 19, 2017, and "China: Party Congress Ends...So What?" dated November 1, 2017, both available at gps.bcaresearch.com 4 Please see China Investment Strategy Weekly Report, "China Is Easing Up On The Brake, Not Pressing The Accelerator" dated July 26, 2018, available at cis.bcaresearch.com 5 Smelser, Neil J. "The Rational and the Ambivalent in the Social Sciences: 1997 Presidential Address." American Sociological Review, vol. 63, no. 1, Feb. 1998, pp. 1-16. 6 The Li-Keqiang index is based on railways freight traffic, bank credit, and electricity output. 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 Recent data in the U.S. has been mixed: Gross Domestic Product growth underperformed expectations slightly, coming in at 4.1%, reflecting a large decline in inventories. In fact, real final sales were strong, growing at a 5.1%. The ISM manufacturing survey also came in slightly below expectations, softening to 58.1 from 60.2 in July. It is still indicative of above-trend growth. However, the Chicago PMI surprised positively, coming in at 65.5. This measure also increased form last month's reading. While the DXY was able to rally this week thanks to growing tensions between the U.S. and China, we expect the dollar to have short-term downside, as the temporary stimulus by the Chinese authorities should give an ephemeral boost to global growth, a development that would hurt the dollar. That being said, impact should ultimately prove to be transient, and the dollar. Report Links: Rhetoric Is Not Always Policy - July 27, 2018 Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area has been mixed: The yearly growth of GDP underperformed expectations, coming in at 2.1%. This also represented a decrease relative to the previous quarter. However, both core and headline inflation surprised to the upside, coming in at 2.1% and 1.1% respectively. Moreover, the European Commission's economic sentiment indicator also outperformed to the upside, coming in at 112.1. However, this measure decreased from last month's reading. EUR/USD was relatively flat for most of the week until a wave of risk aversion prompted by worries of a Sino-U.S. trade war took hold of the market, lifting the dollar in the process. In a mirror image to our dollar view, we expect the euro to have upside in the next couple of months, but resume its downward trajectory by the end of the year. Report Links: Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: Retail sales yearly growth beat expectations, coming in at 1.5%. Moreover, the jobs-to-applicants ratio also surprised to the upside, coming in at 1.62. However, the unemployment rate surprised negatively, coming in at 2.4% and increasing from last month's number. However, this reflected an increase in the participation rate. Finally, the consumer confidence index also underperformed expectations, coming in at 43.5. USD/JPY has risen by roughly 0.5% this week after it became clear that the BoJ only marginally adjusted its policy, in a way that only confirmed its highly dovish bias. Interestingly, while the spike in JGB yields has reverberated across global bond markets, it has not been able to provide a boost for the yen. While we expect the trade-weighted yen to appreciate by the end of this year as Chinese policymakers still want China to de-lever, a period of interim weakness is possible as the PBoC tries to buffet the Chinese economy against the impact of U.S. protectionism. Report Links: Rhetoric Is Not Always Policy - July 27, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Rome Is Burning: Is It The End? - June 1, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: The Nationwide house price index yearly growth rate outperformed expectations, coming in at 2.5%. This measure also increased relatively to last month's number. Moreover, PMI construction also surprised to the upside, coming in at 55.8, and increasing from last month's reading. However, Markit manufacturing PMI underperformed expectations, coming in at 54. GBP/USD was relatively flat this week, but ultimately experienced a large fall following the hike by the BoE as investors began to worry that the "old lady" is making a policy error that will need to be reversed. Overall, we remain negative on cable, as the ability for the BoE to continue on their hiking campaign will be limited given the current political turmoil in Britain. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia has been mixed: Building permit yearly growth outperformed expectations, coming in at 1.6%. Moreover, producer prices also surprised positively, coming in at 1.5%. However this measure decreased compared to last month's reading. Finally, the RBA Commodity Index SDR yearly growth surprised to the downside, coming in at 7.6%. AUD/USD fell this week as market wrestle with the risk to global growth created by the China-U.S. trade war. Overall, we continue to be negative on the Aussie on a cyclical basis, as this currency is the most exposed in the G10 to a slowdown in the Chinese industrial sectors. That said, a bout of stimulus in China could provide some short-term upside to AUD. Report Links: What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 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 Recent data in New Zealand has been mixed: Employment growth surprised to the upside, coming in at 0.5%. However, this measure slowed from last month's reading. Moreover, the participation rate outperformed expectations, coming in at 10.9% and increasing from last month's number. However, the unemployment rate underperformed expectations, coming in at 4.5% and increasing from last month's reading. NZD/USD experienced a large fall this week. We are negative on the NZD on a cyclical basis, as tightening by both China and the U.S. along with trade tensions will provide for a toxic cocktail for small open economies like New Zealand. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada has been mixed: Industrial production month-mon-month growth outperformed expectations, coming in at 0.5%. Moreover, Monthly GDP growth also surprised positively, coming in at an annualized rate of 0.5%. However, the Markit Manufacturing PMI underperformed expectations, coming in at 56.9. This measure also declined relative to last month's number. The CAD is the only currency that managed to appreciate against the USD this week, despite a rather pitiful performance for crude oil. This dynamics comforts in our tactical bullish stance on the loonie. In fact, this pair is our preferred vehicle to play the countertrend correction in the U.S. dollar. Meanwhile, on a cyclical basis we are positive on the Canadian dollar within the commodity complex. Not only do supply constraint within OPEC will help oil outperform base metals, but also, the BoC is the only central bank within this group that is currently lifting interest rates. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 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: The KOF leading indicator underperformed expectations, coming in at 101.1, and declining relatively to last month's reading. However, retail sales yearly growth surprised to the upside, coming in at 0.3%. Finally, the SVME Purchasing Manager's Index also surprised positively, coming in at 61.9, and increasing from last month's number. EUR/CHF has been relatively flat this week. On a long term basis, we are bullish on this cross, as inflationary pressures are still very weak in Switzerland. Therefore, the SNB will maintain its ultra-dovish stance, hurting the franc in the process. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 USD/NOK rallied vigorously this week. While the generalized dollar strength has been key culprit behind the depreciation of the NOK, the fall in oil prices only added fuel to the fire. Overall, we expect this cross to go up by the end of the year, as the interaction of Chinese and U.S. policy will likely push up the USD and weigh on commodities. That being said, the NOK will probably outperform within the commodity space, given that it is cheap and that supply cuts by OPEC should help oil prices on a relative basis. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden has been mixed: Retail sales yearly growth surprised to the downside, coming in at 0.2%, and declining substantially, from 3.1% last month. However, the annual growth rate of GDP outperformed expectations, coming in at very strong 3.3%. This measure stayed flat relative to the first quarter. Finally, Manufacturing PMI came in at 57.4, increasing from last month's number. USD/SEK still rallied this week as the SEK is particularly sensitive to the outlook for global growth. We are positive on the Swedish Krona on a long-term basis, as Sweden is the country in the G10 where monetary policy is most misaligned with economic fundamentals. Thus, if the Sweden continues to show strength, the Riksbank will eventually have to respond. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Dear Client, This week we are sending you two Special Reports. One report deals with the outlook for U.S. fiscal policy and government debt. It was written by Mark McClellan, Chief Strategist of the monthly Bank Credit Analyst, and was first published in the July edition of that publication. We are also sending a Special Report on the topic of global yield curves that was written by Chief Global Fixed Income Strategist Robert Robis. We trust you will find both reports very informative. Best regards, Ryan Swift Highlights Congress is conducting a major economic experiment that has never been attempted in the U.S. outside of wartime; substantial fiscal stimulus when the economy is already at full employment. The budget deficit is on track to surpass 6% of GDP in a few years. It would likely peak above 8% in the case of a recession. The alarming long-term U.S. fiscal outlook is well known, but it has just become far worse. The combination of rising life expectancy and a decline in the ratio of taxpayers to retirees will place growing financial strains on the Social Security and Medicare systems. The federal government will be spilling far more red ink over the next decade than during any economic expansion phase since the 1940s. The debt/GDP ratio could surpass the previous peak set during WWII within 12 years. Shockingly large budget deficits in the past have sparked some attempt in Congress to limit the damage. Unfortunately, there will be little appetite to tighten the fiscal purse strings for the next decade. Voters have shifted to the left and politicians are following along. Factors that explain the political shift include disappointing income growth, income inequality, and rising political clout for Millennials, Hispanics and the elderly. Fiscal conservatism is out of fashion and this is unlikely to change over the next decade, no matter which party is in power. This means that a market riot will be required to shake voters and the political establishment into making the tough decisions necessary. While the U.S. is not at imminent risk of a market riot over the deteriorating fiscal trends, there are costs: in the long-term, the dollar will be weaker, borrowing rates will be higher and living standards will be lower than otherwise would be the case. Feature Profligacy: (Noun) Unconstrained by convention or morality. Congress is conducting a major economic experiment that has never been attempted before in the U.S. outside of wartime; substantial fiscal stimulus at a time when the economy is already at full employment. Investors are celebrating the growth-positive aspects of the new fiscal tailwind at the moment, but it may wind up generating a party that is followed by a hangover as the Fed is forced to lean hard against the resulting inflationary pressures. Moreover, even in the absence of a recession, the federal government will likely be spilling far more red ink than during any economic expansion since the 1940s (Chart 1). What are the long-term implications of this macro experiment? Will the U.S. continue to easily fund large and sustained budget deficits? Chart 1U.S. Deficits Will Be Extremely Large For A Non-Recessionary Period U.S. Deficits Will Be Extremely Large For A Non-Recessionary Period U.S. Deficits Will Be Extremely Large For A Non-Recessionary Period Historically, shockingly large budget deficits sparked some attempt by Congress to limit the damage. Unfortunately, we argue in this Special Report that there will be little appetite to tighten the fiscal purse strings for the next decade. Voters have shifted to the left and politicians are following along. While the U.S. is not at imminent risk of a market riot over the deteriorating fiscal trends, the dollar will be weaker, borrowing rates will be higher and living standards will be lower than otherwise would be the case. On The Bright Side The Trump tax cuts, the immediate expensing of capital spending and a lighter regulatory touch have stirred animal spirits in the U.S. The Administration's trade policies are a source of concern, but CEO confidence is generally high. The NFIB survey highlights that small business owners are almost euphoric regarding the outlook. The IMF estimates that the tax cuts and less restrictive spending caps will provide a direct fiscal thrust of 0.8% in 2018 and 0.9% in 2019 (Chart 2). The overall impact on the economy over the next 12-18 months could be larger to the extent that business leaders follow through on their newfound bullishness and ramp up capital spending. Chart 2Lots Of Fiscal Stimulus In 2018 And 2019 U.S. Fiscal Policy: An Unprecedented Macro Experiment U.S. Fiscal Policy: An Unprecedented Macro Experiment Fiscal policy is a clear positive for stocks and other risk assets in the near term, as long as inflation is slow to respond. In addition to the near-term boost, there will be longer-term benefits from the 2017 tax act. Various provisions of the act affect the long-run productive potential of the U.S. economy, by promoting increases in investment and labor supply. Corporate tax cuts and the full expensing of business capital outlays should permanently increase the nation's capital stock relative to what it otherwise would be, leading to a slightly faster trend pace of productivity growth. Similarly, lower income taxes are projected to encourage more people to enter the workforce or to work longer hours. The CBO estimates that the tax act will boost the level of potential real GDP by 0.9% by the middle of the next decade. This may not sound like much, but it translates into almost a million extra jobs. The supply-side benefits of the 2017 tax act are therefore meaningful. Unfortunately, given the lack of offsetting spending cuts, it comes at the cost of a dramatically worse medium- and long-term outlook for government debt. The CBO estimates that the recent changes in fiscal policy will cumulatively add $1.7 trillion to the federal government's debt pile, relative to the previous baseline (Chart 3). The annual deficit is projected to surpass $1 trillion in 2020, and peak as a share of GDP at 5.4% in 2022. Federal government debt held by the private sector will rise from 76% this year to 96% in 2028 in this scenario. The budget situation begins to look better after 2020 in the CBO's baseline forecast because a raft of "temporary provisions" are assumed to sunset as per current law, including some of the personal tax cuts and deductions included in the 2017 tax package. As is usually the case, the vast majority of these provisions are likely to be extended. The CBO performed an alternative scenario in which it extends the temporary provisions and grows the spending caps at the rate of inflation after 2020. In this more realistic scenario, the deficit reaches 7% of GDP by 2028 and the federal debt-to-GDP ratio hits 105% (Chart 3). Chart 3Comparing To The Reagan Era Comparing To The Reagan Era Comparing To The Reagan Era Moreover, there will undoubtedly be a recession sometime in the next five years. Even a mild downturn, on par with the early 1990s, could inflate the budget deficit to 8% or more of GDP. The Demographic Time Bomb The pressure that the aging population will place on federal coffers over the medium term is well known, but it is worth reviewing in light of Washington's new attitude toward deficit financing. The combination of rising life expectancy and a decline in the ratio of taxpayers to retirees will place growing financial strains on the Social Security and Medicare systems. In 1970, there were 5.4 people between the ages of 20 and 64 for every person 65 or older. That ratio has since dropped to 4 and will be down to 2.6 within the next 20 years (Chart 4). Spending on entitlements (Social Security, Medicare, Medicaid, Income Security and government pensions) is on an unsustainable trajectory (Charts 5 and 6). In fiscal 2017, these programs absorbed 76% of federal revenues and the CBO estimates that this will rise to almost 100% by 2028, absent any change in law. If we also include net interest costs, total mandatory spending1 is projected to exceed total federal government revenues as early as next year, meaning that deficit financing will be required for all discretionary spending. Chart 4The Withering ##br##Support Ratio The Withering Support Ratio The Withering Support Ratio Chart 5Entitlements Will Explode ##br##Mandatory Spending Entitlements Will Explode Mandatory Spending Entitlements Will Explode Mandatory Spending Chart 6All Discretionary Spending ##br## To Be Deficit Financed? All Discretionary Spending To Be Deficit Financed? All Discretionary Spending To Be Deficit Financed? The CBO last published a multi-decade outlook in 2017 (Chart 7). The Federal debt/GDP ratio was projected to reach 150% by 2047. If we adjust this for the new (higher) starting point in 2028 provided by the CBO's alternative scenario, the debt/GDP ratio would top 164% in 2047. Chart 7An Unsustainable Debt Accumulation An Unsustainable Debt Accumulation An Unsustainable Debt Accumulation To put this into perspective, the demands of WWII swelled the federal debt/GDP ratio to 106% in 1946, the highest on record going back to the early 1700s (Chart 8). The debt ratio could rocket past that level before 2030, even in the absence of a recession. Chart 8U.S. Debt In Historical Context U.S. Debt In Historical Context U.S. Debt In Historical Context These extremely long-term projections are only meant to be suggestive. A lot of things can happen in the coming years that could make the trajectory better or even worse. But the point is that current levels of taxation are insufficient to fund entitlements in their current form in the long run. Chart 9 shows that outlays as a share of GDP have persistently exceeded revenues since the mid-1970s, except for a brief period during the Clinton Administration. The gap is set to widen over the coming decade. Something will have to give. Chart 9U.S. Outlays And Revenues U.S. Outlays And Revenues U.S. Outlays And Revenues Forget Starving The Beast "Starve the Beast" refers to the idea that the size of government can be restrained through a low-tax regime that spurs growth and pressures Congress to cut spending and control the budget deficit. It has been the mantra of Republicans since the Reagan era. The 1981 Reagan tax cuts included an across-the-board reduction in marginal tax rates, taking the top rate down from 70% to 50%. Corporate taxes were slashed by $150 billion over a 5-year period and tax rates were indexed for inflation, among other changes. It was not surprising that the budget deficit subsequently ballooned. Outrage grew among fiscal conservatives, but Congress spent the next few years passing laws to reverse the loss of revenues, rather than aggressively attacking the spending side. Today, Congressional fiscal hawks are in retreat and the Republican Party under President Donald Trump is not as fiscally conservative as it once was. This trend reflects the pull toward the center of the economic policy spectrum in response to a shift to the left among voters. BCA's political strategists have highlighted that this is the "median voter theory" (MVT) in action.2 The MVT posits that parties and politicians will approximate the policy choices of the median voter in order to win an election or stay in power. Every U.S. presidential election involves candidates making a mad dash to the most popularly appealing positions. President Trump exhibited this process when he ran in the Republican primary on a platform of increased infrastructure spending and zero cuts to "entitlement" spending. The Great Financial Crisis, disappointingly slow growth, stagnating middle class incomes and the widening income distribution have resulted in a leftward shift among voters on economic issues. Adding to the shift is the rising political clout of the Millennial generation, which generally favors more government involvement in the economy and will become the major voting block as it ages in the 2020s. There also are important changes underway in the ethnic composition of the electorate. The rising proportion of Hispanic voters will on balance favor the Democrats, according to voting trends (Chart 10). A previous Special Report by Peter Berezin, BCA's Chief Global Strategist, predicted that Texas will become a swing state in as little as a decade and a solid Democrat state by 2030.3 Chart 10The Proportion Of Minority Voters Set To Grow The Proportion Of Minority Voters Set To Grow The Proportion Of Minority Voters Set To Grow President Trump's shift to the left on economic policy helped him to out-flank Clinton in the election, particularly in the Rust Belt, where his protectionist and anti-austerity message resonated. Even his anti-immigration appeal is mostly based on economic reasoning - i.e. jobs, rather than cultural factors. Trump has admitted that he is not all that concerned about taking the country deeper into hock. The Republican rank-and-file has generally gone along with Trump's agenda because he has delivered traditional Republican tax cuts and continues to rate highly among his supporters (his approval is around 90% among Republicans). Fiscal hawks within the GOP have been forced to the sidelines while Trump and moderate Republicans have passed bipartisan spending increases with Democratic assistance. Where's The Outrage? The implication is that, unlike the Reagan years, we do not expect there will be a strong political force capable of leading a fight against budget deficits. After a decade of disappointing income growth, voters are in no mood for tax hikes. On the spending side, health care and pensions are still politically untouchable. A recent study by the Pew Research Center confirms that only a very small percentage of Americans of either political stripe would agree with cuts to spending on education, Medicare, Social Security, defense, infrastructure, veterans or anti-terrorism efforts (Chart 11). It is therefore no surprise that a populist such as Trump has promised to defend entitlement programs. Moreover, the graying of America will make it increasingly difficult for politicians to tame the entitlement beast. An aging population might generally favor the GOP, but it will also solidify opposition towards cutting Medicare and Social Security. As for defense, U.S. military spending was 3.3% of GDP and almost 15% of total spending in 2017 (Chart 12). Congress recently lifted the spending cap for defense expenditures, but it is still projected to fall as a share of total government spending and GDP in the coming years. It is conceivable that Congress could eventually trim the defense budget even faster, but spending is already low by historical standards and it is hard to see any future Congress gutting the military at a time when the global challenge from China and Russia is rising. Indeed, given the geopolitical atmosphere of great power competition, defense spending is more likely to rise. Chart 11Entitlements Are Popular* U.S. Fiscal Policy: An Unprecedented Macro Experiment U.S. Fiscal Policy: An Unprecedented Macro Experiment Chart 12What's Left To Cut? What's Left To Cut? What's Left To Cut? So, what is left to cut? If entitlements and defense are off the table, that leaves non-defense discretionary spending as the sacrificial lamb. This category includes spending by the Departments of Agriculture, Education, Energy, Homeland Security, Health and Human Services, Justice, State and Veteran Affairs. Such spending has already declined sharply during the past several decades (Chart 12). Non-defense discretionary spending amounted to $610 billion in 2017, which is only 15.3% of total federal spending. To put this into perspective, cutting every last cent of non-defense discretionary spending by 2022 would still leave a budget deficit of about 2½% of GDP. And it would be political suicide. The Departments of Education, Health and Human Services, Homeland Security, Justice and Veterans Affairs account for more than half of non-defense discretionary spending. But these programs are very popular among voters. And, at only 1.3% of total spending, eliminating all foreign aid won't make much difference. Either President Trump or Vice-President Mike Pence will be the GOP presidential candidate in 2020. Pence could be more fiscally conservative than Trump, but Congress is unlikely to remain GOP-controlled through 2024. Similarly, it is difficult to see the Democrats making more than a token effort to rein in the deficit if the party is in charge after 2020. Perhaps they will raise taxes on the rich and push the corporate rate back up a bit, but voters will probably not favor a full reversal of the Trump tax cuts. Democrats will not tackle entitlements either. In other words, we can forget about "starving the beast" as a viable option no matter which party is in power. There will be little appetite for fiscal austerity in the U.S. through to the mid-2020s at a minimum. International Comparison This all places the U.S. out of sync with other major industrialized countries, where structural budget deficits have been tamed in most cases and are expected to remain so according to the IMF's latest projections (Chart 13). The U.S. cyclically-adjusted budget deficit is projected to be almost 7% of GDP in 2019, by far the highest among other industrialized countries except for Norway. Spain and Italy are expected to have relatively small structural deficits of 2½% and 0.8%, respectively, next year. Greece is running a small structural surplus! Including all levels of government, the IMF estimates that the U.S. general government gross debt/GDP ratio is projected to be well above that of the U.K., France, Germany, Spain and Portugal in 2023 (Chart 14). It is expected to be on par with Italy at that time, although the newly-installed populist government there is likely to negotiate a loosening of the fiscal rules with Brussels, leading to higher debt levels than the IMF currently expects. Chart 13U.S. Budget Deficit Stands Out U.S. Fiscal Policy: An Unprecedented Macro Experiment U.S. Fiscal Policy: An Unprecedented Macro Experiment Chart 14International Debt Comparison U.S. Fiscal Policy: An Unprecedented Macro Experiment U.S. Fiscal Policy: An Unprecedented Macro Experiment The implication is that the U.S. government appears destined to become one of the most indebted in the developed world. The Fiscal Tipping Point Investors are not yet worried about the path of U.S. fiscal policy; the yield curve is quite flat, CDS spreads on U.S. Treasurys have not moved and the dollar is still overvalued by most traditional measures. The challenge is timing when a fiscally-induced crisis might occur. A warning bell does not ring when government debt or deficits reach certain levels. Fiscal trends generally do not suddenly spiral out of control - it is a gradual and insidious process reflected in multi-year deficits and slowly accumulating debt burdens. Eventually, a tipping point is reached where the only solution is drastic policy shifts or in extreme cases, default. Along the way, there are a number of signs that fiscal trends are entering dangerous territory. The relevance of the various signs will be different for each country, reflecting, among other things, the depth and structure of the financial system, the soundness of the economy, the dependence on foreign capital, and the asset preferences of domestic investors. Some key signs of building fiscal stress are given in Box 1. None of the factors in Box 1 appear to be a threat at the moment for the U.S. Moreover, comparisons with other countries that have hit the debt wall in the past are not that helpful because the U.S. is a special case. It has a huge economy and has political and military clout. The dollar is the world's main reserve currency and the country is able to borrow in its own currency. This suggests that the U.S. will be able to "get away with" its borrowing habit for longer than other countries have in the past. At the same time, financial markets are fickle and, even with hindsight, it not always clear why investors switch from acceptance to bearishness about a particular state of affairs. Box 1: Traditional Signs Of An Approaching Debt Crisis Government deficits absorb a rising share of net private savings, leaving little for new investment. Interest payments account for an increasingly large share of government revenues, squeezing out discretionary spending and requiring tough budget action merely to stop the deficit from rising. The government exhausts its ability to raise tax burdens. Traditional sources of debt finance dry up, requiring alternative funding strategies. Fears of inflation and/or default lead to a rising risk premium on interest rates and/ or a falling exchange rate. Political shifts occur as governments get blamed for eroding living standards, high taxes, and continued pressure to cut spending. The Costs Of Fiscal Profligacy Even if the U.S. is not near a fiscal tipping point, this does not mean that massive debt accumulation is costless: Interest Costs: Spending 3% of GDP on servicing the federal government's debt load over the next decade is not a disaster. Nonetheless, it does reduce the tax dollars available to fund entitlements or investing in infrastructure. Counter-Cyclical Fiscal Policy: Lawmakers would have less flexibility to use tax and spending policies to respond to unexpected events, such as natural disasters or recessions. As noted above, a recession in 2020 could generate a federal deficit of more than 8% of GDP. In that case, Congress may feel constrained in supporting the economy with even temporary fiscal stimulus. National Savings: Because government borrowing reduces national savings, then either capital spending must assume a smaller share of the economy or the U.S. must borrow more from abroad. Most likely it will be some combination of both. Crowding Out: If global savings are not in plentiful supply, then the additional U.S. debt issuance will place upward pressure on domestic interest rates and thereby "crowd out" business capital spending. This would reduce the nation's capital stock, leading to lower growth in productivity and living standards than would otherwise be the case. The CBO estimates that the positive impact on the capital stock from the changes to the corporate tax structure will overwhelm the negative impact from higher interest rates over the next decade. Nonetheless, the crowding out effect may dominate over a longer-time horizon. Academic studies suggest that every percentage point rise in the government's debt-to-GDP ratio adds 2-3 basis points to the equilibrium level of bond yields. If this is correct, then a rise in the U.S. ratio of 25 percentage points over the next decade in the CBO's baseline would lift equilibrium long-term bond yields by a meaningful 50-75 basis points. Much depends, however, on global savings backdrop at the time. External Trade Gap: If global savings are plentiful, then it may not take much of a rise in U.S. interest rates to attract the necessary foreign inflows to fund both the higher U.S. federal deficit and the private sector's borrowing requirements. Of course, this implies a larger current account deficit and a faster accumulation of foreign IOUs. Twin Deficits The U.S. has run a current account deficit for most of the past 40 years, which has cumulated into a rising stock of foreign-owned debt. The Net International Investment Position (NIIP) is the difference between the stock of foreign assets held by U.S. residents and the stock of U.S. assets held by foreign investors. The NIIP has fallen increasingly into the red over the past few decades, reaching 40% of GDP today (Chart 15). The current account deficit was 2.4% at the end of 2017, matching the post-Lehman average. Nonetheless, this deficit is set to worsen as increased domestic demand related to the fiscal stimulus is partly satisfied via higher imports. Chart 15Scenarios For The U.S. Net International Investment Position Scenarios For The U.S. Net International Investment Position Scenarios For The U.S. Net International Investment Position We estimate that a two percentage point rise in the budget deficit relative to the baseline could add a percentage point or more to the current account deficit, taking it up close to 4% of GDP. Upward pressure on the external deficit will also be accentuated in the next few years to the extent that the U.S. business sector ramps up capital spending. Chart 16Structural Drivers Of the U.S. Dollar Structural Drivers Of the U.S. Dollar Structural Drivers Of the U.S. Dollar The implication is that the NIIP will fall deeper into negative territory at an even faster pace. A 2% current account deficit would be roughly consistent with stabilization in the NIIP/GDP ratio. But a 4% deficit would cause the NIIP to deteriorate to almost 80% of GDP by 2040 (Chart 15). The sustainability of the U.S. twin deficits has been an area of intense debate among academics and market practitioners for many years. The U.S. has been able to get away with the twin deficits for so long in part because of the dollar's status as the world's premier reserve currency. The critical role of the dollar in international transactions underpins global demand for the currency. This has allowed the U.S. to issue most of its debt obligations in U.S. dollars, forcing the currency risk onto foreign investors. The worry is that foreign investors will at some point begin to question the desirability of an oversized exposure to U.S. assets within their global portfolios. We argued in our April 2018 Special Report 4 that the U.S. situation is not that dire that the U.S. dollar and Treasury bond prices are about to fall off a cliff because of sudden concerns about the unsustainability of the current account deficit. Even though the NIIP/GDP ratio will continue to deteriorate in the coming years, it does not appear that the U.S. is close to the point where foreign investors would begin to seriously question America's ability or willingness to service its debt. That said, the "twin deficits" and the downward trend in U.S. productivity relative to the rest of the world will ensure that the underlying long-term trend in the dollar will remain down (Chart 16).5 Conclusions The long-term U.S. fiscal outlook was dire even before the Great Recession and the associated shift to the political left in America. Fiscal conservatism is out of fashion and this is unlikely to change before the mid-2020s, no matter which party is in power. This means that a market riot will be required to shake voters and the political establishment into making the tough decisions. Given demographic trends, it appears more likely that taxes will rise than entitlements cut. We do not foresee a crisis occurring in the next few years. Nonetheless, arguing that the U.S. fiscal situation is sustainable for the foreseeable future does not mean that it is desirable. There will be costs associated with current fiscal trends, even on a relatively short 5-10 year horizon. Interest costs will mushroom, potentially crowding out government spending in other areas. U.S. government debt has already been downgraded by S&P to AA+ in 2013, and the other two main rating agencies are likely to follow suit during the next recession as the deficit balloons to 8% or more. Investors may begin to demand a risk premium in order to entice them to continually raise their exposure to U.S. government bonds in their portfolios. Taxes will eventually have to rise to service the government debt, and some capital spending will be crowded out, both of which will undermine the economy's growth potential. Finally, the dollar will also be weaker than it otherwise would be in the long-term, representing an erosion in America's standard of living because everything imported is more expensive. Could Japan offer a roadmap for the U.S.? The Bank of Japan has effectively monetized 43% of the JGB market and has control over yields, at least out to the 10-year maturity. Moreover, Japan has enjoyed a "free lunch" so far because monetization has not resulted in inflation. The reason that Japan has enjoyed a free lunch is that it has suffered from a chronic lack of demand and excess savings in the private sector. The government has persistently run a deficit and fiscally stimulated the economy in order to offset insufficient demand in the private sector. The Bank of Japan purchased bonds and drove short-term interest rates down to zero. These policies have made very slow progress in eradicating lingering deflationary economic forces. However, if animal spirits in the business sector perk up, then inflation could make a comeback unless the policy stimulus is dialed down in a timely manner. In other words, the BoJ-financed fiscal "free lunch" should disappear at some point. The U.S. is in a very different situation. There is no lack of aggregate demand or excessive savings in the private sector. The economy is at full employment, and thus persistent budget deficits should turn into inflation much more quickly than was the case in Japan. In other words, the U.S. is unlikely to enjoy much of a "free lunch", whether the Fed monetizes the debt or not. Mark McClellan Senior Vice President The Bank Credit Analyst 1 Mandatory spending refers to entitlements; that is, government expenditure programs that are required by current law. These include Social Security, Medicare, Medicaid, government pensions and other smaller programs. 2 Please see Geopolitical Strategy Monthly Report, "Introducing The Median Voter Theory," June 8, 2016, available at gps.bcaresearch.com 3 Please see The Bank Credit Analyst, "America's Fiscal Fortune: Leave Your Wallet On The Way Out," June 2011, available at bca.bcaresearch.com 4 Please see The Bank Credit Analyst Special Report, "U.S. Twin Deficits: Is The Dollar Doomed?," April, 2018, available at bca.bcaresearch.com 5 In the near term, fiscal stimulus and increased business capital spending will likely boost the dollar. But this effect on the dollar will reverse in the long-term.

Highlights Without swift and considerable fiscal austerity or aggressive privatization, Brazil's public debt situation will become uncontrollable. Brazilian voters' priorities and preferences are for more public spending, not fiscal austerity. Hence, the upcoming president will not have a mandate to pursue fiscal austerity. The sole politically viable solution to stabilize Brazil's public debt situation is to boost nominal GDP growth - something that can only be achieved by sacrificing the exchange rate. The real is set to depreciate considerably. Provided the currency is key to the performance of Brazilian asset prices, the latter will remain in a bear market. Stay put/underweight on Brazilian risk assets. Feature Brazil is approaching a major showdown between creditors and the government. The country's public debt burden is out of control and unsustainable, unless immediate and drastic actions on the fiscal front are undertaken. At the same time, the economy has barely recovered after an extended period of depression, and the general population does not have the appetite for fiscal austerity. Crucially, the nation is heading into presidential and general elections in October. Whoever is elected, the new president will struggle to stabilize public debt dynamics amid a weak economy and the public's intolerance for fiscal tightening. On the surface, the plunge in Brazilian financial markets in recent months could well be attributed to the truckers' strike following the liberalization of fuel prices. The authorities hiked fuel prices because the deteriorating budget situation forced them to discontinue subsiding it. However, the strike was a symptom of a much deeper problem: the government's debt dynamics are degenerating, while the population and businesses have grown tired of the prolonged depression - and are deeply opposed to any kind of fiscal austerity. The sole macro solution to this debt problem is to boost nominal growth. This can be achieved via much lower real interest rates and/or a major currency devaluation. The latter will be detrimental to foreign investors holding Brazilian assets. Fiscal Austerity Is Required... Chart I-1Nominal Growth (A Proxy For Revenue) Is Lower Than Borrowing Costs Nominal Growth (A Proxy For Revenue) Is Lower Than Borrowing Costs Nominal Growth (A Proxy For Revenue) Is Lower Than Borrowing Costs Brazil continues to head towards a fiscal debacle. Not only does the government's fiscal position remain untenable, but nominal GDP growth has also relapsed to its 2015 lows (Chart I-1). The lack of nominal growth is depressing government revenues. Importantly, the widened gap between nominal GDP growth that currently stands at 4% and local currency borrowing rates of 10% is not sustainable (Chart I-1). Barring swift and substantial fiscal tightening, weak economic growth and high borrowing costs will ensure that the public debt-to-GDP ratio continues to rise into the foreseeable future. A rising debt-to-GDP ratio without clear government policies and actions to tackle indebtedness will feed into a higher risk premium in the exchange rate as well as government borrowing costs. Hence, a vicious cycle will likely unravel: escalating public debt will exert upward pressure on the government's borrowing costs, rising interest rate payments on public debt will keep the fiscal deficit wide and, consequently, the debt-to-GDP ratio will continue to escalate. Table 1 presents three scenarios for Brazil's public debt trajectory. In our base case scenario, the gross debt-to-GDP ratio1 reaches 82% by the end of 2019. In fact, even under the optimistic scenario, the gross public debt-to-to GDP ratio will continue to rise and end up at 80%. Table 1Brazil: Public Debt Sustainability Test Brazil: Faceoff Time Brazil: Faceoff Time Chart I-2High Debt Is Not A Problem In The U.S. High Debt Is Not A Problem In The U.S. High Debt Is Not A Problem In The U.S. A public debt burden above 80% of GDP would not be alarming if interest rates on that debt were not in the double digits. For example, the U.S.'s public debt burden of 100% of GDP is not a problem because interest rates are low, in fact well below nominal GDP growth (Chart I-2). To stabilize the public debt dynamics, the Brazilian government must run primary fiscal surpluses. In the late 1990s and early 2000s, Brazil escaped a public debt trap because the government tightened fiscal policy considerably. They adopted Fiscal Responsibility Law in 2000, whereby the authorities were required by law to keep government expenditures limited to 50% of net revenues for that year. In turn, this allowed governments to run comfortable primary fiscal surpluses of 3% and above (Chart I-3). As shown on this chart, Brazil ran primary surpluses of 3-4% from 2001 through to 2012. Presently, the primary fiscal balance stands at -1.5% of GDP (Chart I-3, bottom panel). To stabilize the public debt dynamics, the government must undertake fiscal tightening of about 3% of GDP within the next 12-24 months to bring the primary surplus to around 1.5% of GDP. However, such fiscal tightening at a time when the economy is still very weak will push it back into recession. More importantly such fiscal tightening is politically unfeasible, as discussed below. Brazil's Achilles heel has been and remains social security finances. The social security deficit at the moment amounts to 3% of GDP (Chart I-4). According to IMF projections,2 social security expenditures will rise to 15% of GDP by 2021, bringing the total social security deficit to 12% of GDP under the current system. Chart I-3Brazilian Public Debt Dynamics Are Unsustainable Brazilian Public Debt Dynamics Are Unsustainable Brazilian Public Debt Dynamics Are Unsustainable Chart I-4Brazil's Social Security Deficit Brazil's Social Security Deficit Brazil's Social Security Deficit Crucially, Brazil is facing demographic headwinds that are contributing to the ballooning social security deficit. In particular, a rapidly aging population and rising life expectancy are all expected to drag government finances lower in the coming decades (Chart I-5). The social security deficit has increased in recent years to 40% of the overall deficit. Chart I-5Deteriorating Demographics Deteriorating Demographics Deteriorating Demographics Major and front-loaded cuts in social security expenditures are vital to stabilize government finances and debt dynamics. However, there is little support among the population and Congress for such austerity measures (we discuss this in more detail in the next section). Aggressive privatization could be a one-off short-term solution if the proceeds are used to reduce public debt. This could avert a vicious cycle of rising risk premiums, higher interest rates and larger debt burdens, at least for a while. However, the recent case of the privatization of Eletrobras shows that the process has been much slower than expected. Moreover, the total estimated sale price of Eletrobras will only produce BRL 12 billion. This compares with a BRL 104 billion annual primary deficit. Further, a sale of the Brazilian government's ownership of oil giant Petrobras would bring in an estimated BRL 90-95 billion, or 1.6% of GDP (this assumes a sale of a 64% stake in common shares, including government, BDNES and Caixa shares). This is still less than the annual primary deficit of BRL 104 billion (1.5% of GDP). Consequently, even aggressive privatization will not be sufficient to reduce debt or improve the nation's fiscal position on a sustainable basis. Further, aggressive privatization is not politically feasible as it lacks public support, and Congressional approvals on this matter will be a challenge. Bottom Line: The public debt burden is surging and fiscal dynamics remain unsustainable. Without swift and considerable fiscal austerity or aggressive privatization, Brazil's public debt situation will become uncontrollable. ...But Is Politically Unfeasible The prospects for fiscal reforms and improved public debt sustainability are dependent on the upcoming presidential elections. As October's vote approaches, social security and privatization reforms will be key determinants of the path of Brazil's risk premium for the foreseeable future. The presidential elections are scheduled for October 7 and 28 (a second round will be held if no candidate achieves an absolute majority of the vote). Uncertainty is unusually high. Yet investors need to understand the constraints that underpin the current presidential race. First, Brazilian voters' priorities and preferences are for more public spending, not fiscal austerity. According to polls conducted by Confederacao Nacional da Industria (CNI), the top five priorities of respondents are to improve health and education, and raise wages (Chart I-6). By contrast, only 3% of respondents believe that pension reform (cutting spending) should be a top government priority. Chart 6Brazil's Population Is Not Open To Fiscal Austerity Brazil: Faceoff Time Brazil: Faceoff Time This polling confirms our thesis that the median voter in Brazil remains firmly on the left of the economic policy spectrum.3 The combined support for left-leaning candidates Lula, Marina Silva and Ciro Gomes remains close to 50% (Table 2). Table 2The Left Is Ahead Brazil: Faceoff Time Brazil: Faceoff Time On the whole, fiscal austerity and privatization, as proposed by centrist and right-leaning candidates, will garner little support from the electorate. Second, Brazil's Congress is one the most fractious in the world. With over 20 political parties in Congress, the key to passing critical reforms is contingent on the ability of the president to form, maintain and reward a coalition that can muster majority votes in Congress. Crucially, reforms requiring constitutional amendments, such as the pension system, would need a supermajority of 308 out of 513 seats in the Chamber of Deputies, or 60% of congressmen. As the recent experience of acting president Temer shows, this will be difficult. Temer was an experienced political operator and the head of the largest party in Congress, yet even he failed to gain sufficient support to pass social security reforms, even when they were watered down and their costs back-loaded. There are low odds that any of the existing presidential candidates - all of whom have single-digit or low double-digit support rates - will be able to get enough votes to adopt meaningful social security reforms. True, the right-wing candidate, Jair Bolsonaro, has proposed aggressive privatization and spending cuts to rein in the public debt. Ultimately, only policies of this kind can reduce spending, correct the debt trajectory, stabilize the foreign exchange rate, and enable the country to avoid a vicious cycle of escalating risk premiums in financial markets. That, in turn, would give the economy some breathing room -- a buying opportunity in financial markets might emerge. However, Jair Bolsonaro faces an uphill battle in the presidential election given that the median voter is on the left. Even if elected, he is unlikely to garner support for privatization and austerity in a fractionalised Congress. Bottom Line: Brazilian voters' priorities and preferences are for more public spending, not fiscal austerity. Hence, the upcoming president will not have a mandate to pursue fiscal austerity. Monetary Policy And The Exchange Rate Given fiscal austerity is politically unviable, the other option to stabilize the debt-to-GDP ratio is to boost nominal GDP. Yet the nominal GDP growth rate has relapsed to 2015 lows (refer to Chart I-1 above). Even though real GDP is slowly recovering, inflation has plunged, depressing nominal growth (Chart I-7). As a result, real rates in Brazil remain very high (Chart I-7, bottom panel). This in turn has curbed the economic recovery. Low income growth and high real rates are not only impairing public sector creditworthiness, but they are also hurting the private sector's ability to service its debt. Consistently, weaker nominal GDP growth points to a renewed rise in NPLs and NPL provisions at banks (shown inverted in the chart) (Chart I-8). Chart I-7Real Rates Are Still Punishingly High In Brazil Real Rates Are Still Punishingly High In Brazil Real Rates Are Still Punishingly High In Brazil Chart I-8Banks' Bad Loans And Provisions Are Set To Rise Banks' Bad Loans And Provisions Are Set To Rise Banks' Bad Loans And Provisions Are Set To Rise Monetary policy in Brazil is constrained by exchange rate movements. With the exchange rate currently under selling pressure, the central bank is unlikely to reduce interest rates for now. The next government will have no option but to force the central bank to reduce nominal and real interest rates in an attempt to both boost nominal growth and decrease public debt servicing costs. The victim of this policy will be the currency: the Brazilian real will plunge. The good news for the government is that 96% of its debt is in local currency. Hence, sizable currency depreciation will not have much of an effect on the public debt burden. Table 3External Debt As Of Q4 2017 Brazil: Faceoff Time Brazil: Faceoff Time That said, companies and banks have high levels of external debt (Table 3), and they will suffer at the hands of significant currency depreciation. However, this is the most politically viable and economically feasible way to avoid a public debt fiasco. If the government's pressure on the central bank to reduce interest rates leads to a riot in financial markets and borrowing costs on government debt rise, the government may put pressure on the central bank and state-owned commercial banks to monetize public debt - i.e., purchase government bonds to bring bond yields down. In short, Brazil could institute quantitative easing to reduce and cap government bond yields. The U.S., the UK, Japan, the euro area and Sweden have all done this, and the new government in Brazil may also opt for such a solution. It might either be done in a transparent way, as central banks in the developed economies did, or it might be done in a disguised manner. Chart I-9Divergence Between Central Bank Reserves & The Real Divergence Between Central Bank Reserves & The Real Divergence Between Central Bank Reserves & The Real Interestingly, there are some indications the central bank is trying to err on the side of easier money, despite the latest currency depreciation. Specifically, it has in recent months been injecting more liquidity into the banking system, despite the sharp selloff in the real, as illustrated in Chart I-9. This constitutes a departure from past policy reactions to selloffs in the real, and in a way is a form of disguised easing. The central bank's recent liquidity additions have prevented interbank rates - and hence the entire structure of interest rates - from increasing more than they otherwise would have. In short, the upcoming government might resort to open or disguised public debt monetization to prevent a fiscal debacle. Needless to say, the Brazilian real will plummet in such a scenario. Bottom Line: The sole politically viable solution to stabilize Brazil's public debt situation is to boost nominal GDP growth - something that can only be achieved by sacrificing the exchange rate. Financial Markets The currency is the key to the performance of Brazilian asset prices. The real will depreciate much further. In addition to the above factors, the following will continue to weigh on the currency: Export growth is decelerating (Chart I-10), and this trend is likely to persist as China's growth slows further and commodities prices drop. The currency is not yet very cheap, according to the real effective exchange rate based on consumer and producer prices (Chart I-11). Chart I-10Brazilian Export Growth Is Decelerating Brazilian Export Growth Is Decelerating Brazilian Export Growth Is Decelerating Chart I-11The Real Is Not Cheap The Real Is Not Cheap The Real Is Not Cheap Foreign debt obligations - external debt servicing over the next 12 months - are elevated both in dollars and from a historical perspective relative to exports (Chart I-12). Not surprisingly, demand for dollars is very strong, as evidenced by rising U.S. dollar funding rates (Chart I-13 ). Finally, even though interest rate differentials over the U.S. have never been a key driving force behind the real, they are currently at a record low (Chart I-14). Chart I-12Foreign Private Sector Debt Is High Foreign Private Sector Debt Is High Foreign Private Sector Debt Is High Chart I-13Demand For U.S. Dollars Is Strong Demand For U.S. Dollars Is Strong Demand For U.S. Dollars Is Strong Chart I-14Brazilian Interest Rate Differentials: At A Historical Low Brazilian Interest Rate Differentials: At A Historical Low Brazilian Interest Rate Differentials: At A Historical Low Chart I-15Brazil: Weak Trade Balance Is Negative For Equities Brazil: Weak Trade Balance Is Negative For Equities Brazil: Weak Trade Balance Is Negative For Equities With respect to equities, Brazilian share prices perform poorly when the current account and trade balances are deteriorating (Chart I-15). Falling commodities prices are negative for resource companies. Finally, the stock market's long-term technical profile seems to suggest that a major top has been reached in share prices in U.S. dollar terms and the path of least resistance is down (Chart I-16). Chart I-16Brazilian Stocks In U.S. Dollars Brazilian Stocks In U.S. Dollars Brazilian Stocks In U.S. Dollars Investment Conclusions We remain negative on Brazil's financial markets. Further depreciation in the currency will continue, and will cause a selloff in equities, local bonds and sovereign and corporate credit markets. Dedicated EM portfolios should continue to underweight Brazil in equity and fixed-income portfolios. We continue recommending a long position in the nation's sovereign CDSs. The BRL is among our favoured currency shorts - we are maintaining both our short BRL/long USD and our short BRL/long MXN positions. Among equity sectors, we are reiterating our short position in bank stocks. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthur@bcaresearch.com Andrija Vesic, Research Analyst AndrijaV@bcaresearch.com 1 In our simulations, we used gross government debt, which is calculated as total government public debt excluding central bank holdings of government securities. Gross public debt-to-GDP ratio is now at 74%. Under the older methodology, which included accounting for government debt held by the central bank, the public debt-to-GDP ratio would have been 85%. 2 Cuevas et al. IMF Working Paper; Fiscal Challenges of Population Aging in Brazil, March 2017 3 Pease see Emerging Markets Strategy Special Report "Brazil's Election: Separating Signal From The Noise", dated September 10, 2014, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

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

Highlights Subdued long-term inflation expectations and central bank bond purchases have suppressed the term premium. This is set to change, as quantitative easing turns into quantitative tightening and shrinking output gaps around the world start to push up inflation. The neutral rate in the U.S. is likely higher than the Federal Reserve realizes, which could leave the Fed behind the curve in normalizing monetary policy. A spike in the term premium is unlikely this year, given the prospect of a stronger dollar and ongoing stresses in emerging markets. Next year may be a different story, however. Fixed-income investors with a 12-to-18 month horizon should maintain duration risk at below-benchmark levels. Asset allocators should keep equity and credit exposure at neutral. Within the equity space, investors should favor developed market equities over their EM peers and defensive sectors over cyclicals. Feature The Mystery Of The Falling Term Premium The yield on a bond can be decomposed into the expected path of short-term rates and a term premium. Historically, the term premium has been positive, meaning that investors could expect to earn a higher return by purchasing a bond rather than by rolling over a short-term bill.1 More recently, the term premium has turned negative in many economies (Chart 1). Not only are investors willing to forego the extra return for taking on duration risk, but they are actually willing to sacrifice return when buying long-term bonds. Chart 1Term Premia Across Developed Markets Are Low Term Premia Across Developed Markets Are Low Term Premia Across Developed Markets Are Low There are two main reasons why the term premium has fallen: Long-term inflation expectations have been very subdued, which has made bonds a hedge against bad economic outcomes. Central bank purchases have depressed yields, while forward guidance has dampened interest-rate volatility. Bonds And Risk Some commentators like to describe the riskiness of a security by how volatile its price is, or if they want to get a bit more sophisticated, the skew of its returns. But this is not really the right way to think about risk. As Harry Markowitz first discussed in 1952 in his seminal paper "Portfolio Selection," investors ultimately care about their overall level of wealth. If the price of a certain security goes up when the prices of all others go down, investors should prefer to hold this particular security even if it offers a subpar expected return. Bonds today play the role of this safe security. Chart 2 shows the rolling correlation between monthly changes in the 10-year Treasury bond yield and the S&P 500. The correlation was generally negative between the late-1960s and late-1990s: Bond yields back then tended to rise whenever the S&P 500 was falling. This made bonds a bad hedge against lower equity prices. Chart 2Bond Yields Now Tend To Rise When Equity Prices Go Up Bond Yields Now Tend To Rise When Equity Prices Go Up Bond Yields Now Tend To Rise When Equity Prices Go Up Over the past two decades, however, bond yields have generally declined whenever the stock market has swooned. Since a lower bond yield implies a higher bond price, bonds have been a good hedge against equity risk in particular, and a weaker economy in general. As a consequence, investors are now willing to pay a premium to hold long-term bonds. This has bid up the price of bonds, so much so that the term premium has dipped into negative territory. Receding Inflation Fears Have Made Bonds Safer Why did the correlation between bond yields and stock market returns change? The answer has a lot to do with what happened to inflation. Bond yields can go up because of expectations of stronger growth or because of the anticipation of higher inflation. The former is good for equities, while the latter is typically bad for equities because it heralds additional monetary tightening. As inflation expectations became increasingly unhinged in the second half of the 1960s, inflationary shocks became the dominant driver of bond yields. When bond yields went up during that period, stock prices usually fell. That changed in the 1990s, as inflation stabilized at low levels and growth became the primary driver of yields once again (Chart 3). Chart 3Long-Term Inflation Expectations Have ##br##Remained Subdued For Over Two Decades Long-Term Inflation Expectations Have Remained Subdued For Over Two Decades Long-Term Inflation Expectations Have Remained Subdued For Over Two Decades Following the financial crisis, inflationary concerns were supplanted by worries about deflation. Falling inflation is generally good for bond investors. If inflation declines, the real purchasing power of a bond's interest and principal payments will go up. For investors who have to mark-to-market their portfolios, the benefits of lower inflation are especially clear. A decline in inflation will take the pressure off central banks to hike rates. This will cause the price of existing bonds to rise, delivering an immediate capital gain to their holders. Moreover, to the extent that falling inflation expectations typically accompany rising worries about the growth outlook, investors will benefit from a decline in the expected path of real interest rates. QE And The Term Premium While falling inflation expectations have been the most important driver of the decline in the term premium, central bank asset purchases have also lent a helping hand. In standard macroeconomic models, bond yields are determined at the margin by the willingness of private investors to hold the existing stock of debt. If a central bank buys bonds, this reduces the volume of bonds that the private sector can hold. To induce private investors to hold fewer bonds, bond yields must decline. There is no consensus about how much quantitative easing has depressed bond yields. A Fed study published in April of last year estimated that QE had depressed the 10-year yield by 100 basis points at the time of writing, a number that the authors expected to decline to 85 basis points by the end of 2017.2 Other studies found that the peak impact on yields has ranged from 90-to-200 basis points. One thing that is empirically undeniable is that there is a large international component to bond yields. The steep decline in the U.S. term premium in 2014 was mainly driven by the expectation - ultimately proven correct - that the ECB would launch its own QE program. Asset purchases by the Bank of Japan, along with its yield curve control policy, also contributed to lower bond yields in the rest of the world. Things are beginning to change, however (Chart 4). The Fed is now letting its balance sheet shrink by about $40 billion per month, a number that will rise to $50 billion in October. The Bank of England has kept its holdings of gilts and corporate bonds constant for over a year, while the ECB intends to start tapering asset purchases later this year. The Bank of Japan continues to buy assets, but even there, the pace of annual purchases has fallen from about 80 trillion yen in 2015-16 to 35 trillion at present. Meanwhile, the use of forward guidance - which was arguably even more instrumental in suppressing interest rate volatility and pushing down the term premium than QE - is likely to be scaled back, at least in the United States. Fed Chair Powell said on May 25: "I think [forward guidance] will have a significantly smaller role going forward." Incoming New York Fed President John Williams echoed this sentiment, noting in a Bloomberg interview that "I think this forward guidance, at some point, will be past its shelf life."3 Opening The Fiscal Spigots Just as central banks are purchasing fewer bonds in the open market, bond issuance is set to rise. Usually the U.S. budget deficit narrows whenever the unemployment rate declines, as strong economic growth draws in more tax revenue and spending on social programs drops (Chart 5). Things are different this time around. The Congressional Budget Office (CBO) expects the U.S. budget deficit to increase from 2.4% of GDP in 2015 to 4.6% of GDP in 2019. Chart 4From Quantitative Easing To ##br##Quantitative Tightening From Quantitative Easing To Quantitative Tightening From Quantitative Easing To Quantitative Tightening Chart 5Unlike In The Past, The U.S. Budget Deficit Is Set To Widen Even ##br##If The Unemployment Rate Continues To Decline Unlike In The Past, The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline Unlike In The Past, The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The Trump tax cuts have imperiled the long-term fiscal outlook. Up until last year, the U.S. fiscal picture appeared much better than it once did. In 2009, the amount of federal debt held by the public was projected to exceed 250% of GDP in 2046. By 2016, that forecast had been reduced to 113% of GDP, thanks mainly to the economic recovery and slower projected spending growth on health care following the introduction of the Affordable Care Act (Chart 6). The Trump tax cuts have blown those forecasts out of the water. We estimate that government debt held by the public will increase to almost 190% of GDP in 2046 if current policies are maintained. Chart 6Trump Tax Cuts Have Put Debt Trajectory ##br##Back On An Unsustainable Path Term Premium Explosion: A Rising Risk To Markets Term Premium Explosion: A Rising Risk To Markets While the stock of debt, rather than the flow, determines bond yields in the standard bond pricing model, flows can still matter if they provide a reliable signal as to how large the stock of debt will be in the future. Given that changes in fiscal policy are often hard to reverse, the deterioration in the fiscal outlook suggests that the stock of government debt will be much larger than investors had expected a few years ago. This justifies a higher term premium today. Broken Accelerator? Subdued inflation expectations have kept the term premium in check, but the prospect of ill-timed fiscal stimulus raises doubts about whether this state of affairs will persist. What would happen to inflation if the economy found itself in an overheated state for a prolonged period of time? The truth is that no one really knows the answer to that question. Some prominent economists have contended that nothing terrible would transpire. They argue that the entire concept of the Non-Accelerating Inflation Rate of Unemployment (NAIRU) is passé. In their view, the magnitude of economic slack determines the level of inflation, not the rate of change in inflation. Recent data provides some support to their views. Shrinking output gaps in much of the world during the past eight years have failed to raise inflation by very much, let alone cause inflation to accelerate to the upside (Chart 7). If an overheated economy simply results in modestly higher inflation, rather than increasing inflation, central banks have little to fear. A bit more inflation would allow central bankers to target a higher nominal interest rate, thus giving them greater scope to cut rates in the event of an economic downturn. Higher inflation could also improve labor market flexibility by permitting real wages to fall in the presence of nominal wage rigidities.4 In addition, as we have argued in the past, modestly higher inflation could make the financial system less susceptible to asset bubbles.5 Unfortunately, the case for letting the economy overheat is not so straightforward. For one thing, the relationship between inflation and unemployment tends to be non-linear. As Chart 8 illustrates, an economy's aggregate supply curve is likely to be quite shallow when there is a lot of excess capacity but rather steep when most of the slack has been absorbed. We may simply have not yet reached the steep side of the aggregate supply curve. Chart 7Developed Markets: Inflation Has Remained ##br##Low Despite Shrinking Output Gaps Developed Markets: Inflation Has Remained Low Despite Shrinking Output Gaps Developed Markets: Inflation Has Remained Low Despite Shrinking Output Gaps Chart 8Inflationary Pressures Tend To Increase ##br##When Spare Capacity Is Absorbed Term Premium Explosion: A Rising Risk To Markets Term Premium Explosion: A Rising Risk To Markets The experience of the late 1960s illustrates this point. Core inflation was remarkably stable during the first half of the decade, even as the unemployment rate continued to drift lower. In economic parlance, the Phillips curve was very flat. However, once the unemployment rate fell below 4%, core inflation took off, rising from 1.5% in early 1966 to nearly 4% in 1967 (Chart 9). Inflation ultimately made its way to 6% in 1970, three years before the first oil shock struck. Anchors Away The upward trend in inflation observed during the 1970s underscores another point, which is that there is no unique mapping between the unemployment rate and inflation. To use a bit of economic jargon, not only does the slope of the Phillips curve vary depending on what the unemployment rate is, but the intercept of the curve could potentially move up or down in response to changes in long-term inflation expectations (Chart 10). Chart 9Inflation In The 1960s Took Off Once ##br##The Economy Began To Overheat Inflation In The 1960s Took Off Once The Economy Began To Overheat Inflation In The 1960s Took Off Once The Economy Began To Overheat Chart 10An Increase In Inflation Expectations Can ##br##Cause The Phillips Curve To Shift Upwards Term Premium Explosion: A Rising Risk To Markets Term Premium Explosion: A Rising Risk To Markets Chart 11Market Expectations Versus The Fed Dots Market Expectations Versus The Fed Dots Market Expectations Versus The Fed Dots This is a point that Milton Friedman and Edmund Phelps made more than fifty years ago. Friedman and Phelps argued that central banks could only stimulate the economy if they delivered more inflation than people were anticipating. Higher-than-expected inflation would push down real interest rates, leading to more spending. As the two economists correctly noted, however, such an outcome would only occur if people systematically underestimated what inflation would end up being. If people made inflation forecasts in a fairly rational manner, the apparent trade-off between higher inflation and lower unemployment would evaporate: Inflation would rise, but output would not be any greater than before. One of the errors that central banks made in the 1970s is that they kept interest rates too low for too long in the mistaken belief that slower growth was the result of inadequate demand rather than a decline in the growth rate in the economy's productive capacity and a higher equilibrium rate of unemployment. Today, the error may be in thinking that the neutral rate of interest is lower than it really is. As we argued several weeks ago, cyclical factors have probably pushed up the neutral rate quite a bit over the past few years.6 Neither the Fed dots nor market pricing are adequately discounting this possibility (Chart 11). Inflation is a notoriously lagging indicator. It typically does not peak until after a recession has begun and does not bottom until the recovery is well underway (Chart 12). By the time the Fed realizes it is behind the curve, inflation could already be substantially higher. The fact that the New York Fed's Underlying Inflation Gauge - which leads core CPI inflation by about 18 months - has risen to over 3% provides some evidence in support of this view (Chart 13). Chart 12Inflation Is A Lagging Indicator Term Premium Explosion: A Rising Risk To Markets Term Premium Explosion: A Rising Risk To Markets Chart 13Upside Risks To U.S. Inflation Upside Risks To U.S. Inflation Upside Risks To U.S. Inflation Investment Conclusions A sudden increase in the term premium could set in motion a vicious circle where bond yields rise and the stock market falls at the same. In such a setting, bonds would lose much of their appeal as a hedge against equity drawdowns. This could put even more upward pressure on the term premium, leading to even lower stock prices. Chart 14 shows that the MOVE index, a measure of implied volatility for the Treasury market, remains near historically low levels. Just as investors were too complacent about the possibility of an equity volatility spike earlier this year, they are too complacent about the possibility of an increase in bond volatility. Chart 14Investors Are Too Complacent Investors Are Too Complacent Investors Are Too Complacent Getting the timing of any change in the term premium is critical, of course. It often takes a while for an overheated economy to generate inflation. The unemployment rate fell nearly two percentage points below its full employment level in the 1960s before inflation took off. The U.S. economy is only now starting to boil over. Moreover, if the dollar continues to strengthen over the coming months, as we expect, this could put downward pressure on commodity prices. Thus, we do not foresee a major inflation-induced spike in the term premium this year. Next year may be a very different story. If inflation ratchets higher in 2019, the term premium could jump. The resulting tightening in financial conditions could pave the way for a recession in 2020. Fixed-income investors with a 12-to-18 month horizon should maintain duration risk at below-benchmark levels. We downgraded global equities and credit exposure to neutral last month. Within the equity space, investors should favor developed market equities over their EM peers and defensive sectors over deep cyclicals such as industrials and materials. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Note that the term premium and the slope of the yield curve are different concepts. The slope of the yield curve measures the difference in yields between two maturities at any given point in time. In contrast, the term premium measures the difference between the return on a long-term bond and the return an investor would receive by rolling over a short-term bill over the life of that bond. Unlike the slope of the yield curve, which can be observed directly, the term premium has to be estimated using market expectations of the future path of short-term rates. 2 Please see Brian Bonis, Ihrig, Jane, and Wei, Min, "The Effect of the Federal Reserve's Securities Holdings on Longer-term Interest Rates," FEDS Notes, Federal Reserve (April 20, 2017); Edison Yu, "Did Quantitative Easing Work?" Economic Insight, Federal Reserve Bank of Philadelphia Research Department (First quarter 2016); and "Unconventional Monetary Policies -- Recent Experience And Prospects," IMF (April 18, 2013). 3 Jeanna Smialek, "Powell Sees Significantly Smaller Role for Fed Forward Guidance," Bloomberg (May 25, 2018); and Jeanna Smialek, "The Incoming New York Fed Chief Talks About Inflation and the Yield Curve," Bloomberg (May 16 2018). 4 A low-inflation environment can have adverse economic consequences during economic downturns due to the presence of downward rigidity of nominal wages. Firms typically try to reduce costs when demand for their products and services declines, but employers tend to be unwilling or unable to cut nominal wages. In this context, higher inflation provides a potential way to overcome nominal wage rigidity as it helps real wages to adjust to negative shocks. When inflation is low, real wages become less flexible, making it more likely that firms will opt for job cuts as a means to decrease overall costs. 5 Please see Global Investment Strategy Weekly Report, "Tinbergen's Ghost," dated May 11, 2018. 6 Please see Global Investment Strategy Weekly Report, "U.S. Housing Will Drive The Global Business Cycle... Again," dated July 6, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Upside risks on base metals are being ignored. The U.S. labor market continues to tighten and businesses face escalating labor and input costs. There will be costs associated with current fiscal trends, even on a relatively short 5-10 year horizon. Feature Chart 1Core Inflation Creeping Higher Along With Wages Core Inflation Creeping Higher Along With Wages Core Inflation Creeping Higher Along With Wages Last week, U.S. equity prices reached their highest level since early February. The 1% drop in the trade-weighted U.S. dollar contributed to weakness in both oil and gold prices. 10-year Treasury yields were little changed, despite higher U.S. inflation readings. Base metal prices continued to decline, linked to escalating trade tensions between the U.S. and China and concerns over the health of China's economy. Comments from Fed Chair Powell late in the week on the benefits of fiscal policy for the U.S. economy were welcomed by markets. We discuss base metal prices, trade, inflation, the Fed and the implication of the U.S.'s precarious fiscal position in this week's report. We examine BCA's view on base metals in the context of disruptions to global trade and a slowdown in Chinese economic activity in the next section. The June CPI report suggests U.S. inflation is drifting towards the Fed's target. However, with no serious inflation outburst occurring at the moment, there is no need for the Fed to deviate from its path of gradual rate hikes in the near term. U.S. core CPI rose by 0.16% m/m in June, which is not quite consistent with a 2% annual inflation rate. Nonetheless, the underlying trend still shows a steady creep higher in inflation (Chart 1). The year-over-year core CPI rate ticked up to 2.3% from 2.2%. Core CPI inflation of about 2.5% is consistent with the Fed's 2% target for the core PCE deflator. The main source of upward pressure on U.S. inflation will come from core services (ex-shelter and medical care). We find that this subcomponent of core CPI is the most correlated with the tightness in the labor market and wage pressures. However, it accounts for only 25% of core CPI and, while improving, the acceleration in wages is mild (panel 4). Inflation, the labor market and trade were all discussed at the June FOMC meeting. Below, we assess the central bank's mid-June discussion on these topics as markets brace for the Fed's latest Beige Book (July 18) and the late July FOMC meeting. Fiscal policy was also discussed at the June FOMC meeting. The final section of this week's report examines the long term budget outlook and its implication for the economy and financial assets. Base Metals Update BCA's Commodity & Energy Strategy service notes1 that the London Metal Exchange Index (LMEX) will remain under significant downward pressure until fears of an escalating Sino - U.S. trade dispute are allayed. If this dispute evolves into a full-blown trade war, as our geopolitical strategists expect,2 emerging markets (EM) economies embedded in global supply chains could be hard hit. This would have ramifications for commodity prices in general and base metals in particular. Alternatively, if this trade dispute develops into a more open and free global trading system, EM income growth will significantly drive up commodity demand, especially for metals (Chart 2). However, a more open trading system would take time to develop and is beyond a 6-12 month investment horizon. BCA's view is that the dollar will continue to climb as the Fed boosts rates more than the market expects and as U.S. domestic economic growth outpaces global growth (Chart 3). Moreover, the ongoing trade row will put upward pressure on the dollar. We remain long on the dollar.3 Chart 2EM Macro Variables##BR##Drive LMEX EM Macro Variables Drive LMEX EM Macro Variables Drive LMEX Chart 3Divergent Paths For Growth And##BR##Rates To Drive U.S. Dollar Higher Divergent Paths For Growth And Rates To Drive U.S. Dollar Higher Divergent Paths For Growth And Rates To Drive U.S. Dollar Higher Bottom Line: Fears of a global trade war are punishing the EM economies and weighing on the prices of base metals. However, upside risks, for the most part, are being ignored, according to BCA's Commodity & Energy Strategy service. As a result, our commodity team sees some tactical long trading opportunities in copper, but the prospect of a worsening trade war is not kind for base metals. Oil is a different story.4 The Disappearing Act Data from the National Federation of Independent Business (NFIB) in June and the Job Openings and Labor Turnover Survey (JOLTS) in May support our stance that the slack in the U.S. labor market is disappearing and will ultimately lead to higher wage inflation and a peak in profit margins. Job openings and hiring plans at small businesses are at an all-time high (Chart 4, panel 1). Chart 4 also shows that small business owners' compensation plans (panel 2) remained near record levels in April and that concerns about "quality of labor" have never been higher (panel 3). Moreover, 7% of small firms say that the cost of labor is their most critical problem (panel 4). This concern has more than doubled since 2013. Job openings according to the JOLTS data also hit a new zenith in April, but ticked down a bit in May, which created an even wider gap between openings and hires (Chart 5, panel 1). Moreover, quits minus layoffs, another indicator of labor market slack, reached a record high (panel 2). The implication is that businesses of all sizes face a much tighter labor market. Chart 4Labor Market Slack Is Disappearing... Labor Market Slack Is Disappearing... Labor Market Slack Is Disappearing... Chart 5... Putting Pressure On Margins ... Putting Pressure On Margins ... Putting Pressure On Margins Moreover, the robust labor situation is widespread. Charts 6A and 6B show the ratio of job openings to the number of unemployed in 10 sectors of the economy. The ratio is at an all-time high in nine of the sectors. The exception is the information segment, which includes newspapers and magazines, broadcasting and telecommunications. Chart 7 shows that businesses are increasingly worried about the impact of escalating input costs on margins. Firms in the Atlanta Fed region expect a 2% bump in their input costs in the next 12 months; in early 2016, those same firms saw only a 1.3% rise (panel 1). Nearly 80% of managements expect their unit costs to climb by at least 1.1% in the next year. More than 20% of firms expect their input costs to jump at least 3.1% in the same period. Chart 6AStrength In The Labor Market... Strength In The Labor Market... Strength In The Labor Market... Chart 6B... Is Broad-Based ... Is Broad-Based ... Is Broad-Based Chart 7Businesses Worried About Input Costs Businesses Worried About Input Costs Businesses Worried About Input Costs Small businesses are increasingly able to pass on prices to consumers (Chart 5, panels 3 and 4). At 14%, having rolled over slightly, the percentage of small businesses reporting price changes remains near a 10-year high in June (panel 2). Moreover, 24% of small businesses planned price hikes in June, also a 7-year high. In late 2016, only about 4% of these entities expected to boost prices in the next 12 months (panel 3). Moreover, the New York Fed's Underlying Inflation Gauge5 hit a 13-year high in June (not shown). Bottom Line: The U.S. labor market continues to tighten and businesses face escalating labor and input costs. The implication is that margins may soon reach a top. In last week's report,6 we showed that the performance of a broad range of U.S. and global risk assets falters after margins peak late in the business cycle. Moreover, shortages of labor and some raw materials will push up inflation and keep the Fed on track to tighten two more times this year. BCA's view is that by mid-2019, the central bank will find itself behind the curve on inflation and begin to tighten more aggressively. Shortages and capacity constraints in the important trucking industry support our view. Keep On Trucking The trucking industry exemplifies the robust labor market, with strong demand for trucking services and shortages of drivers. Wage inflation remains muted in the trucking industry, despite strong demand for trucking services and shortages of drivers. Nonetheless, anecdotal data suggest that wages are understated in the trucking industry. Freight costs, which are key components in firms' input costs, affect the economy as a whole. Table 1 shows that trucking is one of many industries with labor shortages according to the 2018 Beige Books. However, the JOLTS data show that trucking has labor constraints, but very little wage inflation. The PPI for truck transportation services7 (a good proxy for what trucking firms charge customers) is up 7.7% year-over year (Chart 8). Some of that increase is linked to higher gasoline prices. However, it is difficult to split out the impact of wage costs from the gasoline costs in the PPI. Table 1Labor 'Shortages' Identified##BR##In The Beige Book Constrained Constrained Chart 8Margin Pressure In##BR##The Trucking Industry Margin Pressure In The Trucking Industry Margin Pressure In The Trucking Industry A Cass Freight Index that tracks full-truckload prices, but excludes fuel and fuel surcharges, rose 9% year-over-year in May (not shown).8 The broad Cass Freight Index climbed 17.3% year-over year in May, and suggests further gains are ahead for U.S. capital spending (Chart 9). Moreover, the latest survey by the FTR Transport Intelligence for June surged for orders of heavy trucks, with June being the highest on record at 140% year-over-year (not shown).9 Chart 9Supply Constraints In The Freight Business Will Erode U.S. Profit Margins Supply Constraints In The Freight Business Will Erode U.S. Profit Margins Supply Constraints In The Freight Business Will Erode U.S. Profit Margins The implication is that demand for trucking services remains vigorous and will ultimately push up wages. Higher wages in trucking mean higher shipping costs, and portends a peak in U.S. corporate margins later this year. A Divided FOMC The labor market, wages and inflation were key topics at the June 12-13 Federal Open Market Committee (FOMC) meeting. Trade and fiscal policy were also discussed. Policymakers noted that some firms have responded to a lack of qualified workers by offering training, introducing automation and boosting wages. This is typical late-cycle behavior. Fed economists recently updated their quantitative assessments of the FOMC's meeting minutes.10 The note provides a guide (Table 1 in the Fed paper and Table 2) to the number of quantitative descriptors (one, a couple, a few, etc.). We use this rubric to assess the FOMC's latest views. Table 3 evaluates the Fed's latest thinking on the labor market and wages, while Table 4 assesses the FOMC's discussion of inflation and inflation expectations. Table 2FOMC Minutes Rubric Constrained Constrained Table 3FOMC Assessment Of The Labor Market And Wages At June 2018 Meeting Constrained Constrained FOMC participants generally expected the unemployment rate to either remain below or decline further below their estimates of the longer run normal rate. Only several FOMC members thought that the unemployment rate overstated the labor market's strength. Furthermore, a number of members anticipated wage inflation to pick up (Table 3) given that the unemployment rate is expected to stay below the committee's view of NAIRU. Table 4 shows that FOMC members generally agreed that inflation was on track to meet the Fed's 2% target. However, many participants saw downside risks to inflation linked to political and economic turmoil in Europe and the emerging markets. A number noted that it was premature to conclude that the Fed had achieved its 2% inflation target. Nonetheless, some members worried that a prolonged stretch of economic activity above the economy's long-term potential could "give rise to inflationary pressures or financial imbalances." Only a few noted that inflation expectations were not consistent with the Fed's 2% objective. Only one member argued that the postponing rate hikes would help push up inflation expectations. Table 4FOMC Assessment Of Inflation And Inflation Expectations At June 2018 Meeting Constrained Constrained On trade, most FOMC participants noted that the uncertainty and risks associated with trade policy had intensified and expressed concern over the potential negative effects on business sentiment and investment spending. The committee continued to see fiscal policy as a plus for economic growth in the next few years. Nonetheless, a few participants worried that fiscal policy is not on a sustainable path (See next section, "An Unprecedented Macro Experiment"). Financial stability was not on the agenda at the latest FOMC meeting, although Fed Chair Powell discussed the topic at his mid-June news conference.11 Moreover, in a radio interview12 last week, Powell also mentioned financial stability. Our view is that the Fed will continue to focus on vulnerabilities in the U.S. and overseas financial markets in upcoming meetings.13 Bottom Line: So far, Fed policymakers have maintained their gradual approach to tightening policy (i.e. 25 basis points per quarter) as they try to balance the risk of a major inflation overshoot against the hazards of prematurely ending the economic expansion. Several policymakers reiterated that long-term inflation expectations are still not high enough to be consistent with meeting the 2% inflation target over the medium term. That is why we expect the Fed to become more aggressive in targeting an economic slowdown when the 10-year TIPS breakeven rate moves back into its 2.3-2.5% range.14 Stay tuned. An Unprecedented Macro Experiment15 Congress is conducting an extra-ordinary economic experiment: substantial fiscal stimulus when the economy is already at full employment. Investors are celebrating the growth-positive aspects of the new fiscal tailwind. However, the celebration could be followed by a hangover as the Fed is forced to lean hard against the resulting inflationary pressures. Moreover, even in the absence of a recession, the federal government will likely spill far more red ink than during any other economic expansion since the 1940s (Chart 10). Moreover, the debt ratio, which swelled to 106% in 1946 after WWII, could rocket past that level before 2030, even in the absence of a recession (Chart 11). What are the long-term implications of this macro experiment? Will the U.S. continue to easily fund large and sustained budget deficits? Chart 10U.S. Deficits Will Be Extremely Large For A Non-Recessionary Period U.S. Deficits Will Be Extremely Large For A Non-Recessionary Period U.S. Deficits Will Be Extremely Large For A Non-Recessionary Period Chart 11U.S. Debt In Historical Context U.S. Debt In Historical Context U.S. Debt In Historical Context Historically, shockingly large budget deficits sparked some attempt by Congress to limit the damage. Unfortunately, there will be little appetite to tighten the fiscal purse strings for the next decade. Politicians are following the voters shift to the left. While the U.S. is not at imminent risk of a market riot over the deteriorating fiscal trends, the dollar will be weaker, borrowing rates will be higher and living standards will be lower than otherwise would be the case. "Starve the Beast" refers to the idea that the size of government can be restrained through a low-tax regime that spurs growth and pressures Congress to cut spending and control the budget deficit. It has been the mantra of Republicans since the Reagan era. The 1981 Reagan tax cuts included an across-the-board reduction in marginal tax rates, taking the top rate down from 70% to 50%. Corporate taxes were slashed by $150 billion over a 5-year period and tax rates were indexed for inflation, among other changes. It was not surprising that the budget deficit subsequently ballooned. Outrage grew among fiscal conservatives, but Congress spent the next few years passing laws to reverse the loss of revenues, rather than aggressively attacking the spending side. Today, Congressional fiscal hawks are in retreat and the Republican Party under President Donald Trump is not as fiscally conservative as in the past. This trend reflects the pull toward the center of the economic policy spectrum in response to a shift to the left among voters. BCA's political strategists have highlighted that this is the "median voter theory" (MVT) in action.16 The MVT posits that parties and politicians will approximate the policy choices of the median voter in order to win an election or stay in power. Every U.S. presidential election involves candidates making a mad dash to the most popularly appealing positions. President Trump exhibited this process when he ran in the Republican primary on a platform of increased infrastructure spending and zero cuts to "entitlement" spending. The Great Financial Crisis, disappointingly slow growth, stagnating middle-class incomes and the widening income distribution have resulted in a leftward shift among voters on economic issues. Adding to the shift is the rising political clout of the Millennial generation, which generally favors more government involvement in the economy and will become the major voting block in the 2020s. President Trump's shift to the left on economic policy helped him to out-flank Clinton in the election, particularly in the Rust Belt, where his protectionist and anti-austerity message resonated. Even his anti-immigration appeal is mostly based on economic reasoning (i.e. jobs rather than cultural factors). Trump has admitted that he is not all that concerned about taking the country deeper into hock. The Republican rank-and-file has generally gone along with Trump's agenda because he has delivered traditional Republican tax cuts and continues to have high approval ratings among his supporters. Fiscal hawks within the GOP have been forced to the sidelines while Trump and moderate Republicans have passed bipartisan spending increases with Democratic assistance. Unlike the Reagan years, we do not expect that there will be a strong political force capable of leading a fight against budget deficits. The long-term U.S. fiscal outlook was dire even before the Great Recession and the associated shift to the political left in America. Fiscal conservatism is out of fashion and this is unlikely to change before the mid-2020s, no matter which party is in power. This means that a market riot will be required to shake up voters and the political establishment into making tough decisions. Given demographic trends, it appears more likely that taxes will be on the rise than entitlements will be cut. We do not foresee a crisis in the next few years. Nonetheless, arguing that the U.S. fiscal situation is sustainable for the foreseeable future does not mean that it is desirable. There will be costs associated with current fiscal trends, even on a relatively short 5-10 year horizon. Interest costs will mushroom, potentially crowding out government spending in other areas (Chart 12). U.S. government debt has already been downgraded by the S&P to AA+ in 2013, and the other two main rating agencies will probably follow suit during the next recession as the deficit balloons to 8% or more. Investors may begin to demand a risk premium to entice them to continually raise their exposure to U.S. government bonds. Chart 12An Unsustainable Debt Accumulation An Unsustainable Debt Accumulation An Unsustainable Debt Accumulation Chart 13Structural Drivers Of The U.S. Dollar Structural Drivers Of The U.S. Dollar Structural Drivers Of The U.S. Dollar Taxes will eventually rise to service the government debt and some capital spending will be crowded out, both of which will undermine the economy's growth potential (Chart 13). Finally, the dollar will also be weaker than it otherwise would be in the long-term, representing an erosion in America's standard of living because imports will be more expensive. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Escalating Trade Disputes Pressuring Base Metals", published July 12, 2018. Available at gps.bcaresearch.com. 2 Please see BCA Research's Geopolitical Strategy Special Report, "The U.S. And China: Sizing Up The Crisis", published July 11, 2018. Available at gps.bcaresearch.com. 3 Please see BCA Research's Global Investment Strategy Weekly Report, "U.S. Housing Will Drive The Global Business Cycle... Again", published July 6, 2018. Available at gis.bcaresearch.com. 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Brinkmanship Fuels Chaos In Oil Markets, And Raises The Odds Of Conflict In The Gulf", published July 5, 2018. Available at ces.bcaresearch.com. 5 https://www.newyorkfed.org/research/policy/underlying-inflation-gauge 6 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Revisiting The Late Cycle View", published July 9, 2018. Available at usis.bcaresearch.com. 7 See Table 10 https://www.bls.gov/ppi/ppidr201806.pdf 8 https://www.cassinfo.com/transportation-expense-management/supply-chain-analysis/cass-freight-index.aspx 9 https://ftrintel.com/news/ftr-reports-north-american-class-8-orders-for-june-at-historic-highs 10 https://www.federalreserve.gov/econres/notes/feds-notes/the-fomc-meeting-minutes-an-update-of-counting-words-20170803.htm 11 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20180613.pdf 12 https://www.marketplace.org/2018/07/12/economy/powell-transcript 13 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate," July 24, 2017. Available at usis.bcaresearch.com. 14 Please see BCA Research's U.S. Bond Strategy Portfolio Allocation Summary "The Deflationary Mindset", published July 10, 2018. Available at usbs.bcaresearch.com. 15 Please see BCA Research's The Bank Credit Analyst Monthly Publication, "July 2018", published June 28, 2018. Available at bca.bcaresearch.com. 16 Please see BCA Research's Geopolitical Strategy Monthly Report, "Introducing The Median Voter Theory," June 8, 2016. Available at gps.bcaresearch.com.